Building the marginalist theory of the firm
The marginalist theory of the firm was built upon Alfred Marshall’s work, retaining one aspect only of his twofold view of the firm. On the one hand, in his Principles (1890), the owner-entrepreneur is considered a decision-maker, and the emphasis is on shortperiod and long-period equilibria of industries and representative firms.
Since manufacturing firms have a finite life cycle of expansion and decline, the long-period supply of an industry is provided by different firms at specific moments of their lives, and the “representative” firm is a fictitious average. This approach leads to an elaborate discussion of the firm’s behaviour, of its costs and returns and thus of its optimal size. Here, the “undertaker” is the capitalist-owner-manager who provides “the supply of business power in command of capital [which] may be regarded as consisting of three elements, the supply of capital, the supply of the business power to manage it, and the supply of the organization by which the two are brought together and made effective for production” (Principles VI, 7). The first function is rewarded by “interest”, the others by “earnings of management”.On the other hand, Marshall also conceived the firm from a more dynamic perspective, as a source of growth. The entrepreneur-founder of the firm is now an innovator, who obtains a quasi-rent that disappears in the long run. The discussions of the advantages of the division of labour in Industry and Trade (1919) and in the Principles follow Smith and Charles Babbage. In this approach, the Marshallian firm is not a passive player but interacts with its environment (Loasby 1999).
The cost controversy of the 1920s focused the attention on Marshall’s equilibrium approach. His concept of “external economies”, and its reinterpretation by Arthur Pigou in his Wealth and Welfare (1912), gave rise to a controversy on the forms of costs. One of the results of this debate was the refinement of Marshall’s analysis on the optimal size of the firm (Pigou 1932) and on the theory of costs and production (Viner 1931).
In the same vein, Joan Robinson (1933) generalized the Marshallian behaviour of firms to monopolistic situations: each firm is characterized by a production function and confronted with a demand curve, and it maximizes its profits. While introducing the fictitious Marshallian firm into the core of microeconomics, Robinson lost sight of the firm as an organization. Edward Chamberlin (1933), through his general theory of market structure (monopolistic competition), was the first to insist on the multidimensionality of the strategy of the firm: price, differentiation and advertisement. Formalizing some of Marshall’s insights, but disregarding others, Robinson’s and Chamberlin’s works mark the birth of industrial organization and of the neoclassical theory of the firm, emerging at the same time as consumer theory (Hicks and Allen 1934). The neoclassical theory of the firm soon became and would remain dominant. Since this theory assumes perfect information and focuses on static equilibrium, it leaves no role for an entrepreneur making decisions under uncertainty, reacting to and causing change. Paradoxically, this is a theory of the firm in which there is no firm: the “firm” is an optimization process, with given technology. This is in fact a theory of prices, so the issue at hand is the allocation of resources and not the process of their production, with its creation and use of knowledge. The increasing formalization of economics no doubt favoured this neglect of the entrepreneur, production and organization. But there were also some seminal critical works, more or less at the margins of mainstream economics.