Dissing the Corporation

6 September 2007 at 10:50 am Peter G. Klein 6 comments

| Peter Klein |

Several papers in economic history, law, and political economy argue that the corporate form owes its emergence and persistence not to superior performance, but to legal privilege. This two-part series by Piet-Hein van Eeghen in the Journal of Libertarian Studies (1, 2) makes such a case, as do many essays by regular O&M commentator Kevin Carson. I tend to be somewhat skeptical of this literature, finding it insufficiently comparative institutional and not always consistent with the historical record as I understand it.

A new paper by Naomi Lamoreaux, whose work I very much admire, may force me to rethink my views, however. In “Putting the Corporation in its Place” (NBER Working Paper No. 13109) Lamoreaux and her coauthors Timothy Guinnane, Ron Harris, and Jean-Laurent Rosenthal argue that entrepreneurs in common-law countries tended to choose the corporate form over the next-best alternative, the partnership, only because a still more desirable alternative, the private limited liability company, was not available.

Here is the abstract:

This article challenges the idea that the corporation is a globally superior form of business organization and that the Anglo-American common-law is more conducive to economic development than the code-based legal systems characteristic of continental Europe. Although the corporation had important advantages over the main alternative form of organization (partnerships), it also had disadvantages that limited its appeal to small- and medium-sized enterprises (SMEs). As a result, when businesses were provided with an intermediate choice, the private limited liability company (PLLC) that combined the advantages of legal personhood and joint stock with a flexible internal organizational structure, most chose not to organize as corporations. This article tracks the changes that occurred in the menu of business organizational forms in two common-law countries (the UK and the US) and two countries governed by legal codes (France and Germany) and presents data showing the rapidity with which firms in each country responded to enabling legislation for PLLCs. We show that the PLLC was introduced first and most easily in a code country (Germany) and last and with the most difficulty in a common-law country (the US). Late introduction was associated with prolonged use of the partnership form, suggesting that the disadvantages of corporations did indeed weigh heavily on SMEs.

There are interesting implications here for the legal origin debate as well. Check it out.

Entry filed under: - Klein -, Business/Economic History, Classical Liberalism, Entrepreneurship, Institutions, Theory of the Firm.

More on Eship and Transaction Costs Thank You, Steve

6 Comments Add your own

1. Paul Jaminet | 6 September 2007 at 1:36 pm

One might ask: if 3 institutional forms is better than 2, would not N (with N large) be better than 3? And why can’t any institutional form be replicated by a set (nexus or other network) of contracts? It might be more to the point to look into why contracting to innovative institutional forms is so costly that people prefer the default institutions established by law, even if they are highly imperfect. Do the courts fail to give adequate respect to contracts?
2. Kevin Carson | 6 September 2007 at 7:28 pm

Thanks for the link, Peter. I’ll enjoy reading Lamoreaux’s paper.
3. JC | 6 September 2007 at 9:19 pm

There’s also:

Lamoreaux, N. R., & Rosenthal, J.-L. (2005). Legal Regime and Contractual Flexibility: A Comparison of Business’s Organizational Choices in France and the United States During the Era of Industrialization. American Law & Economics Review, 7(1), 28-61.
4. Twofish | 7 September 2007 at 3:36 am

Corporations have one element that is impossible to replicate with contracts and that is limited liability. If I do something in my capacity as a corporate agent, my liability is limited to the assets of the corporation, and a third-party cannot sue to recover my personal assets. This can’t be replicated by a contract because I don’t know who to contract with before the start of the lawsuit.

Also, shareholders of a corporation cannot simply cash out. I can sell my shares of Exxon-Mobil, but I can’t go to Exxon-Mobil and redeem my shares for corporate assets. This aspect of corporations can be replicated by contracts with small numbers of people, but it becomes impractical for large numbers of people since everyone then has to agree with each other to do this.

Some of the issues questions that this raises are:

1) are the two elements that I’ve stated (limited liability and non-alienable assets) the *only* essential elements of a corporation that cannot be replicated by contracts

2) what is the basic framework that we can use to create a taxonomy of corporate forms. In particular, is the public corporation and the closely-held corporation essentially the same thing or essentially different things. Is there a continuum between the two or are they two different beast? (My experience with Chinese corporate forms suggests that the latter is the case).

3) A related issue. What elements of a “marriage” are not reproducable by contract? (This is a non-academic legal question for gay people).

4) What are the consequences for political philosophy if there are elements of a corporation (or a marriage) that cannot be reproduced by contract? One objection that I have toward some theories of social justice and politics is that the assume that all legal relationships can be reduced to contracts among individuals, and I do not believe that this is the case.
5. Paul Jaminet | 7 September 2007 at 9:38 am

Twofish – Contracts could replicate limited liability, if the courts enforced liability-limiting provisions. However, the courts have generally held that people cannot bargain away their right to sue, or the amount of damages they can sue for, in contracts.

Since shareholders in corporations cannot claim or force distribution of corporate assets, unless the right to do so has been granted by contract, I do not understand the other issue you raise.
6. Twofish | 7 September 2007 at 9:18 pm

The problem is that you have to have a limited liability contract with every single natural or legal person, current or future, on the planet. I invest in a pool with some other investors, and we all agree not to sue each other. No problem. However, we do something that harms a farmer in Botswana that was not born when we created the investment pool. That farmer can sue us and we are personally liable for unlimited damages since that farmer in Botswana never had a contractual agreement with any of us.

This is a feature that makes limited liability impossible ro replicate via contract law.

The second issue is “merely” logistical. Basically shareholders don’t have the right to withdraw funds from a corporation because a corporation is a separate legal person. You can give up the right to withdraw funds by contract, but in the absence of a separate legal entity, this means that any person who wants to own a share of a company has to have a contract with every other person that contributed money to the company. That’s bearly feasible if you have four or five people. Practically impossible if you have several thousand.

One thing about the corporation is that I think the idea of limited liability is essential for a modern market. Again, there is the interesting case of Chinese state-owned enterprises. Many Chinese SOE’s are corporations which are 100% state owned. However, a 100% state owned corporation is still very different from a state agency. The difference is that a state-owned corporation has its own bank account which is separate from the government’s. This allows thte SOE to have a balance sheet, to have profit and losses, and to be forced to exist independently from the state’s taxing power and the state’s regulatory power. It’s the existence of this corporate form that makes Chinese SOE’s very different from an Oskar Lange pseudo-market.