The Competitiveness of Nations in a Global Knowledge-Based Economy

Brian J. Loasby

Management Economics and the Theory of the Firm [1]

Journal of Industrial Economics, 15 (3)

July 1967, 165-176.



The Assumption of Profit Maximization

The Objectives of the Firm

Optimizing and Satisficing


THE origin of this paper is a belief that, whatever its virtues as a major component of the theory of value, the theory of the firm as it exists at present is an inadequate basis for analysing the process of managerial decision-making.  Professional economists working in industry are ready enough to declare (to take two examples) [2] that “the theory of the firm based on the marginal analysis is most unlikely to have any relevance to the real world and is of negligible use to economists earning their livings in it”; or that “in such analyses as I have attempted of the actual processes of decision-making in business I have frankly found the theory almost completely irrelevant”.  Perhaps, indeed, few academic economists would nowadays dispute this point.  Of course many of the concepts used in the theory of the firm are valuable; but the integrated theory is not.

Customary forms of theorizing about the firm require that the firms of the real world be treated as ‘black boxes’, which transform information inputs into decision outputs by managerial processes which need not be properly understood provided that their effects can be calculated.  Now this is, in principle, a perfectly legitimate intellectual procedure; it is not necessary to be able to explain in order to be able to predict. [3]  The fact that no one yet understands exactly what happens within a blast-furnace does not prevent blast-furnaces from being used; and the establishment of statistical relationships does not depend upon the ability to analyse the processes which create those relationships.  However, it is precisely the managerial processes within these ‘black boxes’ which form the subject matter of management economics.  If management economics is to make a more adequate contribution to explaining business behaviour, to increasing the efficiency of management, and to the development of management education, economists must begin to look more carefully at managerial processes.  For this purpose, the assumptions of the traditional theory are hopelessly inadequate.

1. My thanks to all those who have commented on various drafts of this paper are not intended to disclaim my responsibility for its present form; in particular, the implied interpretations of P. W. S. Andrews’s work do not necessarily carry his approval.  Our arguments are quite different.

2. Both privately communicated.

3. For a discussion of this argument, see K. J. Cohen and R. M. Cyert, Theory of the Firm (Englewood Cliffs, N.J., 1965), Chap. 2.


The Assumption of Profit Maximization

The assumption that the objectives of the firm can be adequately summarized as the maximization of its profits has had a long life.  Perhaps its persistence can be best explained by the aura of rationality which clings to it, and to the kind of behaviour that apparently follows from it.  Since the behaviour postulated by the marginal theory of the firm is rational behaviour, then that is the way firms should behave.  Profit maximization therefore becomes a test of managerial competence; it is indeed virtually a moral issue.  Since the logic of the theory is impeccable, evidence that any actual firm does not behave in this way cannot disprove it; it merely shows that the firm is badly managed.  Why, then, should one bother with empirical testing?

This paper is not concerned with the question, to which P. W. S. Andrews has directed his attention, whether the commended behaviour does indeed lead to maximum profits, even on its own assumptions. [4]  But it does need to be remembered, by those who extol the virtue of profit-maximizing behaviour, that such behaviour is rational only if the object is to make as much money as possible.  To argue the rationality of profit maximization as an objective is strictly meaningless; rationality is an efficiency measure, concerned with the relationship of means to ends.  It can say nothing about the ends themselves.  If businessmen choose to prefer other aims to the maximization of profit, the preference may be inconvenient for the theorist, but it cannot be called irrational.

The assumption of profit maximization also appears to have practical advantages.  The argument that no better assumptions are available has, it is true, now been undermined by progress in other branches of the social sciences - which economists, as a class, too readily ignore; but since not many attempts have yet been made to work out the economic consequences of alternative assumptions, most economists, being interested in teaching, using or refining the existing corpus of theory, rather than labouring on major new constructions, continue to behave as if the argument was still valid.

Around this unchanged position one is nowadays likely to find another, and much stronger, defence.  Since all assumptions must be unrealistic in varying degrees, the validity of the assumptions must be judged by the validity of the results to which they lead; and it is claimed that profit maximization, while avoiding the complications introduced by alternative assumptions, produces results which are valid enough for the purposes for which the theory

4. P. W. S. Andrews, On Competition in Economic Theory (London, 1964).


is to be used.  This article is not intended to challenge that defence; but it must be pointed out that the purposes for which the theory of the firm is to be used explicitly exclude the explanation of decision processes within the firm.

This was not always so; the restriction represents a forced withdrawal from ground which was once thought to be unmistakably within the province of the economist.  This abandoned ground has now been invaded by organization theory and operational research, among others, and the occasional forays of economists into the area are unsupported by any substantial body of general theory.  As long as this situation persists, any claims by economists that their subject should be at the centre of the study of management looks distinctly shaky - it has the appearance of the discredited argument that specialists need to be co-ordinated by someone who does not have the disadvantage of specific relevant expertise.

Profit maximization has, finally, a strong intellectual appeal.  It provides a unique solution for each problem; more complex criteria do not.  This point is well illustrated by two recent attempts to construct a theory which is based on other assumptions.  In developing his theory of managerial capitalism, in which managers attempt to maximize the growth of their companies, subject to certain constraints, Marris finds himself relying heavily on the takeover bid and the threat of a bid to ensure that all managers behave in the same way - a job much more elegantly performed in the accepted theory by the assumption of free entry. [5]  O. E. Williamson’s proposition that managers attempt to maximize a utility function which has as its three principal components retained profits, staff and ‘managerial slack’ (approximately equivalent to managerial rent) appears to allow for different relative valuations of the three components by different managers, and therefore for different decisions in identical situations.  The only hope for unique solutions in Mr. Williamson’s world appears to be an economy managed by fully conditioned organization men. [6]

But the intellectual appeal of profit maximization is spurious.  If, instead of assumptions, one starts with the observed behaviour of firms, then the virtue of simplicity becomes weakness, and the defects of complexity become virtues.  All firms do not behave in the same way in similar circumstances, and a theory which helps to explain why they do not is perhaps to be preferred to one which asserts that they should.

5. R. Marris, The Economic Theory of ‘Managerial’ Capitalism (London, 1964).

6. O. E. Williamson, ‘A Model of Rational Managerial Behaviour’, in R. M. Cyert and J. G. March, A Behavioral Theory of the Firm (Englewood Cliffs, N.J., 1963), pp. 237-52.


The weakness of traditional theory is well displayed in situations of oligopoly, where it has tended to adopt the attitude of the legendary Scottish preacher: “Brethren, here is a great difficulty.  Let us look it firmly in the face and pass on.”  The difficulty is that, within the traditional framework, the solution depends on the behaviour of individuals, and the theory has no way of handling this behaviour.  The tendency to argue that only collusion is rational, and that other kinds of behaviour are irrational and therefore beyond the reach of analysis is a counsel of despair, resulting from the naive equation of rationality with profit maximization.

The great attraction of perfect competition theory, which was inherited by monopolistic and imperfect competition theories too (but which oligopoly theory lacks), was its determinism; it had no need of the individual.  It is time that he was allowed back.  It would be foolish to claim that the decision-makers in industry have more than a limited discretion.  In some instances - for example, the special case of perfect competition - they have none at all; but, in general, it is safest to assume that there is a constrained area within which they have some freedom of choice.  Occasionally, that choice can be as crucial as a casting vote.  In order to explain and predict these choices we need to examine more carefully the objectives of the decision-makers.


The Objectives of the Firm

‘Profit maximization’ is in fact not one assumption but two: first, that the objective is profit, and second, that the desired level of performance is the optimum.  These assumptions, although closely related, are best considered separately.

It has generally been accepted that profits, like other forms of income, are desired, not for themselves, but for the satisfactions over which they can give command.  But although it has long been recognized that the activities by which wages are earned may include important direct sources of satisfaction or dissatisfaction in their own right, no similar refinement has been applied to the concept of profits.  Allowance is made for variations in risk and occasionally for leisure-preference, but that is all.  It seems just as likely, however, that those who make the major decisions within a firm should be interested in the total net advantages - including possibly substantial satisfactions from the job itself - deriving from their activities as that wage-earners should be interested in the total net advantages of their jobs: indeed, given that the formers’ incomes are usually much bigger and therefore provide a much bigger margin over the


cost of necessities, they might be thought to be more interested in the non-pecuniary factors, as their cost in terms of the value of income foregone would probably appear less. [7]  The possible net advantages to be sought from the control of a business - and therefore the possible range of objectives of the business - may be conveniently grouped into four sets, which may be labelled economic, social, psychological, and organizational.

The set of economic objectives will obviously include profit; the other objectives will usually be partly complementary to profit and partly competitive with it.  Cyert and March work with a set of five: in addition to profit they list objectives for production (including both level and stability of output), stock levels, sales and market share. [8]   In The Practice of Management, Drucker, after declaring that a business needs objectives in every key area, lists these ‘key areas’ as follows: market standing, innovation, productivity, availability of resources, profitability, managerial performance and development, worker performance and attitude, and public responsibility. [9]  It should be noticed that, whereas Cyert and March are describing, Drucker is an advocate; but his advocacy is directed squarely at business practice.

Forgetting for a moment the last two on Drucker’s list, we may notice a striking contrast between these two sets of economic objectives.  Profit is the only one that is included in both.  Market standing is by no means the same as market share: it is much more a matter of the firm’s reputation with its customers and distributors, and the relation between its range of existing and potential products on the one hand, and its existing and potential markets on the other. [10]  The distinction between the two lists is simple, and one that is very familiar in economics: the former is a short-period set, the latter a long-period set.  This is as it should be, for Cyert and March are concerned essentially with the day-to-day behaviour of the firm while Drucker is concerned rather to lift the businessman’s eyes from the pressures of the day and to consider major issues of policy.  The fact that short-period objectives can be described whereas long-period objectives apparently need to be advocated has a significance of its own in explaining business behaviour.

For each of these sets of objectives, it would be possible to argue that profit is the fundamental objective, and that all the others are

7. Douglas McGregor, The Human Side of Enterprise (New York, 1960), discusses the manager’s job as a direct source of satisfaction, and considers the organizational - but not the economic - consequences.

8. Cyert and March, pp. 40-3.

9. P. F. Drucker, The Practice of Management (London, 5955), pp. 52—3.

10. Drucker, p. 55.


objectives which will be set in such a way as to contribute to its achievement.  It would be possible; but it would not be very plausible.  Apart from the argument to be adduced shortly, that particular members of the firm will associate themselves - and be required by their organizational responsibilities to associate themselves - with particular objectives, the performance of a firm in terms of for example, its share of the market or its record of technical innovation may well produce satisfactions to the decision-makers which they may value more highly than the profit foregone by attracting dearly bought custom or by pursuing expensive ingenuity.  If a more single-minded firm makes higher profits, why should they worry?  The satisfaction they desire cannot be achieved in that way.  For them, the attempt to maximize profits would be irrational.

This first group of objectives may legitimately be considered as the proper concern of the economist.  The remaining three sets lie outside his particular territory; but he should be prepared to accept the findings of those who have investigated them.  Two of the sets are suggested by the last two items on Drucker’s list.  Almost all large companies, at least, would accept in principle that they have certain public responsibilities, which it is not realistic to dismiss as ways of obtaining long-run profits. [11]  This is particularly true of companies operating overseas in emergent countries.  It is also obviously true of nationalized industries, which are not expected to be profit-maximizers, and are therefore implicitly excluded from the theory of the firm - a striking omission, one would have thought. [12]

Fogarty has recently argued that some at least of these responsibilities should be written into a new Corporation Act. [13]  Without necessarily accepting that argument, one may certainly accept its implication that this is a set of objectives which is different from the economic set just discussed.  To be a good employer, to assist the local community, to be, in general, a well-behaved and respected member of society - these are aims which are widely accepted by firms, and nowadays widely expected by the public.  In fact, the company that appears to be seeking nothing but profits is likely to have a poor reputation with the public - and there are few firms which do not put some value on their reputation in its own right, and not simply as an aid to profit.  What this value is the economist can attempt to measure in terms of profit foregone; why it should be what it is does not necessarily concern him.  What does concern him is that his  assumptions about it should be reasonable.

11. R. Eells, The Meaning of Modern Business (New York, 5960), p. 70.  Much of this book is concerned with these issues.

12. I owe this point to Mr. D. K. Clarke of the Department of Politics, University of Bristol.

13. M. P. Fogarty, Companies Beyond Jenkins (London, 1965).


‘Worker performance and attitude’ may be considered in part as falling within the definition of a firm’s responsibilities to society.  In part, however, it falls within the category of more specifically psychological satisfactions desired by the firm’s decision-makers.  These satisfactions may be socially desirable, as, in general, good human relations are, or undesirable, as the wish to exert power may usually be; what is certainly true is that these satisfactions are not simply means to an end, but important ends in their own right.  (It is to be hoped, for example, that we have now passed the stage at which good human relations were thought to be rewarded - indeed often measured - by increased profitability.)  The firm’s decision-makers bring their own objectives to work with them.  Some of these objectives are sought through the pursuit of the economic objectives of the business, but others can be achieved only by modifying these objectives. [14]  For example, “many owners of small firms are reluctant to let any share of their firm leave their own hands... the price of such independence may well be a failure to grow”. [15]  Once again, the economist can attempt to measure the cost of these psychological objectives, but for his assumptions about their nature and force he must rely on the social and industrial psychologists.

There remains one more set of objectives to be considered.  The content of this set has been hinted at in the use of the phrase ‘the firm’s decision-makers’.  Existing theory is still built around the idea of the entrepreneur.  Of course it is realized that the business run by the owner-manager is no longer typical of industry, and there has been some uneasy recognition that the manager who is not the owner may be interested in other things than profit.  That this may also be true of the owner-manager has escaped general notice; but it will be observed that our arguments so far do not depend on whether or not the business is managed by its owners.  There has also been some search for the identity of the ‘entrepreneur’ in modern business.  Some are still to be identified; but it is significant that they are to be found predominantly among the creators of new business or among the successful takeover-bidders.  In the great majority of large firms the entrepreneur does not exist.  In his place there is an organization; and an organization is not a collective entrepreneur.  It has distinctive features of its own, which are the concern of organization theorists.

Hitherto, the interest of economists in organization has been confined to the relationship between organizational size and effi-

14. Cyert and March, Chap. 3; McGregor, Chaps. 3-4.

15. J. A. Bates, The Financing of Small Business (London, 1964), pp. 20-1.


ciency; and it is remarkable, looking back, to see how well the debate over the existence of managerial diseconomies of scale was kept going without anyone inquiring how organizations actually work.  But for some time now other social scientists have been observing that members of an organization may have varying objectives of their own, and that conflicts of interest are not confined simply to those between management and the shop-floor.  In addition, the manager’s terms of reference, and the demands of the job itself, provide a set of objectives for his sphere of responsibility; and as a practical guide to departmental decision-making an objective of maximizing company profits is useless.  Moreover, it is much too facile to believe that the sum even of all the departmental objectives - let alone the sum of all managerial objectives - is equal to the objective of the organization as a whole.  To get this equation even approximately right is one of the major problems in running any large organization.  Economists, when they have recognized this problem at all, have assumed that it can be solved by an appropriate organization structure and management control system.  Such an assumption is not often justified; and the relationship between departmental and company objectives deserves the specific attention of economists.

It has been argued so far that the simple assumption of profit as the objective should be replaced by a composite assumption including economic, social, psychological, and organizational sets of objectives.  Some of these objectives will become effective, not so much by influencing the choice between alternative courses of action, but rather by suppressing one or more of these alternatives altogether; they will not even be considered, because they conflict with company policy.  But how is this company policy formulated?  There is no reason to believe that all firms have identical sets of objectives, or indeed that any one firm uses the same set for all decisions.  Is there anything one can say about the formation of a firm’s preference system?

A possible answer seems to be that it can be discussed in terms similar to those used in analysing the preference system of the individual consumer.  The objectives of the organization, like the goods and services demanded by the individual consumer (which are his objectives) are subject to substitution at the margin.  Absolute priorities are perhaps as rare in the one case as the other (though continuous marginal adjustment, as will be argued later, is unlikely either).  When considering objectives other than profit, one can distinguish income and substitution effects (research and development objectives gaining weight relatively to sales as profits increase,


for example); and one can analyse the forces which tend to produce particular patterns of objectives as one can analyse the forces which tend to produce particular patterns of consumption.  These patterns may vary not only between firms but also from time to time within the individual firm, as circumstances change.  This is not an area in which the economist has any special skill; but it is work which comes naturally to psychologists, sociologists and organization theorists.  Unfortunately, psychologists, sociologists and organization theorists agree rather less often than economists, so that the economist who wishes to use their ideas is faced with the problem of choosing between them.

At this point it is necessary to consider a fundamental objection to this type of argument.  Is not the advocacy of more complex assumptions about objectives open to the retort by E. A. G. Robinson to Andrews’s theory which he misread as an account of simple full-cost pricing behaviour?  If some firms base their actions on objectives of this sort, while other firms go simply for profits, then surely “the wicked nonconformists will triumph, and the respectable ritualists will suffer”. [16]

It is possible, but it is not particularly likely.  It is not particularly likely for four reasons, the first two of which refer to friction within the system, the other two to the working of the system itself.  First, there are so many ‘respectable’ firms about that the successes of the pure profit-seekers are unlikely to make much impact.  Second, the advance of the profit-seekers is impeded by elements of monopoly and by the limited mobility of resources in relation to the rate of change in the equilibrium position.  Third, success in achieving these other objectives, as has been stressed, may be explicitly regarded as a partial substitute for profit.  (Robinson’s original argument against Andrews assumed that all firms were profit-seekers.)  The fourth reason is that it is not at all easy to be an efficient profit-seeker; as this reason also affects the optimization assumption it must be considered separately.

The theory of the firm was originally developed on the assumption of perfect knowledge.  That assumption has now been substantially modified, and its modification has allowed the development of sophisticated theories of decision-taking under conditions of uncertainty.  But this uncertainty relates simply to the future outcome of alternative courses of action; and it is uncertainty of a probabilistic kind.  But uncertainty extends much wider than this.  Companies just do not have the information which the traditional theory

16. E. A. G. Robinson, ‘The Pricing of Manufactured Products’, in Economic Journal, December 1950, p. 774.


assumes that they have.  A shrewd economist working in the intelligence department of a major company reports, for example, that despite the efforts of a team of economists, “we know very little indeed about the particular demand curve facing our particular firm.  Similarly we know very little about our cost curves”. [17]  That firms should be unable to construct the marginal functions required by customary forms of theory is not surprising; but if these functions cannot be constructed, of what use are the simple decision rules for profit maximization?  Moreover, if a firm does not know (except in an accounting sense, with its semi-arbitrary allocations) what its costs are, how much less likely is it to know what they ought to be?  Yet it is this ‘ideal’ cost curve which is assumed to be known in traditional theory - which thus cannot recognize cost control as an economic problem.  Optimization - or, more probably, sub-optimization - may be possible in some situations; but it is difficult to see how a firm can be a thoroughgoing conscious optimizer without a great deal more information than it commonly possesses.

Profit maximization is not, therefore, usually an operational objective.  In practice, it must be replaced by objectives that are operational, and these generally possess one or both of two features: they are partial objectives, of the kind listed above (often departmental objectives), or they are expressed in terms of satisfactory rather than ideal performance.  The first feature has already been discussed; it is now time to discuss the second.


Optimizing and Satisficing

The argument that firms characteristically formulate their objectives in terms of satisfactory levels of performance is associated particularly with the work of Simon. [18]  To many economists this approach appears less intellectually satisfying than the optimization assumption, for while there is only one optimum level there may be many levels which might prove satisfactory to different people; and while the optimum level is objectively determined, what determines the appropriate level of satisfaction? [19]

This objection can be met in two different ways.  Let us begin with the more conservative of the two.  If one retains for a moment the usual assumptions about consistency, rationality, and knowledge, then the situation facing a firm at a particular time will determine an ideal level of achievement for each of its objectives, just as the situation facing a consumer will determine an ideal level of expendi-

17. Private communication.

18. H. A. Simon, Administrative Behavior, 2nd edn. (New York, 1961), p. xxv.

19. Marris, pp. 267-8.


ture on each desired commodity.  But what happens if we withdraw these assumptions?  In order to remain continuously at the highest possible level of satisfaction in the face of continually changing circumstances, a consumer needs far more knowledge and far more mental ability (for this seems to be a major component of the assumption of ‘rationality’) than he can be expected to possess; and the same is true of the multi-objective firm.  Therefore, even if we postulate an original consistency of objectives (which is most unlikely to be found in practice), this will soon be eroded.  It is because optimization is unworkable that satisficing takes its place.  The practical alternative is usually sub-optimization.  There is no reason to believe that this will in general produce better results, and it is certainly likely to precipitate more conflicts within the organization.

A second ‘conservative’ argument in favour of using levels of satisfaction instead of ideal standards is that decisions are not in practice costless, and that they should not therefore be taken unless the cost of taking them is exceeded by the increased satisfaction that results.  Continuous marginal adjustment, it has just been argued, is usually impossible; if it is possible, it is probably too expensive.  What an organization (like the individual consumer) needs is a set of indicators which will tell it when to review its present pattern of behaviour.  This set of indicators is provided by the standards of performance established in all the important decision areas.

On the basis of these ‘conservative’ arguments it appears that satisficing behaviour (as it has been styled by Simon) can be justified as the best practical approximation to optimal behaviour, in a world where the assumptions underlying optimal behaviour are invalid.  Satisficing can be rational.  (This is not to argue that every example of satisficing behaviour found in practice can be thus justified.)  But does this conclusion not mean that management economics can continue to use the assumption of optimization, while admitting that the frictions of imperfect knowledge, imperfect rationality, and the cost of decisions will prevent the behaviour of firms from more than approximating to the results so obtained?  It does not; because these factors are not mere frictions.  They are important elements in the managerial decision process.

The best answer to the objection of the optimizers is far more radical.  They complain that the level of satisfaction cannot be determined by the accepted methodology of economic theory, which requires that general analytic conclusions be derived by logical argument from initial assumptions.  But, as always, the wide extension of a general conclusion has to be paid for by the shallowness of its intension; it is possible to say something about all firms


only by saying little about any particular firm.  It is thus perhaps inevitable that any theory which claims to be the theory of the firm should regard any particular firm as a ‘black box’.  But in looking at a particular firm, to ask how the level of satisfaction is logically determined is to ask the wrong question.  Instead of deriving equilibrium conditions by logical argument from initial assumptions, the satisficing approach explains a specific, possibly transient, state in terms of development by a dynamic process from specified initial conditions.  Differences in the levels that are judged satisfactory by different firms - and in different countries - do indeed exist.  Optimization theory has difficulty in explaining them logically; satisficing theory can explain them as the product of an analysable process.

The weakness of traditional theory in dealing with specific situations is shown by its inability to discuss efficiency except as a function of scale or of location.  This weakness may bias recommendations for public policy.  An economic evaluation of location policy, while considering the relative advantages of different sites, and the possible effects of dividing a firm’s organization, is liable to ignore the (possibly more important) impact of a move in stimulating a review of the firm’s policy and operating methods. [20]  Proposals for improving industrial efficiency concentrate on the size and degree of specialization of firms.  The efficiency of management, instead of being recognized as a major determinant of the firm’s performance, is treated as a function of the scale of its operations.  If all firms are assumed to be maximizing their profits, what else can one do - except perhaps to make some unhelpful remarks about managerial competence?  This is a concept which the traditional theory is unable to analyse, but which satisficing theory can approach in terms of the levels of performance which are accepted as satisfactory.

Thus, whatever its virtues as a major component of the theory of value, the theory of the firm as it exists at present is not only an inadequate basis for analysing the process of managerial decision-making; it is also an inadequate basis for the analysis of some major topics which economists still (rightly) regard as lying within their province.  It is outside the scope of this article to do more than suggest how the alternative assumptions of multiple objectives and standards of satisfaction can be used to develop an appropriate analytical apparatus for tackling these problems.  But since the problems are undeniably important, perhaps even the suggestion of a solution is enough to stimulate effort.

University of Bristol

20. This point is developed in my article, ‘Making Location Policy Work’, Lloyds Bank Review, January 1967, pp. 41-2.