Theories of The Firm

Different firms belonging to same industry, facing the same market environment behave differently.

Thus there is a need for theories of the firm.

The theory of firm assumes that the firm seeks to maximize profits and minimize cost and on the basis of that it predicts how much of a particular commodity the firm should produce under different forms of market structure or organization.

Combines and organizes resources for the purpose of producing goods and/or services for sale.

Internalizes transactions, reducing transactions costs

Primary goal is to maximize the wealth or value of the firm

Objectives

1)   Profit Maximization

2)   Sales Maximization

3)   Increasing Market shares

4)   Building a good business reputation

5)   Financial stability and liquidity

6)   Maintenance of good labour relations

7)   Job satisfaction

8)   Leisure and peace of mind.

Traditional Theory of the Firm

The classical theory of the firm relied heavily on the notion that firms are small, owner-managed organizations, such as proprietorships, operating in highly competitive markets whose demand functions are given and where only normal profits can be earned.

If the firm did not therefore maximize profits it would fail to survive under these conditions.

There are two main objections to this notion

The model of a profit-maximizing firm is an owner-managed firm producing only one good, which knows all future cost and revenue streams with certainty.

Such a  firm could indeed choose the levels of output and price that would maximize its profits.

But, in fact, firms are faced with much more complex decisions, to be taken in a dynamic and  uncertain environment, and in this case it is far less clear how a profit-maximizing firm will behave.

Firms may be aiming to do something completely different; for example to maximize sales or growth.

Such an objection may well apply to modern joint-stock companies or to any other company that is not managed by its owners.