Theory of the Firm

In developing the supply and demand approach to economics, 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, 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, we need 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."

In the remainder of this chapter we will apply the concepts of marginal productivity and diminishing returns to the theory of the firm. First we will talk a bit about business firms and their role in a market economy, then we will return to the marginal productivity approach.