Sunday, 31 July 2016

Why, for so long, was there no theory of the firm?

The theory of the firm is one of the more recent innovations in economics having only really started around 1970. This is strange since we have been producing stuff since humans become human. The question is therefore why did it take so long for anyone one to ask questions about the institutional organization of production. I will argue there are at least two parts to the answer to this question.

The first is that microeconomics in general is a relatively new area of research having really only taken off with the neoclassical revolution of the 1870s. Before then most discussion of economic issues was about what we would now call macroeconomic questions. The mercantilists, the physiocrats and the classical economists, for example, emphasised macroeconomic inquiries.

There were at times, in the mercantilist literature, much discussion of firms but it was a limited discussion. Limited in the sense that it dealt not with issues to do with firms per se but with the effects of firms on more macro issues such as recession, bullion and the balance of trade. In addition it gave occasion for the crystallization of protectionist doctrine. It was also limited in that it largely dealt only with the regulated companies and the opposition to their monopolies.

Foss and Klein (2006: 7-8) 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 (2004: 63) 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”.
Thus the firm wasn’t examined because microeconomic questions in general weren’t examined.

The second part of the answer is that firms weren’t for a long time of much importance to the economy as a whole. For much of human history production and consumption were very closely interconnected. Production for those outside of the production unit was largely unknown. That is, there was little production for trade. The production and consumption units were, by and large, the same. This point is important since some form of trade is a necessary, if not sufficient, condition for a firm to exist since without trade consumption and production must coincide, that is, the objectives of the producer and consumer will be the same. The coincidence of consumption and production in a world without trade, or at least a world with little trade, was noted as a potential problem by McDonald and Snooks (1986) in their analysis of manorial production in Domesday England:
“In the absence of trade, all the goods produced on the manor will be consumed on the manor. Such a situation makes it difficult to interpret the results of our production function estimates, because it becomes difficult to draw a distinction between the manor as a unit of production and as a unit of consumption: manorial production behaviour will be inextricably combined with the lord’s consumption preferences (or utility function). The underlying reason is that the implicit prices of output reflect both the production and the consumption behaviour of the manor, rather than just the costs of manorial production” (McDonald and Snooks 1986: 99).
So for the firm to become a major player in the economy, the market had to grow to the point where trade, both national and international, was large enough to allow the division of labour to develop and for specialised production units to be able to develop and survive. It is only then that production can be separated from consumption and firms can become separate from households.

It is only when self-sufficiency makes way for specialisation and trade that a discussion of firms becomes relevant.

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