Theory of the Firm

Econ 1, Foldvary

Economists divide an economy into three sectors.
Households, who own all assets.
Firms, which produce all goods. Firms don't own assets. People own assets.
Government, which sets rules and redistributes wealth.

A firm is an organization that transforms inputs into outputs.
In the abstract, the firm is the production function Q = f (N,L,K)

Two kinds or order:
organizational: hierarchy, centralized control, in a firm.
The spontaneous order of a free society and free market.

Firms include government enterprises such as the USPS, military, schools.
Firms include nonprofit organizations.
Each household also has the role of a firm, with home production.
You are a firm, because you produce things.

An entrepreneur is a person who organizes the factors of production in order to innovate, and who is a residual claimant on the economic profits.

The economic profits can also be shared with investors.

The entrepreneur takes inventions and discoveries and finds new and better ways to market and sell them. The entrepreneur does not necessarily own the business.

We are all to some extent entrepreneurs.

Are you an entrepreneur? I am an academic entrepreneur!

Economists assume that the purpose of a firm is to maximize profits.

But there are also psychic rewards to entrepreneurs.

Why are there large firms rather than just individuals who contract?

In any contract, there is a principal-agent problem.

Opportunism: taking advantage at the expense of another, contrary to a contract.

The shareholders are the principals. The directors, managers, and workers are the agents.

The agents often maximize their utility rather than that of the principals.

Ways to overcome this: profit sharing, monitoring, takeovers of inefficient firms.

Some workers may want to shirk if they can get away with it - not work so hard.

This is overcome by monitoring, incentives, and psychic sympathy.

1. Economies of scale.

Teem production, such as a hunting party, needs several hunters under the direction of a leader.

Mankiw, p. 280: The efficient scale of a firm: the quantity that minimizes average total cost.

In atomistic competition, firms operate on the efficient scale.

With market power, price is above marginal cost, and firms often operate on a less efficient scale because they wish to maximize profit.

With monopolistic competition, the firm cannot operate at the most efficient level.

But product variety is a compensating benefit, so the market economy overall is efficient.

In the long run, there can be economies of scale that induce a larger size of operation.

But that does not completely answer the question of organization.

Why are there unified, centralized, companies with a hierarchy under the direction of an executive rather than many individuals contracting?

2. The transaction-cost theory of the firm.

A transaction cost is a cost other than what is directly paid for a good.

When you shop for groceries, the transaction costs include the travel cost and the time cost.

Ronald Coase developed the theory that big firms exist to minimize internal transaction costs in interdependent production.

There would be high negotiating, monitoring, and enforcement costs if many individuals contract with one another.

Transaction costs are reduced by giving the manager the authority over the terms of trade.

A firm is an elaborate long-term contract among owners, directors, employees, and government.

3. The firm is an efficient way of allocating property rights.

Contracts are incomplete. We can't predict all situations. The future is uncertain.

The firm gives the owner of assets default control when the contract is not clear.

These are "residual rights of control."

Some managers price assets and services within a firm in order to induce efficient use.

Each department buys goods and services as if in a market. There are imputed prices.

Outside factors are hired to the quantity where marginal product equals price.

The same principle applies to internal factors.

But the "output" of a department is often vague.

Governments tread in-firm transactions differently than transactions among firms and customers.

There is no sales tax when a department or division obtains goods and equipment within.

There are no income taxes on transactions within a firm.

As a firm expands, internal transaction costs increase with management overhead.

There arise diseconomies of scale.

This can be partly overcome with decentralized divisions.

Types of firms

Single proprietor (70% of for-profits)

Partnership (8%).


Limited partnership.

Corporation (20% of enterprises, 90% of revenue). Legal persons. Includes non-profits.



Government as a firm, cooperative or single proprietor.