Raymond Hayden Economics

Theory Of The Firm

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At its simplest level, a business enterprise represents a series of contractual relationships that specify the rights and responsibilities of various parties (see Figure 1.2). People directly involved include customers, stockholders, management, employees, and suppliers. Society is also involved because businesses use scarce resources, pay taxes, provide employment opportunities, and produce much of society's material and services output. Firms are a useful device for producing and distributing goods and services. They are economic entities and are best analyzed in the context of an economic model.

theory of the firm

Basic model of business expected value maximization

Optimization of profits in light of uncertainty and the time value of money value of the firm

Present value of the firm's expected future net cash flows present value

Worth in current dollars

Expected Value Maximization

The model of business is called the theory of the firm. In its simplest version, the firm is thought to have profit maximization as its primary goal. The firm's owner-manager is assumed to be working to maximize the firm's short-run profits. Today, the emphasis on profits has been broadened to encompass uncertainty and the time value of money. In this more complete model, the primary goal of the firm is long-term expected value maximization.

The value of the firm is the present value of the firm's expected future net cash flows. If cash flows are equated to profits for simplicity, the value of the firm today, or its present value,

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