On Logical Difficulties, Philosophy, and the T.C.E. Explanation of the Firm

Abstract

By exploring the implications of the linkage between Knight and Pragmatism, some non-trivial implications can be argued to exist. Specifically, section 2 outlines the T.C.E. literature, and how it exists in an atmosphere mixed with Marshallian competition and Knightian uncertainty. Section 3 then considers the disparate philosophical positions behind the work of Knight and Marshall. Knight's critique of Marshall is seminal, not because of any trivial technical innovations that Knight may have inspired within economic theory, but because Knight grounds his work on a philosophical viewpoint that effectively devastated Hegelian philosophy: American Pragmatism. Section 4 then links together the previous two sections by considering how the T.C.E. literature exhibits a dependency on both Pragmatism and Hegelian philosophy. The non-trivial implications of understanding the T.C.E. literature as a branch of Marshallian economics, which recognises Knightian uncertainty, are developed in section 5. Possible conclusions and a summary of the argument are provided in section 6.

Keywords:

• uncertainty
• Knight
• the theory of the firm
• Pragmatic philosophy
• Hegelian philosophy
• Transaction Cost Economics

Notes

Since space limitations do not permit an adequate treatment of the linkage between Pragmatism and Knightian uncertainty, this link has been developed elsewhere (Hands 2006; Nash 2003a). Pragmatism refers to the work of Charles Pierce (1868a, 1868b, 1958), William James (1890] 1981, 1897, 1909), and John Dewey. While extensive reference is made to Dewey, this is not meant to indicate the relative importance of Dewey. The linkage, between Knight and Pragmatism, can be contrasted to some of the literature on Knight (Foss 1993, 1996; Langlois and Cosgel 1993). Some recent commentary, such as Nelson (2001), does not address the philosophical heritage of Knight in an adequate manner, and instead tries to argue that Knight's contribution is mainly due to his religious struggles (Nelson 2001). While interesting, such analysis fails to address a significant source of inspiration for Knight's proposition of uncertainty; Pragmatic philosophy. In some limited way, this work follows the line of argument that is suggested by Slater and Spencer (2000). However, this work focuses on the underlying philosophical basis of Knightian uncertainty. As Slater and Spencer argue,The founding figures of transaction cost economics, Ronald Coase and Oliver Williamson, have steered away from offering a detailed explanation of the nature and origins of uncertainty. Coase, in particular, passes over the Knightian distinction between risk and uncertainty, leaving unclear his own position on uncertainty. (Slater and Spencer 2000: 67)

Maybe this reluctance to explore the meaning of uncertainty goes some way to explaining the current state of the theory of the firm. For example, Jensen and Meckling describe the theory of the firm as “an empty box” (Jensen and Meckling 1976: 308; Marris 1964; Penrose 1959). In addition, Winter argues, “I think we must acknowledge that the present state [of the theory of the firm] is one of incoherence” (Williamson and Winter 1991, p. 179 [brackets added]).

(Knight 1921] 1985).

The authors fully realise that Knight was critical of certain aspects of Pragmatic philosophy (Hands 2006; Nash 2003a). Yet these criticisms do not detract from the underlying use of Pragmatism as a basis for his proposition of uncertainty.

Even mentioning philosophy, in connection with the discussion of modern economic theory, is a controversial venture, according to the current orthodox economist, since the current conception is that economics has, somehow, become “value-free,” being analogous to the physical science. As Mirowski indicates,

In economics, the facade of the repudiation of philosophical preconceptions is propped up by the widespread conviction that modern economics has successfully adopted the character and attributes of a science. (Mirowski 1987: 1001)

The authors are not alone in their appreciation of Knight, as others have also come to realise that Knight's explanation of the firm might be significant. For example, Demsetz indicates,

From the birth of modern economics in 1776 to 1970, a span of almost 200 years, only two works seem to have been written about the theory of the firm that have altered the perspectives of the profession – Knight's Risk, Uncertainty, and Profit (1921) and Coase's “The Nature of the Firm” (1937). (Demsetz 1991: 159)

The linkage between Marshallian economics and Hegel has been elaborated elsewhere (Groenewegen 1990). As Klaes indicates, the relationship between the T.C.E. literature and Marshall is also well known,

Some economists regard the transaction cost concept as inseparably wedded to a framework of analysis that attempts to reduce institutional features of the economy to the core neoclassical notion of cost, thereby failing to develop conceptual tools more attuned to the complexities of economic institutions. (Klaes 2007: 4)

For those who doubt the importance of transaction costs, it is instructive to note what Coase says about them,

My purpose in that article [NOF] was simply to explain why there were firms and for this it was enough to show that there were costs that could be avoided by their formation, now commonly called transaction costs. (Coase 1988] 1991: 67 [brackets added])

And in addition,

I cannot say exactly how I came to hit upon a solution [to the explanation of the firm]; getting an idea is the kind of process in which you don't know what you are doing until you have done it. The solution was to realise that there were costs of marking transactions in a market economy and that it was necessary to incorporate them into the analysis. (Coase 1988] 1991: 67 [brackets added])

While the link between Pragmatic philosophy and the proposition of Knightian uncertainty exists elsewhere, a logical link between Knightian uncertainty and Coase appears unavoidable, from a logical viewpoint, despite the objections that Coase has voiced on this matter,

It can, I think, be said with some confidence that Knight played no part in the development of my ideas on the firm, a point I emphasise because some have thought the contrary. (Coase 1988] 1991: 49)

See Hands (2006) and Nash (2002). A reviewer has noted that T.C.E. literature does not have a theory of the firm, because it fails to recognise Knightian uncertainty, as Knightian uncertainty, as opposed to an extreme form of risk. In contrast, the present section argues that Coase does refer to Knightian uncertainty for several significant reasons, as elaborated herein.

Alchian and Demsetz (1972).

Alchian and Demsetz (1972: 779–781); Demsetz (1997).

Williamson (1975); Langlois and Foss (1998).

Williamson (1971, 1975). Recently, the central proponent of the governance theory of the firm has argued that the transaction cost theory of the firm may not be truly “comparative” (Williamson 2000: 17–19).

Space limitations prevent a detailed examination of these conditions, however some elaboration is provided later.

Generally, Hegelian philosophy represents a development of Kant's work (1787] 1929, 1790] 1997) which, among other things, conceives the mind to be an organ that synthesises perception, according to a priori structures, which transcend the existence of any one individual. Idealism claims that the human mind only indirectly knows objects, since the human mind only directly knows sensations, ideas, images, or representations. It is these directly known ideas, not the objects themselves, which effectively represent objects (Pippin 1991, 1993, 1996). Such philosophy also influenced some American economics before Knight (Clark J.B. 1886] 1961, 1899; and Clark J.M. 1923, 1925).

Kant's assertion that knowledge of the Transcendental realm, or of things “as they are,” is limited to the fact one can have somewhat vague intimations of this realm, through both aesthetic experience and moral life. Such an assertion might be argued to cloud Kant's position on the question of the certainty of human knowledge. On the one hand, Kant argues that one can prove the objectivity of human knowledge by using Transcendental knowledge as a means of checking the correctness of sense perception. As Kant says,

I entitle Transcendental all knowledge which is occupied not so much with objects as with our mode of knowledge of objects in so far as this mode of knowledge is to be possible a priori. A system of such concepts might be entitled Transcendental philosophy … Its purpose is not to extend knowledge, but only to correct it, and to supply a touchstone of the value, or lack of value, of all a priori knowledge. (Kant 1787] 1929: 59)

On the other hand, it is evident that Kant generally counsels one against such a proposition of using Transcendental knowledge to check sense perception.

Marshall (1890] 1920, Book 6, Ch. 2, para. 34). See also,

The price of 36s has thus some claim to be called the true equilibrium price: because if it were fixed on at the beginning, and adhered to throughout, it would exactly equate demand and supply (i.e. the amount which buyers were willing to purchase at that price would be just equal to that for which sellers were willing to take that price); and because every dealer who has a perfect knowledge of the circumstances of the market expects that price to be established. If he sees the price differing much from 36s he expects that a change will come before long, and by anticipating it he helps it to come quickly. (Marshall 1890] 1920, Book 5, Ch. 2, Para. 8 [emphasis added])

Again, Marshall uses the reference to perfect knowledge, where he implies that some dealers can have perfect knowledge, thereby supporting his general point that a difference in degree, not kind, separates actual from perfect competition (see also Marshall 1890] 1920: Book 6, Ch. 8, para. 36).

 Marshall gradually distanced himself from Hegel over time. Specifically, Groenewegen argues that while Marshall took his bearings from the Idealist philosophy of Hegel, he gradually reduces reliance upon it, so that,

Marshall's use of Hegel tends to suggest that Marshall increasingly presented … [Hegel] as a historical source useful in illuminating certain aspects of human history rather than as his mentor in philosophy of history whose system had provided useful suggestions for enhancing the understanding of the development of economic society and its counterpart, economic theory and doctrine. (Groenewegen 1990: 80 [brackets added])

Such conclusions influenced Marshall (Marshall 1890] 1920; Groenewegen 1990; Singer 1983] 1997: 192–193; Hassner 1963b] 1987: 732–760).

Knight notes that the ideal of autonomy in modern economics is antiquated and that as the scale of economic organisation grows, that ideal becomes more and more irrelevant (Knight 1932: 110–111). While Robinson Crusoe might be autonomous, the typical economic agent is increasingly less autonomous (Knight 1947). (See also Rousseau 1765] 1991: 184–186, 1770] 1964)

This is not to suggest that Hegelian philosophy is not without internal inconsistency, or that Marshall's work cleanly fits into the strictures of Hegelian philosophy, since Hegel emphasises certain aspects of human experience, while not emphasising others. While debate about the relative importance of perfect competition, to Marshallian economics, can be anticipated, the importance of perfect competition to Marshall remains apparent, even though Marshall's critical acceptance of Hegelian philosophy is illustrated, apart from other things, in the way Marshall refers to examples of partial, not general, equilibrium. In addition, one should also bear in mind the influence of Spencer upon Marshall, where Spencer generally argued for the survival of the fittest, and for a limited government role in assisting the weakest in the community (Spencer [1984] 1976; Degler 1991).

See Hume (1739] 1985; 1748).

Peirce (1868a; 1868b).

Dewey ([1916] 1960: 23; Knight [1921] 1985: 22–50). Neither the author, nor Knight is uncritical of Dewey ([1882–1888] 1967, [1895–1898a] 1967, [1895–1898b] 1967). Knight's criticism of Dewey is reasonably well known, and Strauss's criticism of Dewey is also significant in many respects (Strauss 1959] 1988: 279–281; Platt 1908, 1909; Rorty 1979, 1998] 1999). Strauss generally sees a modern development of philosophy from Machiavelli ([1513] 1985, [1517] 1996, to Hobbes ([1651] 1950) and Locke ([1698] 1967), with further revisions from Hume, Kant, Hegel, and Nietzsche. The Pragmatists very much add to the development of modern philosophy initiated by Nietzsche ([1884] 1956, [1886] 1993, [1887] 1996). Generally, the Straussian view is that the modern development of philosophy sets out to: (i) draw a significant distinction between man and nature, and (ii) to ensure that man masters nature. Locke merely illustrates these ideas, where he says, that Nature gives us nothing of value; value and property are both created through the act of labour (Locke [1698] 1967: 305–306; Vaughn 1978).

Dewey (1939), Knight ([1921] 1985, 251), Razeen (1997). For example, explicit insurance contracts, which might allow the firm to insure itself against the possibility of an adverse outcome that might be associated with the decision of an entrepreneur, are generally not feasible, primarily because of this problem of disentanglement (Knight [1921] 1985: 251; Runde 1998).

Like Hegelian philosophy, Pragmatism is not argued to be without logical inconsistency. For example, if all knowledge cannot be distinguished from engagement with reality, then the derivation of any unchanging “truth” becomes difficult.

Dewey ([1895–1898b]1967: 96–110; [1903–1906]1976: 107–127). This conception of knowledge and uncertainty can be contrasted to the Continental definition of uncertainty, which tended to be based on the unbridgeable gap between mind and world which Sartre develops (Sartre 1956: 218; see also Savage 1954; Schmidt 1996).

Specifically, this conclusion can be substantiated by considering the idea of perfect competition, with reference to the abovementioned five aspects of the Pragmatic theory of knowledge. Here, each aspect of Pragmatic philosophy serves to systematically rule out the existence of perfect competition.

The linkages between Pragmatic philosophy and Knightian uncertainty cannot be fully elaborated here, and have been dealt with elsewhere in the literature (Nash 2003a).

Boudreaux and Holcombe (1989), Slater and Spencer (2000), Groenewegen (1990).

In addition, Marshall envisages no great difference, between actual and perfect competition, since, for example, Marshall indicates that some dealers in a market may possess perfect knowledge and some may not, hence the comparison to perfect competition becomes somewhat feasible (see also Samuelson 1976). As Marshall indicates,

The price of 36s. has thus some claim to be called the true equilibrium price: because if it were fixed on at the beginning, and adhered to throughout, it would exactly equate demand and supply (i.e. the amount which buyers were willing to purchase at that price would be just equal to that for which sellers were willing to take that price); and because every dealer who has a perfect knowledge of the circumstances of the market expects that price to be established. (Marshall [1890] 1920: Book 5, Ch. 2, Para. 8 [emphasis added]).

This conclusion, regarding the fact that Coase's analysis represents a modified Marshallian analysis, is consistent with other assessments of Coase. See the following: (i) Lawson (1997), (ii) Loasby (1976, 1990), (iii) Pratten (1997); and (iv) Slater and Spencer (2000). For example, Slater and Spencer argue as follows,

Both [Williamson and Coase] see uncertainty as conditional in effect, being curtailed with other sources of transaction costs through an appropriate mix of market and internal governance. Williamson follows Coase in emphasizing the efficiency attributes of markets and hierarchies, showing the equilibrium conditions that allow for the achievement of minimum transaction costs under both governance mechanisms. Their approach remains firmly rooted in orthodoxy, building toward a general equilibrium conception of the allocation of transactions in the economy. (Slater and Spencer 2000: 67 [brackets added])

Generally, the confusion in the T.C.E. literature is argued to begin with Coase, and so the linkage between Knightian uncertainty and Coase is elaborated.

While Coase is somewhat quick to distance himself from Knight, and his work, Coase does concede that Knight's ideas were, “so much in the air at LSE that I would be exposed to them without reading him” (Coase [1988] 1991: 49). While problematic to establish, especially given Coase's view on the matter, the following three points can be argued to substantiate a logical linkage between Coase and Knight, both in terms of Coase's influences and of the logical structure of NOF itself. Hence one might argue that even though Coase uses the word “uncertainty,” he might use it in a different sense from Knight, and hence Coase might possibly escape the claim that his idea of “marketing cost” has anything to do with Knightian uncertainty, or the Pragmatic theory of knowledge that supported the proposition of Knightian uncertainty. Yet such an argument, rejecting the linkage between NOF and RUP, seems tenuous; at least from a logical point of view.

More specifically, if Coase was using an extreme form of risk, and not Knightian uncertainty, then it would be difficult to establish the permanence of marketing costs, since risk was already part of previous analyses, and risk was not thought to justify the permanent suspension of the price mechanism. Only by using something qualitatively distinct from risk, as an axiomatic premise of his analysis, can Coase launch his analysis of the firm. As Coase indicates,

The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of “organizing” production through the price mechanism is that of discovering what the relevant prices are. This cost may be reduced but it will not be eliminated by the emergence of specialists who will sell this information … Again, in certain markets, e.g., produce ex-changes, a technique is devised for minimizing these contract costs; but they are not eliminated. (Coase 1937: 390 [emphases added]).

Specifically, in section three of NOF, Coase extensively refers to the term “uncertainty,” when discussing the Knightian firm. It remains highly unlikely that Coase is referring to a different type of uncertainty to Knightian uncertainty here, in section three, unless Coase thought that Knight, within RUP, was not discussing Knightian uncertainty. Moreover, Coase considers a situation without “uncertainty” and with “uncertainty,” and Coase never distinguishes between Knightian uncertainty, and other forms of uncertainty that might exist, throughout NOF.

For example, while each team member can terminate their own individual contracts, only the monitor can alter the contracting rights with all, or part, of the team.

Asset specificity is defined in relation to a situation of perfect competition, where it cannot exist, such that if asset specificity exists, then the parties to any transaction become hostage to the outcomes of a particular transaction for a significant period, in the period after the execution of the transaction.

Simon had earlier developed the idea of bounded rationality by arguing that imperfections in information may distort the way rationality manifests itself, in comparison to situation of perfect competition (Simon 1957).

One can only discuss “distortions” from what might occur in situations of perfect competition, if one assesses actual competition through the looking glass of perfect competition.

Opportunism is where imperfections in knowledge, in comparison to a state of perfect information, allow economic agents to distort information, so that they can seek their own utility maximisation, by effectively reducing the utility of either the employer, or of the firm as a whole.

Boudreaux and Holcombe (1989); Klaes (2007); Lawson (1997); Pratten (1997); Slater and Spencer (2000).

Coase indicates his own lack of knowledge in the following quote,

In retrospect, it may well be that the most important contribution of “The Nature of the Firm” to economics will be considered to have been the explicit introduction of the concept of transaction costs into economic analysis but it was not my aim to change the character of economic theory. Indeed, given that the ideas in the article were developed by a young man who knew virtually no economics it is inconceivable that he should have that in mind (Coase [1988] 1991: 62).

A referee to this work has pointed out the import of Hume and the logical empiricism of the Vienna Circle to mainstream economics.

For example, at one point Coase argues that, “It is hoped to show in the following paper that a definition of the firm may be obtained which … is tractable by two of the most powerful instruments of economic analysis developed by Marshall … Our definition must, of course, ‘relate to formal relations which are capable of being conceived exactly’” (Coase 1937: 387, [1988] 1991: 52). Yet, at other places Coase indicates that the integration of transaction costs within more formal economic analysis represents a “formidable task” (Coase [1988] 1991: 63). Moreover, Coase indicates that other, more mathematically gifted economists, such as Duncan Black, had been unable to present transaction costs in a mathematical form. As Coase indicates, “That Black was unable to put transaction costs … into mathematical form was not due to an inability on his part to handle the mathematics. Black had taken a degree in physics and mathematics before switching to economics” (Coase [1988] 1991: 64).

Like all authors, however, Knight had doubts, indeed deep concerns, with the gripping philosophical systems of our day. While other authors have already identified problems with the theory of the firm, their analyses are of a different form. For example, see the following: (i) Lawson (1997), (ii) Loasby (1976, 1990), (iii) Pratten (1997), (iv) Slater and Spencer (2000).