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Theories of the Firm




TASK:  Discuss the following theories of the firm giving an account of the objectives, strengths, and weaknesses and their practical application in the Kenyan market:

(a). Neoclassical Theory of the Firm

(b). Transactional Theory of the Firm

(c). Principal-Agent Theorem








The theory of the firm has evolved from representing the firm as a purely profit maximising automaton or “black box”, operating in a space-less and timeless environment (neoclassical theory).  While to some extent this view continues to prevail in introductory courses in microeconomics, a number of other perspectives are widely held.  The firm is now seen either as a more complex organisation where control and ownership are distinct, and/or as a nexus of different activities, composed of diverse constituents.  The roles of transactions, of technologies and of contracts have all been focused upon, with varying degrees of intensity by the different schools of thought.

In a recent article, Chandler (1992) referred to four “established theories involving the firm”. These he named as the neoclassical, principal-agent, transactions cost, and evolutionary theories. In addition, particularly important in the context of the development of modern theories of the firm, there is the managerial theory. Finally, not “established”, but interesting as an example of the application of the new firm, is the cooperative game theory of the firm.

According to the neoclassical vision, the firm is an abstraction, an idealised form of business, whose existence is solely explained by the purely economic motive of generating a profit.  Generally, profit is generated through satisfying wants by producing a good or a service on a given market and at a given price.  The firm’s legal or organisational characteristics are insignificant.  The only objective guiding its operations is the desire to maximise profit (or minimise costs).

Neoclassical firm is thus a profit-maximising (or cost-minimising) entity operating in an exogenously given environment which lies beyond its control.  It is described by a production function which shows the relationship between inputs and outputs.  Costs can be derived from the production function, as long as the prices of the inputs on the input (or factor) markets are known.  Revenues can be derived from the demand schedule. The demand schedule shows the number of units of the good that the consumers are willing to buy at each different price per unit; the price actually paid multiplied by the number of units bought is the firm’s revenue.  The quantity the firm will produce is the profit maximising level of output.  Profit is the difference between costs and revenues.  The firm will continue to increase output as long as the last (marginal) unit produced adds to total profit.  If the revenue obtained from selling the last unit produced (marginal revenue) is greater than the cost of producing the last unit (marginal cost), then output will continue to be increased.  When the last unit no longer adds to profit – when marginal revenue (MR) equals marginal cost (MC) – then profit is maximised.

Criticism to Neoclassical Theory of the Firm

Hart (1995) criticizes the neoclassical model based on three characteristics of the theory. First, he notes that the theory completely ignores incentive problems within the firm. The firm is a perfectly efficient ‘black box’. Second, the theory has nothing to say about the internal organization of the firm. Nothing is said about the hierarchical structure, how decisions are made, who has authority within a firm. Third, the theory tells us nothing about how to pin down the boundaries of the firm. The theory is as much a theory of plant or division size as firm size. As Hart points out “[t]o put it in stark terms … neoclassical theory is consistent with there being one huge firm in the world, with every existing firm … being a division of this firm. It is also consistent with every plant and division of an existing firm becoming a separate and independent firm (Hart, 1995).

Cyert and Hedrick (1972) addressed similar points. They argue that in the neoclassical system the firm doesn’t exist, that no real world problems of firms are considered, that there are no organizational problems or any internal decision-making process at all. “In one sense the controversy over the theory of the firm has arisen over a non-existent entity. The crux of microeconomics is the competitive system. Within the competitive model there is a hypothetical construct called the firm. This construct consists of a single decision criterion and an ability to get information from an external world, called the “market” (Cyert & March, 2003). The information received from the market enables the firm to apply its decision criterion, and the competitive system then proceeds to allocate resources and produce output. The market information determines the behavior of the so called firm. None of the problems of real firms can find a home within this special construct. There are no organizational problems nor is there any room for analysis of the internal decision-making process.” (Cyert & Hedrick, 2003). Thus within the neoclassical model of the price system, the firm’s only role is to allow input owners to convert inputs into outputs in response to market prices. Firms have no internal organization since they have no need of one, they have no owners since there is nothing to own.

One of the first challenges to the neoclassical theory of the firm as a profit-maximising centre was presented by Hall and Hitch (1999).  In their article, the authors criticise the “obscurity” surrounding the precise content of the terms “marginal and average revenue”, and raise questions about the nature of the demand curve assumed to be facing the firm. Their major criticism, however, focuses on that tenet of neoclassical theory according to which entrepreneurial behaviour will result in the equating of marginal cost with marginal revenue.

In the neoclassical paradigm, profit maximisation is performed in the light of perfectly known cost and demand conditions. Imperfect information, and thus uncertainty, are irrelevant in this theory since markets are characterised by transparency, and since the equilibrium reached by the firm is the result of the interactions between variables defined in the present period of time. The firm operates in a timeless environment; the future is ignored.


A different perspective focuses on how firms ensure the supply of inputs on the one hand and reach the final consumer on the other hand: rather than production functions, firms are regarded here as governance structures (Williamson, 1985). Transaction cost theory concentrates on the relative efficiency of different exchange processes. If for the firm-as-a-production-function view the internalization of one or more stages of production might generate technological economies (that is savings on the costs of physical inputs), for the firm-as-organization view it could lead also to transactional economies (that is savings on the costs of exchange inputs, when reduced amounts of resources are required to get the intermediate inputs). An intermediate step between pure market exchange and vertical integration is the use of short term and long term contracts. The decision to enter durable contractual relationships by signing long term contracts and the alternative vertical integration strategy share the sam.............

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