Theory of the firm

The theory of the firm consists of a number of economic theories that describe, explain, and predict the nature of the firm, company, or corporation, including its existence, behaviour, structure, and relationship to the market.

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.

expected value maximization principle

Decision theory rule that the alternative with largest expected value (EV) should be chosen.

Value of the firm According to the text, Managerial Economics and Business Strategy by Michael R. Baye, the value of a firm is the present value of the firms current and future profits. The value of a firm is linked to profit maximization. A firm looking to maximize their profits is actually concerned with maximizing its value. As such, it is important for a firm to be able to determine its present value accurately. The value of a firm can be simplified using time value of money principles. Thus, the value of a firm is defined as the present value of expected future cash flows plus current cash flows. In this case, we will assume the expected cash flows to be equal to the expected profits for the firm. In order to calculate the value of the firm most companies discount the expected future profits to today using a given interest rate, i, and then add in the current profits.

Present Value Present Value, also known as present discounted value, is the value on a given date of a payment or series of payments made at other times. If the payments are in the future, they are discounted to reflect the time value of money and other factors such as investment risk. If they are in the past, their value is correspondingly enhanced to reflect that those payments have been (or could have been) earning interest in the intervening time. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful "like to like" basis.

Optimize

Satisficing Satisficing, a portmanteau "combining satisfy with suffice",[1] is a decision-making strategy that attempts to meet an acceptability threshold. This is contrasted with optimal decisionmaking, an approach that specifically attempts to find the best option available. A satisficing strategy may often be (near) optimal if the costs of the decision-making process itself, such as the cost of obtaining complete information, are considered in the outcome calculus. The word satisfice was given its current meaning by Herbert A. Simon in 1956,[2] although the idea "was first posited in Administrative Behavior, published in 1947."[3][4] He pointed out that human beings lack the cognitive resources to optimize: we usually do not know the relevant probabilities of outcomes, we can rarely evaluate all outcomes with sufficient precision, and our memories are weak and unreliable. A more realistic approach to rationality takes into account these limitations: This is called bounded rationality. "Satisficing" can also be regarded as combining "satisfying" and "sacrificing."[citation needed] In this usage the satisficing solution satisfies some criteria and sacrifices others. Some consequentialist theories in moral philosophy use the concept of satisficing in the same sense, though most call for optimization instead.

Business Profit Profit is a very important concept for any business particularly a start-up Profit is the financial return or reward that entrepreneurs aim to achieve to reflect the risk that they take. Given that most entrepreneurs invest in order to make a return, the profit earned by a business can be used to measure the success of that investment. Profit is also an important signal to other providers of finance to a business. Banks, suppliers and other lenders are more likely to provide finance to a business that can demonstrate that it makes a profit (or is very likely to do so in the near future) and that it can pay debts as they fall due. Profit is also an important source of finance for a business. Profits earned which are kept in the business (i.e. not distributed to the owners via dividends or other payments) are known as retained profits. Retained profits are an important source of finance for any business, but especially start-up or small businesses. The moment a product is sold for more than it cost to produce, then a profit is earned which can be reinvested.

Normal Rate of Return The rate of return on an investment, expressed as a percentage of the total amount invested. Rate of return is usually, but not always, calculated annually. also called return.

Economic Profit The amount remaining after subtracting from the total income of a company the total monetary cost of all business activities, as well as the opportunity cost of profits that could have been made by investing resources in alternative business activities. The economic profit measures both the financial status of the firm, and the effectiveness of the firm's decision-making strategies.

Profit Margin The amount remaining after subtracting from the total income of a company the total monetary cost of all business activities, as well as the opportunity cost of profits that could have been made by investing resources in alternative business activities. The economic

profit measures both the financial status of the firm, and the effectiveness of the firm's decision-making strategies.

Return on Stockholders Equity The return on stockholders equity, or return on equity, is a corporations net income after income taxes divided by average amount of stockholders equity during the period of the net income.

Frictional Profit Theory

Monopoly Profit Theory In economics, a firm is a monopoly when, because of the lack of any viable competition, it is able to become the sole producer of the industry's product.[1][2][3][4][5] In a normal competitive situation, the price the firm gets for its product is exactly the same as the Marginal cost of producing the product.[1][2][3] Because the monopoly firm does not have to worry about losing customers to competitors, it can set a price that is significantly higher the Marginal (Economic) cost of producing (the last unit of) the product.[1][3] Therefore, a monopoly Situation usually allows the firm to set a monopoly price which is higher than the price that would be found in a more competitive industry.,[1][2] and to generate an economic profit over and above the normal profit that is typically found in a perfectly competitive industry. The economic profit obtained by a monopoly firm is referred to as monopoly profit. The existence of a monopoly, and therefore the existence of a monopoly price and monopoly profit, depend on the existence of barriers to entry: these stop other firms from entering into the industry and sapping away profits.

Innovation Profit Theory