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Firm, theory of

That part of microeconomics which is concerned with explaining and predicting decisions of the firm, particularly in respect of output, price, inputs and changes in these. The theory deals with the firm at a very high leve! of abstraction. It assumes away many of the characteristics of modem firms – divorce of ownership from man­agement as represented in the joint-stock company, large, complex organizational structures, imperfections of information about the external environment the firm faces – and considers the firm as attempt­ing to maximize profits subject to given known demand and cost conditions. The nat ure of these demand conditions, and therefore of the levels of output and inputs selected by the firm, may differ according to whether the firms seil in a perfect or imperfect market. Nevertheless the underlying theory of the firm is the same in each case: the firm maximizes profits with full information and complete certainty, with no problems of an organizational character. The theory is obviously unrealistic in a descriptive sense. Nevertheless it is still a cornerstone of the accepted body of microeconomics. This is not, as some would argue, because economists are so obsessed with theoretical elegance and neat abstractions that they ignore the ‘real world’. Rather, it is because the theory is so simple and yet so powerful: it permits a wide range of predictions to be made about the behaviour offirms, which are reasonably accurate and which might not be obtained so easily and unambiguously from more complicated theories. In addition, it is the essential first step in the process of building up a theory of markets and from that a theory of the process of resource allocation in the economy as a whole, and these have yielded considerable insights into the workings of free market economies. There has, however, been a great deal of dissatisfaction with the tradi­tional theory of the firm. Partly this arises from a desire for realism for its own sake, and partly from the fact that certain predictions of the theory seem to have been refuted, e.g. that firms will not change price in response to a change in a fixed cost. Finally, the importance of oligopolistic markets has created a need for revision of the theory of the firm for two reasons: (a) the indeterminacy of the standard theory of the firm in situations of oligopoly suggests that if definite predictions are to be made, more attention must be paid to the actual behaviour of firms in such situations; and (b) the fact that oligopolistic firms are to some extent shielded from competitive pres­sures means that they have discretion to pursue goals other than profits. Since the early 1950s there has been a steady development of theories which attempt to improve upon the traditional one. The most signifcant developments have concentrated on the objectives of the finn, i.e. the assumption of profit maximization. It was observed that stockholders, the recipients of profits and the owners of the firm tend not to participate actively in running their firms, but instead merely expect a reasonable leve! of dividend to be maintained while managers actually control the decisionmaking. This then led to a series of theories based on the hypothesis that decisions would be taken to further the objectives of the top executives, subject always to the constraint that shareholders were paid satisfactory levels of dividends. Thus, a theory put forward by W. J. Baumol in Business Behaviour, Value, and Growth suggested that firms would try to maximize their size as measured by sales revenue, since managerial satisfaction and rewards depended more on size than profits. This led to certain predictions of behaviour which differ from those which would be made by profit maximization, e.g. firms would produce !arger outputs and advertise more than under profit maximization, and would respond to an increase in fixed costs by raising prices. A model on similar lines was developed by Oliver E. Williamson in The Economics of Discretionary Behaviour. He suggested that the satis­faction of managers depended on the sizes of their departments (as measured by administrative expenditure), the amount of declared profits they could retain rather than distribute to shareholders (since this then gave them discretion to make investments which do not have to meet with the approval of shareholders), and finally the size of expense accounts and amount of other perquisites (company cars, etc.) which managers are able to get for themselves. Again, the theory gives a wide range of predictions which differ both from the classical model and the theory of Baumol just described. A third mode! somewhat in this vein is that developed by R. Marris in The Economic Theory of Managerial Capitalism, which took the maximization of the rate of growth of the firm as being the managerial objective. The notable feature of this model is that it drops the static framework of the conventional theory (maintained in the two models discussed above) and attempts explicitly to construct an analysis of the growth rate of the firm. The common feature of these ‘modem’ theories of the firm is that they concentrate on the objectives of the firm, still tending to ignore prob­lems of organization and imperfections in information. They also assume that the firm attempts to maximize ·something, i.e. seeks the greatest value possible rather than achieve certain satisfactory levels of sales, profits, etc. In these respects they are still very close to the traditional approach. The most significant departure from this has been made by the behavioural therory of the firm, which drops the assumption that firms maximize something to concentrate on the decision processes of the firm and the way in which these are affected by the organizational environment. This last theory probably comes doser than any other to being a realistic description of real-world firms.

Reference: The Penguin Dictionary of Economics, 3rd edt.