Theory of the firm

 The theory of the firm 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.

In simplified terms, the theory of the firm aims to answer these questions:

1. Existence. Why do firms emerge? Why are not all transactions in the economy mediated over the market?
2. 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?
3. Organization. Why are the firms structured in such a specific way, for example as to the hierarchy or decentralization? What is the interplay of formal and informal relationships?
4. Heterogeneity of firm actions/performances. What drives different actions and performances of firms?
5. Evidence. What tests are there for respective theories of the firm?

Firms exist as an alternative system to the market-price mechanism when it is more efficient to produce in a non-market environment. For example, in a labor market, it might be very difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. It might also be costly for employees to shift companies every day looking for alternatives. Similarly, it may be costly for companies to find new suppliers daily. Thus firms engage in a long-term contract with their employees or long-term contract with suppliers to minimize the cost or maximize the value of property rights.

The First World War period saw change of emphasis in economic theory away from industry-level analysis which mainly included analyzing markets to analysis at the level of the firm, as it became increasingly clear that perfect competition was no longer an adequate model of how firms behaved. Economic theory until then had focused on trying to understand markets alone and there had been little understanding why firms or organizations exist. Markets are guided by prices and quality as illustrated by vegetable markets where the buyer is free to switch sellers in an exchange. The need for a revised theory of the firm was emphasized by empirical studies by Adolf Berle and Gardiner Means, who made it clear that ownership of typical American corporation is spread over a wide number of shareholders, leaving control in the hands of managers who own very little equity themselves. R.L. Hall and Charles J. Hitch found that executives made decision by rule of thumb rather than the marginalist way.

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