How economics changes: A case study of the theory of the firm (Part 1 of 2)
How economics changes: A case study of the theory of the firm (Part 1 of 2)
Why did economics ignore the firm for so long?
An interesting conundrum for all disciplines, not just economics, is how the discipline develops through time. Do new, better ideas simply develop out of old notions? Is the process of development gradual or punctuated? Is there a sudden large change where new ideas supplant old ones at one moment, or just gradual change over time as new ideas are absorbed into the mainstream of thinking? Are there ‘revolutions’ in thought?
In economics, was there a neoclassical revolution? Ditto the Keynesian revolution, Cambridge revolution, rational expectations revolution, and monopolistic competition revolution? And if so, what made these events revolutions?
Is there one process of change applicable to all areas of economics or do different fields develop in different ways?
Is it far from clear there are good, agreed-upon answers to such questions.
Gradualism rather than revolution
In 1890, when taking stock of the development of economics in general, the leading economist of his age Alfred Marshall wrote that some
of the best work of the present generation has indeed appeared at first sight to be antagonistic to that of earlier writers; but when it has had time to settle down into its proper place, and its rough edges have been worn away, it has been found to involve no real breach of continuity in the development of the science. The new doctrines have supplemented the older, have extended, developed, and sometimes corrected them, and often have given them a different tone by a new distribution of emphasis; but very seldom have subverted them (Marshall, 1920: v).1
Around 70 years later G. W. Guillebaud and Milton Friedman made a similar point:
The new ideas and new criticisms, which then seemed to threaten to overturn the old orthodoxy, have, in the outcome, been absorbed within it and have served rather to strengthen and deepen it, by adding needed modifications and changing emphasis, and by introducing an altered and on the whole more precise terminology (Guillebaud and Friedman 1958: vi).
Gradualism rather than revolution for Marshall, Guillebaud and Friedman then. What I will argue here is that these comments about the discipline in general apply with full force to the particular case of the development of the theory of the firm. Many non-mainstream ideas have been integrated into the mainstream and have not so much subverted contemporary theory as broadened the range of topics that the theory can handle.
But first, to give perspective, I must note that the history of the theory of the firm is a story of opportunities not taken. For a long time, there were frameworks available that could have led to a theory of the firm, but none of them did until the 1970s. This raises two fundamental questions:
Why was the firm, as an important economic institution in its own right, ignored for so long? and
What changed in the 1970s?
Why was the firm ignored for so long?
Firms did not matter much
As to the first question, Foss & Klein (2006: 6–7) argue that there is the possibility of an empirical reason for the firm being overlooked — the relative unimportance of the (large, vertically integrated, often diversified) firm. Until relatively recently firms were simply not a large part of the economy. Thus analysing anonymous ‘firms’ may not have been a bad approximation to the empirical realities of the time. But there have been firms of reasonable size since ancient times (Bresson, 2014: 45; Silver, 1995: 143). While the existence of large firms in the pre-modern era should give us purse to think before accepting the Foss & Klein argument at face value, we have to ask even if large firms did exist, just how extensive a part of their respective economies were they? Recall, for example, the comment made by Bresson (2014: 45) that while large handicraft workshops did exist in ancient Greece they were rare. Taking agricultural production in medieval England as another example, Persson & Sharp (2015: 97) write that it
is important to point out here that the share of estate production in total agricultural production has often been exaggerated because the estates were the only producers which kept records. Medieval England, which is usually considered an economy dominated by big estates, had a substantial share of peasant household production. Peasants who were leasing land and owner-occupiers produced most of the agricultural output, probably as much as 75 per cent even in the medieval period.
Mokyr (2002: 122-3) notes that there were some, if not many, large firms in the UK before the industrial revolution. Adam Smith also acknowledged that large firms, in particular, chartered companies did exist in his time, but they were not the norm.
Most firms were small, with many larger firms being partnerships and thus restricted in their ability to expand, and they would cooperate in production via long supply chains in which each firm would specialise in making a small contribution to the overall production process.2
It, therefore, seems reasonable to conclude that a much smaller proportion of total production came from large firms in the past than comes from the modern integrated corporation in the contemporary economy. Thus, there was, to a degree, an empirical justification for economic theory ignoring the firm in the past, but there is much less of one for doing so today.
Economic theory thought not relevant
During the neoclassical period, firms were ignored simply because many economists did not see economic theory as being relevant to business or saw the internal workings of the firm to be outside the competence of economists. Edwin Cannan saw the usefulness of economics as being in politics rather than business, the
practical usefulness of economic theory is not in private business but in politics, and I for one regret the disappearance of the old name “political economy", in which that truth was recognised (Cannan 1902: 60).
And on the relationship between economic theory and business,
I do not mean to argue that a knowledge of economic theory will enable a man to conduct his private business with success. Doubtless many of the particular subjects of study which come under the head of economics are useful in the conduct of business, but I doubt if economic theory itself is. … economic theory does not tell a man the exact moment to leave off the production of one thing and begin that of another; it does not tell him the precise moment when prices have reached the bottom or the top. It is, perhaps, rather likely to make him expect the inevitable to arrive far sooner than it actually does, and to make him underrate, not the foresight, but the want of foresight of the rest of the world (Cannan 1902: 459-60).
Cannan was not alone in making this type of argument, the Cambridge economist Arthur Pigou wrote:
it is not the business of economists to teach woollen manufacturers to make and sell wool, or brewers how to make and sell beer, or any other business men how to do their job. If that was what we were out for, we should, I imagine, immediately quit our desks and get somebody – doubtless at a heavy premium, for we should be thoroughly inefficient – to take us into his woollen mill or his brewery (Pigou 1922: 463-4).
At the LSE Lionel Robbins argued similarly, in that the
technical arts of production are simply to be grouped among the given factors influencing the relative scarcity of different economic goods. The technique of cotton manufacture … is no part of the subject-matter of Economics” (Robbins 1935: 33).
A lack of tools
There is also the question of whether before the genesis of the transaction cost (TCE) framework, economists’ development of a theory of the firm was limited by the lack of tools to deal with the task. Backhouse (2002: 318) has put forward this possibility:
“Coase, instead, saw the firm as an organization or, as Williamson put it, as a governance structure. This is, of course, obvious. However, it was not until Coase introduced the idea of transaction costs that economists had any way in which to analyse this. Many economists had studied the organization of industry (a classic example is Marshall’s Industry and Trade, 1919[1920]), but such work was largely descriptive. Economists had not found a theoretical framework that could explain why industries were organized as they were”.
Even if there is some truth to Backhouse’s argument there is still the question, To what degree is this endogenous? Were tools not developed because economists had no interest in questions to do with the firm?
Normative not positive thinking
It could, in addition, be argued that another reason for the lack of emphasis on the theory of the firm was a more general lack of emphasis on positive economics for much of the history of economic analysis. Thinking on economic matters began and developed with a more normative/moral orientation than is common today. Sewall (1901: 1) points out that
“[t]he Greeks, in common with most ancient peoples, had no conception of “rational laws governing the phenomena of the distribution of wealth.” They studied human conduct to discover a man’s duty, or to ascertain what kind of actions constituted noble lives, rather than to know the ultimate relations of all actions”.
Around 80 years after Sewall, Lionel Robbins argued that
both Plato and Aristotle were more famous as general philosophers, moral philosophers and as philosophers concerned with metaphysics, the nature of the world, epistemology and so on and so forth. And their anticipations of economics –and in the case of Aristotle it is extremely important and in the case of Plato it is outstanding but not so influential-their concern as moral philosophers with questions of an economic nature arose essentially with their concern with the good State. What was the good State? … And approaching the good State from the question What is justice in a good State? (Robbins 1998: 11).
Whittaker (1940: 362) explains that in the early Christian period, attention was focused on the form of production. The question of which occupations should be pursued, and thus what goods and services should be produced, was emphasised.
This normative/moral view of economics lasted, at least to some degree, up until the 20th century. In the conclusion to his paper, ‘A Short History of Economics As a Moral Science’ James Alvey outlines the decline of economics as a moral science:
[a]fter the introductory remarks, I set out [ . . . ] a brief history of economics before Adam Smith, showing that it was generally (with the exception of the mercantilists) conceived of as a part of moral philosophy. [ . . . ] I presented elements of the new interpretation of Smith, which show the latter as a developer of economics as a moral science. [ . . . ] I showed that even after Smith, up to the beginning of the present century, a number of leading economic theorists conceived of economics as a moral science, either in theory or in practice. [ . . . ] I sketched the decline of economics as a moral science. The key factor was the emergence and influence of positivism. The current view of the detachment of economics from moral science and morals, in particular, is alien to much of the history of the discipline (Alvey 1999: 68).
Examples of positivism referred to above would include works such as Robbins (1935) and Friedman (1953).
Macro versus micro
In combination with this, there was, as has been argued above a concentration on macroeconomic issues rather than microeconomic concerns for much of the history of the development of economics. It was not until the ‘marginal revolution’ of the 1870s that microeconomic questions began to come to the fore. Less emphasis on microeconomics in general lessened the probability of a microeconomic-based theory developing in the particular case of the theory of production or the firm.
Given that a normative/macro orientation to economic analysis lasted for much of the history of the discipline it is perhaps not surprising that for much of this time less emphasis was placed on purely positive/micro questions, including questions to do with the microeconomic theory of production or the firm, than is the current norm. It had to wait until the 20th century when the emphasis within economics shifted more towards both positive questions and microeconomic issues before questions to do with the existence, boundaries and internal organisation of firms were asked and provisional answers were proposed.
While an emphasis on normative/macro considerations does not necessarily preclude the formulation of a theory of production or the firm it can help create an environment that is not conducive to the development of such a theory.
Markets more important than firms
Foss (1997: 176) puts forward another possible reason,
some 25 years ago Ronald Coase (1972, p. 63) observed tartly that his 1937 essay ‘The Nature of the Firm’ had been “much cited and little used,” and – it is fair to say – economists did in general neglect the firm. The reason? The conviction – brilliantly articulated by Fritz Machlup (1967) – that the purpose of economic theory primarily is to explain market-level phenomena, and that the firm is therefore, at most, an intermediate step in the price theoretic logic.
Formalism killed the firm star
Lastly, Foss and Klein (2006) contend that it was the rise in formalism in economics that resulted in the firm being ignored.
[W]hile these advances in tooled knowledge are partly the result of the increased use of formal methods in economics, it was the rise of formalism in economic theory that was largely responsible for the neglect of the firm’s characteristics in the first place. In other words, if the purpose of economic theory is prediction, not explanation, then treating the firm as a production function or a price taker is perfectly acceptable, as long as it generates accurate predictions (Friedman 1953: 150) (Foss & Klein 2006: 2, footnote 2).
Coase ignored
Ronald Coase’s work, in particular his 1937 paper ‘The Nature of the Firm’, was the main catalyst for the development of the theory of the firm starting in the 1970s. Looking at the reception of Coase’s paper at the time of its publication, it was muted at best. It has been suggested there were two main reasons, in addition to those given above, for this. First was the fact that the theory of the firm as it was developing at the time was aimed at the ‘rationalisation debate’ that was then underway. The theory before Coase
was a response, coming from a group of professional economists, to the non-theoretical rule-of-thumb view of firms that was frequently presented under the umbrella term of “rationalization” (Brady 1932) — an industrial policy proposal connected with manufacturing industries in particular — and not an explanation associated with the question of why firms exist within a market economy (Cristiano 2015: 599).
Coase’s work, on the other hand, was offering “an explanation associated with the question of why firms exist within a market economy” and thus was not a contribution to the rationalisation debate. This put Coase at odds with those participating in the debate.
This means Coase received little attention since he answered a question that at the time no one had asked. The economic theorists at the time were not primarily concerned with “why firms exist within a market economy”. Secondly for those in the rationalisation debate, Coase’s work offered little that was considered useful. To begin with, Coase’s work was a theory of the firm with no policy prescriptions offered and additionally, those economists interested in the firm at the time were investigating the case in which the market was more efficient than the firm while Coase was, effectively, looking at the opposite situation; where the firm arose because it was more efficient than the market.
Thus, for whatever reason, or combination of reasons, it must be conceded that it took a long time for a genuine theory of the firm to develop.
What changed around 1970?
In Part 2 of this post I address the second fundamental question: what changed around 1970? And what can we conclude from this case study about the broader question: how does the economics discipline change over time?
By Paul Walker
[With thanks to the editor for helpful comments on earlier drafts.]
Consider the day-labourers woollen coat example from Book I, Chapter I of Smith’s "Wealth of Nations" (Smith 1776).