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:

Y=K^\frac{1}{2}L^\frac{1}{2}

where:

• Y is the amount of output
• K is the amount of capital
• L is the amount of labour.

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:

• It allows for mathematical formalisation of the decision making

• It is useful for examining how a firm’s choices are influenced by changes in the outside environment, such as a change in wages or introduction of a tax

• It is useful for understanding strategic interactions between firms if there is imperfect competition.

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

• It says little about the internal architecture or workings of the firm. There are many decision makers within firms, including owners, managers and workers. For instance, there may be a board that appoints a CEO, who while keeping some decision rights, delegates most of them.

• It ignores conflicts of interest between the different decision makers. Many of those decision makers do not have a primary objective of maximising the value of the firm. They are, after all, individual economic agents with their own preferences. They can have different interests.

• It provides no insight into the boundaries of the firm. Why do firms employ workers for some services, and contract for or purchase other services?