Book Series
Theories of the Firm
Fifth Edition
Demetri Kantarelis

Epilogue: Epilogue

PagesContents
363-366It was about the Neoclassical Theory of the Firm, which in its basic form views the firm as a black box rational entity. The theory is built on imaginary but plausible production and demand functions and it establishes the principal of profit maximisation according to which profit is maximised when marginal revenue is equal to marginal cost. The theory may be used, among many other things, to describe various market structures, regulation issues, strategic pricing, barriers to entry, economies of scale and scope and even optimum portfolio selection of risky assets. The main weakness of the theory is that it assumes complete information and, as a result, there is no agency problem or concern for transaction costs because of conflict between owners and suppliers of inputs (even specific to whatever the firm produces) in the market system. Another weakness of the theory is that it does not allow for evolution of the firm. It was about the Transactions Cost Theory of the Firm, which focuses on problems of asymmetric information involved in transactions. The firm, according to this theory, comes into existence because it successfully minimises 'make' inputs costs (through vertical integration) and 'buy' inputs costs (using available markets.) The more specific are the inputs that the firm needs, the more likely it is that it would produce them internally and/or acquire them through joint ventures and alliances. The weakness of this theory is that it does not take into consideration agency costs or firm evolution. Additionally, the Grossman, Hart and Moor vertical integration and asset ownership theory, otherwise known as the property rights approach, assumes that each integrated firm consists of an owner who is also the manager. But, if firms consist of many individuals (human assets with unobservable value), then how should firms integrate when firm value is ingrained in human capital, or, how should they integrate in the face of unobserved investments in human capital that cannot be transferred? It was about the Principal-Agent Theory of the Firm, which extends the neoclassical theory by adding agents to the firm. The theory is concerned with friction due to asymmetric information between owners of firms and their stakeholders or managers and employees; the friction between agent and principal, requires precise measurement of agent performance and the engineering of incentive mechanisms. The weaknesses of the theory are many: it is difficult to engineer incentive mechanisms, it relies on complicated incomplete contracts (border line unenforceable), it ignores transaction costs (both external and internal), and it does not allow for firm evolution. It was about the Evolutionary Theory of the Firm, which places emphasis on production capabilities and process as well as product innovation. The firm according to this theory, see Schumpeter (1934) and Penrose (1959), possesses unique resources, tied semi-permanently to the firm, and capabilities; the firm's recourses can be classified into four categories: financial, physical, human and organisational. The theory sees the firm as a reactor to change and a creator of change for competitive advantage. The firm, as a creator of change, may cause creative destruction, which in turn may give birth to new industries and enable sectors of, or entire, economies to grow. Although many countries have established architectures to support entrepreneurial endeavours, a weakness of the theory remains: process and product innovation (especially the latter) are mostly due to serendipity and as a result 'entrepreneurship' is an expensive factor of production; in the pursuit of profit and general well-being, it cannot be easily programmed within a firm or a nation.
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