Variations in for-profit firms

There are a variety of forms of the for-profit firm. These include, of course, the perfect-agent single proprietorship or imperfect agent man- aged corporation, as described earlier. Here I consider the alternative for- profit organizational forms of the general partnership, the labor owned firm, and the consumer cooperative. The profit motive is common to all of these; however, the property rights structure and the form in which profit is distributed vary.

A general partnership is one form of employee-owned firm. In a general partnership, each partner is an investor (shareholder) and a contributing member and administrator (manager) of the firm. Each partner there- fore has both residual rights and control rights, typically in proportion to his or her invested capital. Total firm profits depend on the partici- pation of each partner. For each partner, the firm becomes essentially a common property resource with the associated incentive for free riding as a way to expropriate returns from the other partners. The agency problem therefore exists in a partnership as it does in a corporation. The agency problem may be mitigated, however, by the presence (and there- fore the monitoring) of other partners.

Under this property rights structure a partnership is more likely to occur and be an efficient form of organization when the preferences of the individual partners are more closely aligned and when monitoring costs are low (Fama and Jensen, 1983a). These conditions arise among small groups of members of a  profession,  such  as  accounting,  health care services, and legal services, for example. Separation of ownership and control is absent or at least minimized in the small professional partnership. The  predicted  decision  behavior  of  general  partners  in a small partnership where professional interests are aligned would be similar to that of the perfect agency neoclassical firm.

In some partnerships there may be a large number of general partners. The expectation of free riding and associated monitoring costs increase in this situation. The internal structure of a large partnership may be designed in response to the higher monitoring costs, assigning control rights to a smaller group of general partners, such as those with longer tenure, referred to as senior partners. For example, large law firms min- imize monitoring costs through their use of regularly reported billable hours (an input measure) of its current and prospective partners. These are reviewed by senior partners who also determine the allocation of resources within the law firm. This creates an interesting situation of separation of ownership and control. For senior partners there is no separation of ownership and  control.  For  junior  partners,  however, there is significant separation of ownership and control, despite their being on the premises and apparently in a position to observe  and monitor the decision makers (that is, the senior partners).

The predicted behavior of a general partnership in this situation would be more like that of a managerial-type corporation subject to separation of ownership and control than that of a neoclassical firm characterized by perfect agency. In this case senior partners have all or most of the control rights; junior partners are more in the position of shareholders with residual rights but limited or no control rights. Senior partners, therefore, have economic property rights and may direct allocation of resources within the partnership to  promote  their own utility. For example, they may choose clients and cases and allocate staff assignments that increase their prestige and income relative to profit for the partnership as a whole. Such decisions by senior partners also add to the prestige and income of the partnership; however, the benefits to junior partners, while positive, would be less than propor- tionate to their invested capital shares because senior partners are in the position to expropriate some of those benefits to their own satisfaction. The ability of junior partners to monitor the managerial  behavior  of senior partners is limited due to the hierarchical nature of their rela- tionship within the partnership, however. Monitoring costs are high. Fama and Jensen (1983a) point out that because ‘the residual claims in a large professional partnership are not alienable, unfriendly outside takeovers are not possible. Inside takeovers by dissident partners are possible, however, because the managing boards of these organizations are elected by the partner-residual claimants’ (p. 317). Because of the inalienable rights associated with the large partnership, junior partners cannot sell their shares, as shareholders of a corporation may do, except by leaving the partnership. Even with elected board members, however, it is very costly for junior partners to attempt to take over management. Although the total profit of the partnership may be maximized by sen- ior partner decisions, the output of legal services would be provided at a higher than minimum cost as resources are diverted to increase utility of the senior partners relative to other partners in the firm.

The labor owned firm is another form of employee ownership. The labor owned firm differs from a partnership in that labor has residual rights but does not have control rights. The employees (labor) as prin- cipals own shares of the firm and hire separate managers (as agents) who have legal control rights. In this type of firm the role of the man- ager as decision maker is the same as in the corporation: ostensibly to maximize the return to the employee owners.

An important difference between this situation and that of the corpo- ration (and a similarity to the general partnership) is that the employee shareholders are on the premises and are more able to observe the effects of managerial decisions. This has the effect of reducing the degree of separation of ownership from control and the associated agency prob- lem. If the manager’s compensation includes shares of the firm or stock options as well as salary, the property rights structure of a labor owned firm becomes more similar to that of a general partnership. If labor preferences are themselves closely aligned, then their increased ability to observe and monitor managerial decision behavior will mitigate managerial economic property rights. That is, the situation here would be more like that of a small general partnership where the interests of all partners (here labor and management) are aligned.

The rights structures will not be the same, however. Unlike partners of the same profession, in the labor owned firm the organizational posi- tion, the actual work done, and preferences of  labor  and  management will not be so closely aligned beyond the common factor of some degree of shareholding. The firm’s employees as shareholders may be in a posi- tion much like that of junior partners in a large general partnership. That is, they are shareholders because they are employees; the use of capital markets to discipline a manager is limited. This increases  monitoring costs to the employee-shareholders and correspondingly increases the degree of separation of ownership and control. The manager has eco- nomic property rights and is in the  position  to  expropriate  residual rights from the employees. This is more likely in large labor owned firms where employee interests are more variable and consequently less aligned. The managerial decisions could maximize profit for the firm but would produce output at a higher than minimum cost in order to pro- mote managerial preferences for staff and discretionary income.

Another form of the for-profit firm is the consumer cooperative. Consumer ownership is more common in wholesale and supply mar- kets in the US than in retail markets. In Western Europe, however, con- sumer ownership is more prevalent (Hansmann, 1996). In a consumer cooperative consumers have residual rights and the manager has control rights. Consumer-owners obtain their residual in the form of dividends and/or discounted prices.

The degree to which there is an agency problem in consumer coopera- tives, where the manager is able to expropriate some of the consumer- owners’ residual, is a priori unclear. A relatively low monitoring cost is consistent with frequent patronage of the cooperative by consumer- owners. If, however, a primary rationale for the existence of consumer cooperatives is as a means to counteract market power, as Hansmann (1996) suggests, then consumer-owners do not have access to information on which to evaluate their return via discounted prices, for competitive prices would be unavailable for comparison. This is not to say that consumer-owners do not receive their minimum required return,  only that they are not likely to receive the maximum residual possible. In terms of economic property rights held by the manager and the associated allo- cation of resources through the firm, the position of consumer-owners may be analogous to that of corporate shareholders with a minimum required profit with the important difference that the consumer-owners may not sell their shares. That is, the consumer-owners do not have the use of capital markets to discipline managerial decision behavior.

The predicted outcome for a consumer cooperative would be similar to that of the large general partnership or the labor owned firm where the manager has stock options. Assuming that the manager of the coop- erative is also a member of the cooperative, that is, a consumer-owner, he or she is in the position much like that of the senior partner or the manager of an employee owned firm who owns shares. The manager of the consumer cooperative therefore would be in a position to maximize his or her utility at the expense of  other  consumer-owners,  ensuring them their minimum return but not  a  maximum  return.  The  profit  of the cooperative may be maximized but again output is produced at a higher than minimum cost as managerial utility is increased through the diversion of resources to increase managerial benefits, such as discre- tionary profit.

There are international variations in firm organization also. The greater tendency toward consumer cooperatives in Western Europe relative to the US has already been noted.1 Other international variations in firm organization and behavior exist as well. Carpenter and Rondi (2000, 2001) point out specific characteristics of firm and industry structure in Italy. In particular, they show that even mature Italian firms tend to be small and tightly controlled, usually by family members. The corporate firm structure in Italy therefore differs significantly from that of the cor- porate structure in the US examined in Chapter 5. There is effectively little or no separation of ownership and control in Italian firms, so that owners have full residual and control rights.

Carpenter and Rondi also note the importance of an alternative orga- nizational structure in Italian industries: that of the pyramidical group. In the pyramidical structure the group is headed by a parent company with a controlling equity stake in the other firms in the group. Unlike the holding company-subsidiary form more common in the US, the firms in  the  Italian  pyramidical  group  remain  legally  independent. In the constrained financial markets of the Italian economy, the pyra- midical group provides a means of financing investments that other- wise would be unavailable to the small Italian firms in the group.

The pyramidical group presents a source of agency problems,  how- ever. This structure results in the separation of ownership and control, in which controlling shareholders  in  the  head  or  parent  firm  are  able to expropriate residual from the minority shareholders. Controlling shareholders are able to do this through the economic property rights that these shareholders obtain through their control over investment financing decisions to members of the pyramidical group. These share- holders are therefore in the position to direct financing to firms for investments that may provide nonpecuniary benefits to the funding decision maker(s) rather than maximize shareholder residual (Carpenter and Rondi, 2000, pp. 369–70).

In many countries, independent firms may also form a business alliance or joint venture to take advantage of potential economies of scale or scope for a particular project or venture. These may be long term or short term alliances and may be either domestic or international in scope. For example, business alliances include those between US airlines for ticketing and marketing services and those between US and European or Asian automobile manufacturing firms, such as where a European or Asian firm operates a manufacturing plant in the US. Buckley and Casson (1996) note that some areas of firms’ activities, such as those related to production and input supply, technology, and research and development, are more likely to provide a basis for joint ventures. These firms (and their shareholders) share residual rights related to the alliance from the specific projects but retain their individ- ual residual rights as well as control rights, such as limiting access of other firms in the alliance to specific firm proprietary information.

It is important to note two additional aspects of business alliances. One is that each firm in these alliances is a complex organization and is subject to the agency problems as depicted in the managerial model. The second, noted by Buckley and Casson (1996), is that ‘in comparing the behavior of large firms legally domiciled in different countries, dif- ferences in behavior are just as likely to reflect cultural differences in the attitudes of senior management as the influence of fiscal and regulatory environment of the home country. Cultural attitudes are certainly likely to dominate in respect of the disposition to co-operate with other firms’ (p. 425). I consider cultural issues and the way that they may affect model predictions more fully in Chapter 12.

A special type of alliance in the Japanese economy is the keiretsu. These are groups of related firms which may own minority shares in each other and may also include relationships with financial institu- tions. The keiretsu are characterized by long term business and personal or social relationships that exist among officers (that is, managers) of member firms and are encouraged among lower level employees as well. The social bonds inherent in the keiretsu promote an agency problem. The decision makers have control rights and, therefore, economic prop- erty rights through their ability to make investment decisions that pro- mote their own nonpecuniary (social) benefits rather than maximizing the residual return to shareholders. Inefficient investment decisions related to social bonds associated with the keiretsu became evident throughout the Japanese economy in the 1990s as managers of finan- cial institutions, loyal to their social relationships with managers of manufacturing firms, continued to provide financing for questionable investments.

Another international variation in firm property rights structure exists in a number of Western European countries, including Germany, Austria, the Netherlands, Denmark, Sweden, and France, based on the policy of codetermination. This policy is codified in law and requires the participation of labor in the management of the firm. The degree of required labor participation varies across the different countries. The effect in any case, however, is a change in the property rights system faced by the decision maker, for labor is included in the monitoring activities of the firm’s board of directors, as well as has an active role in management decisions. Pejovich (1990) summarizes the property rights implications of codetermination, stating: ‘The laws change the prevail- ing relationship between the shareholders, managers, employees, and labor unions. Consequently, they affect the location of decision-making powers, appropriability of rewards, and the relationship between risk taking and bearing of costs in labor participatory firms’ (p. 69). Pejovich concludes that codetermination increases inefficiency because it increases the separation between the decision maker and the individu- als who bear the risk from the decision.

Furubotn and Richter (2000) consider the decision by employees to invest in firm-specific human capital and the associated risk. On this basis they disagree with Pejovich, suggesting that codetermination pro- motes labor’s investment in firm-specific human capital by providing labor with a share in the returns from that investment. In their view the different rights structure associated with codetermination solves the agency problem between employees as investors and managers as deci- sion makers. Their analysis of employee risk bearing is consistent with the position taken by Garud and Shapira (1997) that employees are stakeholders in firms that are not subject to codetermination, such as in the US and Great Britain.

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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