Vaguely Defined Property Rights

4 April 2007 at 11:00 am 14 comments

| 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.

Entry filed under: - Klein -, Food and Agriculture, Management Theory, Theory of the Firm.

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14 Comments Add your own

  • 1. Ivan Pongracic Jr.  |  4 April 2007 at 8:55 pm

    Peter, very interesting. Thanks for sharing this. You say: “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.”

    OK, how’s this for ‘meeting the burden’: Koch Industries (largest privately-held company in the world)? 3M? Google? Or how about W.L. Gore & Associates (for decades now as radically decentralized as it gets – and doing quite well)? The fact is that there exist real, successful firms that are engaging in decentralization (in various degrees). In my studies I have come across many more.

    It is important for us as economists trying to explain the workings of firms to understand the trade-offs associated with different internal structures. It is also important to see that the real business world is heterogeneous and not all firms fit the simple Coase/Williamson theory. I don’t understand why it has to be ‘us vs. them’, anyway? Are we really here to take sides on the issues you raise above? That seems a somewhat dogmatic attitude – and what an issue to be dogmatic about! “I will go to my death defending the Coase/Williamson conception of the firm!!”

    Sorry, just joking a bit…. Anyway, decentralization is a real phenomenon and has been with us for many decades. It behooves us to try to explain it – not to dismiss it – or champion it. My two cents…

    Ivan Pongracic Jr.
    Hillsdale College

  • 2. Peter Klein  |  4 April 2007 at 10:28 pm

    Ivan, I don’t disagree at all. Certainly there are many successful examples of radical decentralization, just as there are examples of more hierarchically organized forms as well. As you say, one size doesn’t fit all. There’s no need to take sides! My claim is simply that in the academic literature, these issues are not always treated in a balanced, comparative way. Often the benefits of decentralization (e.g., more effective use of dispersed specific knowledge) are touted while the costs of decentralization are downplayed or ignored altogether.

    Actually, the comments above apply primarily to cooperatives and stakeholder-managed firms, not corporations attempting to maximize shareholder value through strong delegation. As Nicolai and I argue in our “Original and Derived Judgment” paper such firms have well defined property rights — “original” decision rights are held by asset owners, while employees, even when enjoying many de facto rights of control, exercise a strictly limited, well-defined, form of “derived” judgment. I suppose adding “radical decentralization” to my list of targets was a bit of rhetorical flourish.

  • 3. Ivan Pongracic Jr.  |  4 April 2007 at 11:10 pm

    Excellent, Peter, I’m glad we agree. In fact, I have “Original and Derived Judgment” on the very top of my ‘to-read’ pile! I’ll be taking it with me to Cancun (APEE conference) on Friday, and reading it on the beach! It sounds like it’s right up my alley – looking forward to it.


  • 4. Kevin Carson  |  5 April 2007 at 12:19 am

    Very thoughtful post. I’m not about to try crafting an argument as to whether the information and agency problems of hierarchy outweigh these admitted problems of worker-ownership (although you can probably guess my visceral inclination). It would involve way too much counterfactual speculation about the predominant direction in which the present structure of incentives differs from a free market, and we’d both probably wind up leaving through the door by which we came.

    But you might find this article by David Ellerman useful, on alternative ways of defining property rights in a worker-owned firm: “Workers’ Cooperatives: The Question of Legal Structure” in Robert Jackall and Henry M. Levin, eds., Worker Cooperatives in America (Berkeley, Los Angeles, London: University of California Press, 1984). As I recall, it includes considerable discussion of ways in which a member’s individual investment account can be tracked severably from his equity rights in the firm.

    In the meantime, this will give me food for thought.

  • 5. Dick Langlois  |  5 April 2007 at 8:22 am

    I must confess that I haven’t (yet) read Cook’s work. But in my view the best general work on the cooperative is that of Henry Hansmann (click here if you have access to JSTOR). He points out that all forms of organization are really cooperatives. The ordinary public corporation is a capitalist’s cooperative. We see this form most often because giving capital suppliers ownership rights usually minimizes the sum of ownership costs and the costs of contracting with other parties (“patrons”) who aren’t owners. But sometimes there are special reasons for other forms. In the case of what we think of as coops (Ocean Spray, Sunkist, AP, IGA, True Value), the issue that overrides the costs of ownership in that form (which both Cook and Hansmann point to) are the costs of contracting with non-owners — in the typical case a monopoly seller or monopsony buyer. In my view, the biggest problem with such coops is lack of adaptability, which I guess is related to Cook’s first three points. That’s why a lot of financials and insurance companies de-mutualized a few years ago, and why Ocean Spray is in trouble.

    Which brings us to the issue of worker participation. One of my pet peeves is the legions of people writing articles wondering why we don’t see many labor-managed firms — why labor doesn’t hire capital. The answer is that we observe tons of labor-managed firms. But they aren’t proletarian-manged firms: they are high-human-capital firms like law firms, medical practices, accounting firms. In these cases workers are the low-cost owners (even though they may face costs 4 and 5 in Cook’s scheme) because, especially as there is little non-human capital involved, they are the most costly class of patrons to monitor. When there is a lot of non-human K involved and workers are not highly skilled, capital suppliers are the low-cost owners. (That’s why more people have studied Mondragon than have worked there.)

    If capitalist coops (regular firms) have high-human-K employees, then we should expect some decentalization (“labor management”) in respect of at least some decision rights. But that really begs the Coasean question: if workers are most costly to monitor, why not make each one his or her own firm? The answer is that there have to be offsetting benefits of (some degree of) hierarchy. What are these? This is my question about the Kochian internal-market approach. If there are no synergies among workers (a la Alchian and Demsetz, at the very least), why not decentralize all the way to the market? And if there are such synergies, how do you solve the internal pricing problems?

  • 6. Kevin Carson  |  6 April 2007 at 2:16 am

    It makes perfect sense to say with Coase that a free market will establish the boundaries between hierarchy and market based on the point at which internal agency costs outweigh external transaction costs. It also makes sense to say that if hierarchies exist, they must possess some advantage in the existing environment that outweighs their inefficiency costs. But neither one by itself, nor both together, imply that the current prevalence of hierarchies over markets or cooperatives must reflect some superior efficiency in a free market. The real is not necessarily rational.

    This is not, after all, a free market. The prevalence of corporate hierarchy may reflect, in part, its superior efficiency at exploiting some privilege or other. Corporate hierarchies are excellent, e.g., for exercising control over “intellectual property” [sic] and operating a tollgate between information workers and consumers. In some cases, like Nike as described by Naomi Klein, the corporation has outsourced most actual production to independent contractors, and retained control only over central finance, patents, and trademarks.

    It’s often said that slavery is the most inefficient way to organize production. The only thing less efficient, from the slave-owner’s perspective, is having to do the work himself or to negotiate a wage with a free human being. A particular form of organizing production may be quite bad in terms of operating efficiencies, and yet be very efficient indeed from the perspective of those at the top.

  • 7. Peter Klein  |  6 April 2007 at 6:27 pm

    Kevin, thanks for the Ellerman cite; I’ll check it out. And of course you’re right that we can’t say for sure what firm sizes and structures would be selected in a free market. As far as making conjectures, though, is there any time-series or cross-sectional evidence that smaller firms, more decentralized firms, worker-owned firms, and the like arise more often in less interventionist economies? In agriculture the usual assumption is the opposite, namely that cooperatives have survived mainly due to special protection like the Capper-Volstead Act.

    Dick, thanks for mentioning Hansmann (whom Cook cites heavily). And I think you are asking exactly the right questions. The fact that even highly decentralized firms like Koch Industries remain firms, rather than networks of independent contractors, suggest that there are non-trivial benefits of hierarchy that contribute to the optimal mix.

  • 8. Kevin Carson  |  7 April 2007 at 1:16 pm

    I’m not sure about the time-series or cross-sectional studies, Peter. I doubt there’s much along those lines, though, just because the measures of government intervention are themselves apt to be a source of political controversy. Here are a couple of links:

    Yours Truly. The Neoliberal Myth of “Small Government”
    Nicholas Hildyard. The Myth of the Minimalist State: Free Market Ambiguities

    On agriculture, I won’t try to guess the effects state intervention has on the cooperative form as such. But my gut reaction is that farming would be much smaller-scale and more local, on average, in a free market; and that would tend to mean a greater prevalence of family farms and other operator-owned farms, all other things being equal. The current model of agribusiness is heavily reliant on subsidized long-distance transportation, subsidized irrigation water, and (in the Third World) state-backed latifundismo at the expense of traditional property rights in the land. In the U.S., ag subsidies go disproportionately to large-scale cereal farming, and are primarily a way for the largest operators to collect taxpayer rents on the portion of their huge land holdings they keep idle. In addition, government-funded R&D is aimed primarily at centralizing “Green Revolution” technologies adapted mainly to the needs of large-scale agribusiness with subsidized inputs.

  • 9. Joseph Wang  |  9 April 2007 at 12:51 pm

    Hi all,

    I’ve been very interested in applying Austrian economics to the issue of Chinese industrial restructuring, and I have a very, very rough paper here

    Basically, I’m trying to argue that a corporation is a “unit of planning” and that the purpose of corporate finance is to interface the unit of planning with the larger economy which is too large to be planned because of the economic calculation problem. The argument is that for an individual or small group, the difficulty of creating a market outweighs the problems of direct planning. For a national economy, the calculation cost of a market is far less than the cost of direct planning. In between there is a “natural scale” for a “unit of planning” that interacts as a single agent in the market, but is bureaucratically planned internally.

    One thing that helps me write these papers is that I’ve actually worked in a corporation.

    Anyhow some comments on worker owned companies:

    1) The theory of worker owned companies works better than the practice because at the end of the day sometimes you have to make a decision, and if the workers disagree you have to have a political process and you might end up being on the side that wins or the side that loses. In any case there is a disconnect between what happens and the decisions that one would personally make.

    2) One other problem with worker owned companies is that if the company gets run into the ground, you lose both your income and any value in your control rights for the company. From a portfolio management standpoint it makes sense to take the income you make from the company you work at, and buy control shares of another company so that you have more diversification.

    3) Professions which do have worker owned companies often are structured this way because of legal restrictions. Doctors and lawyers are generally legally prohibited from creating joint-stock corporations, and so the corporate forms that exist are usually state mandated.

  • 10. Joseph Wang  |  9 April 2007 at 1:09 pm

    One more thing. Even in corporations that are decentralized or “worker-driven” the management has the authority to change that. This authority comes from the fact that the management has legal authority and control over the bank account. The issue of human authority and interaction is much more complex than a lot of the academic literature seems to imply.

    One other thing that a lot of talk about worker managed companies don’t talk about is that, in my experience, the only real vote that you have in a corporation is to vote with your feet and leave. If you end up with a situation where you make it more difficult for a worker to get up and leave and work for someone else, you might end up actually decreasing the control that the worker has.

    Finally, as a worker, I’d really prefer in some cases to just get cash in lieu of marginally useful control rights. If I get cash, it’s mine and the cash is not encumbered with what other people in the company do. If I get control rights, then the value of those rights is determined by things that I may have no control over.

  • 11. Vaguely Defined Property Rights Indeed « Instead of a Blog  |  18 December 2008 at 10:02 pm

    […] all fairness, however, Carson, in a comment on Klein’s 2007 article “Vaguely Defined Property Rights”, suggested that Klein investigate some of Ellerman’s ideas of the sort I’ve presented […]

  • […] was referring to his 2007 article “Vaguely Defined Property Rights” where he essentially argues, using Mike Cook as a primary source, against the LMF on […]

  • […] regard to (d), Klein thinks that non-corporate forms suffer from vaguely defined property rights. I found this claim puzzling, since “vaguely defined property rights” are notoriously a problem […]

  • […] all fairness, however, Carson, in a comment on Klein’s 2007 article“Vaguely Defined Property Rights”, suggested that Klein investigate some of Ellerman’s ideas of the sort I’ve presented here. I […]

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