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What is Firm Theory?

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  • Written By: K.M. Doyle
  • Edited By: W. Everett
  • Last Modified Date: 05 November 2016
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Firm theory, also called the theory of the firm, is an economic theory that attempts to identify why firms exist, why they are organized the way that they are, and why they behave in the way that they do. The theory of the firm was developed after World War I in response to industrialization and the changing nature of competition. A number of economic theories make up the theory of the firm.

Firms exist in order to maximize profits, according to firm theory. The goal of maximizing profits drives all decisions that a company makes. When a company determines prices, allocates resources, and hires employees, its underlying motivation is to maximize profits. For example, in a labor market, a company will hire workers for the long term in order to maximize profits by retaining workers. In a market of high unemployment, profits may be maximized by contracting with workers for the short term as demand dictates. According to this firm theory, the company is basing its hiring practices on the present economic conditions, and is selecting the method that allows it to maximize its profits in that particular market.

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The theory of the firm promotes organizational effectiveness, as this is what enables companies to maximize profits. In order to be effective, companies will aim to reduce transaction costs by negotiating contracts for multiple transactions, rather than operating in a free market system where each transaction is negotiated individually. The firm must measure transaction costs and determine how to spread them over multiple transactions in order to maximize profits. This reduces the transaction cost for each unit of product.

This firm theory is complemented by the theory of the consumer, which states that consumers will seek to maximize utility in the goods they consume. Taken together, economists assert that theory of the firm and the theory of the consumer should describe all behavior in the marketplace. These two theories have the effect of balancing each other, as the theory of the firm produces the most effective firm and the theory of consumer produces the most effective consumer.

As economies have shifted, so has firm theory. When firm theory originated, the United States economy was shifting from a number of small, cottage-based industries to national industrialization, with large companies employing thousands of workers. Today, the knowledge-based theory of the firm states that knowledge is the most significant resource of the firm. Those firms with advanced knowledge will be able to more effectively maximize profits.

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hamje32
Post 2

@David09 - I believe that some companies have been able to maintain a “made in America” first focus and still deliver good products at good prices.

It depends on the leadership of the firm. A theory of the growth of the firm should reveal how two competing companies, faced with the same set of circumstances, choose different paths and arrive at different results.

Personally, I believe that companies that continue to think like entrepreneurs, always adapting and always innovating, will be most successful.

David09
Post 1

I guess that firm theory would account for why companies, in an attempt to maximize profits, sometimes move work overseas where they can get cheaper labor and lower tax rates.

I think a theory of a firm in this sense is little more than a rehash of the idea of survival of the fittest, a kind of economic natural selection. People sometimes protest these kinds of things, but it is about profits in the end.

I certainly see nothing wrong with profit myself, but I wish that we would create an economic climate in the United States that would provide incentives to these firms to stay here, and create jobs here.

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