Adam Smith's missed opportunity
Smith gave us no theory of the firm
Adam Smith is a past master for all manner of persons, for Conservatives and for Marxists, for liberals and for anti-radicals, for economists, philosophers, and sociologists. Different groups admire different things in his work and one may sometimes doubt whether all the different things can be held together consistently. Still, each of them is persuasive enough to have made its mark as a truth of some profundity.
Or so philosopher D. D. Raphael wrote when summing up Adam Smith’s contribution to modern thought1. NZAE members, and those of similar organisations, typically consider Smith to stand at the head of the pantheon of economists. His book An Inquiry into the Nature and Causes of the Wealth of Nations2 is seen as the foundation of the classical school of economics, and the classical school is seen as initiating economics as we know it.
An unquestionably famous figure
Smith is a famous figure, both as a philosopher and an economist. For example, James Otteson wrote
In my judgment, Smith is one of the great philosophical figures of the Western tradition. Note that I said philosophical figures: His significance goes well beyond what falls within the purview of “economics” today.3
Similarly, Craig Smith wrote that “Smith was one of the most profound thinkers to emerge from Scotland, Britain and indeed Europe”.4 And Eamonn Butler described The Wealth of Nations as “one of the most influential books ever written”.5
Smith got 4 (or 5) things wrong
But all thinkers, no matter how great or influential, get things wrong, and Smith was no exception. Otteson argues in his book Adam Smith that there were four wrong steps in The Wealth of Nations and The Theory of Moral Sentiments,6 the latter being Smith’s first and lesser-known book.
In his chapter "What Smith Got Wrong", Otteson identifies four errors:
1. Labor Theory of Value,
2. Happiness and Tranquility,
3. Committing the Great Mind Fallacy? and
4. Smithian Limited Government and Human Prosperity.7
I believe that Smith made a fifth error — he missed the opportunity to formulate a theory of the firm. He had building blocks on which to base such a theory, he just didn't develop them.
In particular, he could have expanded his discussions of specialisation and the division of labour and of joint-stock companies to formulate such a theory.8
Sticking it to the pin factory
Smith opened his magnum opus with the justly famous discussion of the division of labour at the microeconomic level using the influential pin factory example but quickly
moved the analysis to the market level. Paul McNulty, when discussing Smith’s approach to the division of labour, commented that
[h]aving conceptualized division of labor in terms of the organization of work within the enterprise, however, Smith subsequently failed to develop or even to pursue systematically that line of analysis. His ideas on the division of labor could, for example, have led him toward an analysis of task assignment, management, or organization. Such an intra-firm approach would have foreshadowed the much later−indeed, quite recent−efforts in this direction by Herbert Simon, Oliver Williamson, Harvey Leibenstein, and others, a body of work which Leibenstein calls “micro-microeconomics”. Further attention on Smith’s part to intra-firm matters would not have been altogether surprising in the light of the then-emerging factory system at the hands of contemporaries Matthew Boulton, James Watt, Josiah Wedgwood, and others. But, instead, Smith quickly turned his attention away from the internal organization of the enterprise, and outward toward the market and the realm of exchange, perhaps because he found therein both the source of division of labor, in the “propensity in human nature … to truck, barter and exchange” and its effective limits.9
You only have to look at the much more recent literature to see that a division of labour approach to the firm is feasible.10
A lack of governance
A further missed opportunity is when Smith discussed joint-stock companies. He could have considered agency problems and corporate governance.
Smith’s discussion of joint-stock companies started with an examination of the English East India Company in a long footnote added to the second edition of The Wealth of Nations. He expanded this analysis in a supplement to the second edition, which was
subsequently incorporated into the text of the third edition. Smith added this material to a subsection “Of the publick Works and Institutions for facilitating the Commerce of the Society”, which is to do with goods and services largely provided by the government today. To us, this may seem a strange placement until we realise, as Mark Donoghue has noted, that
the key historical fact is that in Smith’s time private enterprise was often the vehicle utilised for the delivery of public works
and
Smith’s discussion of public works under the heading, the “third duty of the Sovereign”, designates the sovereign’s traditional roles and responsibilities in respect of public works in an era before such responsibilities were absorbed by the modern state.11
Public works, in Smith’s day, included the provision of roads, bridges, canals and water supply. Smith saw joint-stock firms, such as the East India Company, as a way of providing such works.
Smith, when considering the internal organisation of joint-stock firms, raised, but did not develop a theory of, what we would now call, principal-agent problems arising from the separation of ownership from control. He famously remarked
the directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.12
While highlighting the problem, Smith did not offer anything in the way of a solution insofar as he did not develop a general theory of agency problems or corporate governance.
Firms just weren't relevant or important
Perhaps the most obvious reason for Smith not discussing the firm in depth is that he wasn't interested in the firm as such. He was, as the full title of The Wealth of Nations suggests, interested in economic growth, and its nature and causes. This didn't require a theory of the firm that explained their existence, boundaries and internal organisation.
There may also be an empirical reason — the relative unimportance of the firm in the 18th Century. Until relatively recently firms were simply not a large part of the economy. But that explanation is not wholly convincing since large firms existed before Smith’s time, and the classical economists knew this. A more precise and more defensible explanation would be that large, vertically integrated and diversified firms were not empirically important until recently.
Most firms in Smith’s time were small, with many larger firms being partnerships and thus restricted in their ability to expand. Firms cooperated in production via long supply chains in which each firm would specialise in making a small contribution to the overall production process. As an example, consider Smith’s description of the making of the woollen coat for a day labourer.
Observe the accommodation of the most common artificer or day-labourer in a civilized and thriving country, and you will perceive that the number of people of whose industry a part, though but a small part, has been employed in procuring him this accommodation, exceeds all computation. The woollen coat, for example, which covers the day-labourer, as coarse and rough as it may appear, is the produce of the joint labour of a great multitude of workmen. The shepherd, the sorter of the wool, the wool-comber or carder, the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser, with many others, must all join their different arts in order to complete even this homely production.13
For whatever reason, Smith did not develop a theory of the firm.14 Michael Best's summary of Smith's position is that “Adam Smith did not elaborate a theory of the firm”.15 Philip Williams argued that
the firm was disembodied and became a unit in which resources congeal in the productive process. When we come to examine the equilibrium/value theory of The Wealth of Nations it will be shown that, in that context, the firm is little more than a passive conduit which assists in the movement of resources between alternative activities.16
No meaningful classical economic theory of the firm
Smith’s line of thinking was followed by the classical economists more generally, resulting in a situation in which there was no meaningful theory of the firm within classical economics. Kenneth Arrow summarised this situation by noting,
in classical theory, from Smith to Mill, fixed coefficients in production are assumed. In such a context, the individual firm plays little role in the general equilibrium of the economy. The scale of any one firm is indeterminate, but the demand conditions determine the scale of the industry and the demand by the industry for inputs. The firm’s role is purely passive, and no meaningful boundaries between firms are established17
Howard Bowen argued similarly,
economists of the classical tradition had usually assumed that the level and distribution of income and the allocation of resources were determined by forces that could be understood without a detailed theory of the firm. […] Everything else would be settled by the impersonal forces of the market, and there would be no need to consider in detail the decisions and actions of the individual firm.18
Mark Blaug, the doyen of historians of economic thought, stated it most simply: the classical economists “had no theory of the firm”.19
By Paul Walker
Raphael, D. D. (1985). Adam Smith, Oxford: Oxford University Press. p.1
Smith, Adam (1776). An Inquiry into the Nature and Causes of the Wealth of Nations, Volumes I and II, R. H. Campbell & A. S. Skinner (general eds.), W. B. Todd (textual ed.), Indianapolis: Liberty Classics, 1981. Free online copy.
Otteson, J. R. (2011). Adam Smith (Major Conservative and Libertarian Thinkers Volume 16, Series Editor: John Meadowcroft), New York: Continuum. p.135
Smith, Craig (2007). ‘Commentary: The Relevance of Adam Smith Today’. In Eamonn Butler, Adam Smith - A Primer (pp.118-22), London: Institute of Economic Affairs. p.118
Butler, Eamonn (2007). Adam Smith - A Primer, London: Institute of Economic Affairs. p. 25
Smith, Adam (1759). The Theory of Moral Sentiments, D. D. Raphael & A. L. Macfie (eds.), Indianapolis: Liberty Classics, 1982. Free online copy.
Otteson (2011): Chapter 8.
Michel Zouboulakis (2015), on the other hand, argues that Smith’s discussion of the division of labour does offer an elementary explanation for the existence of firms. In the Zouboulakis view of Smith, the existence of firms is explained through division of labour dynamics. As the market grows more firms are created and they become larger thereby employing more labour and capital and thus there is an increase in specialisation and the division of labour. This in turn increases efficiency and productivity which increases general economic wellbeing.
Zouboulakis, Michel S. (2015). ‘Elements of a theory of the firm in Adam Smith and John Stuart Mill’. In George C. Bitros & Nicholas C. Kyriazis (eds.), Essays in Contemporary Economics: A Festschrift in Memory of A. D. Karayiannis (pp. 45-52), Heidelberg: Springer Cham. Working paper version: Zouboulakis, Michel, ‘Elements of a Theory of the Firm in Adam Smith and John Stuart Mill’ (September 26, 2014). Available at SSRN: https://ssrn.com/abstract=2651062
McNulty, Paul J. (1984). ‘On the Nature and Theory of Economic Organization: the Role of the Firm Reconsidered’, History of Political Economy, 16(2) Summer: 233-53. pp. 237-8
For example:
Becker, Gary S. & Kevin M. Murphy (1992). ‘The Division of Labor, Coordination Costs, and Knowledge’, Quarterly Journal of Economics, 107(4) November: 1137-60.
Frank, Lawrence K. (1925). ‘The Significance of Industrial Integration’, Journal of Political Economy, 33(2) April: 179-95.
Rauh, Michael T. (2018). ‘The O-ring Theory of the Firm’, Journal of Economics & Management Strategy, 27(1) Spring: 82-101.
Robinson, E. A. G. (1931). The Structure of Competitive Industry, London: Nisbet & Co.
Stigler, George J. (1951). ‘The Division of Labor is Limited by the Extent of the Market’, Journal of Political Economy, 59(3) June: 185-93.
Donoghue, M. (2020). ‘Adam Smith and the Honourable East India Company’, History of Economics Review, 77(1): 1–19. p.12
Smith (1776): Book V, Chapter 1, Part III, p. 741
Smith (1776): Book 1, Chapter 1, p.13
cf. Zouboulakis (2015).
Best, Michael H. (2012). ‘The Obscure Firm in the Wealth of Nations’. In Michael Dietrich & Jackie Kraff (eds.), Handbook on the Economics and Theory of the Firm (pp. 29–41), Cheltenham, UK: Edward Elgar Publishing Ltd. p. 29
Williams, Philip L. (1978). The Emergence of the Theory of the Firm: From Adam Smith to Alfred Marshall, London: The Macmillan Press. p.11
Arrow, Kenneth J. (1971). ‘The Firm in General Equilibrium Theory’. In R. Marris & A. Wood, (eds.), The Corporate Economy: Growth, Competition, and Innovative Potential (pp. 68-110), London: Macmillan. p. 68
Bowen, Howard R. (1955). The Business Enterprise as a Subject for Research: Prepared for the Committee on Business Enterprise Research, Social Science Research Council, Pamphlet No. 11, New York: Social Science Research Council. pp. 5-6
Blaug, Mark (1958). ‘The Classical Economists and the Factory Acts — A Re-examination’, The Quarterly Journal of Economics, 72(2) May: 211-26. p. 226