Theory of the firm
The Theory of the Firm is a key concept in economics that seeks to understand how and why firms operate in the marketplace. It primarily posits that firms exist to maximize profits, exploring the motivations behind their actions in both selling goods and services and acquiring necessary resources for production. Introduced by economist Ronald Coase in the 1930s, the theory evolved from earlier economic frameworks, such as classical and neoclassical economics, which focused on competition, supply and demand, and the rationality of decision-making.
Coase's work highlighted that firms can be more efficient than market transactions due to the high costs of using external markets for labor and services. This efficiency explains why firms often choose to employ teams rather than rely on individual contractors. The theory also intersects with consumer behavior, suggesting that firms are more likely to succeed when they align their offerings with consumer needs, thereby maximizing both consumer utility and their own profits.
Within the Theory of the Firm, there are two prominent perspectives: the resource-based theory, which emphasizes the unique resources that give firms a competitive edge, and the activity-based theory, which focuses on how firms utilize their resources to create value. These varying viewpoints contribute to a deeper understanding of firm behavior in the economic landscape.
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Theory of the firm
Theory of the firm is a fundamental economic concept that attempts to describe why firms operate in the manner they do. More specifically, the theory of the firm seeks to explain what motivates firms to act within the context of the market in which they sell various goods and services and the market in which they purchase the resources they need to produce those goods and services. At its core, the theory of the firm is built on the basic premise that all firms are ultimately motivated by the desire to maximize profits. Beyond this, there are two major views of the theory of the firm, including the resource-based theory of the firm and the activity-based theory of the firm. Both seek to further explain how the theory of the firm works by looking at it in different ways. Since it was first introduced by British economist Ronald Coase in the 1930s, the theory of the firm has emerged as one of the most important tenets of modern economics.
Background
Until the late nineteenth century, economic theory was limited to what is now referred to as classical economics. Based on centuries of economic thought and observation, the basic tenets of classical economics were first definitively outlined by eighteenth-century Scottish economist Adam Smith. As developed by Smith and others, classical economics was based on the idea that economic growth was promoted by free competition and free trade, and that communities thrive when individuals each follow their own self-interests. Further, classical economists like Smith held that the value of a product is determined simply by the cost of materials plus the cost of labor.
By around the turn of the twentieth century, classical economics began to be supplanted by a new school of economic thought called neoclassical economics. Neoclassical economics went further than classical economics and attempted to more clearly define the mechanics of a healthy economy. Most importantly, neoclassical economics is centered on the idea of supply and demand and the relationship between these factors and each individual's rationality and ability to maximize utility and profit. Utility, in this case, refers to the total amount of satisfaction that one derives from a particular good or service. Neoclassical economics holds that individuals make decisions based on informed evaluations of utility. In addition, neoclassical economics holds that the value of a good or service is determined not just by the cost of materials and labor, but also by the perceived value that consumers place on that good or service.
As it rose to prominence in the twentieth century, neoclassical economics came to provide the foundation for the theory of the firm. While most economists up to that point focused most of their attention on analyzing either the division of labor within firms or the broader economic systems in which firms existed, few thought much about the importance of firms themselves. In 1937, economist Ronald Coase wrote "The Nature of the Firm," a landmark essay in which he described the economic importance of the firm and explained why economies are made up of a small number of firms instead of a large number of independent, self-employed individuals who contract with one another. Through this crucial work, Coase developed the theory of the firm as it is known in the present day.
Overview
During the course of his studies, Coase observed that the typical model of economics did not correlate with the inner workings of firms. In other words, many of the changes that occur within firms—such as the movement of an employee from one division to another—often have nothing to do with external economic forces. This observation led Coase to wonder why firms exist and why some business-related activities are influenced by economic forces while others are influenced by firms themselves. Coase's subsequent research into these questions ultimately resulted in the development of the theory of the firm.
Coase determined that firms arise because of the high costs associated with using markets. In most cases, it is more cost-effective for a business owner to hire employees to complete certain tasks than it would be to seek out and reach agreements with individual contractors who then each complete one of these tasks. Simply put, this fundamental truth reveals that firms exist because it is cheaper to rely on a team of employees rather than on a whole host of individual contractors. In relation to his second question, Coase also determined that some business-related activities are influenced by firms themselves rather than any outside economic factors because firms ultimately make decisions with the express purpose of maximizing profits. This means that any and all decisions a firm makes are based on the desire to increase profits regardless of any outside economic influences. Taken in full, all of this describes the theory of the firm.
The theory of the firm goes hand in hand with the -theory of the consumer. Where the theory of the firm states that firms seek to maximize profits, the theory of the consumer states that consumers seek to maximize their utility. When a firm supplies a good or service that fulfills consumers' needs and desires and maximizes consumer utility, consumers are more likely to purchase that good or service and, in doing so, maximize the firm's profits.
Among modern economists, there are two major views on the theory of the firm: the resource-based theory of the firm and the activity-based theory of the firm. The resource-based theory of the firm states that differences in performance among different firms result from variables in each firm's particular resources and capabilities. A firm's unique resources lend it competitive advantages that other firms do not necessarily share and allow it to thrive in the market. In short, a firm is only as strong as the value of the resources it has at its disposal. The activity-based theory of the firm, meanwhile, states that the performance of a firm depends on the activities it performs. In this view, the resources a firm possesses are less important than what it does with those resources to create value for the consumer. The activity-based theory of the firm assumes that all necessary resources can be acquired—a notion that effectively negates the competitive advantages particular to the resource-based theory of the firm and places greater emphasis on the activities a firm undertakes in the effort to produce a good or service that provides maximum value for the consumer.
Bibliography
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Dietrich, Michael, and Jackie Krafft, editors. Handbook on the Economics and Theory of the Firm. Edward Elgar Publishing, 2012.
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Yglesias, Matthew. "Ronald Coase, the Economist Who Explained Why We Have Companies." Slate, 3 Sept. 2013, www.slate.com/blogs/moneybox/2013/09/03/ronald‗coase‗s‗theory‗of‗the‗firm.html. Accessed 20 Dec. 2017.