Incentives matter: Adam Smith file 3

In Book V., Chapter 1, Part III, of An Inquiry into the Nature and Causes of the Wealth of Nations Adam Smith wrote on the different incentives faced by the directors of regulated companies and those the directors of joint stock companies,

... the directors of a regulated company have no particular interest in the prosperity of the general trade of the company for the sake of which such forts and garrisons are maintained. The decay of that general trade may even frequently contribute to the advantage of their own private trade; as by diminishing the number of their competitors it may enable them both to buy cheaper, and to sell dearer. The directors of a joint stock company, on the contrary, having only their share in the profits which are made upon the common stock committed to their management, have no private trade of their own of which the interest can be separated from that of the general trade of the company. Their private interest is connected with the prosperity of the general trade of the company, and with the maintenance of the forts and garrisons which are necessary for its defence. They are more likely, therefore, to have that continual and careful attention which that maintenance necessarily requires.

But then went on to warn about the incentives facing directors of joint stock companies,

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.

But as Gavin Kennedy has pointed out,

[t]he polemic is strong but ought not to obscure the fact that his criticism of the organisational structure of joint-stock trading companies did not extend to all joint stock companies. He recommended them for such activities as banks, citing in particular the Bank of England, the Bank of Scotland and the Royal Bank of Scotland (all still profitably trading today without the whiff of corruption, nor the stench, of corruption and scandal). They were also highly efficient as well as being honest and did not have exclusive monopolies in their fields of business.

He also recommended joint-stock companies for activities like the insurance industry and canals; the need for vast capitals to run these companies successfully made the joint stock arrangements necessary.