There are some readily identifiable building blocks and analytic tools employed in virtually all models within contemporary orthodox theory of the behavior of firms and industries.3 These same struc-tures are visible in models spanning a very diverse set of specific inquiries. While our discussion of the orthodox art form will be quite general, it might be useful for the reader to keep in mind the central and best-known example of orthodox modeling of firm and industry behavior: the standard textbook model of the determination of firm and industry inputs and outputs, and prices.
In orthodox theory, firms are viewed as operating according to a set of decision rules that determine what they do as a functi on of ex ternal (market) and internal (such as available capital stock) condi tions. The theory con tains a sharp answer to the question “Why are the rules the way they are?/I-an answer that also yields predictions about the scope or characteristics of the rules. The rules reflect maxi mizing behavior on the part of firms. This is one structural pillar of orthodox models.
A maximization model of firm behavior usually contains three separable components . First, there is a specification of what it is the firms in the industry are seeking to maximize-usually profit or present value, but in some cases the objective is something different or more complex. Second, there is a specification of a set of things that the firms know how to do. Where the focus is on production in a traditional sense, these things might be specified as activities or techniques, assumptions made about the characteristics of activities and their mixability and about the properties of the “production set” thus determined. But in models concerned with other questions, the set of things a firm knows how to do might comprise advertising pol icies or financial asset portfolios. The third component of a maxi mizing model is the presumption that a firm’s action can be viewed as the result of choice of the action that maximizes the degree to which its obj ective is achieved, given its set of known alternative ac tions, market constraints, and perhaps other internal constraints (like the available quantities of factors that are fixed in the short run) . In some models, the representation of maximizing behavior takes into account information imperfections, costs, and constraints.
The maximization approach permits the deduction of a decision rule or set of rules employed by a firm-a rule or rules that specify a firm’s actions as a function of market conditions, given its capabili ties and objectives. It attempts a theoretical explanation of firm deci sion rules in the sense that it traces their origin and accounts for their characteristics by reference to these underlying considerations, together with the maximization procedure. The decision rules them selves are the operational part of the theory. In some cases a maximi zation model generates predictions about the form of the decision rules. For example, if the production set is strictly convex and firms treat prices as parameters, the “output supply rule” relating produc-tion to product price is continuous and a price increase never decreases the output supplied. More generally, the maximization hy pothesis leads analysts to try to figure out why a firm is doing some thing, or what it would do differently under different conditions, on the basis of an assessment of its objectives and its choice set.
The other major structural pillar of orthodox models is the concept of equilibrium. This is an extremely powerful and flexible concept; a full equilibrium in an orthodox model may be an equilib rium in two or three distinguishable senses relating to a number of different com ponents or variables within the model’s overall structure. The role and result of all these equilibrium conditions is to generate within the logic of the model conclusions about economic behavior itself-as distinguished from the conclusions about the rules of behavior that are generated by the maximization analysis. In the most basic example, the supply and demand curves in a market are simply aggregations of behavioral rules of individual sellers and buyers, which for each actor describe the transaction quantity that would be most desirable at each possible value of the market price .. The actual value of the price-and hence the actual behavior of the actors-is determined by the supply-demand equilibrium condi tion, which picks out the specific price for which the aggregate de sired purchase quantity precisely equals the aggregate quantity sell ers wish to sell. Although the details may be different and much more complex, the spirit of equilibrium analysis in economics is al most always the same as in this basic example: to impose an equilib rium condition is to add an equation to the mathematical system characterizing the model and thus to provide for the determination, within the model, of the value of another variable.
Formal models embodying the central orthodox concepts of maxi mization and equilibrium have been built with a variety of mathe-matical tools. Indeed, the range and rate of change of the set of math ematical devices employed to explore an essentially constant set of theoretical concepts is such as to make one suspect that the key mechanisms in the process involve th e levels of mathematical so phistication attained by researchers and their audiences, and not any deep affinities between the mathematical tools and the subject matter. Calculus techniques are, however, increasingly central in the intermediate and advanced pedagogy of the subject, and they have long been an important research tool. They do seem to provide a nat ural and efficient way of expressing some of the key ideas of ortho doxy, particularly those relating to maximizing behavior. Given some ancillary assumptions about the shape and smoothness of the frontiers of the choice set and other constraints, maximizing choices can be deduced by setting the appropri ate derivatives equal to zero.
Lagrangian multipliers associated with the constraints have a natural connection to theoretical understanding of pricing. Eq uilibrium of the set of firms in question implies that the equations characterizing their maximizing behavior must be simultaneously satisfied. These mathematical ideas seem to fit the subject matter extremely well; undoubtedly, that is at least partly because they have significantly influenced the development of thinking about the subject matter.
Source: Nelson Richard R., Winter Sidney G. (1985), An Evolutionary Theory of Economic Change, Belknap Press: An Imprint of Harvard University Press.