tag:blogger.com,1999:blog-8133337349608142588.post2163736255163780502..comments2020-04-01T23:47:57.325-07:00Comments on Fresh Economic Thinking: Time for a new theory of the firmCameron Murrayhttp://www.blogger.com/profile/08737859133901303110noreply@blogger.comBlogger38125tag:blogger.com,1999:blog-8133337349608142588.post-20106093702980713732014-02-22T18:03:36.012-08:002014-02-22T18:03:36.012-08:00Good comment. Yep. All of what you said is true.
...Good comment. Yep. All of what you said is true.<br /><br />I certainly have considered the effect of gearing. Your point about a fixed gearing ratio does rescue our model. <br /><br />Although it is probably not clear in the linked working paper, in our model a firm chooses capital inputs and the output level simultaneously. We might consider they choose the maximum risk-adjusted leverage as well. Thus to expand output, and in the process increase input costs, requires additional input of equity at the previous leverage ratio. <br /><br />I discussed our rough approach (that we have since refined and incorporated in the paper) here<br />http://ckmurray.blogspot.com.au/2014/02/the-firm-existence-puzzle-and-how-we.html <br /><br />The whole idea of a capital constraint becomes obviously crucial to our model. Which is strange, because economics is apparently the study of scarcity, yet in partial equilibrium analysis we often forget that. We typically invoke arbitrary time periods to handle scarcity (short run models etc). <br /><br />If you haven't read my other follow up post, you might find it interesting<br />http://ckmurray.blogspot.com.au/2014/01/why-is-return-seeking-optimal.htmlCameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-43732766594291086582014-02-22T06:00:16.842-08:002014-02-22T06:00:16.842-08:00I need to have another look at the paper but to ge...I need to have another look at the paper but to get these results you seem to need a strong limit on gearing- either via credit constraints or risk aversion. Otherwise, maximizing return on equity would entail near standard behavior- so long as marginal returns are above the cost of credit, borrowing to fund capacity expansion will increase return on equity. Now if there is a fixed gearing ratio then your result holds but conversely if credit is available subject to average or marginal returns being above some (perhaps increasing in gearing) threshold then high return projects which decrease average return on capital may increase return on equity if marginal returns are above the threshold value and the capacity expansion is then largely funded via credit. Modelling credit constraints using some realistic formula may provide ambiguity in firm behavior such that standard, and non-standard results as developed in your paper are possible.<br />Kieran Lattyhttps://sydney.academia.edu/KieranLattynoreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-90594099991721311792014-01-26T17:19:35.645-08:002014-01-26T17:19:35.645-08:00The reason why bang for your buck matters more tha...The reason why bang for your buck matters more than bang alone is the uncertainty, I think. The bang on an investment only actually becomes known for definite at some point in the future. Buck is committed prior to fruition. This is why, contra to the example given in comments above, firms often (but not always to the fullest degree) opt for cost minimization and rent seeking.Anonymoushttps://www.blogger.com/profile/17797928102421103389noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-65856866904560249962014-01-24T08:49:39.759-08:002014-01-24T08:49:39.759-08:00"Because there is an ability to delay investm..."Because there is an ability to delay investment, deferring capital improvement maintains the option value to develop at a later date to a much higher density. It may currently seem optimal to develop a 3 storey apartment building, but if I delay investing, I might be able to develop a 10 storey building in five years time and increase my return on the land."<br /><br />Can you point to cases where the pattern of land development requires this model of behaviour to explain it? Do landowners ever have the option to redevelop existing land, so being able to go from 3 storey to 10 storey buildings?Tim Lundhttps://www.blogger.com/profile/13500342515409938108noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-50962522358631593122014-01-21T09:02:58.182-08:002014-01-21T09:02:58.182-08:00IRR is not valid criterion when choosing among exc...IRR is not valid criterion when choosing among exclusive projects (every textbook, and even even Wikipedia says so). And when the firm chooses output, it is essentially choosing from mutually exclusive "projects".<br />Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-67897329197542186172014-01-20T22:52:45.112-08:002014-01-20T22:52:45.112-08:00Ahhh, but what kind of firm? There are different ...Ahhh, but what kind of firm? There are different kinds of firms. Two examples are manufacturers and banks. Both are firms.<br />Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-67008185817359381792014-01-20T22:51:00.626-08:002014-01-20T22:51:00.626-08:00Maybe the accountants already have a theory of the...Maybe the accountants already have a theory of the firm. If that is so than economists ignorant of accounting could only come up with some thing bastardized version.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-15174091468228974192014-01-20T21:12:23.014-08:002014-01-20T21:12:23.014-08:00If we restrict our problem to commodity markets an...If we restrict our problem to commodity markets and firms dealing with commodities (metals for example), we would see a far more complex picture emerging. MR=MC is actually meaningless here, as one would notice that commodity prices in this part of the cycle has a drooping nature over a five year horizon and still investments are happening all over the world, which is essentially shifting the supply curve further to the right while the demand curve isn't making any change. The firms are stuck in the middle as taking out capacity which is less efficient or less productive takes time and sometimes not possible (like a whole town's livelihood would change if a large plant is shutdown). So the overhang of capacity stays while new investments are being made unabated largely due to the current financial conditions. The impact of all this on prices is bad, but the firms are stuck in the middle.Anonymoushttps://www.blogger.com/profile/14075186641564390804noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-40443376035122143332014-01-20T21:07:01.852-08:002014-01-20T21:07:01.852-08:00"Assuming a firm has a fixed amount to invest..."Assuming a firm has a fixed amount to invest at any one time surely maximising the total size of the return (profit) and the rate of return (return) are the same thing."<br /><br />This is certainly true, but the existence of a cost curve implies that firms do not have a fixed amount to invest, and that they can change their investment along the cost curve. Thus, in this sense the objectives of profits vs returns, as we show, lead to different output choices.Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-48072307113512544272014-01-20T19:53:47.009-08:002014-01-20T19:53:47.009-08:00"The point of doing so is to make it clear th..."The point of doing so is to make it clear the the firm makes forward-looking decisions at all time."<br /><br />But it doesn't, because there's nothing that links individual time periods together. If you added let's say capital accumulation with some adjustment costs, then you would have truly forward-looking behavior - but even then, the objective function (discounted average of static within-period rates of return?) makes little sense.<br /><br />"Thus, if they can vary their choice of the size of their investment - meaning cost curves exist - then they will do so at the point that maximises the rate of return."<br /><br />Again, I don't see why that should be the case. Even when firm can adjust continuously its inputs, it's possible that return-maximizing choice will result in small-scale operation with large relative return but low absolute profit, as in my example (in fact it's pretty much a mathematical necessity that it will operate at smaller scale than profit-maximizing firm). Moreover, if financial markets evaluate firm's value as discounted sum of future profits, any other strategy than period-by-period profit-maximization in your model will decrease, not increase the firm's value.<br /><br />"Again, the existence of these curve really relies on relaxing the assumptions free entry and no ability to delay."<br /><br />Cost curves are derived from the firm's dual problem (minimize cost of input factors given required level of output and technological constraints), and as such doesn't require any assumptions about free entry, delay, etc. Since your model is static and doesn't deal explicitly with any of those either, I must confess I don't understand what you're getting at here.<br /><br />"All the evidence points to firm behaviour being consistent with conditions of real options, rather than on the standard model."<br /><br />But real options ARE part of the standard model, once dynamics and irreversibility are properly added to the model. In real options literature, the objective function is typically to maximize discounted sum of profits. I'm not sure what you mean by "under conditions of real options that value maximisation occurs when firms maximise their total rate of return." In these models, value maximization occurs when discounted sum of profits is maximized, by definition. It's true that one way of presenting the intuition behind real options is to say that given the option to wait, the required return for the project to be undertaken is higher than the one given by vanilla NPV criterion. That's not the same as maximizing "total return".<br /><br />"Actually, the free entry and exit assumption in monopolistic competition rules out conditions of irreversibility, ability to delay etc (which is why it maintains the MR-MC condition of profit maximisation)."<br /><br />Monopolistic competition doesn't require free entry (e.g. in many DSGE models, you have fixed number of monopolistically-competitive firms making positive profits), and definitely doesn't imply MR=MC. In fact, it leads to mark-up pricing, with mark-up determined by the demand elasticity of substitution between individual goods (the more likely are consumers to substitute between goods, the lower is markup).ivansmlhttps://www.blogger.com/profile/00955626621561436702noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-2150298688737701642014-01-20T19:09:12.723-08:002014-01-20T19:09:12.723-08:00To be more clear, we do not claim that a firm-spec...To be more clear, we do not claim that a firm-specific demand curve is new, but that is useful for our model because it allows us to vary a single parameter to represent the degree of competition. <br /><br />How firms respond to this, under the less restrictive assumptions about entry etc, is what is new.Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-56895434674485957732014-01-20T18:53:37.247-08:002014-01-20T18:53:37.247-08:00"what's the point of time integral in equ..."what's the point of time integral in equation 1, when everything afterwards is static?"<br /><br />The point of doing so is to make it clear the the firm makes forward-looking decisions at all time. The whole nature of the rate of return is that it is a measure per period of time. We simplify to Eq (6) because decisions are made at all points in time. Maybe we could treat p(q) as an expectation, but I don't think that changes much. <br /><br />"Why should this be the firm's objective? Do you really claim that in a static setting, facing exclusive choice between two projects, one with cost 1$ and payoff 2$, the other with cost 1 million $ and payoff 1.5 million $, a firm should/would choose the first? I see absolutely no reason for that to be true."<br /><br />Yeah they will choose the first. When they have made their return due to the increased value of their business, they will look at more investments. Or do you believe these types of massively high return (but small) investments are merely left hanging?<br /><br />"Returns vs. profits - we usually speak of returns in dynamic setting, with payoffs coming later than investments. In such case, standard theory says that firms should maximize their value (i.e. discounted sum of future profits), not just immediate profit."<br /><br />Yeah sure. If you have a fixed amount to invest then maximising profits and the rate of return is the same. However, the existence of a cost curve for a firm implies they can vary the amount they choose to invest in any production activity. Thus, if they can vary their choice of the size of their investment - meaning cost curves exist - then they will do so at the point that maximises the rate of return. <br /><br />Again, the existence of these curve really relies on relaxing the assumptions free entry and no ability to delay. None of these assumptions make any sense in almost every real life setting. That's the standard theory. By not imposing these assumptions you get return-seeking as a value-maximising proposition. <br /><br />"Real options are presented as disproving standard theory, but in fact are perfectly consistent with it, once one explicitly adds irreversibilities to the standard model (with value maximization, Bellman equations and everything)."<br /><br />Nor did we say that standard theory is disproved - only that it is not generally applicable, and relies on the special case when maximising profits does maximise the rate of return. All the evidence points to firm behaviour being consistent with conditions of real options, rather than on the standard model. Thus we question the usefulness of the standard model, and note that no alternative has been explored in detail. <br /><br />We make the point that under conditions of real options that value maximisation occurs when firms maximise their total rate of return. So why hadn't this entered a model of firm production choices yet?<br /><br />"* You say that in your model "All firms operate in their own markets, whose demand schedule is influenced by the offerings in substitute markets." - yet that's exactly what formal models of monopolistic competition such as Dixit-Stiglitz (1977) are about. Nothing new here."<br /><br />Actually, the free entry and exit assumption in monopolistic competition rules out conditions of irreversibility, ability to delay etc (which is why it maintains the MR-MC condition of profit maximisation). This assumption about market conditions is, in my view, a rather gargantuan conceptual leap. <br /><br />If we rule out the standard rather restrictive assumptions about market conditions then we fall back on to return-maximising as the value maximising objective of a firm, as per real options. Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-61925243409847646552014-01-20T18:12:03.877-08:002014-01-20T18:12:03.877-08:00So, if I understand this correctly, the whole poin...So, if I understand this correctly, the whole point is that firms maximize p(q)*q/c(q) instead of usual p(q)*q - c(q). This is followed by lots of needlessly complicated calculus (e.g. what's the point of time integral in equation 1, when everything afterwards is static?).<br /><br />Why should this be the firm's objective? Do you really claim that in a static setting, facing exclusive choice between two projects, one with cost 1$ and payoff 2$, the other with cost 1 million $ and payoff 1.5 million $, a firm should/would choose the first? I see absolutely no reason for that to be true.<br /><br />As for other criticisms of mainstream theory, sorry but they're mostly false. Few examples:<br /><br />* Returns vs. profits - we usually speak of returns in dynamic setting, with payoffs coming later than investments. In such case, standard theory says that firms should maximize their value (i.e. discounted sum of future profits), not just immediate profit.<br /><br />* Real options are presented as disproving standard theory, but in fact are perfectly consistent with it, once one explicitly adds irreversibilities to the standard model (with value maximization, Bellman equations and everything).<br /><br />* You say that in your model "All firms operate in their own markets, whose demand schedule is influenced by the offerings in substitute markets." - yet that's exactly what formal models of monopolistic competition such as Dixit-Stiglitz (1977) are about. Nothing new here.ivansmlhttps://www.blogger.com/profile/00955626621561436702noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-29768610584246807722014-01-20T17:19:51.054-08:002014-01-20T17:19:51.054-08:00Anon,
Sure you can do that. And I did in early d...Anon, <br />Sure you can do that. And I did in early drafts when I was fleshing out the idea. But we didn't, and chose to stick to the complete formulation. <br /><br />Nick,<br />Equations 6-12 in the paper work through the optimal conditions. <br /><br />Also, yeah, you screwed up the maths. <br /><br />"Which implies it sets output where (MR-MC)TC = MC(TR-TC) ?"<br /><br />Correct<br /><br />"Or, MR = MC + MC(TR-TC)/TC"<br /><br />No. You can cancel the MC.TC term on each side, then you get MR.TC=MC.TR<br /><br />Or, MR = MC.TR / TC<br /><br />Which is our equation 12 (cancelling the q)<br /><br />MR = MC.P / ATC<br />Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-37164162915446385572014-01-20T17:19:33.266-08:002014-01-20T17:19:33.266-08:00This comment has been removed by a blog administrator.Wingatehttps://www.blogger.com/profile/16358512562693562856noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-43103428840675411422014-01-20T16:53:48.860-08:002014-01-20T16:53:48.860-08:00"Although, I should say that it is typical (n..."Although, I should say that it is typical (not universal) to assume that the firm's objective is profits, no one views this as foundational to the theory, but just a simplifying assumption"<br /><br />Not sure what you are getting at here. Remember, models are merely an assembly of assumptions - the assumptions are the model so to speak. Therefore if there is a fairly radical change in behaviour from a change to the assumption of firm objective, then clearly it is a foundation of the theory, for it determines all the predictions. <br /><br />"What you are doing, on the other hand, is a new theory of competitive markets based on a new (more accurate?) understanding of firm incentives."<br /><br />Thanks, I hope so. The aggregation question here is interesting. We obviously plan to do more work on this. But as far as the existence of a firm, and firm boundaries, the contribution here is that there must exist some economies of scale for a firm (a production unit of any type) to exist at all. That seems pretty important. <br /><br />Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-63668530154001722332014-01-20T15:26:38.275-08:002014-01-20T15:26:38.275-08:00Your use of the terminology "Theory of the Fi...Your use of the terminology "Theory of the Firm" is misleading. Most microeconomists use that term to mean "theory of the boundaries of the firm", which investigates why firms should exist at all and focuses on limitations of contracting or complimentarities between factors. Although, I should say that it is typical (not universal) to assume that the firm's objective is profits, no one views this as foundational to the theory, but just a simplifying assumption.<br /><br />What you are doing, on the other hand, is a new theory of competitive markets based on a new (more accurate?) understanding of firm incentives. That's something different. I will say that I need to think whether I like your formulation or not: it sounds a lot like some theories of imperfect competition, such as monopolistic competition which I am in fact a fan of.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-37738442151668300272014-01-20T15:07:32.511-08:002014-01-20T15:07:32.511-08:00It looks like an economist has actually read a 10K...It looks like an economist has actually read a 10K filing or corporate press release. I took a couple of terms as an undergraduate and found a huge disconnect between how individuals, investors and corporations made their decisions and what they were teaching me in class. I was familiar with accounting, so it was a shock to find so many conflicts between basic accounting concepts and how people used them in decision making and economic theory. It's great to see a few economists examining their assumptions and trying to incorporate real world knowledge. Even the quantum theorists realized that they had to predict classical physics at the statistical extreme.Kaleberghttps://www.blogger.com/profile/05283840743310507878noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-34508434787597633422014-01-20T15:02:38.601-08:002014-01-20T15:02:38.601-08:00Price is important, but availability, brand prefer...Price is important, but availability, brand preference and a host of other factors come into play otherwise supermarkets wouldn't even carry non-generic products.Kaleberghttps://www.blogger.com/profile/05283840743310507878noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-74168046251461290542014-01-20T14:37:44.943-08:002014-01-20T14:37:44.943-08:00I'm going to just assume you haven't read ...I'm going to just assume you haven't read the post or the linked working paper. The new theory is that firms maximise their rate of return on costs, not their revenue. I also explained that the basis for such as theory is the work on real options, which you are also welcome to read up on, that demonstrates that this is a firm value maximising condition under very realistic conditions of irreversible investment, uncertainty, and an ability to delay. Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-79867245276023835312014-01-20T14:34:59.082-08:002014-01-20T14:34:59.082-08:00Yeah, that's basically right. A lot of stuff i...Yeah, that's basically right. A lot of stuff is very similar. But I can't think of one example where they are identical. <br /><br />I a world of similar goods we have a continuum of products, where any market definition will arbitrarily draws a boundary. Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-67437075530801274032014-01-20T14:33:15.919-08:002014-01-20T14:33:15.919-08:00Why not just simplify and say it maximizes TR/TC?
...Why not just simplify and say it maximizes TR/TC?<br /><br />(TR-TC)/TC = TR/TC - 1 after all...Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-33435386245078051992014-01-20T14:32:56.621-08:002014-01-20T14:32:56.621-08:00I understand you fruit tree example Nick. However...I understand you fruit tree example Nick. However they way you describe it is a very rare case indeed, and not the conditions where return-maximisation is at play. <br /><br />In your example there is no ability to delay. The tree is already there, the fruit is there. If it doesn't get picked today I can't pick it tomorrow (or maybe I can, and then my interpretation holds and you leave some fruit on the tree for a later date). <br /><br />But this is not usually the case. Usually I will have to decide when and what type of trees to plant in the first place. I make this decision by considering how best to maximise my rate of return on costs. <br /><br />Further, you seem to imply that the revenue from selling fruit occurs instantly. But what if that is not the case. What if I have to incur the costs today, but don't sell for a year (I'm making jam). And in the mean time I will have the opportunity to pick fruit many times? <br /><br />Lastly, the model does explicitly show that there needs to be some returns to scale of firm production to take place. If the real world is like my model suggest, then a situation such as your example would be extremely rare, to the point where no farmer would invest in creating such conditions. Cameron Murrayhttps://www.blogger.com/profile/08737859133901303110noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-28370370880570643062014-01-20T13:14:18.897-08:002014-01-20T13:14:18.897-08:00Assuming a firm has a fixed amount to invest at an...Assuming a firm has a fixed amount to invest at any one time surely maximising the total size of the return (profit) and the rate of return (return) are the same thing. It is true that when new expenditure is considered in a firm there is a close scrutiny of the return on investment but surely this is because each new potential expenditure is usually for a different amount (a different fraction of the total available) so rate of return is a better relative metric than absolute level of return.<br /><br />The distinctions I suppose is risk. A company might choose to invest less than all its available cash because the potential rate of return available does not warrant the necessary risk where as a lesser project might have a better risk/reward ratio.Anonymoushttps://www.blogger.com/profile/07906919886136550720noreply@blogger.comtag:blogger.com,1999:blog-8133337349608142588.post-44834434575056742752014-01-20T10:13:24.208-08:002014-01-20T10:13:24.208-08:00Why would anyone try to maximize anything besides ...Why would anyone try to maximize anything besides profits or expected profits with some sort of risk aversion? <br /><br />I'm not saying there isn't a reason, but the theory for profit maximization explanation is simple. They maximize profits to maximize payoffs. <br /><br />Why would firm owner's want to maximize revenue? Unless we are in a world with a principal-agent problem, where the firm owner incentives the manager to maximize revenue, thus still maximizing the owners' profits. But that is not the direction you appear to be going.Anonymousnoreply@blogger.com