What do you mean by theory of firm, Managerial Economics

Q. What do you mean by Theory of Firm?

Microeconomics especially the theory of firm, assumed importance and attracted considerable attention in the early 20thcentury. This shift ensued after the growing realisation that perfect competition assumption of the classical economists wasn't a ground reality. This realisation resulted in a spate of efforts to analyse and understand the behaviour of individual firms. In perfect competition, all firms are presumed to be price takers and consequently studies into the behaviour of individual firms weren't called for. Because the reality was far different, the urgency to study the behaviour of firms of all sizes was obvious. Naturally theory of the firm, rather how firms, small andbig, behave under different circumstances began to attract wide attention, especially in the aftermath of World War I.

The need for a revised theory of the firm was emphasised by empirical studies undertaken by Berle and Means that made it clear that ownership of a typical American corporation is spread over a wide number of shareholders, leaving control in the hands of managers who own very little equity themselves. Hitch and Hall found that executives made decisions by rule of thumb rather than in accordance to marginal analyses. Firms exist as an alternative system to market mechanism when it's more efficient to produce in a non-price environment. For illustration in a labour market, it may be very costly or difficult for firms or organisation to involve in production when they have to fire and hire their workers depending on supply/demand conditions. It may also be expensive for employees to shift companies everyday looking for better alternatives. So firms engage in a long-term contract with their employees to minimise the cost.

Klein (1983) asserts that 'Economists now recognise that such a sharp distinction [between inter- and intra-firm transactions] doesn't exist and that it's useful to consider also transactions occurring within the firm as representing market (contractual) relationships'. The costs involved in such transactions which are within a firm or even between the firms are transaction costs.

According to Putterman, this is an exaggeration-most economists accept a distinction between the two forms though also that two merge into each other; extent of a firm isn't simply defined by its capital stock. Richardson for illustration, notes that a rigid distinction fails because of existence of intermediate forms between market and firm such as inter-firm co-operation. 

Eventually whether the firm constitutes a domain of bureaucratic direction which is shielded from market forces or simply 'a legal fiction', 'a nexus for a set of contracting relationships among individuals' (Meckling andJensen) is 'a function of the completeness ofmarkets and ability of market forces to penetrate intra-firm relationships'.

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