Wednesday 31 December 2014

Adam Smith, classical economics and the firm, or rather the lack of a firm

I have written before on The firm in classical economics and noted Mark Blaug's famous point that that the classical economists simply
"[ ... ] had no theory of the firm".
Blaug is not the only one to argue in this way, Kenneth Arrow explains,
"[i]n 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 established".
When writing about Adam Smith's approach to the firm Philip L. Williams 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"
while Michael Best states simply that
"Adam Smith did not elaborate a theory of the firm".
Howard Bowen argues in a similar fashion:
"[ ... ] 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".
When looking at Adam Smith's magnum opus, An Inquiry into the Nature and Causes of The Wealth of Nations, it should be noted that Smith begins 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 Paul McNulty 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".
So the question raised by all of this is, Why no theory of the firm in classical economics? At least part of the answer may be that the theories being analysed in classical economics are macroeconomic theories, they are theories of the production of an entire economy rather than (microeconomic) theories of firm production. D. P. O'Brien remarked that
"[c]lassical economics ruled economic thought for about 100 years. It focused on macroeconomic issues and economic growth. Because the growth was taking place in an open economy, with a currency that (except during 1797-1819) was convertible into gold, the classical writers were necessarily concerned with the balance of payments, the money supply, and the price level. Monetary theory occupied a central place, and their achievements in this area were substantial and - with their trade theory - are still with us today".
Nicolai Foss and Peter Klein note that classical economics was largely carried out at the aggregate level with microeconomic analysis acting as little more than a handmaiden to the macro-level investigation,
"[e]conomics began to a large extent in an aggregative mode, as witness, for example, the "Political Arithmetick" of Sir William Petty, and the dominant interest of most of the classical economists in distribution issues. Analysis of pricing, that is to say, analysis of a phenomenon on a lower level of analysis than distributional analysis, was to a large extent only a means to an end, namely to analyze the functional income distribution".
O'Brien makes the same basic point by noting the differences in emphasis between classical and neoclassical economics:
"[t]he core of neo-Classical economics is the theory of microeconomic allocation, to which students are introduced in their first year in an elementary and largely intuitive form, and which receives increasingly sophisticated statements during succeeding years of study. On top of this, as a sort of icing on the cake, comes the macroeconomics theory of income determination, with, in little attached boxes so to speak, theories of growth and trade appended. But the approach of the Classical economists was the very reverse of this. For them the central propositions of economics concerned macroeconomic problems. Their focus above all was on the problem of growth, and the macroeconomic distribution conclusions which followed from their view of growth. On the one hand, international trade, at least for Smith, was inextricably bound up with all this: on the other, the microeconomic problems of value and microdistribution took their place as subsets of the greater whole".
So the lack of a theory of the firm may reflect a more general lack of microeconomics in the writings of the classical school. Classical economics was largely about the macroeconomic problems of growth, monetary policy and trade. It took the "neoclassical revolution" of the 1870s to bring about a theory of firm level production but even this wasn't a theory of the firm. Development of such theories had to wait until as recently as the 1970s when Coase's ideas on the firm started to be taken seriously.

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