Fleckner on Adam Smith on the joint stock company

That Adam Smith was not a huge fan of the joint stock company is well known. But what exactly did he think and why did he think it? And why was he wrong? These questions are considered in a new paper Adam Smith on the Joint Stock Company by Andreas Martin Fleckner.

The abstract reads:

In 1784, Adam Smith released the third and definitive edition of the Wealth of Nations, the most influential work in economics ever written. Of the eighty pages he added, more than thirty deal with “joint stock companies” and other commercial organizations. While these additions caused many observers to praise Smith as the first to coin the governance problems in firms, a closer examination of his remarks reveals that Smith’s theory of the firm, or the lack thereof, is in fact one of his work’s weaker parts. Smith thought history had shown that joint stock companies cannot compete with smaller firms, attributed this fact to certain organizational deficits, and concluded that joint stock companies should be established only under rare circumstances. Yet, in the following decades, exactly the opposite came to pass, with joint stock companies thriving in almost all fields and markets today. What made Smith so pessimistic about the joint stock company? The answer lies, this paper argues, in the sources Smith consulted, the companies he studied, and the general beliefs he held. Why did Smith’s pessimism turn out to be wrong? Smith probably overestimated the joint stock company’s weaknesses and underestimated developments that helped overcome them, such as technological progress, organizational innovations, and regulatory responses.

Fleckner raises a number of interesting questions to do with Smith's analysis of the firm. Let me make a couple of comments.

First Fleckner notes that Smith (and the classical economists who followed him) showed little interest in the firm. It could be argued that there are two reasons for this. Firstly the An Inquiry into the Nature and Causes of the Wealth of Nations was largely a book concerned with macro economics, in particular with growth theory and thus a study of firms as such had little to offer. The historian of economic thought D. P. O'Brien has 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".

Secondly large firms were not an empirically important part of the economy in Smith's day. Most production at the time was little more than household based production or small scale production based around a master craftsman and a few apprentices. Often the larger firms that did exist were partnerships rather than joint stock.

This lack of interest in the firm by Smith, and the following classical economists, explains why "Not once does he speak of a “firm,” nor does he develop anything that would resemble a theory of the firm." And when Smith does show interest it is not in terms of the firm in general - the no theory of the firm point - but in particular firms, the regulated and joint stock companies - mainly the East India Company.

Fleckner also notes that Smith placed his discussion of the joint stock company in a section of the Wealth of Nations to do with goods and services provided by the government. Smith put the discussion in the section to do with “Expence of publick Works and publick Institutions”. Smith explains that: "The third ... duty of the sovereign or commonwealth is that of erecting and maintaining those publick institutions and those publick works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature, that the profit could never repay the expence to any individual or small number of individuals, and which it, therefore, cannot be expected that any individual or small number of individuals should erect or maintain".

Fleckner explains,

Smith adds two further distinctions before he finally gets to the joint stock company. In a first step, Smith subdivides the public goods into “publick Works and Institutions for facilitating the Commerce of the Society” (pp. 93–150), “Institutions for the Education of Youth” (pp. 150–92), and “Institutions for the Instruction of People of all Ages” (pp. 192–237). In a second step, he breaks the first group into those public works and institutions “necessary for facilitating Commerce in general” (pp. 93–107) and those “necessary for facilitating particular Branches of Commerce” (pp. 107–50). What kind of public works and institutions does Smith have in mind here? For “facilitating Commerce in general,” Smith thinks of the “erection and maintenance of the publick works which facilitate the commerce of any country, such as good roads, bridges, navigable canals, harbours, &c.” (pp. 93–4). This list at the outset of the section is almost complete, supplemented only by a “coinage” (pp. 94–5) and a “post-office” (pp. 95, 99, 243–4).

In the first (1776, vol. II, p. 340) and second (1778, vol. II, p. 342) editions, Smith’s discussion of public works and institutions that facilitate commerce concludes at this point. In the third edition, his older remarks become the first subsection, on the promotion of commerce in general, followed by new thoughts on public works and institutions that facilitate particular branches of commerce.

These new thoughts include thoughts on the joint stock company. This seems a strange place to put such a discussion.

Fleckner goes on to say that,

Unlike the older parts, the new section on particular branches of commerce lacks a concise definition and a list of introductory examples. Smith speaks in a rather bored tone of “particular institutions …, which again require a particular and extraordinary expence” (p. 107). To illustrate, he adds (ibid.): “Some particular branches of commerce, which are carried on with barbarous and uncivilized nations, require extraordinary protection. An ordinary store or counting-house could give little security to the goods of the merchants who trade to the western coast of Africa. To defend them from the barbarous natives, it is necessary that the place where they are deposited, should be, in some measure, fortified.”

If Smith had stopped here, with the insight that overseas trading requires additional protection, and moved on to other branches of commerce, hardly any reader would have criticized him for leaving out important information, given the wide range of topics under consideration. Yet, Smith does not stop here. He gets carried away by his example and, to mimic a British idiom, literally goes round the fortified houses. In the next sentence, he mentions another example of a place where commerce needs special protection: “Indostan” (p. 107). This brings him, for the first time, to the trading companies (p. 107): “[I]t was under pretence of securing their persons and property from violence, that both the English and French East India Companies were allowed to erect the first forts which they possessed in that country.” Now Smith goes into the details of overseas trading and discusses the role of ambassadors, ministers, and consuls (p. 108), along with an outline of commercial organizations engaged in overseas trading (pp. 107–10). He then examines in great depth, without any further sub-division, regulated companies (pp. 110–22) and joint stock companies (pp. 122–50). While Smith’s original context, the promotion of particular branches of commerce, seems to be almost forgotten, the facilities that prompted him to discuss overseas trading are frequently mentioned: “forts” and “garrisons,” also “settlements” and “habitations.” For Smith, the protection of foreign trading posts is apparently the most important cost factor in overseas trading. Ships and cargoes, in contrast, are only rarely brought up, and never as a major item of expenditure. Not even once does Smith refer to the scope, the duration, and the risk of the voyages as factors that caused overseas trading to be more capital-intensive than local exchange.

Fleckner then says,

Returning to the initial question of why Smith added his comments to the chapter on public expenses: Has Smith made a good case for discussing the joint stock company in this context? Is it clear how the joint stock company relates to “publick Works and Institutions for facilitating the Commerce of the Society”? Does it intuitively make sense how Smith incorporates his remarks?

In Fleckner's view the answer to this question is no. But let me make the case that if thought of in modern terms the answer could be yes.

What the government was doing can be seen as a form of contracting out. Today if the government want some good or service provided, eg rubbish collection, instead of providing that good itself the government pays a private firms to do it.

If "extraordinary protection" needs to be provided to traders in "barbarous and uncivilized nations" and the government doesn't want to provide such protection services itself then it could get the private trading firm to do so. And if the government doesn't want to pay for such services directly it could give the firm a monopoly as a way for the firm to recover its costs. So the consumer rather than the government ends up paying. Great for the government even if not so great for the consumer.

Now it seems unlikely that Smith was thinking in this way but it does at least make some sense of the placement of Smith's discussion.

Another point to keep in mind when thinking about Smith's analysis of companies is his criticism of firm's structure, eg are they partnerships, joint stock, regulated companies etc, versus his criticism of monopolies. Smith saw the, obvious, problems with giving a firm a monopoly to trade and saw shortcomings, mainly related to principal-agent issues, with the joint stock companies. But these are separate issues and should be treated as such.

And Smith did see a use for the joint stock company is areas such a banking, insurance, water supply and construction of aqueducts and canals.