Ownership, Control and the Firm

One highly important book for my dissertation is Harold Demsetz's (1988) Ownership, Control and the Firm. The Organization of Economic Activity Volume I. Here are the notes I made of this book for my later use. Presented like this, I fully admit that my notes are not much worth for an outsider reader. Anyway, I will summarize and open up some key points in Finnish later on this blog.

First of all, Demsetz creates a framework for the economics of ownership:

A. Ownership as an exogenous phenomenon

1. The identity of owners (or the assignment of rights)

2. The truncation of ownership rights

3. Normative and ethical dimensions of ownership

B. Ownership as an endogenous phenomenon

1. Allocation by individual action

2. Allocation by cooperative action

(a) Management of the business firm (the corporation)

(b) The distribution of wealth and efficient control

Other remarks I wanted to point out:

• A general peculiarity of recent literature is that its focus often is not on ownership itself. For example Coase's paper The Problem of Social Cost (1960) is about externalities, not ownership.
• The essence of effective regulation is to truncate the bundle of rights that defines ownership.
• In the zero-transaction-cost, zero-income-effects model, the same mix of output, a mix that is efficient, results from the negotiated solution no matter who owns the relevant entitlement (p. 14).
• One may conclude from Coase's reasoning that the identity of owners has no impact on resource allocation in a competitive setting in the absence of transaction costs if the affected parties play no significant role in the overall patterns of demand for goods. With positive transaction costs or with affected parties significantly impacting the pattern of demand for goods, the identity of owners affect the mix of output that is efficient, but does not alter the conclusion that each resulting mix of output is efficient when judged by the demands emanating from the wealth distribution associated with a particular specification of ownership. (p. 16)

• The important paper by Averch and Johnson (1962) argues persuasively that owners seek to maximize utility through increased investment in enlarging firm size when regulators bar higher rates of return on capital. (p. 18)
• The general conclusion is that constraining the ability of persons to exercise specific rights of ownership causes them to rely in greater degree of substitute margins of adjustment in their attempt to maximize utility. (p. 18)
• It is impossible to describe the complete set of rights that are potentially ownable, and to discuss these as being owned privately or by the state. (p. 19)
• A positive theory of ownership requires a systematic treatment of these determinants of the structure of ownership rights. In the Coasian world of fully developed rights and zero transaction costs, the identity of owners has no resource allocation consequences; in the world of changing and evolving rights, in which information and transaction costs cannot be zero, the identity of owners, the content of the bundle of ownership rights, and the structure of ownership all have consequences. This is why some bundles of rights are more appropriate to one set of underlying conditions than to another. (p. 20)
• Two different context arise in the literature that treats ownership endogenously. The first bears on what may be called allocation by individual action. It emphasizes a context in which decisions by owners are assumed to be fully carried out, as if no other individuals need cooperate in executing these decisions. Although agency problem cannot be dismissed completely here, no attempt is made to deal with them explicitly in this literature. The owner of a herd of cattle decides on the size of the herd, and, it is assumed, this decision actually brings the desired herd into being. The second context explicitly considers how ownership bears on the probability that a team of individuals actually executes the desired allocation of resources. Cooperative action is required to implement owner decisions, and agency problems occupy center-stage. (p. 20)
• One useful way to consider of two components of the bundle of rights: exclusivity and alienability. Exclusivity refers to the right to determine who may use a scarce resource in a particular way. The notion of exclusivity, of course, derives from the right ti insist that no one other than the "owner" use the resource, but this notion is extended here to include the right of the owner to determine who else may use a resource. Alienability refers to the right to reassign ownership to someone else. It includes the right to offer for sale at any price. (p.21)
• Whereas full communal ownership rewards the ability to occupy or to use a resource before others do, the quasi-communal/private arrangement, exemplified by rent control, rewards desired personal characteristics. In comparison to full and quasi-communal ownership, full private ownership gives greater emphasis to willingness and ability to pay. (p. 22)
• Ownership is more productive in some circumstances than in others. Little benefit is obtained from enforcing private ownership of resources that are not scarce, and there may be a cost for doing so. Such resources need not be husbanded because they are ample enough in supply to satisfy all potentially competing uses. Legal ownership of the right to use sunshine or to use the open seas as a roadway for international commerce serve little allocative function under normal conditions. Private or state ownership could create potential monopoly problems, and attendant policing costs, only if enforcement of entitlements were possible. Communal rights serve the productive function of barring such monopolies, but communal rights become increasingly counterproductive as conditions of "natural" scarcity become more prevalent. (p. 23)
• More relevant to the practical problem of resource allocation, the productivity of full ownership increases as the number of alternative uses to which scarce resources can be put increases. Private ownership of resources held in "liquid" condition is more productive than private ownership of an already-in-place sewer system constructed to carry waste liquid away. Private ownership may improve on the operation and maintenance of such system, but it no longer can improve easily on the uses to which the resources embodied in the sewer system can be put. The longer-run the perspective taken, the more productive is full private ownership, precisely because the long-run view is that in which maximum resource fungibility exists. In addition, the more certain are the values to be obtained from alternative deployment of resources, the less useful are the opinions and risk-taking preferences of private entrepreneurs, and the easier it is to substitute state ownership for private ownership without incurring as great a penalty. (p. 23)
• The full private ownership increases in productivity as does the scarcity value of a resource, the ease with which is use can be monitored, the competitiveness of its production, the variety of the uses to which it can be put, the uncertainty of its values in these uses, and the longer the perspective taken. (p. 24)
• The larger the size of a society, the more likely it is that underlying conditions favor private ownership. (p. 24)
• As societies grow in size, so must their dependency on private ownership. Effective decentralization cannot be achieved without de facto movement toward private ownership because privatization means that controllers of resources (their "owners") bear more of the consequences of their actions than do controllers (the bureaucracy) when "the state" is owner. It is precisely this "bearing of consequences" that is prerequisite to an effective incentive system once bureaucratic costs undermine the effectiveness of non-market incentives. Hence, the larger a society becomes, the more it will institute private ownership arrangements (or the more it will isolate itself from international competition and social interaction). The shift from individual to family, from family to clan, from clan to small nation, and from small nation to large nation requires ever greater reliance on private ownership. (p. 24)
• Only World War II, a period of imposed isolation, and propagandized ideological preference have slowed Russia's movement toward capitalistic institutions, a move that began prior to the Russian revolution and will inevitably continue. Similarly, China cannot long retain the degree of centralized control that has existed since World War II. These may be interpreted as violent reorganizations of ownership rights, constituting huge redistributions in wealth, in which the state takes entitlements away from previous private owners. Once this forced taking of entitlements has been accomplished, once the old distribution of wealth has been altered, it becomes imperative for the state to relinquish control again to private individuals through some more preferred redistribution of wealth. If a large society is to succeed in raising living standards, the state cannot persist in owning the wealth of a nation. Effective, well directed control of resources cannot be obtained through bureaucratic incentives in a large society. Self-interest must be harnessed to the task. The economics of control requires decentralization, and effective decentralization requires considerable privatization if self-interest is to be marshaled in wealth-enhancing ways. (p. 24-25)
• The problem of control persists in capitalistic societies, mainly for three reasons. First, it persists because the desires of owners must be translated into cooperative action by employees (the agency problem). Second, it persists because the optimum-size firm sometimes requires a commitment of equity capital, to establish effective control, that exceeds the capabilities of a single individual private owner (the diffuse ownership problem). Third, it persists because private interests sometimes diverge from social interests (the monopoly and externality problems). (p. 25)
• Standard price theory implicitly assumes that a single person owns and manages the theoretical firm, costlessly combining inputs to maximize profits. The structure of ownership varies, of course, and it is important in understanding the organization of economic activity to understand how and why it varies. The analysis of this problem has generated derivative papers on three topics: insider trading, the distribution of wealth, and the amenity potential of a firm's output.
• Effective control of enterprise and the distribution of wealth are not independent when large size is efficient. If we are to have effective control, we cannot have wealth equality. If we have wealth equality, we cannot have effective control of enterprise. The linkage between wealth distribution and effective control derives from the need to concentrate the ownership of enterprise in the hands of a few owners if control is to be effective. If large-scale enterprise is efficient, an equal distribution of wealth undermines our ability to concentrate ownership in this fashion. The control function of ownership thus provides a logical linkage to macro questions that are usually discussed without reference to the efficiency of enterprise.
• Most of the legal infringements on the operations of free markets can be expected to worsen the well-being of those being discriminated against. (p. 90)
• An owner of property rights possesses the consent of fellow men to allow him to act in particular ways. An owners expects the community to prevent others from interfering with his actions, provided that these actions are not prohibited in the specifications of his rights. Property rights convey the right to benefit of harm oneself or others. (p. 104)
• A primary function of property rights is that of guiding incentives to achieve a greater internationalization of externalities. (p. 105)
• All that is needed for internationalization is ownership which includes the right of sale. It is the prohibition of a property right adjustment, the prohibition of the establishment of an ownership title that can thenceforth be exchanged, that precludes the internationalization of external costs and benefits. (p. 106)
• The output mix that results when the exchange of property rights is allowed is efficient and the mix is independent of who is assigned ownership. (p. 106)
• The emergence of new property rights takes place in response to the desires of the interacting persons for adjustment to new benefit-cost possibilities. (p. 107)
• Leacock clearly established the fact that a close relationship existed, both historically and geographically, between the development of private rights in land and the development of the commercial fur trade. (p. 108)
• Forms of ownership: 1) Communal ownership 2) Private ownership and 3) State ownership. (p. 110)
• Communal ownership means a right which can be exercised by all members of the community. Frequently the rights to till and to hunt the land have been communally owned. Communal ownership means that the community denies to the state or to individual citizens the right to interfere with any person's exercise of communally ownerd rights.
• Private ownership implies that the community recognizes the right of the owner to exclude others from exercising the owner's private rights.
• State ownership implies that the state may exclude anyone from the use of a right as long as the state follows accepted political procedures for determining who may not use state-owned property. (p. 110)
• If a single person owns land, he will attempt to maximize its present value by taking into account alternative future streams of benefits and costs and selecting that one which he believes will maximize the present value of his privately owned land rights. We all know that this means that he will attempt to take into account the supply and demand conditions that he thinks will exist after his death. It is very difficult to see how the existing communal owners can reach an agreement that takes account of these costs. (p.111)
• An owner of a private right to use land acts as a broker whose wealth depends on how well he takes into account the competing claims of the present and the future. (p.111)
• The concentration of benefits and costs on owners create incentives to utilize resources more efficiently. (p. 112)
• The interplay of scale economics, negotiation costs, externalities, and the modification of property rights can be seen in the most notable "exception" to the assertion that ownership tends to be an individual affair: the publicly held corporation. I assume that significant economies of scale in the operation of large corporations is a fact and, also, that large requirements for equity capital can be satisfied more cheaply by acquiring the capital from many purchasers of equity shares. While economies of scale in operating these enterprises exist, economies of scale in provision of capital do not. Hence, it becomes desirable for many "owners" to form a joint-stock company. (p. 113)
• But if all owners participate in each decision that needs to be made by such a company, the scale of economics of operating the company will be overcome quick by high negotiating costs. Hence a delegation of authority for most decisions takes place and, for most of these, a small management group becomes the de facto owners. Effective ownership, that is effective control of property, is thus legally concentrated in management's hands. This is the first legal modification, and it takes place in recognition of the high negotiating costs that would otherwise obtain. (p.114)
• The structure of ownership, however, creates some externality difficulties under the law of partnership. If the corporation should fail, partnership law commits each shareholder to meet the debts of the corporation up to the limits of his financial ability. Thus managerial de facto ownership can have considerable external effects on shareholders. Should property rights remain unmodified, this externality would make it exceedingly difficult for entrepreneurs to acquire equity capital from wealthy individuals. A second legal modification, limited liability, has taken place to reduce the effect of this externality. De facto management ownership and limited liability combine to minimize the overall cost of operating large enterprises. Shareholders are essentially lenders of equity capital and not owners, although they do participate in such infrequent decisions as those involving mergers. What shareholders really owe are their shares and not the corporation. Ownership in the sense of control again becomes a largely individual affair. The shareholders own their shares, and the president of the corporation and possibly a few other top executives control the corporation. (p. 114)
• The mark of a capitalistic society is that resources are owned and allocated by such non-governmental organizations as firms, households, and markets. Resource owners increase productivity through cooperative specialization, and this leads to the demand for economic organizations that facilitate cooperation. (p. 119)
• It is an entire bundle of rights, (1) to be residual claimant; (2) to observe input behavior; (3) to be the central party common to all contracts with inputs; (4) to alter the membership of the team; and (5) to sell these rights, that defines the ownership (or the employer) of the classical (capitalist, free-enterprise) firm. The coalescing of these rights has arisen, because it resolves the shirking-information problem of team production better than does the non-centralized contractual arrangement. The relationship of each team member to the owner of the firm (i.e. the party common to all input contracts and the residual claimant) is simply a "quid pro quo" contract. Each makes a purchase and sale. (p. 125)
• Two necessary conditions exists for the emergence of the firm on the prior assumption that more than pecuniary wealth enters utility functions. (1) It is possible to increase productivity through team-oriented production, a production technique for which it is costly measure the marginal outputs of the cooperating inputs. This makes it more difficult to restrict shirking through simple market exchange between cooperating inputs. (2) It is economical to estimate marginal productivity by observing or specifiying input behavior. The simultaneous occurrence of both these preconditions leads to the contractual organizations of inputs, known as the classical capitalist firms, with (a) joint input production, (b) several input owners, (c) one party who is common to all the contracts of the joint inputs, (d) who has rights to renegotiate any input's contract independently of contracts with other input owners, (e) who holds the residual claim, and (f) who has the right to sell his central contractual residual status. (p. 126)
• An implicit "auxiliary" assumption is that the cost of team production is increased if the residual claim is not held entirely by the central monitor. That is if profit-sharing had to be relied upon for al team members, losses from the resulting increase in central monitor shirking would exceed the output gains from the increased incentives of other team members not to shirk. If the optimal team size is only two owners of inputs, then an equal division of profits and losses between them will leave each with stronger incentives to reduce shirking than if the optimal team size is large, for in the latter case only a smaller percentage of the losses occasioned by the shirker will be borne by him. Incentive to shirk are positively related to the optimal size of the team under an equal profit-sharing scheme. (p. 129)
• If every stockowner participated in each decision in a corporation, not only would large bureaucratic costs be incurred, but many would shirk the task of becoming well informed on the issue to be decided, since the losses associated with unexpectedly bad decisions would be borne in large part by the many other corporate shareholders. More effective control of corporate activity is achieved for most purposes by transferring decision authority to a smaller group, whose main function is to negotiate with and manage the other inputs of the team. The corporate stockholders retain the authority to revise the membership of the management group and the authority over major decisions that affect the structure of the corporation or its dissolution. (p. 131)
• Without capitalization of future benefits, there would be less incentive to incur the costs required to exert informed decisive influence on the corporation's policies and managing personnel. Temporarily, the structure of ownership is reformed, moving away from diffused ownership into decisive power blocs, and this is a transient resurgence of the classical firm with power again concentrated in those who have title to the residual. (p. 132)
• In assessing the significance of stockholders' power, it is not the usual diffusion of voting power that is significant, but instead the frequency with which voting congeals into decisive changes. (p. 132)
• Resources whose user cost is harder to detect when used by someone else tend to be owner-used. Absentee ownership, in the lay language, will be less likely. Assume momentarily that labor service cannot be performed in the absence of its owner. The labor owner can more cheaply monitor any abuse of himself than if somehow labor-services could be provided without the labor owner observing its mode of use or knowing what was happening. Also, his incentive to abuse himself is increased if he does not own himself. (p. 135)
• Instead of thinking of shareholders as joint owners, we can think of them as investors, like bondholders, except that the stockholders are more optimistic than bondholders about the enterprise prospects... In sum, is it the case that the stockholder-investor relationship is one emanating from the division of ownership among several people, or is it that the collection of investment funds from people of varying anticipations is the underlying factor? (p. 139)
• Henry Manne made it clear that is is hard to understand why an investor who wishes to back and "share" in the consequences of some new business should necessarily have to acquire voting power in order to invest in the venture. In fact, we invest in some ventures in the hope that no other stockholders will be so "foolish" as to try to toss out the incumbent management. We want him to have the power to stay in office, and for the prospect of sharing in his fortunes we buy nonvoting common stock. Our willingness to invest is enhanced by the knowledge that we outside investors will be "milked" beyond our initial discounted anticipations. (p. 141)
• If all the contestant teams were owned by one owner , overinvestments in sports would be avoided, much as ownership of common fisheries or underground oil or water reserce would prevent overinvestments. (p. 141)
• Professional athletes having sold their source of service to the team owners then enter into sports activity, are owned by team owners. Here the team owners must monitor the athletes' physical condition and behavior to protect the team owners' wealth. The athlete has less incentive to protect or enhance his athletic prowess since capital value changes have less impact on his own wealth and more on the team owners'. (p. 142)
• From the birth of modern economics in 1776 to 1970, only two works seem to have been written about the theory of the firm that have altered the perspectives of the profession; Knight's Risk, Uncertainty, and Profit (1921) and Coase's The Nature of The Firm" (1937). (p. 144)
• Our understanding of firms can be improved by recognizing that management is a scarce resource employed in a world in which knowledge is incomplete and costly to obtain. (p. 147)
• Owners and management make commitments to each other in order to solicit many years of devoted service; human capital specificity arises as a result of long tenure. Conditions change, requiring these commitments to be broken if the firm is to survive. Unlike the claim made by the literature on opportunism, owners or top management do not rush out to break these commitments. Behavior that is opportunistic toward employees is facilitated through mergers, possibly vertical ones, by bringing in new owners and management who are personally free of these past commitments. (p. 155)
• Vertical separation of ownership becomes more practical the more dedicated in use are the assets used in vertically related activities. (p. 169)
• Vertically integrating assets that already exist and are separately owned allows no escape from the distributional consequences of opportunism because the price at which such assets are merged surely reflects how the owners' assets are locked in. In this case, integration would be motivated more by the desire to avoid risk than by the possibility of avoiding the expected distributional consequences of opportunism. This suggests that a desire to avoid the distributional consequences of opportunism leads to the use of "original" vertical integration - vertical integration set in place by a sole owner of the assets rather than through merger. (p. 170)
• The possibility of relying on outside contractors (vertical separation) to circumvent the ability of unions to tie up assets in the event of labor disputes has not escaped the attention of private and state owners of firms. It even merits its own name - "out-sourcing". (p.171)
• Stigler's theory of vertical integration proposes a negative relationship between vertical integration and the size of a particular market as it grows (or as it exists in different locations). As the market matures, vertical integration is displaced by increasing specialization; if the size of the industry begins to diminish, a reverse process of vertical integration sets in. (p. 177)
• Thorstein Veblen saw the alleged separation of ownership and control as a transfer of control from capitalist to engineers. He believed capitalists were mainly interested in creating scarcity through monopolization, while engineers were mainly interested in technical efficiency and output growth. (p. 188)
• We have two opposing forces at work. The "pure" effect of specialized ownership is to reduce on-the-job consumption below levels that would obtain if owners were also managers. The opposing force is the increase in monitoring cost associated with organization structures most likely to create specialized ownership interests. The shareholder of a large publicly held corporation derives no direct utility from on-the-job consumption of management, so his interests are fixed on the bottom line of the profit and loss statement. The more broadly based is the ownership of the firm, the greater is the cost of monitoring management. (p 193)
• The division of property rights allows persons the option of combining "ownership" and control in any mixture that they wish, given the budget constraints they face. Investment funds and control, therefore, become available at lower costs to society than would be possible were fractional ownership barred. The advent of the modern corporation, organized exchanges, and corporation law have reduced the cost of specializing one's interest as between the different tasks of owning and managing. (p.194)
• The viability of a business organization depends on how well three conditions are satisfied: 1) The tasks of fixed-wage workers must be easy to monitor. 2) The funds that the owner-president is able and willing to commit to the equity of the firm must be sufficient to maintain an effective scale of operations. 3) The owner's taste for managing and his ability to lead the firm must be appropriate to the situation in which the firm finds itself. (p. 196)
• The larger is the competitively viable size, ceteris paribus, the larger is the firm's capital resources and, generally, the greater is the market value of a given fraction of ownership. The higher price of a given fraction of the firm should, in itself, reduce the degree to which ownership is concentrated. (p. 203)
• Larger firms realize a lower overall cost with a more diffuse ownership structure than do small firms. The choice by owners of a diffuse ownership structure, therefore, is consistent with stockholder wealth (or utility-)maximizing behavior. (p.205)
• Control potential is the wealth gain achievable through more effective monitoring of managerial performance by a firm's owners. (p. 205).
• Two industries are likely to call forth tight control in order to indulge personal preferences. These are professional sport clubs and mass media firms. Winning the World Series or believing that one is systematically influencing public opinion plausibly provides utility to some owners even if profit is reduced from levels otherwise achievable. These consumption goals arise from the particular tastes of owners, so their achievement requires owners to be in a position to influence managerial decisions. Hence, ownership should be more concentrated in firms for which this type of amenity potential is greater. (p. 208)
• Overutilization of scarce resources arises because the use of the resource, usually owned by the government, is underpriced. Asking a zero price for the use of our lakes and streams has been a basic source of water pollution. Asking too low a price to remove timber from state forests has resulted in overcutting. The fact that freeways are free during rush hours results in bumper-to-bumper traffic. The failure to charge higher landing fees during the late afternoon hours results in congestion over major airfields. (p. 256)
• For abolitionists, freedom meant the release of slaves from restrictions imposed by owners. Socialists interpret being free as the absence of restrictions stemming from poverty, while Hayek interprets being free as the absence the restrictions stemming from private and public coercion. (p. 281)