In his masterwork, Adam Smith (1776) provides two particularly deep insights about economic activity: the spontaneous organization of self-interested market exchange (the “invisible hand”) and the nature and implications of production specialization (the “pin factory”). Smith sought to explain decentralized market cooperation by large numbers of persons who efficiently price and distribute specialized output. John Stuart Mill notably generalized Adam Smith’s division of labor to the “more fundamental” principle of worker cooperation.
Much later, Arthur Okun (1981) fundamentally enriched Smith’s insights with his “invisible handshake”. His invisible handshake helped introduce economists to fair treatment as a critical determinant of employer-employee relations. Adam Smith anticipated that contribution. In The Theory of Moral Sentiments, Smith identifies critical motivators of behavior to be the interrelated factors of status, respect, and justice, with the latter generally equivalent to equitable treatment: “… we find ourselves to be under a stricter obligation to act according to justice than agreeably to friendship, charity or generosity; that the practice of these last-mentioned virtues seems to be left to some measure to our own choice, but that, somehow or other, we feel ourselves to be in a peculiar manner tied, bound, and obliged to the observation of justice.” The invisible handshake became the organizing metaphor for Okun’s (incomplete) analysis of optimizing exchange inside large, specialized establishments, featuring a class of wage rigidity through which nominal-demand disturbances induce same-direction movement in production, employment, and income.
Okun, like Smith, was onto something important. Rational nonmarket price-mediated exchange is necessary if rigorous economic theory is to accommodate the mutation of pin factories into the large, specialized corporations ubiquitously organized in the aftermath of the Second Industrial Revolution. Bureaucratic workplaces, producing goods or services, are needed to motivate employee cooperation in circumstances of costly, asymmetric intra-firm information and routinized jobs.
The third part of our story introduces the vastly underappreciated Alfred Chandler’s (1997) “new corporate forms”. His modeling of rational personnel practices in the context of workplace information asymmetries distills best-practices management of workplace behavior that has evolved over time, In his narrative, trend productivity growth was transformed by increasing returns associated with the spread of large, bureaucratic firms, dating from the late 1800s. The new corporate firms were enabled by the creation of railroad, steamship, telegraph and cable systems, reducing delivery times and uncertainties for large flows of goods through national and international economies. The wave of uncomplex technological innovations that accompanied the reorganization of industry exploited the potential for high-volume, high-speed production. From Chandler (italics added): “Entrepreneurs and firms in these nations [U.S., Britain, Germany] pioneered the commercialization of new capital-intensive technologies by making the investments and creating the new corporate forms required to fully exploit their profit-making potential.”
Those corporate forms round out our survey of the crucial Smith, Okun, and Chandler innovations that enable the generalization of rational exchange the marketplace to information-challenged workplaces. Downward nominal wage rigidity over stationary business cycles and chronic wage rent are made consistent with optimization and equilibrium and are located inside highly specialized firms that we all know are the home for mass involuntary job loss resulting from adverse demand disturbances.
It is surprising, and increasingly problematic, that macroeconomists did not adapt to the Second Industrial Revolution. Deep thinking about integrating production and price-mediated exchange in the tradition of Smith, Okun, and Chandler is little rewarded in modern macroeconomics. Mainstream theorists are expected to think incrementally, pushing aside the massively altered production landscape that transformed workplace exchange into a critical economic activity. Coherent macro thinking has, for many generations, remained fixed in the profession’s comfort zone of market transactions. Meanwhile, the intra-firm class of optimizing decision rules, constraints, and exchange mechanisms has been studied elsewhere, finding homes in business schools and the burgeoning best-practices management literature. The cavalier dismissal of workplace modeling as insufficiently incremental is an exercise in hubris that has greatly damaged the stabilization-relevance of consensus theory.
The crowding out of the powerful implications of specialized production was inspired by Walras, Jevons, Menger, and other authors of the marginalist revolution, who conceptualized economies as market systems in search of general equilibrium. It is interesting that Continental-tradition economists worked during, but were able to contain their interest in, the onset of the global transformation to large-scale, highly specialized production. Today, rigorous analysis that occupies the profession’s mainstream remains proudly coterminous with the study of market exchange, as illustrated by the otherwise admirable micro textbook by Mas-Colell, Whinston, and Green (1995, p.127): “Many aspects enter a full description of a firm: Who owns it? Who manages it? How is it managed? How is it organized? What can it do? Of all these questions, we concentrate on the last one. Our justification is not that the other questions are not interesting (indeed, they are), but that we want to arrive as quickly as possible at a minimal conceptual apparatus that allows us to analyze market behavior. Thus, our model of production possibilities is going to be very parsimonious: The firm is viewed merely as a ‘black box’, able to transform inputs into outputs.” The GEM Project makes clear that choice is most consequential.
Blog Type: New Keynesians Chicago, Illinois