By Paul Walker 09/04/2016 3


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 o thers, 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. 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.


3 Responses to “Things Adam Smith got wrong”

  • There is a huge difference between, on the one hand, stating something that turned out to be wrong, and on the other hand, an armchair critic two centuries later opining that maybe he could have stated something but he didn’t. The lede is grossly misleading.

  • The mistake was not developing the ideas he had. As I note you can argue he had good reasons for not doing so but as is also noted his approach was followed by (classical and neoclassical) economists right up to around 1970. You could ague that the legacy of Smith is that the theory of the firm is still one of the less developed areas n economics. This matters because of the importance of firms to the operation of an economy.

  • Hi Paul, very interesting article and as a small businessman I think you are correct. Perhaps it was a function of Smith’s time, the small business had not yet emerged as the power house of the economy. It was the age of the beginning of the industrial revolution where the economy was still predominately agrarian but changing rapidly. People lived in villages or on farm holdings as a pheasants, industry was emerging as coal mining, ship building (for the navy) etc and there were joint stock companies but these were large organisations relative to the rest of the economy. I think your point about failure of AS and future economists was one of the significant failings of Economics asa profession