Vaguely Defined Property Rights
| Peter Klein |
The shareholder model of the firm has come under increasing criticism from a variety of quarters. Stakeholder approaches argue that employees, suppliers, customers, community members, and others with relationships to the firm should have their preferences taken into account. Theories of worker empowerment, “flatter hierarchies,” and similar approaches advocate delegating decision rights to employees, not top management. Models of loose and open collaboration treat the firm as simply a node in a cluster or network of firms, with decision authority widely dispersed throughout the larger structure.
All these approaches, despite their differences, reject the standard shareholder model in which the firm’s owners, as residual claimants, possess unique rights of decision management and control. And yet, there is a substantial literature on the organizational costs of alternative models, particularly those in which residual claims are not alienable, separable from other agent roles in the organization, or marketable. These costs have not been widely appreciated in the literature on stakeholder management, worker-managed teams and firms, and the like.
My colleague Mike Cook, a specialist in cooperatives, describes these as costs of “vaguely defined property rights.” Mike argues that cooperatives, partnerships, and similar structures are plagued by two kinds of free-rider problems, a horizon problem, a portfolio problem, a control problem, and an influence costs problem, all because their equity shares are not alienable assets that trade in secondary markets. Consider each in turn.
1. The external free-rider constraint is a common-resource problem occurring when property rights are non-tradable, insecure, or unassigned. De jure property rights in a patron- or worker-owned firm, or de facto property rights in a stakeholder-managed firm, are not well specified and enforced to ensure that current members and non-members bear the full costs or receive the full benefits of their actions. This occurs particularly in open-membership cooperatives. A more complex type of free-rider problem results from the common-property (or insider free-rider) problem. This occurs when new members obtain the same patronage and residual rights as existing members and are entitled to the same payment per unit of patronage. This set of equally distributed rights combined with the lack of a market to establish a price for residual claims reflecting accrued and present equivalents of future earnings potential creates an intergenerational conflict. Because rates of return to existing members are diluted, overall investment incentives are attenuated.
2. The horizon problem occurs when a member’s residual claim on the net income generated by an asset is shorter than the productive life of that asset. This problem is caused in cooperatives by restrictions on transferability of residual claimant rights and the restricted liquidity through a secondary market for the transfer of such rights. The horizon problem creates an investment environment in which members have little incentive to contribute to growth opportunities. Because future earnings cannot be captured completely by current cooperative stockholders, managers and boards of directors are pressured to maximize short-term benefits to members even though such a policy may be harmful in the long run.
3. Because cooperative investments lack transferability, liquidity, and appreciation mechanisms for the exchange of residual claims, member-patrons are unable to adjust their cooperative asset portfolios to match their personal risk preferences. In cooperatives, the investment decision is “tied” to the patronage decision and thus, from an investment point of view, members hold suboptimal portfolios. This portfolio problem leads to situations where members attempt to encourage cooperative decision-makers to rearrange the cooperative’s investment portfolio even if the reduced risk means lower expected returns.
4. The control problem in a cooperative arises from the costs of trying to prevent the divergence of interests between the membership and the board. Governance is particularly costly in a cooperative because cooperatives do not publicly release their financial statements, cooperatives do not face the external pressures faced by publicly traded firms, and cooperative members serving as directors may have little or no experience in exercising control.
5. The influence costs problem arises when organizational decisions affect the distribution of wealth or other benefits among members or constituent groups of the organization. The affected individuals or groups, in pursuit of their self interests, attempt to influence the decision to their benefit. The influence costs problem can be viewed as a collective decision making problem. Because shares in most cooperatives are neither transferable nor tradable, members that cannot exit have little choice but to engage in influence activities. If the cooperative is engaged in a wide range of activities, diverse objectives among its members can lead to damaging influence activities that increase transaction costs within the cooperative, lead to wrong or no decisions at all, and finally, may lead to the dissolution of the cooperative. (See Cook and Iliopoulos 2000 and Cook and Chaddad 2004 for details.)
These problems are not specific to cooperatives, but apply to any organization in which equity shares are not alienable, separable, and marketable. Concepts of the firm emphasizing stakeholders, worker-managed teams, radical decentralization, and the like need to grapple with these organizational problems and explain how the benefits of such forms outweigh the costs. My sense is that the critics of the shareholder model have not yet met this burden.