Theory of The Firm - Overview

Overview

In simplified terms, the theory of the firm aims to answer these questions:

1. Existence – why do firms emerge, why are not all transactions in the economy mediated over the market?
2. Boundaries – why is the boundary between firms and the market located exactly there as to size and output variety? Which transactions are performed internally and which are negotiated on the market?
3. Organization – why are firms structured in such a specific way, for example as to hierarchy or decentralization? What is the interplay of formal and informal relationships?
4. Heterogeneity of firm actions/performances – what drives different actions and performances of firms?

Firms exist as an alternative system to the market-price mechanism when it is more efficient to produce in a non-market environment. For example, in a labor market, it might be very difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. It might also be costly for employees to shift companies every day looking for better alternatives. Thus, firms engage in a long-term contract with their employees to minimize the cost.