Theory of a Firm

Managerial economics employs economic concepts and principles, which are known as the theory of Firm or ‘Economics of the Firm’. Thus, its scope is narrower than that of pure economic theory

At its simplest level, a business enterprise represents a series of contractual relationships that specify the rights and responsibilities of various parties (see below diagram). People directly involved include customers, stockholders, management, employees, and suppliers.

The economic theory of the firm holds that stockholders should be the prime beneficiaries of an organization’s activities. The theory is associated with top-down leadership and cost cutting through rationalization and downsizing. With immediate stock price dominating management activities, the economic theory of the firm has been criticized as being too short-term, as opposed to the longer-term thinking behind stakeholder theory.

Firms are a useful device for producing and distributing goods and services. They are economic entities and are best analyzed in the context of an economic model.

Theory of Firm

Theory of the firm is related to comprehending how firms come into being, what are their objectives, how they behave and improve their performance and how they establish their credentials and standing in society or an economy and so on. The theory of the firm aims at answering the following questions:

  1. Existence – why do firms emerge and exist, why are not all transactions in the economy mediated over the market?
  2. Which of their transactions are performed internally and which are negotiated in the market?
  3. Organisation – why are firms structured in such a specific way? What is the interplay of formal and informal relationships?
  4. Heterogeneity of firm actions/performances – what drives different actions and performances of firms?

Important concepts in theory of firm are

1. Short run vs. Long run

The behaviour of cost is usually analysed under two set of conditions. Short run is a time period in which the amounts of some input are fixed. Long run is a time period during which there is sufficiently long time to allow full flexibility in all inputs used.

2. Explicit vs. Implicit cost

Explicit cost is a cost that is incurred when an actual cash payment is made for inputs. Explicit costs are those which are clearly stated and recorded such as material costs (prices paid to suppliers), Labour costs (wage paid), depreciation cost on fixed asset and other expenses such as building rental. Implicit cost is the opportunity cost of inputs used in production for which no actual payment is made.

3. Accounting profit vs. Economic profit

Accounting profit consist sales revenue minus the explicit cost of the business. Economic profits consist of sales revenue minus total opportunity cost that is both explicit cost and implicit cost.


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