It’s time to wrap up my survey of Adam Smith’s digression on joint stock companies, which first appeared in his 1784 pamphlet Additions and Corrections to the First and Second Editions of Dr. Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations (Smith 1784). Simply put, to sum up my multi-part survey thus far, Adam Smith is not a big fan of joint stock companies. According to Smith, even when a joint stock company is granted monopoly rights, it is still almost always destined fail due to the inherent conflict of interest or fundamental disconnect between the owners of the company (shareholders) and the agents who are actually running it (managers/directors).

More specifically, as we saw in some of my previous posts on Smith’s digression on joint stock companies (see here), this corporate principal-agent problem manifests itself in the divergent time horizons and misaligned incentives of the shareholders on the one hand, who bear the ultimate financial risk of failure, and the agents of the company on the other, who will be tempted to pursue high-risk ventures or engage in wasteful expenses in order to aggrandize their own personal lucre and power, or in the immortal words of Adam Smith (1784, p. 60), “The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.” In short, the directors and managers of a corporation are playing with other people’s money, not their their own!

But are there any circumstances in which a joint stock company can overcome this handicap? For Smith, ever the intellectually-honest and astute pragmatist, the answer is a qualified yes! More specifically, in paragraphs 32 to 39 of the last part of his 1784 pamphlet (pp. 76-79), the Scottish scholar identifies four — but only four — lines of business in which joint stock companies can succeed in making money even without a monopoly: banking, insurance, canals, and waterworks.

What about corporations in other types of industries, like copper mining, lead smelting, and glass grinding — the three examples that Adam Smith himself refers to in the last paragraph (para. 40) of his pamphlet? In a word (ok, two words), no dice. Smith writes: “Except the four trades above mentioned [i.e., banking, insurance, canals, and waterworks], I have not been able to recollect any other in which all the three circumstances requisite for rendering reasonable the establishment of a joint stock company concur.” (Smith 1784, p. 79) So, what are these three necessary conditions for a joint stock company to succeed?

1. Greater and more general utility than common trades. “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 …” (p. 78) In other words, the enterprise must serve a broad public purpose or provide a significant utility to society at large, such as the provision of credit (banking), spreading financial risk (insurance), or providing critical public infrastructure (canals and waterworks).
2. Large capital expenditures to go into business. “[A]nd secondly, that it [the undertaking] requires a greater capital than can easily be collected into a private copartnery.” (p. 78) That is, in order to get off the ground, the business requires a capital expenditure far greater than what could readily be raised by a standard private partnership or individual private fortunes.
3. Routine and uniform operations. The third requisite condition is that the operations of the company must be capable of being reduced to a strict rule, routine, or “uniformity of method as admits of little or no variation” (p. 76). Why is the uniformity of business operations so crucial? Because uniformity and routine reduce the temptation of the managers to pursue high-risk ventures and make it easier for the shareholders to monitor the performance of the agents of the corporation.

Nota bene: I will offer some closing thoughts on Adam Smith’s 1784 pamphlet as a whole in my next post.