Foundations of Organisational Economics: Histories and Theories of the Firm and Production

This essay provides introductions to five of the major topics to do with the history of the theory of production and the theory of the firm. The first chapter is an introduction. The second considers the change from a normative approach to the theory of production to a largely positive approach. Before, roughly, the 17th century the main approaches to the theory of production were normative. The third looks at the relationship (or the lack of a relationship) between the division of labour and the theory of the firm. Even today the mainstream of economics does not emphasise the division of labour in the theory of the firm. In the fourth chapter, the development of the proto-neoclassical approach to production is examined. The development of theories of monopoly, oligopoly and perfect competition as well as the theory of input utilisation are discussed. The fifth chapter looks at Marshall’s idea of the representative firm. This was the main early neoclassical approach to the theory of industry-level production. Marshal wished to be able to construct an industry supply curve without having to assume all firms were identical. The sixth examines the challenges to the neoclassical model in the period 1940-1970. The last chapter is a short conclusion.

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The representative firm

Marshall's idea of  'representative firm' was created to reconcile his dynamic view of individual firms with the static view of industries. But this idea was somewhat nebulous and did not last very long in the economics literature. Marshall first wrote about the representative firm in his Principles of Economics published in 1890 but the idea was driven out of the literature by 1928, when it was replaced by A. C. Pigou's idea of the `equilibrium firm'.

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Partial versus general equilibrium: the theory of the firm example

A point worth making about the modern models of the theory of the firm is that they illustrate a general issue to do with post-1970 microeconomics, namely, the retreat from the use of general equilibrium (GE) models.

Historian of economic thought Roger Backhouse writes that

 “[i]n the 1940s and 1950s general equilibrium theory [ ...] became seen as the central theoretical framework around which economics was based” (Backhouse 2002: 254)

and that by the

“[ ...] early 1960s, confidence in general equilibrium theory, and with it economics as a whole, as at its height, with Debreu’s Theory of Value being widely seen as providing a rigorous, axiomatic framework at the centre of the discipline” (Backhouse 2002: 261), 

but

“[ ...] there were problems that could not be tackled within the Arrow-Debreu framework. These include money (attempts were made to develop a general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models, often dealing only with a specific part of the economy or with a particular problem. The search for ever more general models of general competitive equilibrium, that culminated in Theory of Value, was over” (Backhouse 2002: 262).

As early as 1955 Milton Friedman was suggesting that to deal with “substantive hypotheses about economic phenomena” a move away from Walrasian towards Marshallian analysis was required. When reviewing Walras’s contribution to GE, as developed in Walras’s famous Elements of Pure Economics, Friedman argued,

“[e]conomics not only requires a framework for organizing our ideas [which Walras provides], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall” (Friedman 1955: 908).

By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

All the models considered in this book are partial equilibrium models, but in this regard, the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back, presumably temporarily, on GE theory and has worked almost exclusively within a partial equilibrium framework. This illustrates the point that there is a close relationship between the economic mainstream and the theory of the firm; when the mainstream forgoes general equilibrium, so does the theory of the firm.

One major path of influence from the mainstream of modern economics to the development of the theory of the firm has been via contract theory. But contract theory is an example of the mainstream’s increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of GE. As Salanie (2005: 2) has argued,

“[t]he theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well defined institutional settings”.

The Foss, Lando and Thomsen classification scheme for the theory of the firm clearly illustrates the movement of the current theory of the firm literature away from GE towards partial equilibrium analysis. The scheme divides the contemporary theory into two groups based on which of the standard assumptions of GE theory is violated when modelling issues to do with the firm. The theories are divided into either a principal-agent group, based on violating the ‘symmetric information’ assumption, or an incomplete contracts group, based on the violation of the ‘complete contracts’ assumption. The reference point approach extends the incomplete contracts grouping to situations where ex-post trade is only partially contractible.

The introduction of the entrepreneur, as in the models proposed by Silver, Spulber and by Foss and Klein, also challenges, albeit in a different way, the standard GE model since, as William Baumol noted more than 40 years ago, the entrepreneur has no place in formal neoclassical theory.

“Contrast all this with the entrepreneur’s place in the formal theory. Look for him in the index of some of the most noted of recent writings on value theory, in neoclassical or activity analysis models of the firm. The references are scanty and more often they are totally absent. The theoretical firm is entrepreneurless−the Prince of Denmark has been expunged from the discussion of Hamlet” (Baumol 1968: 66).

The reasons for this are not hard to find. Within the formal model, the ‘firm’ is a production function or production possibilities set, it is simply a means of creating outputs from inputs. Given input prices, technology and demand, the firm maximises profits subject to its production plan being technologically feasible. The firm is modelled as a single agent who faces a set of relatively uncomplicated decisions, e.g. what level of output to produce, how much of each input to utilise etc. Such ‘decisions’ are not decisions at all, they are simple mathematical calculations, implicit in the given conditions. The ‘firm’ can be seen as a set of cost curves and the ‘theory of the firm’ as little more than a calculus problem. In such a world there is a role for a ‘decision maker’ (manager) but no role for an entrepreneur.

The necessity of having to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms or other important economic institutions. Bernard Salanie has noted that,

“[ ...] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models” (Salanie 2005: 1).

This would suggest that to make GE models a ubiquitous tool of microeconomic analysis - including the analysis of issues to do with non-market organisations such as the firm - developing models which can account for information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions and the like is not so much desirable as essential. One catalyst for the development of such a new approach to GE is that partial equilibrium models can obscure the importance of the theory of the firm for overall resource allocation, a point which is more easily appreciated in a GE framework.

The Marshalls (Alfred and Mary) on farming

In the past I have discussed the theory of the farm explaining why farming is one of the few areas left in the economy still dominated by family businesses. The standard argument as to why this is so is given by Allen and Lueck (1998, 2002).

The is key to understanding why so is that the incentives generated within agriculture favour family farms. The two basic issues are opportunities for hired workers to shirk due to random production shocks from nature and the limits on the gains from specialisation and the timing problems caused by seasonality. The trade-off between effect work incentives and gains from specialisation help determine the costs and benefits of different farm organisational types.

The abstract from Allen and Lueck reads:

Using a model based on a trade-off between moral hazard incentives and gains from specialization, this paper explains why farming has generally not converted from small, family-based firms into large, factory-style corporate firms. Nature is both seasonal and random, and the interplay of these qualities generates moral hazard, limits the gains from specialization, and causes timing problems between stages of production. By identifying conditions in which these forces vary, we derive test able predictions about the choice of organization and the extent of farm integration. To test these predictions we study the historical development of several agricultural industries and analyze data from a sample of over 1,000 farms in British Columbia and Louisiana. In general, seasonality and randomness so limit the benefits of specialization that family farms are optimal, but when farmers are successful in mitigating the effects of seasonality and random shocks to output, farm organizations gravitate toward factory processes and corporate ownership.

Allen and Luecks's paper is relatively recent, 1998, so this all looks modern using new ideas to so with contracting to explain family farms. But is it so? A week or so ago I was reading Alfred and Mary Marshall's “The Economics of Industry” published 1879 when I came across the following on pages 57-58:

§ 11. The largest industry is that of agriculture; but there is scarcely any other industry which is able to make so little use of the advantages of division of labour and of production on a large scale. For agricultural labourers cannot be grouped together in large masses ; they must be scattered over the country. And each season of the year has its special work: a man cannot spend his life in reaping. So that the work of agriculture cannot be broken up into a vast number of parts each of which is performed by a band of labourers who devote their lives to acquiring a special skill in this class of work.

Agriculture, however, seems to be following in the steps of manufacture. Field steam-engines are becoming common, and new machines to be worked by them or by horse power are appearing in rapid succession. The fields demand every day a smaller number of dull labourers and a greater number of intelligent mechanics.

This change is exercising an important influence in the competition between small and large farms. The small farmer cannot always afford to have a field steam-engine; he cannot afford to have a great number of machines for occasional use. Thus every year puts him at a greater disadvantage relatively to the large farmer. This disadvantage is diminished but not removed by the rapid growth of a subsidiary industry, which undertakes steam ploughing threshing, &c. for farmers, The growth of this industry is the most important step towards obtaining the advantages of division of labour that has ever been made by agriculture.

In comparison with a small farmer a large farmer gains something in economy of buildings, and in economy of materials. He is able to have a better rotation of crops; he can send a great many labourers into a field in which there is anything to be done quickly. He can, as a rule, borrow capital from the banks more easily than a small farmer can. Lastly, the large farmer is likely to have more knowledge and greater skill and enterprise than the small farmer, He probably received· a better education at starting; and he can afford to leave to subordinates much work that the small farmer does himself, so that he has more time and opportunity for increasing his knowledge, And as farms change hands from time to time, the ablest farmers are likely to find their way to the largest farms. Thus the economy of skill is carried further under a system of large, than under one of small, farms. On the other hand the large farmer loses in the matter of superintendence. The small farmer works hard himself: he watches for every trifling gain and every small saving: and those who work under him have little opportunity of being idle or dishonest.

Its often said that in the late 1800s-early 1900s the answer to any student's question about economics was "It's all in Marshall". Well it appears it is!

Refs.:

• Allen, Douglas W. and Dean Lueck (1998). "The Nature of the Farm", Journal of Law and Economics, 41: 343-86.
• Allen, Douglas W. and Dean Lueck (2002). The Nature of the Farm: Contracts, Risk, and Organization in Agriculture, Cambridge Mass.: The MIT Press.

It appears Alfred Marshall is not guilty after all

One of the strangest things about basic microeconomics is that we write demand curves in the form,
q=D(p) that is, quantity demanded is a function of price,

but we draw them in the form,

The diagram is wrong, as any mathematician will tell you, since given the way the function is written, quantity demanded should be on the vertical axis.

This oddity I always thought was due to Alfred Marshall, which I found a bit odd since Marshall was trained as a mathematician and thus would know perfectly well how to graph a function.

But now I have, belatedly, discovered that Marshall may not be to blame for starting this habit of drawing after all.

In an essay "The influence of German economics on the work of Menger and Marshall" Eric W. Streissler writes,

The "peculiar curve" is Rau's demand curve, which is published in his later (not earlier) editions-to be more precise, from the fourth edition of 1841 onwards. Cournot has presented the first demand curve in the history of economics in 1838; Rau's was the second, only three years later. But Cournot posits his curve without explanation, i.e., quasi-axiomatically, Rau presents a derivation of it, the typical German derivation: individuals differ in their preferences or, more precisely, in their willingness and ability to pay. (His curve assumes each individual buying one unit of a commodity, the typical case for reservation analysis and thus for "price bounds.") But what is more interesting in relation to Marshall: Rau's demand curve alone is drawn exactly like Marshall's, with price on the vertical axis; Cournot's (or Mangoldt's) demand curves are drawn the other way round with prices measured horizontally.(Emphasis added)

The Rau mentioned is Karl Heinrich Rau and the book is Grundsatze der Volkswirthschaftslehre, 1st ed. 1826, 4th ed. 1841.

Ref.:

• Streissler, Eric W. (1990). 'The influence of German economics on the work of Menger and Marshall'. In Bruce J. Caldwell (ed.), Carl Menger and his legacy in economics, Durham: Duke University Press.