Theory Of The Firm

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DEFINITION of 'Theory Of The Firm'

A microeconomic concept founded in neoclassical economics that states that firms (corporations) exist and make decisions in order to maximize profits. Businesses interact with the market to determine pricing and demand and then allocate resources according to models that look to maximize net profits.

The theory of the firm goes along with the theory of the consumer, which states that consumers seek to maximize their overall utility. Modern takes on the theory of the firm sometimes distinguish between long-run motivations (sustainability) and short-run motivations (profit maximization).

INVESTOPEDIA EXPLAINS 'Theory Of The Firm'

The theory of the firm is always being re-analyzed and adapted to suit changing economies and markets. Early economic analysis focused on broad industries, but as the nineteenth century progressed, more economists began to look at the firm level to answer basic questions about why companies produce what they do, and what motivates their choices when allocating capital and labor.

Modern takes on the theory of the firm take such facts as low equity ownership by many decision-makers into account; some feel that CEOs of publicly held companies are interested not only in profit maximization, but also in goals based on sales maximization, public relations and market share.

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