Profit Maximization and the Market Selection Hypothesis

Prajit K. Dutta · Roy Radner

113 citations0/0 files storedThe Review of Economic Studies

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Economic theories and models Capital Investment and Risk Analysis Firm Innovation and Growth

Abstract

We examine the proposition that competitive firms must behave as if they were maximizing profits; otherwise they would go bankrupt, or even fail to be financed in a competitive capital market. We investigate a model in which an entrepreneur raises funds for a risky enterprise on a competitive capital market, by offering a “dividend policy” based on the realized (stochastic) flow of earnings. We show that an entrepreneur who maximizes the expected sum of discounted dividends is sure to fail in finite time. On the other hand, many other behaviours yield positive expected profits and are able to attract investment funds, and yet result in a positive probability of surviving forever. As a consequence, if new firms have sufficiently diverse behaviours, then even if there is a constant stream of new entrants, after a long time practically all of the surviving firms will not have been maximizing profits.

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References

1983An Evolutionary Theory of Economic Change.1990Noise Trader Risk in Financial Markets 1950Uncertainty, Evolution, and Economic Theory 1980Controlled Diffusion Processes 1992Evolution and market behavior 1985Repeated Principal-Agent Games with Discounting 1996Risk vs. profit potential: A model for corporate strategy 1959Games of economic survival

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