Theory of the Firm – Definition

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Theory of the Firm Definition

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.

A Little More on What is the Theory of the Firm

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 firm’s 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 company’s 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.

References for Theory of the Firm

Academic Research on Theory of the Firm

Agency problems and the theory of the firm, Fama, E. F. (1980). Agency problems and the theory of the firm. Journal of political economy, 88(2), 288-307. This paper attempts to explain how the separation of security ownership and control, typical of large corporations, can be an efficient form of economic organization. We first set aside the presumption that a corporation has owners in any meaningful sense. The entrepreneur is also laid to rest, at least for the purposes of the large modern corporation. The two functions usually attributed to the entrepreneur–management and risk bearing–are treated as naturally separate factors within the set of contracts called a firm. The firm is disciplined by competition from other firms, which forces the evolution of devides for efficiently monitoring the performance of the entire team and of its individual members. Individual participants in the firm, and in particular its managers, face both the discipline and opportunities provided by the markets for their services, both within and outside the firm.

Toward a knowledge‐based theory of the firm, Grant, R. M. (1996). Toward a knowledgebased theory of the firm. Strategic management journal, 17(S2), 109-122.

Towards a strategic theory of the firm, Rumelt, R. P. (1997). Towards a strategic theory of the firm. Resources, firms, and strategies: A reader in the resource-based perspective, 131-145.

Corporate social responsibility: A theory of the firm perspective, McWilliams, A., & Siegel, D. (2001). Corporate social responsibility: A theory of the firm perspective. Academy of management review, 26(1), 117-127. We outline a supply and demand model of corporate social responsibility (CSR). Based on this framework, we hypothesize that a firm’s level of CSR will depend on its size, level of diversification, research and development, advertising, government sales, consumer income, labor market conditions, and stage in the industry life cycle. From these hypotheses, we conclude that there is an “ideal” level of CSR, which managers can determine via cost-benefit analysis, and that there is a neutral relationship between CSR and financial performance.

Making knowledge the basis of a dynamic theory of the firm, Spender, J. C. (1996). Making knowledge the basis of a dynamic theory of the firm. Strategic management journal, 17(S2), 45-62. Knowledge is too problematic a concept to make the task of building a dynamic knowledge‐based theory of the firm easy. We must also distinguish the theory from the resource‐based and evolutionary views. The paper begins with a multitype epistemology which admits both the pre‐ and subconscious modes of human knowing and, reframing the concept of the cognizing individual, the collective knowledge of social groups. While both Nelson and Winter, and Nonaka and Takeuchi, successfully sketch theories of the dynamic interactions of these types of organizational knowledge, neither indicates how they are to be contained. Callon and Latour suggest knowledge itself is dynamic and contained within actor networks, so moving us from knowledge as a resource toward knowledge as a process. To simplify this approach, we revisit sociotechnical systems theory, adopt three heuristics from the social constructionist literature, and make a distinction between the systemic and component attributes of the actor network. The result is a very different mode of theorizing, less an objective statement about the nature of firms ‘out there’ than a tool to help managers discover their place in the firm as a dynamic knowledge‐based activity system.

Knowledge of the firm and the evolutionary theory of the multinational corporation, Kogut, B., & Zander, U. (1993). Knowledge of the firm and the evolutionary theory of the multinational corporation. Journal of international business studies, 24(4), 625-645. Firms are social communities that specialize in the creation and internal transfer of knowledge. The multinational corporation arises not out of the failure of markets for the buying and selling of knowledge, but out of its superior efficiency as an organizational vehicle by which to transfer this knowledge across borders. We test the claim that firms specialize in the internal transfer of tacit knowledge by empirically examining the decision to transfer the capability to manufacture new products to wholly owned subsidiaries or to other parties. The empirical results show that the less codifiable and the harder to teach is the technology, the more likely the transfer will be to wholly owned operations. This result implies that the choice of transfer mode is determined by the efficiency of the multinational corporation in transferring knowledge relative to other firms, not relative to an abstract market transaction. The notion of the firm as specializing in the transfer and recombination of knowledge is the foundation to an evolutionary theory of the multinational corporation.

The structure of ownership and the theory of the firm, Demsetz, H. (1983). The structure of ownership and the theory of the firm. The Journal of law and economics, 26(2), 375-390. Provides a model that explains forms of business organizations in terms of ownership structure, on-the-job consumption preferences, and monitoring costs. The thesis of Berle and Means that the separation of ownership and control, or specialized ownership, which characterizes the modern corporation impairs the ability of the profit motive to encourage the most efficient use of resources is critiqued. The idealized owner-managed firm in economic theory operates as a profit-maximizing entity; nevertheless, this idealization rarely holds true for firms generally, even owner-managed ones. Real world businesses often permit on-the-job consumption by managers and employees. In competitive markets, this permitted consumption is traded for reduced monetary compensation. Because on-the-job consumption will take place only when off-the-job consumption would cost more, on-the-job consumption may not represent the dissipation of resources that critics of specialized ownership have contended. The problem of shirking is then taken up and it is shown that specialized ownership puts pressure on non-owner managers to reduce on-the-job consumption to levels even lower than in owner-managed firms. Value-maximizing ownership structure depends on ease of monitoring, desired scale of operations, and the managerial abilities of the potential firm owners. Finally, empirical data is presented against the alleged vacuum in control by owners and it is shown that due to management shareholdings, stock-based managerial income, and sizeable minority shareholdings in modern corporations, a strong linkage continues to exist between management and owner interests. (CAR)

A resource-based theory of the firm: Knowledge versus opportunism, Conner, K. R., & Prahalad, C. K. (1996). A resource-based theory of the firm: Knowledge versus opportunism. Organization science, 7(5), 477-501. This paper develops a resource-based—knowledge-based—theory of the firm. Its thesis is that the organizational mode through which individuals cooperate affects the knowledge they apply to business activity. We focus on the polar cases of organization within a firm as compared to market contracting. There will be a difference in the knowledge that is brought to bear, and hence in joint productivity, under the two options. Thus, as compared to opportunism-based, transaction-cost theory, we advance a separate (yet complementary) answer to the question: why do firms exist? Our aim is to develop an empirically relevant and complementary theory of why firms are formed: a theory based on irreducible knowledge differences between individuals rather than the threat of purposeful cheating or withholding of information. We assume limited cognitive abilities on the part of individuals (bounded rationality), and assume that opportunistic behavior will not occur. The latter allows us to determine whether resource-based theory has independent force, as compared to the opportunism-based, transaction-cost approach. The paper predicts choice of organizational mode, identifying whether firm organization or market contracting will result in the more valuable knowledge being applied to business activity. The resource-based predictions of organizational mode are compared and contrasted with corresponding opportunism-based, transaction-cost ones. A principal point is that knowledge-based considerations can outweigh opportunism-related ones. The paper also establishes the relation of a theory of the firm to a theory of performance differences between competing firms.

The theory of the firm, Holmstrom, B. R., & Tirole, J. (1989). The theory of the firm. Handbook of industrial organization, 1, 61-133.

Knowledge, strategy, and the theory of the firm, Liebeskind, J. P. (1996). Knowledge, strategy, and the theory of the firm. Strategic management journal, 17(S2), 93-107. This paper argues that firms have particular institutional capabilities that allow them to protect knowledge from expropriation and imitation more effectively than market contracting. I argue that it is these generalized institutional capabilities that allow firms to generate and protect the unique resources and capabilities that are central to the strategic theory of the firm.

The Theory of the Firm and the Structure of the Franchise Contract, Rubin, P. H. (1978). The Theory of the Firm and the Structure of the Franchise Contract. The Journal of law and economics, 21(1), 223-233. Uses the tools of Coase’s (1937) theory of the firm, and an analysis of property rights, incentives and monitoring, to assess the nature of the franchise contract. Franchising is of interest to economists because it represents a situation in which there is not a sharp distinction between interfirm and intrafirm transactions. The institutional structure of the franchise is discussed, and a franchise agreement is defined as a contract between two legal firms–the franchisor, or parent company, and the franchisee, a firm set up in a specific location to market the product or service offered by the parent company. The franchisee pays a specific amount of money for the right to market this product or service. The standard explanation of franchising, in terms of capital markets, is then considered and rejected. The theory debated is that franchisors use franchising as a means to raise capital. However, by considering this argument in light of modern capital theory, it is concluded that the franchisor interested in raising capital would do better to create a portfolio of shares in many franchise outlets in order to diversify risks and maximize profit potential. An alternative explanation of franchisee motivations is given which suggests that both parts of the contract give property rights to the parties, i.e., the franchisor and the franchisee, for areas they can most efficiently control. Finally, the application of antitrust law to franchising is found to be false, since it confuses legal categories with economically meaningful ones. (SFL)

The theory of the firm revisited, Demsetz, H. (1988). The theory of the firm revisited. Journal of Law, Economics, & Organization, 4(1), 141-161.

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