Firm theory, also called the theory of the firm, is an economic theory that attempts to identify why firms exist, why they are organized the way that they are, and why they behave in the way that they do. The theory of the firm was developed after World War I in response to industrialization and the changing nature of competition. A number of economic theories make up the theory of the firm.
Firms exist in order to maximize profits, according to firm theory. The goal of maximizing profits drives all decisions that a company makes. When a company determines prices, allocates resources, and hires employees, its underlying motivation is to maximize profits. For example, in a labor market, a company will hire workers for the long term in order to maximize profits by retaining workers. In a market of high unemployment, profits may be maximized by contracting with workers for the short term as demand dictates. According to this firm theory, the company is basing its hiring practices on the present economic conditions, and is selecting the method that allows it to maximize its profits in that particular market.
The theory of the firm promotes organizational effectiveness, as this is what enables companies to maximize profits. In order to be effective, companies will aim to reduce transaction costs by negotiating contracts for multiple transactions, rather than operating in a free market system where each transaction is negotiated individually. The firm must measure transaction costs and determine how to spread them over multiple transactions in order to maximize profits. This reduces the transaction cost for each unit of product.
This firm theory is complemented by the theory of the consumer, which states that consumers will seek to maximize utility in the goods they consume. Taken together, economists assert that theory of the firm and the theory of the consumer should describe all behavior in the marketplace. These two theories have the effect of balancing each other, as the theory of the firm produces the most effective firm and the theory of consumer produces the most effective consumer.
As economies have shifted, so has firm theory. When firm theory originated, the United States economy was shifting from a number of small, cottage-based industries to national industrialization, with large companies employing thousands of workers. Today, the knowledge-based theory of the firm states that knowledge is the most significant resource of the firm. Those firms with advanced knowledge will be able to more effectively maximize profits.