Theme One:

Firms as Optimising Markets

 The Theory of the Firm
Historical Background
The Classical Economists; namely, Adam
Smith, David Ricardo and Karl Marx
argued that value depended upon
embedded labour.
So, the ‘price of production’ reflected the
prevailing supply conditions. Market prices
fluctuated around these ‘gravitational’
prices with firms as a unit of supply.
 The Marginalist Revolution
Origins of Neo-classical Theory
From the 1870s, the Marginalist ‘revolution’
challenged this view through the work of
William Stanley Jevons, Carl Menger
and Leon Walras.
The value lies in subjective utility, known as
the utilitarian philosophy.
Hence, rational and optimal decisions are
made at the margin.
 The Marshallian Firm
Alfred Marshall
The Neo-Classical Theory culminated with
Marshall’s ‘Principles of Economics’ first
published in 1890.
Here, value and price is determined by the
intersection of demand and supply. Hence,
the firm is a price-taker from the market.
In the long run competition ensures p = ac
where behaviour by firms is atomistic.
 Deductive Emphasis
The deductive emphasis explored the formal
logical properties of firms and markets.
Frank Knight showed the conditions of
‘perfect competition’ that led to p = ac.
Francis Edgeworth contributed general
equilibrium and maximising welfare.
John Bates Clark showed factor returns
exhaust output and reflect marginal
productivity.
 Inductive Emphasis
The inductive emphasis reflected concerns
with exploring institutional reality.
Alfred Chandler considered the growth of
firms such as U-form and M-form.
A.A. Berle and G.C. Means identified the
growth of joint-stock organisations.
R. Hall and C.J. Hitch showed prices are
not set following marginal conditions i.e.
there are ‘sticky’ prices.
Structure-Conduct-Performance
The Market S-C-P approach retains the
notion of optimising.
However, the peripheral assumptions of
perfect competition are relaxed.
The S-C-P approach predicts performance
(welfare) on the basis of market structure.
Hence, it introduces rivalry and reverse
causality and allows for different market
structures such as oligopoly.
 Other Approaches
Managerial theories float the idea of other
objectives for the firm rather than profit
maximisation e.g. sales revenue.
Behavioural theories advance the idea of
uncertainty and environment of the firm.
Game Theory is an alternative approach
principally using the prisoners’ dilemma.
Recent developments include Agency
Theory and Transaction Costs.
 Conclusions
The historical development of the Theory of
the firm reflects the methodological debate
for over two hundred years.
The context and environment of the firm is
now viewed as important.
Optimising behaviour has been challenged
and institutions are shown to be important.
There is a focus on the causal process
rather than the prediction of events.