Hans Siggaard Jensen Copenhagen Business School The Historical Foundation of Business Economics Abstract An analysis of the emergence

of business economics as a separate field is presented. Important factors are the issue of efficiency and optimization in the newly emerged firms and the problems of measurement and theory thereby posed. The analogy to engineering and engineering science is presented and focus is put on the development of the efficiency concept in the area of energy and thermodynamics. The differences between economics in the tradition of political economy and the economics of business economics are presented and related to the problem of the application of knowledge in the solution of practical problems in the social science field. This focuses attention on the concept of rationality and thus on the various theoretical attempts at providing a theoretical foundation for business economics based on micro-economics and aspects of other disciplines such as organization, strategy and leadership. I. An early attempt at providing a study of business is Charles Babbage's The Economy of Machinery and Manufactures from 1832 (1.), in which he among other things made an empirical study of the effects of the division of labour, thus giving a measure of the gains from such division. It proved much more difficult than expected to get the relevant figures and numbers. It was difficult to know what and how to measure the actual processes involved in pin-manufacture. And it was difficult to transform and interpret the data he actually got. This is not surprising given the experience that people had in other fields, where they tried to measure processes and phenomena without adequate theory. A good examlpe is the discussion on the efficiency of types of water-wheels which is difficult to decide on emperical data alone, when one does not have well developed thermo-

dynamic concepts to guide the measurements. So Babbage measured both some purely physical phenomena and qualities like the duration of a process and the amount or number of material produced. And he also measured some purely economic phenomena like the price and costs of material and processes involved. His intention in the work was to provide relevant knowledge so that the work in the factories could be organized in the most efficient way. This involved both the use of machines and the organisation of the activities. He did the work in a period where there actually existed factories that could be studied. And he had some indicators of efficiency but no clear theory about it, and thus again it was difficult to know what to measure and to have some units of measurement. The purpose for Babbage was clearly that the owner of a factory should get as much profit as possible, and thus profitability could be seen as a measure of efficiency. But again Babbage did not have a clear concept of profitability. We may say that his situation was very much like the situation viz a viz steam engines. It was clear that some engines were better than others, and there could be made quite a good deal of observations and experiments with them - enormous amounts of date could be collected - but it was not quite clear how to use and interpret the data. One steam-engine was more efficient than another, but why it was so was also quite unclear. II. Later in the century Frederick Taylor investigated work-processes and their organisation and came up with a number of new ways of understanding work - chiefly connected to the concept of a task - and proposed new ways of organising it in the manufacturing industries (2.). It was called "scientific management". The ideas of Taylor were based on measurement and comparison. One way of doing things was superior to another if the amount of work involved in one was smaller than in the other. This involves measurement of some physical properties according to Taylor. So if from the same raw materials either the same can be produced in shorter time by the same number of people, or more can be produced in the same time by the same number of people - presupposing equal level of skill (whatever that might mean), then there is a gain in efficiency. So one proces can be said to be more optimal or efficient than another on the basis of these measurements and comparisons. This only involves the ordinal measurement and purely physical concepts. Through such comparis-

ons one could decide between different ways of doing things, and thus constantly increase efficiency. Taylor also supposed that thereby profitability could be increased. Furthermore he presupposed a simple mereology, namely that if one optimized each part, the whole would also be optimized. So in a way Taylor thought that one could run a factory at its best without at any time using economic concepts - unless one regards the idea of optimizing as economic in itself. Purely physical concepts and measurements would do. The complex whole had to to broken down into simple parts, and the simple parts had to be optimized. Thereby the optimization of the whole would be achieved. It is a simple additive mereology, which we find in many system contexts. The idea is that there is a part-whole relationship in which one can infer directly from properties of the parts to properties of the whole, and from aims and purposes attached to the parts to aims and purposes attached to the whole. An example of a different type of relationship between part and whole is the invisible hand relationship between the individual agent and the economy as a whole. III. Taylor thus saw the problems of management as a type of problem that could be solved using measurements and models connected to the optimization of a flow of physical entities, tasks considered as events or series of events occuring in time. At the same time Taylor developed his principles of management and the organisation of work the modern form of economics had appeared. Classical political economy had concerned itself with the solution of problems connected with a society as a whole. Smith, Ricardo, Marx all asked very broad general questions about the best form of taxation, the benefits of international trade etc. The provision of solutions to such problems was what made economics political. The marginalist "revolution" changed that considerably. It focused on the phenomena of exchange and the level of an industry. We see this clearly in the work of Marshall. There is a - sort of - hidden assumption about the homogeneity of the single industry. Basically the main claim is that if one accepts a marginal utility theory of value and opts for a free market economy, then the free marked economy through the various mechanisms at work will itself provide an optimal solution to the various optimization problems, namely the best use of available resources given the wants and desires of the agents participating in the economy. We might say that basically optimization can be achieved and maybe even more

important can be explained by using only economic concepts, if we accept utility and preference as economic concepts - although of course they might be considered as psychological/folk-psychological. We can say that the price-mechanism and the phenomenon of value are the optimizing "actors". Much has been said and written about the emergence of marginalist economics and the role that physical models and analogies not to say metaphors have played in this. It is clear that the succesfull application of the mathematical apparatus that was found in advanced physcial theories was important to Jevons, Walras and in a certain complicated way also Marshall. Mirowski (3.) has analysed the importance of ideas from thermodynamics. I will only point out that the foundation of economics as an independent and non-political science through the work of the first marginalists can be characterized as an attempt to give economics its own domain, and to construct that domain as as purely economic as possible. Although Jevons was interested in numbers and statistics, we may say that he was even more interested in functions, and so was Walras. An abstract functional theory was aimed at. And the functions would of course at some point involve inputs that were physcial, like quantities of goods and number of produced entities. But the aim was to create an economic theory based on purely economic concepts. Jevons theory of exchange is a good example (4.). Problems of mereology, the aggregation of the phenomena when there were many agents and exchanges, that is a complex society was considered as simple. It was only when actual economic developments proved contrary that the micro-macro relation became much more critical and problematical. The work of Keynes established then a completely different type of relationsship much more like the one Maxwell and especially Ludwig Boltzmann had established in physics between the micro- and the macro-level, insisting on the necessity for two-level descriptions that were not related in the simple mereological way that allowed for direct inheritance up or down of properties. In thermodynamics one level of description - the micro-level - is statistical, whereas the other level - the macro-level - is deterministic. But then the micro-level involved in Keynes' theory is significantly different from the one that we find in Jevons and Marshall, where the idea is the the single fundamental element of the economic system should be the foundation of description and explanation,

whereas Keynes rather worked with a number of different microphenonoma connected to psychological expectations and habits and norms of behaviour. Both the marshallian and the keynesian type of economic theory basically left the problems of the firm unsolved, or rather as a mystery as famously pointed out by Coase (5.). Furthermore the issues of providing guidance for decision-making at the level of the firm was also left totally out. The old classical economics had at least attempted to provide solutions to political problems as stated earlier, and to a certain extent also some business problems, as exemplfied by Babbage. Marginalist theory was seen in a way much more as a justification and explanation of a economic system, than as a theory that should provide answers to actual decision problems, actual practical problems. These occured in the firms, and the firms were not themselves spontaneous economic orders, such as the economy as a whole, and neither were they simple or elementary economic agents. Although the economic theory of Marshall and other neo-classical economists have this model, considering the firm as a "black box" or a production-function. IV. The development of thermodynamics after around 1850 made it possible to give a precise meaning to efficiency. One could now measure and compute the energy involved in the work a machine did. It was not only possible to compare machines and decide which one was better, it was also possible to give an answer to the question how efficient a given type of machine could get. Not only ordinal measurements were possible but also cardinal ones. The best steam engine would always be less efficient than the best diesel-engine if given the same amount of energy is input. It could always perform a larger amount of work given the same input of energy. The fact that one could measure the amount of energy in a given fuel whether it was coal or diesel-oil was here of decisive importance. So efficiency could be conceptualized as a flow of energy, and it could be modelled as an input-output function that depended upon f.i. the design of the machine involved. Carnot had looked at an idealised heat-machine, now it became possible to look at different actual machines that performed work, mechanical or thermodynamical. As soon as this became theoretically fairly well-understood technological consequences were drawn. Providing the heat so to say inside the piston was obviously more efficient than providing it as heat for a boiler. Providing

the steam directly at the wheel as in a turbine more efficient than through a piston. Diesel-engines, Otto-engines and various forms of turbines were then developed. Of course one can not say that their desings were deduced from thermodynamics, but thermodynamics provided a new conceptual "climate" in which new questions and problems could be posed, and new criticisms of old designs could be formulated. The otherwise advanced steam-engine could suddenly be seen as essentialle defective, because it had a limit to its efficiency. We might say that a mechanical system in its capacity for work was dependent not only on the input but also its design and conceptual and theoretical foundation. There may be other reasons why a given machine is preferred rather than that, but these were eventually to be overcome as hindrances of achieving a higher degree of efficiency. It was also understood of course that the ideal machine was impossible, the machine that worked by itself or that transformed all energy to work - the 100% efficient machine. V. At the end of last century all engineers that had a scientific training understood these things. At about the same time the modern type of firm emerged with its complex organisation. Chandler and Hounshell (6.) among others have told part of the story. Management decisions had to be made. The basis of such decisions where at best shaky. The processes involved were poorly understood, and there were nearly no way to obtain data on which to base decisions. Information and knowledge was simply lacking. As both Chandler and Hounshell has pointed out the newly emerged corporations were organisations of much greater complexity than hitherto known. They involved complex decisionmaking both concerning the material side of production and the economic side. Also at the same time large financial and insurance companies emerged necessitating enormous amounts of data-handling (6.). What has been termed the "institutions of capitalist society" took shape. Often military leaders were called in to manage these new organisations because it was believed that they knew about management and leadership. In a certain way they did, but they cam from a type of organisaiton where economics and optimization was not of great importance. These organisations were not entities that were placed on a market, whereas the firms were. VI. It was natural to think that the problems of decision making could

be solved on the basis of the accounts that any firm kept. They showed the inputs and outputs both in terms of material - the amount of raw material, the amount produced and sold, the number of hours worked etc. - and in terms of money - the salaries paid, the costs of raw materials, the income from sales etc.. An important purpose of accounts were to show the value of a company, considering it as a sort of commodity. This in no way helped showing the flow of value through the company, seeing the company as a sort of inputoutput system. The task then was to develop methods of accounting that could show the degree of economizing in the various parts of the company. This necessitated both an understanding of the way the company actually functioned, not as a physical and social system, but as an economical system. It was necessary to be able to account for the flow of value throught the company as an input-output system. But it was also necessary to give precise meaning to the idea of a degree of economizing, and that concept was then understood in analogy to the thermodynamic concept of efficiency - as a degree of effectiveness. This set the agenda of a whole research programme that saw the development of systems of accounting as the central task of business economics, systems of accounting that would give a model of the company as a system of flows of economic value. The german research programme that was established by Eugen Schmalenbach exemplfies this approach, and it had enormous influence in particularly the scandinavian countries (7.) VII. We can now formulate three different types of approaches to the solution of problems of management and business administration. One is based on the idea that it is possible to solve such problems by optimizing only purely physically measured properties. The underlying idea is that economizing is basically trivial, because it is achieved if you optimize at the level of the basic parts of the economic system, which is understood as an organisation. Society as a whole then is basically seen as a large company. There is no market in the sense that an economy can be understood as just a large corporation. Decisions need to be made at all levels, and the necessary information has to be available. Taylor is a godd example of this approach, which sees management as fundamentally a non-economic phenomenon. This was also the reason why socialsts and communists - like Lenin - could embrace the tayloristic ideas. We could also say

that production-functions are only dependent on technology, and the aim of management is to optimize these, so that you get a situation where there is only one efficient (in the usual economic sense of efficiency) production plan. Decisions concerning technology, human qualifications and organisation should try to get to this situation. Management is basically a non-economic discipline. The second approach to decision-making in business can be termed the purely economical. The idea is that business and the economic system as a whole should be organised in such a way that the impersonal economic forces would by themselves secure an optimum. This is the idea which sees the spontaneous order of the market as the essence of economic optimization. If there are business decicions to be made the are in a way obvious given the relevant information. You simply decide so as to optimize, and the need for decision is then a kind of imperfection of the economic system brought about among other things because of the existence of firms. But basically there are no difference between a firm and any other economic agent. Thus business economics is simply economics. The neo-classical theory of the firm and the theory of production-functions as developed at around 1900 f.i. by Clark (8.) are good examples. This approach has continued in the development of the theory of the firm, but of course has been transformed by the work of Coase mentioned earlier and the succeeding developments. The basic concept is the concept of value, and the fundamental problem is that value in the marginalist conception of it only exists on a market. This was exactly what changed the concept of value from a classical to a neo-classical economic concept. Both are social concepts in the sense that they are not reducible to physical properties like mass and time, but are dependent upon essentially social phenomena, but it is of course extremely significant that the two concepts differ as to what social phenomena are involved. The neo-classical concept only has meaning when there are free markets so that exchange can take place and marginal phenomena can occur. But firms are not themselves markets, so there is a problem. This creates the possibility for a third conception of decision-making in business, namely that we have a case of mixed rationalities. There is both a physical side, which has to do with managing operations as physical and social processes that are conceptualised as non-economical, and efficiency has a non-economic mean-

ing, and we have to do with markets, where the is a market for products and a market for production-factors involved. But the firm can not be reduced to a production function, and decision-making neither to a choice between different efficient production-plans given technology. The production-function concept is usually being defined for a given state of technical knowledge, and is considered a technical relationship, that is, not dependent upon essentially economical properties. Of course the value of the output of a production function would be an economical concept. So we may say that the third possibility is based on the idea that business economics is a mixed "disocurse" because it involves both economical and physical concepts and that optimization has to be done taking both types of optimization into account. In the german debates on the nature of business economics that took place in the 1920's the essential problem was exactly this relation between the technical optimization of production and the economical optimization. Business economics had as its purpose the solution of this "conflict", which could be done only under the assumption of firms as part of a common economy, where the individual economic agent - person or company - should abstain from profit maximization in so far as this was detrimental to the common good. This of course would be non-sense seen from a purely economical point of view, where exactly the "invisible hand" arguments and the market concept made sure that there was no contridiction or dilemma of decision making. Later developments looking at the economics of markets and organisations - in this context often termed "hierarchies" - has taken up the issue, using a concept of costs transaction costs - that are not neo-classical in the traditional sense of costs being an economical concept that has a meaning only in the context of a market (9.). Because there was in business decisions this mixed rationality Schmalenbach considered it impossible to develop business economics into a strict science, it had to be a type of art (10.). Notes: 1. See Babbage 1832 especially Chapter XIX termed "On the division of labour", 2. see Taylor 1911,

3. see Mirowski 1989, 4. see Jevons 1871 especially his Chapter IV The Theory of Exchange, 5. see Coase 1937, 6. see Beniger 1984 for a treatment of this issue, 7. see Schmalenbach 1920, see also Kruk et. al. 1984, and the many later editions of Schmalenbach 1920; Schmalenbach is in Germany often named the as the Adam Smith of business economics, 8. see Clark 1899, and for a modern classical exposition Shephard 1970 9. I am of course thinking of transaction cost theory and particularly the work of Williamson, 10. see Schmalenbach 1911/12. References: Babbage, Ch.: The Economy of Machinery and Manufactures (1832), vol. 8 The Works of Charles Babbage, London 1989 Beniger, J.R.: The Control Revolution, Cambridge, Mass. 1986 Chandler, A.D.: The Visible Hand, Cambridge, Mass. 1977 Clark, J.B.: The Distributio of Wealth, New York 1899 Coase, R.H.: "The Nature of the Firm" Economica 1937, New Series IV Hounshell, D.A.: From the American System to Mass Production 1800-1932, Baltimore 1984 Jevons, W.S.: The Theory of Political Economy, London 1871 Kruk et. al.: Eugen Schmalenbach - Der Mann, Sein Werk, Die Wirkung, Stuttgart 1984 Marshall, A.: Principles of Economics, London 1890 Mirowski, P.: More Heat than Light, Cambridge 1989 Schmalenbach, E.: Grundlagen dynamischer Bilanzlehre, 2.ed. Leipzig 1920 Schmalenbach, E.: "Die Privatwirtschaftslehre als Kunstlehre", Zeitschrift fr betriebswirtschaftliche Forschung, annual series 6, 1911-12 Shephard, R.W.: Theory of Cost and Production Functions, Princeton 1970 Taylor, Fr.: Principles of Scientific Management, New York 1911

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(Present affiliation [2009]: School of Education, University of Aarhus, Professor of philosophy of science)

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