I have referred to the fact that neoclassical models are internally contradictory. In doing so I have a particular criticism in mind: ceteris paribus is automatically violated by almost any change in a neoclassical partial equilibrium model, as changes generate ripple effects throughout the rest of the economy. One of the clearest examples of this is Williamson’s Managerial Utility model – a standard, run of the mill model of oligopolistic firms that most students will encounter. Let’s take a look:
Williamson’s model basically says that some firms do not maximise profit, but have a disconnect between management and ownership. Managers then seek to maximise their own utility rather than that of the owners or the firm. Williamson defines a utility function of a manager as a line where the balance between ‘staff expenditure’ and ‘discretionary profits’ is acceptable:
Manager 1 will be happy with any point on u1, manager 2 with any point on u2, etc.
We then have the relationship between staff expenditure and discretionary profits*:
Combining the two:
The point at which the two curves cross satisfies maximum utility and so determines the level of discretionary profit and staff expenditure.
Here’s the problem: you cannot change staff expenditure whilst holding all other things constant. Why? Because if you change the amount of staff you employ, you will change the wage share of the economy. This will alter the composition of demand for goods and services, generating Cantillion-esque effects and trickling through until it affects the firm in question. This creates a feedback loop, meaning the curves will be shifting constantly.
This is a massive problem with the equilibrium models that are widely used by economists. Arguments of this type do not only apply to theories of the firm – supply and demand and IS/LM are subject to similar criticisms. Whilst some of the qualitative aspects of mainstream economics are acceptable, these types of internally contradictory models have to be abandoned in favour of dynamic ones before it can move forward.
*If you are wondering why on earth these curves are shaped the way they are, you should know this is exactly how economics is taught. You are not told how the diagrams are derived, what purpose they serve, and theories are rarely filtered based on whether or not they are empirically verified. In fact, many models, including this one, are almost impossible to verify empirically.