What Is a Firm in Economics?

The terms “Firm,” “Company,” “Business,” and “Establishment” are often used interchangeably to refer to any organization that offers goods or services. But this isn’t simply a case of the English language having multiple synonyms with the same meaning. 

When you’re studying economics, you should understand that these terms have different meanings, which we will breakdown for you in the article below. Keep reading to find out more!

What Is a Firm and an Industry?

Broadly speaking, the definition of a ‘firm’ in the field of economics is any company that seeks to make a profit by manufacturing or selling products or services – or both – to consumers. For example, one of the most common uses of this term is for ‘law firms,’ which usually sell services in relation to the law. However, other organizations can be firms too, including those that prove accounting services, design services, education, and consultancy services.

However, an industry is something entirely different from a firm. There are typically many firms within an industry, and all combined industries making up the economy.

A single industry consists of all firms that output a specific product or service. This includes three broad ‘categories’: retail industries, in which firms sell products to customers directly; wholesale, in which firms trade products with other firms; and service industries, which offer services to both businesses and individuals. 

What Is an Example of a Firm?

To really understand the different types of firms that exist, we should understand that just like there are different types of industry, there are also different types of firms. For example:

  • Entrepreneurs working for themselves: A self-employed individual who owns and runs their own company.
  • A private company: Typically small to medium in size (SME), these companies are usually owned by a small group of individuals and seek to maximize profits.
  • A public limited company, or PLC: These are usually large companies that have floated on the stock market. Members of the public may buy individual shares in these companies and thus gain from any profits made.
  • Co-operatives or social ventures: These are companies that don’t aim to maximize their profits, but rather seek to achieve goals for social or economical benefit.
  • Companies owned by the government: In specific sectors, some of the largest companies are owned by the government. For example, state-owned postal services and utility companies.

What Is the Role of a Firm?

To understand the purpose of firms, you should look into the ‘Theory of the Firm‘, a concept in microeconomics that will inevitably rear its head in any economics degree curriculum. 

Firms are one of the three crucial elements in the circular flow of money through the economy. They take money for goods and services while providing an income to skilled workers through a salary. They also pay taxes to the government, and, in turn, benefit from government spending in key areas (e.g. infrastructure). There are several elements to a firm’s role in an economy:

  • In economic theory, there’s a term called the ‘factors of production’; these are inputs – resources – that are processed into outputs through production. For example, firms employ civilians to produce goods and services, paying a salary to those individuals. In turn, those individuals can then spend money on goods and services produced by other firms.
  • New product development. In order to maximize profits, firms will invest in the production of new goods and services to satisfy consumers. This could be through the opening of new stores where demand is high – such as with coffee shops – or through the implementation of new products, such as when the first smartphones were released.
  • Investment in new technology and capital. Firms will always want to make the biggest profit possible from their capital and workforce. This will be reflected through the development of new technology and methods aimed at improving productivity. Improved productivity in an economy leads to a higher standard of living, and without this innovation and use of capital, economies would grow more slowly.
  • Providing end-users (consumers) with goods and services. By providing consumers with access to a broad range of goods, firms drive the economy. In an economy where there are no firms, individuals would have to grow or hunt their own food. By offering consumers food products, firms allow those individuals to redirect their time towards other forms of work, such as building and manufacturing. By solving everyday problems and simplifying life through technological advancement, firms advance the economy.

What Is the Difference Between a Firm and a Company?

As we’ve touched on above, the terms ‘firm’ and ‘company’ are often used interchangeably; however, there are key differences between these two entities. These differences can be found in different areas of the firm or company and its processes.

  • Creation of a firm or company: A partnership firm can be created by a simple agreement, whereas a company requires a specific legal process to be followed.
  • Regulation: Both are also regulated under different acts – firms under the Partnership Act of 1932, and companies under the Companies Act 2017.
  • Membership: Partnership firms may have between two and 20 partners, while companies can have employees or shareholders in far greater numbers.
  • Management: In terms of day to day operations, management within a company comprises directors. However, within a partnership firm, each partner is expected to take equal ownership of the running of the business.
  • Profit: Within a firm, profit is divided up among the partners that make up the firm; this is done at a ratio that is documented within the partnership agreement. However, within a company, profit is divided up among the company’s directors based on their allocation of shares.

This is by no means an exhaustive breakdown of these terms; other differences exist too. For example, partners within a firm are not permitted to make any contracts with their firm, while shareholders within a company can form a wide range of agreements. Additionally, the partners within a partnership firm have ownership of all the firm’s property, whereas all property within a company belongs to the company itself. Our final point here is around succession, with all company shares being easily transferable from one member to their heir. However, a partnership firm can be damaged by the transfer of shares or inheritance.