PROPERTY RIGHTS

Lecture 5: Support and Attenuation of Property Rights by Government

•  Transaction costs and their reduction: why the firm?
•  The form of the firm; transaction costs again.
•  The corporation and specialization
•  The separation of ownership

 

This lecture examines the relationship between property rights and the firm. Formal markets are only one arena of exchange in an advanced economy; another arena is the firm. More generally, this explores the importance of property rights for understanding the various patterns of organization and contracting found in a complex society. Some goods are traded on spot markets, some goods by various types of market contracts between, and others within the firm, again according to various sets of contracts. Further, firms themselves differ greatly in their organizational structures. Firms have varying ownership patterns, and differing degrees of vertical and horizontal integration. Property rights and a closely related concept � transaction cost � are crucial to the explanation of why firms exist and how they are organized, and to a more general theory of organization.

In the neoclassical theory of perfection competition, utility-maximizing consumers and profit-maximizing firms exchange goods and services in markets. Positing equilibrium, economists can use this model to explain various economic phenomena. One implication of the model is that in a perfectly competitive market the total gains from trade are maximized � that is, the allocation cannot be improved upon.

However, this theory is incomplete as an explanation of economic behavior. If markets allocate goods so well, then why do firms exist? Some goods and activities are not exchanged in formal markets, but are instead produced and traded within a firm. For example, a single firm may purchase iron ore in the market and produce steel pipes from it that it sells in the market. But in converting the ore to steel, the firm produces a number of intermediate products � iron ingots which are converted to steel bars which are converted to steel sheets which are rolled and welded into pipes. Why doesn't the firm shorten this process by instead buying steel bars, or sheet steel. Or why does the firm buy ore instead of mining ore itself. What determines the boundaries of the firm? The theory of perfectly competitive markets has nothing to say about this.

Similarly, why are some firms organized as corporations, others as partnerships, still others as sole proprietorships? Again, the basic neoclassical theory has nothing to say.

Why do firms exist, if market trading works so well? Nobel Laureate Ronald Coase attacked this question in one of his earliest papers (Coase, 1937). The insight that he developed in providing an answer also has proven to be crucial in understanding the economics of property rights. Coase's answer is deceptively simple: if agents sometimes choose to use firms to organize their behavior instead of trading on spot markets, it must be that there are costs to making market transactions � transaction costs . When agents decide to undertake an activity, they take all costs into account, including the cost of using a market vs. the cost of using a firm . Activities which entail low costs when organized on the market relative to costs when they are organized in a firm will be organized in the market. Activities which have lower costs when organized within a firm will be undertaken within the firm.

In the neoclassical model of the perfectly competitive market, all agents are perfectly informed as to opportunities for trade, all possible trades are made, and all trades are enforced � e.g. no one cheats or reneges on a deal. Given these assumptions, it is understandable why neoclassical theory missed transaction costs: it is simply assumed that there are no costs to making trades. However, there are numerous potentially costly activities associated with any exchange, whether it occurs within a market or within a firm. One must identify potential trading partners, one must negotiate terms of trade, and one must ascertain that the terms of the trade are actually followed. (See Eggertsson, 1990, Chapter 1, for a more detailed account.) All of these activities are costly; they generate transaction costs.

Transaction costs can be understood in several ways. They are costs of measurement � one must identify the attributes of assets to be traded by each party, of the characteristics of the trading parties (e.g. are they trustworthy?), and of the methods available for enforcing an agreed-upon trade. At the same time, they are costs of acquiring information � with perfectly informed agents these are assumed to be zero. And � most important for our purposes � they are costs of defining and maintaining property rights. To see this, consider the following.

A property right, in the de facto sense, is the ability to control an asset, or some aspects of an asset. In a world in which trading is costless, the perfectly competitive world, one perfectly informed agent agrees to trade with another perfectly informed agent. The trade occurs, each party receives exactly what was expected, and the story ends. With perfect information, there is no possibility of one's losing control over one's property rights involuntarily or unexpectedly due to the opportunistic behavior of another. Property rights are perfectly defined. And if information is not perfect, then there is uncertainty as to exactly what one has to trade, and � more importantly � what one receives in trade. Establishing one's rights in this context is equivalent to measuring attributes, monitoring behavior, and seeing that the terms of any trade are enforced.

For example, consider the pipe-making firm. In determining which steps in the production of pipes it will undertake itself, and which it will hire from other firms, it compares the transaction costs of organizing the activity in the firm and purchasing it in the market. The firm is likely to use the market for activities when it is relatively easy to measure a trading partner's compliance. For example, the quantity and quality of ore may the crucial factors to the pipe-making firm. These probably are easily measured. If the quality of intermediate iron and steel (ingots, sheets) is not easily measured and the firm has exacting standards required for its pipes, it may choose to produce these itself. In this way, it avoids measurement costs by monitoring the production process. Thus, we would expect to see activities organized in firms when monitoring and measuring costs are relatively high.

Or perhaps the firm can cheaply measure intermediate metal products and therefore could buy from another firm at reasonable cost. But suppose that the pipe-making firm needs a steady supply of high quality sheet steel to fulfill demand for its specialized pipes, and another firm agrees to supply it with sheet steel. The pipe-maker is now dependent on the sheet steel maker, who could suddenly demand different terms of trade. The pipe-maker could be faced with a choice between paying much more for its inputs than it had planned, or failing to fulfill its contracts with its customers. In situations where the threat of such opportunistic behavior is high, activity will tend to be organized in firms. This is most likely when production involves the investment in highly specific assets, i.e. assets that have little alternative use.

These insights strengthen the basic neoclassical analysis by including an important set of costs. Transacting, trading, exchanging are costly activities, and the costs depend on the nature of what is being traded. Are the goods and services easily measured? Do they require specific investments by one or more of the trading parties? The form of the trades also matters. Are the trades are repeated or not? Are the assets traded simultaneously or over time? Are the trading parties known to each other? Do they have reputations which inspire trust? Another factor is the availability of enforcement mechanisms. Will impartial courts settle disputes over contract fulfillment? The study of costly transacting allows us to study these issues, and to systematically explain why economic activity is organized in markets in some cases and in firms in others.

It should be noted that all of the transactions being studied are voluntary transactions, and in that sense all are market transactions. The issue is the type of contract being used. It was implied in the beginning of this lecture that there is a choice: market transactions or activity within the firm. However, it is much more accurate to say that market trading can be organized by a wide variety of contractual relations. These range from �one-shot" spot market trades, to contracts for repeated trades over time, to contracts that give form to a firm. In any given instance, the choice of contracts depends on the relative costs of different forms of transaction. These, in turn, depend on monitoring and measurement costs, potential for opportunistic behavior, and available enforcement mechanisms � i.e. on the costs of establishing, protecting, and exchanging rights to assets (property rights). It is sometimes said that a firm is an island of central planning in a market system, but this is misleading. A firm in a market system is a creation of market contracts, and is subject to the same benefit-cost calculus as simpler market transactions.

One other point should be noted. The costs of contracting are influenced by ex ante and ex post considerations. That is, the incentive and information structures facing trading partners before agreeing on a trade differs from those which exist after a bargain has been struck and a contract signed. Prior to trading, costly activities include finding potential trade partners, agreeing on qualities of the assets to be traded, estimating what sort of price one might offer, etc. Once a contract has been signed, either party might be able to gain by reneging on the deal in some way. Avoiding such opportunism requires costly monitoring to assure compliance with contractual terms. For a standard, widely available commodity traded in a market that approaches perfect competition, these costs are likely quite low. For specialized products made for particular buyers using specialized assets, these costs may be quite high.

The form of the firm; transaction costs again

Property rights and transaction cost analysis can explain the existence of the firm, something that the pure neoclassical model does poorly. Similarly, given that economic activity is organized within a firm, transaction cost analysis can say a great deal about how the firm is organized. Transaction cost analysis is the basis of a theory of organization.

Firm ownership can take a variety of forms: sole-proprietorship, partnership, and limited liability corporation. Limited liability corporations can be further divided into private and public (in the latter, ownership shares are traded in stock markets). Each form of ownership has differing transaction costs in different dimensions. In a sole-proprietorship, for example, a single individual holds ultimate authority in the firm, and bears ultimate responsibility. In a publicly-held limited liability corporation, ownership and management authority are typically divided. This separation between ownership and management permits specialization and the gains that division of labor provides. At the same time, it introduces additional transaction costs, since steps must be taken to assure that managers operate in the interests of the owners.

Transaction cost theory suggests that when firms are organized, rights will be assigned in the following way: the party that is best able to influence the productivity of the asset will be assigned control over it, and will hold the right to the additional income generated by the asset, that is, the party will be the �residual claimant.� This will tend to reduce incentives to shirk, to divert assets to other uses, or to engage in other sorts of opportunistic behavior. This principle applies to ownership of the firm, to organization of activity within the firm, and to market trading in general. Property rights to control over assets and to the income streams generated from them will, in the profit-maximizing firm, be assigned to the agents who are best able to influence them, in order to maximize their value. However, this of course is conditional upon the laws, available enforcement mechanisms, and other relevant institutions (see Lecture 8 for a discussion of the role of institutions).

For example, when the output of an individual worker is easily measured, it is likely that workers will be paid on the basis of individual performance. This gives them incentives to perform well and to maximize the output for a given level of effort. Such contracts can be used at various levels in a firm � from the basic worker to mid-level managers to chief executives, who may depend on performance bonuses for most of their compensation. Sales personnel are often paid a percentage of the revenue from each sale they make. A sale is an easily measured event, and paying on this basis provides incentive to perform well.

Other sorts of contributions to productive activity are not easily measured. In circumstances where multiple workers contribute to a single effort, in a fashion in which it is difficult to measure the individual contribution, it is more likely that workers will be paid on a different basis, such as an hourly wage, or a monthly salary. In this event, a worker who is able to shirk (put in time at work with below-standard effort and output) will still be paid. Hence, in such circumstances there will be some form of costly monitoring to reduce shirking, e.g. hiring a supervisor. Thus, there are costs to different kinds of wage contract, and the kind contract chosen will be the one that is expected to maximize the net value of output produced from a given amount of resources.

The problem of monitoring behavior and writing employment contracts is an example of the principal-agent problem. The principal-agent problem arises in situations where one party � the principal � contracts with a second party � the agent � to undertake some activity in the principal's behalf. In some circumstances, the agent might gain from doing his best to achieve the principal's objective, but in others might gain even more from shirking or engaging in other opportunistic behavior. It is costly for the principal to monitor the agent's behavior for opportunism. Transaction cost analysis suggests that the principal will write a contract that minimizes the costs of such monitoring, subject to institutional constraints and availability of monitoring technology. We will return to the principal-agent problem below, in the discussion of divided ownership.

The modern corporation is a contractual form that permits great gains in specialization to be made. It does so by incurring additional monitoring costs. In a sole proprietorship, a single owner holds authority and responsibility for the firm. This owner gains when the firm does well, and loses when it does poorly. Since the owner is managing the firm himself, there is no principal-agent problem, and hence little question that he needs to monitor his own behavior to avoid shirking. Similarly, partnerships require only a small amount of monitoring. With a small number of partners, monitoring of behavior of the various owners is generally a low-cost matter. However, with a large corporation, monitoring of decision makers can become a very important, and costly, issue. We will address the questions of these costs in the next section, but for now it simply important to note that these costs are incurred. Why are they incurred, if they could be avoided by having a different form of ownership, e.g. a sole proprietorship?

The answer is that some forms of economic activity are highly complex, and require specialized knowledge � that is, they require a number of highly specialized and independent decision makers. A sole proprietor could always hire the services of specialists, of course, but when activities become sufficiently complex, they require managers with a degree of autonomy. A corporate form permits the hiring of specialized managers with a high degree of autonomy. The monitoring costs are incurred in cases where the value of specialized management provides greater returns than it costs.

Similarly, transaction costs related to specialization help to define the boundaries of the firm, i.e. which activities it undertakes and which it purchases in the market. To see further how one can analyze boundaries of the firm in this way, consider again the pipe-making firm. Suppose it produces two kinds of pipes � low pressure pipes for transporting water, sewage, etc., and high pressure pipes used in transporting oil in refineries. Assume that manufacturing these requires two very different grades of sheet metal. The sheet metal for producing low pressure pipes is common, has many uses, and can be purchased from a number of suppliers. But suppose the firm has its own unique design for high pressure pipes, one which require a highly specialized kind of sheet metal that is not used elsewhere.

In the case of the low-pressure pipe material, the pipe-making firm can safely rely on the market. If one supplier has difficulties in supplying the pipe-maker, or suddenly tries to raise its prices, the pipe-maker can go elsewhere. Similarly, the pipe-maker cannot suddenly threaten the sheet metal producer with a lower price, since the metal has use elsewhere.

The case of the sheet metal for high-pressure pipes is quite different. If the supplier agrees to provide the sheet metal, but suddenly reneges and demands a higher price, it may be quite difficult for the pipe-maker to do anything but submit, to fulfill contracts in the short run. This would be the case if valuable pipe contracts were placed at risk and no alternative input source could be developed quickly and cheaply enough. Similarly, circumstances might permit the pipe-maker to suddenly demand a lower price from the sheet metal producer, once the specialized machinery to make the sheet metal was in place. So long as the pipe-maker offers more than the alternative uses would generate, the sheet-metal producer might have little alternative but to give in. These problems are exacerbated when parties have made substantial investments that are specific to this sheet metal � again, �specific� meaning that the investments, in equipment, skills, etc., have no alternative use that is nearly as valuable.

One solution to these �holdup� problems is to write complex and detailed contracts; this is sometimes done, of course, but the more complex the contractual details, the more difficult to monitor and enforce. The higher the enforcement costs, and the greater the potential losses from holdup, the less suitable this solution. In such case, the least cost solution could be for the firms to become vertically integrated. That is, the pipe-making firm and specialized sheet metal firm can be combined under single ownership into one firm. This form of vertical integration improves overall productivity in the economy, by reducing opportunism and hence permitting more valuable production to be undertaken.

The corporate form of firm organization also permits more horizontal integration, in which a firm engages in production in a variety of activities that are not connected vertically. The ability of corporations to hire specialized management permits them to have multiple divisions, engaged in different areas on an industry, or even different industries. For example, one American firm, Rockwell Automation, has four divisions: automation equipment, software, electric motors and related items, and gears, bearings, and similar industrial machinery. This possibility for diversification permits a corporation to become a specialized provider of management services. Such diversification permits a corporation to survive a downturn in one of its areas of activity. Also, it may transfer (sell) or buy divisions of other corporations. Such trading of divisions should be expected to increase the value of a division's output, since the corporation that believes it can use the division most productively will bid the most for it. If the corporation is wrong, it will take losses, and if it cannot correct the problem is likely to sell the division to a corporation that can.

For example, a forerunner of Rockwell Automation, North American Rockwell, had divisions that produced aircraft, household goods (dishes) and recreational equipment (for golf and bowling), among other things. As markets changed and the management expertise of the company changed as well, it sold these divisions, and now, as Rockwell Automation, it specializes in production of industrial automation equipment, software, industrial electric motors, ball bearings, and other kinds of precision equipment for manufacturers. The aircraft market, in particular, has changed � Rockwell sold its last aircraft division in 1996 to Boeing, an aircraft specialist. The ability to make changes such as these permits a corporation to acquire the assets it thinks it can use most productively, and to sell those that other corporations could use more productively. This dynamism permits corporations to respond to changing economic conditions, and helps concentrate specialized resources in the hands of those who can use them most productively at each point in time.

The specialization that a corporate form permits also entails additional monitoring costs. Managers of firms are specialists, often hired by owners, particularly in the case of so-called public corporations (corporations whose ownership shares are sold publicly). This potentially raises a principal-agent problem. How can owners ensure that managers will run the corporation in a way that coincides with the owners' interest? Managers might, for example, run firms so as to maximize managers' benefits � providing themselves with excellent offices, lavish �business trips� that are actually vacations, and in general reducing personal costs to themselves by avoiding productive activities and diverting the funds saved to benefit themselves. It is sometimes alleged that the separation of ownership and management is a serious problem for modern corporations.

However, it is difficult to demonstrate actual examples of loss from such separation. In principle, design of a contract should entirely eliminate incentives for opportunistic behavior. Of course, �perfect� contracts are no more relevant than perfect information. Contracting and monitoring are costly, and hence imperfect. However, a manager's salary, bonuses, and other forms of compensation can be made to depend on his performance. The salary will reflect both the owners' expectations of his future productivity and their view of his alternative opportunities on the market. (See Alchian, 1969 for a good discussion of this point.) In many cases, a large portion of managers' compensation is paid in stock and stock options. In this way interests of managers are further aligned with those of owners, since managers are among the owners and the value of their stock options rise if the firm does well. If managers' actions fail to increase the value of the firm as owners perceive it, this will be reflected in declining stock prices. Management hence has an interest in taking actions that support the value of the firms' shares. Typically this means increasing its profitability, by improving product lines, cutting costs, acquiring new promising divisions, and selling divisions that do not improve profits over time.

While there may be instances of opportunistic behavior by managers, the owners have the incentive to take action to curb this behavior. This action may involve directly interfering with manager behavior, e.g. by issuing demands at a stockholders' meeting, acquiring sufficient shares to sit on the board of directors, rewriting managers' contracts, etc. Or it may be indirect � the owners can simply sell their shares in the company. As more shares are put on the market, the share price is depressed, and the managers will bear consequences of this.

In short, the market provides incentives and mechanisms for curbing opportunism arising from the principal-agent problem. These mechanisms are costly, so we can expect that there will still be instances of such opportunism occurring. However, the systematic tendency will be for individuals to take actions to prevent it, thus maximizing the productivity of privately owned assets and total wealth. This depends, of course, on the ability of individuals to freely write contracts and access to means of enforcement. We will return to these issues in Lecture 8.

REFERENCES

Alchian, A. 1969. �Corporate Management and Property Rights.� In Economic Forces at Work . Indianapolis: Liberty Press. 1977.

Barzel, Y. 1997. Economic Analysis of Property Rights . 2 nd ed. Cambridge University Press.

Coase, R. 1937. The Nature of the Firm. Economica 4 (Nov. 1937). Reprinted in R. Coase. 1988. The Firm, The Market, and the Law. University of Chicago Press.

Eggertson, T. 1990. Economic Behavior and Institutions . New York: Cambridge University Press.

Williamson, O. 1985. The Economic Institutions of Capitalism . New York: The Free Press.