Notes

Outline

Moral hazard and monitoring. Moral hazard: the incentive to cheat in the absence of penalties for cheating. Origins in insurance. Another kind of “plasticity” of behavior after contract is signed. If monitoring is costly, agents have incentive to supply less effort than they agreed to. Alchian and Demsetz: costly monitoring explains the organization of the firm.

Moral hazard and monitoring. Marginal products of team members not separately measurable. Members paid on the basis of the whole team’s output. Incentive to shirk. Each member receives all the benefits of shirking (leisure) but can spread the costs of shirking to other members. Inefficiency. Since everyone has the same incentives, all shirk, and the team ends up in a low-output equilibrium no one wants.

Moral hazard and monitoring. Solution. One team member becomes the “boss” and specializes in monitoring the others. But who guards the guardian? “Boss” also becomes the owner — the residual claimant — and is monitored by the market. Did Chinese bargemen hire someone to whip them?

Separation of ownership and control. Big modern firms are not owner managed (as in Alchian and Demsetz story). Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property (1932). Separation of ownership and control. Managers “plunder” stockholders.

Agency theory. Divergence of interest between principal and agent.

Agency theory. Monitoring expenditures by the principal. Bonding expenditures by the agent. The residual loss of misaligned incentives.

Separation of ownership and control. Agency costs of separation small compared to increased capital supply. Risk diversification benefits of passive ownership. Modern corporation has mechanisms to reduce agency costs. Stock market. Takeover market. Managerial labor market. Expert boards.

Who owns the firm? Owners are those persons who share two formal rights: the right to control the firm and the right to appropriate the firm’s residual earnings. Formal not de facto rights. It is often efficient to assign the formal right of control to persons who are not in a position to exercise that right very effectively. Because giving those rights to others would create worse incentives. For example: why managers don’t have formal ownership rights.

Who owns the firm? Ownership falls to a class of patrons. Capital suppliers. Customers. Input suppliers. Workers. Government. No one (but non-profits have donors). All ownership structures are really coops.

Who owns the firm? Which patrons should own the firm? Balance the costs of contracting (with non-owning patrons) and the costs of ownership (for owning patrons).

Who owns the firm? Monopoly or monopsony. Example: bottleneck stage. Contractual lock-in. Relation-specific assets. Asymmetric information. One party has specialized knowledge that is costly to transmit to others.

Who owns the firm? Monitoring (agency) costs. All else equal, patrons who are least-cost monitors are most efficient owners. Collective decision-making. How to aggregate the interests of members of a patron class? Risk bearing. Which class in the best position to bear risk?

Who owns the firm? A “capitalists cooperative.” Because of asymmetric information, all other patrons have higher agency costs. Risk diversification benefits of investor ownership. Common denominator of profit reduces costs of decision-making.

Who owns the firm? Retail coops rare. Customers not homogeneous. Campus bookstores and monopoly. Most customer cooperatives are at the wholesale level. Ace, True Value, IGA, Associated Press, Sunbeam Bread. Monopoly supply stage. Coops and franchises. Financial and insurance mutuals.

Who owns the firm? Analogous to customer coops. Monopsony processing stage. Common in agriculture. Ocean Spray, Land o’ Lakes, Cabot, Sunkist, much of French wine. The electric power grid? Problems of collective decision-making and flexibility?

Who owns the firm? Proletarian coops rare. Unskilled workers easier to monitor than other patrons. Most worker-owned firms in professional services. Law, medicine, consulting. Professionals can monitor one another more cheaply than can outsiders. Little physical capital per worker. Are professional firms consumer coops? Independent firms sharing common assets.

Who owns the firm? Some kinds of transactions pose special agency problems. Payments to third parties to provide goods and services (United Way) Support of public goods (PBS). Customers (donors) are the natural residual claimants. But monitoring by donors costly. Ownership by other patrons creates incentives to appropriate donor resources.

Who owns the firm? So managers “hold the firm in trust” for the donors. No residual claims – but that needn’t mean no profit. Reliance on formal rules and bureaucracy. Because market control mechanisms absent. Boards of directors chosen for impartiality not expertise. Important donors sit on board. Are non-profits really donors coops?