SSRN Id2721811 PDF

Andreas Martin Fleckner
Adam Smith on the

Joint Stock Company
Max Planck Institute for Tax Law and Public Finance

Working Paper 2016 01
January 2016
Max Planck Institute for

Tax Law and Public Finance
Department of Business and Tax Law
Department of Public Economics
http://www.tax.mpg.de
Electronic copy available at: http://ssrn.com/abstract=2721811

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Electronic copy available at: http://ssrn.com/abstract=2721811
Adam Smith on the J oint Stock Company
Andreas Martin Fleckner*
In 1784, Adam Smith released the third and definitive edition of the Wealth of Na-
tions, the most influential work in economics ever written. Of the eighty pages he
added, more than thirty deal with joint stock companies and other commercial or-
ganizations. While these additions caused many observers to praise Smith as the
first to coin the governance problems in firms, a closer examination of his remarks
reveals that Smiths theory of the firm, or the lack thereof, is in fact one of his works
weaker parts. Smith thought history had shown that joint stock companies cannot
compete with smaller firms, attributed this fact to certain organizational deficits, and
concluded that joint stock companies should be established only under rare circum-
stances. Yet, in the following decades, exactly the opposite came to pass, with joint
stock companies thriving in almost all fields and markets today. What made Smith
so pessimistic about the joint stock company? The answer lies, this paper argues, in
the sources Smith consulted, the companies he studied, and the general beliefs he
held. Why did Smiths pessimism turn out to be wrong? Smith probably overesti-
mated the joint stock companys weaknesses and underestimated developments that
helped overcome them, such as technological progress, organizational innovations,
and regulatory responses.
Keywords: Adam Smith, theory of the firm, joint stock company, stock corporation,
corporate governance, agency
JEL Classification: B12, B31, D23, G34, H41, K22, L22, N43, O33
* For many valuable comments and suggestions, the author is indebted to David Ciepley, Corinna R.
Coupette, Andreas Engert, Benjamin M. Friedman, Gen Goto, Klaus J. Hopt, Matthijs de Jongh, Amin
Kachabia, Thilo Kuntz, Philipp Aron Leimbach, Daniel Schwander, David Grant Smith, Holger Spamann,
Felix Steffek, as well as to participants in the Economics and Politics seminar at Harvard University
(Fall 201314) and in the faculty workshop at the University of Glasgows School of Law (January 2014).
The usual disclaimers apply.
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ANDREAS MARTIN FLECKNER
I. Introduction. Smith and the firm..................................................................................................... 3
II. Analysis. What did Smith say about joint stock companies? ...................................................... 9
1. Context. publick Works and publick Institutions ............................................................. 9
2. Concept. trade upon a joint stock without being a private copartnery .................... 15
3. Pessimism. in the long-run proved, universally, either burdensome or useless ........ 18
III. Investigation. What made Smith so pessimistic? ........................................................................ 24
1. Genesis. a compleat History of all the trading companies in G. Britain ...................... 24
2. Sources. a much more sober and judicious writer, Mr. Anderson................................ 28
3. Beliefs. the freer and more general the competition ... ................................................... 36
IV. Speculation. Why did Smiths pessimism turn out to be wrong?............................................. 43
1. Technology. Capital demand, information flow, market mechanisms ............................ 44
2. Organization. Control rights, supervisory boards, incentive schemes ............................ 46
3. Regulation. Minority rights, mandatory disclosure, state authorities.............................. 47
V. Summary. Main findings and positions ....................................................................................... 51
Bibliography .............................................................................................................................................. 52
Chart 1. Context of Smiths joint stock company ................................................................................ 56
Chart 2. Concept of Smiths joint stock company ............................................................................... 57
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ADAM SMITH ON THE JOINT STOCK COMPANY
I. Introduction. Smith and the firm
Today, publicly traded companies extract coal, oil, and gas; supply electricity and water;
maintain local, national, and global communication networks; deliver mail and parcels; operate
trains, aircraft, and ships; offer financial services from checking accounts to mortgages to in-
vestment banking; produce fertilizers and drugs, autos and trucks, laptops and phones; and so
on. Whenever there are lucrative projects calling for great sums of capital, investors stand ready
to team up and fund them. Large firms have become a cornerstone of modern society.
In stark contrast to this success story stands the treatment of firms in Adam Smiths Wealth
of Nations, another cornerstone of modern society and the most influential work in economics
ever written. In the first edition of the Wealth of Nations, Smith basically ignored entities and
associations set up to finance capital-intensive projects (Smith 1776). Large firms are mentioned
where they were common, such as in banking or overseas trading, but their structure and their
legal status remain in the dark.
It seems that Smith himself realized that this was a major shortcoming of his work. For in
the second edition, he added a long footnote that shed some light on the English East India
Companys inner dynamics (Smith 1778, vol. II, p. 257). In Smiths eyes, however, this was ap-
parently just a drop in the ocean. So when he prepared a supplement to the second edition, he
devoted more than thirty pages, or roughly 40 percent of the new passages, to joint stock com-
panies and other commercial organizations. These additions were first typeset separately, in
quarto format, like the first two editions (Smith 1784a), and then, in octavo format, incorporated
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into the third edition of the Wealth of Nations (Smith 1784, vol. III, pp. 10750), the edition that
Smith considered the definitive version of his work (infra note 8). Yet, while the Wealth of Na-
tions now featured a discussion of large firms, the essence of the additions is rather disturbing:
Joint stock companies are portrayed as organizations prone (or even doomed) to failure. From
Smiths gloomy account, no one would expect large firms to ever become a cornerstone of mod-
ern society. What made Smith so pessimistic? Why did his pessimism turn out to be wrong?
Despite both Smiths fame and the joint stock companys success, Smiths remarks on the
latter have garnered surprisingly little attention. Among the better known accounts of Smith,
only a few mention his comments on the joint stock company (e.g., Rae 1895, pp. 3614; Viner
1927, pp. 2257, 231; Ross 2010, pp. 37984), and none analyzes them at length. A similar picture
emerges from major works in economic and legal history (e.g., Schmoller 1893, pp. 9656, 1010
3; Scott 1912, vol. I, pp. 44861; Heckscher 1994 [1931], vol. I, pp. 374, 380, 4145, 4525, vol. II,
p. 283; Harris 2000, pp. 108, 2045, 210, 272). Not much more can be found in the journal litera-
ture. There is only one paper, published in the Journal of Political Economy, that is specifically
dedicated to Adam Smiths Analysis of Joint-Stock Companies (Anderson and Tollison 1982).
But that paper differs in many ways from the analysis hereinafter. Two other articles, both of
roughly twenty pages, mention Smiths position along with the views of other famous econo-
mists, without going into much detail given the space available (Amsler et al. 1981; Henderson
1986).
There are two plausible explanations for the disinterest in Smiths comments on the joint
stock company. The first is that research into the theory of the firm gained momentum compar-
Draft (2016-01-03) 4
atively late, long after the publication of the Wealth of Nations,1 and has remained one of the less
developed and agreed-upon areas of economics (Hart 2011, p. 102).2
The second explanation is that Smiths remarks on the joint stock company are less succinct
than other parts of the work. John Stuart Mill calls Smiths skepticism one of those over-
statements of a true principle, often met with in Adam Smith, and criticizes him for fix[ing]
his observation too exclusively on the superior energy and more unremitting attention brought
to owner-managed firms, while overlook[ing] various countervailing considerations which go
a great way towards neutralizing even that great point of superiority (Mill 1871, pp. 1745).
Gustav Schmoller bemoans that Smiths judgment was doctrinaire and based upon one-sided
accounts (Schmoller 1893, pp. 10101 n. 2).3 William Robert Scott writes that [i]t may be prem-
ised that the parts of the Wealth of Nations, treating of companies, show less of the remarkable
economic investigation of the writer at first hand than almost any other part of the book and
[i]t almost seems as if Smith selected from his authority such data as would tell against certain
companies, and there are a few passages which suggestthough one hesitates to say italmost
1 Ronald Coases seminal article which, in retrospect, started the modern debate appeared as late as
1937, and another couple of decades passed before the topic sparked greater interest.
2 Probably the best evidence of the traditional disinterest in the theory of the firm is the fact that the
firm has no prominent place, if it is broached at all, in books on the history of economic thought. Two
examples: In Sandmo 2011, a new and very readable book, none of the almost 500 pages are devoted to
the theory of the firm (the selection of topics is explained on pp. vii, 23, 112); in Heilbroner 1999, one of
the best-selling books in economics of all time, firms are mentioned more frequently, especially those
whose shares are publicly traded, but there is no discussion of the issues that are typically associated with
the theory of the firm (which, given the broad scope of the book, is not meant to be a criticism; neither
Heilbroner nor Sandmo would have been well advised to focus on the firm).
3 Translation from the German (wie doktrinr und auf einseitigen Berichten aufgebaut das Urteil
Smiths in vielfacher Beziehung hier ist). Schmoller relies on Macpherson 1812, pp. 335410.
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an animus against the East India undertaking (Scott 1912, vol. I, pp. 4489). For Jacob Viner,
Smith made a reasonable inference from past experience, but a bad forecast of the subsequent
trend (Viner 1927, p. 231). Eli F. Heckscher believes that Smiths knowledge of the facts was
probably superficial, but his reasoning was clear and consistent (Heckscher 1994 [1931],
vol. I, p. 452).4 Yet even Heckscher concludes, contrary to Smith, that the companies, in the
absence of an effective state authority, were indispensable (p. 454).
Much more positive are Gary M. Anderson and Robert D. Tollison, the authors of the
aforementioned paper on Smith. They argue that [t]he conventional wisdom regarding Adam
Smiths view of the corporation is based on a substantial misinterpretation of judgments ex-
pressed in The Wealth of Nations (Anderson and Tollison 1982, p. 1254). Their central claim is
that Smiths evaluation of the joint-stock firm was not moralistic but instead based on available
empirical evidence (p. 1237) and that [t]he popular view that Smiths discussion of the joint-
stock firm is muddled or moralistic is wrong (pp. 12378). However, while Anderson and
Tollison offer some interesting insights into Smiths thinking, they rely on a number of assump-
tions that are dubious upon closer examination (infra notes 6, 20, 21, 26, 28, 31, 33, 36, 40, and
accompanying text).
This paper has three purposes: first, to study in detail what Smith thought about joint stock
companies; second, to find out what may have caused his pessimism; and third, to speculate
what factors he may have missed. The implications are manifold. A better understanding of
Smiths remarks will provide new insights into some of his key economic positions, such as on
4 The first quote is missing in Heckscher 1931, vol. I, p. 408.
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competition, on self-interested behavior, or on speculation. Those interested in corporate and
economic history will find in Smith a prominent eyewitness of the publics attitude toward joint
business ventures shortly before their success story began. And, probably most importantly:
While the theory of the firm has fascinated recent generations of economists, the words of Smith,
the godfather of modern economics, have been largely ignored to date. This is a major omission,
even as Smiths analysis is flawed in many waysfor understanding why Smith was wrong,
and what he may have missed, will offer fresh perspectives on the various elements in the theo-
ry of the firm that economists are still struggling with.5
A few words on the terminology and on the exact scope of the paper. Joint stock compa-
ny is Smiths term for the institution that in todays English is known as the stock corpora-
tion, the business corporation, the public limited company, or still the joint stock compa-
ny. Smith also mentions regulated companies and private copartneries. But Smith has no
general term for these organizations, let alone a general concept of collective business ventures.
5 The purpose of the paper is to better understand Smiths view of the joint stock company rather than
to correct factual inaccuracies and questionable assumptions about Smiths position elsewhere. Examples
of the latter are so ubiquitous, especially in the modern corporate governance literature, that any selection
of references would be arbitrary. Three errors are very common. First, many scholars date Smiths re-
marks on the joint stock company to 1776, while they in fact did not appear before 1784 (it is not the dif-
ference of a few years that is alarming but the fact that both the original and the modern editions indicate
that the remarks were added later, as discussed infra sub III. 1., suggesting that Smiths remarks are more
often cited than read). Second, scholars refer to Smith in the context of todays private joint business ven-
tures, while he discusses joint stock companies in the context of public works and institutions (see infra sub
II. 1.). Third, scholars praise Smith as the first to coin certain agency and corporate governance problems,
but in apparent ignorance of his policy recommendations: Smiths solution to the control problem is not to
make control easier, for instance by imposing disclosure obligations or granting shareholders more rights,
but to limit the scope of joint stock companies to businesses that follow a routine and therefore require
less control (see infra sub II. 3.).
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Not once does he speak of a firm, nor does he develop anything that would resemble a theory
of the firm.6 While it is therefore more accurate to write about Adam Smith on the Joint Stock
Company than about Adam Smith on the Firm, it is important to bear in mind that a joint stock
company of today differs in many respects (size, scope, regulation) from what Smith called a
joint stock company.7
The remainder of the paper proceeds as follows. Section II offers a detailed analysis of
Smiths remarks, that is, the context in which he discusses joint stock companies, the concept he
associates with them, and the pessimistic conclusions he draws from his findings. Section III
aims to explain what factors and events may have caused Smiths pessimism. The focus is on
the sources Smith consulted, on the companies he studied, and on the general beliefs he held.
Section IV ventures a guess why Smiths pessimism turned out to be wrong and why the joint
stock company, despite his concerns, became a cornerstone of modern society. Technological
progress, organizational innovations, and regulatory responses are presented as the main devel-
opments that Smith may have overlooked or underestimated. Section V summarizes the main
findings and positions.
6 Anderson and Tollison (1982, p. 1237) nevertheless commence their papers abstract with the remark
that they defend Adam Smiths theory of the firm from the standpoint of positive economics (emphasis
added). Similar (and equally problematic) expressions recur throughout their paper (pp. 1237, 1240, 1242,
1244, 1245, 1254, 1255).
7 Whether the modern type evolved from Smiths joint stock companies, and how it was influenced
by them, is beyond the scope of the paper. The author is working on a more detailed account of Smiths
terminology, comparing it to earlier works in Latin, French, Spanish, and German.
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II. Analysis. What did Smith say about joint stock companies?
In the first decades of the 19th century, policy makers and scholars were very familiar with
Smiths comments on the joint stock company. The same cannot be said today. Only a few
catchphrases are still well-known (such as other peoples money), and they are often quoted
out of context and in a way that gives a wrong impression of Smiths position (especially his
policy recommendations). So any modern discussion of Smith has to commence with an analy-
sis of what he said about joint stock companies before one can start investigating the reasons
why he said what he did.
1. Context. publick Works and publick Institutions
An Inquiry into the Nature and Causes of the Wealth of Nations is divided into five books (see
chart 1 in the appendix). Book Five, Of the Revenue of the Sovereign or Commonwealth, is
the one of interest here (pp. 44465).8 It has three chapters: first Of the Expences of the Sover-
eign or Commonwealth (pp. 44241), second Of the Sources of the general or publick Revenue
of the Society (pp. 241394), and third Of publick Debts (pp. 394465). This division into
8For the remainder of the paper, if no other source is given, all page numbers refer to (and all quotes
are taken from) Smith 1784, vol. III, the third edition. Smith considered this version the definitive edition
of his work: This Edition will probably see me out and I should therefor chuse to leave it behind me as
perfect as I can make it. (Smith 1987 [1783], letter no. 227, p. 266). In the subsequent edition, the fourth,
Smith confirmed that he has made no alterations of any kind (Smith 1786, vol. I, advertisement). The
fifth edition, the last in Smiths lifetime, repeats that clause (Smith 1789, vol. I, advertisement). Today, the
standard reference work is the Glasgow edition (Smith 1976). It discusses Smiths involvement in subse-
quent changes (ibid., 634), but concludes that the third edition, of 1784, is the last that Smith contributed
to and therefore has to be accepted as representing his final version (ibid., 63).
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public expenditure and public income intuitively makes sense. Yet, it may come as a surprise to
the modern reader that Smith, for many the personification of laissez-faire, devotes an entire
chapter to goods and services provided by the government. In fact, with almost 200 pages, the
chapter on public expenses is the longest chapter of the entire treatise. Equally surprisingly, it is
the very chapter to which Smith added his comments on the joint stock company, not an institu-
tion a modern observer would even remotely associate with expenses of the government. What
is Smiths rationale for discussing joint stock companies in this context?
There is no explicit answer, and readers of Smith will have to cover more ground to under-
stand the organization of the material. Within the Expences of the Sovereign or Common-
wealth, Smith identifies four types of expenditure: Expence of Defence (pp. 4472), Expence
of Justice (pp. 7292), Expence of publick Works and publick Institutions (pp. 92237), and
Expence of supporting the Dignity of the Sovereign (pp. 2378). Only the third area is of in-
terest here, public works and institutions. In Smiths words (pp. 923): The third ... duty of the
sovereign or commonwealth is that of erecting and maintaining those publick institutions and
those publick works, which, though they may be in the highest degree advantageous to a great
society, are, however, of such a nature, that the profit could never repay the expence to any in-
dividual or small number of individuals, and which it, therefore, cannot be expected that any
individual or small number of individuals should erect or maintain.9 Because this definition is
9 A similar expression can be found at the end of Book Four (pp. 423): According to the system of
natural liberty, the sovereign has only three duties to attend to; three duties of great importance, indeed,
but plain and intelligible to common understandings: ...; and, thirdly, the duty of erecting and maintain-
ing certain publick works and certain publick institutions, which it can never be for the interest of any
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at odds with some later comments, it is worth repeating Smiths line of reasoning here: There are
public institutions and works that benefit society as a whole, but individuals will not provide
them because they cannot expect to make a profit. So the government has to step in.
Smith adds two further distinctions before he finally gets to the joint stock company. In a
first step, Smith subdivides the public goods into publick Works and Institutions for facilitating
the Commerce of the Society (pp. 93150), Institutions for the Education of Youth (pp. 150
92), and Institutions for the Instruction of People of all Ages (pp. 192237). In a second step,
he breaks the first group into those public works and institutions necessary for facilitating
Commerce in general (pp. 93107) and those necessary for facilitating particular Branches of
Commerce (pp. 10750). What kind of public works and institutions does Smith have in mind
here? For facilitating Commerce in general, Smith thinks of the erection and maintenance of
the publick works which facilitate the commerce of any country, such as good roads, bridges,
navigable canals, harbours, &c. (pp. 934). This list at the outset of the section is almost com-
plete, supplemented only by a coinage (pp. 945) and a post-office (pp. 95, 99, 2434).
In the first (1776, vol. II, p. 340) and second (1778, vol. II, p. 342) editions, Smiths discussion
of public works and institutions that facilitate commerce concludes at this point. In the third
edition, his older remarks become the first subsection, on the promotion of commerce in general,
followed by new thoughts on public works and institutions that facilitate particular branches of
commerce. These are the passages that Smith prepared for the third edition, and this is the con-
individual, or small number of individuals, to erect and maintain; because the profit could never repay
the expence to any individual or small number of individuals, though it may frequently do much more
than repay it to a great society.
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text in which he discusses the joint stock company.
Unlike the older parts, the new section on particular branches of commerce lacks a concise
definition and a list of introductory examples. Smith speaks in a rather bored tone of particular
institutions , which again require a particular and extraordinary expence (p. 107). To illus-
trate, he adds (ibid.): Some particular branches of commerce, which are carried on with barba-
rous and uncivilized nations, require extraordinary protection. An ordinary store or counting-
house could give little security to the goods of the merchants who trade to the western coast of
Africa. To defend them from the barbarous natives, it is necessary that the place where they are
deposited, should be, in some measure, fortified.
If Smith had stopped here, with the insight that overseas trading requires additional protec-
tion, and moved on to other branches of commerce, hardly any reader would have criticized
him for leaving out important information, given the wide range of topics under consideration.
Yet, Smith does not stop here. He gets carried away by his example and, to mimic a British idi-
om, literally goes round the fortified houses. In the next sentence, he mentions another example
of a place where commerce needs special protection: Indostan (p. 107). This brings him, for
the first time, to the trading companies (p. 107): [I]t was under pretence of securing their per-
sons and property from violence, that both the English and French East India Companies were
allowed to erect the first forts which they possessed in that country. Now Smith goes into the
details of overseas trading and discusses the role of ambassadors, ministers, and consuls
(p. 108), along with an outline of commercial organizations engaged in overseas trading
(pp. 10710). He then examines in great depth, without any further sub-division, regulated
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companies (pp. 11022) and joint stock companies (pp. 12250). While Smiths original context,
the promotion of particular branches of commerce, seems to be almost forgotten, the facilities
that prompted him to discuss overseas trading are frequently mentioned: forts10 and garri-
sons,11 also settlements12 and habitations.13 For Smith, the protection of foreign trading
posts is apparently the most important cost factor in overseas trading. Ships and cargoes, in
contrast, are only rarely brought up, and never as a major item of expenditure.14 Not even once
does Smith refer to the scope, the duration, and the risk of the voyages as factors that caused
overseas trading to be more capital-intensive than local exchange.15
Returning to the initial question of why Smith added his comments to the chapter on public
expenses: Has Smith made a good case for discussing the joint stock company in this context? Is
it clear how the joint stock company relates to publick Works and Institutions for facilitating
the Commerce of the Society? Does it intuitively make sense how Smith incorporates his re-
marks? It is difficult to come up with anything but a negative answer. First, the new passages
differ in style and length; attentive readers will recognize them as subsequent additions. Se-
cond, and more irritatingly, the link to the other topics of the chapter is weak; the transition
from the old to the new material has a flavor of arbitrariness, flagging the new passages as for-
eign material. Smiths deductive system has reached its limits here, the organization of the ma-
10 Pp. 116, 117, 118, 119, 120, 121, 125, 126, 127, 128, 143, 144.
11 Pp. 116, 117, 118, 120, 121, 122, 125, 126, 128, 143, 144.
12 Pp. 120, 127, 138, 139.
13 P. 127.
14 Pp. 113, 127, 129, 131, 132.
15 For scholars interested in the trading companies, it may be worthwhile to collect the historical data
and explore how large the costs of fortification were compared to the other cost factors mentioned above.
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terial is more associative than logical.
That a different classification of the joint stock company would have been more convincing
becomes most evident at the end of Smiths introductory comments on overseas trading, where
he says (pp. 10910): [I]n the greater part of the commercial states of Europe, particular compa-
nies of merchants have had the address to perswade the legislature to entrust to them the per-
formance of this part of the duty of the sovereign, together with all the powers which are neces-
sarily connected with it. These powers are apparently those mentioned toward the end of
the analysis (p. 143): With the right of possessing forts and garrisons in distant and barbarous
countries, is necessarily connected the right of making peace and war in those countries. Upon
closer examination, these remarks are rather odd. If the sovereign fulfills his duty by delegating
the task to companies of merchants, how does a forty-page analysis of such companies fit into a
section that, according to its introduction, discusses the duty of the sovereign or common-
wealth ... of erecting and maintaining certain publick institutions and ... publick works
(p. 92)? One would expect Smith to devote at least the same number of pages to the institutions
that the sovereign provides without delegation. Or one would expect him to give an explana-
tion of why delegation requires extra scrutiny, perhaps including an analysis of its risks and
benefits. Smith does neither. Nor does he imply, in whatever way, that the joint stock company
itself ranks among the publick institutions and ... publick works (which would reduce the ten-
sions). Forts, garrisons, etc. are the public goods he has in mind. The joint stock company
is merely a provider of them.
There is another, even more serious friction. Recall that Smith sees the government in
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charge of providing institutions and works that are of such a nature, that the profit could never
repay the expence to any individual or small number of individuals (p. 93). Under these cir-
cumstances, that is, with no prospect of ever making a profit (never): Why would any group
of merchants in their right mind perswade the legislature to entrust to them the performance of
this part of the duty of the sovereign (pp. 10910)? Will an undertaking all of a sudden become
profitable, just because it is funded by companies of merchants rather than any individual or
small number of individuals? Why? Other passages, where Smith praises the competitive ad-
vantage of smaller market participants over joint stock companies (pp. 124, 125, 131, 133, 1445),
would suggest the exact opposite. Or is Smith implying that exclusive rights will tilt the balance
in favor of joint stock companies? But what would prevent any individual or small number of
individuals from earning the monopoly rent? Bans on further delegation? Difficulties to bor-
row against the privileges? Both constraints may keep smaller market participants away from
very large undertakings, especially overseas trading, but not from the general projects that
Smith mentions, such as the maintenance of roads, bridges, or canals.
To put the context of Smiths remarks in one sentence: Joint stock companies are discussed
as providers of public works and institutions that facilitate particular branches of commerce.
Chart 1 (in the appendix) provides a summary of Smiths various distinctions and categories.
2. Concept. trade upon a joint stock without being a private copartnery
Smith compares three types of commercial organizations, apparently following their legal
nature rather than their size or structure in practice: regulated companies, joint stock compa-
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nies, and private copartneries. His focus is first on regulated companies (pp. 11022), then
on joint stock companies (pp. 12250). Private copartneries are not separately dealt with, but
cited by Smith throughout to illustrate and highlight differences.
For Smith, the key feature that distinguishes joint stock companies and regulated companies
is whether or not their members trade upon a joint stock. This dichotomy lies at the heart of
his discussion, and he introduces it right at the outset of his analysis (p. 110):16
When those companies do not trade upon a When they trade upon a joint stock, each
joint stock, but are obliged to admit any per- member sharing in the common profit or loss
son, properly qualified, upon paying a certain in proportion to his share in this stock, they
fine, and agreeing to submit to the regulations are called joint stock companies.
of the company, each member trading upon
his own stock, and at his own risk, they are
called regulated companies.
Unlike joint stock companies, regulated companies do not constitute joint business ventures.
They merely provide a framework for concerted business activity, similar to guilds of merchants
engaged in overseas trading. Smith saw this very clearly (p. 110): Regulated companies resem-
ble, in every respect, the corporations of trades, so common in the cities and towns of all the dif-
ferent countries of Europe; and are a sort of enlarged monopolies of the same kind. Examples
discussed by Smith include the antient merchant adventurers company, now commonly called
the Hamburgh Company (pp. 1113), the Russia[n] Company (pp. 1113), the Eastland
Company (pp. 1113), the Turk[e]y Company (pp. 111, 1136, 1212), and the African Com-
pany (pp. 111, 11722).
While the joint stock companys characteristics appear indirectly here and there to explain
16 The quote in the right column immediately follows the quote in the left column (emphasis added).
Draft (2016-01-03) 16
certain features of regulated companies (pp. 1167, 118), Smith shifts gears when he turns from
the regulated companies specifically to the joint stock companies. The latter are described in
contrast not to regulated companies but to private copartneriesperhaps because he considered
both to be trading upon a joint stock and therefore saw a need to highlight the differences be-
tween the two (see chart 2 in the appendix). Smith writes (pp. 1223):17
First, In a private copartnery, no partner, In a joint stock company, on the contrary, no

without the consent of the company, can member can demand payment of his share
transfer his share to another person, or intro-from the company; but each member can,
duce a new member into the company. Each without their consent, transfer his share to
member, however, may, upon proper warn- another person, and thereby introduce a new
ing, withdraw from the copartnery, and de- member. The value of a share in a joint stock is
mand payment from them of his share of the always the price which it will bring in the
common stock. market; and this may be either greater or less,
in any proportion, than the sum which its
owner stands credited for in the stock of the
company.
Secondly, In a private copartnery, each part- In a joint stock company, on the contrary,
ner is bound for the debts contracted by the each partner is bound only to the extent of his
company to the whole extent of his fortune. share.
Smiths characteristics of the joint stock company have remained typical of publicly traded
firms up to the present day: no unilateral withdrawal, transferability of shares, limited liability.18
The only key element missing in Smiths synopsis above is the separation of ownership from
control. Yet the tension arising from this feature is Smiths very topic in the paragraphs that
17 The quote in the right column immediately follows the quote in the left column, as do the quotes in
the second row. So the order is .
18 Smith does not say whether the members private creditors were barred from seizing common assets,
an important feature of large firms along with the exclusion of unilateral withdrawal by their members.
For general accounts of the stock corporations central characteristics, see, e.g., Armour et al. 2009, pp. 1
16 (legal personality, limited liability, transferable shares, delegated management, investor ownership)
and Fleckner 2010, pp. 3762 (separation of ownership from control, protection of private assets, protec-
tion of common assets, transferability of shares).
17 Draft (2016-01-03)
follow, and one of the main reasons why he is so pessimistic about joint stock companies
which brings us to the third and final step in the analysis of Smiths comments.
3. Pessimism. in the long-run proved, universally, either burdensome or useless
Writing about the reasons why Smith became so influential, Joseph Schumpeter once noted
(1954, p. 185): Last but not least, argument and material were enlivened by advocacy which is
after all what attracts a wider public: everywhere, the professor turned his chair into a seat of
judgment and bestowed praise and blame.
Smiths account of the joint stock company is a good example. His very first comment on
the trading companies, preceding everything else he has to say about them, including their divi-
sion into regulated and joint stock companies, reads as follows (p. 110): These companies,
though they may, perhaps, have been useful for the first introduction of some branches of com-
merce, ..., have in the long-run proved, universally, either burdensome or useless, and have ei-
ther mismanaged or confined the trade.19 How does Schumpeters professor explain his
damning judgment?
Smiths pessimism rests on two pillars: the observation that many joint stock companies
failed (practice) and the conviction that their structure was prone to mismanagement (theory).
Both made Smith argue that joint stock companies should have a very limited scope (conclusion).
Similar expressions, with respect to joint stock companies, can be found on p. 124 (see infra text ac-
19
companying note 27) and, with respect to regulated companies, on p. 113 ([t]o be merely useless, indeed,
is perhaps the highest eulogy which can ever justly be bestowed upon a regulated company).
Draft (2016-01-03) 18
(a) Practice. it would appear from experience
Smith observed that many joint stock companies could not compete with other market par-
ticipants. This is the key message of Anderson and Tollison (1982). They believe that empirical
evidence, the joint stock companys poor survivorship record, caused Smiths skepticism, and
they relentlessly emphasize this.20 What they do not provide, though, is an analysis of the evi-
dence that Smith allegedly relied on.21
It is true that Smith frequently points out how badly many joint stock companies fared.22 It
is also true that Smiths few examples of successful joint stock companies are mostly those that
resemble private copartneries or that are engaged in routine operations.23 But neither did Smith
have reliable empirical evidence at hand, as will be shown later, nor was there any such evi-
dence readily available at the time. And even if such a survivorship record had existed, noth-
ing would have stopped Smith from concluding that the joint stock companys high rate of fail-
ure was the result of other factors, for instance, because joint stock companies were the form of
choice for risky business ventures, or because other market participants, especially interlopers,
were free-riding on the expenses that joint stock companies incurred in opening and securing
new markets.
20 Anderson and Tollison 1982, pp. 1237, 1240, 12401, 1241, 1243, 1244, 1245, 1254, 12545.
21 Interestingly, Anderson and Tollison (1982, p. 1240 n. 4) themselves recognize at the outset of their
paper how incomplete Smiths sources were when they note that for no apparent reason Smith ... fails to
acknowledge the existence of firms which were joint-stock in terms of organization but were unincorpo-
rated by charter.
22 Pp. 124, 125, 126, 128, 129, 130, 131, 133, 138, 1423, 1445, 149, also (with respect to trading compa-
nies in general) p. 110 (reproduced supra sub 3).

23 Resemble private copartneries: pp. 1278, 132, 149 (but pp. 1356); engaged in routine operations:
pp. 1467 (more on this infra sub (c)).
19 Draft (2016-01-03)
What Smith had and what he relied on was anecdotal evidence. He never claims otherwise,
that is, he never says he had consulted any type of record or collected any data. His boldest
statement is the following (p. 131, emphasis added): That a joint stock company should be able
to carry on successfully any branch of foreign trade, when private adventurers can come into
any sort of open and fair competition with them, seems contrary to all experience. A similar ex-
pression appears in his conclusions (p. 144, emphasis added): Without a monopoly, however, a
joint stock company, it would appear from experience, cannot long carry on any branch of foreign
trade. Note that Smith is cautious in both cases, as indicated by the words seems, would,
and appear. On a third occasion, Smith mentions recent experience (p. 143).24
It is safe to assume that Smith would not have seen reasons to scrutinize the joint stock
company without the many failures he observed. Anderson and Tollison (1982) have a point
here. But, as Smiths cautious wording above suggests, it is equally likely that his conclusions
about the joint stock company would have been less assertive had he not come across another
source of doubt: the joint stock companys organizational challenges (the topic of the next sec-
tion).
(b) Theory. total exemption from trouble and from risk coupled with other peoples money
Following his introductory synopsis, comparing joint stock companies and private
copartneries, Smith immediately turns to the joint stock companys internal organization
24 Reproduced infra in note 39. Note also his general comment, with respect to all trading companies,
on p. 110 (reproduced supra sub 3): These companies ... have in the long-run proved, universally, either
burdensome or useless (emphasis added).
Draft (2016-01-03) 20
(p. 123): The trade of a joint stock company is always managed by a court of directors. This
court, indeed, is frequently subject, in many respects, to the controul of a general court of pro-
prietors. But Smith realized that the proprietors may not have the best incentives for making
proper use of their controul, and describes what is today known as the separation of ownership
from control (p. 123, immediately following the last quote):
But the greater part of those proprietors seldom pretend to understand any thing of the busi-
ness of the company; and when the spirit of faction happens not to prevail among them, give
themselves no trouble about it, but receive contentedly such half yearly or yearly dividend, as
the directors think proper to make to them. This total exemption from trouble and from risk,
beyond a limited sum, encourages many people to become adventurers in joint stock compa-
nies, who would, upon no account, hazard their fortunes in any private copartnery.
It is not only the proprietors incentives that are weak or distorted. Just eight lines later,
Smith changes the perspective and takes a look at the joint stock companys directors (p. 124):
The directors of such companies, however, being the managers rather of other peoples money
than of their own, it cannot well be expected, that they should watch over it with the same anx-
ious 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 masters honour, and very easily give themselves a dispensation from having it. Negli-
gence and profusion, therefore, must always prevail, more or less, in the management of the
affairs of such a company.
Of all his comments on joint stock companies, this declaration is without doubt Smiths most
famous, particularly his characterization of the directors as the managers of other peoples
money. Many famous authors adopted and extended this notion (e.g., Jhering 1877, vol. I,
p. 229 or Marx 1894, vol. III/1, p. 428), and some even went so far as to publish books under the
title (most famously Brandeis 1914).25 Today, entire libraries could be filled with monographs,
25 Whether these authors read Smith, heard about the phrase from someone else, or independently
21 Draft (2016-01-03)
handbooks, and papers discussing agency and corporate governance problems similar to those
observed by Smith. Note, however, that Smith neither used the modern terms, agency or
corporate governance, nor developed a general theorya fact that is often overlooked.26
After his famous remarks on the directors of the joint stock company, Smith does not wait
for the next line to start his conclusion (p. 124, continuing from the previous quote):
It is upon this account that joint stock companies for foreign trade have seldom been able to
maintain the competition against private adventurers. They have, accordingly, very seldom
succeeded without an exclusive privilege; and frequently have not succeeded with one. With-
out an exclusive privilege they have commonly mismanaged the trade. With an exclusive privi-
lege they have both mismanaged and confined it.27
Smiths line of reasoning could not be clearer. He outlines the joint stock companys typical
structure, identifies some organizational deficits, and explains that it is upon this account and
accordingly difficult for joint stock companies to successfully compete with others.28 This
along with the anecdotal evidence mentioned aboveis the basis of Smiths pessimism about
the joint stock company.29
came up with it, would require additional studies. A cursory search through earlier works shows that the
expression other peoples money had been popular long before Smith (at least in other contexts).
26 Even the Smith literature seems to ignore this from time to time. An example is Henderson 1986,
p. 114, who believes that the joint stock companys organizational challenges let Smith develop his anal-
ysis of the agency problem in the joint-stock form of business organization (similar expressions can be
found on pp. 114, 115, 129). Other examples, from Anderson and Tollison 1982, are noted supra (note 6).
27 A similar conclusion appears on pp. 1445.
28 Anderson and Tollison present a different line of reasoning (1982, pp. 1238, 1240, 1242, 1245, and
elsewhere), but it is difficult to understand why. Smith makes no secret of how he comes to his conclu-
sions, and there is no reason to assume that he does not mean what he says. It seems that Henderson 1986
disagrees with Anderson and Tollisons approach too (there is no explicit rejection, though).
29 Note that Smith sees some advantages (better incentives, more capital) of joint stock companies over
regulated companies (pp. 1167).
Draft (2016-01-03) 22
(c) Conclusion. requisite for rendering reasonable the establishment of a joint stock company
As a result of his practical observations and theoretical concerns, Smith considers only four
areas suitable for joint stock companies (p. 146):
The only trades which it seems possible for a joint stock company to carry on successfully,
without an exclusive privilege, are those, of which all the operations are capable of being re-
duced to what is called a Routine, or to such a uniformity of method as admits of little or no
variation. Of this kind is, first, the banking trade; secondly, the trade of insurance from fire,
and from sea risk and capture in time of war; thirdly, the trade of making and maintaining a
navigable cut or canal; and, fourthly, the similar trade of bringing water for the supply of a
great city.
Most noteworthy is the trade not mentioned by Smith, neither here nor later: overseas
trading, historically the main business of joint stock companies and also of Smiths example
companies (see below). The reason for omitting overseas trading is of course that this business
requires, at least in Smiths eyes, the opposite of following a Routine or a uniformity of
method as admits of little or no variation (ibid.), as he had explained shortly before with explic-
it reference to the many variations in foreign trade (pp. 1445).
Limiting the scope of joint stock companies to those that promise to be profitable, that is, to
those following a routine, is just the first of Smiths two-step policy recommendation. The se-
cond step is more normative (pp. 1478):
To render such an establishment perfectly reasonable, with the circumstance of being reduci-
ble to strict rule and method, two other circumstances ought to concur. First, it ought to appear
with the clearest evidence, that the undertaking is of greater and more general utility than the
greater part of common trades; and secondly, that it requires a greater capital than can easily be
collected into a private copartnery.
Summarizing all his requirements, Smith concludes: Except the four trades above men-
tioned, I have not been able to recollect any other in which all the three circumstances, requisite
23 Draft (2016-01-03)
for rendering reasonable the establishment of a joint stock company, concur. (p. 149). To re-
peat, the four trades are banking, certain forms of insurance, the management of waterways,
and water supply; the three circumstances are apparently that the joint stock companys busi-
ness follows a routine, has a high social utility, and demands great sums of capital.
III. Investigation. What made Smith so pessimistic?
Smith is very pessimistic about joint stock companies, and he is not shy about expressing his
opinion. But he does not explain how and why he developed this position. What prompted him
to add a section about the joint stock company? Which information did he draw on? Were there
any general beliefs that made him skeptical of joint stock companies?
Even the most thorough perusal of Smiths additions, or their context, will prove insufficient
to answer these questions. We must look for other sources to better understand his pessimism.
1. Genesis. a compleat History of all the trading companies in G. Britain
When did Smith compose his comments on the joint stock company? John Rae, Smiths
most influential biographer, believes that before the close of 1782 Smith had written some
considerable additions to the Wealth of Nations, which he proposed to insert in the third edition
(Rae 1895, p. 361). Among these additions was, according to Rae, a history of the trading com-
panies of Great Britain, including, no doubt, his history of the East India Company, which
Mr. Thorold Rogers supposed him to have written ten years before and kept in his desk
Draft (2016-01-03) 24
(pp. 3612).30 These remarks of Rae are easily misunderstood, and indeed more recent observers
did misinterpret them.31
There are three unknowns in the genesis of Smiths comments. First, when did Smith start
mulling over joint stock companies? Second, when did he compose his additions to the Wealth of
Nations? And third, when did he finish revising and polishing the additions? These questions
are best approached in reverse order, given the available evidence.
On December 7, 1782, Smith sent a letter to Thomas Cadell, his publisher and bookseller.32
Smith apologizes for the fact that he still has not finished the new edition of the Wealth of Na-
tions, which he calls his proper business, and then goes on to say (emphasis added): I am
now, however, heartily engaged at my proper work and I hope in two or three months to send
you up the second Edition corrected in many places, with three or four very considerable addi-
tions; chiefly to the second volume; among the rest is a short, but I flatter myself, a compleat History
of all the trading companies in G. Britain. That Smith still needed several months to complete the
new edition implies that he was still in the middle of his revisions. This included the additions,
it seems, because only a few lines later, Smith says that [t]he price must depend upon the bulk
30 Rae does not provide a source for Rogerss supposition, and a glance through Rogerss publications
yielded no results. Many thanks are due to Corinna R. Coupette who, on the authors suggestion, perused
Rogerss various works, only to confirm the negative finding. Any hints that may help unravel the mys-
tery would be greatly appreciated.
31 Anderson and Tollison write, based on Rae, that according to Smith, in a letter to his publisher, ...,
this material existed in the form of a draft as early as 1774 (1982, p. 1240). This is factually wrong. Smith
himself does not mention a draft of the new section, and Rae does not say anything of relevance except
what is quoted above in the text.
32 Smith 1987 [1782], letter no. 222, pp. 2634. A (slightly modified) transcript of this letter is also re-
produced in Rae 1895, p. 362.
25 Draft (2016-01-03)
of the Additions when they are all written out, indicating that he was still working on them.
This interpretation is further supported by a letter dated May 22, 1783, this time sent to Wil-
liam Strahan, Smiths publisher and printer.33 Smith says that he had been working on the new
edition for the past several months, but was still waiting for some information in order to
compleat all the Additions which I propose to make to my third edition. Among the additions
was, in Smiths words, A short History and, I presume, a full exposition of the Absurdity and
hurtfulness of almost all our chartered trading companies. Smith expects to finish his work in
about a month after he receives the information that he is still missing (unrelated to the trading
companies). Two follow-up letters to Strahan, one dated October 6, 1783,34 the other November
20, 1783,35 show that Smith made progress but was still waiting for data.36 All this suggests that
Smiths additions, probably including his remarks on the joint stock company, are not the result
of a spontaneous whim but rather of recurring considerations and revisions that extended much
longer than previously assumed, apparently well into 1783 and possibly even 1784.37
33 Smith 1987 [1783], letter no. 227, p. 266. This letter was apparently unknown to Rae 1895. A tran-
script of the letter appeared at the latest in Scott 1937, pp. 2867, but seems to have escaped the attention
of many scholars, including Anderson and Tollison 1982.
34 The alterations and additions which I propose to make to my new Edition of the Wealth of Nations
are now either finished compleatly [or soon will be] ... I still ... wait for the Accounts which our good
friend Sir Grey Cooper was so kind as to promise me soon after the late political revolution. (Smith 1987
[1783], letter no. 231, p. 269; brackets and omissions by the editors).
35 I have been looking every post day for the arrival of the Accounts which our friend Sir Grey Cooper
has been so good as to promise me; and which ... he was so good as to say he would deliver to you.
(Smith 1987 [1783], letter no. 232, p. 270).
36 Neither Rae 1895 nor Anderson and Tollison 1982 knew of the two follow-up letters.
37 Two remarks in the third edition of the Wealth of Nations point in the same direction. In its foreword
(Advertisement), Smith mentions several additions, among them a new article to the chapter upon the
expences of the sovereign, and explains: In all these additions, the present state of things means always
Draft (2016-01-03) 26
Other than from these letters, nothing is known about the genesis of Smiths remarks, nei-
ther when he started thinking in more detail about joint stock companies, nor when he began to
compose the additions. Twenty years earlier, in his Lectures on Jurisprudence (176264), Smith
had briefly touched upon the trading companies and their effects on commodity prices (Smith
1978 [176264], pp. 363, 497]). But according to the lecture notes, there was no mention of joint
stock companies or the challenges that come with the organization of large firms. At this time,
Smith was either not familiar with the joint stock company or he did not believe that its charac-
teristics were relevant to his discussion. It seems that either of the two conditions persisted all
the way through the preparation of the first edition of the Wealth of Nations (1776).
Nothing is known about the reasons that caused Smith to add the footnote on the English
East India Companys inner dynamics (mentioned supra sub I) to the second edition (Smith 1778,
vol. II, p. 257). This is unfortunate, though not a great calamity given the limited scope of the
footnote.38 It is equally uncertain what moved Smith to give greater consideration to joint stock
companies and prepare a thirty-page addition to the third edition. Rae speculates that current
events, rekindled political debates, may have prompted Smith to compose a careful examina-
tion of the chartered and regulated corporations, and especially of the East India Company
(Rae 1895, p. 363). But this is just a shot in the dark, given the scarce evidence related to the
the state in which they were during the year 1783 and the beginning of the present year 1784. (Smith
1784, vol. I, Advertisement; emphasis by Smith). And in the new section on joint stock companies, Smith
speaks on one occasion of now (1784) (vol. III, p. 143; ditto Smith 1784a, p. 74).
38 In general, the changes to the second edition were insignificant. In Smiths own words (Smith 1987
[1780], letter no. 208, p. 250): I have made a good number of corrections, none of which, however, affect
even in the slightest degree, the general principles, or Plan of the System.
27 Draft (2016-01-03)
third editions general initiation (Ross 2010, pp. 368, 371, 3801). Even worse, there is no trace
whatsoever of when Smith started composing his remarks on the joint stock company.39
2. Sources. a much more sober and judicious writer, Mr. Anderson
In the absence of other evidence, it may seem that the best starting place to dissect Smiths
comments on the joint stock company is the set of sources he consulted to prepare the com-
ments. This is easier said than done, though, because Smith, as elsewhere in his treatise and in
accordance with the conventions of his age, only rarely refers to other works and authorities.
That Smith read much more than he cited is a safe assumption, and also supported by the fact
that he speaks of many events, especially overseas, that he did not know from personal experi-
ence. Uncovering Smiths sources, therefore, requires combining two strategies: first, to com-
prehensively analyze the few sources that he does explicitly mention, and second, to look behind
the scenes and compare his remarks with other sources that he may have used.
Smith refers to a surprisingly large number of acts, international treaties, parliamentary in-
quiries, and the like.40 However, while public debates may have sparked his interest in the sub-
ject, and official documents may have further fueled it, most of what he writes cannot be traced
back to these primary sources. Nor does the way he presents them suggest that he read them in
The best evidence in support of Raes hypothesis, but not mentioned by him, is a remark by Smith
39
immediately following his account of the East India Company (p. 143, emphasis added): How unjustly,
how capriciously, how cruelly they [sc. joint stock companies] have commonly exercised it [sc. the right of
possessing forts and garrisons, as well the right of making peace and war], is too well known from recent
experience.
40 Pp. 112, 114, 115, 116, 118, 119, 120, 121, 124, 125, 126, 129, 130, 132, 133, 134, 135, 136, 137, 138, 139,
141, 142, 143, 145.
Draft (2016-01-03) 28
detail, if at all. How about information coming straight from the horses mouth, that is, from the
individual companies? On one occasion, Smith cites the bye-laws of regulated companies
without further elaboration (pp. 1135), on another, financial data published in the Cruttenden
East Indiaman (p. 137). There are no traces of other primary sources. This puts a big question
mark on the central claim of Anderson and Tollison (1982) that Smiths discussion is based on
empirical evidence and data.
Instead, Smiths main source was in all likelihood the Scottish economist Adam Anderson
(16921765) and his celebrated treatise on the Origin of Commerce (1764). Anderson is very fa-
vorably introduced by Smith as a much more sober and judicious writer, Mr. Anderson, author
of The Historical and Chronological Deduction of Commerce (p. 128). That no specific page
reference is given by Smith, and that the works main title, Origin of Commerce, is omitted, may
be inconvenient but is nothing modern readers should find fault withthis is perfectly in line
with the practices of Smiths age. What is odd, though, is the fact that Andersons first appear-
ance is also his last; Smith never refers to Anderson or his work again. From the references in
the Wealth of Nations, no one would ever conclude that Smith used Anderson a lot. Yet, for those
familiar with Andersons work, it is quite obvious how much Smiths additions owe to Ander-
son, especially the latters diligent collection of dates and figures.41 And we also know that
41 Ditto Scott 1912, vol. I, p. 448 and Heckscher 1994 [1931], vol. I, p. 452. For a collection of evidence,
see the Glasgow editions apparatus (Smith 1976, vol. II, pp. 73158), where numerous notes relate Smiths
discussion to Andersons work: nn. 2, 3, 8, 9, 22 (general comment), 25, 26, 29, 35, 39, 42, 43, 48, 51, 58, 66,
79.
29 Draft (2016-01-03)
Smith ordered a private copy of the work as early as 1767,42 went through it in 1780,43 and kept it
until his death.44
Smith mentions only three other authors: Josiah Child ( 163099), an economist and leading
figure of the English East India Company (pp. 112, 116, 117); Arthur Dobbs (16891765), a leg-
endary governor of North Carolina (p. 128); and Andr Morellet (17271819), a French econo-
mist and writer (p. 145).45 No specific references are given by Smith, but it is almost certain that
the books he had in mind were the fifth edition of Childs New Discourse of Trade (1751), 46
Dobbss Account of the Countries adjoining to Hudsons Bay (1744),47 and Morellets Examen de la
rponse ... (1769b), a rejoinder to a critique of his essay on the Compagnie des Indes (1769a).48 While
Dobbs plays only a minor role in Smiths line of reasoning, both Child and Morellet apparently
had a critical influence.
42 From a letter to Cadell (dated March 25, 1766, but in fact of March 1767): send me as soon as possi-
ble the Account of the whole expence including that of the two last books you was so good as to procure
for me; viz, Anderson and Postlethwait (Smith 1987 [1767], letter no. 102, p. 124); see also Smiths letter
infra (note 43).
43 As suggested by a remark in another letter to Cadell (of October 25, [1780]): So long ago as the year
1767, sometime in the month of march, a few days before I left London, I bought of you a copy of Ander-
sons History of Commerce. ... In this copy I lately discovered an Imperfection ... . If you could get this
imperfection supplied, you would oblige me greatly. (Smith 1987 [1780], letter no. 206, p. 248).
44 Smiths copy of Andersons second volume (in which Anderson primarily discusses the trading
companies) could be located: Mizuta 2000, p. 8 (no. 38).

45 In the older parts (on the public works and institutions in general), Smith also refers to Franois Ber-
nier ( 162088), a physician and world traveler (p. 104; already in 1776, vol. II, p. 338 and 1778, vol. II,
p. 340). Smith owned a private copy of at least one of Berniers books: Mizuta 2000, p. 26 (no. 158).
46 Of which Smith owned a copy: Mizuta 2000, p. 53 (no. 357).
47 The Glasgow editions apparatus (Smith 1976, vol. II, p. 744 nn. 378) suggests, probably correctly,
that Smith refers to Dobbss 1744 work. There is no entry for Dobbs in Mizuta 2000 (which makes it un-
likely, though not impossible that Smith owned a private copy).
48 It seems that Smith possessed a copy of the rejoinder (Morellet 1769b): Mizuta 2000, p. 176 no. 1187
(note that the quote in no. 1189 should be moved to no. 1187).
Draft (2016-01-03) 30
Childs most important contribution to the field is the very first sentence of his chapter
Concerning the Companies of Merchants (pp. 7784), where he observes: Companies of mer-
chants are of two sorts, viz. companies in joint stock, such as the East-India-Company, ...; the
other sorts are companies who trade not by a joint stock, but only are under a government and
regulation, such are the Hamborough-Company, ... (p. 77). As seen above, the joint stock
distinction also lies at the heart of Smiths additions. Did Smith adopt it from Child? There is
no hard evidence to confirm or exclude the possibility that he did. At the time of writing, the
idea was already widely known (another famous example is Bsch 1784, p. 105).49 So Smith
could have learned of it from someone else, or he himself may have re-invented it. However,
given that Smith owned a copy of Childs work, it is not far-fetched to assume (as Schmoller
1893, pp. 9656 n. 6 does) that this part of Smiths analysis was indeed directly inspired by
Child.
Even more influential for Smith was Morellet: first because they knew each other (the best
evidence of which is Smith 1987 [1786], letter no. 259), second because Morellets work is one of
the pillars upon which Smiths practical assumptions rest. Smith writes (p. 145):
An eminent French author, of great knowledge in matters of political oeconomy, the Abb
Morellet, gives a list of fifty-five joint stock companies for foreign trade, which have been estab-
lished in different parts of Europe since the year 1600, and which, according to him, have all
failed from mismanagement, notwithstanding they had exclusive privileges. He has been mis-
informed with regard to the history of two or three of them, which were not joint stock compa-
nies and have not failed. But, in compensation, there have been several joint stock companies
which have failed, and which he has omitted.
49 For Bsch, the key feature is combined commercial operations through joint activity or with all the
assets of the members (vereinten Betrieb der Geschfte durch verbundene Thtigkeit oder mit dem
gesamten Vermgen der Mitglieder). Nothing else is implied by trading upon a joint stock.
31 Draft (2016-01-03)
Morellets Examen de la rponse ... (1769b) indeed features a list of fifty-five failed companies
(pp. 358). Yet Smiths presentation of it is quite imprecise. Morellet calls it a list Des
principales Compagnies de commerce maritime Privilge exclusif, formes & tombes en Eu-
rope depuis le commencement du 17e sicle (p. 35). This is not a list of fifty-five joint stock
companies for foreign trade (Smiths words; emphasis added). Even more troublesome, Morellets
list includes thirty-three French but only nine English and three Dutch companies. So this is a
list much less representative than Smith indicates, even considering his own caveats.
There are no other authors whose influence on Smiths analysis could be traced with a high
degree of certainty. Heckscher (1994 [1931], vol. I, p. 452) mentions Abb Raynals Histoire
philosophique des tablissemens dans les deux Indes as Smiths main source along with Andersons
Origin of Commerce, but it seems that Heckscher confused Abb Raynal with Abb Morellet.50
Anderson and Tollison (1982, pp. 12489 n. 7) also draw attention to Josiah Tucker (171399), a
prolific writer on economic and political topics, of whom Smiths library included at least eleven
works (Mizuta 2000, pp. xviii, 2568). But there is no evidence that Smith, when he composed
his remarks on the joint stock company, read any of those volumes.
Is Smiths analysis partly based on his own observations and experiences? Long ago, Viner
(1927, p. 216) generally noted that [i]n the Wealth of Nations Smith made use of a rich harvest of
facts gathered by personal observation at home and abroad, by conversation and correspond-
ence with many keen and intelligent observers of the current scene, by wide reading in a miscel-
50 Mizuta 2000, p. 212 (no. 14112) lists two works of Abb Raynal, including the one Heckscher seems
to have in mind. But there is no evidence that Smith used this work in the present context.
Draft (2016-01-03) 32
lany of sources, from law books to travelers tales. In a similar vein, but specifically in the pre-
sent context, Heckscher (1994 [1931], vol. I, p. 415) argued that [t]he extremely narrow limits set
by him [sc. Smith] to the applicability of the joint stock company type would have been impos-
sible if, at the time, these companies had occupied an important position in the actual business
life, which he always valued very highly. And Heckscher on another occasion (p. 454): Adam
Smiths conclusion was that the possibilities of non-monopolistic trading companies were strict-
ly limited. ... This was connected not only with his general atomistic outlook but also with the
hard economic facts with which he was familiar and which seemed to him to apply much more
universally than actually they did.
Smith does not explicitly allude to any individual observations and experiences, besides the
three general experience phrases mentioned above (pp. 131, 143, 144), and there is no evidence
from elsewhere that personal contact with joint stock companies, such as employment as an ad-
viser or investments in stocks, may have influenced what he wrote.51 However, it is very likely
that he at least indirectly came across a number of joint stock companies during his life, both
through the various positions he held, such as Commissioner of Customs, and as an observant
fellow citizen, and it is therefore worth having a closer look at the individual companies he men-
51 Smith apparently got recommended to the English East India Company in 1772 to function as an ad-
viser. From a letter of Smith to William Pulteney, a member of Parliament (of September 3, 1772): I think
myself very much honoured and obliged to you for having mentioned me to the east India Directors as a
person who could be of any use to them. You have acted in your old way of doing your friends a good
office behind their backs, pretty much as other people do them a bad one. (Smith 1987 [1772], letter
no. 132, p. 164). But there is no evidence that this recommendation led to any sort of employment. Smith
either never received an offer by the company, or he turned it down.
33 Draft (2016-01-03)
tions.52
Smiths main focus is on the African Company (pp. 1246), the Hudsons Bay Company
(pp. 1268), the South Sea Company (pp. 1235, 12831), andmost notablythe English
East India Company (pp. 13143).53 In addition, he mentions the Bank of England (pp. 124,
146), the United Company of Merchants trading to the East Indies (p. 125), the London As-
surance (p. 147), the Royal Exchange Assurance (p. 147), the copper company of London
(p. 149), as well as the lead smelting company, the glass grinding company, and the mine-
adventurers company (all p. 149). 54 Smith also talks about foreign companies: the famous
Dutch East India Company (p. 132) as well as Portugueze and French companies engaged
in slave trading (p. 129).55 While Smith may have stumbled upon some of these companies dur-
ing his travels, especially to London (where he also lived for some time), he cites only three truly
local companies: [t]he two banks of Edinburgh (p. 146), apparently the Bank of Scotland and
the Royal Bank of Scotland, as well as the British Linen Company of Edinburgh (p. 149).
In total, the list adds up to sixteen companies or types of companies. Most of what Smith
says, however, is based on information about two companies with scandals not seen elsewhere:
52 Evidence of Smiths indirect contact with the English East India Company can be found, e.g., in let-
ters to David Hume (June 7, 1767; Smith 1987 [1767], letter no. 103, p. 125), to Cadell (1780; ibid., letter
no. 212, p. 255), and to William Eden (December 15, 1783; ibid., letter no. 233, p. 272).
53 The English East India Company is also mentioned in other parts of the work (most notably in vol. II,
pp. 47685), as is the South Sea Company (vol. I, p. 481; vol. III, p. 407).
54 No other financial institution is discussed more often by Smith, and at greater length, than the Bank
of England (especially in vol. I, pp. 45183).

55 The Dutch East India Company is also mentioned elsewhere (e.g., in vol. II, pp. 47685), along with a
few less prominent companies (such as the Danish East India Company, the Dutch West India Company,
and the French East India Company).
Draft (2016-01-03) 34
the South Sea Company and the English East India Company. This is obvious from the term
trading companies, used by Smith in his letters as shorthand for all companies under consid-
eration, whether engaged in trading or not,56 and also from an analysis of the recurring ele-
ments of Smiths critique (summarized hereinafter in modern terms): the shareholders indiffer-
ence (pp. 128, 1402); the misguided incentives of managers and employees (pp. 128, 130, 131,
1389, 1402, 144, 145, 14950); the joint stock companys disadvantages compared to other mar-
ket participants (pp. 124, 125, 131, 133, 1445), even compared to the government (p. 143); their
lack of commercial success (pp. 125, 126, 128, 129, 130, 131, 133, 138, 1423, 144, 145); and the
negative consequences of monopolies and other exclusive rights for trading (pp. 124, 125, 126,
129, 132, 135, 144, 145).
Smith was of course right to focus on the South Sea Company and the English East India
Company, considering the interests of his audience. But it is doubtful that these two companies
represent a good sample of all the joint stock companies. Had Smith paid the same attention to
the Bank of England or the Dutch East India Company, two companies quite prominent in other
parts of the treatise, the picture he drew would most likely have been more positive. A similar
swing might have occurred if Smith had accounted for joint business ventures that issued shares
but remained unincorporated (supra note 21).
The list of recurring critiques also suggests that Smiths personal observations and experi-
ences were of little importance. That the famous Credit Crisis of 1772, especially the failure of
56 Smith 1987 [1782], letter no. 222, p. 263 (supra note 32 and accompanying text); Smith 1987 [1783], let-
ter no. 227, p. 266 (supra note 33 and accompanying text).
35 Draft (2016-01-03)
Scotlands so-called Ayr Bank (Hamilton 1956), influenced Smiths position on banking is well
explained in a recent dissertation (Goodspeed 2015). But the same could not be said for Smiths
position on joint stock companies. The Ayr Bank wasin Smiths termsnot a joint stock com-
pany, but a private copartnery, known as Douglas, Heron, and Company.57 Smith discusses
the firm in his section on banking (1784, vol. I, pp. 4718), but he makes no mention of it in the
new passages. If the banks fate affected Smiths position on joint stock companies at all, then
perhaps it was as an example that banking was an objective more suitable for joint stock compa-
nies than for copartneries.58
After this survey of Smiths sources, there is still no definitive answer to the question of
what made Smith so pessimistic about joint stock companies. However, the set of influences
that can be identified suggests that Smiths selection of sources played an important role in
shaping his position: Smith based his discussion more on secondary than on primary sources, he
relied on a few authors, and he focused on the two companies that produced the most outrage.
It is not far-fetched to assume that his conclusions would have been more positive had he turned
to other sources and companies as well.
3. Beliefs. the freer and more general the competition ...
That an icon of capitalism dooms one of its most successful institutions is surprising, to say
The original contract, the by-laws, and further sources are reprinted in The Precipitation and Fall ...
57
1778 (of which Smith owned a copy: Mizuta 2000, pp. 789, no. 519).
58 In a completely different context, Smith gives a very favorable account of the Bank of Amsterdams
operations (Smith 1784, vol. II, pp. 21935).
Draft (2016-01-03) 36
the least. It is even more surprising that this naysayer is Adam Smith, the personification of un-
wavering optimism in economic matters. If the pessimists among the political economists
Thomas Robert Malthus, David Ricardo, or Karl Marxhad written off the joint stock company,
no one would raise an eyebrow. But Smith?
The sources Smith relied on help us understand what made him so pessimistic about the
joint stock company. But they give rise to several follow-up questions. Why did Smith choose
this selection of authorities? Why that sample of companies? Was it bad luck? Inattentiveness?
Intention? An example of confirmation bias? Evidence of Viners assertion that Smith at times
showed more catholicity than scientific discrimination in what he accepted as supporting evi-
dence (Viner 1927, p. 199)? Are there any general beliefs that may have caused Smith to be-
come prejudiced against joint stock companies? Can they explain why Smith was so pessimistic
about them?
Any attempt to answer these questions will be just that: an attempt. For Smith nowhere
states what his key economic beliefs are, nor does he say why or why not joint stock companies
may be in conflict with them. What follows, then, is conjecture and, given the lack of concrete
evidence, more speculative than the comments on the genesis and the sources of Smiths re-
marks.59
A central insight of the Wealth of Nations is that society benefits from competition and suffers
59 It is, therefore, no surprise that different authors will come up with different lists of possible con-
flicts. A famous example is the account of Berle and Means 1932, who see the modern corporation in
conflict with Smiths concepts of private property, of wealth, of private enterprise, of individual initiative,
of the profit motive, and of competition (pp. 34551).
37 Draft (2016-01-03)
from forces that constrain it. Competition is the cure-all remedy prescribed by Doctor Smith, the
panacea, the main foundation of his optimism. The more competition, the better (1784, vol. I,
p. 499): In general, if any branch of trade, or any division of labour, be advantageous to the
publick, the freer and more general the competition, it will always be the more so. Oligopolies,
monopolies, and similar exclusive rights, in contrast, must then be disadvantageous to the
publick, to mimic Smiths wording, because they limit or even preclude competition. Indeed,
Smiths aversion to everything that constrains competition is present as clear as day throughout
his remarks on the joint stock company. Exclusive rights are among the core characteristics that
Smith associates with the trading companies and that he, as seen above, relentlessly criticizes in
his account of the joint stock company. Interestingly, this is also the very context in which Smith
had mentioned the trading companies twenty years earlier in his Lectures on Jurisprudence (1762
64), confirming that the adverse impact on competition is Smiths main worry about them
(Smith 1978 [176264], pp. 363, 497).60
Given Smiths enthusiasm for free competition, it is a natural assumption that he was skep-
tical of an institution that, he believed, typically could not compete with other market partici-
pants except for the exclusive rights it enjoyed. But even without formal privileges or outside
the latters primary scope, joint stock companies may have appeared to Smith as a de facto threat
to competition, especially those whose position was strong enough to influence the price level in
adjacent markets. Most telling of Smiths concern about market abuse is a famous remark of his
60 Smith 1978 [176264] also discusses the French Mississippi Company (pp. 5159, 521) and the English
South Sea Company (pp. 519, 538), but they are portrayed as atypical schemes rather than normal trad-
ing companies.
Draft (2016-01-03) 38
in a slightly different context (1784, vol. I, p. 200): People of the same trade seldom meet to-
gether, even for merriment and diversion, but the conversation ends in a conspiracy against the
publick, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings,
by any law which either could be executed, or would be consistent with liberty and justice. But
though the law cannot hinder people of the same trade from sometimes assembling together, it
ought to do nothing to facilitate such assemblies; much less to render them necessary. Smith
talks about guilds and similar corporations here, fearing that the mere fact that people of the
same trade get to know each other may facilitate price fixing. However, it seems perfectly legit-
imate to extend this notion to the trading companies, given that Smith himself did so in his Lec-
tures on Jurisprudence.61 His comparison of guilds and regulated companies in the Wealth of Na-
tions follows the same rationale.62 From this perspective, joint stock companies look even worse
than regulated companies, because the latters members continue to compete with one another,
at least to some degree, whereas members of joint stock companies cease to be competitors and
instead start maximizing common profits.
It appears, then, that joint stock companies were at odds with Smiths plea for competition
in at least two ways. First, joint stock companies reduced competition by keeping potential
61 Smith 1978 [176264], p. 363 (All such companys prevent a free concurrence, which brings down the
price of every thing to its naturall height. A few persons can never make this concurrence, and these few
can easily lay their heads together and join in bringing in a small quantity and selling it very high, which
would be prevented by a free concurrence.). Similarly Smith 1784, vol. III, p. 115 (In all trades, the regu-
lar established traders, even though not incorporated, naturally combine to raise profits, which are no-
way so likely to be kept, at all times, down to their proper level, as by the occasional competition of specu-
lative adventurers.).
62 Smith 1784, vol. III, p. 110: [regulated companies] are a sort of enlarged monopolies of the same
kind (reproduced supra sub II. 2.).
39 Draft (2016-01-03)
competitors off the market, either de jure (exclusive rights) or de facto (market abuse), or through
a combination of both. Second, joint stock companies distorted the competitive process and its
selection of the most efficient market participants because they managed to stay afloat, despite
organizational flaws, thanks to their de jure and de facto powers.
Related to competition, but more general is a second point: Smiths confidence in the virtues
of self-interested behavior or, as it is often referred to, his atomistic view of society (recall
Heckscher above). Smith believed that individuals were very good at identifying their personal
interests, and that on balance everyone was better off when individuals followed them (first wel-
fare theorem of economics). If this is true, then decisions made by individuals focusing on private
interests are more likely to be accurate than decisions made by groups focusing on common in-
terests. The reason is that managing other peoples money and, more generally, teaming up
with others to pursue collective goals creates conflicts of interest: Effort costs will typically be
borne by the individual, while profits will be divided among all participants. There may be fac-
tors, such as economies of scale and gains from collaboration, or strategies, such as incentive
schemes and monitoring mechanisms, that reduce the tensions. But it is easy to see why Smiths
confidence in self-interested behavior may have caused him to overestimate the risks of collabo-
ration and underestimate the ability of people to join forces and advance common goals.
Smiths third (and last) general belief that warrants mention here is his aversion to all forms
of speculation. This requires some explanation because at first view, Smiths analysis of the joint
stock company seems to be totally unaffected by the fact that traders may speculate in its bonds
or stocks. All Smith has to say about securities trading, in his comments on the joint stock com-
Draft (2016-01-03) 40
pany, is the following (related to the South Sea Company): The knavery and extravagance of
their stock-jobbing projects are sufficiently known, and the explication of them would be foreign
to the present subject. (p. 128) Unlike many observers before and after him, Smith apparently
did not consider the fact that the joint stock companys securities were freely transferable and, as
a consequence, publicly traded to be a major source of disruption and disorder. This is also ob-
vious from his list of characteristics reproduced above, where he mentions the transferability of
shares and their market valuation without any reservations (p. 123). So, was Smith really indif-
ferent toward stock trading?
Other statements by Smith point in a different direction. Most telling is a quote from the
beginning of the Wealth of Nations (1784, vol. I, p. 164): The chance of gain is by every man more
or less over-valued, and the chance of loss is by most men under-valued, and by scarce any man,
who is in tolerable health and spirits, valued more than it is worth. Smith cites the universal
success of lotteries as evidence in the next sentence. But later in the work, he repeats the same
notion in the context of projects typically undertaken by joint stock companies (vol. II, pp. 354
5). And with the mention of projects, we are in the middle of a Smithian minefield. For Smith
has almost nothing positive to say about speculative projects and their initiators, the projec-
tors. The worst of all is of course his compatriot John Law, one of the greatest projectors of all
time, along with his main scheme, the Mississippi company, both collapsing in the bubble
year of 1720.63 But also elsewhere, no reader will fail to notice the unfavorable picture that
63 Smith 1978 [176264], pp. 5159, 521; Smith 1784, vol. I, pp. 4789; vol. II, pp. 3689, 378. Smiths pri-
vate library included two works of John Law: Mizuta 2000, pp. 1445 (nn. 9612); the authorship of the
41 Draft (2016-01-03)
Smith draws of the projectors.64 An expression like prodigals and projectors is no accident; it
is the phrase that best catches Smiths sentiments.65 The projecting age, and the shock waves
from its collapse, show their long lasting impact here, even two generations later.
It would pose no problem to add a long list of other statements that reflect Smiths dislike of
speculative behavior.66 Smith even went so far as to defend maximum interest rates set by the
government to curb speculation, a position famously dismissed by Jeremy Bentham.67 Against
this background, it comes as no surprise that Smith was also suspicious of stock trading and
related activities.68 That the financial markets would turn out to be one of the major constraints
on management is nothing one would expect from a perusal of Smiths works. The very same
individuals whom Smith trusted to make rational self-interested decisions would not lose their
prudence when they enter the stock market, or would they?
Except for the very last observation, the recurring theme running through this subsection
has been that the more freely individuals can compete and the more freely they can follow their
interests, the better off everyone is at the end of the day. Joint stock companies obstructed both
mechanisms. In a joint stock company, former competitors became partners of a joint enterprise,
and individual interests gave way to common goals. On top of that, joint stock companies at-
second work is dubious.

64 Smith 1784, vol. I, pp. 1767, 454, 461, 46671, 4748; vol. II, pp. 445, 71; vol. III, p. 99. Quite favora-
bly, in contrast, Smith 1784, vol. III, p. 115 (reproduced in note 61).
65 Smith 1784, vol. II, p. 44 (on two occasions).
66 Smith 1784, vol. I, pp. 1745, 179; vol. II, pp. 19, 3545.
67 Smith 1784, vol. I, pp. 1356; vol. II, pp. 445. Benthams Defence of Usury (1787/90) is reprinted, inter
alia, in Smith 1987, pp. 388404.

68 Smith 1978 [176264], pp. 518, 5358; Smith 1784, vol. I, pp. 4789; vol. II, p. 231; vol. III, p. 128 (re-
produced in the text above).
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tracted speculators and enticed investors to make imprudent decisions. What Smith had learned
about joint stock companies in practice and derived from their inner structure in theory was
perfectly in line with his general beliefs.69
IV. Speculation. Why did Smiths pessimism turn out to be wrong?
All over the world, the joint stock company has become the form of choice for large firms.
Most prominent are the French socit anonyme, the German Aktiengesellschaft, the UK public lim-
ited company, and the US corporation. Whether in terms of profit, revenue, workforce, or other
criteria, many rank among the most successful players in the market. This success story stands
in stark contrast to Smiths gloomy picture of the joint stock company. It is of course true that
we frequently witness the sort of mismanagement and self-dealing that Smith thought would
make joint stock companies fall behind competitors. But these cases are clearly outliers, contrary
to Smiths assumptions. What factors did he miss?
Finding out why Smiths pessimism turned out to be wrong is much more difficult than it
may appear at first glance. For it is essentially no less than asking how the large business firm
69 As readers will notice, this section has refrained from explaining Smiths view of the joint stock com-
pany by turning to his other major work, The Theory of Moral Sentiments (Smith 1759; last version to which
Smith contributed: Smith 1790). While it may be possible to draw some analogies to positions developed
in The Theory of Moral Sentiments, any such explanations would stand on shaky grounds because Smith
does not comment on the joint stock company and its setting in The Theory of Moral Sentiments. Moreover,
it is not at all clear whether Smith thought that his positions in the two works were in perfect harmony, an
ambiguity that gave rise to the centuries-old controversy over possible frictions (known as Das Adam
Smith-Problem, a German term). For both reasons, The Theory of Moral Sentiments has been excluded
from the discussion above.
43 Draft (2016-01-03)
evolved, and what advantages it enjoys over smaller competitors. These are intricate questions
directly leading to the firms history and theory, two areas in which scholarship is still a long
way off from a consensus.70 Three closely related explanations will be presented here: techno-
logical progress, organizational innovations, and regulatory responses.
1. Technology. Capital demand, information flow, market mechanisms
In books on the history of economic thought, technological progress is typically one of the
recurring themes. It has no prominent place, however, in the sections devoted to Adam Smith
and his Wealth of Nations.71 This is not an oversight or accident. Readers who would like to learn
more about technological progress are not directed to Smiths treatise but rather to the works of
David Ricardo, Karl Marx, or Joseph Schumpeter. A similar picture emerges from the literature
on technological progress.72
Both discourseson the history of economic thought and on technological progress
suggest that Smith was unacquainted with the advances of technology or underestimated their
consequences. There is some truth to this.73 At the time when Smith composed the Wealth of
Nations, the improvements that were about to revolutionize all sectors of life were still in their
infancy. Smith noticed some of them; his famous pin factory is a good example (1784, vol. I,
70 Fleckner 2010, pp. 186; on the main theories in economics: Gibbons 2005; Hart 1995, pp. 155; Hart
2011.
Schumpeter 1954, pp. 18194; Heilbroner 1999, pp. 4274; Sandmo 2011, pp. 3259.
71
Smith is frequently mentioned in Mokyr 1990 and 2002, but as someone who saw specialization (di-
72
vision of labor), not technological progress, as the main driver of economic growth.
73 Explicitly Sandmo 2011, pp. 578.
Draft (2016-01-03) 44
pp. 79). But Smith was an early witness of an eruption that would last longer and reach further
than any contemporary could foresee.74 In fact, if one wanted to compile a list of factors that,
from a modern perspective, are missing in the Wealth of Nations, technological progress would
be a good candidate for the top spot.
How did technological progress fuel the rise of the joint stock company? Two effects are
critical: capital demand and capital supply. Technological progress increased demand for capi-
tal to an extent that no one, neither Smith nor one of his peers, would have imagined. For Smith,
seasoned companies engaged in the provision of public goods and services were the joint stock
companys prime field of application. Those firms indeed kept using the joint stock format to
satisfy their capital needs. But how about younger companies? Smith did not believe that joint
stock companies would be suitable for risky businesses (i.e., those that do not follow a rou-
tine). Yet this is exactly where they spread. Only half a century later, railway companies
then all but routine businessespopped up around the globe and issued shares on a scale un-
seen before. The joint stock company became the form of choice for growth companies hoping
to lure outside capital. The pin factories of today, such as internet and biotech companies, are
typically not organized as private copartneries but rather as joint stock companies (initially often
closely held, then publicly traded).
Technological progress also revolutionized the supply side, the structure of the joint stock
company. First faster and more reliable postal service, then telegraph and telephone, later the
74 More critical of Smith is Mokyr 1990, p. 243 (Smiths lack of enthusiasm for inventions was excep-
tional for his time).
45 Draft (2016-01-03)
internet, improved the flow of information within large firms and among their various stake-
holders. As a result, shareholders are now in a much better position to keep an eye on manage-
ment than they were when Smith composed his remarks. In addition, communication and in-
formation technologies allowed another institution to emerge as a major watchdog: the market.
Smith saw joint stock companies compete (and lose) on the product market. But he did not con-
sider the positive effects of competition on other markets. The stock market is regarded as a
foreign subject by Smith, the market for corporate directors and managers is not mentioned at
all, let alone the corporate takeover market. Given his confidence in competition and the market
mechanism, Smith would be pleased to see how strong a control mechanism each of these mar-
kets have become.
2. Organization. Control rights, supervisory boards, incentive schemes
Smith was wrong about the joint stock companys prospects. But with his analysis of the
joint stock companys inner dynamics, he was spot on. In fact, thanks to an impressive literature
on principal-agent conflicts, teamwork, moral hazard, and other branches of contract theory,
Smiths intuition now rests on firm formal ground.75
However, even without deeper insights into the functioning of firms, chances are that the
organization of large firms will improve over time, following a natural (or Darwinian) selection
process: Well-organized firms will prosper and grow, badly-organized firms will shrink and
Any selection of research papers would be either arbitrary or too long. The principal monographs or
75
treatises, respectively, are Hart 1995, Bolton and Dewatripont 2005, and Salani 2005.
Draft (2016-01-03) 46
eventually disappear (unless they face no competition). This does not mean that the most effi-
cient governance regime will always and instantly prevail. But in the long run, over decades
and centuries, history has produced a wide array of examples that, taken together, form a steep
learning curve. Managers avoided mistakes they had made in the past or heard of from else-
where. So did investors and other stakeholders. They improved bookkeeping and accounting;
they gave stockholders more control rights; they established supervisory, oversight, and moni-
toring boards; they elected independent directors; and so on.
At the same time, the inner dynamics of large firms were understood better and better.
Smith suggested solving the control problem by limiting joint stock companies to businesses
that require little or no control. Modern tools are less invasive. They try to bring the interests of
management in line with the interests of shareholders, creditors, and other stakeholders. So-
phisticated incentive schemes are one of the major strategies. They do not fully remove the risks
associated with managing other peoples money, and they create their own problems. But
overall, they constitute a major step in reducing the conflicts of interest that Smith was so wor-
ried about.76
3. Regulation. Minority rights, mandatory disclosure, state authorities
At the time when Smith lived, neither the English nor any other government in the world
had tried to address the organizational challenges that come with joint stock companies. All
The leading international account is Kraakman et al. 2009. Two recent collections include Davies et
76
al. 2013 and Fleckner and Hopt 2013.
47 Draft (2016-01-03)
that governments had done was very specific and short-lived. The Dutch had banned certain
forms of short-selling in the stocks of their East India Company (1610);77 England had restricted
the number of Stock-Jobbers (1697),78 and later passed the infamous Bubble Act (1720).79
There had been no attempt by any government to regulate joint stock companies in a systematic
way, let alone to create a comprehensive regulatory framework.
This changed in the decades following Smiths death. France enacted the Code de Commerce,
featuring the worlds first general rules on joint stock companies (1807);80 Austria and Prussia
followed the same path (1843), 81 culminating in a comprehensive regime twenty years later
(1861);82 England repealed the Bubble Act (1825),83 enacted three important joint stock compa-
77 Placaet, Tegens het verkoopen ende transporteren der Actien inde Oost-Indische Compagnie (Febru-
ary 27, 1610); reproduced in: Groot Placaet-Boeck, vol. I, s Graven-Hage: van Wouw, 1658, cols. 5536.
78 An Act to restraine the Number and ill Practice of Brokers and Stock-Jobbers [1697], 8 & 9 Gul. III.,
c. 32.
79 An Act for better securing certain Powers and Privileges intended to be granted by his Majesty by
two Charters for Assurance of Ships and Merchandizes at Sea, and for lending Money upon Bottomry;
and for restraining several extravagant and unwarrantable Practices therein mentioned [June 11, 1720], 6
Geo. I., c. 18.
80 Arts. 19, 2937, 40, 45 of the Code de Commerce (September 1015, 1807), Bulletin des lois, N. 164,
pp. 161283.
81 Secs. 12, 16 Vorschrift ber das Verhltniss der Privat-Vereine zur Staatsverwaltung (November 5,
1843), Ferdinand des Ersten politische Gesetze und Verordnungen 71 (1845), pp. 26576 (Austria). Gesetz ber
die Aktiengesellschaften (November 9, 1843), Gesetz-Sammlung fr die Kniglichen Preuischen Staaten,
pp. 3416 (Prussia).
82 Arts. 173249 of the Entwurf eines allgemeinen deutschen Handelsgesetz-Buchs (March 12, 1861);
reproduced, e.g., in: Protokolle der Commission zur Berathung eines allgemeinen deutschen Handelsgesetz-
Buches, suppl. vol. to prots. DXLVIIIDLXXXIX, Nuremberg: Tmmel, 1861.
83 An Act to repeal so much of an Act passed in the Sixth Year of His late Majesty King George the
First, as relates to the restraining several extravagant and unwarrantable Practices in the said Act men-
tioned; and for conferring additional Powers upon His Majesty, with respect to the granting of Charters of
Incorporation to trading and other Companies (July 5, 1825), 6 Geo. IV., c. 91.
Draft (2016-01-03) 48
ny acts (1844),84 and consolidated them along with various others in a single companies act
(1862).85 Court decisions of similar importance could be added, especially from common law
countries.
Some of the new rules merely confirmed or enhanced organizational innovations already in
place; others were imposed on the companies, whether they found them useful or not. Minority
rights for shareholders, uniform bookkeeping rules, and disclosure requirements are prominent
examples. Over time, a comprehensive legal framework evolved in all major jurisdictions, in-
cluding those with a common law tradition.86 Statutes nowadays govern everything from the
basic structure of joint stock companies to the fine print of their accounting. In some jurisdic-
tions, the bulk of the statutory provisions consists of default options from which companies can
depart. Delaware is the most prominent example. In other jurisdictions, governments follow a
one-size-fits-all approach and make almost all provisions mandatory. Germany is notorious for
this.87
Whether Smith would have welcomed any of the regulatory responses is difficult to say. On
no occasion does he mention state intervention as an instrument to police joint stock companies
84 An Act for the Registration, Incorporation, and Regulation of Joint Stock Companies (September 5,
1844), 7 & 8 Vict., c. 110. An Act for facilitating the winding up the Affairs of Joint Stock Companies una-
ble to meet their pecuniary Engagements (September 5, 1844), 7 & 8 Vict., c. 111. An Act to regulate Joint
Stock Banks in England (September 5, 1844), 7 & 8 Vict., c. 113.
85 An Act for the Incorporation, Regulation, and Winding-up of Trading Companies and other Associa-
tions (August 7, 1862), 25 & 26 Vict., c. 89.

86 The two most prominent examples are the U.K.s Companies Act 2006 (November 8, 2006), 2006
c. 46, and the Delaware General Corporation Law (8 Del. C. s. 101, et seq.), as amended.
87 The differences in practice are likely to be smaller than many observers believe. The controversy
would benefit from more empirical work.
49 Draft (2016-01-03)
and cure the deficits that he observed. If he had realized that joint stock companies also com-
pete on the capital, labor, and takeover market, as explained above, he may have argued that
most of the rules enacted by governments are superfluous or, even worse, harmful because they
distort competition. But he could have recognized that some forms of intervention are nonethe-
less beneficial. To name just three examples: Governments can impose sanctions that are una-
vailable to private parties, such as imprisonment for self-dealing or for misleading financial
statements; governments can establish charter regimes or appoint state supervisors who monitor
publicly traded joint stock companies, to overcome the rational apathy of individual sharehold-
ers; and governments can prevent individual companies from becoming de facto monopolists
through antitrust laws and agencies that foster competition.
Had Smith known of these regulatory responses, along with the technological advances and
the organizational innovations, his view of the joint stock company might have been much more
positive. That he missed developments that would emerge in the future is of course nothing we
can blame him for. Smith was endowed with more than the ordinary allotment of common
sense, but he was not a prophet (Viner 1927, p. 231). The joint stock company is a good exam-
ple. Not in his wildest dreams (or nightmares) would Smith have imagined how many joint
stock companies would one day populate the economic world. However, in all fairness, it has
been a long way from Smiths companies engaged in the provision of publick Works and Insti-
tutions for facilitating the Commerce of the Society to todays business behemoths with share-
holders, creditors, and employees spread around the globe.
Draft (2016-01-03) 50
V. Summary. Main findings and positions
1. The firm has no prominent place in Adam Smiths Wealth of Nations. Smith does not use
the term, nor does he develop anything resembling a theory of the firm. But Smith added a new
section to the third edition of the Wealth of Nations, featuring comments on the joint stock com-
pany and the organizational challenges inherent to them. These remarks deserve more attention
among economists, historians, and lawyers. (Section I)
2. Smith discusses joint stock companies as providers of public works and institutions that
facilitate particular branches of commerce. Smiths joint stock companies separate ownership
from control, offer limited liability, exclude unilateral withdrawal, and permit free transfer of
shares, all similar to the modern type. Smith, however, does not believe that joint stock compa-
nies can compete with smaller market participants, except for the exclusive rights they typically
enjoyed. He concludes that joint stock companies should be established only under rare circum-
stances. (Section II)
3. Little is known about the genesis of Smiths remarks. His letters suggest that the addi-
tions are not the result of a spontaneous whim but rather of careful deliberations. At the same
time, the sources he consulted and the companies he studied are surprisingly unrepresentative
of the social phenomenon. The resulta very pessimistic view of the joint stock companyis in
line with his general beliefs, such as on competition, on self-interested behavior, and on specula-
tion. (Section III)
4. Technological progress increased the demand for capital, especially for risky projects,
and facilitated its accumulation in the form of joint stock companies. Over time, the inner dy-
51 Draft (2016-01-03)
namics of large firms were understood better and better, and organizational innovations miti-
gated the conflicts of interest between managers and other stakeholders. Further relief came
from regulatory responses to the joint stock companys inherent weaknesses. Smith did not an-
ticipate any of these developments, or he underestimated their positive effects. (Section IV)
5. Economists are still struggling to identify the factors that make large firms so successful.
They can take comfort in the fact that Adam Smith, the godfather of modern economics, also
struggled. In fact, it would be difficult to find an area where Smith was as wrong as in his
gloomy forecast of the joint stock company. But this does not mean that those interested in the
firm should ignore Smith and his Wealth of Nations. Quite the contrary. For when we ponder
why Smiths pessimism turned out to be wrong, and why large firms could become so dominant
notwithstanding his concerns, we are right on track to better understand the firm.
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55 Draft (2016-01-03)
Chart 1. Context of Smiths joint stock company
An Inquiry into the Nature and Causes of the Wealth of Nations
Book I Book II Book III Book IV Book V

Of the Causes of Of the Nature, Of the different Of Systems Of the Revenue
Improvement in Accumulation, Progress of of political of the Sovereign
the productive and Employ- Opulence in Oeconomy or Common-
Powers of Labour ment of Stock different Nations wealth

Chapter I Chapter II Chapter III

Of the Expences of Of the Sources of Of publick Debts
the Sovereign or the general or publick
Commonwealth Revenue of the Society
Part I Part II Part III Part IV

Of the Expence Of the Expence Of the Expence Of the Expence
of Defence of Justice of publick Works of supporting the
and publick Dignity of the
Institutions Sovereign
Article I Article II Article III

Of the publick Works Of the Expence of the Of the Expence of the
and Institutions for Institutions for the Institutions for the
facilitating the Commerce Education of Youth Instruction of People of
of the Society all Ages
Of the Publick Works and Of the Publick Works and

Institutions which are necessary Institutions which are necessary
for facilitating Commerce for facilitating particular Branches
in general of Commerce
(added to the third edition)
Draft (2016-01-03) 56
Chart 2. Concept of Smiths joint stock company
Commercial Organizations
individual stock joint stock
no withdrawal withdrawal
transferability no transferability
limited liability unlimited liability
regulated joint stock private

companies companies copartneries
57 Draft (2016-01-03)

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Andreas Martin Fleckner

Adam Smith on the

Max Planck Institute for Tax Law and Public Finance

Max Planck Institute for

Electronic copy available at: http://ssrn.com/abstract=2721811

Max Planck Institute for Tax Law and Public Finance

Andreas Martin Fleckner*

I. Introduction. Smith and the firm..................................................................................................... 3

1. Context. publick Works and publick Institutions ............................................................. 9

3. Pessimism. in the long-run proved, universally, either burdensome or useless ........ 18

III. Investigation. What made Smith so pessimistic? ........................................................................ 24

1. Genesis. a compleat History of all the trading companies in G. Britain ...................... 24

2. Sources. a much more sober and judicious writer, Mr. Anderson................................ 28

IV. Speculation. Why did Smiths pessimism turn out to be wrong?............................................. 43

1. Technology. Capital demand, information flow, market mechanisms ............................ 44

2. Organization. Control rights, supervisory boards, incentive schemes ............................ 46

3. Regulation. Minority rights, mandatory disclosure, state authorities.............................. 47

V. Summary. Main findings and positions ....................................................................................... 51

Chart 1. Context of Smiths joint stock company ................................................................................ 56

Chart 2. Concept of Smiths joint stock company ............................................................................... 57

I. Introduction. Smith and the firm

legal status remain in the dark.

developed and agreed-upon areas of economics (Hart 2011, p. 102).2

to owner-managed firms, while overlook[ing] various countervailing considerations which go

absence of an effective state authority, were indispensable (p. 454).

Smiths view of the corporation is based on a substantial misinterpretation of judgments ex-

4 The first quote is missing in Heckscher 1931, vol. I, p. 408.

competition, on self-interested behavior, or on speculation. Those interested in corporate and

ry of the firm that economists are still struggling with.5

joint stock company.7

findings and positions.

why he said what he did.

1. Context. publick Works and publick Institutions

is Smiths rationale for discussing joint stock companies in this context?

text in which he discusses the joint stock company.

deposited, should be, in some measure, fortified.

overseas trading to be more capital-intensive than local exchange.15

14 Pp. 113, 127, 129, 131, 132.

terial is more associative than logical.

is merely a provider of them.

Smith mentions, such as the maintenance of roads, bridges, or canals.

2. Concept. trade upon a joint stock without being a private copartnery

cited by Smith throughout to illustrate and highlight differences.

pany (pp. 111, 11722).

contrast not to regulated companies but to private copartneriesperhaps because he considered

First, In a private copartnery, no partner, In a joint stock company, on the contrary, no

3. Pessimism. in the long-run proved, universally, either burdensome or useless

judgment and bestowed praise and blame.

(a) Practice. it would appear from experience

dence that Smith allegedly relied on.21

nies in general) p. 110 (reproduced supra sub 3).

pp. 1467 (more on this infra sub (c)).

from control (p. 123, immediately following the last quote):

the joint stock company.29

regulated companies (pp. 1167).

areas suitable for joint stock companies (p. 146):

requires, at least in Smiths eyes, the opposite of following a Routine or a uniformity of

it reference to the many variations in foreign trade (pp. 1445).

cond step is more normative (pp. 1478):

III. Investigation. What made Smith so pessimistic?

1. Genesis. a compleat History of all the trading companies in G. Britain

did misinterpret them.31

are best approached in reverse order, given the available evidence.