Profit Maximization and the Market Selection Hypothesis

Profit Maximization and the Market Selection Hypothesis 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. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Review of Economic Studies Oxford University Press

Profit Maximization and the Market Selection Hypothesis

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Publisher
Oxford University Press
Copyright
© Published by Oxford University Press.
Subject
Articles
ISSN
0034-6527
eISSN
1467-937X
D.O.I.
10.1111/1467-937X.00108
Publisher site
See Article on Publisher Site

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.

Journal

The Review of Economic StudiesOxford University Press

Published: Oct 1, 1999

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