A theory of markets with return-seeking firms

Neoclassical theory erroneously makes the assumption that firms maximise profits on a fixed endowment of physical capital leading to the pervasive rule of thumb that firms produce at a level of output where marginal revenues equal marginal costs. However this is merely a special case of the general goal of firms maximising returns on all costs. Firms adopting a return-seeking strategy make decisions that are consistent with fundamental assumptions of financial analysis and outperform profit maximising firms. Introducing time and a measure of incremental capital unit into the model overcomes many limitations with mainstream analysis, particularly in relation to capital investment decisions. This new framework provides a more general model with which to consider market interactions and allows for observable pricing mechanisms, such as mark-up pricing, downward sloping cost curves at the firm level, and ignorance of marginal costs by firm managers. It also reveals that the leap between the positive descriptive model and the normative welfare implications of markets outcomes cannot be bridged by the fundamental welfare theorems.