Property rights and traditional industrial organization theory and policy

Traditional industrial organization theory and policy is based on the neoclassical model of the firm as a pure profit maximizing entity. The model underlying traditional industrial organization policy thus assumes complete and enforceable private rights to all firms, with no agency problems, regardless of the market structure within which the firm operates. The structural distinction among markets is determined according to whether those rights accrue to larger or smaller numbers of firms or owners. A larger share of available rights may be appropri- ated through efficiencies, such as by innovating, differentiating one’s product, capturing available scale or scope economies via merger or minimizing transactions costs. Alternatively, it is possible to think of the quest for market power as a strategy by a firm or owner to appro- priate a larger share of available property rights in the long run.

Bull and Ordover (1987) provide an example of the way that organi- zational structure can affect market structure in the context of the neo- classical model of profit maximization with no agency problem. They conceive of the neoclassical firm as a system of managers whose role is to screen projects. They find that in the circumstances where rejected projects are not revealed and may be continued to be considered  by other firms, competition produces social waste and is therefore less effi- cient than a monopolistic market structure. These circumstances essen- tially define a situation of market failure (externality) where monopoly structure permits a more complete appropriation of rights than does a competitive structure. This situation is similar to the familiar common property market failure where a lack of appropriability results in less efficiency under a competitive market structure than under monopoly. It is clear that fully defined and enforceable property rights are important to the implications of the traditional industrial organization model where perfectly competitive markets are efficient and, therefore, to policies based on this model. Property rights structures that exist in corporations, public sector bureaus, and nonprofit organizations vary considerably from the fully defined property rights structure that is critical to the industrial organization SCP and other structural models. Consider now the effects of variations in the property rights structures on industrial organization theory and policy.

In the corporate form of for-profit organization,  shareholders  have legal residual rights and managers have legal control rights.  In  the absence of perfect agency, corporate managers have economic property rights. They are in a position to expropriate at least some part of share- holders’ residual rights as they maximize their own utility.  This  may occur even when managerial compensation consists in part of corporate shares or stock options and managerial incentives appear to be aligned with the interests of shareholders. In this model, managers are predicted to increase their own utility rather than maximizing shareholder prof- its by making decisions that increase managerial authority or power, prestige, income, and discretionary profit.

Accordingly, utility maximizing corporate managers would be expected to promote firm growth beyond the profit maximizing level. Managers may accomplish this in a number of ways. One way is to take on projects with a high level of risk, spreading the risk across share- holders. This may result from using a larger than optimal level of debt financing or from choosing a larger than optimal number of projects so that the net marginal return to shareholders is reduced. A second way managers may promote firm growth is through mergers. Mergers may increase managerial discretionary profit through efficiencies such as real economies of scale or scope, or by reducing transactions costs, or through pecuniary economies that redistribute costs to other firms. Managerial discretionary profit is increased because only part of the cost savings is passed through to shareholders.

Utility maximizing managers with economic property rights have an incentive to increase corporate size and alter industry structure. Under this rights structure, utility maximizing behavior by managers can have the effect of altering industry structure without evident changes in firm behavior or performance because neither prices nor shareholder prof- itability may be significantly affected. The differences may arise in the unobservable values of managerial discretionary profit. Thus property rights provides a basis for the X-inefficiency predicted by Leibenstein (1966). Traditional industrial organization theories and policies which evaluate firm efficiency on the basis of structural changes on cost, price, and profit effects may therefore yield incorrect predictions and actions regarding allocation of resources through the corporate based market system.

Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.

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