An Illustration: The Classical Capitalist Firm

In an important article, Alchian and Harold Demsetz (1972) offered this sort of explanation for most of the distinctive features of the classical capitalist firm. This section will elucidate this explanation and supplement it with Yoram Barzefs (1987) account of the other defining features of this type of firm.

According to Alchian and Demsetz, what is distinctive about the classical capitalist firm is that it is team production with a centralized contracting agent who is the residual claimant.⁹ What explains this structure? Their explanation starts from the observation that “the economic organization through which input owners cooperate will make better use of their com­parative advantages to the extent that it facilitates the payment of rewards in accord with productivity” (1972, 778). The idea is that if rewards were neg­atively correlated with productive contribution or if there were no correla­tion between reward and productive contribution, the organization would not survive in competition with others that positively correlated reward to productivity. So whatever organization exists, it must achieve a positive cor­relation between reward and productive contribution.

However, achieving this correlation is often no easy matter, especially in the case of team production where individual output is hard (i.e., costly) to meter. Team production involves several types of inputs whose product is not the sum of separable outputs of each cooperating resource (1972, 779). This mode of production can greatly increase total productivity, but at the cost of making individual contribution hard to ascertain. The reason that this is a problem—a cost—is that it creates an incentive for individual team mem­bers to shirk, that is, to reduce their input.

This can be modeled as a prisoner’s dilemma or public goods problem. Each individual might prefer that no one shirks but because shirking is hard to detect, anyone who shirks gets all of the benefits but suffers only a fraction of the costs in the form of reduced output. Everyone reasons like this, and as a result, everyone chooses to shirk. Output falls and all are worse off, even according to their own schedule Ofpreferences for income and leisure—that is, each member of the team would prefer less shirking and more output— and hence more income—than they actually end up with.

Before investigating how this problem is solved, it is worth pointing out that ‘shirking,’ the term Alchian and Demsetz use, has misleading connota­tions. It suggests that the input in question is limited to labor contribution and that shirking consists in avoiding labor by putting forth less than aver­age—or less than expected—physical or mental effort. Both connotations are too narrow, however. A broader term is needed to encompass the range of behaviors that Alchian and Demsetz have in mind. Following Oliver Williamson the term ‘opportunism’ can be used to designate the broader range of behaviors of which shirking is a special case (1985, chaps. 1, 2). The inputs that can be reduced by opportunism are not limited to labor. Regular suppliers of any input may act opportunistically.¹⁰ Providers of raw materials and semifinished products may shortweight deliveries, provide goods of sub­standard quality, or adopt policies that encourage or permit these things to happen. Even as it applies to laborers, the connotations of the term ‘shirking’ are too narrow. Workers may act opportunistically not only by hiding out in the restroom and taking longer breaks but also by such things as beating up on equipment to make the job go easier, working carelessly, pursuing office politics instead of doing the job, and in general, engaging in activities unre­lated or only marginally related to the task at hand.

The obvious solution to the general problem of opportunism among input providers is for one of the team members to specialize as a monitor of other input providers. What is monitoring? Perhaps what comes most readily to mind is metering outputs and administering discipline. Once again, however, there is much more to monitoring than the term might suggest. Alchian and Demsetz say, “We use the term ‘monitor’ to connote several activities in addi­tion to its disciplinary connotation. It connotes measuring output perfor­mance, apportioning rewards, observing the input behavior of inputs as means of detecting or estimating their marginal productivity and giving assignments or instructions in what to do and how to do it” (1972, 782).

By hypothesis, metering (i.e., measuring) individual output is difficult in team production—though if one person specializes in monitoring, it should be somewhat easier than if each team member tries to meter the output of all the others. However, since metering individual output is difficult, what often happens is that the monitor makes his estimates based on some more easily observable substitute—usually his own or someone else’s direct observation of individual input. For example, the monitor might make unannounced inspection trips to the work station or solicit the opinion of other team mem­bers who work in the immediate area as a way of evaluating the input of any given worker.

The obvious question this story invites is Juvenal’s ^lQuis custodiet ipsos cus­todes?’—or, Who monitors the monitor? Monitoring is itself difficult to mon­itor, so does the problem not recur at the next level? Alchian and Demsetz maintain that this problem can be solved most efficiently by making the mon­itor the residual claimant; he gets what is left over after all other input own­ers have been paid. By closing the gap between principal and agent, this sys­tem gives the monitor a strong incentive to pay other inputs as close to their marginal value as possible. If he pays them less than their marginal value, other monitors will have an incentive to hire these input owners away for more than he is paying them. Ifhe pays them more than their marginal value, then he ends up with less for himself. (It is not hard to guess which side is the “caution side” on which monitors seek to err.)

Observing and metering inputs is not the only way for the monitor to prevent shirking and other forms of opportunism. The quotation from Alchian and Demsetz suggests that the monitor might also redesign the pro­duction process (which presupposes that he has the power to do so) to make individual contributions more easily metered or else less in need of meter­ing because they are more intrinsically interesting. And he must have the power to discipline input providers, including the power to terminate the contracts of those who cannot resist the temptation to act opportunistically or who cannot perform at a market-determined level of proficiency. This means that the monitor must be the central contracting agent with all the other input providers. Finally, so that the monitor pays due regard to the medium- and long-term wealth consequences of his monitoring (and other) actions, he has to be able to sell his monitoring rights and his rights of resid­ual claimancy.

It is in the interests of all team members that this arrangement exist. In the absence of a monitor, the incentive to act opportunistically will be signif­icant. The reason for this is that the extent of a person’s opportunism is gen­erally not widely known among all other input providers.¹¹ Because of this fact, in the absence of a monitor, it is not possible to reach agreement on an acceptable level of opportunism. It is easy to understand how a self-reinforc­ing process of increased opportunism could get underway, resulting in the dissipation of the benefits of team production. All team members will be worse off as a result—worse off than they would have been if they had been on a team whose members feel the occasional lash of the monitor.

This story is intended to explain a number of features of the classical cap­italist firm:

1. why there is a single monitor

2. why that monitor has residual claimant status

3. why the monitor can determine (within a broad “zone of acceptance”) how inputs are to be used or combined¹²

4. why the monitor is the central contracting agent (and ultimate decision­making authority) with all the other input providers, which entails that he can renegotiate the terms of the contract with each team member, up to and including firing any team member.¹³

There are two other defining features of the classical capitalist firm that this story does not explain: (1) why the monitor-residual claimant is the firm’s entrepreneur and (2) why he is also the primary provider of capital.

Yoram Barzel (1987) has endeavored to explain both of these features of the classical capitalist firm. The basic explanation is the same as that advanced by Alchian and Demsetz: high monitoring costs make it most efficient for the residual claimant to be the entrepreneur and the primary provider of capi­tal goods. What the entrepreneur does is set the terms and conditions for the interactions between the firm and the market.

Barzel offers a similar explanation for why the entrepreneur-residual claimant is also the primary provider of capital. The explanation focuses on entrepreneurial decisions about which venture(s) to pursue. It is very diffi­cult to monitor the investigation and assessment of possible ventures. This means that the risks of any venture are not independent of the entrepreneur’s actions. If he is diligent in investigating and assessing opportunities for the firm, the risks go down; if he is not, they go up.

If the entrepreneur is operating entirely with the capital of others, then he has an incentive to pursue much higher-risk, higher-payoff ventures than he otherwise would. These risks are further enhanced if he is the sole resid­ual claimant and the other providers of capital have the status of bondhold­ers. In contrast, by putting up a substantial portion of the capital himself, he is, in effect, providing a bond that he will act diligently in investigating and assessing possible ventures, as well as in his monitoring tasks and in his other dealings across the firm-market interface. This bonding arrangement has the same consequences as good monitoring (Barzel 1987, 112-13).

This concludes a series of hypothetical rational choice explanations for the salient features of the classical capitalist firm. Seven comments on this series, in no particular order, are warranted:

• There are differences among classical capitalist firms; the series only explains what they have in common. In particular, it explains why all of the functionally defined economic roles except those of (labor and nonlabor) input providers are concentrated in one individual.

• These explanations are not genetic explanations; that is, they are not explanations of how the classical capitalist firm came into being. It is not nec­essary to suppose that someone or some group reasoned all of this out in the misty predawn of capitalism and decided to set up firms in this way. The true story of the genesis of this type of organization is undoubtedly messier and unpleasant in a number of respects. Nevertheless, how the classical capitalist firm came into being is simply not addressed in this account.

• These explanations are evolutionary in the sense that they explain why organizations that have this form would survive in competition with alterna­tives that lack this form in one or more respects. For example, suppose there is an environment in which there are two types of firms: those for which the entrepreneur-residual claimant does not provide most of the capital and those for which he does. The account explains why the latter type would tend to survive and prosper and the former would not. The actual competition may well not have been piecemeal in this way, however. Moreover, Alchian and Demsetz make no effort to document an historical struggle for survival among different organizational forms with the classical capitalist firm com­ing out on top, although, in point of fact, some sort of struggle must have taken place, since the classical capitalist firm has not been around from the beginning of civilization. Nevertheless, they have made no effort to dig up the organizational equivalent of the skeletons of the short-necked giraffes who did not thrive or prosper. Of course, the historical record does tell us some­thing about how production was organized in the precapitalist era, but the Alchian-Demsetz-Barzel account does not rule out a role for extraeconomic (e.g., political) factors in the explanation of the rise of the classical capitalist firm. Indeed this account does not rule out a role for extraeconomic factors in explaining the persistence of the classical capitalist firm if the phenome­non is overdetermined. In other words, the efficiency considerations identi­fied by Alchian, Demsetz, and Barzel may be sufficient to explain the persis­tence of the classical capitalist firm, but extraeconomic factors may enhance its stability.

• As the previous example suggests, these explanations are explicitly or implicitly comparative in that they suggest that alternative modes of organi­zation (in this case, alternative ways of dealing with shirking and other forms of opportunism) are inferior from the standpoint of transactions cost effi­ciencies. For them to be fully convincing, the alternatives would have to be more explicitly and systematically articulated and compared.¹⁴

• All of these explanations contain implicit ceteris paribus clauses. And often, all else is not equal. Perhaps most important is the fact that capital requirements are sometimes too high for one individual to supply most of the firm’s capital. In other words, the transaction costs of coordinating some activ­ities across markets are sufficiently high to make it more efficient to bring under one roof more capital than any one person can supply. As will be explained in the third section of chapter 5, under such circumstances, it is more efficient to effect a partial separation of the roles of monitor, entrepre­neur, provider of capital, and residual claimant—a separation of the sort that one finds in the open corporation. There are also special circumstances under which closed corporations, partnerships, and cooperatives minimize trans­action costs and so are superior, from the standpoint of transactions cost effi­ciencies, to the classical capitalist firm. All of these exceptions and complica­tions are covered by ceteris paribus clauses implicit in these explanations. These clauses will be systematically uncovered in the next chapter.

• Implicit in the various explanations of how opportunism is minimized in the classical capitalist firm are hints about how such a firm prevents or minimizes exploitative exchange. For example, since the entrepreneur pro­vides most of the capital himself, he cannot exploit the primary providers of capital by pursuing an unconscionably high risk venture that will make him big profits if it succeeds and dissipate someone else’s capital if it fails. To take another example, by reducing shirking, the monitor keeps the owner of the firm (viz., himself) from being exploited by lazy workers.

• Implicit in these explanations are the general features of the economic environment that create the potential for exploitative exchange. Specifically, the gains from team production, the penchant most people have for oppor­tunistic behavior, and the informational asymmetries that allow people to practice the opportunistic arts are general phenomena that are ubiquitous in a modern market economy. The next two sections will systematically identify and discuss these general phenomena or background conditions that make exploitation possible in any market economy, and indeed perhaps in any eco­nomic system whatsoever.