Abstract
In this paper we consider the effect of epsilon maximization on firm behavior. In particular we focus on the dynamic behavior of firms with the use of the example of price‐setting: We show how almost-rational firms can be more volatile in their behavior. However, if a lexicographic preference for simplicity is made, then we can explain nominal price rigidity as a result of epsilon optimization. The behavior of the firm—which is consistent with its long‐term survival—is examined. We argue that epsilon-optimization is consistent with survival in any context in which something is optimized: such as sales revenue.
Highlights
The idea of bounded rationality became popular in the economics of the firm with the publication in Cyert and Marsh (1963) of the book A Behavioral Theory of the Firm by Richard M
Since profit maximization is required for survival, there is no discretion for managers; and bounded rationality is not possible in the long run
Whether we classify a particular enterprise as belonging to the Archer/farmer set or Akerlof‐Yellen inertia set will depend on how we describe and specify the activities in terms of our economic model
Summary
Perfect rationality has been the approach that has been adopted by most economics for over a century. The agent has a well‐defined objective function that enables the best solution to be identified from a given range of possibilities. The agent solves: Max U(x) subject to x ∈ S ⊂ Rn. The set S may itself be determined by some parameters (prices and income in the case of the budget set). In the case of the consumer, the budget set is determined by prices and income: Indirect utility identifies the maximum utility given prices and income. Firms that do not minimize costs and maximize profits will not survive against maximizers. Since profit maximization is required for survival, there is no discretion for managers; and bounded rationality is not possible in the long run (unless, perhaps, in the special case where it is universal across all firms)
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