Optimality Arguments and the Theory of the Firm

Abstract

In the last decade or so economists have started tackling the difficult but largely ignored task of developing a real theory of the firm. Of course, sociologists and organizational theorists have studied the firm for decades. And economists always had a theory of the firm. However, that theory was largely a black box: it said little more than that firms would maximize profits and that the behavior of the firm would be determined by the familiar neoclassical production function. That account was not just abstract but also unrealistic. It generally assumed that managers and owners were one, that management had complete and more or less costless information about the productivity of employees, that management decisions were carried out without cost and completely, that contracts for inputs could completely specify the conditions of their use, and so on. The new economic work on the firm is exciting precisely because it tries to avoid such assumptions. Instead, recent economic models try to extend the standard maximizing under constraints approach to explain these real world phenomena. As a result, it is an important step toward both making neoclassical theory richer, more realistic, and more testable and toward bringing a powerful theory to an area where the piecemeal approaches of sociology and organizational theory have dominated.