2. 2
Theory of the Firm
AE 11 – Mrs. Cruz
• It consists of a number of economic theories that
explain and predict the nature of the firm,
company, or corporation, including its existence,
behavior, structure and relationship to the
market.
3. 3
The theory of the firm aims to
answer the following:
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• Existence – Why do firms emerge? Why are
not all transactions in the economy mediated
over the market?
• Boundaries – Why is the boundary between
firms and the market located exactly there
with relation to size and output variety?
Which transactions are performed internally
and which are negotiated on the market?
4. 4
The theory of the firm aims to
answer the following:
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• Organization – Why are firms structured in such
a specific way, for example as to hierarchy or
decentralization? What is the interplay of formal
and informal relationships?
• Heterogeneity of firm actions/performances –
What drives different actions and performances
of firms?
• Evidence – What tests are there for respective
theories of firm?
5. 5
Thoughts to Ponder:
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Why do you think firms
need to engage in a long
term contract with their
employees and suppliers?
6. 6
Adolf Berle
and Gardiner
Means
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The Modern Corporation and Private
Property
“All powers granted to
a corporation are
necessarily and at all
times exercisable only
for the ratable benefit of
all the shareholders.”
7. 7
Ronald
Coase
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Transaction Cost Theory
People begin to organize their
production in firms when the
transaction cost of
coordinating production
through the market exchange,
given imperfect information,
is greater than within the firm.
9. 9
Reasons why firms might arise:
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• If some people prefer to work under direction
and are prepared to pay for the privilege
• If some people prefer to direct others and are
prepared to pay for this
• If purchasers prefer goods produced by firms
10. 10
Managerial Theories
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• It suggests that managers would seek to maximize
their own utility and consider the implications of this
for firm behavior in contrast to the profit maximizing
case.
• It suggests that managers’ interests are best served by
maximizing sales after achieving a minimum level of
profit which satisfies the shareholders.
• Principal-Agent Analysis
11. 11
Behavioral Approach
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• People possess limited cognitive ability and so can
exercise only “bounded rationality” when making
decisions in complex, uncertain situations.”
• Firms cannot be regarded as monolith because different
individuals and groups within it have their own
aspirations and conflicting interests, and that the firm
behavior is the weighted outcome of these conflicts.
12. 12
Team Production
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• The firm emerges because extra output is
provided by team production, but that the
success of this depends on being able to manage
the team so that metering problems and attended
shirking can be overcome, by estimating
marginal productivity by observing or specifying
input behavior.
13. 13
Asset Specificity
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• Assets are specific to each other such that their
value is much less in a second-best use.
14. 14
Efficiency Wage Model
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• 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.
• It suggests promotion incentives within the firm as an
alternative to morale-damaging monitoring, where
promotion is based on objectively measurable
performance.
15. 15
Gift Exchange Model of
Reciprocity
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• 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.
16. 16
Property Rights Approach
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• Also known as the Grossman-Hart-Moore Theory
• If contracts cannot specify what is to be done given
every possible contingency, then property rights
matter.
