What is the 'Theory of the Firm'

The theory of the firm is the microeconomic concept founded in neoclassical economics that states that firms exist and make decisions to maximize profits. Firms interact with the market to determine pricing and demand and then allocate resources according to models that look to maximize net profits.

BREAKING DOWN 'Theory of the Firm'

In the theory of the firm, the behavior of any business entity is said to be driven by profit maximization. This theory governs decision making in a variety of areas including resource allocation, production technique, pricing adjustments, and volume production.

The theory of the firm works side by side with the theory of the consumer, which states that consumers seek to maximize their overall utility. In this case, utility refers to the perceived value a consumer places on a good or service, sometimes referred to as the level of happiness the customer experiences from the good or service. For example, when consumers purchase a good for $10, they expect to receive a minimum of $10 in utility from the purchased good.

Expansion on the Theory of the Firm

Modern takes on the theory of the firm sometimes distinguish between long-run motivations, such as sustainability, and short-run motivations, such as profit maximization. The theory is always being analyzed and adapted to suit changing economies and markets. Early economic analysis focused on broad industries, but as the 19th 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.

Risks Associated with the Theory of the Firm's Profit Maximization Goal

Modern takes on the theory of the firm take such facts as low equity ownership by many decision makers into account; some feel that chief executive officers (CEOs) of publicly held companies are interested in profit maximization as well as in goals based on sales maximization, public relations, and market share. Solely focusing on profit maximization comes with a level of risk in regards to public perception and a loss of a sense of goodwill between the business and other individuals or entities.

Further risks exist when a firm focuses on a single strategy within the marketplace. If a business relies on the sale of one particular good for its overall success, and the associated product fails within the marketplace, this can lead to a financial collapse of that particular company or department within the company.

For example, Sega, a gaming console producer, had success with its Sega Genesis console. Sega subsequently released the Dreamcast in Japan in 1998 and in the United States in 1999. First-day U.S. sales reached $100 million. However, the Dreamcast couldn't play DVDs like the rival PlayStation 2, which led to the Dreamcast's eventual failure within the marketplace. Even after a price drop, consumer interest was not rekindled, and Sega's gaming console division ultimately fell.

RELATED TERMS
  1. Traditional Theory Of Capital Structure

    The Traditional Theory of Capital Structure states that a firm's ...
  2. Entity Theory

    Entity theory is the assumption that the economic activities ...
  3. Decision Theory

    Decision theory is an interdisciplinary approach to determine ...
  4. Mechanism Design Theory

    Mechanism design theory is an economic theory that seeks to study ...
  5. Neoclassical Growth Theory

    The neoclassical growth theory is an economic concept where equilibrium ...
  6. Residual Equity Theory

    Residual equity theory assumes common shareholders to be the ...
Related Articles
  1. Insights

    5 Nobel Prize-Winning Economic Theories You Should Know About

    Here are 5 prize-winning economic theories that you’ll want to be familiar with.
  2. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification.
  3. Investing

    Power Up Your Portfolio With Video Game Stocks

    Level up your winnings by investing in this fast-paced, highly skilled industry.
  4. Investing

    Oil As An Asset: Hotelling's Theory On Price

    Not sure where oil prices are headed? This theory provides some insight.
  5. Managing Wealth

    The Science of Making Better Investment Decisions

    Neuroeconomics attempts to bridge neuroscience, cognitive psychology and economics in order to understand the mechanisms underlying economic decision making.
RELATED FAQS
  1. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  2. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  3. Is Maximizing Stock Price Like Maximizing Profit?

    Yes ... but a stock's price depends on many variables, and profits are just one of them. Read Answer >>
  4. Why is game theory useful in business?

    The concepts of game theory became a revolutionary interdisciplinary phenomenon, but they are still relevant for business ... Read Answer >>
  5. How does money supply affect inflation?

    Learn about two competing economic theories of the role of the money supply and whether money supply causes inflation in ... Read Answer >>
Trading Center