Theory of the Firm: What It Is and How It Works in Economics

What Is the Theory of the Firm?

In neoclassical economics—an approach to economics focusing on the determination of goods, outputs, and income distributions in markets through supply and demand—the theory of the firm is a microeconomic concept that states that a firm exists and make decisions to maximize profits.

A firm maximizes profits by creating a gap between revenue and costs.

Understanding the Theory of the Firm

Neoclassical economics dominates mainstream economics today, so the theory of the firm (and other theories associated with neoclassicism) influences decision-making in a variety of areas, including resource allocation, production techniques, pricing adjustments, and the volume of production.

While early economic analysis focused on broad industries, as the 19th century progressed, more economists began to ask basic questions about why companies produce what they produce and what motivates their choices when allocating capital and labor.

However, the theory has been debated and expanded to consider whether a company's goal is to maximize profits in the short-term or long-term. Modern takes on the theory of the firm sometimes distinguish between long-run motivations, such as sustainability, and short-run motivations, such as profit maximization.

If a company's goal is to maximize short-term profits, it might find ways to increase efficiency, boost revenue and reduce costs. However, companies that utilize fixed assets, like equipment, would ultimately need to make capital investments to ensure the company is profitable in the long-term. The use of cash to invest in assets would undoubtedly hurt short-term profits but would help with the long-term viability of the company.

Competition (not just profit) can also impact the decision making of company executives. If competition is strong, the company will need to not only maximize profits but also stay one step ahead of its competitors by reinventing itself and adapting its offerings. Therefore, long-term profits could only be maximized if there's a balance between short-term profits and investing in the future.

Theory of the Firm vs. Theory of the Consumer

The theory of the firm works side by side with the theory of the consumer, which states that consumers seek to maximize their overall utility. In this case, utility refers to the perceived value a consumer places on a good or service, sometimes referred to as the level of happiness the customer experiences from the good or service. For example, when consumers purchase a good for $10, they expect to receive a minimum of $10 in utility from the purchased good.

Special Considerations

Risks to Companies that Adhere to the Theory of the Firm

Risks exist for companies that subscribe to a profit-maximization goal. Solely focusing on profit maximization comes with a level of risk in regards to public perception—and a loss of goodwill between the company, consumers, investors, and the public.

A modern take on the theory of the firm proposes that maximizing profits is not the only driving goal of a company, particularly with publicly held companies. Companies that have issued equity or sold stock have diluted their ownership. This scenario (of low equity ownership by the decision-makers in the company) can lead to chief executive officers (CEOs) having multiple goals, including profit maximization, sales maximization, public relations, and market share.

Further risks exist when a firm focuses on a single strategy within the marketplace in order to maximize profits. If a company relies on the sale of one particular good for its overall success, and the associated product eventually fails within the marketplace, the company can fall into financial hardship. Competition and the lack of investment in its long-term success—such as updating and expanding product offerings—can eventually drive a company into bankruptcy.