What was this industrial system for which the South fought and risked life, reputation and wealth and which a growing element in the North viewed first with hesitating tolerance, then with distaste and finally with economic fear and moral horror?
[Black Reconstruction, W.E.B. Du Bois, 1933, p.8]

Economists of the late 19th century developed a view of the world that was isotropic; they were determined to find a general system of laws that applied the same way in all places. Their forebears tended to notice patterns, but the marginalists, for the most part, were determined to find a cartesian system of rules that transcended, or anticipated, the laws of nature. They wanted to show that economics was almost a parallel of physics. The relations between persons, represented by their wills and endowments, could be deduced endlessly to explain reality, provided one had the proper disciplines of mind, and had a perfect knowledge of initial endowments.

For such an outlook, there could be no such thing as an "industrial system." There was only the economy. It was more or less without boundaries. It was like the ether of space, in which the laws of Newtonian physics and Maxwell's equations operated smoothly and infallibly.

In developing countries such as the USA and Germany, economics tended to split ideologically, with some—like John Bates Clark—favoring laissez-faire, and others—like Gustav [von] Schmoller—sided with the "historicist" school, which argued that affluence required a policy of state management. The coexistence of these rival social sciences led to a division of labor between them, with the neoclassicists of North America tending to be polemical (as, for example, Simon Newcomb and Frank W. Taussig), and the historicists tending to go into social research. Since historicism is prescriptive, and a true federal republic is unlikely to ever be capable of embracing any such prescription, the North American historicists—led by Richard Theodore Ely">Richard Ely and Henry C. Adams—turned to empirical research in the social sciences. As a result, we call this group of heretics "institutionalists." Their special attention was directed at the nature of institutions that carved out economic space within the economy.

Because the neoclassical school of economists was at once caught up in an academic struggle with the historicists/institutionalists, they were determed to deny institutions any determining role in the form the economy could take. Rather, the neoclassical economists insisted that economic institutions themselves (viz., corporations) sprang from economic efficiency. As an example of this, consider Ronald Coase's "The Nature of the Firm" (PDF), 1937. Coase's paper is< I have realized, a microcosm of classical economic thought (albeit, partly because of his citations). Herewith is the neoclassical vision:

Let us consider the description of the economic system given by Sir Arthur Salter. "The normal economic system works itself. For its current operation it is under no central control, it needs no central survey. Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive." An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organization but an organism. The economic system "works itself." This does not mean that there is no planning by individuals. These exercise foresight and choose between alternatives.

Sir Arthur Salter's description, however, gives a very incomplete picture of our economic system. Within a firm, the description does not fit at all. For instance, in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from Y to X until the difference between the prices in X and Y, except insofar as it compensates for other differential advantages, disappears. Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so. Those who object to economic planning on the grounds that the problem is solved by price movements can be answered by pointing out that there is planning within our economic system which is quite different from the individual planning mentioned above and which is akin to what is normally called economic planning... As D.H. Robertson points out, we find "islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk." But in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organization necessary? Why are there these "islands of conscious power"?

Orthodoxy: Economics as Celestial Mechanics

The notion that the firm, rather than individual owners of capital endowments, was the real agent of decision in the capitalist system might have appeared to have been a tip of the hat to the institutionalists. In fact, "The Nature of the Firm" was an attempt by Coase to prove that economics, as understood by the neoclassicists, could indeed supply an explanation for the firm's emergence as "an organism rather than an organization," i.e., something that evolved without any relevant human agency. This does not mean that Coase was so extreme a skeptic as to deny the existence of Henry Ford or John D. Rockefeller. It meant that Coase (and neoclassicists in general) would take the position that the markets had favored Ford Motor Company and Standard Oil taking the form they did. Had Ford or Rockefeller died in childhood, then some other entity would have furnished the automobile or refined petrochemicals in a similar way. Given the available technology and the nature of the market for these items, it followed that there was an ideal size of the firm for a particular product. The firm would require persons of peculiar abilities, and someone would necessarily emerge to fill the bill.

Economics is full of hypotheses like this one: substituting universal laws for conscious agency, and beyond the realm of testing. Not only is there no means of testing to see if the auto industry would be materially different if Henry Ford had died in childhood, or if it emerged in Canada instead of the USA, the concept is essentially meaningless. By insisting that the laws of economics determine the optimum size of a firm for any given sort of business, amounts to a tautology. Of course it does. Even if I manage to decisively prove that, say, General Motors is far larger than the optimum size for a firm,¹ Coase might object that other Japanese and European firms operate under different constraints, and represent essentially different enterprises with different outputs. But that's my point. Most industries will have a cluster of firms ranging in size from small to large, with the medium either more, equally, or less, profitable than those at either extreme.

I could spend a far longer time than I have examining the profits over different time horizons, different capital market structures, or different corporate law regimes; examine the returns on equity (ROE) over different time horizons; or contrive any comparison you like. The fact that firms do exist with performance varying widely, sometimes over very long periods of time; or else, a firm's performance over time may vary when its size does not, or a firm's performance over time may be consistently excellent while its size is not, are all outcomes that Coase must have known about.

Coase was not claiming to devise a theory that would predict the exact size of a firm given readily available information about the industry in which it operated. In fact, his paper was mainly intended to attack Frank H Knight's theory of uncertainty. Coase, in other words, wrote his paper as a salvo on behalf of the apologetics. Knight, while generally siding with laissez-faire, denounced the Panglossian claims made for it by the apologetic school. There were consequences, Knight declared, to defending free markets with a bodyguard of humbug. Coase manfully rose to strike a blow for humbug.

The humbug that Knight scoffed at, and Coase defended, was the absence of any sort of political or institutional role in the free enterprise economy. We may find it odd that Coase had a beef with Knight's perfectly plausible concept of uncertainty playing a role in the size of the firm. The ability of an entrepreneur to shield himself from unquantifiable risks associated with increases in costs of production by buying out suppliers, is an imminently compelling reason for expanding the size of a firm. However, not being quantifiable, it is political. That, Coase cannot accept.

Risk is an economic matter. Uncertainty—unquantifiable risk—is a political one. A random incidence of property crime, with minor variations over time, can be factored into the costs of doing business. The possibility of public resentment at a monopolist giving way to nationalization of the firm, cannot be. If the possibility is real, it must be eliminated. If the monopolist absolutely positively cannot install a falangist regime in the country he operates out of, then he will stew about it and become obsessive. The notion that a firm is the size it is to suppress the consequences of the manager's own incompetence, and not to maximize shareholder ROE, is a grave and fundamental challenge to the apologist's position. The moral virtue and historic inevitability of the capitalist system's behavior is called into question; it is contingent upon results. Knight favored laissez-faire because it was the least bad system. Coase championed it as definitionally, immutably optimal. Oddly, it was fairly exotic to point out it didn't exist.

From the Industrial Firm to Industrial System

While an economy represented the space in which transactions and production occurred, a corporation is a planner whose size is determined by politics rather than by economics. It takes its size partly in response to uncertainties, such as the unknowable possibility that its suppliers or retailers will gain an advantage over it. The risk of one's customers being engulfed by a monopsonoid retailer, if plausible, will very likely trump comparative transaction costs when considering a merger. Another consideration is the expected future costs of transactions: if superior industrial technologies requires massive investments in new plant and equipment, then the entrepreneur will be seeking an optimal path, rather than an optimal state.

Choosing an optimal path involves planning for a future under certain assumptions about trends in costs and prices. Over the period being planned, it may be expected that there will be years in which the firm is losing money, since it is operating at an excessively large size; at the end of the period, the firms profits (in the aggregate) will be, or have been, greater than if it had optimized from quarter-to-quarter. Different management teams might choose different assumptions about trends, or different time horizons, leading to historic (institutional or personal) peculiarities in the composition of the economy.

While these aspects are both decisive and outside the scope of purely economic theory, they do not refute it. They merely impose limitations on its aplicability, much the way psychology does not necessarily predict the behavior of a person held at gunpoint (rather, the gunman does).

However, an industrial firm is only a part of an industrial system, which is also peculiar to prevailing technological, historical, and personal conditions. We usually think of industry as either the business of manufacturing and construction; an industrial system, however, is a process of converting available factors of production into goods, and using the goods to obtain further factors of production. Notice my phrase, "using the goods to obtain further factors of production." This may include selling the goods to a population of grateful customers for money, but it may also include pointing the "goods" at fearful natives and extorting factors of production from them; or combinations of the two (selling extorted goods for money to buy goods like rifles and gunboats).

The need of industrial systems to convert outputs to future inputs has always been a serious concern, even with the widespread use of money. Partly this is because the industrial system may have to interact with other industrial systems, sometimes in predatory ways. Industrial systems usually involve numerous firms, of varying sizes, which depend on each other and which have distinctive political interests. For example, in the antebellum era of US history, there was the South, which favored low tariffs and free trade, and the North, which favored high tariffs for infant industry. The rival demands of these two industrial systems played a signifant role in the outbreak of civil war. The industrial system of oil and gas, for example, favors urban sprawl and drilling in federal lands. Manufacturing interests do not; they require large compact cities with heavy spending on infrastructure: manufacturing is heavily reliant on network spillovers and easy transport. In Europe or Northeast Asia, where manufacturing interests are powerful, there is a major public sector role in the economy.

Industrial systems are guided by the laws of economics, of course, but these "laws" are only part of the total picture. And in most cases, economists play dumb about what those laws are. For example, a firm's managers are not interested in maximizing profit, unless they own the firm themselves. Even then, they probably aren't interested in maximizing profit. Many of the clues that a textbook manager would have to indicate whether to expand or shrink are not available anyway. Bidding prices upward to get marginal revenues to equal marginal costs may only get customers to resent you. And anyway, the managers may not find it useful to know that they're supposed to increase output until MP = MC: increase output of what? A more reasonable expectation is that managers are trying to maximize rents they can expropriate from the firm. They need to convince the board of directors that theyre good managers, not maximize profits. If they can do both, that's nice, but expecting someone to perform a service for which they are not compensated is bad economics.

The fact that managers do not necessary share the interests of those for whom they manage is called "the agency problem," and comes up in the New Testament (Luke 16:1-8). Now, Jesus clearly expected his audience to understand the agency problem. Economists usually make some mumbling acknowledgement that this exists in the corporation, but they punish you with excommunication (or really huge dollops of utter nonsense) if you make too much of it.

But there are consequenses of this sort of nonsense. Economics in its current state is not merely in the business of proclaiming the infallibility of the free market, but insisting that the free market is whatever the nation's cadres of industrial managers want. For decades this shilling has become so extreme it has lost any shred of academic merit. We are drifting into a state of affairs where industrial managers have command over wages, prices, and regulatory climate; where well over 3% annually of GDP is spent on shaping and manipulating public tastes (suggesting that managers have a great faith in the efficacy of advertising); and where the military power of the state has become a handmaiden of the industrial system we have. This is not unlike the situation that prevailed in the USSR. And yet, the same economists who ferociously defend this as the apex of free market democracy, will erupt in a towering rage at any regulation in the public interest, with the most extravagant redbaiting rhetoric.

By acknowledging the existence of industrial systems, we can begin to at least discuss the possibility (I would say, the blatantly obvious reality) that our economic space is occupied by command and control. It is time we realized this is command and control by aglomerations of firms known as industrial systems, that these industrial systems have rival desires with respect to each other, and that they are the holders of the whip hand.

[Economics] [US History] [Uncertainty]

ADDITIONAL READING: Clarence Ayres, The Theory of Economic Progress (1996-internet edition), originally written 1962;

Frank H. Knight, Risk, Uncertainty, and Profit (complete text online), 1921

From this, one might conclude that Renault is Goldilock's preferred automaker: firms bigger than it suffer from excessive impedence of market forces, while smaller firms like FHI suffer from excessive transaction costs. But Toyota ($178 billion sales/11.7 billion profits) is 3.2 times the size of Renault, more consistently profitable, and in between Renault and GMC in size. Porsche is smaller than FHI ($7.8 B/$949 M), and Daihatsu's ($10.9 B/$240 M) auto division is bigger than Subaru (i.e., FHI's auto division).