Even if we pretend that market demand curve is sound which it isn’t then supply curve and theory of the firm isn’t sound. Core message – Market supply curve as invalid as demand curve. Starting point – How realistic is neoclassical? And Does realism matter?
In 1953 Friedman argued that realism of neoclassical model doesn’t matter. Even if firms don’t consciously set MC=MR wouldn’t be profitable firms unless they did so unconsciously. The as of defence.
Friedman’s famous Can’t criticize theory for unrealistic assumptions – Methodology paper. Directed at criticisms of theory of firm because Businessmen don’t equate MC to MR. Friedman’s defence included billard player analogy: Excellent predictions would be yielded by the hypothesis that the billiard player made his shots as if he knew the complicated mathematical formulas that would give the optimum directions. Our confidence in this hypothesis is not based on the belief that billiard palyers can or do go through the process described. It derives rather from the belief that unless they were capable of reaching essentially the same result they would not in fact be expert billiard players. (p. 21).
It is only a short step from these examples to the economic hypothesis that under a wide range of circumstances individual firms behave as if they knew the relevant cost and demand functions. Calculated marginal cost and marginal revenue from all actions open to them and pushed each line of action to the point at which the relevant marginal cost and marginal revenue were equal. So Friedman’s argument is even though firms don’t consciously set MC = MR unless what they did had the same effect, they wouldn’t maximize profits.
Computer simulation lets us test this: Set up textbook market demand curve – Artificial firms that are instrumentally rational profit-maximiser. Choose output level at random, Choose amount to vary output, Vary output – If profit rises keep going in same direction, if profit falls reverse direction. See what happens: DO instrumentally rational profit-maximisers behave as neoclassical economics predicts?
Textbook demand and supply curves. Parameter values that give realistic (big) quantities. Theory predictions are: Can test this with computer program; Artificial industry with demand and supply functions as above; Start with 1 firm, find what it does; then 2 firms .. then 100 firms.
Program starts with 1 firm; Randomly chose output level – Randomly chose amount to vary output. Iterates change in output for 1000 cycles. Finds where output converges to. Does the same for 2 firms, then 3 out to 100 firms. Neoclassical theory predicts. With comparable costs the more firms in an industry the higher the output and the lower the price. In particular monopoly less price higher than competitive industry (say 100 firms). And the winner is – Not the textbooks. So maybe firms aren’t profit-maximisers?
In practice Friedman’s billiards players do not behave as he expected – Don’t equate MC and MR; Make higher profits than theory predicts as a result; No difference between competitive firms and monopoly.
Doesn’t involve collusion either.
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