The paradox of monitoring
The theory of the classical firm assigns to one factor of production, typically capital, the role of deciding the monitor of, first, its own performance and, second, the performance of the other factor, that is, labour.
Monitoring is in itself a productive task, since it prevents shirking, that is, a suboptimal use of the means of production, typically in the interest of one of those involved in the process of production but not coincident with the purpose of the operation. Oliver Williamson calls this the problem of subgoal pursuit. The marginal productivity of the factors of production, both labour and capital, depends on managerial services, and in particular the marginal productivity of labour depends on managerial inputs, as the marginal productivity of management depends on the willingness of workers to be efficiently managed. The marginal productivity of either one of these factors determines, ultimately, its remuneration. Both wages and managers’ earnings depend, ultimately, on their marginal productivity, measuring errors notwithstanding. Hence, when in both line work and management there is an element of discretion, a system of monitoring needs to be found that does not depend on any one of these factors.If we look at the situation as it existed in West Germany in 1949, when the newly elected government with its tiny majority announced its intention to pass the legislation that would introduce codetermination, setting up an efficient governance structure amounted to a substantial organizational and legislative challenge. Six elements of that situation stand out:
1. To begin with, German companies in 1949 had virtually no access to international capital markets. Since there were no local capital markets either, investments had to be made out of profits not yet realized. These profits, in turn, obviously depended on the size of investment.
The larger the investment could be, the larger could be the marginal and total productivity of labour, and hence the wage. However, no capital markets being available and investments having to be paid out of gains not yet being made, the larger the net profits of the firm the larger the wage, but the larger the wages fund, the smaller the net profits of the firm and hence the smaller the investments to be made and hence the smaller the marginal productivity of labour. This strange paradox called for a resolution.2. Owing to both the war damage and the ensuing dismantling campaigns, many firms found themselves with insufficient or no equipment. The firms’ book assets having been reduced by war and ensuing inflation, currency reform and depreciations to next to nothing, the real assets consisted in the firm’s history, a site which often resembled a pile of rubble, and a willing workforce. The history also included the memory of how to produce, of how to organize, how to link up with former suppliers and customers, and how to work with the local government.
3. Some of these former customers, however, were not currently available. German companies had to re-establish their previous international customer relationships, itself a time-consuming process, and a difficult one as, because of the war, technological advances had not been realized in civilian production.
4. The reputation of former owners and managers was often tainted. Immediately after the war, some of the owners had been detained in camps, and what had been a business relationship with the government was now seen as criminal complicity. Hence firms often also lacked the credit that they had formerly enjoyed through the reputation of their owners. In part, the new managers, who had to a large extent also been recruited from the labour movement, formed the reputation on which credit could be extended.
5. On the other hand, firms in 1949 invariably met strong market demand, as citizens were trying to rebuild their lives, as either refugees or survivors of the bombing raids.
Many people had lost their household possessions and were eager to rebuild a normal life. The strong materialism characteristic of the 1950s and 1960s in Germany bears ample witness to these initial shortages.6. Finally, political life was reconstituting itself from the bottom up. Only in 1949 had a limited federal government been formed. In 1945, first local, then regional and later state governments had been formed. Only in 1948 was the currency re-established with the consequent emergence of markets. In 1949, the war and post-war period was still very much dominating people’s minds. The experience of the newly created market, in many ways the first free market since 1914, was still very fresh.
What, then, is the appropriate governance structure of corporations to adopt in order to rise out of such precarious conditions? It is obvious that the classical firm, under these conditions, is not the appropriate answer. The monitors themselves needed to be monitored.