Thursday, January 10, 2008

Bunny Slippers and the Theory of the Firm

I've been meaning to blog on this for a couple days. But no time like the presnet.

When teaching economics, I've often had trouble explaining the theory of the firm. I suspect part of it is my preference for macro over micro, but more importantly, I always felt I lacked a good anecdotal way of going beyond the definition. If you also have trouble; fret no more. Here's as good an explanation as I've run across.

Michael Munger at The Library of Economics and Liberty has an essay on this very subject. In my opinion, it's clear, interesting, and helpful. It explains why firms fill a significant role in the marketplace. As we know, if markets are so powerful, everyone should be negotiating for everything all the time. But firms provide a vital function, as Munger points out, by reducing transaction costs. That aspect explains, for example, why we have financial intermediaries (banks, etc.) instead of negotiating with other individuals on how and where to lend our excess funds or how and where to borrow.

I hope you find this helpful. Please share your thoughts.

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