A history of the contemporary mainstream economic theory of the firm 1920 - 2020. A story of opportunities taken and missed.

We will examine the opportunities that were taken and those that were missed in the development of the mainstream economic theory of the firm over the period from 1920 to 2020. The 1920s were the earliest time when ideas that came to form part of the contemporary mainstream economic theories of the firm were put forward. The main ideas and people that have shaped – or, in several cases, not shaped - the history of the theory of the firm will be examined so that we can see how the theories have changed through time and how we got the theories we see today.

A history of the contemporary mainstream economic theory of the firm 1920 - 2020. A story of opportunities ... by Paul Walker

100 years of the theory of the firm. Or may be only 50.

Depending on how you pick your starting point there has been, roughly, 50 or 100 years of the mainstream economic theory of the firm.

In support of the 100 years view it has been argued that the mainstream approaches to the firm began in 1921. This (minority) view is succinctly expressed by Harold Demsetz

“[ … ] it can be said without hesitation that Knight launched the modern theory of the firm in 1921” (Demsetz 1988: 244).

The more commonly accepted 50-year position is that the theory of the firm did not begin until the 1970s, with the advent of the Coaseian-based approaches to the firm. 

But even if the earlier starting date is accepted, it must be said that the period 1920 to 1970 is something of a ‘dark age’ for the theory of the firm. It is largely one of missed opportunities with just two works contributing to the way mainstream economists think about the firm today. Knight (1921) and Coase (1937) can be seen as ‘precursors’ to the modern theories of the firm while the theories developed from these precursors represent the ‘opportunities taken’. The ‘opportunities taken’, including the transaction cost approach, the principal agent approach, the incomplete contracts approach and the reference point approach, all of which started to develop post-1970.

Those works which apply the division of labour to the theory of the firm (more correctly, to the theory of firm-level production) as well as the partial models of the firm arising from the ‘rationalisation’ debate along with Plant (1937) and Malmgren (1961) are part of the ‘opportunities missed’ from the 1920 to 1970 period.

Despite the division of labour being a very old idea in economics, dating from at least the ancient Indians, Greeks and Chinese, it took more than two thousand years for it to give rise to a theory of production, but it has not generated a genuine theory of the firm. Following on from the ancient scholars, in the medieval period both Islamic and Christian theologians and philosophers analysed the concept, and consequences, of the division of labour. The pre-classical, classical and neoclassical economists continued and expanded the enquiry, but all without applying the division of labour to the theory of the producer or the firm. One possible exception to this rule is Adam Smith. Zouboulakis (2015) argues that Smith’s discussion of the division of labour does offer an elementary explanation for the existence of firms. In Zouboulakis’s view of Smith the existence of firms is explained through division of labour dynamics. As the market grows more firms are created and they become larger thereby employing more labour and capital and thus there is an increase in specialisation and the division of labour. This in turn increases efficiency and productivity which increases general economic wellbeing.

It was not until the 20th century that a division of labour-based theory of production finally appeared. In the 1920s Lawrence Frank saw an increasing division of labour as giving rise to the vertically integrated producer. In the 1930s E. A. G. Robinson argued that the division of labour affected the size of the producer due to its effects on production technology and management. By the 1950s George Stigler was arguing that the size of the producer was limited by the division of labour due to the division of labour being limited by the extent of the market. In the 1990s Gary Becker and Kevin Murphy saw the size of the producer as being limited not just by the size of the market but also, more often, by coordination costs. In 2018 Michael Rauh showed that the division of labour, which translates to the size of the producer, can be, depending on circumstances, limited by the extent of the labour market, moral hazard or an ‘O-ring’ property. In this paper Rauh utilises a stochastic or ‘O-ring’ production function. Importantly with an O-ring production function, if one part of the production process fails, the whole process fails.

But despite this, belated, interest in the division of labour, within the contemporary mainstream economics literature the division of labour is still very much a minority approach to the analysis of production and has had no impact on the mainstream theory of the firm.

Concerning ‘rationalisation’ Cristiano (2015: 601) explains,

"[i]t was associated with the idea that it was possible to reduce average costs per unit of output by means of larger firms without necessarily incurring the problem of monopoly power—an idea that enjoyed wide circulation in the British press at that time. Henry Clay (1929, p. 171) wrote that rationalization “implies industrial combination with the object of securing not monopoly prices, but certain productive economies". Writing about the situation in Lancashire in 1926, John Maynard Keynes sympathized with ``what the Germans are calling `rationalisation', that is, the concentration of demand on the most efficient plants, which are worked at full stretch and the rest closed down" (1971–89, XIX, p. 579; hereinafter CWK ); "a `rationalising' process designed to cut down overhead costs by the amalgamation, grouping or elimination of mills'' ( CWK, XIX, p. 584)".

During the rationalisation debate, Lavington (1927) and Robinson (1931) argued that the size of the firm is determined by a trade-off between increasing returns to scale and decreasing returns to management. However, these are only partial models of the firm because there is no recognition of the need for transaction costs in the models.

Plant (1937) made a notable, and most surely underrated, contribution to the theory of the firm. The paper is usual for its time in that it made a notable contribution to the theory of organisations before the 1970s renaissance of the theory of the firm. Plant’s ‘Centralize or Decentralize?’ furnished detail and content for several aspects of Coase’s arguments where those facets were left underdeveloped by Coase. 

It is a contribution in which, for example, the “[ . . . ] discussion provides more empirical content than Coase regarding the costs of using the price system and the results on firm size [ . . . ]” (Boudreaux and Holcombe 1989: 149). In Robert Hébert and Albert Link’s view, Plant develops a transaction cost approach to the firm independently of Coase. 

“A “transaction costs” approach to the firm was pioneered independently by Plant (1937), who attempted to explain why firms become centralized or decentralized” (Hébert and Link 2006: 383).

 Carlo Cristiano also sees transaction cost arguments in Plant’s work, 

“[t]he concept of a cost in using the market, along with the idea that business size depends on the balance between this cost and coordination costs, is implicit but nonetheless rather clear in Plant’s argumentation” (Cristiano 2015: 610). 

All this is no mean feat. 

And yet today we see no ‘Plantian’ research agenda. Plant’s work has been ignored in the history of the theory of the firm.

Malmgren (1961) provided the first amplification of Coase’s analysis in his ‘The Nature of the Firm’ paper. 

Malmgren’s primary sources of insight came from the works of Coase, Hayek, Richardson and Penrose. Lise Arena argues that 

“[h]is contributions favoured a multi-disciplinary approach, incorporating ideas not only from economics, but also from organisational theory, game theory and information theory” (Arena 2021: 88).

 Klaes (2000) argues that Malmgren was the first person to associate Coase’s analysis with the idea of transaction costs. 

“Malmgren (1961) was also the first to link Coase (1937) with the notion of transaction costs. It appears that Malmgren broadly adopted Coase’s general strategy of analysing the nature of the firm. However, while Coase focused predominantly on the costs of organizing transactions across the market, while following closely the reasoning of Kaldor (1934) and Robinson (1934) regarding internal limits to firm size, Malmgren predominantly sought to exploit Marschak’s theory of information for the analysis of internal organization” (Klaes 2000: 571, footnote 10).

 Malmgren combined the ideas of Coase, Hayek, Richardson and Penrose in such a way as to be able to examine ideas which have only begun to be examined in the mainstream theory of economic organisation in recent times.

 Three central contributions have been identified in Malmgren’s work (Foss 1996: 349).

 1.  Malmgren ‘operationalised’ the Coaseian approach to the theory of the firm. He ‘operationalises’ - in the sense of Williamson (1985) – the Coaseian approach insofar as he analyses the determines of transaction costs which is something Coase did not investigate in any depth. Transactions within the firm may be less costly than across the market because of the firm’s ability to control information. Firms can provide ‘precedents’ and ‘customs’ which can act as a focal point which eliminates divergence of expectations. Thus ‘intra-firm’ transactions are less costly than ‘inter-firm’ transactions.

“Not only are a number of events predictable over the duration of the entire production plan, but also less information is required to describe that set of events for control purposes [ . . . ] operating rules of quite simple nature replace a more thorough analysis of every possible transaction which might arise in market determined allocation of resources over the set of activities which make up the firm”. (Malmgren 1961: 404).

 2. Malmgren also managed to combine contractual and knowledge-based approaches to the firm and

 3. Also he took an economic approach to notions such as ‘business culture’ which are still not well theorised.

Malmgren argued that if agents shared a common ‘business culture’ or ‘firm-specific mental constructs’ (Foss 1997: 192) (sometimes also referred to as ‘corporate culture’ (Cremer 1990) or ‘models of the world’ (Marengo 1995)) then getting the incentives right was the main objective of organisational design. But if different sections of a firm differ in their understanding of a given message, then creating a common knowledge base and getting a uniform ‘business culture’ so that everyone is on the same page becomes the major organisational objective. That is, Malmgren saw that the coordination of the within-the-firm division of knowledge required a shared ‘corporate culture’.

Along with this Malmgren’s work suggests it could be possible to construct an opportunism-free approach to the theory of the firm, something not contemplated in the economic mainstream even today. Malmgren’s approach sees firms as not as institutions that align incentives, but rather as organisations that control information. So while he takes an overall Coaseian approach it is something of a variation on the Coasian theme and a different variation from that of other later Coaseian followers.

That the firm is different from the market, in Malmgren’s framework, is because of its ability to store knowledge and simulate learning. Firms exist because they can more efficiently solve knowledge-related problems than can the market. The pooling of information in the firm lowers the cost ‘of discovering what the relevant prices are’ and the providing of ‘ ‘precedents’and ‘customs’ which can act as a focal point’ can help ‘complete’ the missing clauses in a long, (incomplete) open-ended employment contract. Thus firms save on information and transaction costs relative to the market. This provides an incentive to create firms.

But, Coase (1937) and Knight (1921) aside, all this post-1920 work has been to no avail as it has not been applied to modern mainstream thinking to do with the theory of the firm. This work represents ‘opportunities missed’ so that the first 50 years of the 1920-2020 period resulted in little of importance being contributed to the theory of the firm.

It had to wait until the 1970s before the theory of the firm took off. It was only post-1970 that the importance of Coase (1937) and Knight (1921) was recognised and the development of the contemporary theory of the firm got underway. 

So counting from 1970, there has only been 50 years of the theory of the firm.

References:

• Arena, Lise (2021). Oxford’s Contributions to Industrial Economics from the 1920s to the 1980s. In Robert A. Cord (ed.), The Palgrave Companion to Oxford Economics (pp.75-100), Cham, Switzerland: Palgrave Macmillan.
• Boudreaux, D. and R. Holcombe (1989). `The Coasian and Knightian Theories of the Firm', Managerial and Decision Economics, 10(2) June: 147-54.
• Coase, Ronald Harry (1937). ‘The Nature of the Firm’, Economica, n.s. 4 no. 16 November: 386-405.
• Crémer, Jacques (1990). ‘Common Knowledge and the Coordination of Economic Activities’. In Masahiko Aoki, Bo Gustaffson and Oliver E. Williamson (eds.), The Firm as a Nexus of Treaties (pp. 53-76), London: Sage.
• Cristiano, Carlo (2015). `Theories of the Firm in England Before Coase: Stemming the Tide of `Rationalization' on the Eve of The Nature Of The Firm ', Journal of the History of Economic Thought, 37(4) December: 597-614. 
• Demsetz, Harold (1988). ‘Profit as a Functional Return: Reconsidering Knight’s Views’. In Harold Demsetz, Ownership, Control, and the Firm: The Organization of Economic Activity, (vol. I pp. 236-47), Oxford: Basil Blackwell.
• Foss, Nicolai J. (1996). ‘Harald B. Malmgren’s Analysis of he Firm: lessons for modern theorists?’, Review of Political Economy, 8(4): 349-66.
• Foss, Nicolai J. (1997). ‘Austrian insights and the theory of the firm’. In Advances in Austrian Economics (Advances in Austrian Economics, Vol. 4, pp. 175-98), Bingley: Emerald Group Publishing Limited.
• Hébert, Robert F. and Albert N. Link (2006). `Historical Perspectives on the Entrepreneur', Foundations and Trends in Entrepreneurship, 2(4): 261-408.
• Klaes, Matthias (2008). ‘Transaction Costs, History Of’. In Steven N. Durlauf and Lawrence E. Blume (eds.), The New Palgrave Dictionary of Economics, 2nd edn., Basingstoke: Palgrave Macmillan.
• Knight, Frank H. (1921). Risk, Uncertainty and Pro t, Boston: Houghton Mifflin Company.
• Lavington, F. (1927). `Technical Influences on Vertical Integration', Economica, 7 (No. 19) March: 27-36.
• Malmgren, H. B. (1961). `Information, Expectations and the Theory of the Firm', Quarterly Journal of Economics, 75(3) August: 399-421.
• Marengo, L.(1995). ‘Structure, Competence, and Learning in Organizations?’, Wirtschaftspolitische Bläter, 42(6): 454-64. 
• Plant, Arnold (1937). `Centralize or Decentralize?'. In Arnold Plant (ed.), Some Modern Business Problems: A Series of Studies (pp. 3-33), London: Longmans, Green and Co.
• Robinson, E. A. G. (1931). The Structure of Competitive Industry, London: Nisbet & Co.
• Williamson, Oliver E. (1985). The Economic Institutions of Capital ism, New York: The Free Press.
• Zouboulakis, Michel S. (2015). ‘Elements of a theory of the firm in Adam Smith and John Stuart Mill’. In George C. Bitros and Nicholas C. Kyriazis (eds.), Essays in Contemporary Economics: A Fests chrift in Memory of A. D. Karayiannis (pp. 45-52), Heidelberg: Springer.

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.

Foundations of Organisation... by Paul Walker on Scribd

The division of labour and the mainstream theory of the firm

This paper looks at the influence (or lack of influence) that ideas to do with the division of labour have had on the mainstream economic theory of the firm. The notion of the division of labour goes back at least to the ancient Greeks and ancient Chinese but it took two thousand years before the division of labour was used to create a theory of the firm. It was only in the 20th century that such a theory started to be developed.

The division of labour and the mainstream theory of the firm by Paul Walker on Scribd

The division of labour and the firm: Rauh (forthcoming)

An interesting new paper which develops a theory, incorporating the division of labour and specialisation and a stochastic ('O-ring') production function, to explain the incentive structure and size of the firm is The O-ring theory of the firm by Micheal T. Rauh, which is set to appear in the Journal of Economics & Management Strategy.

A note on the name 'O-ring'. The O-ring production function was introduced by Kremer (1993). The name comes from the fact that it was an O-ring failure that caused the space shuttle Challenger disaster. The basic idea is that the failure of a small component can have large adverse consequences. Here one part of the production process failing causes the whole process to fail.

Rauh assumes a production process that can be divided into a number of distinct tasks. This makes it possible for the tasks to be allocated across workers (the division of labour) and for workers to make investments in task-specific human capital (specialisation). This is the kind of situation just discussed in the Becker and Murphy paper. We saw that an increase in employment gave rise to a greater division of labour, that is, fewer tasks assigned to each worker, and greater specialisation and thus higher productivity. Importantly Rauh postulates an additional feature of the production process: a breakdown at any point in production, which could be due to shirking, poor decision-making or a negative shock, will have serious adverse consequences for the successful manufacturing of the product--this is the 'O-ring' type production function.

This second condition has important implications for the moral hazard problems that arise within a firm. In the first best case, the principal can directly monitor individual worker effort and thus will be able to identify and respond to any shirking by workers with probability one. In the second best case, individual output can be monitored and again shirking can be punished with probability one. Note that in this case a worker who experiences a negative shock will also be punished. In the third best case all workers will be punished, with probability one, if any single worker shirks. In each of the three cases there will be no free rider issues since shirkers cannot hide behind the efforts of their co-workers.

Rauh considers a production process where the set of tasks is the unit interval. The principal chooses the number of workers, and the set of tasks to be performed is divided equally across all workers. Each of the workers is able to choose their production effort and their level of investment in task-specific human capital for each task they are assigned. To produce one unit of output requires one unit of output of each task. This means that you get zero output if any of the workers shirks or suffers an adverse shock in any of their assigned tasks. In line with Becker and Murphy (1992) greater levels of employment implies fewer tasks being assigned to each worker, which in turn means the workers can increase their investments in human capital for each of their reduced set of assigned tasks. This results in greater productivity and thus increasing returns to employment.

The stochastic (O-ring) nature of the production function is thought about in the following way.

"In addition to production effort and investments in human capital, each agent monitors his assigned tasks and makes decisions about whether or not a problem has arisen, whether or not to halt production to fix it, whether he can fix it himself, and which potential solution is appropriate. When there is only one agent, there is a high probability that at least some of these decisions will be faulty because he has limited cognitive resources and performs all the tasks himself. When there are two agents, the probability that either one will make a mistake should be lower because each performs only half the set of tasks and can therefore devote more care and attention to each of them. On the other hand, we now have two probabilities instead of one, so the effect of an increase in employment is ambiguous" (Rauh forthcoming: 2).

More formally, the probability that a worker suffers a negative shock to at least one of the tasks they have been allocated is an increasing function of the proportion of tasks being performed by that worker. Under an assumption of independence, the probability of a product defect is the product of the individual probabilities. If the number of workers is increased this results in two effects. First, it will decrease the probability that each worker will suffer a negative shock. Secondly, it will increase the number of points in the production process at which a negative shock can occur. Rauh then defines a production process as satisfying the O-ring property if the probability of a defect occurring is increasing in the number of workers and converges to one as the number of workers goes to infinity.

Given this background, the main question for the paper is then considered: What limits the size of a firm? For Rauh the answer has to do with the effects (or lack of effects) of moral hazard. Since there is a one-to-one relationship between the division of labour and the level of employment in the paper, the question can be rephrased as, What limits the division of labour? As has been noted above Becker and Murphy (1992) see this limit as be determined not by the extent of the market, as Adam Smith argued, but rather by coordination costs, including agency costs.

When determining the relationship between moral hazard and the size of the firm, "[ ... ] the optimal employment level balances the following considerations: (i) the increasing returns to employment due to specialization and division of labor, (ii) the O-ring property of the production technology, where the probability of team failure increases with the size of the team, and (iii) the marginal cost of employment (the cost of hiring another agent)" (Rauh forthcoming: 2).

In the first best case of no moral hazard Rauh shows that the standard zero incentive, full insurance contract is employed. Effectively the firm is behaving as if it were a perfectly competitive wage-taker despite it being a monopolist. Since, in this case, each worker's payment is fixed, the firm's labour costs (the number of workers times the expected payment to each worker) are linear in workers and the marginal cost of a worker is constant. Importantly, however, given increasing returns to employment, which arises from specialisation and the division of labour, but only linearly increasing costs to employment, these costs cannot limit the extent of employment. Thus, in this case, the extent of the market for labour or the O-ring property must be limiting employment and thus the size of the firm. If it wasn't for these constraints the first best firm would be of infinite size since there are increasing returns to employment.

Next Rauh considers the second best contract. Here effort cannot be observed but individual output can. Rauh shows that the optimal (second best) contract involves awarding a bonus to a worker when their individual output is high, i.e., when the worker's effort is first best and there is a positive shock, and replacing the worker otherwise. Rauh shows that the worker’s bonus is decreasing in employment. This follows from the fact that as employment increases the proportion of tasks carried out by each worker falls which increases the likelihood of a positive shock. This increases the expected value of the worker’s payment if the worker selects the first best effect level. This means the principal can reduce the bonus paid to the worker. It is also shown that this reduction in the bonus reduces the expected payment to the worker and this implies that the payment is decreasing in employment as well. If this type of effect is large enough then the marginal cost of an extra worker can decline with employment and could even be negative. In this situation the second best cost of employment could be less than the first best (constant) marginal cost of employment. This would mean the second best firm could be larger than the first best firm. Thus, the second best firm would have weak incentives (low bonus), low expected pay (small worker payment) and an excessive division of labour (and an excessive amount of specialisation). Motivation is provided by the fact that shirking workers will be identified and fired, rather than through the use of incentive schemes. As before, as the level of employment increases fewer tasks are carried out by each worker and the probability of a positive shock converges to one. This means that the second best expected payment to a worker converges to the first best payment. In turn, this means that the second best cost function tends towards the (linear) first best cost function. Thus as with the first best case the increasing returns resulting to employment resulting from the division of labour and specialisation cannot be contained by an asymptotically linear cost of employment. Rauh concludes from this that when the principal can monitor individual output, even if not effort, the size of the firm under moral hazard is again limited by either the total number of workers available or the O-ring property .

Lastly, Rauh looks at the third best situation where the where the principal can observe only team output. Here the results are the opposite of the second best case. This is because the third best incentive relies on the probability that all workers experience a positive shock rather than depending on the probabilities that individual workers experience a positive shock. Given the O-ring property, an increase in workers increases the probability that an individual worker experiences a positive shock but reduces the probability that all workers experience a positive shock. In this case increasing the number of workers decreases the team probability of success and this decreases the expected payments made to workers when they put in the first best level of effort. This means that the principal will increase the third best bonus, which increases the third best expected payment to workers and the marginal cost of employment. From this it is clear that all of the third best bonus, expected payments and the marginal cost of a worker are increasing in the number of workers. This is the opposite of the second best case above.

As the number of workers employed continues to increase, the third best bonus, expected payments and the marginal cost of employment all explode. This is contrary to the second best case where all these variables tended to their first best levels. The third best marginal cost of employment is shown to always exceeds the first and second best marginal costs of employment. This means the third best firm is usually smaller than either the first or second best firms.

Thus for Rauh's model moral hazard concerns only limit the division of labour, and the size of the firm, when the principal can monitor just the output of the whole team. When either worker's effort or individual output can be observed either the extent of the labour market or the O-ring property limit the extent of the division of labour or the size of the firm.

Rauh's paper is interesting in part because it combines, in some ways, the older division of labour approach to the firm with the more modern principal agent approach to the firm. The more modern mainstream approaches to the firm don't emphasise the division of labour with their emphasis being more on incomplete contracts and agency problems. The division of labour approach has largely fallen out of favour.

Well worth a read if you are into the theory of the firm.

Refs.:

• Becker, Gary S. and Kevin M. Murphy (1992). 'The Division of Labor, Coordination Costs, and Knowledge', Quarterly Journal of Economics, 107 (4) November: 1137-60.
• Kremer, M. (1993). 'The O-ring theory of economic development', Quarterly Journal of Economics, 108(3) August: 551-75.
• Rauh, Michael T. (forthcoming). 'The O-ring theory of the firm', Journal of Economics & Management Strategy.

The division of labour and the firm: Robinson (1931)

This material relates to Robinson (1931).

One of the earliest attempts to relate the division of labour to the size of firms was Robinson (1931). In The Structure of Competitive Industry Robinson offered an analysis of the factors that determined the optimum size for a firm. For Robinson the interaction of five factors determined the size of the firm: technique, management, finance, marketing and risk of fluctuations. These various theoretical optima have then to be reconciled in the size or constitution of a real firm after allowing for difficulties and anomalies of growth. The division of labour has a role to play with regard to technique and management. Because of this we will concentrate on these two factors here.

For Robinson the optimum firm is that firm which in existing conditions of technique and organising ability produces at the minimum of long-run average costs. Under the conditions of perfect competition we would expect to see the optimum firm emerge but under conditions of imperfect competition, Robinson notes, it may not materialise. Consider, for example, the case of monopolistic competition in which a firm will be in equilibrium at less than the minimum of average cost.

The first application of the division of labour to the size of the firm that Robinson considers is the relationship between the division of labour and the optimum technical unit. Robinson follows Adam Smith in seeing three different reasons for the division of labour giving rise to more efficient production. First is the increase in dexterity of workmen; secondly, the saving of time which is commonly lost in passing from one type of work to another; and thirdly, the invention of a great number of machines which facilitate and abridge labour, and thus enable one person to do the work of many.

With regard to the issue of dexterity, Robinson notes Smith's observation that a person who works at a given task for some time is likely to develop a skill or knack for doing that task. In addition the division of labour can allow those people with a natural skill for carrying out a given task to specialise in that task.

Adam Smith (and Robinson) also saw an advantage in the division of labour in that specialisation at a task saved the time that would otherwise be spent on passing from one task to another. Time could be saved because workers do not have to move between machines or processes. Also time would be lost if machines had to be reset to perform a different function. The division of labour saves time by concentrating both workers and machine upon a given function, and a larger factory enjoys an advantage over a smaller one in so far as it makes this concentration possible.

The third economy Smith saw is due to the development of specialised equipment to carry out the tasks that the manufacture of an item is divided into. Separation of a process into its constituent parts makes development of machines to carry out those parts easier.

It is important to keep in mind when considering the size of a firm that the principle of the division of labour requires a firm of sufficient size to obtain the maximum profitable division of labour. This size will differ across industries depending on the nature of the production process for that industry and how detailed a division of labour can be implemented for that particular process. Larger firms will, often, have the capacity to implement a greater division of labour than a smaller firm, giving the larger firm an advantage in terms of efficiency.

The next issue discussed by Robinson is what he calls `the integration of process'. Robinson explains that often a large firm has fewer rather than more processes of manufacture. They can utilise a large machine which has been designed to takeover what would otherwise be a series of manual, or at least less completely mechanical, operations. A complicated machine can perform two or three or more consecutive processes and it can thereby eliminate the labour and time which would be required to up the work on each of the successive earlier machines. Only large firms can keep such a machine running at its full capacity and this fact gives the large firm an advantage over the smaller, and less mechanised, firm. But this difficulty can be overcome by the small firm as long as the size of the market for the process is large enough. If a given process requires a scale of production too great for a smaller firm the small firm can outsource the process to specialist firm. But such outsourcing if only possible if the extent of the market for a particular process is large enough to allow the division of labour to develop to the point where a specialist firm is viable. Robinson refers to this outsoucing as 'vertical disintegration'.

The second of the areas for which Robinson sees the division of labour having a role to play is with regard to management. A manager in a small firm will have multiple tasks to preform, some of which he will be good at, others that he will not be so good at. In a larger firm a division of labour can develop which allows managers to specialise on those function for which they are best suited. The larger firm gains in two ways from its division of managerial labour: 1) special abilities to be used to their fullest extent. Talents are not wasted by having managers carry out functions which could be better assigned to another manager with a particular ability at that function. 2) a manger who specialises in a given task will increase their knowledge of that task.

A potential downside of the managerial division of labour is the problem of coordination. As the division of labour becomes greater the problems associated with the coordination of the different parts of the production process also increases. As new tasks are created by dividing up the production process, new administrative functions are also created to coordinate the ever more disjoint production process. The advantage that a larger firm has over the smaller depends, in a large part, on how well it solves this coordination problem.

An additional theoretical problem with Robinson's discussion follows from the implicate assumption in the competitive model that complete contracts can be written. In such a world it is not clear why a firm is needed to carry out production at all. As Coase (1937) first highlighted in a world of complete contracts any organisation form can mimic any other meaning that production could be carried out via the market just as efficiently as within a firm.

Refs.:

• Coase, R. H. (1937). `The Nature of the Firm', Economica, New Series 4 No. 16 November: 386-405.
• Robinson, E A G. (1931). The Structure of Competitive Industry, Cambridge: Cambridge University Press.

The division of labour and the firm: Stigler (1951)

"The division of labor is not a quaint practice of eighteenth-century pin factories; it is a fundamental principle of economic organization."
Stigler (1951: 193)
The following discussion covers material from Stigler (1951) which is one paper that offers a theory of the boundaries of a firm based on the division of labour. Interestingly Adam Smith, despite his famous discussion of the division of labour in the pin factory, did not develop a theory of the firm based on it.

Stigler begins his argument by saying that the division of labour, and its limit due to the extent of the market, lies at the core of a theory of the functions, and thus the boundaries, of a firm. Stigler outlines this theory in the second section of his paper.

In this theory a firm is seen as engaging in a series of distinct operations leading to the production of a final product. That is, the firm is partitioned not among its input markets but among the functions or process that determine the scope of its activities. And thus determine the firm's boundaries.

To allow the graphical representation of the firm's costs of production we will assume that the average costs of each activity depends only on the rate of output of the firm. In addition, if we assume that there is a constant proportion between the rate of output of each activity and the rate of output of the final product then all the cost functions can be drawn on the same diagram and the vertical sum of these costs will be the conventional average cost curve for the firm. With reference to the diagram below to produce q units of final output requires a given number of units of activity 1, costing C_1(q), a number of unit of activity 2, costing C_2(q), and a number of units of activity 3, costing C_3(q). These costs can be summed to give the average cost of production for q units of output, C_1(q)+C_2(q)+C_3(q).

With respect to the shape of the average cost curves for the various activities, some are increasing continuously (C_1), some are falling continuously (C_3) and some are conventionally U-shaped, (C_2).

Now consider the Adam Smith's idea that the division of labour is limited by the extent of the market. First take the activities for which there are increasing returns, Why doesn't the firm exploit the returns more fully and in the process become a monopoly in the output market? Because as the firm expands outputs other activities also have to be increased and some of these are subject to diminishing returns and these cost increases are such that they overwhelm the cost advantages of the increasing returns and increase the average cost of the final product. So why then does the firm not abandon these C_3-like activities and let some other firm (and thus industry) specialise in them to exploit the increasing returns fully? At a given time the market for these activities may be too small to support specialised firms. Given this firms must perform these activities for themselves.

But with an expansion of the market for the increasing returns activity firms specialised in that activity would develop. The firms currently carrying out this activity for its own consumption would forgo this activity and let it be taken over by a new (monopoly) firm. This monopoly could not fully exploit its market power however since it has charge a price which is less than the average cost of production for the firm abandoning the activity. As the market for this activity grows even larger the number of firms specialising in it grows. That is the industry becomes increasingly competitive.

The abandonment of this activity by the original firms will change the cost function for each firm. The cost curve, C_1, will be replaced by a horizontal line (the black dashed line in the diagram above) in the effective region. This also changes the average cost curve for the final product with the new curve (black dashed curve in the diagram above) being lower than the current curve.

What about the increasing cost case? Why not abandon or reduce use of those activities with increasing cost? Much of the previous discussion carries over to this case with the exception that as the market and the industry grows the original firms does not have to stop utilising that activity completely. Part of the needed use of that activity can still be produced in-house without high average (and marginal) cost, with the rest being purchased via the market.

Ref.:

• Stigler, George J. (1951). "The Division of Labor is Limited by the Extent of the Market", Journal of Political Economy, Vol. 59, No. 3 June, pp. 185-193.