A Behavioral Theory of the Firm

Richard Michael Cyert, James G. March

• Publisher: Barakaldo Books
• Year: 2020
• eBook ISBN: 9781839744228
• Topic: Economics
• Subtopic: Investments & Securities
• Index: Economics

The behavioral theory of the firm first appeared in the 1963 book A Behavioral Theory of the Firm by Richard M. Cyert and James G. March. The work on the behavioral theory started in 1952 when March, a political scientist, joined Carnegie Mellon University, where Cyert was an economist.
Before this model was formed, the existing theory of the firm had two main assumptions: profit maximization and perfect knowledge. Cyert and March questioned these two critical assumptions.—Print ed.

 

A BEHAVIORAL THEORY OF THE FIRM

 

1 — INTRODUCTION

This book is about the business firm and the way it makes economic decisions. We propose to make detailed observations of the procedures by which firms make decisions and to use these observations as a basis for a theory of decision making within business organizations. Our articles of faith are simple. We believe that, in order to understand contemporary economic decision making, we need to supplement the study of market factors with an examination of the internal operation of the firm—to study the effects of organizational structure and conventional practice on the development of goals, the formation of expectations, and the execution of choices.

The rationale for such a belief is also simple. The modern “representative firm” is a large, complex organization. Its major functions are performed by different divisions more or less coordinated by a set of control procedures. It ordinarily produces many products, buys and sells in many different markets. Within the firm, information is generated and processed, decisions are made, results are evaluated, and procedures are changed. The external environment of the firm consists, in part, of other firms with comparable characteristics. If the market completely determined the firm’s economic behavior, these internal attributes would be little more than irrelevant artifacts. But the market is neither so pervasive nor so straightforward. The modern firm has some control over the market; it has discretion within the market; it sees the market through an organizational filter.

The elaboration of these articles of faith into a theory of the firm involved four major research commitments. They are commitments that evolved during the course of the research, but they constitute a general retrospective characterization of our research strategy:

1. Focus on a small number of key economic decisions made by the firm. In the first instance, these were price and output decisions; subsequently they included internal allocation and market strategy decisions.

2. Develop process-oriented models of the firm. That is, we viewed decisions of the firm as the result of a well-defined sequence of behaviors in that firm; we wished to study the decisions by studying the process.

3. Link models of the firm as closely as possible to empirical observations of both the decision output and the process structure of actual business organizations. The models were to be both explicitly based on observations of firms and subject to empirical test against the actual behavior of identifiable firms.

4. Develop a theory with generality beyond the specific firms studied. We wanted a set of summary concepts and relations that could be used to understand the behavior of a variety of organizations in a variety of decision situations.

Each of these commitments was critical to the research; each in some way characterizes the theory that resulted.

The focus on a specific set of economic decisions (i.e., price and output) was intended to constrain the tendency of theories of decision making to become excessively general. Quite simply, we wanted models that could predict actual decisions (if provided with necessary data), not simply models that could predict some qualitative properties of those decisions. Obviously, we wanted both kinds of predictions if we could manage them, but by restricting our focus we hoped to strengthen the specificity of the models.

The emphasis on studying actual decision processes implies a description of the firm’s decision in terms of a specific series of steps used to reach that decision. The process is specified by drawing a flow diagram and executing a computer program that simulates the process in some detail. We wanted to study the actual making of decisions and reproduce the behavior as fully as possible within the confines of theoretical manageability.

The insistence on empirical content follows naturally from the emphasis on identifying the actual process of decision. It is hard to imagine constructing a process model without detailed observation of the ways in which business organizations make decisions. Thus, the empirical commitment has forced us to reconsider the traditional truculence of the firm with respect to outside investigation. We were constrained to secure research access to a number of firms under conditions that protected the competitive position of the firm without interfering with the disclosure needs of a research study.

Finally, the commitment to theoretical generality was intended to complement the insistence on specificity in models with a similar insistence on generality of concepts and broad structure. We did not want the theory to be limited to descriptive models of specific firms making specific decisions. We required a set of explanatory concepts that would serve as a framework for analysis and further research.

The results of our efforts to develop an empirically relevant, process-oriented, general theory of economic decision making by a business firm are summarized in this book. We hope they suggest both the utility and some of the problems of theoretical research on decision making in the firm. More generally, we hope they support the case for the legitimacy and importance of the business firm as a unit for detailed empirical study and theoretical analysis. More specifically, we hope that the rudiments of a behavioral theory of the firm presented in the following chapters will prove relevant both to economic theory and to the theory of complex organizations.

2 — ANTECEDENTS OF THE BEHAVIORAL THEORY OF THE FIRM{1}

In a modern market society, economic decisions on price, output, product lines, product mix, resource allocation, and other standard economic variables are made not by individual entrepreneurs but by a complex of private and public institutions. Many of these decisions are made within the large, multifunctional, and complicated organizations called firms. These are simple facts. They may not be facts with which economic theory should concern itself, but the disparity between the process by which business decisions appear to be made by complex organizations in the real world and the way in which they are explained by economic theory has provided material for several decades of debate{2}In this chapter, we propose to discuss the theory of the firm, the debates over it, and the relevance of existing theories of organizations to a revised theory of the firm. With such a discussion, we hope to articulate both our view of the limitations of existing theories and our motives for developing the behavioral theory of the firm outlined in this volume.

2.1 The Theory of the Firm

Any brief presentation of a body of theory is likely to suffer from the distortion dictated by condensation. This problem is severe when the theory has been a focus for controversy and the writers making the condensation are parties to the controversy. We are in such a position in describing the theory of the firm. Nevertheless, without completely concealing our prejudices, we describe in this section the current consensus on the theory of the firm, the challenges to that theory, and the rejoinders of the defenders of orthodoxy.

2.1.1 Current consensus on the theory of the firm

It will become clear below that there is disagreement about the theory of the firm in three respects. There is disagreement about (1) what the theory is, (2) the extent to which the theory is defective, and (3) appropriate methods for improving the theory.

The first of these disagreements makes it difficult to describe any current consensus on the theory of the firm. We are sympathetic with the view that, in fact, there is no consensus. At the same time, a case can be made for moderate agreement. We believe a fair number of economists would agree, except for questions of detail, on the general characterization of the theory of the firm given in this section.{3}

Assuming that the firm is operating within a perfectly competitive market, the generally received theory asserts that the objective of the firm is to maximize net revenue in the face of given prices and a technologically determined production function. Net revenue (profits, or expected profits) is the difference between receipts and the sum of fixed and variable costs. The production function is a relation between factors of production and their corresponding outputs determined by physical conditions within the firm. Maximization of profit is accomplished by determining the optimal mix of outputs (products) and inputs (factors), i.e., the equilibrium position.

Existing theory of the firm treats two main areas—the conditions for maximum net revenue, and the analysis of shifts in equilibrium positions. The usual method for obtaining a solution is first to derive the conditions for minimum cost at any fixed output and subsequently to determine the optimal level of output. This analysis, however, is usually limited to the single product firm. A somewhat more general treatment is gained from the Hicks-Allen analysis of the multiproduct firm.

Using the methods of differential calculus, the Lagrangean multiplier, and the theory of quadratic forms, the propositions listed below are generally derived. The first two are given by a direct consideration of the sufficient conditions for an equilibrium.

1. n equations may be derived and solved for the optimal quantities of the firm’s n commodities (both inputs and outputs).

2. At equilibrium, the marginal rate of substitution between two products, or between two factors, is equal to the ratio of their prices.

If we turn to variations near the equilibrium, the necessary conditions yield further re...

Table of contents

• Title page
• ACKNOWLEDGMENTS
• 1 - INTRODUCTION
• 2 - ANTECEDENTS OF THE BEHAVIORAL THEORY OF THE FIRM
• 3 - ORGANIZATIONAL GOALS
• 4 - ORGANIZATIONAL EXPECTATIONS
• 5 - ORGANIZATIONAL CHOICE
• 6 - A SUMMARY OF BASIC CONCEPTS IN THE BEHAVIORAL THEORY OF THE FIRM
• 7 - A SPECIFIC PRICE AND OUTPUT MODEL
• 8 - A GENERAL MODEL OF PRICE AND OUTPUT DETERMINATION
• 9 - A MODEL OF RATIONAL MANAGERIAL BEHAVIOR
• 10 - A MODEL OF TRUST INVESTMENT BEHAVIOR
• 11 - SOME IMPLICATIONS
• A - ASSUMPTION, PREDICTION, AND EXPLANATION IN ECONOMICS
• B - COMPUTER MODELS IN DYNAMIC ECONOMICS