Concept of Firm: Definition, Nature and Classification

1. The neoclassical firm

In the literature, the concept of firm is explored by different theoretical approaches. In neoclassical theory, the firm is considered as a “black box”, that assembles all of necessary elements for organizing and implementing the production and business activities.

Economists in the late 19th and early 20th centuries regarded firms as “black boxes”, because they either did not desire to study them or, more accurately, because they could not comprehend the complex operations and functioning of the firm. The black box firm was only described by economists in a limited manner through measurable factors outside the box. Accordingly, a traditional firm, often associated with an owner who also manages the business, was seen as a unit, whose main activities involve transforming inputs such as raw materials, labor, services, etc., into outputs such as finished products, waste, etc. These activities are executed based on a technical relationship, known as the production function.

Specifically, the firm owner hires workers and purchases raw materials, services, etc. Based on their management capacity, they allocate labor, operate machinery and equipment, utilize raw materials; they also monitor, supervise, and adjust production and business activities to generate output, including final products for the market and various types of waste. This firm, whose internal operations are temporarily overlooked, is managed by an individual, or a group representing the business owners. For them, the ultimate goal is profit maximization.

2. The managerial firm

Not accepting the secretive functioning of the “black box” firm, modern economists delve deep into exploring the organizational and operational activities within firms. The separation of management rights from ownership of the firm emerged, when firm owners as principals entrusted hired managers (agents) to carry out operational and managerial activities in the shareholders’ interests. This separation leads to the consequence that, as Adam Smith argued, “The directors of such companies, however, being the managers rather of other people’s money than of their own, cannot be expected to watch over it with the same anxious vigilance with which the partners in a private copartnership frequently watch over their own” (Smith, 1977). This also gives rise to the modern model of managerial firm, that is organized and managed not by the “Invisible Hand,” but under the “Visible Hand” of managers.

Delving further into studying firms, behavioral economists offer extensive research to better understand the decision-making process of individuals within firms, thereby addressing significant limitations in traditional neoclassical theory. Specifically, according to agency theory, firm is defined as “an alliance of agents” (such as stakeholders, managers, partners …) who can pursue different benefits (Jensen and Meckling, 1976).

Next, according to transaction cost economics, the analysis of firms should be situated within a comparative framework that considers both internal transaction costs and external value creation. In the perspective of contracts and agreements among members within the firm, Williamson (1975) defines the firm as “a network of specific contracts” between individuals and organizations.

Recently, in the resource-based view, Barney (1991) and Grant (1991) consider the firm as a “place where resources are concentrated”. Firms accumulate and organize their resources to achieve sustainable competitive advantage through developing resources, core competencies, learning and adaptability capabilities.

Regardless of the different approaches, in general, firm is a “strategic” organization that has mission of producing, trading and distributing products, services to customers and/or consumers. To perform these, firm adopt strategy by strategically self-organizing, mobilizing and impacting on its resources (including: materials, finance, human resources, equipment and machinery, information) in a certain scope, by complying with the legislations, and in ensuring a certain profitability level.

3. Firm classification

By the nature of ownership and the limits of responsibility of the owner, business entities can be classified into several types, including:

Sole proprietorship: This is a traditional business model, owned and operated by an individual for personal gain. The owner may conduct business operations alone or with others. This model is associated with unlimited liability, where the owner is fully responsible for all issues arising from the business operations. All assets belong to a single owner.

Partnership: This is a business structure where two or more individuals share ownership. The most common form is where each party has unlimited liability for obligations and debts arising from the business operations. There are three main partnership models: general partnership, limited partnership, and limited liability partnership.

Corporation: Owners have limited liability, and business activities are conducted as legal entities separate from the owners. This model can be state-owned or privately owned, for-profit or nonprofit. A for-profit corporation may have multiple owners as shareholders (or members), who have the right to elect a board of directors to manage the business and hire employees. Such privately owned corporations may be owned by a group of individuals, or partially by the state or state-owned enterprises listed on the stock exchange.

Cooperative: This is a limited liability business model, which can be for-profit or nonprofit. Cooperatives differ from corporations in that they have members (not shareholders) who share power and jointly make decisions within the organization.