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American Economic Association

Theory of the Firm: Past, Present, and Future; An Interpretation


Author(s): Richard M. Cyert and Charles L. Hedrick
Source: Journal of Economic Literature, Vol. 10, No. 2 (Jun., 1972), pp. 398-412
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/2721463 .
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Theoryof the Firm:
Past, Present,and Future;
An Interpretation
By RICHARD M. CYERT
Carnegie-Mellon
University

and CHARLES L. HEDRICK


Carnegie-Mellon
University

Charles Hedrick was supportedduringthisresearchby a National Sci-


ence Foundation Graduate Fellowship. The authorswish to thankD.
Cass, R. Lucas, M. Shubik,and R. Weil fortheirconstructive
criticisms.

FliUTZ MACHLUP,in his 1966presidential place against a backgroundof understand-


addressto the AmericanEconomic Asso- ing what economists are actually doing
ciation [18, 1967], attemptedto look at the when they do research on developing de-
theoryof the firmin perspective.As a for- scriptivetheories of the firm.This paper
mer combatantin the battle to defend vir- will attemptto fill in some of that back-
tue, his account was really an attemptto ground. First,it will be desirable to make
show how much territorywas left in the some commentsabout the theoreticalcon-
hands of themarginalists. textof currentwriting.
Hence, even if the "partialequilibriumanalyst" In one sense the controversyover thethe-
knows full well that the actual situationis not ory of the firmhas arisen over a non-exis-
really a competitiveone, he probablywill still tent entity.The crux of microeconomicsis
make a firsttryusingthe competitive model with the competitivesystem.Withinthe compet-
good old-fashioned profitmaximization.
And if the
resultsappear too odd, appropriatequalifications itivemodel thereis a hypotheticalconstruct
maystillbe able to takecare of themmoresimply called the firm.This constructconsistsof a
than if he had startedwith a cumbersomeman- single decision criterionand an ability to
agerialmodel. (In sayingthis,I am showingmy get informationfrom an external world,
bias.) [18, p. 30]
called the "market"[8, Cyert and March,
More recentlywe have seen a surveyof mi- 1963, pp. 4-16]. The informationreceived
croeconomicsthrough curmudgeonlyeyes fromthe marketenables the firmto apply
[25, Shubik, 1970]. This surveywas essen- its decision criterion,and the competitive
tially a look at various broad approaches systemthen proceeds to allocate resources
that have been taken to microeconomic and produce output. The marketinforma-
problemsand concluded with a "plague on tion determines the behavior of the so-
all yourhouses"pronouncement. called firm.None of the problems of real
We have our own view of which ap- firms can find a home within this special
proaches have been successful and what construct. There are no organizational
needs to be done now. This view will be- problemsnor is thereany roomforanalysis
come apparent soon enough. But we think of the internaldecision-makingprocess. In
it is importantthat such discussions take fact,all of the empiricalcontentin thisneo-
398

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Cyert and Hedrick: Theory of the Firm 399

classical model lies in the descriptionof the neoclassical theoryis being extendedin an
environmentwithin which the firmmust a priorimannerand the extentto which it
operate.Even the sole objectiveof the firm, is being replaced by one of the revisionist
profitmaximization,is determinedby the approaches.
environment because any otherbehaviorof Our approach has been to surveythe lit-
the firmwill lead to its extinction.The the- eratureof the last two yearsand to catego-
ory of the firmis a prioriin the sense that rize the articles.We have examined every
its behavior can be deduced fromassump- articlerelated to the theoryof the firmap-
tionsthatdescribethe environment. pearingin the AmericanEconomic Review,
More empiricalcontentcan be given to the Journalof Political Economy and the
the theoryof the firmin two ways. First, QuarterlyJournalof Economics for 1970
the assumptions describing the environ- and 1971 (I-III). We have not prejudiced
mentcan be made morerealisticwith a re- our resultsby selectingonly those articles
sultingincreased complexityof firmbehav- of special interestto us or viewed as impor-
ior,e.g.,inventorycontrol.If no moredetail tant by some other criterion.We have at-
is added concerningthe behavior of the tempted to classify those articles that
firmother than by changing the assump- showed a definitemodel of the firm' ac-
tionsdescribingthe environment, thetheory cordingto the degree to which that model
remainsa priorias the termis used above. agrees with or departs from neoclassical
The second way to add empiricalcontentis theory.The bulk of thispaper is concerned
to specifysome aspects of the firm'sbehav- with explainingthe resultingclassifications
ior directly.These models cease to be a and examiningin some detail illustrative
priorisince the firm'sbehavioris no longer examplesof each.
deduced from the assumptionsdescribing This surveyis biased in two major ways.
the environment. First,it fails to show the large amount of
The two major revisionist approaches effortthat has gone into articlesthat make
thathave been attemptedso far,the behav- useful commentsabout the theoryof the
ioral and the managerial,fall into the sec- firmbut do not use explicitmodels thatwe
ond category. The behavioral approach could classify.2Second, thereis bias in our
concentrateson makingempiricalanalyses use of onlythreejournals,even thoughwe
of decisionprocessesof individualfirmsand
incorporatingthe resultsinto models of the 'The 42 articlesfoundto be relevantto thisstudy
firm.The managerialapproach incorporates are listedas AppendixI. We are awarethatclassifi-
cationis oftensomewhatarbitrary and apologizein
withinthe objective functionthe resultsof advanceto thoseauthorswho maybe perplexedby
empirical observationsof individual firm the inclusionor exclusionof theirarticlesfromour
behavior.The firmis assumed to maximize list.
2 The Proceedings issue of the American Eco-
the functionas in the standard approach. nomic Reviet is particularly richin thesearticles.
Both approaches utilize behavioral knowl- We would like to call particularattentionto the
edge, but the models differin form.The be- comments ofE. T. Grether and othersin theIndus-
trialOrganizationsectionof the 1970 Proceedings
havioral model contains explicit decision [15, Grether,1970; 26, Singer,1970 and 14, Gra-
rules (generally excluding maximization). bowskiand Mueller,1970]. Their commentsalso
By proper manipulation of the objective indicatetheneedformoredetailin modelsoffirms.
When consideringthe virtuesof the competitive
functionone can derive from managerial model,articleslike thoseof 0. E. Williamson[31,
models some of the broad conclusions of 1971] and J. L. Bower [5, 19,70]are also interest-
thebehavioralmodels. ing.Theyare representative of a growingsuspicion
thata large,horizontallyintegratedcorporation may
The purposeof thispaper is to determine actuallybe moreefficient thana competitive market
fromcurrentwritingsthe extentto which in allocatingresources(particularlycapital).

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400 Journalof EconomicLiterature
picked three journals that are widely read placed on the theoreticalfirms.But a nega-
by Americaneconomists.Many of the mod- tive resultis inconclusivein the lightof the
els that are most directlyresponsiveto the "as if" justification.Second, the main pur-
behavioralchallenge,particularlycomputer pose of neoclassical theoryis to predictthe
simulations,are being published in other behaviorof major economic variables. The
places.3 size of the discrepancybetween the ob-
served resultand the theoreticalmaximum
I. Unmodified
NeoclassicalApproach is an ambiguousmeasure forvalidatingthe
The unmodifiedneoclassical approach is theorysince thereis no way of relatingthe
characterizedby an ideal marketwithfirms size of the profitdiscrepancyto the devia-
for which profitmaximizationis the single tion of price and output from their pre-
determinantof behavior. Thus predictions dicted values. For example, Dittrich and
can readilybe made by combiningthe de- Myersare unconcernedby a 6 percentgap
scriptionof the marketwith the resultsof in income between actual and what would
maximizationof the relevantLagrangian. result from optimum allocation of re-
Constraintssuch as limitedinformation pro- sources. Other writersmightconclude that
cessing ability of the participantsare ex- a 3 percentgap is evidenceof grossmisallo-
cluded frommodels takingthe neoclassical cation [29, Thornton,1971].
approach. It is basically a deductiverather Anotherarticlefittingthisclassification is
than inductive approach to describingthe one by P. L. Swan [28, 1970]. It is a treat-
firm,in the sense thatit does not use empir- ment of the influenceof monopolyon the
ical observationsof the behaviorof the firm introductionof new products.Swan shows
as inputsfordevelopingmodels. the sufficiency of certainconditionson the
S. R. Dittrichand R. H. Myers [9, 1971] demand functionto prove that a monopoly
intend their paper on Chinese agriculture and a competitivemarketproduce the same
in 1937-40 to answer the question of products from a range of available prod-
whethertraditionalagricultureis properly ucts, with given technology.He findsthese
described by the neoclassical theoryof the conditionsto be reasonable ones. Further-
firm.Since optimalallocation of labor and more,he shows thata likelyresultof violat-
capital could gain only about 6 percentin ing them is a speedup of introductionof
income,theyconclude thatneoclassicalthe- new productsby the monopoly compared
ory approximatesthe actual behaviorfairly to the competitivemarket. Machlup [18,
well. There are two problemswith thisap- 1967] had reservationsabout whetherthe
proach.The firstcomes fromthe attemptto neoclassical model was applicable to mo-
short-circuitthe "as if' arguments and nopolies and duopolies; the numberof par-
check profit-maximization directly.In fact ticipantsis small enough so that theirindi-
it would be convincingevidence that the vidual naturesmay become relevant.In fact
neoclassical model did hold if it were this is probably more serious for duopoly
shown that profitactually was maximized than monopoly.As will be seen below, in
by a set of firmsmeetingthe requirements the case of duopoly there is not even a
unique neoclassical solution,and we have
no choice but to talk about strategy.In the
3A quick checkof theextensivebibliography as-
sembledby W. H. Starbuckand J. M. Dutton[27, case of a monopoly,however,there is no
1971] showsthatthe computersimulationarticles opponent to predict, so the situation is
publishedin ManagementSciencealoneoutnumber simpler.It is true that the behavior of a
those in all economicsjournals,44 to 43. When
macroeconomic and purelymethodological articles monopoly may be greatly influencedby
are notcounted,theratioincreasesto 30 to 18. unique policies and otherattributesof that

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Cyertand Hedrick:Theoryof the Firm 401

particularfirm.Nevertheless,if we ignore creased quality or advertisingto be utility-


these individual peculiaritieswe may get producingforthe buyer.Thus the buyer is
predictionsthatwill be trueof an "average" really gettinga bundle of two goods, the
monopoly. Hopefully, the differencebe- basic good and a non-pricecomponent.The
tween the predictionsof this model and a effectis to add anotherdimensionto the ar-
competitivemodel will correctlyrepresent gument,which can be carried throughin
the differencein the real world averaged the same way as without the non-price
over several industries.There will be cir- component. This approach seems to be
cumstances,such as policy debates, when safelywithinthe neoclassical methodology.
we are interestedin knowingwhat behavior W. D. C. Wright [32, 1971] makes an-
is a directresultof monopoly,and we will other extensionwhich formallyis no more
be willingto forgiveerrorsin predictionof significantthan Barzel's. Wright considers
any specificcase due to a failureto repre- the effectof plant location on prices of in-
sent idiosyncraticbehavior. puts and outputs.Transportationcosts will
be a large part of the effect,but theremay
ofthe
II. SimpleExtensions be additional labor costs involved in at-
NeoclassicalApproach tractingworkersto an out-of-the-way loca-
Many papers are based on fairlystraight- tion. This location dependence can be
forward modificationsof the neoclassical added to the profitfunctionin a fairly
method. They extend the model to deal straightforward way, and then conventional
with "real-world"issues not faced by the maximizationdone. The result of the ap-
simple text-bookmodels, but retain the a proach is to develop expressionsfor the
priori character,in that all of the detail partial derivativesof the plant locationand
added is descriptive of the environment. outputwith respectto transportation costs,
The firm'sbehavior is still deduced from etc. The differencebetween this extension
the assumptiondescribingthe environment. and Barzel's is that this one is into an area
In fact,manyof thesemodels are motivated where individual plants must be analyzed.
by the desire to show that the neoclassical Unless the authoris tryingto predictan in-
model can explain events that seem on the dustry-wide"centerof gravity,"this model
surface to be explainable only by behav- must be applied directly to real-world
ioral rules. Even assumingthat these mod- plants.The paper runsthe riskof confusing
els describe correctlythe reaction of real firmsas theoreticalconstructsfor building
participants under the postulated condi- neoclassical models with real firms.The
tions, there is still a major problem. To plantlocationdecisionwould seem a partic-
build a neoclassical model dealing with ev- ularly dangerous place to follow a static
ery possible complicationsimultaneouslyis maximizationapproach since the decision
an obvious absurdity. But the choice of involves more qualitative factors (future
which ones are most importantcan also be tax policyof cityand stategovernments, at-
a difficulttask, especially if the effectsof titudestoward pollutioncontrol,etc.) than
differentcomplicationsinteract. the day-to-daydecisions that are the usual
One of the simplestextensionswas done subject for neoclassical models. Of course,
by Y. Barzel [2, 1970]. The objectiveof his the model also deals with the effectof
paper was to determinewhetherthe exis- changes of location-dependentcostson out-
tence of non-price competitionhad any put, but it would seem thatthe unextended
effecton the validityof the argumentthat model could handle those costs,too.
monopolisticcompetitionleads to inefficient Even furtheralong the dimensionof in-
operation.He proceeds by consideringin- creasingrealismin treatingactual details is

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402 Journalof EconomicLiterature

a model by W. H. L. Anderson[1, 1970]. It the objective function.This modification


is an attemptto explainthe responseof em- can be made by substitutinganotherentity
ploymentto seasonal productionvariations. (sales, for example) for profitsand then
Inventories,both of finishedgoods and in- proceedingto maximize the new entity.A
termediategoods, can be used to smooth second way is to substitutea utilityfunc-
production.He views the actual production tion (which includes the effectsof several
decision as a resultof tradingoffinventory entities)forprofitand proceed to maximize
holdingcosts against a quadratic labor cost utility.The latterapproach enables one to
function.For a given time-pathof sales, he introduceargumentsinto the utilityfunc-
uses the calculus of variationsto minimize tion that have been ignoredby neoclassical
cost. Although this model takes into ac- theory. Both of these approaches were
count more complications,and uses mathe- characterizedas "managerial"in the intro-
matical methodsthat are somewhatforeign duction.A thirdapproach in modification is
to neoclassical models, it is probablymore to add a constraintto the objective func-
nearly in the neoclassical spirit than tion.
Wright's.The complicationsit deals with The firstapproach has been taken by
are characteristic of theentireindustry,and W. J. Baumol [3, 1959]. Since his work has
are not entwinedwith individual firmpol- received sufficient attention,it will not be
icy. Even though the process they use is discussed here. It is of interestto note that
given more internalstructure,the firmsin in our surveyof recentjournal articleswe
the model remain constructs.Nevertheless, do notfindanythatfollowthefirst approach.
thismodel is not the onlyone thatmightbe The second approach stems from0. E.
used for explaining seasonal labor varia- Williamson'sworkand althoughit is not in
tions. The assumptionsof quadratic labor our survey,we will brieflydiscuss a model
cost and no adjustmentcosts are not the taken fromhis recentbook that is a proto-
only ones thatwill lead to similarresults.If typicalexample [30, 1970]. Williamsonde-
we want to keep the model as simple as velops a utilityfunction,U = U(S, p -
possible,we will probablywant to use only O- T) where S is staff,p is profit,p, is
one of the possible explanations.But with minimumprofit,and T is lump sum taxes.
the "as if" philosophyprevalentin neoclas- He thenproceedsto maximizethisfunction.
sical circles,it is not clear how such a deci- He is able to make some interesting predic-
sion should be made. To be fair,we should tions about the different effectsof various
point out that one of the main purposes of kindsof taxes. This model has greatformal
the articleseemed to have been to pointout similarityto neoclassical models, and we
that lack of uniqueness. It had been be- might be tempted to consider it just an-
lieved by some that labor-forceadjustment other extension.In fact, however,it is an
costswere "the"explanationof the factthat attemptto include behavioral characteris-
the labor force varied less than sales, and tics in the model. No longeris an objective
this model was designed to show that the view of the economic task sufficient to de-
phenomenon could be explained without terminebehavior.Some empiricalevidence
postulatingadjustmentcosts. will be needed about the way management
perceivesits taskand whetherit has private
ofthe
III. Modifications objectivesthatit triesto achieve along with
ObjectiveFunction the task. It does have one advantage over
One way to break a little more cleanly an entirely behavioral model, however.
with the neoclassical approach than the Only one behavioral mechanism need be
models previouslydiscussed, is to change chosen, the rest of the model being neo-

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Cyertand Hedrick:Theoryof the Firm 403

classical.One need not tryto build a de- theoutsideand is partoftheobjectiveeco-


tailedbehavioralmodelthatexplainsevery nomicsituation forthemanagement. Given
actionof the firm,but onlyfindone im- thatsituationand profit maximization, this
portantfactorand add it to an already modelfollows,withno need forconsider-
existingframework. That shouldnotblind ationof the actualnatureof thefirm.The
us to thefactthattheresultsof themodel fieldof publicutilitiesis, of course,an ap-
really are the consequencesof the be- propriateplace fora behavioralapproach,
havioral content.The response of this and Zajac mentionsseveralalternatives to
modelto variouskindsof taxationis differ- the Averch-Johnson model.These mustall
ent froma purelyneoclassicalmodel's. depend upon some alternativeto profit
That difference is why the model is ex- maximization, however,and so are clearly
hibitedin the firstplace, and it is clearly on a different plane.
due to Williamson's changingof theobjec-
tivefunction to fithis ideas about"slack." IV. GeneralizedMaximization Techniques
J.P. Newhouse[22,1970]takesa similar, Having consideredextensionswithina
if less formal, approach in trying to explain strictly neoclassicalstructure,and then
thebehaviorofhospital management. For a changes in the objectivefunction, we now
non-profit organization maximization is not consider models that do not use the ordi-
a relevantgoal at all, so rather than just nary maximization methods, although their
supplement it withothergoals,he replaces intentis stillthesame.Thesemethodsarise
it. He viewstheobjectiveof hospitalman- in an attempt to extendneoclassicalmodels
agementas beinga combination ofquantity to cases wherethereis uncertainty. In gen-
and quality of services rendered,con- eral, these models maximize expected
strainedby a certainmaximum deficit. The profit.Such an approachis not the only
additionof the qualitycomponentallows coursethatcould be followed,evenby an
himto explainoverinvestment in expensive, organization whosesole concernwas profit,
"prestigious" equipment,as well as differ- so in a senseit is a behavioralassumption,
encesin thetypeofcaregivenbynon-profit and any modelusingit lacksthe a priori
and profit-making hospitals.Again, al- characterof the usual neoclassicalmodels.
thoughneoclassicalmachinery is used,the However,writersgenerallytend to view
objectivefunction is suchas to haveit used maximization of expectedprofit as the ra-
forbehavioralpurposes. tional alternativeunder uncertainty, and
Thereare otherthingsthatone can do to anyotherhypothesis as havinga behavioral
the objectivefunction(besides changing color.
it). E. E. Zajac's article[33, 1970] deals Even if thefirm's attitudetowardsprofit
with the Averch-Johnson model of regu- is not adequatelyrepresented by its ex-
lated utilities.In this case ratherthan pectedvalue,as longas theattitudeis self-
changethe objectivefunction, he adds a consistentin thesensedescribedbythevon
constraint:percentagereturnon capital Neumann-Morgenstern axioms,it can still
cannotexceedsome"fairreturn" setby the be handledrelatively easily.An articleby
regulating agency.The resultis thatprofit A. Sandmo[24, 1971] is one example.In
maximization leadsto theuse ofmorecapi- fact,a firm whoseattitudes meetthesecon-
tal and less laborthanis otherwise optimal ditionswillmaximize theexpectedvalueof
forthefirm. Although thismodelmayseem someincreasing function of theprofit. This
to have a behavioralflavor,it probably deviceallowssomegeneralstatements tobe
shouldbe viewedas neoclassical.The fair made. However,to get any interesting re-
returnconstraint, afterall, is imposedfrom sultsit is necessaryto makean assumption

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404 Journalof EconomicLiterature
about the shape of the functionof profit. the two participants,neitherknowingthe
Sandmo assumes it is convex,which corre- other's decision until he has made his. By
sponds to an attitudeof risk aversion. An assuming that the participantsmake their
example of the kind of result obtained is decisions at the beginning of alternating
the prediction that output decreases as periods, and follow the same decision for
fixedcosts increase. Of course thisresultis two periods,Cyertand M. H. DeGroot [6,
criticallydependent upon the convexityof 1970] were able to come up with a single
the utilityfunction.This must be called a explicit solution. Althoughthis solution is
behavioral assumptionin the same sense as certainlycloser to being derived from a
the addition of staffto the objective func- prioriassumptionsthan is, say, the Cournot
tion by Williamson.It has the same disad- solution,it should be emphasized that it is
vantage of requiring empirical evaluation based upon a particularbehavioralassump-
and the same advantage of attachingonly a tion. Each participantis assumed to make
single behavioral assumptionto an other- the decision that maximizeshis total long-
wise a priorimodel. run profit if the other participant also
The othertwo papers in thissectiondeal makes his decision this way. 'This seems
with the duopoly problem. As is well- generally consistentwith the neoclassical
known,the difficulty with the duopoly situ- attitude,but the assumptionthat each par-
ation is thatthereis no solutionthatcan de- ticipant expects the other to maximize
serve to be called the neoclassical solution. profitsis not imposed by the environment.
The optimum strategydepends upon the With these provisions,dynamic program-
reactionsof the otherduopolist,and there ming allows an explicitsolutionto be de-
is no obvious optimumway to predictthat. rived by workingback fromthe final pe-
D. K. Osborne [23, 1971] summarizesthe riod. Fortunatelythe solution approaches
situationfromthe point of view of game an asymptoteas it gets away fromthe final
theory. There is a set of widely known period, so that the horizoncan be allowed
strategies,and if one knows that the other to go to infinity.Another indication that
duopolist is using one of those strategies, thisis not reallya unique neoclassical solu-
thereis an optimumstrategyto use against tion is the fact that neitherfirmis as well
it. There is also a maximinsolution,but in offas it could be with explicitor implicit
many cases the opponentwill not be acting collusion. The authors [7, Cyert and De-
to minimizeone's gain, since it is a coopera- Groot, 1971] showed how this cooperative
tive game. There are also Paretooptimalso- situationcould develop fromthe dynamic
lutions,which Osborne seems to thinkare programmingsolutionmentionedhere by a
the most relevant.In fact he draws policy process of Bayesian learning. This model
implications from them, recommending representsto some extenta mergingof be-
policies which prevent the occurrence of havioralassumptionsintoa model in such a
conditionsthat make one particularlyso- way thatmathematicalmethodscan stillbe
cially inefficientset of strategiesPareto op- used forthe analysis.
timal. Although one would certainlynot
call thisa neoclassical paper,it is in a sense Models
V. Non-Maximizing
trying to use game theory to maximize Finally,we come to two papers that are
profits.No other behavioral rules are in- explicitlynon-maximizing. This is not to say
voked than ones relevantto game theory. that they postulate irrationalbehavior or
It turnsout thatmuch of the difficulty of behavior resultingfrom altruismor other
duopolyis due to the usual assumptionthat non-profit motives.Some effortis spent in
decisions must be made simultaneouslyby both papers to justifythead hoc rulesused,

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Cyert and Hedrick: Theory of the Firm 405

fromthe point of view of a firmtryingto still a considerable componentof seasonal


maximize its profits.Nevertheless,the au- variation left in the error.Unfortunately,
thorsapparentlyfeel,forone reason or an- the r-statisticwas not given,so it is difficult
other,that theycannot account forthe full to know how much of the total variation
range of behavior by explicit maximizing was explained the model.
by
models. The other model is G. A. Hay's [16,
The firstsuch model to be considered 1970]. At firstglance it appears to be a
here is in a paper by R. L. Miller [20, maximizing model, since the solution is
1971]. It is an attemptto account for sea- derivedby maximizingrevenueminuscost.
sonal employmentin the textile industry. However, the cost includes terms that
The authorviews firmsas holding"invento- would seem quite strangein a neoclassical
ries" of unused labor during the off-peak model. For example, the desired level of
periods. The reason for holding the inven- inventoryis defined by a + b (produc-
tory is the avoidance of costs involved in tion). Then an inventorycost of c + d
adjusting the labor force. To some extent (actual - desired)2 iS included.Thereis also
there is also a trade-offbetween labor in- an explicit cost for changing production
ventoryand goods inventory,since if the and price. The latter involves (A[P-factor
holding and adjustmentcosts of the latter cost]).2 The justificationis that changing
were negligibleit would be possible to have prices, when there has been no change in
completely smooth production, hence no factorprices,will be consideredan aggres-
need forlabor inventories.The model takes sive action by fellow oligopolists, while
the formof two sets of simultaneousequa- prices that only keep pace with factorcost
tions: one for peak periods, the other for are consideredallowable. The resultof the
off-peakperiods. Goods inventoriesare set maximizationof revenueminuscost over N
inventory
by a theoretically-motivated equa- periods with a discount is a set of linear
tion. Employment and hours during the decision rules forproduction,price,and in-
peak are determined by minimizing a ventory.These were checked against the
quadratic cost function. During off-peak paper and lumber industry,1953-66, with
periods an ad hoc demand forreservelabor reasonablygood results.Again, since there
equation is used, a functionof anticipated is no alternativemodel applied to that data
future sales, product inventories,wages, for comparison,it is difficultto evaluate
product inventoryadjustmentcost, and a success.
trendterm.The model does not assume in- The classificationof this model as non-
stantaneousadjustment,but involvesa par- maximizing may seem strange, since it
tial adjustment towards desired employ- seems to be merelya neoclassicalmodel ex-
ment. tended to include typesof cost notnormally
This model was compared against actual considered. However, it is unlikely that
industrydata, quarterlyfrom1960 to 1967. such costs as (A[P-factor cost])2 are real
The predictedsignsof the regressioncoeffi- monetarycosts. The actual costs of price
cients are all substantiated,and the T-sta- change will be the same whether factor
tisticsappear acceptable, but it is still not price has changed or not. Rather,what is
clear that this model would do any better being looked at is a generalized utility
than an equivalent neoclassical model, say functionin equivalent monetaryunits,and
along the lines of Anderson'smodel men- "costs"are costsin a broadersense thanjust
tioned above. Althoughthe standarddevia- monetary.In this case the cost of raising
tionofthemodelis halfthatof a modelwith- price is a subjectivematterrelatedto a par-
out the demand for reservelabor, there is ticular oligopolistic strategy. One could

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406 Journalof EconomicLiterature
considerclassingthisas anotherexampleof of the model is an interestingand time-hon-
additionsto the objectivefunctionbut that ored one. The real question is whetherthe
is not reallyrighteither.In the case of Wil- resultshave any meaning since the model
liamson, the objective functionrepresents itself has never been in actual practice.
the real final objectives of the firm,and Given a gap, which implies inefficiency,
maximizationtakes place over every possi- how should the systembe changed? Too
ble policy. However, in Hay's model the many empiricalquestions about a competi-
policies are all given and are represented tive systemremain unsolved to use it pre-
by the cost functions.The utilityfunction scriptively.The second typeof articleis ori-
representshow close the firmis to its poli- ented toward drawing furtherinferences
fromthe theory.The approach is to take a
cies, not how close it is to its goal. The poli-
cies are ad hoc and are not entirelyconsis- particularproblem,usuallyone fromthe lit-
tent with each other. Maximizationof the erature,and attemptto analyze the prob-
utilityfunctionrepresentsa tradeoffbe- lem throughthe use of standard models.
tweenthem. This exerciseis useful for helping econo-
miststo understandthe implicationsof the
VI. Assessment of CurrentState models in existence. Unfortunatelythe
to draw defini- analysis makes no attemptto connectwith
As is obvious,it is difficult
tive conclusionsfromthe small surveywe the real world. Thus it is difficultto argue
have made. In fact,the economicliterature thatthis approach leads to new knowledge
is now so large that it is difficultto make about thereal world.
anything resembling a complete survey. Anderson'smodel in Part II (simple ex-
Nevertheless,we feel thatsomleconclusions tensionof the neoclassical approach) dem-
can be made, and we will also attemptto onstratesanotherdifficulty of the neoclassi-
speculate about futuredirections. cal model in derivingnew knowledge.The
Anymodel in any science mustultimately model used can be justifiedsolelyon an "as
be justifiedon the basis of the knowledge if' basis. The underlyingimplicitfirmdeci-
about the real world that is generatedby sion models have no provenrelationshipto
the model. This new knowledgemay come reality.Their justificationcomes fromput-
from empirical work resulting from hy- ting togethera "package" which in the ag-
potheses derived fromthe model or from gregateis not inconsistentwith some data.
theoreticalresultsthatlead to othermodels Andersonshows thathis storyis as good as
and eventually to increased knowledge a previous story,labor adjustment costs.
about the real world. As a firststep in our One method for choosing among alterna-
evaluation,it is useful to examine current tivesmightbe the actual decisionprocesses
workfromthe standpointof the generation used at thefirmlevel.
of new knowledge. In Part III (modificationsof the objec-
In Part I of this paper (the unmodified tive function)we are closerto gainingnew
neoclassical approach) we see two typesof knowledgethan in I and II. The modifica-
articles.The firstis an attemptto apply the tion of the objective functionrepresentsan
maximizationmodel directlyto an economy attempt to utilize empirical knowledge
and draw conclusionsabout the efficiency about the goals of the microeconomicunits.
of resource allocation. The model as ap- The Williamson and Newhouse works are
plied representsa theoreticaloptimumand particularlygood examples of the fruitfuil-
the attemptis to measure empiricallyhow ness of thisapproach. The power of the ap-
close an actual economycomes to the theo- proach comes fromutilizing empirical be-
retical maximumefficiency point. This use havior and building the observationsinto

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Cyertand Hedrick:Theoryof the Firm 407
the objective function.The question that Thus it seems difficultfromthisreviewof
arises is whetherthe individual arguments our surveyto justifythe neoclassical model
are best treatedby combiningthem into a on the basis of leading eitherto new knowl-
single objective function.We suspect that edge about the world or interesting theoret-
betterresultsmightbe obtainedby treating ical results.The need for the simple maxi-
each argumentas a separate goal and ana- mizationapproach functionsas a barrierto
lyzingthe processesof the firmin achieving reaching the world. The most interesting
the individualgoals. resultsseem to us to stem fromthe enrich-
In Part IV (generalized maximization ment of the objective function (in Part
techniques) the approachestakenrepresent III). Work in this area moves the model
an attemptto develop models that will im- closer to givingmore detailed explanations
prove the descriptionof realityby dealing of the real world. More specifically,the in-
with uncertainty.The papers in this cate- clusion within the objective function of
gory are almost all theoreticaland can be variables actually used in the decision pro-
justifiedby the possibilitythat they may cess increasesthe explanatorypower of the
eventuallylead to models withmore empir- model. The latterconclusionis true even if
ical content.The importanceof developing the actual processof decisionmakingis not
models that are dynamic and incorporate utilizedbut is approximatedby a maximiza-
uncertaintyis obvious if economicsis to ex- tion process. We do not wish to leave the
plain reality.The major question again is impression,however, that we believe be-
whetheror not by sacrificingmaximization havioral and managerialmodels to be auto-
and some elegance, models with empirical maticallysuperiorto maximizingones. For
content can be developed more quickly. example,P. A. Frost [13, 1971] gives a max-
Progressin financeis clearlybeing made in imizingmodel to explainbanks'demand for
the analysis of firmbehavior under condi- excess reserves. The model is specifically
tions of uncertainty.The concept of maxi- designed to explain apparentlyanomalous
mizationis retained,but the progresscomes behavior in certainrapidly changingsitua-
fromthe factthatthe objectivefunctionhas tions,and does so quite well, betterin fact
a measurablecounterpartin the real world than a behavioral rule that was previously
[19, Mao, 1969 and 11, Fama and Miller, suggestedas an explanation.The majorthe-
1972]. oretical accomplishmentof that articlewas
The articles in Part V (non-maximizing the derivationof a stable curve of demand
models) are an attemptto develop models for excess reservesas a functionof interest
that incorporate decision rules that have rate. We suspect that the model was suc-
some empiricalvalidity.Some of the rules cessfullargelybecause so much information
are ad hoc rules of thumb,some come from was able to be summarized by a single
the management science literature, and curve. Inevitably this curve representsa
some fromthe empiricallydescriptiveeco- somewhat gross optimum,various detailed
nomic literature.The models are still,how- informationhaving been surpressed or
ever, aimed at explaining the world at a averaged over in its derivation. In fact
gross level-the industry.No attempt is these are just the sortof characteristicswe
made to test individualdecision rules sepa- would expectin a behavioralrule.
ratelyagainstthe decisionprocessesof indi- The crucial problem of findinga substi-
vidual firms.The advantages of a behav- tuteprocessformaximizationand maintain-
ioral approach are not apparentuntil there ing rigoris not easily solved. Nevertheless,
is an attemptto test at the individual firm it is necessaryformore effortto be exerted
level. in this direction,especiallywhen we recog-

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408 Journalof Economic Literature

nize the ambiguityof the meaningof profit the utilization,firstof the thinking-aloud
maximizationunder uncertainty.A further protocol,and then the eye-movementcam-
difficultythat arises fromthe maximization era..The object is to build theorieswiththe
process is the difficulty
of rejectinga model highest possible "density" of explained
when the "as if"philosophynegates looking data.
at actual decision processes. This difficulty One possible path out of the dilemma
is made even more severe by the recogni- faced by microeconomicsis the route of
tion that some maximandcan be found to simulation. Simulation allows the model
explain any series. builder to embed the variables that are
In additionto the difficulties
already dis- deemed relevanton the basis of his empiri-
cussed, there is a great diversityof views cal observations.He can, as well, incorpo-
about the proper objectives of a theoryof rate the actual process of decision making
the firm.(The closestelementto a common and is not bound by conventionalmathe-
thread is the use of the maximizationpro- matics to assumingthat the economicunits
cess.) Stemmingfromthe originalintroduc- maximize.There are many examples of in-
tion of the firmas a hypotheticalconstruct, teresting and successful simulations of
there has been a prevailing opinion that firmsand industries[10, Dutton and Star-
economistsought to be interestedonly in buck, 1971 and 17, Hoggattand Balderston,
propositions that were true for a large 1963]. Simulationmodels can be made for
group of firms(an industry,for example). individual units,markets,or economic sys-
Taking thispointof view eliminatesany in- tems.The models are not elegant and there
tereston the part of the researcherin mak- are problems in testingthe validityof the
ing observations on the way individual models.
firmsoperate.The economistis thenfreeto Nevertheless,these rathertrivialesthetic
make up a story,in the formof a model, problemsdo not explainwhy thisparticular
about the way in which decisions on some methodologyand the behavioral approach
variable of interest(prices, output,invest- to theory have remained relativelyinfre-
ment,advertising,etc.) are made. The story quently used in economics.Reasons spring
thatis viewed as best is the one thatfitsthe to mind-the statusof mathematicalmodels,
aggregatedata best. the trainingof economists,the difficultiesin
This concentrationon group behavior is obtaining the data inherentin the behav-
not peculiar to economics. The social sci- ioral approach, the concern that special
ences as a whole have been characterized models must be developed for each firm,
by the idea that the behavior of individual and so on.4All of these are reasons thatwe
organisms,whethermen or firms,is unpre- believe account in part for the relativeig-
dictable, hence uninteresting.That this noringof an importantapproach at the mi-
view is overlypessimisticmay be suggested croeconomic level. (Simulation has been
by the recent success in explaininghuman accepted as an importanttool at the macro-
problem solving on a minute-by-minute economiclevel.)
level [21, Newell and Simon, 1972]. The Equally important,however, has been
contrastin attitudesbetween the authorsof the lack of agreementon the crucial ques-
thisstudyand the microeconomictradition tionsto which the theoryof the firmshould
is quite interesting.Newell and Simon,to- address itself.The fundamentaldifference
gether with many other psychologistsof centerson the questionof whetherthe the-
similarbent, seem to be constantlylooking
'For someparticularly cogentcritiquesofthebe-
for ways of collecting larger and larger havioralapproach,see the articleby W. J. Baumol
amountsof data per unittime.Thus we see and M. Stewart[4, 1971].

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Cyertand Hedrick:Theoryof the Firm 409
ory should explain actual decision making Case," Amer. Econ. Rev., May 1970, 60
in the firm.The prevailingposition,and the (2), pp. 385-92.
major rationale for neoclassical theory,is BERHOLD, M. "A Theory of Linear Profit-
that the actual process is irrelevant.The Sharing Incentives," Quart. J. Econ.,
critical test is predictionand any process August 1971, 85(3), pp. 460-82.
that produces predictionsvalid in the ag- BISCHOFF, C. W. "A Model of Nonresi-
gregate is adequate. This position is justi- dential Construction in the United
fiedon the"as if"rationale. States," Amer. Econ. Rev., May 1970,
On the basis of our briefsurveywe con- 60(2), pp. 10-17.
clude that thereis growinguneasinesswith BRITrAIN,J. A. "The Incidence of Social
the neoclassicalapproach (Parts III, IV, V) Security Payroll Taxes," Amer. Econ.
but that the above rationaleis stillheld by Rev., March 1971, 61(1), pp. 110-25.
most economists. This position plus the CHIPMAN, J. S. "External Economies of
othervirtuesof mathematicalmodels (pres- Scale and Competitive Equilibrium,"
tige as well as rigor) maintainthe impor- Quart.J. Econ., August 1970, 84(3), pp.
tance of the role of maximization.We see 347-85.
no evidence at this time for a substantial CYERT, R. M. and DEGROOT, M. H. "Multi-
change despite the restrictedprogressbe- period Decision Models withAlternating
ing made by currentapproaches. The real Choice as a Solution to the Duopoly
world stillescapes our models; our explana- Problem,"Quart.J. Econ., August 1970,
tions remain at an aggregate level. The 84(3), pp. 410-29.
problemis clearlydifficult, but we wonder "Bayesian Analysis and Duopoly,"
whethereconomicscan remainan empirical J. Polit. Econ., Sept. 1970, 78(5), pp.
science and continue to ignore the actual 1168-84.
decision-makingprocesses of real firms. DirRicH, S. R. and MYERS, R. H. "Resource
Allocation in Traditional Agriculture:
APPENDIX I
Republican China, 1937-1940," J. Polit.
Econ., July1971,79(4), pp. 887-96.
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410 Journalof Economic Literature

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