Theory of the Firm

For developing the supply and demand approach to economics, the economists first worked out the basis of the demand curve. By treating the demand for a product or service as a rational decision by a (primarily) self-interested individual or family, the economists were able to understand the relation of the demand for one product or service to the demands for other products and services and to many other forms of economic

activity. It was natural to apply the same approach to supply. As a first step, one needs to think about the decision-makers in supplying goods and services and what a “rational decision” to supply goods and services would mean. In economics, this is often called the “theory of the firm.”

A firm is a unit that does business on its own account. Firm is from the Italian word, firma, a signature and the idea is that a firm can commit itself to a contract. Thus, a firm is the decision-maker in supplying goods and services.

There are three main kinds of firms in modern market economies which are as follows:

Proprietorships

A proprietorship (or proprietary business) is a business owned by an individual known as the “proprietor.” Many “mom and pop stores” and other “mom and pop” businesses are proprietorships. Some of the proprietorships are too small even to employ a person full time. Craftsmen, such as plumbers and painters, may have “day jobs” and work as selfemployed proprietors part time after hours. The computer programmers and others may also do that. At the other extreme, some proprietary businesses employ many hundreds of workers in a wide range of specializations. In a proprietorship, a proprietor is almost always the decision-maker for the business. 

Partnerships

A partnership is a business jointly owned by two or more persons. In most of the partnerships, each partner is legally liable for debts and agreements made by any partner. Ofcourse, this requires a great deal of trust and thus, partners generally know one another well enough to have that sort of trust. Family partnerships are very common for that very reason. There are now a few “limited partnerships” in which some of the partners are protected from legal liability for the agreements made by others, beyond some limits. In many cases, one partner is designated as the managing partner and is the main decision maker for the business.

Corporations

A corporation has two characteristics that distinguish it from most of the proprietorships and partnerships which are as follows:

• Limited liability

• Anonymous ownership

Limited liability means that the owner of shares in a corporation cannot lose more than a certain amount if the company fails. Usually, an amount is the money paid to buy the shares. Anonymous ownership means that the owner of the shares can sell them without getting the permission of anyone other than the buyer. By contrast, in most of the partnerships, no single partner can sell without getting the agreement of the other

partners. In such a case, the continuing partners will, ofcourse, want to know about the new partner. And he will not be an “anonymous owner.” In a typical corporation, the shareholders formally elect a board of directors who, in turn, select the officers of the company. One of these officers, often called the “president,” will be the principal decision-maker for the firm but he will be expected to make decisions in the interest of

the shareholders.