Organizations and Markets

Tullock on the Corporation

27 August 2008 at 12:39 am Peter G. Klein 4 comments

| Peter Klein |

Gordon Tullock is retiring this year from George Mason Law School. In the coming weeks you’ll probably be reading a lot of Tullock tributes and Tullock anecdotes (for example, about his famous put-downs). I don’t have much to add on the personal side, but I thought I’d share a remark or two about one of my favorite, and little-known, Tullock articles, “The New Theory of Corporations,” in Erich Streissler, ed., Roads to Freedom: Essays in Honor of Friedrich A. von Hayek (Routledge and Kegan Paul, 1969).

Tullock offers a number of insights into the corporate form and, in particular, the Berle-Means problem, that are well ahead of their time. As Tullock notes in the essay, he draws heavily here on Henry Manne’s work (and, he tells us, many conversations with Manne about these issues). In 1969 the consensus view was that corporations were almost exclusively controlled by salaried managers, running firms in their own interests and largely ignoring the wishes of shareholders. However, Tullock notes:

The theory of management control of corporations, of course, is subject to one very obvious difficulty. It offers no explanation of how managements are changed, and changes of management are an everyday occurrence as any reader of the Wall Street Journal can appreciate. It is true that presidents of large corporations frequently stay in office rather longer than the president of the United States, but they don’t stay in office as long as congressmen and senators, and we would hardly argue that the long tenure of congressmen and senators indicates that we do not have democracy in the United States. Thus, the current orthodoxy that the management actually runs the corporation cannot explain how the management got there or how the everyday occurrence of a change in management occurs. For some reason, this does not seem to disturb the partisans of the . . . Berle and Means theory.

As Tullock explains, and as Nicolai and I have also argued, shareholder-investors choose, in allocating capital to corporations, to delegate day-to-day control of the firm to managers. However, by appointing managers, and by reserving the right to intervene when desired, and to replace poorly performing managers, owners retain “ultimate” decision rights over corporate assets, no matter how many proximate rights are delegated. Tullock puts it this way:

I might well prefer to invest in a corporation even though I knew that the management was less efficient than my own direct management would be because of the advantages with the corporate form brings to me. Under these circumstances the cost of the use of the corporate form would include a certain amount of inefficiency. I would take these costs into account and would thus end up with the type of investment which seemed to me best. It might, or might not, lead to the choice of a corporation, just as the choice of a machine does not normally turn on whether the machine is perfect. We are interested in comparative efficiency, not in attempting to obtain a utopian perfection.

The real problem, then, raised by the critics of the corporation is simply that the stockholders are not obtaining theoretically perfect performance from their managers.

The point about comparative efficiency recalls what Harold Demsetz, writing in the same year, called the “nirvana fallacy” of welfare economics, namely the comparison of real-world market outcomes with hypothetical non-market alternatives. Jensen and Meckling (1976) would later argue that market participants can bid down the share price of manager-controlled firms so that the return on investment in a manager-controlled firm equals that of an owner-controlled firm.

I do have one Tullock story. Gordon spoke at Oliver Williamson’s Institutional Analysis Workshop at Berkeley around 1990, when I was a graduate student. I don’t remember the subject of his paper but, at one point, needing an example of a hypothetical scenario, he said “Now suppose Oliver Williamson is a rapist.” You should have seen the looks of horror on the Williamson students’ faces! Needless to say, that was not the example any of us would have chosen.

Addendum: This Monty Python sketch nicely illustrates the agency cost / organizational slack problem discussed by Tullock.

Entry filed under: - Klein -, Corporate Governance, Law and Economics, Theory of the Firm.