Streetwise Professor

January 19, 2013

Corporations: The Worst Form of Organization, Except for All the Alternatives That Have Been Tried From Time to TIme

Filed under: Uncategorized — The Professor @ 5:58 pm

A certain sort of libertarian-anarcho-libertarians, is probably more accurate-goes apoplectic about the corporate form, and in particular, the limited liability conferred on corporations.  There are Twitter hashtags #limitedliability and #moralhazard where you can get a flavor for this apoplexy.

They seem to harken back to Adam Smith, who was skeptical of corporations:

The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

I yield to no one in my admiration for Adam Smith, but believed it or not, economics has made progress since 1776.  And one of the areas in which progress has been greatest is in the economics of organization.

The watershed paper is by Jensen and Meckling from almost 40 years ago-and ironically, exactly 200 years after the publication of Wealth of Nations. Jensen and Meckling, and the literature that follow it, address many of the phobias of the #limitedliability crowd.

Jensen and Meckling note that the limited liability is not perfect.  There are agency costs associated with it.  There is the “separation of ownership and control problem”, whereby it is costly to incentivize managers of corporations to act in the interest of shareholders.  There are risk shifting problems: equity has an incentive to increase risk at the expenses of debt holders.

But the key thing is that those contracting with corporations know these things.  They know them better than economists, most likely, because they have a very strong incentive to do so.  Meaning that these costs are internalized: the costs of equity and debt reflect these agency costs.  If the costs of the corporate form exceed the costs of alternative forms of organization, greedy individuals have no incentive to adopt this form.

This means that if costs are internalized, choice of the corporate form and equity finance will be efficient, relative to possible alternatives.  To paraphrase Churchill, the corporate form and limited liability are the worst forms of organization, except for all the others that have been tried from time to time.

Put differently: showing that there are costs associated with limited liability and the corporate form and equity finance does not imply that these are inefficient. Many of the critics of the corporate form succumb to the Nirvana fallacy.

The survival of corporations-indeed, their dominance-strongly suggests that they are less costly in most situations than alternative forms of organization.  Nobody compels incorporation.  People choose it.  They choose it in many circumstances-but not in all circumstances-because it is the least costly form of organization.

One under appreciated benefit of limited liability is that alternative forms can greatly inflate the cost of raising capital.  As one example of an alternative, under unlimited liability, any investor in a corporation cares about the wealth of other investors, because his (or her) costs under joint and several liability would be greater, the less wealthy other investors.

This sharply limits the ability of non-limited liability entities to raise capital, and raises the costs of this form of organization.  Investors will invest resources in investigating and monitoring the wealth and risk exposures of other investors.  This inherently limits the number of potential investors.  This, in turn has two deleterious effects.  First, it limits the scale of enterprise, meaning that scale and scope economies cannot be realized.  Second, it limits the potential for diversification.  Remember that diffuse ownership and diversification that are facilitated by the corporate form, public equity, and limited liability, are analogous to insurance: risk is more cheaply insured under the corporate form and limited liability.  Yes, moral hazard is a cost of insurance, but despite the existence of moral hazard, insurance markets exist nonetheless.

Where could externalities arise? Corporations provides something of a shield to equity holders from legal liability from costs imposed on third parties, or with parties with whom it contracts, but somehow deceives or defrauds.  This could conceivably result in an externality, but its practical significance is limited.  Limited liability shifts costs to third parties only to the extent that a corporation’s legal liabilities exceed its equity.  The large corporations that attract the greatest ire typically sufficiently capitalized to pay fully legal judgments assessed against them.  The Johns Manville’s of the world are the exception, not the rule.  Again, costs are almost wholly internalized.

Another criticism leveled against corporations is that they influence government to adopt policies that transfer wealth from taxpayers (or other third parties) to the owners of the corporations.  This criticism has some merit, but this is not sufficient to justify raising the costs of adopting the corporate form.

First, it is again necessary to consider: “what would happen under the alternative”?  Those who think that outlawing corporations will reduce corruption, or will reduce incentives to importune government for favors, are sadly deluded.  That is, the corporation is not a necessary condition for the existence of corrupt influence of government

Second, and relatedly, the fundamental issue here is the discretionary power of government.   If government’s power to redistribute wealth is unconstrained, the politically connected will importune it to provide them benefits.  No corporations? That doesn’t mean there will be no redistribution.  Individual proprietors or partnerships will attempt to influence government.  Indeed, in a world without limited liability, they may have an even stronger incentives than corporations to seek bailouts.  With limited liability, owners’ personal wealth is not at risk beyond their initial investment.  Without limited liability, personal wealth is at risk. This strengthens the incentive to secure government rescues.

It should also be emphasized that in the US today, incorporation is truly democratic.  Anyone can incorporate, and obtain the protections of limited liability.  Incorporation is not a privilege: it is almost a right, and states have liberalized laws to make it extremely easy and cheap to incorporate. Anyone can do it.

This is in stark contrast to Adam Smith’s time, and even in the US until the 1830s.  Early on, corporate charters were special privileges granted by the Crown or legislatures.  In those days, corruption and influence were indeed almost synonymous with incorporation.  Only the favored received corporate charters, and corporate charters conferred special privileges that enriched those that obtained them.

In sum, the anti-corporate types, anarcho-libertarian or socialist, usually fall prey to the Nirvana fallacy.  They obsess on the costs relative to some ideal of a frictionless world.  But that’s not the relevant standard of comparison.  We have to make choices between flawed alternatives.  Limited liability, public equity, and diffuse ownership have costs.  Duh.  But that’s not the issue.  The issue is whether these costs are higher are lower than the costs of alternative ways of organizing economic activity.  The dominance of the corporate form and limited liability, despite the absence of notable externalities, provides compelling evidence that these costs are in fact lower for most economic activities. Not all, but most. And “not all” isn’t important: the fact that people can -and do-sometimes choose other forms means that they choose the corporate form when it is less costly, and don’t when it isn’t.  That’s exactly what we want.

Many of the putative costs of the corporate form identified by the anarcho-libertarian types represent government failures, not market failures.

So spare me the shrieks about the costs of limited liability and corporations. If you want to have a serious discussion, show why corporate form is sometimes-nay, often-chosen despite the fact that it is more costly than the alternatives: again, compared to the real world alternatives, not perfection. Nirvana is still just a band.

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8 Comments »

  1. Wow, Craig, I’m pleased to see that your obsession with apoplectic libertarians runs to actual discussion.

    It wouldn’t be you without the mud-slinging and strawmen, but the latter are surely useful for a broader discussion of what we agree on, so we can highlight differences.

    Sorry that I’m out and can’t sit down to respond now, but I note that readers can see themselves some of my dogmatic, crazy and non-pragmatic thinking on corporations, crony capitalism and the runaway regulatory state here: http://www.google.com/search?hl=en&safe=off&client=ms-android-htc&gl=jp&source=android-browser-type&q=tokyotom+limited+liability+&oq=tokyotom+limited+liability+&gs_l=mobile-gws-hp.12…603816.682246.0.684970.103.65.21.1.2.0.678.8154.1j2j9j7j3j3.25.0.les%3B..0.0…1ac.1.83wM8_j948o

    Comment by TokyoTom — January 19, 2013 @ 7:57 pm

  2. @Tom. Pardon me for taking my valuable time to try to respond to you in a constructive way, based on, you know, actual research from myriad scholars over the last 40 years.

    It won’t happen again.

    The ProfessorComment by The Professor — January 19, 2013 @ 8:19 pm

  3. Craig, I posted awhile back on Stephen Bainbridge’s similar thoughts here: http://blog.kir.com/?p=5577

    Comment by Tom Kirkendall — January 20, 2013 @ 11:06 am

  4. I am reminded of Coase as well. The research he did on the firm was enlightening to me. The more I drive my decision making through Coase theorem, the more rational I become—-> and I make better decisions.

    Comment by Jeff — January 21, 2013 @ 9:26 am

  5. the first really serious examination of the sociological aspects of liability and “professional” management was Veblen’s Absentee Ownership, that went into a lot of these areas back in the 20′s, i.e 90+ years ago.

    Interesting read, from a hstory of thought and its development, plus the man was no dummy.

    Comment by Sotos — January 22, 2013 @ 10:29 am

  6. I thought of a question that keeps popping up amongst my left-leaning peers. It seems that there is a strong desire by them to jail corporate officers for corporate failures or, shall we say, “stretched ethics”. In many cases, I can acknowledge, that companies usually get fines, but nobody gets prosecuted. (and yes, Enron, WorldCom, and others are exceptions or forgotten). Are these the types of costs that you refer to that limited liability prevents? I just don’t know where the line is drawn when there are clear cases of corporate malfeasance.

    Comment by Howard Roark — January 22, 2013 @ 12:13 pm

  7. The line is usually an Ultra Vires act, or deliberate criminal intent on the part of the officer(s). E.g. Fraud, isrepresentation, etc. My understanding is that the LLP used by many law firms was structured so that a partner is not liable for the gross misconduct of another, while maintaining partnership liability in other matters.

    The fly in the ointment is prosecutorial discretion; the Corzine fiasco is a great example of this. It is not easy to prove deliberate intent, but prosecutors have two things going for them: the ability to make life hell if they choose too, or suppress intent. Re JONJON, they are not giving the one witness who could directly tie him in immunity – Gee, I wonder why? (Keep those bucks coming in to the O, Jon!).
    I have often felt that there ought to be a “high” standard for some kind of Reckless Endangerment rule applied to financial crimes, along with the English system of bringing private prosecutions, subject to liability on the plaintiff’s side to reduce frivolous suits. G-D knows, our US ATTY’s or their bosses are too corrupt.

    As regards the Leftards – assuming they view the JONJON affair as OK – ask them how they feel about a President ordering the killing of American Citizens without due process of any kind. Maybe it is needed, though there was one 16 year old targeted because of his father that seems weird. However, it certainly should be done with some kind of independent review, not at the whim of the POTUS and his minions. I think you will find their legal outrage selective, depending on whose ox is being gored (not in the Al “Megabucks” Gore meaning of the word).

    Comment by Sotos — January 22, 2013 @ 5:39 pm

  8. @Sotos. And Berly and Means in the 1930s. They were the ones who coined the idea/phrase “separation of ownership and control.”

    @Howard. Limited liability limits the exposure of the shareholders of a corporation to civil and criminal fines, but does not eliminate it. If those are so large to exhaust the firm’s equity, the civil plaintiffs or public prosecutors cannot come after the individual shareholders for more. But they are exposed up to their equity value. A company with $1 billion in equity can pay a $999 million judgment, or criminal fine. If the fine is $1.1 billion, the company goes bankrupt, and the government is a claimant, but the company’s owners don’t care once they are wiped out whether the judgment is for $1.1 billion, $11 billion, or a shiny new $1 trillion coin.

    It is interesting that the same leftists who go into apoplexy over treating a corporation as a legal person (as in the Citizens United case) but demand they be treated as persons in criminal matters. But for the corporation, it comes down to money, because you can’t throw the legal person in jail.

    Limited liability does not shelter corporate employees or officers from civil judgments or criminal penalties. Just ask Skilling or Ebbers.

    The ProfessorComment by The Professor — January 22, 2013 @ 11:57 pm

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