What is the Theory of the Firm?

The theory of the firm refers to the microeconomic approach devised in neoclassical economics that every firm operates in order to make profits. Companies ascertain the price and demand of the product in the market, and make optimum allocation of resources for increasing their net profits.

How does the Theory of the Firm Work?

According to the theory of the firm, every business organization is driven by the motive of maximizing profits. This theory influences decisions for allocating resources, methods of production, adjustments in prices, and manufacturing in huge quantum. Both the theory of the firm and the theory of the consumer go hand in hand. As per the theory of the consumer, the customer tends to enhance their total utility to the fullest. In economic terms, utility refers to the estimated value a customer uses for measuring the level of happiness or satisfaction derived from the consumption of a specific product or service. For instance, if a customer buys a product worth $5, he or she expects to receive utility of at least the same amount, that is $5 in this case, from the bought product.

Expansion on the theory of the firm

According to the contemporary approach, there is a difference in the short-run motivation and long-term motivation for a company. While long-run motivation involves growth and sustenance of a firm, short-run motivation involves objectives like maximizing profits. Economists still analyze and make editions to this theory so as to make it adaptable to the changing economic and market environment. Earlier, economists emphasized on wider sectors. But with the advancements made in the 19th century, economists have started analyzing and observing at the base level in order to find answers to questions like what organizations do, why they are in a specific business, and what is the motivation for their decisions regarding capital and labor force allocation.

Risks associated with the theory of the firms profit maximization goal

There are a few beliefs such as having less stake in company that are associated with the theory of the firm. Some believe the chief executive officers of public companies not only focus on profit maximization, but also emphasize on increasing sales, maintaining public relations, and having a good market share. If their goal is profit maximization alone, public will be susceptible about their intentions, and the companys reputation or goodwill in the market will be highly affected. In case, a company follows a single strategy for running its operations, there can be many risks associated with it. In case, a business depends on just one product for building its revenues, and that very product eventually fails to make adequate sales in the market, the whole financial structure of the business will be affected, or at least one department of the company. For instance, there was a gaming console manufacturing company named Sega that gained popularity with its Sega Genesis console. Seeing its success, it also launched Dreamcast in Japan in the year 1998, and in the USA in the subsequent year where it was able to make revenues of $100 million on the first day. But, the problem started when the Dreamcast was not able to beat its competitor PlayStation 2 when it was about playing DVDs. This ultimately resulted in the gradual failure of the Dreamcast in the international market. Customers were not ready to buy the product in spite of lowering the prices, and hence, the gaming console department of Sega got shut down.

Relate Topics

• Theory of the Firm
• Capital Formation
• Rent Seeking
• Structure Conduct Performance Model
• Integration
• Co-Insurance Effect
• Conglomerates
• Cost vs Profit Center
• Accelerator Theory
• Market Structure
• Fixed Cost vs Variable Cost
• Actual vs Implicit Costs
• Explicit Costs
• True Cost Economics
• Accounting Profit
• Economic Profit
• What are Factors of Production?
• Factor Income
• Production Function
• Fixed and Variable Inputs
• Short-Run and Long-Run Production
• Short Run
• Total Product
• Marginal Product
• Value of Marginal Product
• Law of Marginal Diminishing Product
• Production Function
• Production Possibilities Frontier
• Capital 
• Labor Theory of Value
• How the Production Function Estimates Inputs
• Factor Payment
• Economic Rent
• Cost Function
• Incremental Cost
• Marginal Input Cost  
• Fixed and Variable Costs
• Diminishing Marginal Productivity
• Costs Relate to Diminishing Marginal Productivity
• Law of Diminishing Marginal Returns
• Average Total Cost
• Average Variable Cost
• Marginal Cost
• Average Profit or Profit Margin
• Accounting Profit
• Economic Profit
• Normal Profit
• Short and Long-Run Production
• Cost Curves
• Long-Run Average Cost (LRAC)
• Production Technologies
• Economies of Scope
• Economies of Scale
• Diseconomies of Scale
• Minimum Efficient Scale
• Increasing, Constant, and Decreasing Returns to Scale
• Shape of the Average Long-Run and Short-Run Cost Curves
• Returns to Scale
• Diseconomies of Scale
• Long-Run Average Cost Curve Affect Industry Competitors
• Technology Shifts the Long-Run Average Cost Curve
• Law of Diminishing Marginal Returns