How economics changes: A case study of the theory of the firm (Part 2 of 2)
How economics changes: A case study of the theory of the firm (Part 2 of 2)
What changed around 1970?
In Part 1 of this post, I asked:
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?
And started to explore these questions with a case study: the history of the theory of the firm.
Part 1 looked at why was the firm, as an important economic institution in its own right, ignored for so long? In this, the second and final part, I ask what changed around 1970 that catalysed the entry of a formal theory of the firm into the mainstream of the economics discipline? I conclude that this case study supports the idea that economics changes gradually, rather than being regularly overturned by revolution.
What changed around 1970?
Turning to the second fundamental question posed in Part 1, it should be noted just how long it took for the theory of the firm to take off. It took around 30 years before Coase became an overnight success. As he has famously put it, before the 1970s ‘The Nature of the Firm’ was “much cited and little used” (Coase 1972: 63). Coase seems to have seen his work as a Marshall/Guillebaud/Friedman-type gradual change rather than a punctuated disruption to economic thought. Coase writes that he wishes to put two of Marshall’s major tools of analysis to good use, hoping to show
that a definition of a firm may be obtained which is not only realistic in that it corresponds to what is meant by a firm in the real world, but is tractable by two of the most powerful instruments of economic analysis developed by Marshall, the idea of the margin and that of substitution, together giving the idea of substitution at the margin (Coase 1937: 386-7; emphasis added.).
Change in economics, in general, was slow and difficult in Coase’s view.
What I’m going to talk about today is why economics will change. I talk about it because I don’t only think it will change, I think it ought to change. [ . . . ] It will take a long time. It won’t be an easy task, but I’m glad there are people here who are willing to undertake it (Coase 2002: 1; emphasis added.).
I think [economics] ought to change. It will take a long time. It won’t be an easy task. (Coase 2002)
1960 causes 1937
What then changed around 1970? What brought about the belated surge of concern for the theory of the firm? Coase’s answer is,
Barzel and Kochin have argued in an unpublished paper that the interest now being shown in “The Nature of the Firm” reflects the influence of my article “The Problem of Social Cost,” published in the October 1960 issue of the Journal of Law and Economics and that the recent literature on the organization of industry which is seemingly derived from “The Nature of the Firm” is in fact much more an outgrowth of the argument in “The Problem of Social Cost.” [ . . . ] However, unlike “The Nature of the Firm,” “The Problem of Social Cost” was an immediate success. It was soon cited and extensively discussed, and this continues to be the case. I do not wish to discuss why these two articles, using so similar an approach, should have been received so differently, but I agree with Barzel and Kochin that the popularity of “The Problem of Social Cost” must have played a very important part in rekindling interest in “The Nature of the Firm” (Coase 1988: 4-5)
Dissatisfaction grows
In addition, there had been a slowly growing dissatisfaction with aspects of the mainstream theory of production since its inception in the 1930s.
An increasing number of economists began to reject the Cannan/Pigou/Robbins-type views and began to see the firm as an important part of the economic system. Dissatisfaction manifested itself in, for example, the full cost and marginalist controversies and the development of the managerial, behavioural and X-inefficiency theories of the firm.1 Many of those involved in the two controversies wanted radical change to occur in the mainstream of economics. They attacked profit maximisation, and rejected marginal theory more generally, they wanted to introduce uncertainty and include more complicated representations of management into models of the firm, among other things. But there were even more radical critiques and radical alternatives to the mainstream. Their alternatives included Galbraith’s ‘theory of countervailing power’, Baran and Sweezy on ‘Monopoly Capital’, Rothchild’s ‘Price Theory and Oligopoly’ and Galbraith’s ‘The New Industrial State’.2 These more revolutionary critiques have had limited influence, however.
Given the number of orthodox assumptions maintained in the managerial, behavioural and X-inefficiency theories, they can be seen as more Marshall, Guillebaud and Friedman-type gradual change. There was also the creation in the 1960s of the (old) property rights economics (PRE) involving economists such as Armen Alchian, Harold Demsetz, and Steven Cheung. These scholars were more neoclassical in their approach than most of the critics, but still wished to transform the mainstream via, in this case, the inclusion of the analysis of property rights and their influence on resource allocation, institutions, and organisations.
The basic analytical category proffered by the PRE is, of course, that of property rights, and the main explanatory aims have consistently been to investigate how the delineation, exchange, and enforcement of property and ownership rights influence resource allocation, and how this frames an economic approach to institutions and organisations (Foss 2010: 92-3).
Say something interesting and show empirical support
Much of the criticism aimed at the orthodoxy could be seen, in one way or another, as coming from non-mainstream agendas but this does not mean it was totally without influence. Ideas that are interesting and supported by the data will get attention even if they come from outside the orthodoxy initially. Oliver Williamson gives support to this idea when he comments that “[e]conomists, in my experience, are very practical fellows. Tell economists something novel or different about phenomena that they are interested in and show that the data line up: that will get their attention” (Williamson 2015: 222).
Williamson himself was influenced by non-mainstream ideas, such as March and Simon (1958) and Cyert and March (1963), in his development of transaction cost economics. He has written about his time at Carnegie-Mellon University that
[t]he selective joinder of organization theory with economics, as these two bear on the theory of the firm, is what motivated my dissertation [ . . . ] and describes much of what I have been up to since (Williamson 2004: 281).
And yet even if motivated by non-mainstream notions, transaction cost economics has become one of the mainstays of (mainstream) organisational economics and won Williamson the 2009 Nobel Prize in economics which places him well up in the pantheon of mainstream economic gods.
The Coaseian (transaction cost or New Institutional Economics (NIE)) framework was recognised as providing insights into the nature of the firm that previous frameworks could not. Coase asked three basic questions:
Why do firms exist?
What determines the boundaries of the firm?
What determines the internal structure of the firm?
Previous approaches to the theory of the firm or production, because they were implicitly zero transaction cost, could not answer such questions and thus Coase offered a new understanding of issues that economists were finally interested in.
While the profession was not much interested in Coase’s questions in 1937, they had by 1970s caught up with Coase in realising there was a need for an economic analysis of property rights and the study of economic institutions more generally.
In line with Williamson’s “show that the data line up” argument, the Coaseian approach (eg. TCE, NIE) is seen by many as an “empirical success story”.
After all, NIE deals with a wide variety of phenomena and is the source of a huge and growing number of refutable implications, to which the data have been kind – which is to say corroborative. NIE is an empirical success story (Williamson 2015: 222).
and
A very large empirical literature exists lending support to the TCE [ . . . ]. In a typical study, some measure of lock-in, such as the specificity of the product procured or investments made, is related to the choice of whether to integrate. The strong association that this literature has found between specificity and integration has made the TCE one of the great success stories in industrial organization over the last 25 years (Whinston 2001: 184-5).
and
TCE was insistent from the outset on developing a predictive theory. Following a slow start, empirical analysis has mushroomed (to which the contributions of the marketing literature has been a major factor). It is broadly conceded that, limitations and qualifications notwithstanding, TCE is an empirical success story (Williamson & Ghani 2012: 80).
Good idea, wrong time
Cristiano (2015: 610) asks of Coase (1937), “A good idea at the wrong time?” And the answer may well be yes, and this helps explain the initial unenthusiastic reception the paper got. But by the 1970s times had changed and economists, thanks in part to the non-mainstream criticisms of standard production theory, had come to see much greater value in institutional analysis, and were more welcoming of Coase’s ideas.
Conclusion: gradualism not revolution
The theory of the firm may be an example of Marshall, Guillebaud and Friedman-type gradualism, where what could be seen initially as non-mainstream ideas have been integrated into the mainstream and have altered and broadened it in the process. While the introduction of new elements may seem, on the surface, to be anti-mainstream, these new theories still utilise many mainstream ideas and thus can be seen as not so much attempts to subvert the contemporary theory as attempts to expand the range of topics that the theory can handle. It can be argued that the discussion of the firm, and more recently the entrepreneur, the formation of firms, and via them the creation of markets, has now, finally, become a respectable mainstream activity.
Before the 1970s the theory of the firm was ignored for reasons that have already been explained. But by around 1970 economists had begun to change their views about the importance of institutions to the understanding of the economy. This meant that ideas to do with the firm gained acceptance in a way they had not before and thus were developed. As Williamson points out, what seems important to the acceptance of new ideas is saying something interesting about phenomena that economists are interested in and showing that the data line up. But timing is also important. A good idea at the wrong time is a wrong idea. Other people must be sympathetic to what is being said. The reaction to Coase’s work is an example of this. In the 1930s economists were not much interested in firms as such but by the 1970s they were. So, change occurs when economists are interested in change. In the case of Coase, we saw that his 1960 paper gained immediate success since economists were interested in what it said, and the success of that paper led to the rereading of his 1937 paper and thus the initiation of the theory of the firm.
In short, there must be both a supply of and demand for new ideas for change to occur. Small gradual changes are more likely to satisfy these criteria and thus gradual change is more likely to gain general acceptance than is large revolutions.
By Paul Walker
[With thanks to the editor for helpful comments on previous drafts of this post.]
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For a short overview of the attacks on the neoclassical model during the 1940-1970 period see Walker (2021: chapter 6).
Sawyer (1979: chapter 9) gives a succinct discussion of these more radical proposals.