theory of the firm

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theory of the firm

the body of theory concerned with how individual firms combine quantities of FACTOR INPUTS to produce OUTPUTS of goods and services and their pricing and output decisions. A basic assumption of the theory is that the objective of the firm is PROFIT MAXIMIZATION. The theory provides an explanation of why SUPPLY CURVES slope upwards.

The theory of the firm in traditional economics is a ‘building block’ in understanding resource allocation processes at the level of the market. To facilitate market analysis, certain simplifying assumptions are made about firms: that all firms are ‘the same ‘, operating with identical cost structures, demand conditions and each having the objective of profit maximization. This portrayal of the firm is an integral element in each of the market structures examined by the THEORY OF MARKETS (see, especially, PERFECT COMPETITION, MONOPOLISTIC COMPETITION).

Although the conventional theory of the firm has been extended to allow for differences in costs between firms (see PRICE LEADERSHIP, X-INEFFICIENCY) and differences in objectives (see SALES-REVENUE MAXIMIZATION, ASSET-GROWTH MAXIMIZATION), its fundamental focus on the market has remained unchanged.

A more radical reformulation of the theory of the firm, the RESOURCE-BASED THEORY OF THE FIRM, shifts the focus of the analysis away from the market to the firm itself, emphasizing the differences between firms in terms of their internal resources and capabilities as a means of establishing COMPETITIVE ADVANTAGES over rival suppliers. See MARGINAL-PHYSICAL PRODUCT, MARGINAL-REVENUE PRODUCT, COST FUNCTION, MARGINAL COST, MARGINAL REVENUE, FIRM OBJECTIVES, THEORY OF MARKETS, MANAGERIAL THEORIES OF THE FIRM, BEHAVIOURAL THEORY OF THE FIRM, PRINCIPAL-AGENT THEORY.

Collins Dictionary of Economics, 4th ed. © C. Pass, B. Lowes, L. Davies 2005
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