W2: The Role of Economic Exchange in shaping the world. The rise of capitalism and firms.

Coase: The Nature of the Firm

‘Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur co-ordinator who directs production. It is clear that these are alternative methods of co-ordinating production. Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organisation at all, well might we ask, why is there any organisation?’

Coase, The Nature of the Firm

‘The operation of a market costs something and by forming an organisation and allowing some authority (an “entrepreneur”) to direct the resources, certain marketing costs are saved. The entrepreneur has to carry out his function at less cost, taking into account the fact that he may get factors of production at a lower price than the market transactions which he supersedes, because it is always possible to revert to the open market if he fails to do this.

Coase, The Nature of the Firm

The Origins of the firm in the UK

Government Charter was required to form private companies.

East India Trading Co. formed in 1600 and Royal Africa Company 1600 both formed to exploit the raw material wealth in Indian Empire and Africa respectively. In the form of goods in India and human slaves in Africa.

Central to the creation of these trading companies was the monopoly rights given to them by the UK parliament. With their own private armies and funded by subscription they were able enforced by the Navigations Act 1620.

The Navigations Act 1620 only permitted ships registered in Britain to trade with ports in different parts of the world, controlled by companies established by English parliament.

Hence the state and private market were inextricably linked from the beginning for the creation of the modern economy.

The Company of Scotland Trading to Africa and the Indies formed in 1695, more widely known as the Scottish Darien Company provides a further example. It’s aim was the development of a colony for trading with the Americas as a rival to the expansion of the English, Spanish and Portuguese trading empires. £500,000 invested in the failed venture in Panama. The near bankruptcy of the Scottish economy led directly to the Scottish Parliament’s vote in 1707 to become a partner in the larger and more established development of Empire through the Act of Union 1707.

The Bubble Act 1720, passed after the speculation in share dealing leading South Sea Company banned investors as shareholders.

Adam Smith in the Wealth of Nations 1776 encapsulated this fear:

“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 co-partnery frequently watch over their own.”

There were similar restrictions placed on the use of new technologies as they emerged. The first patent act is passed in 1538 allowing restriction on the use of a new technology for 14 years. But it is not until the 1830s that courts now ruled in favour of the inventor and new legislation.

After the Bubble Act it was not until the 1850s the existence of firms with sleeping partners or shareholders emerged. Prior to this firms relied upon the creation of partnerships. Small groups would come together to risk their own wealth in the purchase of a ship, a crew and a cargo to be sent abroad where goods could be sold and others purchased before moving to another report where the same process would take place until the ship and its latest cargo would return to the UK, goods and the ship sold and the crew disbanded. Allowing investors to retain their profits.

The temporary nature of these agreements acted to restrict the development of larger enterprises.

Not until 1852 Industrial and provident Societies Act were limited partnerships beginning to be legally permitted and this was expanded by further Act of 1865 and 1867. Only as late as Limited Partnerships Act 1907 was limited liability shareholding legislated to private partnerships.

Marginal revolution and the birth of neo-classical economics

Economic ideas that flow from these developments challenged the role of labour as the source of all value. Aldred Marshall’s Principles of Economics 1890 now identifies marginal analysis for the first time.

No longer is the value solely created by labour but now capital and, in Coase’s work entrepreneurship, now act as the source of value creation. The entrepreneur now incurred risk in establishing a company and their return for taking risk was they became the ‘residual claimant’ after all other costs were paid - residual profit or surplus value.

Value itself is now defined in relation to scarcity and the demand in the market, giving rise to marginal analysis e.g. marginal utility.

Now factors of production: labour, capital and entrepreneurship all contribute to value creation and the return to risk taking by the entrepreneur is the residual claimant - the individual who benefits from what is left after labour and capital are rewarded with their share of the value created.

Property rights: Institutions and the market

Property rights

When contemporary economies develop they take on a number of different forms. The management of these economies utilises various mechanisms, international trade regulation, internal competition policy, legislative structures and government functions. It is not automatically obvious why one mode is favoured rather than another.

Economics usually offers explanations based upon notions of costs and benefits.

Concern here is the exchange of rights over resources through exchange process - property rights.

When exchange takes place - usually accompanied by a physical object - the key change is not simply possession but rights of control.

An owner of property rights has the consent of others to act in a particular way to the assets the property rights are over.

Types of rights

Private rights: Sole rights over use of resource. But doesn’t mean that the persons rights are unconstrained. Landlord and tenant - tenant doesn’t have ownership rights restricting landlords access and use.

Communal rights: Rights as part of a community - graze stock on common land - enclosures and clearances of land were a mechanism for ending communal rights.

Collective rights: rights over a collectively owned asset whose use is collectively decided - horse ownership - decision on entering races may be taken by voting - individual members do not have unrestricted individual rights over use.

Properties of rights

Exchangeable rights: Not all rights are saleable - a tenant cannot re-sell the rights acquired for rent. Company shares provide exchangeable rights.

Alienable and inalienable rights: alienable rights are those which can be transferred - a manager can delegate responsibility without selling the rights. Inalienable rights are untransferable - due to the special knowledge or position - an employer cannot write an employment contract which puts an employee’s life in danger.

Exclusive rights: rights for use to the exclusion of others. The use of the asset must be restricted otherwise the market price would be zero.

Explanation for the capitalist firm comes from the suggestion that once these assets are combined - and the assumption is that all those who combine their assets have proprietorial rights over them - there may be an incentive for one or more of those people to shirk and allow the others to produce - how can these assets be combined without the loss of production from shirking?
Appointment of a monitor - the neo-classical school. Alchian and Demsetz - rights to the residual product - whereby the participants are rewarded by a contract and the monitor receives what is left - ensuring that firstly monitoring is undertaken efficiently and that the monitor is the residual claimant.

The problem of the form of the capitalist firm becomes a problem of co-ordination - an efficiency issue to ensure shirking is minimised.

Coase’s view was that monitoring is expensive and acquiring information is also expensive so that when internal monitoring is less expensive than carrying out transactions externally to the firm then the transaction will be internalised - again an efficiency driven model of the firm.

Monitoring and Principal/Agent theory

Issue is Principal and Agent.

Principal - the owner of property rights.

An Agent - those employed by the principal to undertake the tasks the principal wishes to be carried out.

The principal-agent relationship is an arrangement in which one entity legally appoints another to act on its behalf. In a principal-agent relationship, the agent acts on behalf of the principal and should not have a conflict of interest in carrying out the act. The relationship between the principal and the agent is called the “agency”, and the law of agency establishes guidelines for such a relationship.

• there should be no conflict of interest between the two. If there is, this creates a principal-agent problem.

• the principal agent relationship is expressed clearly through a written contract or is implied through one’s duties and actions.

• Agents have an obligation to perform tasks with a certain level of skill and care and may not intentionally or negligently complete the tasks in an improper manner.

Family control - Sainsbury didn’t have a non-family member on the board of directors until after 1940, the firm had begun in the 1870s, same is true of most early firms. Family control, only once they get too large or ownership becomes more diffuse does link between owners and managers become more indirect.

What stops the agent from simply ignoring the principals wishes and aims and instead feathering their own bed?

Issues of incentive structures, risk allocation and contracting

Share cropping: once slave ownership collapsed in Southern States of America cotton the large plantations, with overseers and large slave gangs broke up with ex-slaves instead renting small holdings from the ex-slave owners. The ex-slaves were unable to purchase the land or rent it due to lack of money so instead the method of payment used was sharecropping.

Sharecropping is a legal arrangement in which a landowner allows a tenant (sharecropper) to use the land in return for a share of the crops produced on the land.

A share (50%) of the cotton output was handed over to the landowner in payment of rent. In this way the original ex-slave owner didn’t require overseers to monitor since the sharecropper would carry out the work themselves. In reality the sharecropper was increasingly impoverished by this process due to the small-scale nature of the farming itself - they bore most of the risk since if the cotton crop failed - croppers share was often not enough to live on.

Agency relationship requires a contract to be drawn by the principal which encourages and rewards effort by the agent and protects the principal from what Williamson identifies as moral hazard and adverse selection.

First-best efficient contract. The idea that a contract can be identified which covers all eventualities and removes moral hazard and adverse selection.

Moral hazard is the term given by the occurrence shirking despite the best contracts. The only way to avoid moral hazard is not to contract at all. “Any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.” - Paul Krugman

Adverse selection is the term given to even in the environment of full knowledge the principal make the wrong decision and choose the incorrect agent. The idea being a case of individual getting run over even though they known how to cross the road safely. In economics the idea that information may be acquired by the agent in the process of completing the contract which permits them to have private information not revealed to the principal. When sellers have information that buyers do not have, or vice versa, about some aspect of product quality. Private knowledge of risk factors involved in the transaction can maximise outcomes, at the expense of the other party.

Observability and Information

Opportunities for shirking come in two forms:

Hidden action

Where contracts fail to specify mechanisms for measurement of performance there introduces mechanisms for shirking. Observability must be of a verifiable and valued kind - surveyor for a house to protect a homeowner from cowboy builders - has the job been carried out? Should they be rewarded - a householder may not have the expertise to judge and therefore has to employ additional expertise.

Hidden action refers to a situation where one party in a transaction or contract can take actions that are not observable by the other party, leading to potential inefficiencies and trust issues.

Manipulation of evaluation

How do you write contracts which specify outcomes - CEO’s have share options and bonuses based upon share price - leading to massive bonuses despite poor performance.

Contracts often tie rewards to observable outcomes such as share price, revenue growth and return on equity.

These are chosen because they are quantifiable and easy to monitor. But the issue is those metrics can be manipulated, or they may not reflect true performance.

In contract theory, when contracts are incomplete or rely on imperfect signals, agents may:

• focus on short-term gains that boost the share price rather than long-term health

• use accounting tricks or financial engineering to make performance appear stronger

• still receive massive bonuses, even if the firm’s underlying value or worker morale is deteriorating.

This creates misalignment between:

• principal’s goals (sustainable growth, firm value)

• agent’s incentives (hit performance targets, cash out)

Hidden Information

Agents may gain or already have information which is hidden from the principal. Walk off with customer base. Many employment contracts stipulate that you won’t work for a rival firm within one or two years.

Agents often have private information - before or during the contract - that the principal can’t observe.

• a salesperson knows the customer base better than the firm

• an employee plans to join a competitor and take clients with them

• a worker knows their true ability, motivation, or effort, but the firm doesn’t

Contracts include non-complete clauses, confidentiality agreements, and non-solicitation terms to try to protect the firm.

From a contract theory perspective:

• This is a classic case of adverse selection (hidden types) or moral hazard (hidden actions).

• The principal designs contracts that limit risk, even at the cost of flexibility or efficiency.

Increasing Observability

Agent knows that information may or may not be viewed to inspect outcomes. Call centres use of technology to monitor activities of agents. How many and how long were their toilet breaks. How many calls are answered per hour, how many key strokes on a keyboard take place?

None of this information tells us about quality of work but is used on the basis that any information is better than none. All of this however increases costs and can be prohibitive.

When performance is hard to measure, firms try to gather proxy data - even if it’s only loosely related to output.

• call centres track toilet breaks, calls per hour, keystrokes

• warehouse workers’ hand movements are monitored

• algorithms decide whether workers are efficient or lazy

From the principal-agent perspective:

• the agent knows they’re being monitored (partially) which can lead to strategic behaviour

• monitoring introduces discipline but also stress and gaming

• it also creates a false sense of control

Contracting

Threshold wage

The wage available elsewhere for agent to contract for principal. The point below which the worker would reject the contract.

First best outcome

Design a contract that ensures interests of principle and agents are one in the same and therefore shirking is unlikely and no need for monitoring. The most efficient outcome that would be achieved if there were no informal constraints, if the principal had complete information about the agent’s actions and preferences.

Second best outcome

Where cost of monitoring prohibitive - level of risk needs to be shared between agent and principle - share option schemes. The optimal contract that can be achieved when there are informal constraints, such as moral hazard or adverse selection. Contracts have to balance incentives and efficiency, acknowledging information problems. It’s about designing the best possible contract given real world limits.

Piece rate contract

evaluation of quantity at end of period. Avoided for complex processes but still used in sweated trades such as textiles industry where the technology is standardised and quality can be ascertained easily. Home working activities whereby the time taken to complete the task is not important as long as the task is completed.

Quality circles

Originating in Japanese manufacturing, encompassing not simply quantity evaluation but standards of output. This devolves control back to workers involved and faces hostility among managers as decision processes now reverts back to workers.

Who owns the firm?

Private ownership

Relatively simple but with joint stock firm where does control lie? owners both own and control the firm. Decision-making is simple due to the lack of separation.

When we move to joint-stock companies (public or large corporations), ownership and control become separated - this introduces complexity and a need for contractual governance mechanisms.

decision rights lie with senior managers - more complex contract specification is required to ensure principal agent problems do not emerge.

• shareholders own the firm, but they delegate decision making authority to senior managers

• managers hold the decision rights

• since managers might pursue their own interests rather than shareholder value, this gives rise to a classic principal-agent problem

• principal-agent problem: the principal can’t perfectly monitor or ensure that the agent acts in their best interest.

• to mitigate this, firms need complex contracts, performance incentives and monitoring systems.

Residual rights with shareholders - dividend payments and share price is the measure of success for the principal (shareholders).

Shareholders: Hold the residual claims on the firm’s profits - that is, they are entitled to what’s left after everyone else has been paid. Their return on investment comes in the form of dividends and capital gains.

This gives shareholders a strong interest in the firm’s long-term profitability and value. So, share price and dividends are typically seen as the main measures of success from their point of view.

Control rights less obvious - appointment of senior managers may require ratification by shareholders but they are alienable rights transferred to most senior managers.

Although shareholders are the owners, they usually do not excercise direct control over the firm’s operations. Instead their control rights are;

• indirect and limited, often excercised through:

  • voting and AGMs

  • appointing or removing board members

  • approving major deicsions

• in practice, many of these rights are delegated or alienable - especially in widely held firms (with many shareholders), control is effectively transferred to senior managers.

This makes the board of directors a crucial intermediary - meant to represent shareholder interests, monitor executives, and hold them accountable.

Neo-classical traditional view of the firm - shareholders - residual claimants are the shareholders.

• the firm is essentially a black box that turns inputs into outputs to maximise profit

• shareholders own the firm and have the residual claim on profits after all costs

• managers are agents hired to act in the interest of these principals (shareholders)

control and decision making authority are delegated, but in theory, aligned with shareholder interests through contract and performance incentives.

Managerial interest view - institutional stock holding - by 1930 49% of corporate wealth in the US was owned by the largest corporations - the residual claimants were the institutions themselves - managers had an independent role as principles in this process.

By the early 20th century, managers had become powerful principals themselves due to dispersed ownership and institutional investors.

This view recognises a divorce of ownership and control:

• by the 1930s, large corporations dominated, and ownership was spread across many small shareholders or institutional investors.

• Shareholders were too dispersed and disorganised to exercise real control.

• as a result, managers gained autonomy, effectively acting as principals, not just agents.

managers began:

• making strategic decisions independent of shareholder interests.

• pursuing their won goals, e.g. firm growth, job security

so even though shareholders were formally residual claimants, real control lay with corporate executives, leading to managerial capitalism.

This raised concerns about managerial slack, inefficiency, and weakened accountability - which led to later emphasis on governance reforms, incentive-based pay, and active institutional investors.

Entrepreneurship view - Again there is a divorce of ownership and control. There is a requirement to raise capital from capital markets by entrepreneurs. ‘Risk’ here may not have been financial for the principal but it was reputation and ability to raise further capital for the manager.

Entrepreneurs do not own all capital, but control it. Their main risks are reputation and future capital access, not always financial.

Here we focus on entrepreneurs who build and run firms but need to raise capital from external investors (shareholders or lenders)

• the ownership-control split is again central: entrepreneurs retain control, but relinquish ownership (at least partially) to access funding.

• the entrepreneur’s incentive is not always based on direct financial ownership, but on:

  • reputation in capital markets

  • ability to attract future funding

  • long-term vision and strategic autonomy

This introduces a broader definition of “risk”:

• financial risk is held by investors

• but entrepreneurial risk includes:

  • reputational damage

  • loss of credibility

  • failure to scale or innovate
    

Contractual incompleteness, dependency and control. Rents accrue to the residual claimant out of team activity. However, the creation of rents suggests that a conflict over their distribution may arise. Transaction specific resources may demand higher levels of payment for co-operation - under this view the firm may even be controlled by workers who extract greater shares of rents from managers in return for co-operation.
The firm is a nexus of incomplete contracts among parties with specific investments and bargaining power.

Under this more institutional and behavioural view:

• firms exist because markets can’t handle all contingencies - contracts are incomplete

• parties (workers, managers, investors) make transaction-specific investments that are valuable only within the firm (e.g., firm specific skills, relationships, technology)

• these investments create dependencies - making parties vulnerable unless they receive adequate returns.

control may shift toward the party with most bargaining power, or whose cooperation is most essential.

• in some cases, this could be workers - especially when:

  • their skills are hard to replace

  • their collective effort drives productivity

  • they can withhold cooperation or go on strike to demand better terms

so even if shareholders legally own the firm, power is fluid, and rents (extra profits) created by the team may be contested.