Other Forms of Exploitation in the Small-to-Medium-sized Cooperative

The purpose of this section is to consider other distinctive opportunities for and methods of exploitation that would be found in small-to-medium-sized market socialist cooperatives.

With regard to these smaller firms, the first subsection will concern exploitation of nonopportunistic workers by opportunistic workers and monitors; the second is about exploitation of and by central contracting agents and directors of the firm’s product; and the third and final subsec­tion considers how the cooperative might collectively exploit the capital providers, that is, the state and ultimately the taxpayers.

Exploitation by Opportunistic Workers and Monitors

It might seem that the cooperative would not face the problem of workers shirking or engaging in other forms of opportunism because, unlike the sit­uation in capitalist organizations, workers are the residual claimants. But that inference is unsound. Production is still team production, which means that individual contribution (and thus its value) is hard to ascertain. This means that the opportunistic worker gets all of the benefits but suffers only a fraction of the costs of his foul deeds. In very small organizations (those with under a dozen, or perhaps twenty, members), this may not mat­ter very much. The income and wealth consequences of shirking and other forms of opportunism by even one member may be so significant for every other member of the cooperative that everyone has a strong incentive to do whatever monitoring is necessary to reduce it to an absolute minimum.

It might be thought that cooperatives would require less monitoring than their capitalist counterparts because the cooperative form of organiza­tion would have a legitimacy in workers’ eyes that their capitalist counter­parts lack in a capitalist system. The problem with this hypothesis, however, is that it overlooks the fact that economic systems (and thus types of organi­zational forms found in them) that persist tend to be in harmony with wide­ly shared views about what kinds of economic relations are legitimate. This is an implication of Marx’s insight that a society’s base (economic structure) determines its superstructure (ideology).¹⁴ Indeed, one of the striking fail­ures of the socialist movement in the past century and a half has been its inability over a protracted period of time to persuade large numbers of people of the illegitimacy of the capitalist system and its organizational forms. The fact is that most workers in existing free enterprise systems do not regard the economic system under which they live as fundamentally illegitimate, despite the herculean efforts of its ideological opponents.

These observations notwithstanding, it is likely that the very small coop­erative will be somewhat better monitored than the very small classical capi­talist firm because all the workers have the status of residual claimants.

The short answer to that question is no, and the reasons are to be found in the transactions cost efficiencies of bringing large amounts of capital under one decision-making roof discussed in the last chapter. The main advantage of expanding the boundary of the firm at the expense of the market is that it yokes together the interests of the ultimate decision-mak­ing authorities who control complementary assets. When these assets are not brought together within the firm, they are controlled by groups or indi­viduals with disparate interests, and contracts have to be negotiated across the market. For reasons discussed on a number of occasions in this book, expropriation hazards (i.e., opportunities for exploitation) can exist in this environment that would otherwise not exist if the firm-market boundary were dissolved at that point. So there would be significant avoidable risks of exploitation if firms were restricted to an artificially small size. To put this in more concrete terms, consider what would happen if a large manu­facturing facility were broken up into numerous very small cooperatives. If the boys in the paint booth had to negotiate a contract to supply the ladies down in final assembly, somebody’s highly specialized assets would be seri­ously at risk. At the very least, extremely complex contracts would have to be negotiated and written. Inevitably, such a society would end up saying to its lawyers what American society has said to its doctors: “Here is the wealth of the nation: take what you think is fair.”

In light of these observations, it is possible to assume for the sake of dis­cussion that there would be no artificial barriers to firm size in a market socialist system and that transactions cost efficiencies would play about the same role in a market socialist system as they play in a free enterprise sys­tem in determining where the firm-market boundary would be drawn.¹⁵ Because of the conceptual connection between transactions cost inefficien­cies and opportunities for exploitation established in chapters 3 and 4, this assumption implies that the opportunities for exploitation that arise or exist because of where the firm-market boundary is located would be about the same in both types of systems.

One final methodological assumption: in what follows, no distinction will be made between very small firms and small-to-medium-sized firms unless there is some reason to believe that there would be systematic differ­ences between them as it pertains to exploitation. (The issue at hand— monitoring—is a case in point.)

Returning to the problem of monitoring in the small-to-medium-sized cooperative, when firms are employing, say, twenty-five or more workers, it will make sense to have a full-time monitor. Unfortunately, monitoring is likely to be significantly less effective in small-to-medium-sized cooperatives than in comparable classical capitalist firms. To see why, notice that there are two important differences between these two types of organizations. One is that in the cooperative, the workers are the ultimate decision-mak­ing authorities. This means that the monitor is either directly elected by the workers or is chosen by a workers’ council elected from their ranks. By contrast, in the classical capitalist firm, the monitor is not responsible to the workers. A second difference is that in the cooperative, unlike in the classi­cal capitalist firm, each of the workers is a fractional residual claimant. Given some plausible assumptions about human behavior, these two facts are responsible for three weaknesses in the cooperative’s monitoring arrangements—weaknesses that do not afflict the classical capitalist firm.

First, unlike the classical capitalist firm, cooperatives face a problem of adverse selection in choosing a monitor. The monitoring job will dispro­portionately attract those with the essentially political skills required to get elected to the job of monitor. Obviously, these skills need not be positively correlated with the ability to succeed at the often disagreeable tasks that a good monitor must do. In point of fact, these political skills might well be negatively correlated with what is required to be a good monitor. Workers would be inclined to vote for those who appear to promise to go easy on them individually (or on their subgroup) and to go hard on everyone else. Convincing people of this sort of thing is the consummate political accom­plishment of successful politicians in a democracy. This is an adverse selec­tion problem because the system encourages people like this (i.e., undesir­able types) to come forward to seek the job of monitor.

Second, a distinctive moral hazard problem is associated with monitor­ing the cooperative. To the extent that opportunism cannot be prevented by redesigning tasks to make them more agreeable, a successful monitor must create a climate in which opportunism is not tolerated. It is hard to see how this could be done without creating a relationship between the monitor and the workers that would be to some extent adversarial. Such a relationship would be difficult to sustain in a context in which the monitor is elected by the workers. In short, it will be difficult for the monitor to put the fear of God in the workers if the workers get to elect God.

Third, monitoring is itself difficult to monitor; the cooperative’s moni­tor has only fractional residual claimant status. This is significant in light of the fact that for most people the monitor’s tasks of metering inputs, appor­tioning rewards, and administering discipline are often intrinsically dis­agreeable—especially for the cooperatives’ monitors, who have the requi­site political skills to get elected to the job.

By contrast, the classical capitalist firm faces none of these problems. Getting and keeping the job of monitor does not depend on the good will of those who are being monitored. The job tends to attract and reward those who are best at running companies, a crucial facet of which is moni­toring team production. Popularity with the workers is neither necessary nor sufficient for getting and keeping the job. In addition, since the moni­tor is the full residual claimant, he bears the full income and wealth conse­quences of his shirking, including the consequences of the shirking and other forms of opportunism of his employees. In the classical capitalist firm, every dollar that the shirking worker filches is filched from the boss. For all these reasons, monitors in the classical capitalist Hrm would gener­ally be more effective at ferreting out and getting rid of parasitic, oppor­tunistic workers (i.e., the exploiters) than their counterparts in the worker cooperative.

How might the defender of market socialism respond to these observa­tions? In the first place, it might be objected that the empirical evidence does not support these theoretical speculations. Bradley and Gelb have found that in the cooperatives of Mondragon (where managers are elected by the workers), monitoring by management is, in point of fact, quite effec­tive; there is even some horizontal monitoring by fellow workers (1981, 211). This evidence is ambiguous, however. The basic problem, which was noted in the general discussion of Mondragon in the first section of this chapter, is that three other factors may be responsible for the low incidence of shirking in Mondragon: (1) these firms compete with capitalist organiza­tions and so must be effectively monitored or in need of little monitoring if they are to survive; (2) there may be selection biases that draw relatively nonopportunistic managers and workers to the Mondragon cooperatives and repel more opportunistic prospective workers and managers; (3) the fact that the Mondragon workers have something approaching equity own­ership in their cooperatives may be an important factor in accounting for effective monitoring. None of these factors would operate in a market socialist system.

Another objection would be to call attention to the fact that market socialism is a competitive economy, which means that firms with serious internal weaknesses would not survive in competition with firms that have avoided these weaknesses. Cooperatives that are taken in by opportunistic monitors would tend not to survive, whereas those that chose more hard­nosed monitors would survive and prosper. Though this is possible, there is little assurance that it will happen, since the undesirable behaviors are largely unobserved and the character traits that are responsible for those behaviors are unobservable. In addition, because one basic type of organi­zational form is mandated, there is much less room for experimentation in organizational structure than in a free enterprise system. In other words, since cooperatives in a market socialist system have to compete only with firms that face similar potential problems, there is no assurance that these problems would be solved by market forces. (On this point, consider public bureaucracies which have no competition from alternative organizational forms.)

Finally, this response overlooks the fact that what is at issue is a compar- ative assessment of the classical capitalist firm and the small-to-medium- sized cooperative. Even if market forces provided some check on the factors that lead to weak monitoring in cooperatives, those factors will still exist and would still have some effect. Monitoring may not be a disaster in the small-to-medium-sized cooperative, but what is at issue is whether or not it would be generally less effective than in comparable classical capitalist firms where the monitor is the full residual claimant (and thus requires no monitoring herself). In this connection, notice that the entrepreneurial gains that can be realized by reducing shirking and other forms of oppor­tunism cannot be fully captured by the person who provides these superior monitoring services in the cooperative. Instead, she must share those gains with all who work in the cooperative. This weakens her incentive to come on board and put up with the inevitable unpleasantness that would attend turning a firm around.¹⁷

Another objection might be that the observation presupposes the absence of trust and solidarity among workers in the cooperatives. The presence of those sentiments would lessen the need for monitoring by mak­ing the workers less disposed to shirk. This means that the internal weak­nesses of the cooperative’s monitoring arrangements are less of a concern. While this possibility cannot be ruled out, there some reason to be skeptical of it. It is not at all clear what it is about the cooperative that would ground this increased trust and solidarity. It might be thought that the basis for this would be the fact that the firm belongs to them; it is theirs. But there is an important sense in which the Hrm does not belong to them: they don’t own it! More exactly, all of the firm’s nonhuman assets belong to society at large and are entrusted to the workers only for as long as they happen to be using those assets. Though they exercise operational control over those assets, at the deepest level, this control is conditional. Indeed this condi­tionality of control is, in some sense, the essence of social ownership.

Two other reasons to be skeptical of the potential for solidarity within the cooperative are related to the workers’ status as residual claimants and ultimate decision makers. As was argued in the last section, a source of fric­tion in the cooperative is the fact that the workers collectively get to decide how the net income of the firm will be divided up (or the criteria that determine how the firm’s income will be divided). Disagreement about this matter is very likely. More generally, as ultimate decision makers, some workers will undoubtedly disagree with the direction the company is tak­ing, who the managers should be, and so on. Indeed, a whole range of issues and decisions are up for discussion and a vote in the cooperative that are up for neither in the classical capitalist firm. It would be unduly opti­mistic to suppose that there would be no sore losers in these disputes. Sore losers in this context are workers who shirk or otherwise act opportunisti­cally in response to being on the losing side of these contentious issues that the workers must address as a collectivity.

Indeed historically, solidarity has been best and most impressive when a group is confronted by a clear and direct threats to individual and group interests. Such threats produce cognitive agreement and a harmony—or even an identity—of interests. Such agreement and harmony would not exist when workers were debating among themselves (being possibly at each other’s throats) about what policies and procedures a firm should adopt and how income should be divided up. The existence of competitor firms may suppress these problems up to a point, but as long as a firm’s back is not to the wall, or as long as its competitors are facing the same problem, it is likely that this basis for solidarity would not exist. These con­siderations suggest that whatever the forces at work on the monitor, the monitor’s task of preventing shirking and other forms of opportunism may be more difficult, not less difficult, than that of her capitalist counterpart.

Let us suppose, however, that the fact that the workers are collectively the ultimate decision makers and residual claimants would not weaken soli­darity within the cooperative. Suppose further that the problem of shirking among the workers was small and insignificant. Even if things started out that way in market socialist economy, it would become a genuine problem because of the systematic weaknesses in the cooperative’s monitoring arrangements. As explained in the first section of this chapter, the dynam­ics of adverse selection and moral hazard systematically shape behavior to conform to the constraints imposed by the institution. In other words, as long as some penchant for opportunism remains in the hearts of the work­ers, the human material in the cooperative will be placed between the anvil of adverse selection and the hammer of moral hazard, resulting in a rise in opportunistic behavior and a strengthening of the penchant for it. It is in this way that shirking—and the exploitation it represents—is transformed from a human problem into a social problem.

Exploitation of and by the Firm’s Managers

Management consists of monitoring, acting as central contracting agent, and being the director of the firm’s product. Monitoring has already been discussed; this subsection considers the other two management functions. The central contracting agent represents the ultimate decision makers in dealing with suppliers of inputs. However, when it comes to labor inputs, it seems reasonable to suppose that in the small-to-medium-sized cooperative, the hiring of new workers would be done by a committee of the whole or a large and representative subcommittee. The decision to hire a new worker is the decision to cut each worker’s share of the firm’s income, so it would undoubtedly be taken with care and only after thorough discussion. Contracts for other inputs, however, would be handled by a central con­tracting agent. The director of the firm’s product manages the output side of the firm-market interface. This includes making decisions about what product(s) to produce, what quality characteristics it shall have, and how it shall be marketed and priced.

It is hard to know how all of the tasks associated with these two roles would be divided up in the small cooperative, though if the classical capital­ist firm is any guide, it is likely that they would be assigned to one per­son—in fact, to the same person who is the monitor.¹⁸ There are obvious efficiency advantages to having one person in charge of both the input and output interface between the firm and the market and to be in charge of the deployment of factors of production within the firm. (The latter is part of the monitor’s job.) This observation is subject to two important qualifica­tions. One is that when the firm reaches a certain size (the medium-sized cooperative), one person will not be able to execute all of these tasks; as in the comparably sized classical capitalist firm, a small and short hierarchy (democratically selected, no doubt) will be needed. The second qualifica­tion is that the cooperative would probably involve the workers in more of the decision making, since this is supposed to be one of the principal virtues of the cooperative in comparison to capitalist firms. However, since complete contracts governing every contingency cannot be written, it is likely that the way this would work is that the membership would have to be consulted on a specified range of decisions (e.g., the introduction of new products), while managers would be granted residual rights of control, that is, all management rights not otherwise assigned to the workers. They would have these residual rights for as long as they occupy the manager’s position.

Though this looks to be a cozy arrangement in which no one could get exploited, in point of fact that is not the case. The numerous opportunities for exploitation implicit in this arrangement are traceable to the nature of the manager’s tasks, coupled with his status as fractional residual claimant. To understand these opportunities, it is necessary to get clearer about what the cooperative’s residuals represent. These residuals are the income of the firm net of nonlabor expenses. For analytical purposes, this income can be conceived of as consisting of two parts: (1) the returns to ordinary labor (this can be thought of as a wage fund) and (2) the returns to entrepre­neurship, which are zero when the market for the firm’s inputs and outputs are competitively efficient. The firm’s manager, in each of her three roles (monitor, central contracting agent, and director of the firm’s product), can be conceived of as providing the firm with labor in the form of (1) routine decision-making services and (2) extraordinary decision-making services (entrepreneurship) in which pure profits for the firm, either positive or negative, hang in the balance. Pure profits in this scenario can be thought of as the returns that the firm gets over or under the going rate of return on its labor assets, just as pure profits in a capitalist firm are the returns that the equity owners get over or under the going rate of return to capital.

The firm’s manager, in her role as central contracting agent and moni­tor, can exercise significant entrepreneurship in searching out the best and least costly input suppliers, in considering and implementing alternative methods of producing the product (including different methods of organiz­ing production), and so on. In her role as director of the firm’s product, she can exercise entrepreneurship by developing new channels of distribution for the firm’s product, restructuring pricing policy, changing the attributes of the product to position it differently in the market, and making any number of changes in the selling effort, such as putting salespersons on commission or taking them off commission. Entrepreneurial activity on both sides of the firm-market interface is extraordinarily important for the success of the firm. If a manager seizes the right opportunities, the margin­al difference can be enormous. On the other hand, if she does a poor job, either by making changes that do not work out or by failing to make changes to keep up with the competition (the equivalent of shirking), nega­tive profits and even ruin can result.

It is now possible to see the significance of the manager’s status as frac­tional residual claimant. If the firm does well as a result of entrepreneurial actions on the part of its manager, the manager gets only a fraction of the value of her contribution. On the other hand, if her entrepreneurial actions (or inactions) fail, the manager pays only a fraction of the costs. These facts create opportunities for exploitation that do not exist in the classical capi­talist firm where the manager is the full residual claimant.

Consider some of the ways in which the cooperative’s manager(s) can exploit the rest of the firm. The central contracting agent can buy inputs from inferior cooperatives of which, for example, her friends or relatives are members and suffer only a fraction of the costs this imposes on the firm. She may fail to exercise due diligence in searching for the best combi­nation of price, quality, and reliable supply of inputs. Similar problems can arise on the output interface. She may fail to seek out new markets for the firm’s product, fail to keep up with innovations, not pay sufficient attention to changing demographics, and so on. In other words, on both fronts, managers may shirk in the provision of routine decision-making services, which can result in real losses for the firm in a changing environment— losses that are spread among all the firm’s members.

In its effects on the firm, this shirking is equivalent to, but conceptually distinct from, poor entrepreneurial judgment on nonroutine questions. Managers may not shirk but can still do a poor job at either or both inter­faces between the firm and the market. Factors that are crucial to a decision may be overlooked or not given appropriate weight. Obvious solutions to new and pressing problems may not be seen, and the cooperative suffers losses as a result. Whether the decisions are routine or not, since managers cannot sell their claims on the residuals, they do not bear the long-term consequences of their decisions. If a cooperative’s manager makes a disas­trous decision that will cost the firm money for the next ten years and she will be leaving in five years (or sooner), then others (future residual claimants) must pay for her mistake.

Of course, cooperatives will make efforts to monitor managers and so prevent shirking and poor entrepreneurship. In addition, they themselves will be called in for advice and consent on major decisions. This would cer­tainly mitigate these problems and it would mean that the membership bears some of the responsibility for whatever decisions are made.¹⁹ But that is not in dispute. The crucial issue is a comparative one, and there can be no doubt that the classical capitalist firm is superior to the small-to-medi­um-sized cooperative on these points. The various forms of on-the-job con­sumption detailed earlier are all found in existing classical capitalist Hrms and indeed constitute a prime cause of business failure. However, since the manager is also the sole residual claimant, he cannot exploit others through his choice to consume on the job. He must bear the full wealth consequences of his decisions, not only in the present period but into the future as well. This is because, unlike the cooperative’s manager, the classi­cal capitalist can sell his claim on the future residuals of the firm, which means that the value of his decisions tends to be capitalized into the value of the firm.

In a related vein, it is worth pointing out that monitoring management is costly and imperfect. It is a mistake to think that the physical proximity of workers and management in the small cooperative would make monitor­ing either relatively easy or less necessary. To keep an eye on management requires something other than an unobstructed line of sight. A good evalu­ation of managerial decision making requires access to the information that the decision maker had, as well as knowledge of the costs of gathering more information. This is part of what makes it difficult and costly to monitor managerial decision making; another part of the problem is that luck can have an imponderable influence on the results of following through on any decision. All of this means that the monitoring activities by the membership of the small-to-medium-sized cooperative will be highly imperfect. This, in turn, implies that it will often be the case that these cooperatives will effec­tively have nowhere else to go when they suffer at the hands of bad man­agement that misrepresents to the workers the value of their contribution; in other words, they do not know that they are having their pockets picked, because they have no cost-effective way to find out that their managers, rather than conditions beyond their managers’ control, are responsible for the firm’s misfortunes. All of this implies that the members of firms with poor managers are exploited by these managers.²⁰ It is worth reemphasiz­ing that these problems simply do not come up in the classical capitalist firm because of the structure of roles of that organization. As full residual claimant (and primary provider of capital), the manager suffers the full income and wealth consequences of her decisions.

A defender of market socialism might point out that all of these prob­lems are also faced by the large open corporation. And indeed that is true. A comparison between the small cooperative and the open corpora­tion would prove less unfavorable to the small cooperative because of this. However, one of the assumptions of this discussion, which was venti­lated at the beginning of this section, is that a market socialist system would have about the same mix of very small, small-to-medium-sized, and large firms as a free enterprise system. This means that the fact that the open corporation suffers some of the defects of the small cooperative is of no comfort to defenders of market socialism: what matters is that it has decisive advantages over its counterpart, the small-to-medium-sized coop­erative.

Turning now to the case of managers who do an exceptionally good job, exploitation would take place in the other direction. Managers who turn routine decisions into nonroutine decisions by exercising initiative and managers who use nonroutine decisions to innovate can position the firm to capture pure profits in the factor markets or in the market for the firm’s product. Moves of this sort are crucial to the operation of the com­petitive process. In the language of chapter 3, these actions turn stagnant markets into markets in transition. However, in a market socialist system, the successful entrepreneur must share whatever pure profits he earns with everyone else in the firm, since the members of the cooperative are the residual claimants. This is also true of those who conceive and develop entirely new products, services, and production processes. Clearly, under these circumstances the successful manager does not get the value of his contribution.²¹ Nor does he really have anywhere else to turn. All coopera­tives require those who exercise the crucial entrepreneurial functions to share the wealth they are responsible for with all other members of the firm. Since, by hypothesis, the private sector is insignificant in a market socialist economy, these managers have no real alternative but to work for a cooperative. In short, they are exploited. This exploitation is mitigated, however, to the extent that the members of the cooperative assist in or monitor decision making. But the workers cannot collectively make or monitor all decisions when the cooperative reaches a certain size (of, say, about two dozen workers).

It is a common observation made by friends of the free enterprise sys­tem that socialism is deficient in encouraging innovation and does not suf­ficiently discourage hidebound, timid (i.e., shirking) management. This is true, and the inefficiencies and wealth losses that this occasions are quite real, but the purpose of this discussion has been to tie these deficiencies to exploitation of and by management. It is not just that people do not have some new products they otherwise would have and that their standard of living is a little lower than it otherwise might be. Another consequence is that some people are getting exploited by others because of this defective economic structure.

By contrast, the manager in the classical capitalist firm experiences the full wealth consequences of his decisions. If he innovates or otherwise exer­cises successful entrepreneurship, he will be able to capture all of the gains of that innovation because he is the sole residual claimant. To these obser­vations it might be responded that the structure of the classical capitalist firm rewards equally the wise and the lucky and punishes equally the fool­ish and unlucky. Indeed, that is true, and if as I have argued elsewhere (Arnold 1987c), people’s deserts are determined by their contributions, then to the extent that the deserts of classical capitalists are attenuated by good or bad luck, these classical capitalists get more or less than they deserve.²² But this has no consequences for exploitation. Lucky classical capitalists are not exploiting anyone, and the unlucky ones are not being exploited by anyone. The only failure of reciprocity is between them and the gods.

Exploitation of the Capital Providers

For reasons explained in the preceding subsections, the exploitation of some members of the cooperative by others is likely to be more serious or significant than comparable forms of exploitation in the classical capitalist firm. However, suppose this is not the case. Suppose that other factors, such as solidarity among the workers, would prevent these forms of exploitation. Workers would rarely think in terms of “I,” “me,” and “mine”; instead, they would think in terms of “we,” “us,” and “our.” Under those cir­cumstances, there could still be exploitation across the boundary between the firm and other organizations, including, notably, state organizations. Indeed, in a market socialist system, it is at the boundary between the firm and the state that those who would be opportunists in the service of their cooperatives would find the mother lode of quasi-rents to be appropriated. This is a consequence of the fact that unlike the classical capitalist firm, in which the residual claimant owns most of the capital that the firm employs, the state effectively owns all the capital that the market socialist cooperative uses.

To understand how exploitation takes place at this boundary, it is help­ful to recall how ownership of the nonhuman productive assets of a society is conceived of in a market socialist system. It is also necessary to under­stand in more detail just what those assets are. In a society that has a mar­ket socialist economic system, the public is supposed to own these assets col­lectively. Since the state is democratically controlled, the state stands in for or represents (albeit imperfectly) the public on this matter. Members of cooperatives are temporarily entrusted with a portion of society’s produc­tive wealth to use for their own benefit and for the benefit of society, but these assets are really owned by society as a whole. That ownership is mani­fested in four distinctive features of a market socialist system noted at the beginning of the second section of this chapter: (1) the cooperative is required to maintain physical plant and equipment and must make pay­ments into a capital reserve fund to replace these goods when their useful life has expired, the former being comparable to maintenance require­ments imposed by lessors on rented equipment in a free enterprise system, the latter to principal on a loan or the replacement cost of a rented capital good; (2) the cooperative must pay a capital usage fee to the state, which is like interest on a loan or a premium paid on a leased capital good over and above the replacement cost; (3) just as a firm cannot sell a leased piece of equipment to someone else or to some other firm and pocket the proceeds, so too a cooperative cannot sell off the assets it uses; and (4) control of the firm’s assets reverts to the state if the firm goes out of business, just as con­trol of a rented piece of equipment would revert to the lessor in the event that the lessee went out of business.

Feature 1 raises a point about accounting that warrants some clarifica­tion.²³ Accountants would prefer the term, ‘capital reserve fund’ to ‘depre­ciation fund’ to describe the fund the cooperative must set up and to which it must make periodic payments. Depreciation is a way of calculating the value of an asset at any particular point in its life. If a machine that costs $x has a useful life of ten years, its value after one year is $.9x. Depreciation schedules are used by accountants to determine the cost of producing a unit of the firm’s product and, of course, these schedules have tax purpos­es. In the accounting sense, however, there can be no such thing as a depreciation fund, since depreciation is simply a way of calculating the value of assets at a given time. A capital reserve fund, on the other hand, is a fund set aside to replace capital goods as they are used up. The difference is important in the present context because the historical cost of an asset may not reflect accurately the current value of that asset. An obvious rea­son for this is that replacement costs may have changed, but there may be other reasons as well (more on this later). The general point is that if the assets of the firm are conceived of as a portion of society’s wealth that the cooperative has the use of on a temporary basis, it is appropriate to demand of the cooperative that it maintain the value of that portion of soci­ety’s wealth to which it has been entrusted. In other words, society is not providing the cooperative with chunks of metal and wire and the like, but instead with some social wealth. This means that firms do not necessarily discharge their obligations to society simply by paying a portion of the his­torical costs of an asset into a capital reserve fund.

This conception of social wealth and the cooperative’s relationship to it has some additional implications for the purchase and sale of capital goods. When a firm wants to initiate a major expansion, it will presumably borrow money from the state (perhaps through state-controlled banks), with which it will purchase capital goods. The firm will then make capital usage pay­ments on those assets. However, firms cannot be required to clear every purchase of equipment with the banks or with the state. If a firm outgrows its copier machine, it has to be able to sell it on the used copier market and use the proceeds and its reserves or its working capital to buy a larger one. The system could not function if purchases like this had to be cleared through the “owner” of the capital (i.e., the state). What the members of the cooperative cannot do, however, is to sell the copier and pocket the money. So although firms can sell capital goods they control, they cannot sell them off, that is, sell them and divert the proceeds to the residuals. What the state can require, then, is that they not reduce the value of the assets of the firm.

The social wealth controlled by the cooperative is not limited to a collec­tion of specific capital goods (and the labor assets that work them). As Jensen and Meckling point out in their discussion of the pure rental firm, there are some assets that cannot be rented from others (1979, 481). These include product design and engineering, specialized training of the labor force, distribution systems, advertising, and the brand-name loyalty of cus­tomers. These assets are very hard to assign a value to, at least in ongoing operations, and markets in them are fairly thin, to say the least. This cre­ates a valuation problem for the state. How much must the firm include in its capital usage payment to cover the value of, for example, the distribu­tion system for its products? After all, it is in effect renting that distribution system from society, so some payment is due. However this problem is resolved, the state would undoubtedly mandate that these intangible assets be properly maintained. On the other hand, in most cases, no monies would have to be paid into a capital reserve fund for these intangibles because they have no finite life if they are properly maintained.

The sum of the salvage value of a firm’s (nonhuman) assets, both tangi­ble and intangible, is almost always much less than the value of the firm itself. The reason for this is that there are significant complementarities among these assets. Indeed, that is part of the explanation for why firms exist at all. This additional value can be imputed to the particular assets of the firm, in which case each of these assets has quasi-rents attached to them. Let us define the quasi-rent value of the firm as the sum of the quasi­rents of its assets, both tangible and intangible. The quasi-rent value of the firm reflects its location—its niche—in the larger economic system of which it is a part. Accountants call this “good will” (Kieso and Weygandt 1983, 572-74), but the term is misleading because the value it represents is something more than the value of intangibles such as customer loyalty. A firm that is making a profit is meeting a certain constellation of needs of its clients and is providing a source of revenue for its input suppliers. Persons and organizations on both the input and output sides of the firm-market boundary will have made at least some investments in their relationship with that particular firm, and the firm will have made corresponding investments in its relationship with them. These investments would be lost if the firm went out of business. When the market socialist state abolishes private ownership and turns firms over to the workers, organized as coop­eratives, part of the social wealth with which the workers are entrusted is the value associated with the firm’s position in the economy and thus the quasi-rent value of the firm. To maintain this value, the management of the cooperative must maintain the position of the firm (in the broadest sense of that term) in the economy.²⁴

To summarize, there are three forms of social wealth owned by society at large (through its representative, the state) that are entrusted to the cooperative: physical assets (e.g., plant and equipment), intangible assets (e.g., product engineering and distribution systems), and the firm itself, whose value is more than the sum of the salvage value of its parts.

This structure of ownership rights to a firm’s nonhuman assets is responsi­ble for a number of opportunities for exploitation by and through the worker cooperative that do not exist in the classical capitalist firm.²⁵ They all stem from the fact that the workers have no equity stake in the firm and thus have a limited time horizon when it comes to the firm and its assets. Unlike the workers in Mondragon, whose members receive an equity pay­out when they quit or retire, when members of a market socialist coopera­tive leave the firm, they receive no payout, since they are not equity own­ers. This limited time horizon attenuates their interest in the firm (specifi­cally their interest in its financial well-being after they leave), at least in comparison to a classical capitalist, who can sell both the particular assets of the firm and his rights to the residuals (i.e., the future cash flows that the firm generates).

It would be implausible to maintain, as Jensen and Meckling (1979) sometimes seem to, that the workers in a cooperative would have no inter­est whatever in their firms after they leave. Ties based on fraternal feelings and solidarity may well serve as a basis for an interest in the well-being of the cooperative that extends beyond their own tenure. Indeed, that interest would very likely be more substantial than the interest of workers in a clas­sical capitalist firm, since the latter are neither its ultimate decision-making authorities nor its residual claimants.

On the other hand, the point of comparison is not between the two sets of workers, but between the workers in the cooperative and the classical capitalist. The latter’s ties based on sentiment are often quite strong, more so if his offspring can inherit the firm—which brings us back to the finan­cial interests involved. As indicated, the financial interests of the workers in the cooperative are systematically different from the classical capitalists, because the former do not own the firm’s assets and have a limited claim on the firm’s residuals. This means that the current workers in a cooperative, who are both ultimate decision makers and residual claimants, have both opportunities and a motive for exploiting capital providers (the state) and possibly future residual claimants (future workers) — opportunities and motives that do not exist in the classical capitalist firm. These opportunities can be found in (1) the maintenance rules for capital goods, (2) the capital reserve requirements, (3) the rule requiring them to maintain intangible assets, and (4) the rule requiring them to maintain the quasi-rent value of the firm itself. Let us consider each of these in turn.

The first of these opportunities involves what Jensen and Meckling call the agency costs of the rental arrangement (1979, 480). To understand what these costs are, consider rental arrangements for capital goods in existing free enterprise systems. Long-term rentals that cover the entire useful life of a capital good are, in point of fact, quite rare; the asset is usually owned outright by the firm that uses it. There is a transactions cost explanation for this. It is difficult to write complete, easily enforced, long-term rental con­tracts governing every contingency for most capital goods. In a long-term contract, acceptable maintenance becomes harder to define, and the replacement cost of the asset becomes more speculative and problematic. For these reasons, it is usually more efficient for the firm to own capital goods outright.

Consider now the cooperative. As explained, it effectively leases all of its capital goods from the state. Although the state requires the cooperative to maintain its assets properly, as was just noted, what counts as proper main­tenance becomes increasingly problematic over the length of the life of an asset. The state would have to set standards to try to ensure that capital goods are properly maintained. The interests of the cooperative’s members lie elsewhere, however. Because their (financial) time horizon does not extend beyond their employment at the cooperative, it would sometimes be in the interests of the cooperative and its monitor—but not the classical capitalist firm and its owner-monitor—to defer or skimp on maintenance whenever doing so would increase net revenues (i.e., residuals) in the short term at the expense of net revenues beyond their time horizon. The state would undoubtedly incur monitoring costs to try to prevent this, but since monitoring is both imperfect and costly, there would be an opportunity for the residual claimants (members of the cooperative) to exploit the capital providers (the state) that would not exist in a classical capitalist firm where these two roles are joined.²⁶ There is no need to suppose that the ultimate decision makers in the cooperative (i.e., the workers) are bent on running the firm into the ground. The issue is never faced like that. Rather, there are many small decisions that have to be made about maintenance, and all that is being supposed here is that the workers would tend to favor deci­sions that benefit them at the expense of the state.

The obvious agency costs of the rental arrangement are those associated with the maintenance of capital goods; the unobvious ones are those associ­ated with the capital reserve fund. One way of thinking about the rule requiring firms to pay an amount equal to replacement costs into a capital reserve fund is that it is a way of keeping the cooperative from consuming its capital by funneling wealth from the capital providers (i.e., the taxpay­ers) into its pocket. The problem with this rule is that it could be manipu­lated by the cooperative because of its highly indeterminate content. This indeterminacy stems from the fact that economic conditions are always in a state of flux, and firms must take this into account when they are planning to replace equipment and other capital goods at the end of their useful lives. What does it mean to set aside enough money to replace your coop­erative’s mainframe computer when computer technology is being continu­ally revolutionized? Presumably, the firm is supposed to set aside enough funds to replace a capital good with something that is functionally equiva­lent, which means that the firm would have to exercise some judgment on this question.

Is the firm itself going to be the same size next year? Is the product mix going to remain unchanged? Has technology changed in ways that affect production facilities? These and countless other questions affect plans to replace—or not to replace—capital goods. Even the decision to continue to produce the same item in the changing world of a market economy is a speculative one, Cequiringjudgment and business acumen. If, for example, a firm is producing home movie cameras at the dawn of the age of the cam­corder, what should they be paying into their capital reserve fund, given that their product is about to become obsolete? And does it really make sense to incur substantial maintenance costs for specialized production equipment that will soon have to be scrapped?

In light of this, it would not be at all surprising if the firm systematically underestimated both maintenance costs and what needed to be paid into the capital reserve fund for those items whose useful life would expire beyond their time horizon. After all, if they underestimate those costs, the bottom line is correspondingly improved in the near term. (Independent of the implications for exploitation, the cumulative effect of this would be to shorten the useful life of all equipment, which would distort the capital structure of the economy even further.)

It is important to understand that the state cannot simply stamp its foot and tell the cooperatives not to “cheat.” Not only are there significant infor­mational asymmetries that cannot be overcome or can only be overcome with monitoring efforts that are not cost-effective, but (as the preceding dis­cussion shows) the facts of the matter are themselves inherently contestable and highly speculative. In summary, then, the epistemological fog sur­rounding the replacement value of firm’s assets creates opportunities for the cooperative’s residual claimants to appropriate for themselves some of the value of those assets when those assets have to be replaced at a time that is beyond their time horizon. In other words, they can exploit the own­ers of the firm’s capital—the state and through it, the taxpayers.

What about assets that do not have to be replaced—intangible capital such as a brand name, a distribution system, product design and engineer­ing, and so on? Since some of the value of these assets would be realized in the future, that is, beyond the current workers’ time horizon, they would have less incentive to protect the long-term value of these assets. Imagine a situation in which control of the firm is effectively in the hands of older workers (who are going to retire in, say, the next five years) in an alliance with those who are planning to move on to other firms in the near term. It would be in the interests of these older workers and the short-timers to sell off, for example, a distribution system to a rival and then lease it back for five years. Or they could sell another firm’s products under their brand name as a way of selling their brand name or customer loyalty. Of course, they are not supposed to be able to sell off capital goods, but the distinction between selling off assets and simply making the adjustments necessary to maintain the position of the firm in the economy is a difficult one to draw. For firms unsure about where to draw the line, consulting firms would doubtless spring up to help them do it to the best of their advantage.

To this it might be objected that these older workers would not sell their younger counterparts down the river. But there is no need to assume an unusually strong penchant for opportunism on the part of the old-timers and the short-timers: transactions that have the effect of selling off intangi­bles could be folded into other transactions that arguably make good busi­ness sense. The systematic bias responsible for selling off intangibles may be a cognitive bias as much as a bias of the heart. In other words, the short­timers (whose ranks would swell as the firm headed toward bankruptcy) and the old-timers may genuinely believe that they are doing what is best for the firm when, in point of fact, what they are doing is best only for themselves. It would not be the first time that people’s beliefs were pro­foundly shaped by their interests.

Finally, the quasi-rents of the firm itself constitutes a store of wealth that can find its way into the pockets of the firm’s ultimate decision makers. How could this wealth be tapped? One way would be to borrow funds and use the proceeds to invest in projects that expand current cash flows at the expense of future cash flows where the loan is repaid in constant amounts over a period of time (Jensen and Meckling 1979, 496). This period of time could extend beyond the termination date of most workers—or of older workers who exercise disproportionate ultimate decision-making authority. In this way, income would be shifted from the future to the present and thus from younger workers—and even from future workers—to older workers.

A second way to tap this quasi-rent value would be to issue long-term bonds (or borrow money from the state designated as working capital) and use the proceeds to increase that year’s payout or fringe benefits. Or work­ers could vote themselves large pension benefits with no funding provi­sions, just as politicians do in dealing with state employees (1979, 484).

Finally, current workers in the cooperative could get access to the quasi­rent value of the firm through the improper exercise of entrepreneurship. It was pointed out previously that the firm has a responsibility to maintain its position in the economy. Presumably, if it improves the firm’s position, it would reap the benefits in the form of increased residuals. But what hap­pens if it retreats from its position in the market? Who bears the losses? Presumably, the residual claimants. But suppose the latter can shift those losses—in effect, the costs of poor entrepreneurship—beyond their time horizon. They would certainly have some incentive to do this. One way that this could happen is that firms could take on excessively risky projects whose benefits accrue in the near term if all goes well and whose costs, if the venture fails, would be spread out over a time period that extends beyond their time horizon.

In these and other ways, present members of the cooperative could access the quasi-rent value of the firm and thereby exploit those to whom it belongs—society at large, or more exactly, the taxpayers. Other groups whose quasi-rents would be appropriable under some of these scenarios are younger workers and future workers in the cooperative because of their residual claimant status. These groups, as well as the taxpayers, are the ones that will have to foot the bill when payment comes due.²⁷

There is some empirical evidence that has a bearing on these issues. Many of these problems have afflicted what used to be Yugoslavia, where the state and not the workers owned the capital of the firms. As Jan Vanek has said in his discussion of the worker cooperative in Yugoslavia,

The danger often referred to in the Yugoslav experience of the work col­lectivities ‘eating up their factories’ can therefore be seen not merely in its crude form of lack of maintenance and of replacement of physical assets, excess distribution [of residuals]... but also in the more subtle form of greater or lesser depreciation of all assets in real terms through improper or inadequate operation of the enterprise. (1972, 220)

Obviously, in a market socialist system, various forms of monitoring would be instituted to try to prevent these and similar predations. These will be discussed in some detail in the second section of the next chapter. Moreover, if real solidarity among the workers existed, it would likely dampen the penchant for opportunism, though it is less plausible to sup­pose that this solidarity would extend easily or completely beyond the boundary of the cooperative to the state bureaucracy charged with moni­toring the firm’s use of society’s capital. After all, the natural human reac­tion to audits and auditors is on par with the natural human reaction to root canal procedures and the endodontists who perform them.

However—and this brings us to the crucial point of this discussion— none of this potential for exploitation exists in the comparable organization in a free enterprise system, the classical capitalist Rrm. The manipulation of maintenance and capital replacement does not create opportunities for exploitation in the classical capitalist firm because the residual claimant also provides the capital and can sell his interest in the firm at any time. Because of that, he suffers the full wealth consequences of any decisions about maintenance, capital replacement, and the sale of intangibles. This is true even of the wealth consequences that are realized in the distant future because those consequences are capitalized into the value of the firm. Moreover, since he owns the firm, he owns its quasi-rent value, so he cannot exploit someone by appropriating this wealth in his capacity as ultimate decision maker. For all these reasons, there are opportunities and motiva­tions for exploitation in a small-to-medium-sized cooperative that simply do not exist in the classical capitalist firm.²⁸