2  Neoclassical theory of the firm

The neoclassical theory of the firm is a foundation of the economic examination of corporate decision making.

Under this theory, firms are characterised as having a central decision maker who acts to maximise the firm’s value. The firm has a set of feasible production plans, typically represented as a production function, by which inputs such as labour, capital and raw materials are converted into output. The inputs and outputs are bought and sold on a spot market in the way that maximises the firms welfare, which is usually represented as profit.

This process might be represented as a simple production function such as the following:



100 units of capital and 100 units of labour can be used to produce 100 units of output. Alternatively, 10 units of labour and 1000 units of capital could be used to produce 100 units of output. The central decision maker decides the quantity to be produced and the level of each input to maximise profit.

Although a simplification, this fiction of the firm as a “black box” is useful and has much power in explaining production and pricing decisions by firms:

However, the treatment of the firm as a black box also has weaknesses.