Comparing Types of Economic Systems

As was just indicated, the main argument of chapters 6 and 7 will seek to establish that the type of market socialist system described in chapter 2 per­mits and encourages a range of exploitative exchanges that are prevented or discouraged in a free enterprise system.

Recall from chapter 1 that the objects of discussion are not particular eco­nomic systems, economic systems as they exist “on the ground.” Instead, the objects of discussion are abstract objects—specifically, types of economic sys­tems, which are distinguished by their type-defining features. Let us begin by reviewing the relevant type-defining features of the two types of economic systems that are to be compared. Here will be found what distinguishes the type of market socialist economic system described in chapter 2 from a free enterprise system.¹ It will be demonstrated that it is these differences that are responsible for the difference in the incidence of exploitative exchange in the two types of systems.

It might be thought that the key difference is that a free enterprise sys­tem permits and exhibits a variety of organizational forms, whereas in a mar­ket socialist system, there are only self-managed worker cooperatives. This is partly accurate but not entirely so. In chapters 1 and 2, it was pointed out that a market socialist system can permit organizational forms other than the self-managed worker cooperative.

The reason for this is that there may be special reasons why state or pri­vate ownership of some firms—or even entire industries—is desirable in a market socialist system. For example, economies of scale might make local telephone service a natural monopoly, and it might be best for natural monopolies to be wholly state-owned. In addition, state control of new invest­ment requires, at some level, political organizations whose members are elected or appointed to register and implement decisions about the rate and direction of economic growth. On the other side of the coin, there may be compelling historical reasons for some segments of the economy to be entirely private. For example, historically well-founded distrust and hostility toward the state on the part of the peasantry may make it advisable for at least small­scale agriculture to be a wholly private sector operation in many countries. Market socialists need not—and should not—dogmatically insist that the worker cooperative be the only form of economic organization to be found in society.

However, both individually and collectively, wholly state-owned firms and private enterprises must be the exception and not the rule if the system is to realize the socialist conception of the good society sketched in chapter 2. The self-managed worker cooperative is the predominant organizational form in this type of market socialist system. This organizational form and the associ­ated scheme of state control of new investment and intervention in the econ­omy together are the chief instrumentalities by which various socialist goals (elements of the socialist conception of the good society) are to be realized. That is the motivation for this type of system, and these instrumentalities can­not be cast aside by permitting widespread private or state ownership of the means of production.

These observations suggest two important differences between a market socialist system and a free enterprise system.

The classical capitalist firm is wholly owned and managed by one and the same individual. He hires and directs the firm’s employees, decides what to produce and how much to charge for the product, and he negotiates all con­tracts with suppliers of inputs. He also provides most, if not all, of the firm’s capital and gets the residuals, that is, what is left over after all input providers are paid. Finally, he can alienate any and all of these rights. In short, all the incidents of ownership that go to constitute full, liberal ownership of the firm are concentrated in this individual. On the other hand, the open corporation involves the partial separation of ownership and management of the firm. The open corporation controls large amounts of capital, too large for any one individual to supply; ownership of the corporation is dispersed among many shareholders. Most of these shareholders are not managers of the firm’s assets, however. Managers (who often have some equity stake in the firm) are hired, usually by a board of directors, who in turn are answerable to the shareholders.² Ownership of shares in the corporation is ownership of the corporation’s assets. This entitles shareholders to a proportional residual claim on the income stream generated by the firm and to some sort of ulti­mate decision-making authority over the firm’s assets (e.g., a proportional vote on who serves on the board of directors). Ownership shares are freely alienable on a stock market, and shareholders’ liability is limited to the extent of their investment.

The classical capitalist firm and the open corporation are the most com­mon and important forms of economic organization in existing free enter­prise systems, though they are not the only ones. There are closely held cor­porations, or “closed corporations” (Fama and Jensen 1983b), in which a few individuals own most of the stock and one of them is the manager. There are also partnerships, in which some but not all of those who work for the firm have a role in managing it and are its residual claimants. These other forms of organization, while not predominant, are at least common in existing free enterprise systems. By contrast, they would be quite uncommon under mar­ket socialism, as would the classical capitalist firm and the open corporation, all for the reasons indicated.

The discussion thus far has omitted one important type, or family of types, of economic organizations found in existing free enterprise systems— organizations that are owned and operated by the state. A significant per­centage of people in existing societies with free enterprise systems are employed by the state in one capacity or another. These organizations have been deliberately omitted for a very simple reason: those who favor a free enterprise system are not in the least interested in defending state ownership or state control of the means of production subject to a few well-defined exceptions. They regard state ownership as an abomination, which, in their vision of the good society, would be eliminated or minimized by privatizing most existing government-owned enterprises.³ What they are defending in this debate is private enterprise, private ownership of the means of produc­tion; in the private sector nearly all organizations are open or closed corpo­rations, partnerships, or classical capitalist firms, with the first and fourth types predominating.

Are all free enterprise systems dominated by the classical capitalist firm and the open corporation? The answer in part depends on how one individ­uates economic systems.

A second and related difference between a market socialist system and a free enterprise system is that a market socialist system must have and enforce laws prohibiting the emergence of these other forms of economic organiza­tion, subject to a few well-defined exceptions. By contrast, in a free enter­prise system, people are free to organize production in any way they choose, subject to the standard prohibitions against slavery, serfdom, and so on. Why must a market socialist society prohibit alternative institutional forms? Recall that socialist critics of the free enterprise system trace the social vices of this type of system to concentration of the incidents of ownership (especially the management rights and income rights) in private hands. This, of course, is exactly what happens in the classical capitalist firm, the closely held corpora­tion, and partnerships.

It might be objected that there is no reason to suppose that such a legal prohibition would be necessary in a market socialist system. It might be said that the benefits of the worker cooperative will be so significant and self-evi­dent that a legal prohibition on these alternative organizational forms would be wholly nugatory. It would be like outlawing slavery in modern America. There are two problems with this. First, absent a legal prohibition, the dis­pute between those who favor a market socialist system and those who favor a free enterprise system tends to dissolve. Those who favor the latter do not in principle have any special animus against worker cooperatives; they sim­ply do not believe that the state should forbid alternative organizational forms. If people chose voluntarily to organize nearly all production through the cooperative form, those who favor a free enterprise system could hardly object (though of course they may believe this is unlikely to happen). Second, there are various incentives for individual firms to take on some of the char­acteristics of one or more of the above types of organizations.⁴ For example, firms facing cyclical demand for their products or services (e.g., firms in the tourist industry) would be tempted to hire nonvoting wage laborers in the busy season and let them go in the off-season. Even if there is a general con­sensus that society is better off if the self-managed cooperative is the pre­dominant organizational form, individual firms may find it in their own inter­ests to be an exception to this general rule. To overcome the public goods nature of this problem, rational individuals facing this situation would seek a legal prohibition on alternative types of economic organizations.⁵

In general, socialists have not hesitated to call for a ban on what Robert Nozick has called “capitalist acts between consenting adults.” The point of these observations is that a legal prohibition on these other organizational forms is well motivated from a socialist perspective. It prohibits the emer­gence of organizational forms that, while not the root of all evil, do account for many undesirable features of societies with free enterprise systems, at least according to socialist thought.

The other major difference between a free enterprise system and a mar­ket socialist system concerns the role of the state in directing the economy. In free enterprise systems, most new investment is financed by one or more of the following methods: (1) individuals’ starting or expanding their own busi­nesses through savings, (2) firms issuing debt, and (3) individuals or firms raising equity capital on the capital markets. By contrast, most new invest­ment in a market socialist system is controlled by the state. This presupposes a set of political institutions responsible for setting the capital usage fee and disbursing investment funds. The details of these institutions were left inde­terminate in chapter 2, which means that they could be filled out in a variety of ways consistent with the other type-defining features of this type of mar­ket socialist system. Finally, the state in a market socialist system is also more activist is preventing or correcting for the social irrationalities that would emerge or do emerge from the operation of the market, though this function has also been left institutionally indeterminate.

The discussion thus far makes it clear that the objects of discussion are two types of economic systems and that the crucial differences between them are organizational. But what exactly is to be proved about these types of systems? To say that a market socialist system permits and encourages a range of exploitative exchanges that are prevented or discouraged in a free enterprise system is less than completely clear.

To clarify what this means, some of the main points of later sections of this chapter need to be foreshadowed. The last two sections of this chapter will argue that in any market system, there are some very general and inelim- inable features of the economic environment that create the potential for, or make possible, exploitative exchange. It is further argued that individuals, acting either for themselves or on behalf of their firms, have some predispo­sition to seize opportunities to exploit others if and when such opportunities present themselves.⁶ Types of economic systems deal with this potential for exploitative exchange more or less well. What chapters 5-7 seek to establish is that a free enterprise system does a better job at this than does a market socialist system.

But what does ‘better’ mean in this context? Because the objects of dis­cussion are abstract types of systems, it makes no sense to interpret this claim as a comparative quantitative judgment about the number of exploitative exchanges that take place “in” each of the two types of systems; that would have no meaning at this level of abstraction. What is needed is some natural way of classifying or categorizing exchanges that can be used to distinguish and compare the two types of systems.

The basis for such a typology is to be found in the fact that the kinds of organizations found in free enterprise and market socialist systems (and indeed in any market economy) can be defined in terms of a network of con­tracts (i.e., exchanges) among occupiers of a relatively small number of func­tionally defined economic roles. Each organizational type has a distinctive pattern of interrelations between and among the following roles:

1. laborers

2. capital providers, that is, those who furnish the capital the firm employs

3. other input suppliers, such as suppliers of raw materials, semifinished products, and specialty goods and services needed for production

4. monitors, that is, those who decide on the deployment of inputs in the productive process and evaluate the performance of laborers and other input providers

5. central contracting agents, that is, those in charge of negotiating con­tracts with all input suppliers

6. directors of the firm’s output, that is, those in charge of determining the product that the firm produces, its characteristics, and its price,

7. ultimate decision makers, that is, those with final decision-making authority about the deployment of the firm’s assets

8. residual claimants, that is, those with a claim on the residual income stream of the firm, which can be defined as what is left over after all other claims against the firm have been satisfied.

A terminological point: in ordinary parlance and among most economists, the term ‘entrepreneur’ is used to refer to someone who occupies roles 5 and 6, that is, someone who is in charge of the interface, on both the input and output sides, between the firm and the market.

Organizational forms (and, by implication, the two types of systems) can be defined and individuated by how these roles are interrelated. Consider the classical capitalist firm, the open corporation, and the market socialist worker cooperative in this light.

The classical capitalist firm. In the classical capitalist firm, one and the same individual occupies roles 2 and 4-8. Call this individual the boss. The boss also has the right to sell any or all of the rights implicit in these other roles, although for reasons detailed later in this chapter, they will normally be sold as a package. There are two variants on the classical capitalist firm: (1) firms that have small and short hierarchies of monitors, central contracting agents, and/or directors of the firm’s output, with one and the same individual at the top of all these hierarchies; and (2) firms that borrow some of their capital (especially start-up capital) from outside sources; typically, however, the boss contributes a nontrivial proportion of the capital employed by the firm.

The open corporation. A distinctive feature of the open corporation is the separation of management from ownership. In terms of the eight roles, this means that monitoring and other management functions (viz., central con­tracting and directing the firm’s product) are not carried out by those who are simultaneously the ultimate decision makers, suppliers of capital, and residual claimants. Those who simultaneously occupy these three roles, the equity owners, employ management, typically by choosing a board of directors which, in turn, hires and supervises the chief executive officer and/or the management team. Although ultimate decision-making authority and resid­ual claimancy are linked to capital provision, sometimes others supply a sub­stantial proportion of the firm’s capital, either in the form of particular cap­ital goods or more often in the form of loans or the purchase of other debt instruments. These capital providers are entitled to a contractually guaran­teed rate of return on their investment, but they have no ultimate decision­making authority and receive none of the residuals. Their claims do, how­ever, have legal priority over the equity owners in that they get paid off first in the event of bankruptcy. Another distinctive feature of the open corpora­tion is that ownership shares are freely alienable on a securities market. Finally, the liability of the equity owners for execution of corporate debt is limited to the amount of their capital investment.

The worker cooperative. There are worker cooperatives in free enterprise systems and elsewhere. The concern of this book, however, is with the coop­erative as it would exist in the type of market socialist system described and motivated in chapter 2.⁷ In that type of system, the cooperative can be defined as follows: all and only the workers are ultimate decision-making authorities. Typically, this decision-making authority will be exercised in accordance with the one person-one vote rule. In that capacity, the workers either elect management (i.e., monitors, central contracting agents, and direc­tors of the firm’s product) directly or elect those who choose the managers. Workers and managers are all residual claimants, though there is no require­ment that they all have the same income. Although the workers have physi­cal possession of, and management rights over, the capital the firm uses, the state effectively owns all the firm’s capital. State ownership of capital is man­ifested in the following four facts: (1) firms must pay the state a capital usage fee on a regular basis, comparable to an interest premium corporations pay to bondholders and other lenders of capital; (2) firms are required to main­tain the value of their capital by following proper maintenance procedures and by paying into a capital reserve fund from which monies are withdrawn to replace capital goods whose useful life has expired; (3) firms may not sell off the capital they control; and (4) the state reassigns the firm’s capital if and when the firm is dissolved. For these reasons, the state can be considered the provider of capital in a market socialist system.

In a free enterprise or market socialist market economy, exchanges among people occur in virtue of their occupation of one or more of the roles given in the list of eight, plus one role not mentioned in that list, namely, the role of customer. In both types of systems, customers include not only consumers but also other firms. A comparative analysis of a free enterprise system and a market socialist system can proceed by examining the types of exchanges that people make in virtue of the roles they occupy (i.e., where they stand) in the respective systems. But how is this comparison to be carried out for the pur­poses of arriving at some overall assessment of exploitation in these two types of systems?

Suppose, as was suggested, that in general, people have some propensity to seize opportunities for exploitation if and when those opportunities pre­sent themselves. Suppose, further, that there are background conditions in any market system that create the potential for exploitative exchange. Finally, suppose that the structure of roles in one type of organization precludes an opportunity for exploitation that another type of organization does not pre­clude and, furthermore, that a plausible story can be told about how people would seize this opportunity in the latter type of organization. For example, in the classical capitalist firm, the ultimate decision maker cannot exploit the provider of capital for the simple reason that the ultimate decision maker is the provider of capital. In this respect, the classical capitalist firm forecloses an opportunity for exploitation that might otherwise exist. By contrast, as chapter 6 will argue, the ultimate decision makers in the worker cooperative would have the opportunity to exploit the providers of capital, and some plausible stories can be told about how that opportunity could be seized. If this is right, the argument establishes motive, opportunity, and method for exploitation in a market socialist system. By contrast, in a free enterprise sys­tem, the motive is there, but the opportunity and a method are not. In the law, at least, that is good enough for convicting one defendant and freeing another. In this way, it will be argued that a market socialist system permits and encourages a range of exploitative exchanges that are precluded or min­imized in a free enterprise system.

Before getting to these arguments, however, a considerable amount of preliminary work needs to be done. The next section will consist of an expo­sition of some of the seminal developments in economics (specifically, trans­actions cost analysis) in the 1930s and 1950s that underlie the discussion of chapters 5-7. The third section is an extended illustration of these develop­ments; it will explain the distinctive organizational efficiencies of the classical capitalist firm. Implicit in this discussion are indications of how this type of organization prevents or minimizes a range of opportunities for exploitation that would otherwise exist. The fourth and Hfth sections explain why that is a good thing, by identifying the general conditions that make exploitative exchange possible in any market economy. In other words, it establishes that there is the potential for exploitation in any market economy—a potential that is dealt with in one way or another (and more or less adequately) by the system’s organizational forms. Chapters 5-7 explain in detail and compare how a free enterprise system and a market socialist system deal with that potential.