Understanding Theories of the Firm: A Comprehensive Analysis

Theories of the Firm

Business economics studies the existence of firms by examining how agents decide to use their scarce resources.

In a market-regulated pricing system, an agent can buy or sell at a price equilibrium. If the market worked efficiently, the existence of firms might seem unnecessary. However, companies exist because the market doesn't always function perfectly.

There are four major areas in the theories of the firm: transaction cost theory, agency theory, strategic management, and business organizational cooperation.

Theory of the Firm: A Basic Production Unit

The theory of the firm views the company as the basic production unit, aiming to maximize profit. It utilizes productive factors and sources of supply of goods and services. The company transforms inputs into outputs. The process of allocation and resource transformation is stated in its production function, which operates under the following assumptions:

• There is a single agent with decision-making power.
• The choice set of alternatives is reduced to the amount of resources used.
• The choice between alternatives is limited to profit maximization.

Internally, the company operates under these conditions. Externally, it connects through the price system. These prices condense data on preferences and costs, leading to socially optimal solutions when ideal conditions exist:

• Prices are fixed and cannot be altered.
• There is perfect information.
• The product is homogeneous and known.
• Universality of markets is assumed.

Under these conditions, the market's invisible hand operates effectively.

In addition, markets are assumed to be perfectly competitive.

However, even neoclassical theory struggles to explain the coordinating mechanisms of agents and the ignorance of certain issues, making it difficult to construct a true theory of the firm. This implies severe constraints for determining the true nature of the firm.

It can be argued that neoclassical theory, rather than being a theory of the firm, should be called production theory.

Limitations of the Neoclassical Theory

The main limitations are:

• The theory assumes that the company makes its decisions mechanically.
• Technology is considered given and accessible to all businesses, which is not always the case.
• Fundamental concern for the equilibrium conditions may not change.
• Non-quantifiable factors (reputation, credibility) have no place in this approach.

Precisely why this is a good starting point when there is no perfect competition.