Theories of the Firm

Theories of the Firm


Despite the importance of profit-making firms in our market economies, and the vast amount of published research about them, the majority of textbooks in economics for students in undergraduate and graduate courses continue to rely on one theory to describe the firm, namely the neoclassical theory of the firm. However, although the theory has delivered classic theoretical principles and has extensively been utilised in policy, especially pricing and regulation, it does not answer some key questions addressed by other theories of the firm.

The objective of this book is to describe essential microeconomics for profit-making business firms. Specifically, after descriptions of the firm's external business environment and some decision-making models, an effort is made to re-discuss certain parts of the Neoclassical Theory of the Firm and additionally describe the Transactions Cost Theory of the Firm, the Principal-Agent Theory of the Firm, and the Evolutionary Theory of the Firm.

The 3rd edition has been enriched with the following topics: insourcing and urbanisation in developing economies (Chapter 1), a more detailed description of decisions based on cost/benefit analysis (Chapter 2), intra-industry trade theory

(Chapter 3), empirics in association with the capital asset pricing model (Chapter 6), mechanism design along with microfinancing and a theory of the banking firm
(Chapter 8). As with the previous edition, the book's intended audiences are upper level undergraduate students in economics, first year graduate students in economics and business, law school students as well as entrepreneurs and business executives. The book may be used as a textbook in Theories of the Firm courses or seminars and as a supplemental reading in intermediate or first year graduate courses in ‘Industrial Organisation', ‘Microeconomics', ‘Managerial Economics' or ‘Economics for Managers', ‘Contracts', ‘Torts', ‘Corporations', ‘Deals', ‘Venture Capital' and other courses.


A business firm is a needs-satisfying machine; it is an entity invented and employed by society to better satisfy the society's interests. A society is better off when properly regulated business firms are allowed to carry the bulk of economic activity than when they are not allowed to exist or are severely regulated by the state. And, as history has documented, societies fare better when they are dependent on such business firms than when they are dependent on central planning.

The business firm generates consumer satisfaction in return for income that gets distributed to its owners, employees, suppliers and public goods recipients. Any firm of any size is in existence because:

* it identifies a consumer need and develops/invents a recipe on how to satisfy that need

* it makes the right decisions with respect to making or buying inputs so that it delivers its recipe at the lowest possible cost

* it provides the best incentives to its stakeholders and because

* it constantly and deliberately evolves through the relentless pursuit of competitive, organisation and strategic advantage.

This book describes four theories about the firm that have emerged since Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations. These theories are:

The Neoclassical Theory, The Transactions Cost Theory, The Principal-Agent Theory, and The Evolutionary Theory.

The Neoclassical Theory of the Firm, in its basic form, views the firm as a black box rational entity. The theory is built on imaginary but plausible production and demand functions and it establishes the principal of profit maximisation according to which profit is maximised when marginal revenue is equal to marginal cost. The theory may be used to, among many other things, describe various market structures, regulation issues, strategic pricing, barriers to entry, economies of scale and scope and even optimum portfolio selection of risky assets. The main weakness of the theory is that it assumes complete information and, as a result, there is no agency problem or concern for transaction costs due to conflict between owners and suppliers of inputs (even specific to whatever the firm produces) in the market system. Another weakness of the theory is that it does not allow for firm evolution.

The Transactions Cost Theory of the Firm focuses on problems of asymmetric information involved in transactions. The firm, according to this theory, comes into existence because it successfully minimises ‘make' inputs costs (through vertical integration) and ‘buy' inputs costs (using available markets). The more specific the inputs that the firm needs are, the more likely it is that it would produce them internally and/or acquires them through joint ventures and alliances. The weakness of this theory is that it does not take into consideration agency costs or firm evolution neither it explains how vertical integration should take place in the face of investments in human assets, with unobservable value, that cannot be transferred.

The Principal-Agent Theory of the Firm extends the neoclassical theory by adding agents to the firm. The theory is concerned with friction due to asymmetric information between owners of firms and their stakeholders or managers and employees; the friction between agent and principal, requires precise measurement of agent performance and the engineering of incentive mechanisms. The weaknesses of the theory are many: it is difficult to engineer incentive mechanisms, it relies on complicated incomplete contracts (borderline unenforceable), it ignores transaction costs (both external and internal), and it does not allow for firm evolution.

The Evolutionary Theory of the Firm places emphasis on production capabilities and process as well as product innovation. The firm according to this theory possesses unique resources, tied semi-permanently to the firm, and capabilities; the firm's recourses can be classified into four categories: financial, physical, human and organisational. The theory sees the firm as a reactor to change and a creator of change for competitive advantage. The firm, as a creator of change, may cause creative destruction, which in turn may give birth to new industries and enable sectors of, or entire, economies to grow. Although many countries have established architectures to support entrepreneurial endeavours, a weakness of the theory remains: process and product innovation (especially the latter) are mostly due to serendipity and as a result ‘entrepreneurship' is a very expensive factor of production; in the pursuit of profit and general well-being, it cannot be easily programmed within a firm or a nation.

The book consists of nine chapters followed by an epilogue:

* Chapters 1 and 2 describe the external environment of the firm and the firm's decision-making process with emphasis on strengths and weaknesses of the following models: rational, satisficing, probabilistic (inclusive of Bayesian), cost/benefit and behavioural.

* Chapters 3-6 are devoted to the Neoclassical Theory of the Firm and some of its applications ranging from market structures to managing a portfolio of risky assets and from free pricing to regulation.

* Chapter 7 describes the Transactions Cost Theory of the Firm and its variants as well as hybrids (structures between the extremes of markets and hierarchies).

* Chapter 8 focuses on the Principal-Agent Theory of the Firm, the central problem of which is how to induce the agent to act in the best interests of the principal when the agent has an informational advantage over, and different interests from, the principal.

* Chapter 9 deals with the Evolutionary Theory of the Firm built around the concepts of creative destruction, competitive advantage, entrepreneurial styles and habitat, strategy and firm structure as well as entrepreneurial architecture.

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