NOTE ON ECONOMIC THEORIES OF THE
FIRM
From: Amitai Aviram, Unincorporated Business Entities: Course Material, ©
2005 All Rights Reserved
The laws
that govern business entities
are designed to facilitate business activity through firms. In
the note below I will explain what firms are, why they are used for business activity, and
what are their strengths and weaknesses
in comparison
to the other common facilitator of
business activity – the network. Then I will describe very briefly economic approaches regarding
the ownership (i.e., control and
rights to surpluses) of the firm. As you
read this note, bear in mind
that the primary role of the business
entity laws that we will study
throughout the course is to mitigate the firm’s weaknesses
so that it is a more effective structure with which to conduct
business.
1. Firm
and Market: Two methods of coordinating
business activity
All economic activity requires cooperation. Even if a single
individual can
produce a product or offer a service by herself (say, bake bread), she would need to rely on
others to provide some of the inputs
for that activity (e.g., grow wheat and
grind it into
flour, or construct the building that serves as a bakery and
the oven that is used to bake the
bread). Other, more complex products necessitate cooperation
either because they require more simultaneous
activities that one individual can
do, or a combination of different
skills that one individual is unlikely
to possess. This interdependence is
often beneficial
even when
it is not necessary,
because it allows individuals to
specialize in one aspect of production.
But
cooperation has its drawbacks. A cooperative effort requires people to agree
on how to share the surplus of the
activity and on
how to manage the coordinated activity.
This is complicated by the fact that individuals
differ in their incentives. For example, one
might want to make a profit quickly,
another might want to re-invest
profits in the business to gain
larger profits in the future, and a third may not
care for the profits as much as for the power of managing the business
or the sense of helping society through philanthropic
activity by the business. Complicating
things further, individuals in
a cooperative activity may act strategically to get a larger share of the
profits or spend a lesser share of
the efforts. For example, an individual
on a team may not
do her best effort, hoping that
other members of the team would pick up the slack. Alternatively,
she may wait until the others
completed their part of the work and
then threaten
to leave the team (rendering the unfinished product useless) unless
she received a larger share of the profits.
Certain social structures have formed to minimize the problems of coordinating business
activities. They can be divided into
two categories: the firm and the network
(the latter is often referred to as
the market, which is a type of network).
The firm
is a centralized structure that is
based on hierarchy. Members of the firm are obligated to follow
other members’ instructions (e.g., the line
worker is obligated to follow the supervisor’s instructions, the supervisor is obligated to follow the instructions
of the middle manager, who follows
the CEO’s instructions).
Production through a firm is
straightforward: a manager figures
out what each firm member needs to
do, and coordinates
their activities by instructing them (sometimes delegating
the role of instruction to lower-ranked
managers).
The network is a decentralized
structure. For the most part, network members decide for themselves what they
should do, and the network provides them with incentives to do the things
that other network members would
like them to do. Markets are the most prominent type
of business networks:
buyers and sellers in a market are not
obligated to buy or sell, and decide
independently whether to do so and
at what price. However, the market
provides incentives
for participants to voluntarily cooperate.
If many market participants want
to buy grain, the price of grain would rise.
As a result, the profit from selling
grain would increase,
which would create an incentive
for people who own grain to sell it on
the market. Furthermore, because of the
increased profitability of selling grain,
participants would have an incentive to produce more grain. The outcome – more grain
grown and
then supplied to those who want to use it – is similar to that in a firm in
which farmers were instructed by the
manager to grow more grain and
deliver it to other firm members who would process it.
You
probably notice, from your own experience,
that business activity is usually conducted in
a hybrid combining both firms and
networks. For example, millers may use the market to
buy wheat, but then process the
wheat into flour through a firm (instructing
their employees how to grind the
wheat and package the flour, rather
than contracting out for these services through the market). Similarly, when
wheat prices rise and the sellers
decide to grow more grain, they may
do so through a firm, instructing the farm hands
how to sow the fields and tend to the wheat.
2. Opportunism and
Agency Costs: When do we use firms, and
when markets?
The
existence of both firms and networks
side by side (and in hybrid structures) suggests that neither structure is always superior to the other
(otherwise, everyone would adopt the
form that is superior and the other
form would disappear). In 1937 a scholar finally
came up with the explanation for when
businesses prefer the firm over the
market and vice versa. Following
a year-long examination of
the relationship between General
Motors and Fisher Body (the manufacturer of GM cars’ bodies), Ronald Coase published a paper called The Theory of the Firm. In that paper Coase argued that the choice
between firms and markets (networks)
comes down to a trade-off between the transaction costs: opportunism when
using the market and agency costs when
using the firm.
(a)
Opportunism: the cost of transacting
through a market
Opportunism is a strategic threat to renege on a
contract, intended to extort a larger portion
of the transaction surplus. It
is particularly powerful if transaction-specific investments were made in
reliance on
the contract. For example, Alice, a promoter of sports events, agrees with Bob, a professional boxer, that Bob will participate in a boxing
match in return
for $10,000. To maximize attendance at
the match, Alice
advertises it extensively. The advertising
costs are transaction-specific, because they advertise the specific
match and the specific participants. Most of
the value of the advertising will be
lost if Bob does not show up for the
match. Suppose that Alice expects that after deducting all expenses,
her profits from organizing the match would be $7,000. After Alice
advertises the match, Bob threatens not to show up unless
he receives another $5,000. If Alice
refuses, Bob will not perform and Alice
will lose the $7,000 of expected profits (or at least the amount that she spent
on advertising). Paying
$5,000 to avoid a loss of $7,000 makes sense,
so Alice may
agree to this opportunistic extortion.
But how
can Bob renege
on his contract? Can’t
Alice sue him
for breach of contract? Reducing
opportunism is the main goal of contract
law, but contract law is
imperfect. The cost of litigation may exceed $5,000, in
which case Alice
would be better off foregoing the
lawsuit. Or there may be only a few boxers with Bob’s fame, and Alice
might be concerned that if she sued Bob, he would refuse to deal
with her in the future and she would be limited to organizing matches with
second-rate boxers. Finally,
Bob can avoid his obligations by feigning sickness,
performing unenthusiastically, or otherwise providing poor performance
that would harm Alice
but would be difficult for her to prove in
court was a breach of contract. Knowing this in
advance, Alice may prefer to yield to Bob’s new demand.
Besides their
susceptibility to opportunism, short-term contracts are not conducive to
long-term investments. For example, when
Alice
advertises Bob she not only increases attendance in the specific match that she
is organizing, but she also increases Bob’s fame. This may increase attendance in Bob’s future
boxing matches, but Alice
may not capture these benefits – Bob may prefer to work for other
promoters. For that reason, Alice will not invest as
much in advertising Bob as she would if she and Bob had a ten-year exclusive
contract. Long-term contracts are a step
away from markets and towards a firm: by binding themselves to each other in a
long-term contract, the parties remove the main element that “keeps them
honest” in a market transaction: competition with third parties with whom they
are easily substitutable. At the same
time, the long-term contract allows each party a greater degree of control of
and coordination with the other party – the main characteristic of a firm.
The
ability to control performance rather than rely on competition in the market is
particularly important in types of business that require close coordination
between several people. A short-term
contract (such as participating in a single boxing match) makes such
coordination difficult. For example,
suppose that Bob was not a boxer but a football player. Also suppose that for each game, the owner of
the team receives bids from athletes and accepts the best players he can get
for the given game. The composition of
the team changes from one game to the next, depending on which players are
available and who offered the cheapest bid.
Even if each player made a good faith effort, they would not play well
because they would not be coordinated and familiar with each other. This is one of the reasons that most team
sport athletes affiliate themselves with teams, rather than play each game with
whoever offers them the highest pay for that game.
(b) Agency costs: the costs of transacting through a firm
Above we
discussed the weaknesses of the
market (short-term contracts). But just as opportunism
is a cost of doing business through the network
(market), agency costs are the costs
of doing business
through a firm. An
agent’s effort increases the principal’s
wealth, but not necessarily the agent’s. If the agent
gets an hourly wage, or a fixed
salary, then he gains nothing from working
harder. Theoretically, his employment contract
may require him to expend a
specified amount of effort, but
effort is hard to measure, so this obligation
may be hard to enforce.
For
example, suppose that Alice
hires Bob (this time, a burger-flipper) as an
employee in her company (a fast-food franchise) for a term of 20 years and in return
for a fixed monthly salary. Alice
now has more control over Bob: she can
train him to follow the franchise rules and shift him between various tasks in
the franchise (taking orders, preparing the food, mopping the floors) depending
on the immediate needs of the business.
This has some advantages over
market transactions, including the ability to invest in training Bob
extensively, and the ability to coordinate between all of the employees so that
they work faster.
But the
quality of Bob’s work depends not only on his training; it is also affected by
his effort. Would Bob have an incentive
to work hard? Alice’s profits may double if Bob takes 20
orders and hour instead of 10. But Bob’s
salary will remain the same. If taking
more orders requires more effort, Bob will likely prefer to take only 10
orders. Professional pride may cause Bob
to work hard even if he’s not paid extra for the effort, but at some point Bob
would decide not to work any harder, even though he might have agreed to work
harder if he were paid more to do so.
But can’t
Alice simply
require Bob to work hard in his employment contract? As with the example above of Bob the Boxer,
there are certain subtle things that Bob can do to expend less effort without
being so overt as to risk getting fired.
Agency costs are the costs of this shirking or of an employer’s actions
to prevent shirking.
The first
type of agency cost is monitoring
expenditures: Alice
can observe Bob (or hire someone to do so), in order to make sure that he is
working hard. Or she might experiment
and find how many orders can an employee be expected to take, and set that as
the benchmark. Even if this works, Alice would incur a cost
for monitoring Bob.
The
second type of agency cost is bonding
expenditures: Alice
can offer Bob more money if he works harder.
For example, she can offer him a bonus if he takes more orders than
average or if the franchise’s profits rise; or she can offer him a share of the
franchise profits, making him her business partner (this is the idea behind
stock option plans for employees). Even
if this causes Bob to work harder, Alice
incurs the cost of these incentive plans.
Finally,
despite monitoring and bonding, Bob is likely not to work as hard as he would
if he were the sole owner of the business.
Monitoring doesn’t always work because he may feign working hard but do
very little, or because his performance does not depend only on his efforts
(the franchise may do well despite his being lazy, or it may do poorly despite
his best efforts). Bonding is also
imperfect – as long as Alice
receives some of the profits of the business, Bob will not have the same
incentive to work hard as he would if he owned 100% of the franchise. The shirking that remains despite monitoring
and bonding is the residual loss – a
third type of agency cost.
(c)
Coase’s Theory of the Firm: Balancing
opportunism and
agency costs
Back to
the theory of the firm: Coase’s insight
was that a business transaction
would be conducted within the firm if (in
the case of the specific transaction) the costs of opportunism
are greater than the agency costs. Conversely, a business
transaction
would be conducted outside of the
firm (through the market or network)
if the agency costs are greater than the costs of opportunism.
For
example, it is very difficult and costly to monitor the performance of professionals. The number of hours that they work is not a
good indicator of the effort they make, and an equally qualified expert needs
to thoroughly learn the matters they deal with in order to assess whether they
shirked. Thus, agency costs are high and
professionals lean towards organization through markets rather than firms. However, many tasks require close
coordination between teams of professionals (e.g., several lawyers working on a
case, or a surgeon, anesthesiologist and nurse working together on an
operation), and facilitating this coordination creates incentives to have the
team work within a firm. As a result of
these competing pressures, most lawyers do not work in-house (as part of the
firm of the client), but are employed by contract (market). They operate as solo practitioners or, when
tasks require team coordination, in relatively small partnerships (65% of U.S.
lawyers operate in a solo practice or a firm of no more than five
lawyers). Though large law firms may
seem sizable, they pale in comparison to other businesses. Only one U.S. law firm had over 2000
attorneys in 2004, while Wal-Mart had 1.1 million employees, General Motors had
321,000 and Citigroup – 259,000.
So why
does Wal-Mart employ so many people? Why
does it not move more of its operations into the market, such as shutting its
stores and contracting with independent storeowners to sell Wal-Mart
products? Coase’s insights seems to
provide a good explanation: Cashiers, shelf-stockers and warehouse workers are
easier to monitor. It is relatively
simple to check if the shelves are stocked, or if the lines of customers in
front of the cashier move along with due speed.
At the same time, opportunism costs are high, because the complex
logistics of Wal-Mart require coordination between employees working at the
procurement department, the warehouses and the stores.
3. What
makes the firm different from a contract? (The firm as a nexus of contracts)
While
Coase’s insight is still regarded as the foundation of the economic analysis of
the firm, his work was challenged over the years. A particularly powerful criticism came from a
1972 article by Armen Alchian and Harold Demsetz. They posed a pointed question: why is a firm
any less susceptible to opportunism than a market transaction? In other words, how is the intra-firm
contract (between the firm and the employee) and less vulnerable to
opportunistic behavior than an inter-firm contract (a market-based contract
between a supplier and a customer)?
The
uniqueness of the firm, claimed Alchian and Demsetz, is not in having a
different type of contract, but in having a different type of organizational
structure. As we discussed earlier,
business activities require stakeholders (groups of people such as
stockholders, bondholders, employees, etc.) to make firm-specific
investments. But once they make these
investments they are vulnerable to opportunism by whoever of the other
stakeholders is in control of the firm (just as Alice became vulnerable to opportunism by Bob
after she advertised the boxing match).
Some of the stakeholders’ expectations can be protected from
opportunistic expropriation by contract, but even the lengthiest contract
cannot cover all possible contingencies.
Even without malicious intent, coordination between
a large number of different stakeholders is difficult. To assuage stakeholders’ concern
about opportunism and facilitate cooperation,
stakeholders may agree to deliver control
of the business process to an independent
third party that is not affiliated
with any of the stakeholders. To be effective, this third party must be:
(1) the central party common to all contracts
with the stakeholders (so that it would have the ability to direct each of the
stakeholders); (2) the owner of the
firm’s residual assets, that is the person
who keeps all remaining assets after paying
the stakeholders according to their
contracts (so that it would have the
incentive
to maximize the business activity’s
profits); and (3) able to observe and assess the input
providers’ behavior (so it would have the ability to minimize
agency costs).
This
third party may be a living person (for example, a general contractor in a
construction project), but the business activity would then be constrained by
the longevity and health of that person.
Instead, law creates a fictitious entity called the corporation (or the
partnership, or the LLC, etc.) to serve as that independent third person. Thus, under this view the corporation is a
nexus that connects all of the contracts with the stakeholders. Since the firm is a fictitious entity, it
hires people – the board of directors – to act on its behalf. This characteristic of the firm, as a nexus
of contracts, is what distinguishes it from market-based contracts in which no
common entity controls the stakeholders or has a residual interest.
4. Who
owns the firm?
The nexus of contracts
framework does not, in itself, inform
us who should act as the nexus – in other words, who should own
the firm. The owner
could either directly manage the
firm, or appoint agents (directors) who will be required to manage the firm for the benefit
of the owner. Note that ideally ownership
should include both the right to control the firm and
the right to the firm’s residual assets.
If the person controlling
the firm is not affected by an increase
or decrease in its assets, she will
have few incentives
to maximize profits (this goes back to the discussion
of agency costs, above).
The
likely candidates to own the firm are those who are involved
in its activities: the stakeholders. However, each type of stakeholders has inherent
conflicts of interest
in controlling the firm, since
each type benefits from a different management strategy.
Shareholders would prefer excessively risky investments, since
they receive the residual profits (which would be large if a high-risk,
high-reward investment succeeds), while their limited liability shields
them from most of the downside of
such an investment’s failure.
Conversely, creditors (such
as bondholders) would prefer
excessively conservative investments,
because they bear the downside of a
failed investment (which may result in
the company defaulting on its
debt), but they do not receive the
profits of a successful investment (other than
their fixed interest payments).
Employees, if they control
the firm, would prefer policies that increased
wages and employment, even
at the expense of
profitability. And
customers, if they controlled the
firm, would focus on lowering prices and
offering products that they need, even
at the cost of profitability. Thus, all
stakeholders are suspect in their
motives when they control the firm.
(a)
Shareholder supremacy norm
Who
should control the firm, then? The
approach that currently dominates American
corporate law is known as the Shareholder Supremacy Norm. This approach focuses on
the ability of each stakeholder to protect its interests
contractually. The easier it is to define a group’s legitimate expectations, to observe whether the expectations are realized, and
provide a remedy if they are not
realized – the less need the group
has to protect its interests through
control of the firm. Creditors have clearly defined expectations:
payment of a specified amount of principal
and interest
at specified times. Contractual remedies can
provide adequate protection against frustrating
these expectations. For example, creditors may secure the firm’s
obligations with collateral, have
priority over other stakeholders in
the dissolution of the firm, and impose a few limitations
as to the firms ability to undertake
risky ventures or to borrow more money.
Employees are in a slightly
less defensible position: their salary and
benefits can
be specified and receive priority in dissolution
(just like creditors), but another
important element of their expectations
– their working conditions
– is very hard to specify. In many
jobs one can
specify the number of hours of work
required, but not other factors of
working conditions such as the specific tasks an employee will do (managers
need some flexibility to reassign tasks) or how pleasant
their colleagues and supervisors
would be (shareholders and creditors
aren’t affected by the amicability
of their fellow group members). Thus,
the most important expectation of employees (their salary) can be reasonably
protected contractually, but other
important expectations are harder to protect through contract law.
But the class of stakeholders least able to protect their expectations is the shareholders. Shareholders’ main
expectation is to earn the firm’s profit after paying
the specified obligations (salaries,
debt, supplier credit, etc.). It is
impossible to assess how much these residual profits should be, since they depend
on the business’
success. Therefore, shareholders cannot contractually enforce
their expectation for profits. Also, as the owners
of the residual assets, any dollar
added to the assets of a solvent
firm is the shareholders’, and every
dollar taken out of the firm’s
assets is the shareholders’ loss.
Therefore, they are the first to be affected by any
action of the firm that impacts its
profits.
Because
shareholders are least able to protect their expectations by contract, the
shareholder supremacy norm asserts that they should control the firm, subject to
contractual obligations (e.g., employment contracts, terms of loans) imposed by
other stakeholders to protect their own expectations. A variance of this theory recognizes that
employees also find it difficult to protect their expectations contractually -
the corporate laws of many European countries (most notably, Germany) adopts the principle of
co-determination, under which both shareholders and employees nominate a firm’s
board of directors. While it is possible
to adopt a similar structure in corporations established under the laws of
American states, this structure is neither mandatory nor the default rule in
any U.S.
state.
Thus,
under the shareholder supremacy norm a firm is to be managed for the benefit
of its shareholders. One way of doing so is to have the firm
managed by its shareholders. As
we will see later in this course, this is the default rule in general
partnerships but not in corporations.
Proponents of the shareholder supremacy norm explain that most
corporations have too many shareholders to effectively manage the firm. AT&T, for example, had about 2.3 million
shareholders in 2005. This is clearly
too large a number of people to coordinate and manage a firm. To make management more efficient, the
default governance system in corporations is republican rather than democratic:
shareholders vote for directors, and the directors manage the company on their
behalf.
(b) Team
production theory
Some
scholars reject the shareholder supremacy norm,
and view the function of
the board of directors not as a body
representative of shareholders, but
as an arbitrator of stakeholder interests.
This line of scholarship, known as
the Team Production Theory, points out to the opportunism
that shareholders may inflict on other stakeholders, and
argues that this cost can be avoided
by placing control
of the firm in the hands of an
independent group – the firm’s board of directors. According
to this theory, stakeholders cannot trust each other, and
only by entrusting the management of the firm to an
independent group do all stakeholders have sufficient peace of mind
that their expectations would not be opportunistically
frustrated by other stakeholders. Proponents of
the team production theory are aware
that there are agency costs to having managers
who are not accountable to any
one group (since
they can play each group against the other to maximize their own independence and benefit
themselves). However, they claim that
there are already mechanisms to monitor the more egregious forms of expropriation of the firm’s assets by its managers (e.g., embezzlement,
seizing the firm’s opportunities, etc.).
As one scholar put it:
“[D]irectors can steal, but
directors cannot
steal much”.
(c) Hansmann’s Ownership of the Firm: Considering the costs of ownership
Henry Hansmann’s
work, Ownership
of the Firm, developed a theory of firm structure that harmonizes the shareholder supremacy and team production
approaches. Hansmann was
perplexed by the phenomenon of non-profit
organizations
participating in business
activities. The underpinnings of the shareholder supremacy theory were that an organization should be owned
by the group of stakeholders that is least able to protect its expectations by contract. Yet non-profit organizations have no
owner at all, even though they do have stakeholders (e.g., a non-profit
hospital has donors and perhaps lenders
that supply capital, employees, patients
and suppliers). How is it that none of the stakeholders captures the benefit of owning (i.e., controlling) the firm?
Hansmann’s reframed the way ownership
was seen. Rather than
considering
ownership as a benefit that is “auctioned”
to the stakeholders that most value it (usually the shareholders), he considered the cost of ownership
(vs. the cost of contracting with the firm).
Ownership entails costs.
One type is monitoring costs: the cost of becoming informed
of the firm’s activities, of communicating among
the group to reach decisions
collectively, and of enforcing
the group’s decisions on the firm’s employees.
Another cost of ownership
is the cost of bearing risk: ownership
includes the right to the firm’s
residual assets – the assets left after paying
all fixed obligations. As we explained
earlier, in a solvent firm residual assets are riskier than fixed obligations
in the same firm. Thus, one
must be willing to bear the cost of
greater risk to be the owner. Intuitively,
one can
see a manifestation of this cost in
the reluctance of some individuals to invest
savings that are critical to them,
such as pensions,
in the stock market (preferring bonds,
perhaps). For those individuals, the cost of ownership
is too high. The cost of bearing risk is not
just a matter of having a taste for
risk; more importantly, it has to do
with the ability to diversify. Suppose
that a firm has a 10% probability of going
bankrupt. A shareholder can
diversify her portfolio, and thus
reduce her risk, by dividing her investment
between ten
companies. One
may fail, but this loss would only
amount to 10% of her total investment
and would be mitigated by profits on the other nine investments. If she
had invested everything in one company,
there would be a 90% probability that she would not
lose at all, but a 10% probability that she would lose her entire savings. This is too great a risk for most people to
voluntarily bear. How well do other stakeholders bear
risk? Bondholders
can diversify by investing
in bonds
of many companies. Customers can
diversify in most cases (you can buy a can
of soft drink in many
places; if one store goes out of
business, you buy at another), but cannot diversify in
some cases (there may be only one airline
flying out of a small airport; if it
goes out of business, customers
would not be able to fly). Employees often
have the least ability to bear more risk of their employer’s failure, since they cannot diversify (e.g., work for ten firms at the same time).
5. Who
owns the firm? (Part II): Applying Hansmann’s
theory
Hansmann argued that the stakeholders that owned the firm were the ones
whose costs of ownership were the
lowest in comparison to their cost of contracting with the firm.
In the rare case that all
stakeholders found that the costs of
ownership exceed the costs of contracting,
the firm would have no owner – it would be a non-profit organization. Hansmann’s theory explains
why there are so many different types of business
entities (corporations, partnerships,
cooperatives, etc.), rather than
just one type of “firm”. Consider
below the application of his theory
to three different lines of business,
each of which is best organized in a different
type of firm: shareholder-owned,
customer-owned, and employee-owned.
(a) The
shareholder-owned firm
For
example, Wal-Mart has numerous
shareholders, bondholders, employees
and customers. Who should control
the firm? As we’ve analyzed above, shareholders have the highest cost of
contracting
(as opposed to owning), because their expectations
are hard to define contractually.
In contrast,
Wal-Mart customers and bondholders can
easily define their expectations from dealing
with Wal-Mart (respectively, receiving
a product at the advertised price, and
receiving specific interest payments
on specified date). Wal-Mart employees are more difficult to
classify. Some of their most important expectations
– their salary and their hours of
work – are easy to define and enforce
by contract. On
the other hand, they have no ability to define
and protect by contract their work environment;
for example, today’s accommodating
supervisor may be replaced by a mean-spirited
boss.
Now let’s
consider the costs of ownership.
First, monitoring costs: All of the groups above are numerous, and
therefore the cost of joint-decision making
would be equally large for all groups.
Employees and customers know more about their specific Wal-Mart store than shareholders or bondholders,
but any employee (or customer) sees
only a small portion of the extensive
business that Wal-Mart does, so the
informational
advantage may not
be significant. Finally,
Employees have a slight advantage
over other stakeholders in enforcing
their collective decision on the firm, since
they are the ones executing the actions
of the firm. However, this advantage would be more significant when
supervising professionals than
supervising tasks such as stocking shelves or working
as a cashier. Since
the latter tasks are easily observable and
their performance is easily
measurable, in this case non-employees
can supervise the employees almost
as effectively as the employees would supervise themselves.
We are
left with the other cost of ownership
– risk. Wal-Mart has numerous shareholders (and
bondholders), most of whom invest in
other companies as well. If Wal-Mart becomes bankrupt,
they will lose a portion of their
portfolio, but not all of their
assets. In
contrast, employees have a much
higher cost of risk bearing: if they
own Wal-Mart and
Wal-Mart becomes bankrupt, they not only
lose their jobs (and income), but also their savings
(which have been invested in
the company). This would be too much of a risk; a prudent employee may want
to invest her money in
other companies, so that if she
loses her job, she does not also
lose her savings.
So what
are the pros and cons of each stakeholder group as owners?
Shareholders and employees
have the highest costs of contracting. Employees
have a lower cost of monitoring, but in
the Wal-Mart context this advantage is slight.
On the other hand, employees have a far higher cost of risk bearing than
shareholders. Thus, Hansmann’s framework suggests that shareholders should own Wal-Mart, and
the other stakeholders should protect their rights contractually. Indeed,
Wal-Mart is a corporation, and shareholder ownership
is the default form of corporation
governance.
(b) The
customer-owned firm
Now let’s
consider a different business:
The wholesale generation and
retail supply of electricity in a
rural area. There are many customers who need
electricity, but in rural areas
there are few power generators that
can supply electricity. Economies
of scale make it impractical for each electricity user to operate her own generator. It makes more sense
to have one large generator that produces and
then sells electricity to all
users. But if only
one seller exists, he will yield monopoly power over the customers, raising the price of electricity. And
if the local market is large enough
for more than one supplier, the supplier himself is risking opportunistic
behavior by the customers – once he
builds the plant, customers may demand to renegotiate
the prices, threatening to get their electricity elsewhere and strand
the supplier with the sunk cost of
building the plant. Thus, the
cost of contracting for rural electricity customers and the electricity generator
is much higher than the cost for a
Wal-Mart customer to buy soft drinks. Now let’s consider
the costs of ownership: Since there is only
one supplier of electricity, and that supplier purchases most of his inputs (e.g., coal or natural
gas from which electricity is produced) from a small number
of suppliers, monitoring costs are relatively low. In
addition, electricity customers tend to be homogeneous
– they all want the same “kind” of electricity (contrast
with different customers preferring different
products at Wal-Mart) and only one
“kind” of electricity is produced,
with the same standard voltage. This too makes monitoring easier than
in a firm that produces numerous different
products, and the homogeneity among
customer preferences lowers the cost
of collective decision making. Finally, the cost of risk bearing:
this factor works against customers,
and in
favor of shareholders. Like the Wal-Mart
employees, the rural users of electricity will suffer a significant
loss if their only supplier of
electricity fails. They will be reluctant to exacerbate this loss with a loss of their investment
in the electricity supplier.
What are
the pros and cons of each group in
the case of the rural electricity wholesaler?
The costs of contracting are highest for the customers, who would have to
pay monopoly prices to the sole
supplier. To avoid this cost, they can own the
supplier and charge themselves only the cost of producing
the electricity without the monopolistic
mark-up. Customers monitoring
costs are relatively low because customer preferences
in this case are homogenous. The
cost of bearing risk is higher for
customers than for shareholders, but
this factor is of lesser importance
in low-risk industries,
where demand is stable and predictable.
So, our
framework suggests that we would see firms owned
by customers in the business of generating and
supplying electricity in small markets.
Unsurprisingly, many
firms in this field are not ordinary
corporations but cooperatives
(“co-ops”), which are owned by their
customers (the retail users of electricity).
Co-ops are also prevalent in other markets with similar characteristics, such
as grocery wholesaling (14% of the industry) and
hardware wholesaling (50% of the industry).
(c) The
employee-owned firm
Finally, consider the business
of providing legal services. The cost of contracting between
employees (lawyers) and the firm is
high, for two reasons: (1) much of
the knowledge that the lawyers
accumulate is firm-specific (e.g., knowledge
of the firm’s clients and the history of the specific cases that the firm
handles). If a lawyer leaves the firm and works for another,
she will have other clients and cases and
this knowledge, which she invested time to acquired, would be useless to
her. This firm-specific investment
makes the lawyer vulnerable to
opportunism. (2) it is more difficult to evaluate the
effort and quality of a lawyer’s
work than that of, say, a cashier at
Wal-Mart, because casual observation
of the lawyer typing a brief or contract does not
tell much of the quality of the work, and
the objective outcome of the lawyer’s work (e.g., winning a
trial) depends heavily on factors other than
the lawyer’s effort. Therefore, the cost
for the firm and the lawyers to contract is high.
What about the costs of ownership? Monitoring professionals
is costly, but a professional is
best monitored by another professional,
who can evaluate her work. Thus, lawyers would be monitored more
effectively by themselves than by another stakeholder group, which does not have the expertise to evaluate the lawyers’
work. Also, lawyers tend to have homogeneous
preferences, because they perform
the same tasks. This lowers their costs
of forming decisions within
the group. The final
criteria – the cost of risk bearing
– once again
works in favor of shareholders and against
employees. This may explain why worker-owned
firms tend to exist in industries
in which business risk is lower.
In the supply of legal services, our framework indicated that employees have very high costs of contracting,
and they have lower costs of monitoring
than other stakeholders. Thus, we’d expect the lawyers to own the firm in
which they work. Indeed,
this is the typical structure of the law firm – the partners
are both employees of the firm and
its owners.
6. Conclusion
Throughout
this course we will study several forms of business entities that serve as
alternatives to the corporation: the sole proprietorship, general partnership,
limited partnership, limited liability partnership, limited liability company,
business trust and the cooperative. Our
focus will be on the legal characteristics of each. However, to understand why each entity is
structured the way that it is, keep asking yourself how each entity reduces the
transaction costs of doing business as compared with transacting via the
market, and as compared with transacting via another type of business entity.