Ebook Inside vs Outside Ownership: A Political Theory of the Firm
Suppose a group of agents by making a joint effort could produce something of value. Much of economic theory is based on the idea that such potential gains from trade would be fully exploited. Implicitly, we assume the existence of institutions that ensure the cooperation of all parties involved, such as complete contracts and their enforcement by a legal system. But in reality contracts are incomplete and courts less than omniscient, and any ex ante agreement, such as on how to split the surplus resulting from a joint activity, is subject to opportunistic behavior ex post. In this paper, we argue that outside ownership of firms may be an institution that fills in the gaps left by imperfect formal enforcement.
Consider the costs that arise from imperfect enforcement. In a joint undertaking, such as a partnership or cooperative, individuals may be able to divert part of the jointly produced surplus for their own uses. There are many examples in the legal literature. A partner may use company money to finance private activities, but claim that the money was used for business purposes. Preparing to support such a claim before a court or an arbitrator, the partner may manipulate documents and accounting information, and hire lawyers or expert witnesses. Since the court has no information about the case apart from what is presented by the parties, the outcome depends partly on strategic, costly decisions by the parties themselves. Hence relying on courts to enforce contracts may in fact exarcerbate rather than reduce the total costs of conflict in a business transaction.
A second, perhaps not as obvious, cost of imperfect enforcement, arises since an agent may have to invest effort also in guarding his share of surplus against the first, appropriative type of activity on the part of others. As noted by Tullock [19], the social costs of theft are not just the resources diverted from productive activity into burglary, but also those used to put locks on doors.
To the extent that they involve costly time and effort, both types of activity are wasteful, since they only serve to reallocate income. Using an established term, we shall refer to such Thomas Hobbes famously suggested that, but for the institution of government, all of society would be engaged in a wasteful war of every man against every man. Only by giving up their natural liberties to the Sovereign, who would then become a more fearsome threat, would citizens avoid internal conflict. Similarly, by selling the firm to outsiders, the members of a partnership involved in distributional conflict may improve on their situation—even if the onlyde facto right that comes with a share is the right to participate in the fight over the surplus.
There is nothing about outside ownership per se that guarantees that the outsiders get anything out of the firm. The insiders in a firm control the accounting machinery. To force the insiders to distribute the produced surplus, the outsiders must first provide evidence that the surplus indeed exists. For instance, they must disentangle book earnings from true earnings. Outside ownership may therefore realistically be viewed as a distributional conflict where the insiders and outsiders fight over the surplus that is generated in the firm by investing costly resources in the covering and uncovering, respectively, of information about the true size of the surplus.
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