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The missing middle?

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From Peter Radford A couple of things before we get started:  when I say that economics is not history, I mean exactly that.  Geology is not history either.  That is not the same as saying that economics ought pay no heed to history.  Let’s not get confused over that.  Economics is its own discipline with rules and territory that its exponents determine.  That might frustrate or annoy some of us who would like to think of it more broadly, but it’s up to us to find doors to open to help in that broadening. Fortunately there are plenty of such doors because the current core of economics is rather narrow with respect to the full range of interesting topics or phenomena that appear to be economic.  In its endeavor to become a more formal activity economics has ceded swathes of territory to

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from Peter Radford

A couple of things before we get started:  when I say that economics is not history, I mean exactly that.  Geology is not history either.  That is not the same as saying that economics ought pay no heed to history.  Let’s not get confused over that.  Economics is its own discipline with rules and territory that its exponents determine.  That might frustrate or annoy some of us who would like to think of it more broadly, but it’s up to us to find doors to open to help in that broadening.

Fortunately there are plenty of such doors because the current core of economics is rather narrow with respect to the full range of interesting topics or phenomena that appear to be economic.  In its endeavor to become a more formal activity economics has ceded swathes of territory to related fields of enquiry.   As I mentioned in the past couple of weeks, it has limited itself so that things like increasing returns are treated as novelties that periodically pop up  and need pressing back down so as not to cause a thorough re-thinking of its core principles.  The list of similar oddities is quite long and results, by and large, from the effort economists have put in to their relentless focus on market activities and their desire to hunt for the mysteries of hidden hands and so on.  Economists have, of course, every right to pursue this narrow and often sterile activity.  And there are many economists who diligently work away at investigating the oddities, although too many seem to want to bend their subject of study to obey the rules of the core rather than to state the more reasonable conclusion that the core itself needs a look at.

My own pet peeve in this regard has always been the great mystery known as the business firm.

Economists have a  terrible grasp of what a firm is, what it does, and why it is impossible to discuss an economy without understanding the role of business.  Far too often people look to economists to talk about business as if a training in economics was relevant to running a business.  It really doesn’t.   As someone who has travelled in the opposite direction I can attest to the weirdness that passes for a “firm” in economics.  A simple way to understand this is to take a look at the curriculum of an average business school.  In one class students study standard micro economics as if that helps them understand what they will face when they get out into the real world.  And in the next class they are taught  a series of tricks and wheezes to confound the market so the businesses they work for can earn profits the “free market” would not provide.  Instead of economics connecting seamlessly with business it is a contradiction of it.

This is not a new problem.  As I have remarked countless times, Ronald Coase threw down the gauntlet back in 1937 with his famous essay “The Nature of the Firm”, the first sentence of which reads thus: “Economic theory has suffered in the past from a failure to state clearly its assumptions”. Well no kidding.  That’s why the sub-discipline of the philosophy of economics is so important.  Economists sometimes are not very clear about what it is they are doing.  There’s a great deal of discussion about growth, production, innovation, and so on, but very few economists actually engage in concrete ways with those things.  Instead they make grandiose abstractions and sweeping generalizations that ignore the way in which, let’s say, innovation, takes place.  To engage with innovation is to engage with learning, discovery, novelty, knowledge, information, and a host of other phenomena that are extremely difficult to fit neatly within a world that assumes perfect information.  So it gets swept under the rug.  Indeed for many decades technological advance was treated as exogenous to the study of growth.

I will get back to Coase in a moment, but I want to be sure we are clear: there is a lot of literature surrounding some of these interesting non-core economic issues.  As a small example, I can recommend the 1967 essay, “Do Machines Make History?” by Robert Heilbroner which tries to tackle the way in which technological development affects its socioeconomic environment.  Technological determinism is, naturally, a contested topic, but I think most of us would agree that the correlation between greater intensification of technological change and greater abundance and prosperity bleeds very heavily into causation.  So why is the topic of learning and innovation not firmly within the core of economics?  And why is knowledge not a fundamental input in that economic oddball, a production function?  Why do we stick with 1800s concepts like “capital” and “labor” neither of which is very precise and muddle the economics of growth with the politics of the class division of the spoils of growth.

In the famous Solow growth model technical progress sits outside and thus unexplained.  In the more recent so-called endogenous growth theories there has been some modest attempt at realism by bringing increases in human capital into the picture with the effect that decreasing returns to capital accumulation were offset by spillover effects from that rising human capital.  In other words we were getting perilously close to bringing knowledge to the foreground with the concomitant nod to the realization that diminishing returns are often eliminated by the intentions of actual human beings.

Think about that: economists kind-of-sort-of realize that human beings deliberately interfere in those equilibrating mechanisms economists dream of in order to subvert the smooth workings of the marketplace.

Which brings me back to Coase.

His central question, which has never been satisfactorily answered despite the best efforts of the transaction cost theorists,  is a simple one: why do firms exist?

The answer to my mind is a lot more complicated than that either Coase or his followers in the transaction cost tradition offered.  That is unless you describe pretty much all of what goes on in a business as a transaction cost.  And this is where we arrive at the dilemma many of us have when we discuss our frustration with economics.

That smooth wonderful equilibrating mechanism, that looks something like a brass clock circa made in 1875, is a description of what would happen in an economy were everyone to stop thinking after the first round of computation given all the usual economics gobbledegook of initial conditions, preferences etc.  The system would glide ever so gently along the path that maximizes the way in which economists like to believe it does.  Economics has stayed within this realm content with understanding how the system evolves towards a steady state.  It makes claims about the properties of this glide path and the the end result.  It defends those claims and studies variations as anomalies rather than as the norm.  Most of the framework of economics dates back to the era of brass clocks: equilibrium, maximization, and marginalism are all concepts born back before the scientific upheavals of the twentieth century.  Economics seems to want to stay there, afraid to engage, except on its periphery, with everything that happened since.

The problem is that people don’t stop thinking.  They learn.  More particularly they learn how to defeat the system.  That so-called human capital is actually an effort to prevent the effects of the market gliding nicely along the path economists so fervently wish it would.

Along with the scientific revolutions that economics appears to have missed is the change in the way in which the economic activity production takes place.  The days of the simple entrepreneurial firm dealing directly with fully informed consumers is long gone.  This gets us to the Coase question in a more concrete way.  Instead of staying within cost efficiency explanations for the firm, a more modern perspective would describe it as a wholly different layer of economic activity, a sort of middle layer, where the processes of production have been enclosed and placed under a centrally planned, information rich, and strategically driven regime precisely to provide a level of coordination unattainable in the open market.  It is not simply a question of cost.  It is a question of possibility.  Modern production requires an extent through time and place, this compounds the uncertainties that surround it.  It requires access to ever greater technical knowledge that involve collectives of people rather than sole-proprietors.  It involves financing, logistics, planning, forethought, control, and many more activities that James Burnham acknowledged in his groundbreaking “The Managerial Revolution” first published in 1941.  It also involves the co-option of the legal form we know as the corporation, which is not at all a modern phenomenon — the Romans had corporations for the same reason we do — and all the legal complications that form brings into the discussion.  Compressing all this into a “production function” is a farce.  Attributing every single aspect of it to the impact of transaction costs is a simplification too far.

Without a solid concept of the firm situated in its core, economics is reduced to a discussion of much economic activity from the outside.  Without engaging with the firm and its consequences, economics has to restrict itself to a more narrow perspective of economic activity.  Which it does and continues to do contentedly.  But it, as a consequence, becomes a very blunt and inaccurate description of what goes on around us in the economy every single day.  It is reduced to a naive version of human behavior on the one hand and a bundled version of aggregate activity on the other, with very little understanding of how the two relate because the process of production and distribution sits somewhere between the two and has properties of its own not included in them.

None of this is novel to anyone familiar with the literature within the traditions of organization theory, economic history, or strategic business management.  From Berle and Means, to Chandler, to Porter, to Foss and their ilk there are countless analysts who have weighed in on how production actually takes place and on how markets are constantly being created and subverted by the actions of the collectives we know as firms.

The problem for those of us who wish economics were a little more engaged with real economies and a little less of a self-referential activity stuck some time ago, the firm is an easy totem of either progress or denial by economists trying to broaden their discipline.  Right now it is not looking too good because most of the activity is on the outside looking in.

But let’s not mock economics for its narrowness.  A gentle chiding will suffice.  For now.

Peter Radford
Peter Radford is publisher of The Radford Free Press, worked as an analyst for banks over fifteen years and has degrees from the London School of Economics and Harvard Business School.

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