Firm, Theory of the

Abstract

It is doubtful if there is yet general agreement among economists on the subject matter designated by the title ‘theory of the firm’, on, that is, the scope and purpose of the part of economics so titled. There is, probably, general agreement on the subject matter of economics itself: the allocation and distribution of scarce resources. (Some economists would have us add explicitly ‘and growth’ to ‘allocation and distribution’, but traditionally growth is subsumed under ‘allocation’.) Then we may take it that the purpose of the theory of the firm is to investigate the behaviour of firms as it affects allocation and distribution. We now come immediately to a fork. An economist who believes that a ‘firm’ is a profit-maximizing agent (whether by conscious, rational decision or otherwise), endowed with a known and given technology, and operating subject to a well-defined market constraint, will see no need for any special theory of the firm: the theory of the firm is nothing but the file of optimizing methods (and perhaps market structures). If firms maximize, how they do it is not of great interest or at least relevance to economics. The economist’s job is simply to cultivate and apply optimizing techniques. Given this view, it is unnecessary to inquire further: to seek to ‘inquire within’ is otiose, perhaps methodologically misguided. (As we shall see, the theory of the firm has been, and perhaps still is, the battleground for some fierce methodological warfare.)

This chapter was originally published in The New Palgrave Dictionary of Economics, 2nd edition, 2008. Edited by Steven N. Durlauf and Lawrence E. Blume