Talk on Adam Smith by Jesse Norman

At a time when economics and politics are both increasingly polarized between left and right, this book, Adam Smith: What He Thought, and Why it Matters, which Jesse Norman will discuss at this event, returns to intellectual first principles to recreate the lost centre of public debate. It offers a Smithian analysis of contemporary markets, predatory capitalism and the 2008 financial crash; it addresses crucial issues of inequality, human dignity and exploitation; and it provides a compelling explanation of why Smith is central to any attempt to defend and renew the market system.

Adam Smith's discovery of trade gravity

From the latest (Vol. 32 No. 2 Spring 2018) issue of the Journal of Economic Perspectives.

Retrospectives: Adam Smith's Discovery of Trade Gravity
Bruce Elmslie

The gravity equation is a current workhorse of empirical trade theory. It is generally acknowledged that this theory, which relates the extent of trade between countries to their respective sizes, distances, and relative trade barriers, was first developed by Jan Tinbergen in 1962. Acceptance of the gravity model as part of the discipline's core was limited by its scant theoretical foundation for the first 40 years of its existence. This paper finds that a theory of trade gravity was first developed by Adam Smith in The Wealth of Nations. Moreover, it is shown that Smith's statement of a proportional relation between economic size and distance came about as an application of his general theory of differential capital productivity in different economic sectors, and his elaboration of a theory of the gains from trade originated by David Hume. It is further shown that Smith had an explanation of the size of border affects in trade volumes, and a gravity theory of trade restrictions.

Something else for which Smith was ahead of his time.

Silent Revolution: the directors cut

The album Silent Revolution by The Benevolent Dictators is an album in which the songs draw on material from the works of Adam Smith. Four songs relate to Smith's A Theory of Moral Sentiments and four related to An Inquiry into the Nature and Causes of the Wealth of Nations.

In the Director's Cut version of Silent Revolution the motivation for and the reasoning behind the songs and the songs relationship to Smith's work is explained.

Silent Revolution by The Benevolent Dictators

Great news, the album Silent Revolution by The Benevolent Dictators is now available. The album is based on the works of Adam Smith. What could be cooler?!!

Songs

1. Fellow-Feeling 03:29
2. Impartial Spectator 04:12
3. Silent Revolution 03:44
4. The Street Porter & the Philosopher 03:51
5. Chinese Earthquake 02:58
6. Pin Factory 02:49
7. The Dumb Specialist 03:50
8. Man of Luxury 04:48

Available in digital and CD formats. Available on Spotify, iTunes, Apple Music, Google Play, and here on bandcamp for web streaming.

Enjoy!!

Dennis Rasmussen on Hume and Smith and "The Infidel and the Professor"

In this audio from EconTalk Russ Roberts interviews Dennis Rasmussen about Rasmussen's new book "The Infidel and the Professor: David Hume, Adam Smith, and the Friendship that Shaped Modern Thought".

How did the friendship between David Hume and Adam Smith influence their ideas? Why do their ideas still matter today? Political Scientist Dennis Rasmussen of Tufts University and author of The Infidel and the Professor talks with EconTalk host Russ Roberts about his book--the intellectual and personal connections between two of the greatest thinkers of all time, David Hume and Adam Smith.

A direct link to the audio is available here.

Its a book that's well worth reading.

From the comments

In the comments to the previous posting "A brief prehistory of the theory of the firm 2" Mark Hubbard asks,

I have no great problem with the corporation. Like all institutions it comes with advantages and disadvantages. I would argue that the advantages outweigh the disadvantages. For a start note that you don't have to form a limited liability company if you want to set up a firm. You could, for example, form a partnership, but most people don't. So the corporation wins out in the (competitive) market for ownership form. This I assume is because the corporation offers more to people that other forms of organisational form. Is it morally defensible to deny people an organisational form they see as advantageous?

In addition note that countries that did not utilise the corporation until recently suffered because of it. For example, see chapter 6 of Kuran (2011) for a discussion of the consequences of a lack of the corporation in Islamic law. Is it morally defensible to deny people the advantages of development?

Not all people love the corporation, Adam Smith is famous for being being against it, except for a few noticeable large capital cases such as banking, insurance, water supply and construction of aqueducts and canals. If you don't use a limited liability firm how do you amass large amounts of capital? One reason for Smith's opposition to the corporation was moral hazard, the managers of the firm may not act in the interests of the firm's owners. Also given limited liability owners only risk a part of their wealth in any given firm so may not monitor management was well as they would if their whole wealth was involved. Such issues have, to a degree at least, been overcome by developments in corporate governance that Smith had no way of knowing. See Fleckner (2016) for more.

Fleckner's 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.

Also limited liability may not be as important to the corporation as many people think. As Henry Hansmann and Reinier Kraakman have written,

In essence, we argue that the essential role of all forms of organizational law is to provide for the creation of a pattern of creditors' rights-a form of  "asset partitioning" - that could not practicably be established otherwise. One aspect of this asset partitioning is the delimitation of the extent to which creditors of an entity can have recourse against the personal assets of the owners or other beneficiaries of the entity. But this function of organizational law which includes the limited liability that is a familiar characteristic of most corporate entities is, we argue, of distinct!y secondary importance. The truly essential aspect of asset partitioning is, in effect, the reverse of limited liability namely, the shielding of the assets of the entity from claims of the creditors of the entity's owners or managers. This means that organizational law is much more important as property law than as contract law. Surprisingly, this crucial function of organizational law has rarely been the explicit focus of commentary or analysis (Hansman and Kraakman 2000: 390, emphasis added).

Ultimately I don't really see the use of the limited liability corporation as a matter of morals, its more a practical matter, can we more easily achieve ours goals using the corporation than by using other organisational forms?

Refs.

• Fleckner, Andreas Martin (2016). 'Adam Smith on the Joint Stock Company', Max Planck Institute for Tax Law and Public Finance Working Paper, 1 January 2016.
• Hansmann, Henry and Reinier Kraakman (2000). `The Essential Role of Organizational Law', Yale Law Journal, 110(3) December: 387–440.
• Kuran, Timur (2011). The Long Divergence: How Islamic Law Held Back the Middle East, Princeton: Princeton University Press.

A brief prehistory of the theory of the firm 2

This is the latest version of the paper and is likely the last version. I can't be bothered making any more corrections or additions to it, so all remaining errors will remain.

A brief prehistory of the theory of the firm by Paul Walker on Scribd

But Adam Smith didn't say that

In a recent posting on the death of Kenneth Arrow Tim Harford writes,

Two achievements [of Arrow's work] are particularly celebrated: his impossibility theorem about the paradoxes of social choice, and his welfare theorems, which formalised the most famous intuition in economics — Adam Smith’s idea that a market produces social good from individual selfishness.

But Adam Smith didn't say that. As the historian of economic thought Mark Blaug notes,

"[ ... ] Smith's faith in the benefits of 'the invisible hand' has absolutely nothing whatever to do with allocative efficiency in circumstances where competition is perfect a la Walras and Pareto; the effort in modern textbooks to enlist Adam Smith in support of what is now known as the 'fundamental theorems of welfare economics' is a historical travesty of major proportions. For one thing, Smith's conception of competition was, as we have seen, a process conception, not an end-state conception. For another society, a decentralised competitive price system was held to be desirable because of its dynamic effects in widening the scope of the market and extending the advantages of the division of labour - in short, because it was a powerful engine for promoting the accumulation of capital and the growth of income" (emphasis added)

In short, it's not clear to me, at least, that Smith would have been much impressed by the work of McKenzie, Debreu and Arrow et al with regard to the approach and results of general equilibrium theory. In fact, in today's terms, I often think of Smith being more Austrian-like than neoclassical-like.

Ref.

• Blaug, Mark 1996. Economic Theory in Retrospect. 5th edn. (pp. 60-1). Cambridge: Cambridge University Press.

A brief prehistory of the theory of the firm

A first draft of a new working paper on the (pre)history of the theory of the firm/theory of production.

The mainstream theory of the firm didn't exist until around 1970. Before then what we had was the `prehistory' of the theory of the firm. For more than two thousand years tools were available that could have given rise to a theory of the firm or, at least, a theory of micro level production, but none appeared. During this time the best that occurred were discussions of macro level or aggregate production. Given the long empirical history of and the importance to the economy of firms one may assume that economists have long been developing a detailed and sophisticated theoretical understanding of the firm but it turns out this is not the case. Up until the 1970s the development of the theory of the firm was a story of neglect and disinterest.

A brief prehistory of the theory of the firm by Paul Walker on Scribd

"Silent Revolution" by The Benevolent Dictators

"Silent Revolution" by The Benevolent Dictators. The first song from the upcoming album about Adam Smith. Inspired by Book 3, Chapters 2-4 of "An Inquiry into the Natures and Causes of the Wealth of Nations" by Adam Smith.

Incentives matter: Adam Smith and teaching file

James R. Otteson reminds us of this point made by Adam Smith on incentives and teaching:

"In other universities the teacher is prohibited from receiving any honorary or fee from his pupils, and his salary constitutes the whole of the revenue which he derives from his office. His interest is, in this case, set as directly in opposition to his duty as it is possible to set it. It is the interest of every man to live as much at his ease as he can; and if his emoluments are to be precisely the same, whether he does, or does not perform some very laborious duty, it is certainly his interest, at least as interest is vulgarly understood, either to neglect it altogether, or, if he is subject to some authority which will not suffer him to do this, to perform it in as careless and slovenly a manner as that authority will permit. If he is naturally active and a lover of labour, it is his interest to employ that activity in any way, from which he can derive some advantage, rather than in the performance of his duty, from which he can derive none."

--Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), V.i.f.7.

A couple of interesting audios from Econ Journal Watch

EJW Audios

Erwin Dekker on Carl Menger on Adam Smith

Erwin Dekker and Stefan Kolev have provided in EJW a first-ever English translation of a remarkable 1891 essay by Carl Menger. In this podcast Dekker discusses the essay, adding context drawn from his own studies (represented by his book The Viennese Students of Civilization: The Meaning and Context of Austrian Economics Reconsidered), to aid in understanding Menger’s times and his legacy.

Frank Machovec on Perfect Competition

Apropos Friedrich Hayek’s essay “The Meaning of Competition,” Frank M. Machovec discusses his book Perfect Competition and the Transformation of Economics (Routledge, 1995).

Does the division of labour matter?

The short answer is yes.

Adam Smith argued that the an increasing division of labour was a driver of technological improvement, increases in output and reductions in the prices of goods and services. But was Smith right?

According to a paper recently accepted by the Quarterly Journal of Economics the answer is yes.

The paper Adam Smith, Watch Prices, and the Industrial Revolution is by Morgan Kelly and Cormac Ó Gráda. They set out to evaluate Smith's claim that watch prices - watches were one of the first mass produced consumer goods and were Smith's prime example of technological progress - may have fallen by up to 95 per cent over the century preceding Smith.

The paper's abstract reads:

Although largely absent from modern accounts of the Industrial Revolution, watches were the first mass produced consumer durable, and were Adam Smith’s pre-eminent example of technological progress. In fact, Smith makes the notable claim that watch prices may have fallen by up to 95 per cent over the preceding century; a claim that this paper attempts to evaluate. We look at changes in the reported value of over 3,200 stolen watches from criminal trials in the Old Bailey in London from 1685 to 1810. Before allowing for quality improvements, we find that the real price of watches in nearly all categories falls steadily by 1.3 per cent per year, equivalent to a fall of 75 per cent over a century, showing that sustained innovation in the production of a highly complex artefact had already appeared in one important sector of the British economy by the early eighteenth century.

The authors also note that,

If we assume modest rises in the quality in silver watches, so that a watch at the 75th percentile in the 1710s was equivalent to one of median quality in the 1770s, we find an annual fall in real prices of 2 per cent or 87 per cent over a century, not far from what Adam Smith suggests.

One wonders how Smith obtained his estimate. He didn't have right fancy econometrics to help him.

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.

Happy birthday Adam Smith .... or not

Yesterday (5th June) many people wished Adam Smith happy birthday assuming that he has just turned 293, but has he? His gravestone gives June 5 as this date of birth,

But there are a couple of problems with celebrating Smith's birthday on June 5th. First we don't actually know Smith's date of birth, no matter what his gravestone says. June 5 is the date of his baptism.

Ian Simpson Ross writes in his book "The Life of Adam Smith",

The Fife seaport of Kirkcaldy, ten miles across the Firth of Forth from Edinburgh, was the scene of Adam Smith's baptism on 5 June 1723, in the Old Parish Kirk of St Brisse (Bryce). Possibly this was his birth-date, though there is no annotation on the 'Register of Baptismes in the Kirk of Kirkcalsie' (Bonar, 1932: 208), stating 'born this day', as there is in the case of Smith's great friend David Hume (Mossner, 1980: 6). It is reported, however, that as an infant Smith was 'infirm and sickly' (Stewart I.2), and understandable anxieties of the time about infant mortality and salvation may have hastened baptism (Flinn, 1977: 284). (Emphasis added)

while Gavin Kennedy writes in his "Adam Smith: A Moral Philosopher and His Political Economy",

His son, the world-famous Adam Smith, was baptised on 5 June (his birth date is unknown; old calendar; Bonar, [1894] 1966, 208).

It is possible that Smith was baptised on the day of his birth, but it is also possible he was not.

There is a second problem with celebrating June 5th. The date 5 June is the date from the Julian calendar. Scotland continued to use the Julian Calendar until 1752. It was only then that the Gregorian calendar was commonly used. Using the Gregorian calendar, as we do today, Smith's date of birth, assuming June 5th to be correct, would be June 16.

Gavin Kennedy on Adam Smith

Gavin Kennedy is Emeritus Professor at Edinburgh Business School, Herio-Watt University and author of" Adam Smith’s Lost Legacy" (Palgrave) 2005; "Adam Smith: a Moral Philosopher and a Political Economist". (Palgrave) 2008, 2nd ed. 2010. He is interviewed on Smith's life and work at Simply Charly.

At the beginning of the interview Kennedy is asked "What would economic theory and practice be like if Smith had not written The Wealth of Nations?". In part Kennedy responds,

If we supposed instead that Smith had not completed WN in 1776, would it have affected the progress of economic theory, given the course of other people's’ published economic ideas in Europe? Clearly, the details of the history of economics would have been different, but by how much we don’t know. I do not think it would have mattered that much because by Smith’s time, and for many decades after him, there was a wide, even occasionally deep, knowledge of political economy in print in northern Europe.

I would argue that one important point about Smith is that he had a following, Before Smith many people wrote about economic issues but no one seemed to have given rise to an ongoing school of thought. They wrote and were largely forgotten but Smith was not. It is the creation of this ongoing discussion of economic ideas and policy that would be missing if Smith hadn't written. What would have replaced Smith we don't know but I would guess it would have resulted in a very different form of economics today.

At one point Kennedy states,

But markets are driven by visible prices and cannot work without them. There is nothing invisible about markets. Adding to markets an “invisible hand” adds nothing to our understanding of how markets work. It confuses rather than adds to knowledge.

And it is true that we see prices and how they change and charge our behaviour in response to them. But what is invisible to us is the "why" of the price changes. We don't know why prices have changed and what's more we don't need to know. The reason can remain "invisible" to us. Just reacting to the price change we see is enough to allocate resources efficiently. Just imagine what would happen if we didn't use prices. A government official sees that there has been a bad harvest of apples and so the supply of apples is reduced. Without prices he would then have to set about allocating what apples we have to those who want apples. How this could be done is far from clear but without prices some, very inefficient method no doubt, would have to be found. With prices, no problems. The reduction in supply causes prices to rise and consumers of apples make their own decision on what to do. Many will cut back on their consumption of apples and hereby move supply and demand towards equilibrium. Note that with prices the "why" of the price increase, the bad harvest, is not known about by consumers and does not need to be known about for them to adjust their behaviour.

On the importance of the idea of the "invisible hand" Craig Smith has pointed out,

It is the idea of the invisible hand, or more generally the idea of social evolution through unintended consequences, which represents Smith’s chief legacy to the modern world. The recognition that many of the most important human achievements are, as Smith’s friend Adam Ferguson observed, the results of human action, not the product of human design, is a profound lesson to us all. It is this observation which leads Smith to his deep scepticism towards ‘men of system’ who would organise humanity to achieve noble ends.

Eamonn Butler summaries things as

The invisible hand idea, as commonly understood, pervades Smith’s work, and would do so even if these two specific references had never existed. For the phrase is a very convenient shorthand for Smith’s idea that human actions have unintended consequences; and that provided a few fundamental rules such as the principles of justice are followed, the self-serving actions of individuals can unintentionally produce a well-functioning and beneficial overall social order.

Consumption is the goal

One of the many things Adam Smith taught us is that the ultimate goal of economic activity is consumption and not as many people, most famously perhaps the mercantilists, seem to think, production. Adam Smith pointed out more than 240 years ago that "Consumption is the sole end and purpose of all production". We value production as a means of getting to the goal of consumption.

Trade helps consumers while protection helps producers and thus if production is the ultimate goal then we should support protection. If on the other hand we see consumption as the ultimate economic goal then we should oppose protection. While this point may be well appreciated among economists its not as well understood by non economists. Don Boudreaux has been trying to correct this situation with an opinion piece in the Pittsburgh Tribune-Review. He writes,

Suppose [...] that we accept an opinion held by many advocates of tariffs and other import restrictions — that opinion being that economic policy should be judged not by how well it enables people to consume but, instead, by how well it keeps current producers doing what they do.

“People take pride in their work,” these protectionists observe. “If trade causes them to lose their jobs, they'll lose their dignity. And preventing honest, hardworking people from losing their dignity is reason enough to restrict trade.”

No one doubts that excelling at a job is a source of self-respect and dignity for workers. But what's the root source of this self-respect and dignity? It's not just the worker's knowledge that she is providing well for herself and her family. If providing well for oneself and one's family were sufficient to create self-respect and dignity, then the successful armed robber and arsonist-for-hire would have self-respect and dignity.

Essential to a producer's self-respect and dignity is the belief that he earns his living honestly. The producer takes justified pride in his work not merely because that work pays him well but because that work is socially useful.

Protectionism, however, destroys this source of pride — or, it would destroy this source of pride if protected producers understood the nature of protectionism. Protectionism allows a handful of producers to earn incomes not by serving consumers but, instead, by being served by consumers. Protectionism is a policy, enforced with threats of violence, that prevents consumers from spending their incomes in ways that promote their own best interests; protectionism is a policy of forcing consumers to spend their incomes in ways that promote the interests of current producers.

Protectionism treats production as the ultimate goal of economic activity — a goal that consumption must be made to serve.

Unlike workers and producers who succeed when trade is free, workers and producers who remain in their current jobs only because of trade barriers do not serve their fellow human beings as well as they possibly can. They do not truly earn their incomes. And there is no dignity in that.

What those who followed Smith also got wrong

The other day I argued that one thing Adam Smith could have done but didn't was develop a theory of the firm. He had building blocks that could have led to some version of such a theory but he didn't go - rightly or wrongly - in this direction.

Given that Smith left the issue of the firm under-theorised did other economists set in and fill the void? It looks like there is a $100 bill being left on the pavement. As noted in the previous post the other classical economists followed Smith in paying the firm little heed. But what of the schools of thought that came after the classical school?

It turns out that in the period following the classical economists, with the possible exception of Alfred Marshall, few economists wrote anything much on the firm. When reviewing the contribution of the old institutionalists to the theory of the firm Hodgson (2012: 55) writes, “[ ...] we search in vain for a well-defined ‘theory of the firm’ within the old institutional economics”. Carl M. Guelzo argues that one of the leading old institutionalists, John R. Commons, “[ ...] did not construct a rigorous theory of the firm since this was never his purpose” (Guelzo 1976: 45). With reference to the German historical school Le Texier (2013: 80) writes “[m]embers of the German historical school such as Gustav von Schmoller analysed at length the birth and growth of the business enterprise, but they were more historians than economists. None of these thinkers proposed a theory of the business firm”. When writing about the work of Joseph Schumpeter, Hanappi (2012: 62) says “[a] well-defined theory of the firm thus cannot be found in Schumpeter’s oeuvres”. As to Austrian economics Per Bylund writes, “[b]ut despite the focus in Austrian economics on [ ...] “mundane economics,” and the fact that “the Austrians [have] so many necessary ingredients for a theory of the firm” [ ...], there is no Austrian theory of the firm” (Bylund 2011: 191) and “[w]hereas the theory of the firm has been a neglected area of study in mainstream economics, it has been missing from the Austrian economics literature” (Bylund 2011: 191). Hutchison (1953: 308) comments “[t]he Austrian School, with the exception of Auspitz and Lieben, did not concern themselves much with the analysis of markets and firms, except in respect to their general principle of imputation”. Hutchison also summarised the early neoclassical contributions to the theory of the firm, and markets, as “Jevons has little on the firm. [ ...] Walras’s assumptions of perfect competition (maintained virtually throughout) and of fixed technical ‘coefficients’, limited his contribution to the analysis of firms and markets, [ ...]. Pareto’s contribution to the theory of firms and markets were not rounded off, and of very varying value, [...]” (Hutchison 1953: 307). Post-1920 the latter neoclassical economists started to develop a theory of firm level production - see any introductory or intermediate microeconomics text book for a discussion of the theory - but it is a model production without firms. Given the model assumes zero transaction costs there is no need for the services of the intermediaries known as firms.

In fact it took till around 1970 before anyone decided to take the firm seriously. It was only then the economists such as Oliver Williamson, Armen Alchian, Harold Demsetz, Michael Jensen, William Meckling, Benjamin Klein, Oliver Hart and many others started to consider the firm as an important economic entity is its own right.

This lack of interest in the firm is baffling given the importance of the firm to economic activity, employment, innovation, growth, income generation and general well-being.

Refs.:

• Bylund, Per L. (2011). ‘Division of Labor and the Firm: An Austrian Attempt at Explaining the Firm in the Market’, Quarterly Journal of Austrian Economics, 14(2): 188-215.
• Guelzo, Carl M. (1976). ‘John R. Commons and the Theory of the Firm’, The American Economist, 20(2) Fall: 40-6.
• Hanappi, Gerhard (2012). ‘Schumpeter’. In Michael Dietrich and Jackie Kraff (eds.), Handbook on the Economics and Theory of the Firm (pp. 62-69), Cheltenham: Edward Elgar Publishing Ltd.
• Hodgson, Geoffrey M. (2012). ‘Veblen, Commons and the theory of the firm’. In Michael Dietrich and Jackie Kraff (eds.), Handbook on the Economics and Theory of the Firm (pp. 55-61), Cheltenham U.K.: Edward Elgar Publishing Ltd.
• Hutchison, T. W. (1953). A Review of Economic Doctrines 1870-1929, Oxford: Oxford University Press.
• Le Texier, Thibault (2013). ‘Veblen, Commons, and the Modern Corporation: Why Management Does Not Fit Economics’, Homo Oeconomicus, 30(1) March: 79-98.

Things Adam Smith got wrong

In short, not many and the things he got right far outweigh the things he got wrong, but as  James R. Otteson argues in his book "Adam Smith" there were some wrong steps.

In his book Otteson has a chapter on "What Smith Got Wrong". He suggests four things:

1. Labor Theory of Value,
2. Happiness and Tranquility,
3. Committing the Great Mind Fallacy? and
4. Smithian Limited Government and Human Prosperity.

I'm going to argue here for a fifth thing, Smith missed the opportunity to formulate a theory of the firm. He had building blocks on which to base such a theory, he just didn't develop them.

In particular I would argue he could have his expanded his discussions of specialisation and the division of labour and of joint-shock companies to formulate some version of a theory of the firm.

Smith who opens his magnum opus, An Inquiry into the Nature and Causes of The Wealth of Nations, 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 McNulty (1984: 237-8) 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”.

Another missed opportunity is when, from the third edition on, Smith discusses ‘joint-shock companies’. When considering the internal organisation of such firms Smith raises, but does not develop a theory of, what we would call today, the principal-agent problems that arise from the separation of ownership from control. Perhaps his most famous remark is,

“[t]he 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” (Smith 1776: Book V, Chapter 1, Part III, p. 741).

But “[ ...] Smith neither used the modern terms, “agency” or “corporate governance,” nor developed a general theory−a fact that is often overlooked” (Fleckner 2016: 22).

Perhaps the most obvious reason for this is that Smith wasn't interested in the firm as such. He was, as the title of this book would suggest, interested in economic growth and its nature and causes. This didn't require a theory of the firm in terms of a theory explaining the existence, boundaries and internal organisation of the firm. There may also be an empirical reason for the firm being overlooked; the relative unimportance of the firm. Until relatively recently firms were simply not a large part of the economy. But it has been pointed out that such an explanation is not wholly convincing. Large firms have existed since before the time of Adam Smith and the classical economists knew this. A more precise, and more defensible, version of the argument would be that the large, vertically integrated and diversified firm was not empirically important until recently.

For whatever reason this line of thinking was followed by the classical economists resulting in a situation which Blaug (1958: 226) could summarise simply by noting that the classical economists “[ ...] had no theory of the firm”.

Refs.:

• Blaug, Mark (1958). ‘The Classical Economists and the Factory Acts-A Re-Examination’, The Quarterly Journal of Economics, 72(2) May: 211-26.
• Fleckner, Andreas Martin (2016). ‘Adam Smith on the Joint Stock Company’, Max Planck Institute for Tax Law and Public Finance Working Paper 2016-01 January.
• McNulty, Paul J. (1984). ‘On the Nature and Theory of Economic Organization: the Role of the Firm Reconsidered’, History of Political Economy, 16(2) Summer: 233-53.
• Otteson, J. R. (2011). Adam Smith (Major Conservative and Libertarian Thinkers Volume 16, Series Editor: John Meadowcroft), New York: Continuum.
• Smith, Adam (1776). An Inquiry into the Nature and Causes of the Wealth of Nations, Volumes I and II, R. H. Campbell and A. S. Skinner (general eds.), W. B. Todd (textual ed.), Indianapolis: Liberty Classics, 1981.

The 20 most influential books in history

From the World Economic Forum comes a list of The 20 most influential books in history. The top ten are,