Saturday, 9 April 2016

Things Adam Smith got wrong

In short, not many and the things he got right far outweigh the things he got wrong, but as  James R. Otteson argues in his book "Adam Smith" there were some wrong steps.

In his book Otteson has a chapter on "What Smith Got Wrong". He suggests four things:
  1. Labor Theory of Value,
  2. Happiness and Tranquility,
  3. Committing the Great Mind Fallacy? and
  4. Smithian Limited Government and Human Prosperity.
I'm going to argue here for a fifth thing, Smith 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 I would argue he could have his expanded his discussions of specialisation and the division of labour and of joint-shock companies to formulate some version of a theory of the firm.

Smith who opens his magnum opus, An Inquiry into the Nature and Causes of The Wealth of Nations, with a discussion of the division of labour at the microeconomic level, the famous pin factory example, but quickly moves the analysis to the market level. When discussing Smith’s approach to the division of labour McNulty (1984: 237-8) comments,
“[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”. [ ...] 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”.
Another missed opportunity is when, from the third edition on, Smith discusses ‘joint-shock companies’. When considering the internal organisation of such firms Smith raises, but does not develop a theory of, what we would call today, the principal-agent problems that arise from the separation of ownership from control. Perhaps his most famous remark is,
“[t]he 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” (Smith 1776: Book V, Chapter 1, Part III, p. 741).

But “[ ...] Smith neither used the modern terms, “agency” or “corporate governance,” nor developed a general theory−a fact that is often overlooked” (Fleckner 2016: 22).

Perhaps the most obvious reason for this is that Smith wasn't interested in the firm as such. He was, as the title of this book would suggest, interested in economic growth and its nature and causes. This didn't require a theory of the firm in terms of a theory explaining the existence, boundaries and internal organisation of the firm. There may also be an empirical reason for the firm being overlooked; the relative unimportance of the firm. Until relatively recently firms were simply not a large part of the economy. But it has been pointed out that such an explanation is not wholly convincing. Large firms have existed since before the time of Adam Smith and the classical economists knew this. A more precise, and more defensible, version of the argument would be that the large, vertically integrated and diversified firm was not empirically important until recently.

For whatever reason this line of thinking was followed by the classical economists resulting in a situation which Blaug (1958: 226) could summarise simply by noting that the classical economists “[ ...] had no theory of the firm”.

  • Blaug, Mark (1958). ‘The Classical Economists and the Factory Acts-A Re-Examination’, The Quarterly Journal of Economics, 72(2) May: 211-26.
  • Fleckner, Andreas Martin (2016). ‘Adam Smith on the Joint Stock Company’, Max Planck Institute for Tax Law and Public Finance Working Paper 2016-01 January.
  • 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.
  • Otteson, J. R. (2011). Adam Smith (Major Conservative and Libertarian Thinkers Volume 16, Series Editor: John Meadowcroft), New York: Continuum.
  • Smith, Adam (1776). An Inquiry into the Nature and Causes of the Wealth of Nations, Volumes I and II, R. H. Campbell and A. S. Skinner (general eds.), W. B. Todd (textual ed.), Indianapolis: Liberty Classics, 1981.


Riko Stevens said...


You might like to consult Philip William's The Emergence of the Theory of the Firm (1978) in this connection. In this book arising from a PhD thesis supervised by Mark Blaug and examined by Terence Hutchison, Williams argues that Adam Smith did indeed formulate a theory of the firm.

Best regards,
Riko Stevens

Paul Walker said...

Hi Riko

I know the book, I have it (in fact I may have two copies).

1) note the quote I give from Mark Blaug that the classical economists, which includes Smith, had no theory of the firm.

2) let me quote from William's book:

"Williams (1978: 11) says, “[t]he 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.” "

Doesn't really sound like a decent theory of the firm.

3) let me note what others have said of Smith's "theory of the firm". Best (2012: 29) states simply that “Adam Smith did not elaborate a theory of the firm”. Fleckner (2016: 8) writes “[n]ot once does he [Adam Smith] speak of a “firm,” nor does he develop anything that would resemble a theory of the firm”."


Best, Michael H. (2012). ‘The obscure firm in the Wealth of Nations’. In Michael Dietrich and Jackie Kraff (eds.), Handbook on the Economics and Theory of the Firm (pp. 29-41), Cheltenham: Edward Elgar Publishing Ltd.

Fleckner, Andreas Martin (2016). ‘Adam Smith on the Joint Stock Company’, Max Planck Institute for Tax Law and Public Finance Working Paper 2016-01 January.

Riko Stevens said...

Hi Paul,

I am pleased to hear that you did not overlook Williams's work. My point is that although Smith may not have developed a "decent theory of the firm", it is true that he did generate a theory of the firm. That is to say, Smith thought abstractly about the firm with reference to general principles. Indeed, to quote from the same page of Williams (1978: 11):

'One of the characteristics of the emergence of the scientific economics which flowered in The Wealth of Nations was the emphasis on classes of firms as contrasted with the emphasis by the pamphleteers on particular firms - such as the East India Company and the Merchant Adventurers. Instead of paying attention to the price charged by a particular firm operating in a particular market, hypotheses were given greater range by referring to classes of firms, classes of markets, and classes of productive factors.'

Of course, we may be quibbling over an issue of semantics. However, I think that it is important to acknowledge the existence of a view that Smith did generate a "theory" of the firm, the quality of which may or may not be wanting.

Riko Stevens

Paul Walker said...

I would argue that Smith's emphasis was on "classes of markets, and classes of productive factors" rather than on "classes of firms". After all the "Wealth of Nations", and the classical economics that followed it, was largely work on macroeconomics, in particular growth theory. As Thomas Sowell written,

“[c]lassical economics was much more than a miscellaneous collection of theories and doctrines. Its particular theories and policy prescriptions revolved around a single central concern: economic growth. Unlike modern growth theory, classical economists were not primarily concerned with the adjustments of the economy to the growth process, but with how such a process could be generated and sustained. The full title of Adam Smith’s classic included the nature and causes of the wealth of nations” (Sowell 2006: 22).

See also O'Brien (2004).

My main point is that Smith had the building blocks of a theory of the firm, eg the division of labour, the separation of ownership from control, but didn't develop them.

Also much of Smith's discussion of firms was also about particular firms, consider his "very violent attack" on the East India Company.

If we compare Smith's discussion with that of the contemporary theory of the firm then his theory isn't a theory of the firm since it does not deal with the questions to do with the existence, boundaries and internal organisation of the firm.

Interestingly if we consider William's discussion of Smith's theory then we only have "half a theory" when we compare it to the neoclassical approach to the firm.

The neoclassical theory considers "firms" decisions in both factor and product markets but as Williams (1978: 3) notes "[a] study of the historical development of the complete theory of the firm would be redundant. It would be redundant because there already exist standard historical treatments of the firm's decisions in factor markets. [Cannan (1917) and Stigler (1941) are given as an examples of such studies] So the present study relates only to the literature of those decisions of the firm which relate directly to product markets − the pricing and production decisions".

But Cannon's discussion is about the wealth, or per capita wealth, of the nation, not the firm or the individual. So his discussion is about use of land, labour and capital in production at the aggregate level. Thus Cannon and Williams, if we see Williams as dealing with microeconomics, are not fully compatible. So even if we accept Williams's view of Smith we don't get, in this sense, a "full" theory of the firm, it at best only deals with behaviour in product markets.

Cannan, Edwin (1917). A History of the Theories of Production and Distribution in English Political Economy from 1776 to 1848, 3rd edn., London: P. S. King & Son.
O’Brien, Denis P. (2004). The Classical Economists Revisited, Princeton: Princeton University Press.
Sowell, Thomas (2006). On Classical Economics, New Haven: Yale University Press.
Stigler, George J. (1941). Production and Distribution Theories: The Formative Period, New York: The Macmillan Company.
Williams, Philip L. (1978). The Emergence of the Theory of the Firm: From Adam Smith to Alfred Marshall, London: The Macmillan Press.