A Spontaneous Order, Politics/Economics

A Spontaneous Order: The Corporation

Consider purchasing a copy of A Spontaneous Order: The Capitalist Case For A Stateless Society

Corporations are one of the most stigmatized and misunderstood institutions in the economy.  Like many other prejudices, however, this malcontent is not completely unfounded as various corporations and their agents have pushed for the implementation of harmful and exploitative measures. However, the vast majority of the harm brought on or encouraged by corporations is ultimately rooted in their relationship with the State. Such harmful measures involve the erection of aggressive barriers to entry into various industries which include, but are not limited to: occupational licensure, intellectual property laws, minimum wage laws, taxes, and other expensive regulations with the ostensible purpose of “protecting the consumer.” Of course, there is nothing wrong with the stated intent of such regulations. Rather, the issue is the means by which they are enforced, and the fact that a single institution has the exclusive legal privilege to create, interpret, and enforce them: the State.

The free market has its own organic (and non-aggressive) regulatory powers which act as a network of checks and balances on the behavior of actors in the market. Natural competition serves to align business interests with the interests of the general consumer. However, attempting to change the organic regulatory system of the market into an artificially controlled one presents a danger in that such powers then become subject to human intrigue and error as opposed to being impartially exercised according to the financial demands of the consumer. Thus, when the State is able to usurp regulatory powers over the marketplace a destructive zero-sum game manifests.  In this context, inherent human self-interest will drive many businesses or firms in the economy to appeal to the State for both defensive and offensive ends. Businesses will realize that choosing to take the noble high road of not appealing to this institution would only result in giving their less scrupulous competitors an unfair advantage. Hence, the formation of the State regulatory agency causes the entrepreneur’s ultimate pursuit of profit to be entangled with two opposing ends: satisfying the consumer and satisfying the State.

It now becomes economic to spend millions of dollars on political campaigns to influence a particular politician to support bills harmful to one’s competitors and favorable to himself. The opportunity costs are the R&D, advertising, or reinvestment into a more robust capital goods infrastructure that may have otherwise taken place. Invariably, the larger a given firm becomes the more involved it will tend to be with matters of the State as its success increasingly comes to rely on compliance with an entrenched regulatory apparatus. Moreover, a larger firm will have more resources by which to direct the State’s power in its own favor and to the expense of its competitors.

It is important to note that, in a free market, the efficacy of a given firm’s pursuit of profit is completely contingent upon the degree to which the consumers’ demands are satisfied. This creates a win-win paradigm: the firm wins when the consumer does and vice versa. However, once the State enters the equation, a win-lose paradigm emerges where one firm may suppress competition via legislative edict.

The power to legislate is the power to perpetrate aggression and is thereby antithetical to private property rights, the free market, and justice. Before the State may do anything it must first confiscate the wealth of its “citizens” so that it may fund its own operations. It then confers upon itself the exclusive right to produce legislation. In other words, any other institution which attempts to produce, interpret, and enforce law will be violently vanquished. Finally, once said legislation has been produced, the State enforces it via the application or threat of physical violence. This would be perfectly legitimate if agents of the State were making such dictates over the use of their own justly acquired property, i.e., over resources which they originally appropriated/homesteaded or received through voluntary exchange.[1] In reality, all the resources the State wields were at one point expropriated or stolen from others, and they are now being used to further erode the property rights of its subjects by dictating to them what they can and cannot do with their property (above and beyond not using it as an instrument to aggress against the persons or property of others).

With all this said, it becomes quite clear why the corporation has come to be a notorious source of exploitation: the largest firms tend to be corporations due to their ability to generate and manage large quantities of capital, i.e., money, factors of production, other assets, etc. Because corporations tend to be the largest firms, they tend also to be the ones most intimately involved with the State, as their existence/profitability relies heavily on legal and regulatory matters. The argument put forth in this chapter is simply this: absent the State, corporations will be profit seeking and wealth producing institutions just like all others in the free market. True exploitation is difficult to imagine if property is respected. That said, any socially maligned behavior that is perpetrated by firms in a free market will be immediately met with losses and damaged reputation, each of which disempowers the exploiter and serves to deter others from acting in kind. The free market accomplishes this, not with aggressive edict, but with the precise and organic mechanism spawned by the presence of consumer choice and competition, namely the price mechanism. Many auditing institutions and private certification agencies may also arise out of the consumer demand for easily recognizable markers for reputable and dubious institutions alike. In essence, the best way to prevent massive exploitation, poverty, and interpersonal conflict is to establish a social order centered around private property rights. Unlike the State, the corporation is a type of firm that is compatible with such rights. Thus, what is commonly perceived as corporate exploitation is in fact a symptom of the State.


The Firm

Before delving into the details of the corporate model, it would behoove us to review the more foundational concept of “the firm.” In the words of Nicolai Foss, the firm is simply “an organization planned with the express purpose of earning profit.”[2] Peter Klein defines the firm as: “the capitalist entrepreneur plus the factors of production that he/she or they own.”[3] In layman’s terms, a firm is a business, i.e. an explicit attempt to earn revenues over losses. In the following sections, we will briefly review the four most prominent legal forms a firm may take: Sole Proprietorship, Partnership, Cooperative, and the Corporation.


Sole Proprietorship

A sole proprietorship (aka proprietorship) is a firm where no legal distinction is made between the firm as an enterprise and the owner. The owner is personally liable for all losses and debts. Every asset and all profits are owned and to be used exclusively at the proprietor’s discretion. The advantages of a sole proprietorship may include:

[1] Only small amounts of capital are needed to start and run one
[2] Easier to organize as there tends to be fewer moving parts
[3] The owner has full discretion over how the firm is run
[4] Because the owner is fully and personally liable for debts, creditors may be more willing to extend credit to a sole-proprietorship than a limited liability firm
[5] The owner keeps all the profits

In contrast some disadvantages may include:

[1] Potential investors or other creditors may be wary of involving themselves with a proprietorship, as the owner has relatively few checks on his behavior when compared with other types of firms

[2] Proprietorships die with the owner, unless he is able to transfer it to someone else. This may be difficult as the successor would have to be both intimately familiar with the firm’s operations and willing to accept total liability for its debts. This will likely be a factor considered by prospective investors and creditors.

[3] These firms tend to have relatively less collateral than other firm types, hence creditors may be more reluctant to extend large amounts of credit.


Partnership

A partnership is legally similar to the proprietorship with the exception that there are two or more owners as opposed to just one. All partners, just like in a proprietorship, are personally liable for the firm’s losses and debts. Conversely, the partners of a firm divvy out the profits and managerial discretion amongst themselves. This alleviates some of the drawbacks of a proprietorship as its continuity is not contingent on a single individual and its debts may be distributed amongst multiple parties. Thus partnerships tend to have more collateral and a greater ability to attract investors and creditors than proprietorships. However, some unique drawbacks will be the inefficiencies and difficulties involved with dissension amongst partners as to what direction to take the firm and how it is to be managed. However, such conflict may be mitigated by the partners agreeing to abide by the outcomes of a majority vote or through some other procedural method. Having multiple owners of a firm presents a series of checks on its direction, which can bring unique costs and benefits. Thus it will be up to the entrepreneur to decide which organizational framework will be most suitable to his enterprise.

Cooperative

Cooperatives are firms which are owned by their patrons. These owners may be the firm’s customers, employees, suppliers or any combination. The common thread here being that the owners have a direct connection or dealing with the firm. Some patrons may have larger shares of ownership over the firm based on their seniority or how much they have invested into it. Moreover, cooperatives tend to be democratically managed. They may or may not have limited liability. All members of the cooperative (or “co-op”) receive a share of the profits in accordance with their proportion of ownership shares. Some co-ops may not even have members with varying levels of ownership, but instead provide an equal amount of shares to all and disperse the profits accordingly.

Corporation

A corporation is a firm whose legal identity is separate and distinct from its owners. Corporations may have their own assets, enter into contracts, sue and be sued, lend or borrow money, and hire employees. Investopedia defines it:

A corporation is created (incorporated) by a group of shareholders who have ownership of the corporation, represented by their holding of common stock. Shareholders elect a Board of Directors (generally receiving one vote per share) who appoint and oversee management of the corporation. Although a corporation does not necessarily have to be for profit, the vast majority of corporations are setup with the goal of providing a return for its shareholders. When you purchase stock you are becoming part owner in a corporation.[4]

One of the distinguishing characteristics of a corporation is that its ownership shares may be held by those whom have no direct tie to the firm, i.e., by people who neither manage, work for, buy from, or supply it. In addition, the shareholders of a corporation are only held financially liable for the firm’s debts up to the amount they invested. For instance, suppose Joe buys ten shares from company X at one dollar each and the following day company X goes bankrupt. Suppose also that the company is divided into one hundred shares of ownership, and the company is one thousand dollars in the hole. With this being the case, Joe would own ten percent of the company but not ten percent of its debt. That is to say, if Joe were a ten percent partner he would have to fork over one hundred dollars to the creditors (ten percent of the company’s debt). However, because Joe is merely a ten percent shareholder of a corporation, his stock merely loses all its value rendering him just ten dollars poorer (the amount he invested into the firm) as opposed to one hundred dollars (ten percent of the firm’s debt). This is due to what is known as the limited liability characteristic of the corporation. Unlike partnerships and proprietorships, owners or shareholders in a corporation are not vulnerable to having their personal assets seized as remuneration for the firm’s debts. The same goes for torts committed by employees of the corporation. That is to say, shareholders are not held legally liable for torts committed by the corporation’s employees just because they are in its employ or were using its assets as the instruments for said torts.

Free Market Society 

Though the previous four legal types of firms are the most common, this is not to say that in a free market society various hybrids of these firms may not arise. So long as no aggression/fraud is being committed, there would be no limitations or prohibitions on what form a given firm may take. Robert Hessen sums this up:

Any firm, regardless of size, can be structured as a corporation, a partnership, a limited partnership, or even one of the rarely used forms, a business trust or an unincorporated joint stock company. Despite textbook claims to the contrary, partnerships are not necessarily small scale or short-lived; they need not cease to exist when a general partner dies or withdraws. Features that are automatic or inherent in a corporation–continuity of existence, hierarchy of authority, freely transferable shares–are optional for a partnership or any other organizational form. The only exceptions arise if government restricts or forbids freedom of contract (such as the rule that forbids limited liability for general partners).[5]


The Corporation

Stocks

A firm may sell its stock (shares of ownership) either privately or publicly on a stock exchange as a means to generate capital. One who purchases stock from a given corporation may be said to own equity in the firm. The Mises Wiki offers an explanation of equity:

Equity is the legal claim of individuals to the assets of a business after deducting all obligations to others, namely, the liabilities. They are often represented as shares of a business which can be traded (for instance in the corporate form of legal business organizations). Organizations formed to assist the exchange of ownership interests in businesses are called stock exchanges.[6]

Shareholders of a given corporation are allotted certain voting rights in proportion to the number of shares they own. In most cases, shareholders will elect a Board of Directors to oversee the corporation’s management and represent their interests, i.e., to act as a governing body ensuring no actions are taken by the firm which could unduly jeopardize the value of its stock. Each shareholder is entitled to a percentage of a firm’s profit commensurate with the percentage of the firm’s shares he/she owns. Thus, if John owns ten percent of a firm’s shares and that firm generates one thousand dollars in profit, then he is entitled to one hundred dollars. One of the important functions of the Board of Directors, however, is to decide whether or not to disperse these profits to the shareholders directly in the form of dividends, use the profits to reinvest and expand the firm, or to repurchase stock. Each of these courses of action may help enhance the growth and value of the firm. However, the action or combination of actions taken will be case-dependent and require information that the average shareholder simply may not possess. This may be because the average shareholder does not have the time or incentive to keep up with the day-to-day management of the firm of which he is a partial owner; this will be especially true if he holds only a small stake in it.

It is for this reason that the discretion over what to do with the company’s profits are delegated to the Board of Directors and the management they oversee. They are generally more aware of where the firm is and what it will take to maintain its growth and profitability. A given corporation may also publish earnings reports at regular intervals to attract creditors and/or investors. Corporations who do not publish their earnings have the benefit of retaining financial privacy from their competitors, but they may find it more difficult to attract investors due to a lack of transparency. There is no universally right or wrong path for a firm to take in this regard; it is simply something that would have to be dealt with on a case by case basis and at the discretion of those with the localized knowledge to make profitable decisions.

Finally, the price of a given corporation’s stock is ultimately driven by investor expectations of its current and expected future profitability. Put differently, one’s willingness to purchase stock at a given price will be contingent upon his projections of its future dividends and/or appreciation. Such projections may be derived from pure intuition, a detailed understanding of the related industry and the prospective company’s role in it, or from the assessments of credible investors (or a combination of these).

Stock Market 

A stock market or stock exchange is a place where securities may be bought and sold. Mises Wiki defines securities:

In finance, a security is an instrument representing ownership (stocks), a debt agreement (bonds) or the rights to ownership (derivatives). A security is essentially a contract that can be assigned a value and traded.[7]

For the purpose of this chapter, we will be focusing on the corporation and stocks. The stock market allows one the ability to extend capital to any publicly traded company. This creates an indispensable market for capital and acts as an additional mechanism by which any market participant may influence the flow and allocation of resources. Other things equal, market actors will tend to invest in those firms which they believe to have the greatest prospects for profits. Subjective factors, however, do play a role. Investors, like everyone, seek to maximize psychic income – of which earning dividends happens to be a large portion.[8] In a free market society, those firms which enjoy large profits will tend to be the ones who add the greatest degree of value to society. The stock market allows anyone to further empower and become, in an additional way, the beneficiaries of various productive enterprises. Contrary to popular belief, such a market acts as a bottom up and organic means by which to direct the flow of capital. Mises comments on the integral functions performed by the stock market:

A stock market is crucial to the existence of capitalism and private property. For it means that there is a functioning market in the exchange of private titles to the means of production. There can be no genuine private ownership of capital without a stock market: there can be no true socialism if such a market is allowed to exist.[9]


Limited Liability
 

One of the most perpetrated myths regarding corporations is that they are or must be creatures of the State. This is categorically false, and is often times mistakenly thought to be the case due to the modern day marriage between various mega-corporations and the State. However, this is merely a symptom of a State regulated economy. There is absolutely no reason why a corporate form of organization cannot be established by voluntary contract. Robert Hessen offers an opinion:

Moreover, to call incorporation a ‘privilege’ implies that individuals have no right to create a corporation. But why is governmental permission needed? Who would be wronged if businesses adopted corporate features by contract? Whose rights would be violated if a firm declared itself to be a unit for the purposes of suing and being sued, holding and conveying title to property, or that it would continue in existence despite the death or withdrawal of its officers or investors, that its shares are freely transferable, or if it asserted limited liability for its debt obligations? If potential creditors find any of these features objectionable, they can negotiate to exclude or modify them.[10]

Limited liability for debts is not an overly complex issue to resolve in a free society. Corporate firms would identify themselves as such to potential creditors, who would thereby understand that if the firm defaulted on a loan, then they could not go after the personal assets of its shareholders. Knowing these limitations, the creditor would be well within its rights to deny an extension of credit, raise the interest rate to compensate for a perceived increase in risk, or negotiate that a portion of the personal assets of the corporation’s managers or officers be included as collateral. There is no fraud or private property rights violation in this situation, therefore there is nothing truly un-libertarian about a corporate model.

The stickier issue, however, is limited liability for torts. To reiterate, this simply shields shareholders from torts committed by other employees while on the job or using the company’s assets. It should be made very clear that this in no way alleviates the legal liability of those who actually commit the torts, but rather insulates the owners of the firm not directly involved with said tort from legal recourse. However, if it is found to be the case that a CEO or other corporate officer committed a tort, then they, of course, would be held responsible. In a free market society, this would not be a unique feature of corporations, but would apply for any owner of a firm whose employee perpetrated a tort absent his involvement. For example, suppose John is a proprietor of a pizzeria and his employee, Fred, crashes a company vehicle into Sue in the course of a pizza delivery. Should John be held liable for Fred’s negligence? Of course not. In a libertarian society, no person would ever be held liable for the actions of another (absent a contract stipulating otherwise). It is silly to think that just because someone else commits a tort with your property, that you would somehow be at least partially responsible for the tort. It is not who owns the instrument of aggression that is legally liable per se, but rather the person who actually caused the property violation.

This is not to say that various corporations could not voluntarily make themselves liable for the actions of their employees for the sake of establishing themselves as a “socially responsible establishment” in the community. A firm may find the development of such a reputation to be conducive to its profit margin. In this case, a firm may declare “we hereby transfer title up to X amount of dollars to any person found to be damaged by the actions of any employee acting within the boundaries of company protocol.” This creates a voluntary binding contract for a given firm to provide restitution for such potential future damages. Above and beyond the binding nature of this contract, a company may also choose to compensate individuals damaged by an employee acting outside the narrow boundaries of company protocol. A company may do this to avoid negative public perception which may impact its profits.  Kinsella provides additional commentary on the compatibility of corporate firm types with libertarian principles:

My view is that corporations are essentially compatible with libertarianism. As for voluntary debts being limited to the corporation’s assets; this is no problem since the creditor knows these limitations when he loans money. What about limited liability for torts or crimes? As mentioned, the person directly responsible for a tort or crime is always liable; sometimes the employer (which is often a corporation) is also liable for the employee’s actions, via respondeat superior. Who else should be responsible? In my view, those who cause the damage are responsible.

Shareholders don’t cause it any more than a bank who loans money to a company causes its employees to commit torts. The shareholders give money; and elect directors. The directors appoint officers/executives. The officers hire employees and direct what goes on. Now to the extent a given manager orders or otherwise causes a given action that damages someone, a case can be made that the manager is causally responsible, jointly liable with the employee who directly caused the damage. It’s harder to argue the directors are so directly responsible, but depending on the facts, it could be argued in some cases. But it’s very fact specific. Perhaps the rules on causation should be relaxed or modified, but this has nothing to do with there being a corporation or not–for the laws of causation should apply to any manager or person of sufficient influence in the organization hierarchy, regardless of legal form of the organization (that is, whether it’s a corporation, partnership, sole proprietorship, or what have you).[11]


The Principal-Agent Problem
 

A common criticism of the corporation is that because the separation of ownership and control is so wide, the conduct of the firm’s managers will tend to stray further from the interest of the shareholders than other types of firms whose managers comprise the entire set of owners. This critique is commonly referred to as the “Principal-Agent Problem.” Such a problem exists when a “principal” delegates powers to an “agent” who has access to greater amounts of and/or more accurate information (a.k.a. asymmetric information) than the principal and whose interests are not perfectly aligned with said “principal.” In the case of the corporation, the “principals” are the shareholders and the “agents” are the managers and officers of the firm. Because information is typically asymmetric in favor of the agents, it is said that it is difficult for the principals to hold them accountable.

Remember, the only reason the principals delegate power to agents in the first place is because they have neither the time nor the expertise to manage said powers to a satisfactory degree of competence. So too, and for the same reasons, would it be difficult for the principals to monitor and hold accountable the agents for any risky or detrimental behavior. Such behavior may include the doling out of oversized bonuses, perks, expensive company cars, private jets, excessive staff, etc. However, varying internal and external control mechanisms have developed to mitigate the negative impact of the aforementioned concerns whilst maintaining many of the corporation’s organizational benefits.

Internal Checks on Corporate Management

What should first be mentioned is that small investors in a firm will likely understand that, being small, they have little say in the direction the firm takes. Thus, if they do not like how a given corporation operates, then they may refrain from investing in it. Likewise, if they are already invested and do not care for the direction the firm is heading, they may sell their shares and invest elsewhere (or nowhere at all). If shareholders are buying or selling shares at substantial levels, this will convey important signals to the managers in the form of rising or falling share prices. The price of a stock reflects an equilibrium, however fleeting, of the current state of market demand – that is, the aggregation of a myriad of individuals’ differing levels of desires and willingness to pay for this stock – and the corresponding supply of such stock.

If speculators suddenly come to market looking to heavily purchase stock, they will initially purchase shares at the prevailing market price. As they purchase more, however (technically, as they satisfy sell orders on the stock exchange), the number of people willing to sell the stock at that prevailing market rate declines, and the only ones holding more of that stock are individuals demanding more money in exchange for them. Now, in order to purchase more stock, these optimistic speculators must purchase them from individuals with greater reservation demand than prior. Thus, with the elimination of those with lower reservation demands, the “market price” the stock would fetch increases. The opposite is true too: Market actors looking to unload their stock on the market will satisfy all the buy orders, and the price they receive for their stock will continue to decline. Generally speaking, substantial “purchases” of shares will result in increasing share prices whereas substantial “selling” will tend to result in decreasing share prices.

Perhaps the most visible defense against corporate mismanagement is the Board of Directors. The Board of Directors are typically comprised of experienced managers and experts in fields related to the given corporation’s industry, and serve as an internal auditing group charged with ensuring shareholder interests are not being compromised by poor managerial practices. The members of the board thus owe their tenure to the continued satisfaction of the shareholders they represent. The Board of Directors also establishes major company policies. These may include but are not limited to the hiring and firing of executives, setting dividends, and determining executive compensation.[12]

If a prospective business decision is large enough, a corporate firm may even hold a shareholder vote on it. Shareholders can, of course, mail in their votes, and they are counted per share owned – not per person – unlike the case in most cooperatives.

A corporation may be set up in such a way that its managers and officers receive bonuses for good performance. This serves to more closely align the interests of the managers with shareholder interests. Officers, managers, and other employees may also be given company stock or stock options. This solution is obvious, as the more stock a manager has, the less separation there is between ownership and control; that is, the more a shares a manager holds, the more aligned his interests will be with other shareholders. The interests, of course, being to safely and securely maximize the corporation’s profits. This does not mean managers will not take any risks or even that they should not, but rather that such risks will be taken with great care and caution. In other words, one is less inclined to be as deliberate with the disposal of other people’s money and property than he is with his own. Thus, when the manager becomes subject to personal losses for the falling of company profits, then he will tend to be more prudent in his decision making.

Large banking institutions or other venture capitalists may purchase substantial equity in various corporations, and thus wield considerable regulatory power over their strategic operations. Moreover, some shareholders may pool their resources and invest as a “block” yielding them considerable influence over the firm’s management as well. Such blocks may form around shareholders who share common interests or ideas as to what direction the given firm should take. Thus corporate managers will have many checks and balances to contend with when running the firm. The combination and degree of these restrictions will tend to evolve and modify according to what configuration is most efficient. After all, managers do require some discretion to be efficacious lest an excess of constraints hinder their ability to perform the very functions placed in their charge.

Last, but not least, is the potential for a manager or officer to lose his job to a subordinate if he is seen as being reckless or incompetent. In other words, there is an internal market for managers. It is not sufficient to make it to the top; one must also maintain considerable performance levels to retain a high position of authority. For example, if a given CEO becomes frivolous with company funds purchasing lavish company jets, cars, and frequenting five star restaurants, then the Board of Directors may decide to terminate him and offer his job to the CFO or whomever else they deem suitable.

External Checks to Corporate Management 

External competition in the market is perhaps the most obvious and visible factor regulating corporate management. If a firm is unable to keep up with changing consumer demand or is unable to match falling competitor prices for its products/services, then it will lose market share. If this trend is not stopped, it will be reflected by a decrease in its share price. Share prices communicate important signals to market actors outside of the firm as well. For instance, falling stock prices may invite investors or competitors to purchase a majority of this failing firm’s shares and institute overhauling measures which involve a restructuring of management. This process is commonly referred to as a “hostile takeover.” Once the firm has been restructured to the satisfaction of the new majority shareholders, they may then decide to sell their shares for a substantial profit. These investors, often referred to as “corporate raiders,” essentially act as organizational handymen revitalizing the productive capacities of various waning firms.

A bank may also temper corporate policy by threatening not to renew a recurring loan in cases where it perceives managing practices to be excessively risky or out of sync with market trends. Mises provides a cogent response to the “separation of ownership and control” criticism of the corporation:

It is asserted that the corporation is operated by the salaried managers, while the shareholders are merely passive spectators. All the powers are concentrated in the hands of hired employees. The shareholders are idle and useless; they harvest what the managers have sown. This doctrine disregards entirely the role that the capital and money market, the stock and bond exchange, which a pertinent idiom simply calls the ‘market,’ plays in the direction of corporate business. The dealings of this market are branded by popular anticapitalistic bias as a hazardous game, as mere gambling. In fact, the changes in the prices of common and preferred stock and of corporate bonds are the means applied by the capitalists for the supreme control of the flow of capital. The price structure as determined by the speculations on the capital and money markets and on the big commodity exchanges not only decides how much capital is available for the conduct of each corporation’s business; it creates a state of affairs to which the managers must adjust their operations in detail.

The general direction of a corporation’s conduct of business is exercised by the stockholders and their elected mandataries, the directors. The directors appoint and discharge the managers. In smaller companies and sometimes even in bigger ones the offices of the directors and the managers are often combined in the same persons. A successful corporation is ultimately never controlled by hired managers. The emergence of an omnipotent managerial class is not a phenomenon of the unhampered market economy. It was, on the contrary, an outgrowth of the interventionist policies consciously aiming at an elimination of the influence of the shareholders and at their virtual expropriation. In Germany, Italy, and Austria it was a preliminary step on the way toward the substitution of government control of business for free enterprise, as has been the case in Great Britain with regard to the Bank of England and the railroads. Similar tendencies are prevalent in the American public utilities. The marvelous achievements of corporate business were not a result of the activities of a salaried managerial oligarchy; they were accomplished by people who were connected with the corporation by means of the ownership of a considerable part or of the greater part of its stock and whom part of the public scorned as promoters and profiteers.[13]


Limitations on the Size of a Firm
 

A common objection leveled against the corporation, and more broadly against capitalism, is the possibility that one firm may acquire a monopoly on an essential resource. Murray Rothbard demonstrates, however, that firms face natural limits on their size due to the calculation problem, which, up until that point, was exclusively applied as a critique of socialism. The calculation problem, however, applies to any resource or good that has no market price regardless of the overarching economic or political structure directing its use. If a given type of good, say oil, is owned by only one entity then it can, by definition, have no market price. Market prices are derived through a bidding process which occurs in trade. Thus, if a good is being exclusively utilized by one entity, by definition it is not being traded and therefore cannot develop such a market price. Without knowing the market price of a good, it then becomes virtually impossible to determine whether or not it is being employed efficiently. [14] In other words, if one were to own the entire amount of a given good he would have no objective base of reference to determine the opportunity costs of employing it in any given manner. The resulting inefficiencies would ultimately hamper his profit margin and may even lead to substantial losses. Thus, a given firm’s size would ultimately be limited by the economic necessity for an external market to exist for all of the goods used in its production processes. Peter Klein expounds upon this limitation to firm size:

Rothbard’s account begins with the recognition that Mises’s position on socialist economic calculation is not exclusively, or even primarily, about socialism, but about the role of prices for capital goods. Entrepreneurs allocate resources based on their expectations about future prices, and the information contained in present prices. To make profits, they need information about all prices, not only the prices of consumer goods but the prices of factors of production. Without markets for capital goods, these goods can have no prices, and hence entrepreneurs cannot make judgments about the relative scarcities of these factors. In any environment, then – socialist or not – where a factor of production has no market price, a potential user of that factor will be unable to make rational decisions about its use. Stated this way, Mises’s claim is simply that efficient resource allocation in a market economy requires well-functioning asset markets. To have such markets, factors of production must be privately owned.

Rothbard’s contribution, was to generalize Mises’ analysis of this problem under socialism to the context of vertical integration and the size of the organization. Rothbard writes in Man, Economy, and State that up to a point, the size of the firm is determined by costs, as in the textbook-model. However, ‘the ultimate limits are set on the relative size of the firm by the necessity for markets to exist in every factor, in order to make it possible for the firm to calculate its profits and losses'[15]

…..The use of internally traded intermediate goods for which no external market reference is available thus introduces distortions that reduce organizational efficiency. This gives us the element missing from contemporary theories of economic organization, an upper bound: the firm is constrained by the need for external markets for all internally traded goods. In other words, no firm can become so large that it is both the unique producer and user of an intermediate product; for then no market-based transfer prices will be available, and the firm will be unable to calculate divisional profit and loss and therefore unable to allocate resources correctly between divisions. Of course, internal organization does avoid the holdup problem, which the firm would face if there were a unique outside supplier; conceivably, this benefit could outweigh the increase in ‘incalculability.'[16] Usually, however, the costs from the loss of calculation will likely exceed the costs of external governance.[17]

Conclusion

Absent the State, the corporation is no threat to the free market. With the advent of the corporation, the general consumer is given the added option to purchase equity in the firm regardless of his interest in the products or services it may offer. This serves as a decentralized mechanism to fluidly and efficiently allocate capital across the market. The resulting added avenue for consumer input in the market will then enable it to more accurately adapt itself to the changing tides of consumer demand. Finally, there is simply no inherent characteristic of a corporation that is anti-libertarian. Creditors that are not comfortable with an institution whose managers and shareholders cannot be held personally liable for debts will simply not extend credit, and anyone who perpetrates a tort will still be held liable for damages. Thus, any attempt to impede the formation of a corporation would be an attempt to limit the freedom of contract which is itself sacred in a free society. If the objection is that corporations are economically inefficient and may only be propped up by the State, then their existence in a free market would be an impotent one. Whatever the case may be, only the most efficient institutions will thrive.

 

References

[1] After all, what one does with his own property is his prerogative, so long as in so doing he does not aggress against the persons or property of others.

[2] Nicolai Juul Foss, “The Theory of the Firm: The Austrians as Precursors and Critics of Contemporary Theory,” in The Review of Austrian Economics 7.1 (1994): 31-65. <https://mises.org/journals/rae/pdf/rae7_1_2.pdf&gt;.

[3] Peter Klein, “Production and the Firm” (lecture presented at Mises University, Ludwig Von Mises Institute, Auburn, Alabama, July 23, 2013).

[4] “Corporation” on Investopedia. http://www.investopedia.com/terms/c/corporation.asp

[5] Robert Hessen, “Corporations” in The Concise Encyclopedia of Economics, Econlib <http://www.econlib.org/library/Enc/Corporations.html&gt;.

[6] “Equity” on Ludwig Von Mises Institute.” <http://wiki.mises.org/wiki/Equity&gt;.

[7] “Security (finance)” Ludwig Von Mises Institute, http://wiki.mises.org/wiki/Security_%28finance%29

[8] Rothbard, “Fundamentals of Human Action” Man, Economy, and State, 71-72.

[9] Rothbard, “A Socialist Stock Market?” Making Economic Sense.

[10] Hessen, ibid.

[11] Stephan Kinsella, “Corporations and Limited Liability for Torts,” in Mises Economics Blog (Ludwig Von Mises Institute, September 10, 2008).

[12] As a side note, recall that shareholders voluntarily and explicitly provide their resources to these organizations for their management, whereas the State requires no such explicit sanction. Instead, it seizes the resources of its citizens at the threat or application of violence regardless of consent and exercises jurisdiction over the property of others; property that it has neither legitimate claim nor authority over as States never acquire said property via original appropriation/homesteading or voluntary exchange. Corporate entities, on the other hand, would have to persuade investors to invest and could only rightfully exercise control over resources they acquired through peaceful means. Finally, shareholders may at any time withdraw their funds without legal consequence. In other words, the difference is between voluntary and involuntary association.

[13] Mises, “The Market,” Human Action, 306-07.

[14] Efficiency as measured in terms of profits or losses – that is, efficiency relates to whether transforming a good in a certain way has made it more valuable in the eyes of the consumer than it was prior.

[15] Rothbard, “Particular Factor Prices and Productive Income,” Man, Economy, and State, 599.

[16] On the inability for firms to economically calculate their internal opportunity costs, see Rothbard, “Particular Factor Prices and Productive Incomes,” Vertical Integration and the Size of the Firm, ibid, 614.

[17]  Peter Klein, “Entrepreneurship and Corporate Governance,” The Capitalist and the Entrepreneur (Auburn: Ludwig Von Mises Institute, 2010), 33.

1 thought on “A Spontaneous Order: The Corporation”

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