Myopic Optimizing and Rules of Thumb in a Micro-Model of Industrial Growth
It has been argued by William Baumol and Richard Quandt (1964) and Day (1967) that rules of thumb can be efficient economic strategies when decision making is costly and when decision makers have imperfect information. The present paper augments this literature and analyzes an industrial growth model in which firms determine production and investment levels by solving a single period optimizing problem. The solution is carried out period after period rather than by making a complete lifetime plan involving forecasts of the future. We portray the firm as myopically groping toward an unknown equilibrium through successive one-period movements made by a simple linear programming allocation of the firm's cash budget.' Cash availability is the channel through which market feedback, operating through the demand function, modifies behavior. Our model can be thought of as a dynamic, rule of thumb, approximation to an intertemporally optimal investment and production path for the firm and industry. It is shown that, under certain conditions of demand and cost, an industry whose firms use our myopic investment rules will converge asymptotically to a perpetually maintainable capital stock. This solution is the long-run equilibrium of the perfectly competitive industry in which price just covers total costs of the marginal firm. In other words, a shortsighted optimization based on complete ignorance of demand can lead to equilibrium in the sense of theories based on perfect knowledge and polyperiodic time horizons. This is only one of several possible outcomes, however, for under somewhat different market conditions fluctuations in investment and production levels will eventually occur, perhaps after a protracted period of growth. The model can also generate S-shaped industry growth paths, simultaneous saving and investment, and investment at less than the maximum possible rate (excess borrowing capacity). All of these are commonly observed patterns of industry behavior. The possibility of industrial instability suggests the need for a risk-avoiding rule at the firm level. The rule introduced is the safety-first principle (see Andrew Roy, Day, Dennis Aigner and Smith), a device that is easily seen to reduce the likelihood of unstable oscillations about industrial equilibrium.
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