What is Theory of the Firm?

In economics, theory of the firm is a principle used to predict how businesses will act based on what the theory claims the goal of the firm or business is. In this case, it states that all decisions are made with the final goal of maximizing profits. While this may seem like a statement of the obvious, the theory helps predict and explain other types of decisions made in an organization.

For example, while many people may not understand why a firm would not mind getting the bad publicity that comes with shutting down factories in one country and moving them to another country where labor is cheap and plentiful, the theory of the firm would, in fact, predict just such an occurrence. If the ultimate goal of the company is to maximize its profit margins, then finding the cheapest way to produce their products is understandable. The theory does not allow for benevolence such as being a good corporate neighbor.

This theory, therefore, may also help explain why some laws are passed and others are not. For example, if a company can get away with spending less money by polluting or disregarding some safety practices, they likely will, according to the theory. If such actions come with substantial penalty, however, such as fines or other such action, then the organization will be less likely to engage in such behavior. This is because those fines would work to minimize profits. The question, in such cases, is determining whether the fines would cost more than providing the extra equipment and processes needed to avoid the punishment. In the end, the risk must be greater than the reward.

While the theory of the firm makes a great deal of sense in certain cases and is a good start at explaining certain business phenomena, it does not explain everything. In some cases, different firms may have goals other than maximizing profits, and some, of course, may not have a goal of profit at all. These non-profit agencies may be operating under a different set of motivations altogether, ones not addressed in the theory.

For this and other reasons, some economists say the theory of the firm needs a complete revision. The theory, published in the 19th century, does not neatly fit into the 21st century economy, with many shareholders having a stake in the decision-making process. Further, some managers may not only be interested in profits, but also building a good reputation for the company and having happy employees. In these cases, the theory would not always make much sense.