Law

Corporate Governance Economic Views of Corporate Governance An outsider to the field of economics would probably take it for granted that economists have a highly developed theory of the firm. After all, firms are engines of growth of modern capitalistic economies, and so economists must surely have fairly sophisticated views of how they behave. In fact, little could be further from the truth. Oliver Hart Firms are such a pervasive element of the economy that to ask ‘why are there firms?’ may appear an odd, even superfluous, question. And yet, given that the dominant economic view has been that resources are allocated according to the price mechanism, the existence of organisations begins to appear as something of mystery. A standard response has been to point to technological requirements, such as the efficiency of a certain scale of production or of a certain rate of production that could not be achieved without the long-term contracts, hierarchy, management, coordination, etc. associated with the firm. (In the previous session, for example, we spoke in very general terms about the efficiencies and power of concentrations of capital, without being explicit about how this might operate in practice.) Other economists, however, have pointed out that the same ends could be achieved by independent short-term contractors, with management services also being bought in as required. Such realisations give new prominence to the question of why firms exist. For those of us who are interested in corporate governance, the answer provided to this question by economists is significant because it will have an impact on the actors who are regarded as integral to the firm, the nature of their relationship with it and ultimately what role if any that they will have in its governance. The notes below are based on the readings set for this meeting of the class. Page references relate to the versions of these readings (with the exception of that by Williamson) collected in Louis Putterman & Randall S. Kroszner (1996) The Economic Nature of the Firm: A Reader (Second Edition) Cambridge: Cambridge University Press. Ronald Coase, ‘The nature of the firm’ The basic observation upon which Coase’s work proceeds is that the market and the organisation are essentially alternative methods of coordinating production. If standard microeconomic theory holds that in the market production is coordinated by the price mechanism, the question arises as to why organisations emerge that essentially supersede the price mechanism. Indeed, it is this characteristic that Coase regards as the ‘distinguishing mark of the firm’ (p91). The thrust of this seminal paper is then to explain the choice between the alternative coordinating mechanisms. Having dismissed such basic suggestions as that firms might emerge because individuals prefer to be directed than to contract independently on a continuous basis or because people prefer to direct others, Coase observes that ‘[t]he main reason why it is profitable to establish a firm would seem to be

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that there is a cost of using the price mechanism’ (p93). Thus, in place of the need to discover the price for every single transaction among a number of factors of production, each factor enters into a contract whereby he agrees, in return for a certain remuneration, ‘to obey the directions of an entrepreneur within certain limits’ (p93). Similarly, as regards the supply of goods or especially services, a long-term contract will reduce the costs associated with a series of short-term contracts. Given the desire of the purchaser in such circumstances to achieve a degree of certainty over the longer term, such an arrangement may ultimately take the form of a contract where a high degree of direction is afforded the purchaser vis-à-vis the supplier, at which point Coase suggests that a firm has emerged. While he does not believe that such additional factors as the existence of sales taxes on market transactions as compared with intra-firm transactions can explain the emergence of firms, they would seem to encourage the growth of firms (pp94-5). For Coase, therefore, a firm ‘consists of a system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur’ (p95). A key advantage of this approach is that it allows one to examine the question of why a firm gets larger or smaller – why, in the ultimate, it is the size it is. Insofar as it is possible to point to the costs associated with market exchange giving rise to the emergence of firms, the question then arises as to why all transactions are not ultimately organised by the entrepreneur rather than being subject to the price mechanism. Coase offers three possible reasons (which may in reality operate in combination):

• a point is reached where the cost of organising the additional transaction is greater than the cost of leaving it to the market;

• the increasing number of transactions to be organised means that a point is reached where the entrepreneur is no longer able to deploy resources most efficiently and where an open market transaction is preferable;

• the supply cost of a factor may rise due to the expansion of the firm, the lower initial cost having been influenced by the smaller size of the firm (p96).

After then dealing with some further details and indicating the shortcomings of certain alternative accounts of the emergence of firms, Coase checks to see whether his account matches reality. By looking at the nature of the legal relationship between employer and employee, he finds that it is indeed the ‘fact of direction which is the essence’ of the relationship (p104). In other words, it is this fact that distinguishes a contract of service (or employment) from a contract for services (a market transaction). Satisfied that the theory is realistic, Coase emphasises that the ‘question always is, will it pay to bring an extra exchange transaction under the organizing authority?’ (p104). The manager will accordingly continually experiment, producing an equilibrium between market and organisation.

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Armen Alchian & Harold Demsetz, ‘Production, information costs, and economic organization’ These authors begin by contesting the basic observation made by Coase that the distinguishing characteristic of the firm is the fact of direction, the ability of the employer to direct the employee. For Alchian and Demsetz there is no difference between the way in which power is exercised in the firm and in the market – the withholding of future business or resort to the courts for redress. The question then again becomes one of explaining why firms emerge, of where the difference lies between organisation and market. For them, it ‘is in a team use of inputs and a centralized position of some party in the contractual arrangements of all other inputs’ (p194). This shifts the question to one of explaining what a team process is and why it leads to the emergence of the firm. They describe the fundamental problem of efficient economic organisation as ‘the metering problem’ (p194), in other words, the problem of ensuring that rewards are appropriately related to productivity. Whereas classical economics assumes that productivity automatically creates reward, Alchian and Demsetz propose that the causal relationship is actually reversed. In other words, it is the precise system of reward which produces a given level of productivity. The quality of the system by which productivity is metered or monitored is therefore crucial for efficiency. For them, what makes metering difficult and thus what leads to a search for means to reduce the costs of metering is team production. Team production arises where the output produced by a team from several types of resources is more than would have been produced by the sum of the separable inputs of each team member and where the difference is sufficient to cover the cost of organising the team. It is this situation which gives rise to metering costs. If it were simply a matter of summing the separable inputs, each input could be measured and rewarded accordingly. But how does one detect an individual’s contribution to team production? One way is to observe individual behaviour. But this has costs and results in a degree of viable shirking – i.e. the amount which it is cheaper to ignore. Competition for places from individuals offering lower costs or greater rewards is an alternative – but this assumes a high level of information for the outsiders. The authors thus examine the classical firm and suggest that an individual can be assigned the function of specialist monitor. The danger that he in turn may shirk can be addressed by paying him the net earnings of the team, by making him, in other words, the residual claimant. But the task of the monitor is a complex one and he thus must enjoy an entire bundle of rights:

1. to be a residual claimant 2. to observe input behaviour 3. to be the central party common to all contracts with inputs 4. to alter the membership of the team 5. to sell these rights (p201).

Alchian and Demsetz assert that the ‘coalescing of these rights has arisen…because it resolves the shirking-information problem of team production better than does the noncentralized contractual arrangement’ (i.e.

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the market) (p201). There is thus nothing distinctive about the contracts which link team members to the owner. The authors then go on to apply their analysis to a number of different organisations, but we are most interested in their treatment of the corporation. The complication introduced by the corporation is that ownership may be very diversified, with a large number of shareholders all owning a small fraction of the firm. In such circumstances, the cost for any one shareholder of informing him or herself about every decision is likely to be higher than the loss incurred by a bad decision. Accordingly, decision making authority is transferred to a smaller group of managers with the shareholders retaining ‘the authority to revise the membership of the management group and over major decisions that affect the structure of the corporation or its dissolution’ (p207). As a result of this arrangement, any individual has the right to sell his or her shares rather than have to accept decisions with which they do not agree and which they are unable individually to influence. Alchian and Demsetz thus provide an account of the market for corporate control. The existence of other groups of would-be external or internal managers and a market for shares means that diversified holdings can ‘congeal’ into temporary blocs in order to displace the existing management. Alchian and Demsetz see these features of corporate structure as having emerged as a result of the ‘problem of delegated authority to manager- monitors’ (p208). Their analysis confirms owners as residual claimants (p212) and identifies the firm as ‘a highly specialized surrogate market’ (p214). Eugene Fama, ‘Agency problems and the theory of the firm’ Fama recognises Alchian and Demsetz’s ‘striking insight’ in seeing the firm as a set of contracts between factors of production, but does not believe that their analysis is capable of explaining the large modern corporation where ownership and control are separated so radically as there between shareholders and directors – despite Alchian and Demsetz’s efforts in this direction. His thesis is that separation of ‘ownership and control can be explained as an efficient form of economic organization within the ‘set of contracts’ perspective. More radically still, he states that:

ownership of capital should not be confused with ownership of the firm. Each factor in a firm is owned by somebody. The firm is just the set of contracts covering the way inputs are joined to create outputs and the way receipts from outputs are shared among inputs. In this ‘nexus of contracts’ perspective, ownership of the firm is an irrelevant concept. Dispelling the tenacious notion that a firm is owned by its security holders [i.e. shareholders] is important because it is a first step towards understanding that control over a firm’s decisions is not necessarily the province of security holders (p304).

Fama wants to develop ‘a perspective on management and risk-bearing as separate factors of production, each faced with a market for its services that provides alternative opportunities and, in the case of management, incentive towards performance’ (p304).

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While shareholders, as risk-bearers, will act optimally insofar as they spread the risk by investing in a portfolio of shares, the manager invests his human capital in one firm. Accordingly, while an individual shareholder may not have much interest in the oversight of the running of a given firm, he will have an interest in an efficient capital market which accurately reflects the risk he has undertaken as well as any rewards (or losses) that ought to accrue to him as a result of his investment decision. The signals thus produced by the capital market with regard to the value of a firm’s shares ‘are likely to be important for the managerial labor market’s revaluations of the firm’s management’ (p305). That said, Fama’s main question remains to be answered: ‘[t]o what extent can the signals provided by the managerial labor market and the capital market…discipline managers?’ (p305-306). He demonstrates that the former does exert many pressures on the firm to ‘sort and compensate managers according to performance’ (p306), but it does not answer the question as to how managers are to be disciplined. This task is allocated to the board of directors, the question then being how this ought best to be constructed. Because of diversified ownership of shares, shareholder domination of the board does not appear to offer effective oversight. Management themselves have an incentive to ensure that the firm is well-run in order to send the right signals to the managerial labor market and thus are prima facie candidates for positions on the board. They may, however, but may equally engage in expropriation and thus there is a need for some check on their behaviour. Accordingly, boards also contain outside directors who ‘stimulate and oversee the competition among the firm’s top managers’ (p307). ‘The role of the board in this framework is to provide a relatively low-cost mechanism for replacing or reordering top managers; lower cost, for example, than the mechanism provided by an outside takeover’ (p308). In contrast, therefore, to Alchian and Demsetz, Fama rejects the allocation of the role of disciplining managers to the shareholders as risk-bearers.

The viability of the large corporation with diffuse security ownership is better explained in terms of a model where the primary disciplining of managers comes through managerial labor markets, both within and outside the firm, with assistance from the panoply of internal and external monitoring devices that evolve to stimulate the ongoing efficiency of the corporate form, and with the market for outside takeovers providing discipline of last resort. (p308)

Michael Jensen and William Meckling, ‘Theory of the firm: managerial behavior, agency costs, and ownership structure’ In this ambitious paper, the authors seek to make advances along a number of fronts in the theory of the firm. Their precise focus is upon the ‘behavioral implications of the property rights specified in the contracts between the owners and managers of the firm’ (p318) which means that they are concerned among other things with the question of agency costs as between owners and managers and with the nature of the firm as a ‘nexus of contracts’.

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In the owner-manager relationship, agency costs arise because, assuming both parties to be utility maximizers, it is likely that the manager, or agent, will not always act in the best interests of the owner, or principal. These costs, therefore, are the sum of:

1. the monitoring expenditures by the principal 2. the bonding expenditures by the agent (i.e. costs incurred by the agent

to guarantee that he will not act so as to harm the principal) 3. the residual loss (i.e. the cost arising from the divergence between the

decisions taken by the agent and the decisions which would maximize the principal’s utility).

For Jensen and Meckling, ‘an explanation of why and how the agency costs generated by the corporate form are born leads to a theory of the ownership (or capital) structure of the firm’ (p319). In contrast to the general literature in this area, they assume that owners and managers solve these agency problems and they investigate the ‘incentives faced by each of the parties and the elements entering in to the determination of the equilibrium contractual form’ of the relationship between manager and owner (p320). Particularly interesting for us in Jensen and Meckling’s paper is their definition of the firm. They locate themselves in the literature stretching from Coase to Alchian and Demsetz, but they regard the focus of the latter as too narrow. In particular, they insist that ‘[c]ontractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, etc.’ (p320). Unlike Alchian and Demsetz, however, who focus only on the costs associated with team production, Jensen and Meckling note that agency costs and monitoring problems exist for all of these contracts. They thus stress that the firm is only a ‘legal fiction which serves as a nexus for contracting relationships and which is also characterized by the existence of divisible residual claims on the assets and cash flows of the organization which can generally be sold without permission of the other contracting individuals’ (p321). Consequently, they see little point in trying to establish what is inside and what is outside the firm. There is only a set of contracts between the firm and the owners of the material, human and capital inputs and consumers of the firm’s outputs. This ‘nexus of contracts’ perspective also makes questions of the firm’s objective function or of its social responsibility irrelevant – or at least no more relevant than they would be to the operation of a market, which is essentially how Jensen and Meckling view the firm. Without going into the more detailed analysis conducted by Jensen and Meckling, it is possible to see that their approach focuses attention on the nature of the contracts that arise for a particular organization, their consequences and the effects of changes ‘exogenous to the organization’ (p321). While they particularly focus on these questions with respect to the relationship between shareholders and managers and thus are frequently cited in support of understandings of the firm and of corporate governance emphasising shareholder value, the market for corporate control, etc., it is useful to bear in mind their insistence on the pervasiveness of the problems of agency and monitoring across all the contractual relations that characterise the firm. If we extend the investigation to those other contractual relationships, will the model of governance change?

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Eugene Fama & Michael Jensen, ‘Organizational forms and investment decisions’ This paper, dealing with a more specific question, is nevertheless within the same stream of literature. Its significance for us is in its focus on the relationship between organisational form and decision-making processes. In the case of what the authors describe as the open corporation (that is, a corporation where ownership and control are separate and whose shares may be freely traded) most shareholders ‘have no direct role in the decision process’ and have interests that conflict with those of the managers. Accordingly, agency problems arise and so, in making investment decisions, shareholders will consider the ‘decision control process’ (p337). The authors state that ‘maximizing market value involves extending decision control mechanisms to the point where the incremental market value of improved decisions is just offset by the market value of the cost of improved decision control’ (p337). Again, therefore, economic analysis justifies a focus on the relationship between shareholders and managers when it comes to corporate governance. But again, since the authors state that their analysis is ‘applicable to all decisions’, the question is raised as to whether a more extensive analysis would yield a different view of corporate governance. Harold Demsetz, ‘The Structure of Ownership and the Theory of the Firm’ This author makes a number of interesting modifications to the debate as it had developed up to this point. His focus is particularly upon the issue of consumption on the job by managers – the issue that becomes the agency problem in the context of the separation of ownership and control and of the diversification of ownership. Demsetz is not convinced that this problem is greater in the latter context and suggests that even where firms are effectively producing goods for employee-consumers, it will be doing so efficiently. As regards the problem of shirking, Demsetz indicates that it can be reduced and all parties to the firm made better off ‘if the monitoring cost required to reduce shirking is less than the value of the resources consumed in shirking’ (p350). He continues ‘[p]resumably, shirking is reduced to its optimal level by various pressures from within and outside the firm’ (p350). The amount that an individual is paid will be reduced by an amount reflecting on the job consumption, with the reduction being greater in firms where the cost of monitoring is higher. Demsetz’s point therefore is that in any situation it is the firm and not those who work for it that bears the cost of monitoring – their total compensation (including pay and on the job consumption) will be the same whether they work for a firm with high cost or with low cost monitoring, only the fractions of each component will change. In choosing a particular form of business organisation, therefore, the firm must check to see whether higher cost monitoring will also lead to reductions in other costs such that the higher cost monitoring is worthwhile. From the corporate governance perspective, therefore, Demsetz’s insights focus attention on the cost of any particular governance arrangement, and

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especially upon its impact on costs beyond those it is immediately concerned with controlling. He does this by indicating the extent to which any arrangement does not have an impact upon the total compensation of, say, the managers whom previous authors have focused upon in terms of the agency problem. Once the overall cost of any governance arrangement (in terms of its effects beyond those it is aimed at achieving) is an issue, a broader range of governance arrangements should be considered in order to discover which is optimal for the firm as a whole. Oliver Hart, ‘An economist’s perspective on the theory of the firm’ Hart’s motivation is a concern with certain shortcomings he perceives in the transaction cost economics approach to the firm. He takes instead a property rights approach to the firm, which focuses attention on the physical or nonhuman assets of the firm. Whereas the TCE approach emphasises the importance of authority within the firm over the price mechanism of the market, Hart points out that it is not clear on the basis of the TCE approach alone what the advantage of the manager is over the independent contractor and thus of the firm over the market. He states instead that ‘[I]n a world of transaction costs and incomplete contracts, ex post residual rights of control will be important because, through their influence on asset usage, they will affect ex post bargaining power and the division of ex post surplus in a relationship’ (p356). Hart is thus able to show that the firm offers advantages over the market to the extent that the owner of an asset has residual rights of control over them and hence the right to withdraw them from employees if their work is unsatisfactory. The employee therefore has more of an incentive to work more efficiently for the owner of the assets he requires to complement his labour input than he does for someone who does not own the assets he requires to complement his labour input. Not only, therefore, does the property rights approach have something to say about the location of the boundaries of the firm vis-à-vis the market, but it also explains why ownership of physical assets leads to control over human assets. It might be thought, accordingly, that Hart’s approach provides an explanation for the priority of shareholders in corporate governance arrangements and the relatively weak position of employees. Shareholders after all own the physical assets of the firm and possess some residual rights of control such as the right to replace directors. The difficulty that Hart acknowledges, however, is that the property rights approach cannot easily accommodate the fact of the separation of ownership and control and the consequent delegation of control to managers. He is nevertheless hopeful that this can eventually be done. Oliver Williamson ‘Corporate Governance’ This author is concerned to know why it is that those who provide capital, the shareholders, both own and control the firm. His argument is that redeployable (i.e. non-specific) assets can be financed by debt, but that specialized and intangible assets must be financed by equity. This is because the former can be transferred to other uses without cost, whereas the latter are bound up with the specific business of the firm and cannot be redeployed

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without cost. Shareholders, of course, provide capital without any guarantee of a return but with a claim to profits after all other costs have been covered. Williamson makes the point that while members of other constituencies are able to protect their positions through contracts (or through the exercise of political power) all of which can be revisited periodically, shareholders make a once for all investment which they cannot adjust periodically (short of outright sale). For this reason, shareholders require control rights over the firm by such mechanisms as the board of directors. While Williamson is thus able to point to reasons why other constituencies should not be represented on the board insofar as they have a direct influence on decisions through voting rights, he is not averse to their presence for informational purposes.

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