The firm is as an economic organization in a market economy, acquiring tangible and intangible productive assets for the purpose of producing goods and services for the market at prices that yield a profit. Innovation is an important part of its activity. This concept of the firm is the concept used in business and managerial economics and in such works of economic history as the superb analyses of Chandler, where he relates the strategy and performance of firms to their structure and where the 'visible hand' of firms becomes as important as the 'invisible hand' of the market.

This approach to the firm differs from the definition of the firm in the theoretical branch of microeconomics which is often called the 'neo-classical', or 'marginalist', theory of the firm, where it is defined almost exclusively with reference to the determination of price and output of a given commodity under given and unchanging conditions. In that theory, the firm is not an organization but an abstract entity; its equilibrium output (size) is determined by the intersection of cost and demand curves under carefully specified competitive circumstances. The theory does not deal with the operations of the firm as such, for it is designed to deal primarily with the logical implications of profit-maximizing behaviour for prices and output, for which it has proved indispensable in the analysis of market systems. Nevertheless, it is already being seriously challenged by a more institutional and sociological approach.

However, even in the neo-classical theory of the firm, the concept of disequilibrium points to considerations that promote expansion of output and which also apply when the firm is defined differently. For example, indivisibilities of plant and equipment which make economies of scale available where plant can be used more fully show up in falling costs and greater equilibrium output. But this concept can only be applied to a given product or an unchanged collection of products because it is impossible to establish the cost curve of a firm if the composition of output to which the costs refer continually changes. Joint costs arising from indivisibilities of output are also important - as, for example, in the production of wool and mutton at the same time. For the same reason, however, they cannot be used in the neo-classical theory of the firm to explain diversification of output.

If the firm is treated as an organization, its growth can in some respects be looked at in terms of the nature and development of organizations. An organization has boundaries, but in the case of firms the effective boundaries are often fuzzy and ill-defined. In a general way, however, the firm can in principle be distinguished from its environment, and its boundaries for all practical purposes reflect the extent to which its administration governs its activities. It is the administrative, bureaucratic, hierarchical or managerial characteristics of decision making with respect to transactions within the firm that distinguish these transactions from those made between independent participants in the market. Unlike market transactions, the activities within the firm are linked to each other within an administrative and managerial framework, although the characteristics of both administration and management vary widely among firms.

Edith Penrose