Economics and Finance of the Firm as an Entity

Abstract:     
Standard finance theory was born from the rib of neoclassical economics. Notwithstanding some assumptions have been modified or relaxed, this neoclassical finance theory (NFT) is still based upon: (1) methodological individualism; (2) the fully rational homo economicus; and (3) the capital markets’ efficiency.
Despite its fast development as a comprehensive decision making theory, NFT is increasingly under attack because of the irrealism (or the anti-realism?) of those basic assumptions.
The main criticisms are usually addressed to both the fully rational agent and capital market efficiency, whilst methodological individualism is more tolerated. The rationale for this chapter is, on the contrary, that the evidence that the real world is a world of organizations and institutions, which cannot be reduced to the mere aggregation of single agents’ behaviors. More dynamic and holistic features and implications have thus to enter the framework.
This chapter focuses on a finance theory built around the concept of a firm as an institution. Therefore it aims at shedding light on the effects that the introduction of the entity-firm concept has on finance theory.
In order to achieve its goal, the chapter is structured as follows. The second section synthesizes NFT from a methodological standpoint, also offering some insights on both its foundation and how it differs from so-called traditional finance. The third section outlines the problem of the missing entity-firm at the core of the analysis, and the fourth section presents the criticisms levelled against full-rationality and capital markets’ efficiency assumptions. The fifth section offers an analysis of how the introduction of the entity-firm concept calls for renewing finance theory, and the sixth section addresses the topic of capital structure decisions under the light of the basic premises of the entity-firm-based finance theory. Finally, conclusions are outlined.

Number of Pages in PDF File: 24

Keywords: Entity theory, theory of firm, theory of finance

JEL Classification: D23, L22, G30, M41

Accepted Paper Series