Friday, January 6, 2023


  Eli-express       Friday, January 6, 2023

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.

 Reconsiderations of transaction cost theory

According to Louis Putterman, most economists accept distinction between intra-firm and interfirm transaction but also that the two shade into each other; the extent of a firm is not simply defined by its capital stock. George Barclay Richardson for example, notes that a rigid distinction fails because of the existence of intermediate forms between firm and market such as inter-firm co-operation.

Klein (1983) asserts that “Economists now recognise that such a sharp distinction does not exist and that it is useful to consider also transactions occurring within the firm as representing market (contractual) relationships.” The costs involved in such transactions that are within a firm or even between the firms are the transaction costs.

Ultimately, whether the firm constitutes a domain of bureaucratic direction that is shielded from market forces or simply “a legal fiction”, “a nexus for a set of contracting relationships among individuals” (as Jensen and Meckling put it) is “a function of the completeness of markets and the ability of market forces to penetrate intra-firm relationships”. 

Managerial and behavioural theories

It was only in the 1960s that the neo-classical theory of the firm was seriously challenged by alternatives such as managerial and behavioral theories. Managerial theories of the firm, as developed by William Baumol (1959 and 1962), Robin Marris (1964) and Oliver E. Williamson (1966), suggest that managers would seek to maximise their own utility and consider the implications of this for firm behavior in contrast to the profit-maximising case. (Baumol suggested that managers’ interests are best served by maximising sales after achieving a minimum level of profit which satisfies shareholders.) More recently this has developed into ‘principal–agent’ analysis (e.g., Spence and Zeckhauser and Ross (1973)on problems of contracting with asymmetric information) which models a widely applicable case where a principal (a shareholder or firm for example) cannot costlessly infer how an agent (a manager or supplier, say) is behaving. This may arise either because the agent has greater expertise or knowledge than the principal, or because the principal cannot directly observe the agent's actions; it is asymmetric information that leads to a problem of moral hazard. This means that to an extent managers can pursue their own interests. Traditional managerial models typically assume that managers, instead of maximising profit, maximise a simple objective utility function (this may include salary, perks, security, power, prestige) subject to an arbitrarily given profit constraint (profit satisficing).

Behavioural approach

The behavioural approach, as developed in particular by Richard Cyert and James G. March of the Carnegie School places emphasis on explaining how decisions are taken within the firm, and goes well beyond neoclassical economics. Much of this depended on Herbert A. Simon’s work in the 1950s concerning behaviour in situations of uncertainty, which argued that “people possess limited cognitive ability and so can exercise only ‘bounded rationality’ when making decisions in complex, uncertain situations”. Thus individuals and groups tend to "satisfice"—that is, to attempt to attain realistic goals, rather than maximize a utility or profit function. Cyert and March argued that the firm cannot be regarded as a monolith, because different individuals and groups within it have their own aspirations and conflicting interests, and that firm behaviour is the weighted outcome of these conflicts. Organisational mechanisms (such as "satisficing" and sequential decision-taking) exist to maintain conflict at levels that are not unacceptably detrimental. Compared to ideal state of productive efficiency, there is organisational slack (Leibenstein's X-inefficiency).

Team production

Armen Alchian and Harold Demsetz's analysis of team production extends and clarifies earlier work by Coase. Thus according to them the firm emerges because extra output is provided by team production, but the success of this depends on being able to manage the team so that metering problems (it is costly to measure the marginal outputs of the co-operating inputs for reward purposes) and attendant shirking (the moral hazard problem) can be overcome, by estimating marginal productivity by observing or specifying input behaviour. Such monitoring as is therefore necessary, however, can only be encouraged effectively if the monitor is the recipient of the activity's residual income (otherwise the monitor herself would have to be monitored, ad infinitum). For Alchian and Demsetz, the firm, therefore, is an entity that brings together a team that is more productive working together than at arm's length through the market, because of informational problems associated with monitoring of effort. In effect, therefore, this is a "principal-agent" theory, since it is asymmetric information within the firm which Alchian and Demsetz emphasise must be overcome. In Barzel (1982)’s theory of the firm, drawing on Jensen and Meckling (1976), the firm emerges as a means of centralising monitoring and thereby avoiding costly redundancy in that function (since in a firm the responsibility for monitoring can be centralised in a way that it cannot if production is organised as a group of workers each acting as a firm).[citation needed]

The weakness in Alchian and Demsetz’s argument, according to Williamson, is that their concept of team production has quite a narrow range of applications, as it assumes outputs cannot be related to individual inputs. In practice, this may have limited applicability (small work group activities, the largest perhaps a symphony orchestra), since most outputs within a firm (such as manufacturing and secretarial work) are separable so that individual inputs can be rewarded on the basis of outputs. Hence team production cannot offer the explanation of why firms (in particular, large multi-plant and multi-product firms) exist.

Asset specificity

For Oliver E. Williamson, the existence of firms derives from ‘asset specificity’ in production, where assets are specific to each other such that their value is much less in a second-best use This causes problems if the assets are owned by different firms (such as purchaser and supplier), because it will lead to protracted bargaining concerning the gains from trade, because both agents are likely to become locked into a position where they are no longer competing with a (possibly large) number of agents in the entire market, and the incentives are no longer there to represent their positions honestly: large-numbers bargaining is transformed into small-number bargaining.

If the transaction is a recurring or lengthy one, re-negotiation may be necessary as a continual power struggle takes place concerning the gains from trade, further increasing the transaction costs. Moreover, there are likely to be situations where a purchaser may require a particular, firm-specific investment of a supplier which would be profitable for both; but after the investment has been made it becomes a sunk cost and the purchaser can attempt to re-negotiate the contract such that the supplier may make a loss on the investment (this is the hold-up problem, which occurs when either party asymmetrically incurs substantial costs or benefits before being paid for or paying for them). In this kind of situation, the most efficient way to overcome the continual conflict of interest between the two agents (or coalitions of agents) may be the removal of one of them from the equation by takeover or merger. Asset specificity can also apply to some extent to both physical and human capital so that the hold-up problem can also occur with labour (e.g. labour can threaten a strike, because of the lack of good alternative human capital; but equally the firm can threaten to fire).

Probably the best constraint on such opportunism is reputation (rather than the law, because of the difficulty of negotiating, writing and enforcement of contracts). If a reputation for opportunism significantly damages an agent's dealings in the future, this alters the incentives to be opportunistic.

Williamson sees the limit on the size of the firm as being given partly by costs of delegation (as a firm's size increases its hierarchical bureaucracy does too), and the large firm's increasing inability to replicate the high-powered incentives of the residual income of an owner-entrepreneur. This is partly because it is in the nature of a large firm that its existence is more secure and less dependent on the actions of any one individual (increasing the incentives to shirk), and because intervention rights from the central characteristic of a firm tend to be accompanied by some form of income insurance to compensate for the lesser responsibility, thereby diluting incentives. Milgrom and Roberts (1990) explain the increased cost of management as due to the incentives of employees to provide false information beneficial to themselves, resulting in costs to managers of filtering information, and often the making of decisions without full information. This grows worse with firm size and more layers in the hierarchy. Empirical analyses of transaction costs have attempted to measure and operationalize transaction costs. Research that attempts to measure transaction costs is the most critical limit to efforts to potential falsification and validation of transaction cost economics. 

Boundaries of the Firm

Boundaries of the firm explores the restrictions on size and output variety of firms, and how and why these restrictions affect production and enterprise success. There are two boundaries, horizontal, and vertical. As part of their corporate strategy, firms must choose between being horizontally broad, vertically deep, or both. Firms with horizontal breadth have numerous product lines or types, whereas firms with vertical depth are integrated into various stages of the value chain. Generally, a firm's capabilities are specific to a particular scope direction, for example, marketing skills lead to horizontal breadth, and production expertise lead to vertical depth


A firm is horizontally broad when it utilises excess indivisible resources to expand into various products, and obtain scope economies. Horizontally broad firms leverage capabilities such as marketing skills, product knowledge, customer service, and reputation for their expansions. Scope economies, or economies of scope, describes the aspect of production wherein cost savings result from the scope of an enterprise, as opposed to the scale (see economies of scale). Meaning, there are economies of scope where it is less expensive for firms to combine two or more product lines into one, than it is to produce each product separately. Scope economies, wherein resources are synergistically used, has been found to improve firm performance.However, coordination, adjustment and execution costs related to producing products synergistically are limiting factors.

A firm is vertically deep if they possess stronger capabilities than external producers, and thus can produce and distribute their good or service more efficiently internally - either upstream or downstream on the manufacturing chain. Vertically deep firms leverage capabilities such as production and process expertise, including technology selection, asset utilisation, and supply chain management. Vertical depth often improves a firm's governance of activities, and contributes to a beneficial exploitation of internal capabilities, but is limited by the costs of hierarchical management, such as monitoring and coordination

The concept of boundaries of can be linked to Coase's understanding of The Nature of the Firm, as it recognises that transaction costs are a significant factor in a firm's decision to outsource, or internally produce, but also considers other influences specific to firms, such as their relevant capabilities, and governance decisions.

Importance of Boundaries

A study of firms in France, illustrated how the number of employees and size of a firm directly impacts levels of productivity, wage and welfare within the organisation. In particular, an analysis of why firms with employees above the threshold of 50 declined in the early 2000s is conducted to further understand the correlation between size and output.[citation needed]

Level of productivity from the study exhibited that overall, producitivty increased along with the firm size quite linearly. Despite this, as the firm size approached the 50 employee range, the level of productivity showed fluctuations and a rather consequential decline in productivity from the 49th to 50th employee Additionally, he data from this study suggests that employee numbers of 50 or above, cause sudden increases in costs. While the total fixed costs was relatively stable up until the 49th employee, once an extra worker was hired, the total fixed costs spiked and increased along with the total variable costs. Possible reasons for this increase in fixed costs could be due to positive "spillovers", where total fixed costs could escalate due to the additional monthly reports done on the employees or tax etc Moreover, it is evident from the study that flexible wages encourage employment and promotes employee welfare. However, it is worth noting that firms with employee numbers above 50 become rigid on their wage allocation for each worker.

All in all, this study shows that smaller firm sizes experience a better output in terms of cost to benefit ratio and foster a hard-working, incentive-focused work environment. While, the number of employees will vary from firm to firm, examining exisiting firms, allows for discrimination in setting boundaries for the firm and are crucial. 

Economic theory of outsourcing

In economic theory, the pros and cons of outsourcing have been discussed since Ronald Coase (1937) asked the famous question: Why is not all production carried on by one big firm? An informal answer has been provided by Oliver Williamson (1979), who has emphasized the importance of different transaction costs within and between firms. The boundaries of the firm (i.e., the distinction between transactions taking place within a firm and transactions between different firms) have been formally studied by Oliver Hart (1995) and his coauthors. According to the property rights approach to the theory of the firm based on incomplete contracting, the ownership structure (i.e., integration or non-integration) determines how the returns to non-contractible investments will be divided in future negotiations. Hence, whether or not outsourcing an activity to a different firm is optimal depends on the relative importance of the investments that the trading partners have to make. For instance, if only one party has to make an important non-contractible investment decision, then this party should be owner. However, the conclusions of the incomplete contracting theory crucially rely on the specification of the negotiations protocol and on whether or not there is asymmetric information. 

Other models

Efficiency wage models like that of Shapiro and Stiglitz (1984) suggest wage rents as an addition to monitoring, since this gives employees an incentive not to shirk, given a certain probability of detection and the consequence of being fired.[citation needed] Williamson, Wachter and Harris (1975) suggest promotion incentives within the firm as an alternative to morale-damaging monitoring, where promotion is based on objectively measurable performance.[citation needed] (The difference between these two approaches may be that the former is applicable to a blue-collar environment, the latter to a white-collar one). Leibenstein (1966) sees a firm's norms or conventions, dependent on its history of management initiatives, labour relations and other factors, as determining the firm's "culture" of effort, thus affecting the firm's productivity and hence size.[citation needed]

George Akerlof (1982) develops a gift exchange model of reciprocity, in which employers offer wages unrelated to variations in output and above the market level, and workers have developed a concern for each other's welfare, such that all put in effort above the minimum required, but the more able workers are not rewarded for their extra productivity; again, size here depends not on rationality or efficiency but on social factors In sum, the limit to the firm's size is given where costs rise to the point where the market can undertake some transactions more efficiently than the firm.

Recently, Yochai Benkler further questioned the rigid distinction between firms and markets based on the increasing salience of “commons-based peer production” systems such as open source software (e.g., Linux), Wikipedia, Creative Commons, etc. He put forth this argument in The Wealth of Networks: How Social Production Transforms Markets and Freedom, which was released in 2006 under a Creative Commons share-alike license.

Grossman–Hart–Moore theory

In modern contract theory, the “theory of the firm” is often identified with the “property rights approach” that was developed by Sanford J. Grossman, Oliver D. Hart, and John H. Moore.The property rights approach to the theory of the firm is also known as the “Grossman–Hart–Moore theory”. In their seminal work, Grossman and Hart (1986), Hart and Moore (1990) and Hart (1995) developed the incomplete contracting paradigm They argue that if contracts cannot specify what is to be done given every possible contingency, then property rights (and hence firm boundaries) matter. Specifically, consider a seller of an intermediate good and a buyer. Should the seller own the physical assets that are necessary to produce the good (non-integration) or should the buyer be the owner (integration)? After relationship-specific investments have been made, the seller and the buyer bargain. When they are symmetrically informed, they will always agree to collaborate. Yet, the division of the ex post surplus depends on the parties’ disagreement payoffs (the payoffs they would get if no ex post agreement were reached), which in turn depend on the ownership structure. Thus, the ownership structure has an influence on the incentives to invest. A central insight of the theory is that the party with the more important investment decision should be the owner. Another prominent conclusion is that joint asset ownership is suboptimal if investments are in human capital.

The Grossman–Hart–Moore model has been successfully applied in many contexts, e.g. with regard to privatization. Chiu (1998) and DeMeza and Lockwood (1998) have extended the model by considering different bargaining games that the parties may play ex post (which can explain ownership by the less important investor) Oliver Williamson (2002) has criticized the Grossman–Hart–Moore model because it is focused on ex ante investment incentives, while it neglects ex post inefficiencies. Schmitz (2006) has studied a variant of the Grossman–Hart–Moore model in which a party may have or acquire private information about its disagreement payoff, which can explain ex post inefficiencies and ownership by the less important investor. Several variants of the Grossman–Hart–Moore model such as the one with private information can also explain joint ownership 




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