Thursday, 7 December 2017

An overview of "A brief prehistory of the theory of the firm"

As the manuscript for "a brief prehistory of the theory of the firm" has been delivered to the publisher its worth giving a short over view of what is covered in the book and why.

Firms play a critical role in the modern economy and society. With regard to the size of the contribution made by firms to economic activity McMillan (2002: 168-9) explains that for the US economy more than 70 percent of all transactions take place within firms leaving less than a third taking place via markets. In a mid-20th century report for the Social Science Research Council in the US economist H. R. Bowen identified the firm as one of the most significant institutions in our society, “[t]he business enterprise is one of the most pervasive and influential institutions of our society, and one in which innumerable important decisions and responses are made. These decisions and responses, in small and large enterprises, are links in the chain of factors determining the range of products available to consumers, the level of national income, the degree of economic security, the rate and direction of economic progress, and the distribution of income. These decisions and responses also significantly influence the character of human relations in industry, the quality of the lives of those who work in industry, and even the power structure of our society” (Bowen 1955: 1). More recently, at the beginning of the 21st century, journalists John Micklethwait and Adrian Wooldridge went so far as to argue that “[t]he most important organization in the world is the company: the basis of the prosperity of the West and the best hope for the future of the rest of the world” (Micklethwait and Wooldridge 2003: xv).

Given the significance of firms to today’s economy it would seem plausible to expect that one component of a proper understanding of how an economy functions would be a sophisticated theoretical understanding of the nature, structure and scope of firms. And yet up until very recent times the theory of the firm has largely been neglected as a field of interest in the study of economics. According to Oliver Hart
“[...] the theory of the firm is one of the less developed and agreed upon areas of economics” (Hart 2011: 102).
Birger Wernerfelt argues similarly insofar as he contends that a
“[...] foundational debate, over what exactly a “firm” is, has been raging in economics. Although two Nobel prizes ii have been awarded for answers to this question, the only agreed-upon proposition is that we, as of 2016, do not have a commonly accepted theory of the firm” (Wernerfelt 2016: 3)
This distinct lack of interest in the theory of the firm has in the recent past extended from theoretical economists to historians of economic thought. Fleckner (2016: 5, footnote 2) comments,
“[p]robably the best evidence of the traditional disinterest in the theory of the firm is the fact that the firm has no prominent place, if it is broached at all, in books on the history of economic thought. Two examples: In Sandmo 2011, a new and very readable book, none of the almost 500 pages are devoted to the theory of the firm (the selection of topics is explained on pp.vii, 23, 112); in Heilbroner 1999, one of the best-selling books in economics of all time, firms are mentioned more frequently, especially those whose shares are publicly traded, but there is no discussion of the issues that are typically associated with the theory of the firm (which, given the broad scope of the book, is not meant to be a criticism; neither Heilbroner nor Sandmo would have been well advised to focus on the firm)”.
Backhouse (2002), another well regarded introduction to the history of economic thought, does better in terms of coverage of the theory of the firm than either Sandmo (2011) or Heilbroner (1999) insofar as Backhouse devotes, roughly, one page out of 369 to the history of the post-1970 developments in the theory of the firm.

That the theory of the firm receives little, if any, treatment in recent history of economics texts is one motivation for this book. Here we wish to offer an introductory investigation into the history of the mainstream iv approach to the theory of the firm or production up until the 1970s. This pre-1970 literature is what is referred to here as the ‘prehistory’ of the theory of the firm. It was only starting in the 1970s that the theory of the firm proper came into being with the work of authors such as Armen Alchian, Robert Crawford, Harold Demsetz, Michael Jensen, Benjamin Klein, William Meckling and Oliver Williamson. These authors started the development of the transaction cost based and contract based theories of the firm. Approaches to the firm such as these were inspired, mainly, by the works of Ronald Coase. Before this time what we had was at best a discussion of the theory of micro-level production, and this only developed around 1930. Up until 1930s the most economics had to offer were theories which were predominantly theories of macro-level production. Before the 1970s the development of the theory of the firm was largely a story of neglect and disinterest.

The discussion in the pages that follow concentrates on the mainstream of economic thought and thus ignores the heterodox approaches to the firm. Concentrating on the mainstream in an introductory discussion is reasonable since it is these theories that students are most likely to meet during their initial studies. Also such an emphasis may do little damage to the story of the development of the theory of the firm since there is a close relationship between the advancement of the theory of the firm and the general economic mainstream. Foss and Klein (2006) claim that
“[...] the evolution of the theory of the firm has never taken place far away from the economic mainstream. On the contrary, it has in fact been much driven by advances in the mainstream, and the relatively limited borrowing from other disciplines that has taken place has usually been strongly adapted to conform to central mainstream tenets” (Foss and Klein 2006: 3).
What we hope to offer here is a concise, readable introduction to the ‘prehistory’ of the firm which is aimed at undergraduates and beginning graduate students. The book has been written in a manner which is, hopefully, understandable to students, with the little mathematics used explained in enough detail that undergraduates can follow it. As background, some knowledge of the basics of the contemporary theory of the firm would be useful. See Walker (2015) and Walker (2016: chapters 3 and 4) for introductions to this literature. The book is designed to give readers an understanding of how the mainstream theories they are taught developed and why the theories are the way they are. This is an understanding that most students, and many of their lecturers, do not have since it is not conveyed via the textbook presentations of the standard models of the firm. These models are presented devoid of all context, there are no consideration given to their development or past and current criticisms of or controversies surrounding the models being discussed. The material on the periods before the neoclassical era is almost never presented. The book may also prove to be of interest to economists working in the history of economic thought and given that most economists are not well acquainted with the history of their subject it could, in addition, be of interest to those working in areas such as the theory of the firm, organisational economics and industrial organisation.

An analysis of the past of the theory of the firm helps cultivate an understanding of the historical developments that have resulted in the contemporary theories. This inquiry helps to add depth to our knowledge of the ideas that are commonly employed today but whose origins lie in past debates to do with production and the firm. It also allows us to see how and why changes in thinking about these issues took place. Such a background will help readers understand why the developments after 1970, when they do finally meet them, are so important and why the modern discussion of the theory of the firm is so different from the past.

As just mentioned the mainstream theory of the firm did not exist, in any meaningful way, until around 1970. It was only then that the current theory of the firm literature began to emerge, based largely upon the work of Ronald Coase and to a lesser degree Frank Knight. It was work by Armen Alchian, Robert Crawford, Harold Demsetz, Michael Jensen, Benjamin Klein, William Meckling and Oliver Williamson, among others, that drove the upswing in interest in the firm among mainstream economists Before then there was no great interest shown in the firm as a significant economic institution by any school of economic thought. For more than two thousand years tools (eg the division of labour) were available that could have given rise to a theory of the firm but none appeared. During this time the best that occurred were discussions of micro-level production, and that only after 1930, while before then the deliberations that did transpire, limited though they were, were more focused on macro-level or aggregate production.

To begin our survey of the development of the theory of production and/or the theory of the firm we briefly look at the history of thought on the division of labour. As has been made clear by work beginning in the twentieth century the division of labour can act as a catalyst for a theory of the firm, but it took more than two thousand years - starting with the ancient Greeks and Chinese - for it to act as such. Until Alfred Marshall at the end of the nineteenth century many authors, including Adam Smith, wrote on the division of labour without applying it to the theory of micro-level production or the firm.

Following on from this discussion we will next consider approaches to production and the firm proposed in the pre-classical, classical and neoclassical periods other than those derived from the division of labour. It will be argued that before the later neoclassical economists no group of writers developed a theory of micro-level production and only Alfred Marshall wrote explicitly on the theory of the firm. Before the neoclassicals the best available theory was one of macro or aggregate production.

As has already been explained the theory of production/the theory of the firm was ignored for a long time in economics. Five, interrelated, explanations for this fact have been put forward. First, the (large/integrated) firm was until very recently just not that important to the economy and thus was ignored by early economic writers. Second, many economists did not see economic theory as being relevant to business or saw the internal workings of the firm to be outside the competence of economists. Thirdly, the development of a theory of the firm was limited by the lack of tools to deal with the task. Fourthly, for much of the development of economic analysis there was a normative/macro origination to economics which could result in a lack of interest in the theory of micro level production and the firm. Lastly, the rise of formalism within economics resulted in the firm being deemphasised.

An extensive bibliography is provided to help guide any readers interested in considering topics raised in the discussion in greater depth.

  • Backhouse, Roger E. (2002). The Ordinary Business of Life: A History of Economics from the Ancient World to the Twenty-First Century, Princeton, NJ: Princeton University Press.
  • Bowen, Howard R. (1955). The Business Enterprise as a Subject for Research: Prepared for the Committee on Business Enterprise Research, Social Science Research Council, Pamphlet No. 11, New York: Social Science Research Council.
  • Fleckner, Andreas Martin (2016). ‘Adam Smith on the Joint Stock Company’, Working Paper of the Max Planck Institute for Tax Law and Public Finance No. 2016-1, 1 January.
  • Foss, Nicolai J. and Peter G. Klein (2006). ‘The Emergence of the Modern Theory of the Firm’, Center for Strategic Management and Globalization, Copenhagen Business School, SMG Working Paper 1/2006, January.
  • Hart, Oliver D. (2011). ‘Thinking about the Firm: A Review of Daniel Spulber’s The Theory of the Firm’, Journal of Economic Literature, 49(1) March: 101-13.
  • Heilbroner, Robert L. (1999). The Worldly Philosophers–The Lives, Times, and Ideas of the Great Economic Thinkers, 7th edn., New York: Simon & Schuster.
  • McMillan, John (2002). Reinventing the Bazaar: A Natural history of Markets, New York: W.W. Norton and Company.
  • Micklethwait, John and Adrian Wooldridge (2003). The Company: A Short History of a Revolutionary Idea, New York: The Modern Library.
  • Sandmo, Agnar (2011). Economics Evolving–A History of Economic Thought, Princeton: Princeton University Press.
  • Walker, Paul (2015). ‘Contracts, Entrepreneurs, Market Creation and Judgement: The Contemporary Mainstream Theory of the Firm in Perspective’, Journal of Economic Surveys, 29(2) April: 317-38.
  • Walker, Paul (2016). The Theory of the Firm: An overview of the economic mainstream, London: Routledge.
  • Wernerfelt, Birger (2016). Adaptation, Specialization, and the Theory of the Firm: Foundations of the Resource-Based View, Cambridge: Cambridge University Press.

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