In this article, I focus on the financial-market entrepreneur—what Rothbard , calls the capitalist-entrepreneur—to outline some features of an Austrian theory of corporate governance. I begin by reviewing the traditional, production-function theory of the firm and suggesting two alternative perspectives: that of the entrepreneur and that of the capitalist.
The subsequent section proposes entrepreneurship and economic calculation as building blocks for an Austrian theory of the firm. Finally, after a brief review of capital-market behavior and the disciplinary role of takeovers, I outline four areas for Austrian research in corporate governance: firms as investments, internal capital markets, comparative corporate governance, and financiers as entrepreneurs. Given the existing state of technology, the prices of inputs, and a demand schedule, the firm maximizes money profits subject to the constraint that its production plans must be technologically feasible.
The firm is modeled as a single actor, facing a series of uncomplicated decisions: what level of output to produce, how much of each factor to hire, and the like. In the long run, the firm may choose an optimal size and output mix, but even these are determined by the characteristics of the production function economies of scale, scope, and sequence.
While descriptively vacuous, the production-function approach has the appeal of analytical tractability along with its elegant parallel to neoclassical consumer theory profit maximization is like utility maximization, isoquants are indifference curves, and so on. Nonetheless, many economists now see it as increasingly unsatisfactory, as unable to account for a variety of real-world business practices: vertical and lateral integration, mergers, geographic and product-line diversification, franchising, long-term commercial contracting, transfer pricing, research joint ventures, and many others.
The theory of profit maximization is nearly always told from the perspective of the manager, the agent who operates the plant, not that of the owner, who supplies the capital to fund the plant. Yet owners control how much authority to delegate to operational managers, so capitalists are the ultimate decisionmakers. To understand the firm, then, we must focus on the actions and plans of the suppliers of financial capital.
Focusing on capital markets and the corporate governance problem highlights a fundamental analytical problem with the traditional approach to the theory of the firm. In the production-function approach, money capital is treated as a factor of production. Hence financial capital receives scant attention. As discussed below, this can be a serious flaw. Two Alternative Perspectives What, then, is the proper way to understand the business firm?
Two alternative perspectives deserve consideration. The first perspective, which has received substantial attention in the Austrian literature, is that of the entrepreneur, or what Mises , pp. Entrepreneurial profit or loss is the difference between these revenues and the initial outlays, less the general rate of interest. As such, profit is the reward for successfully bearing uncertainty. Successful promoters make accurate forecasts of future prices and receive returns greater than their outlays. Those whose forecasts are less accurate earn losses.
Promoters who systematically make poor forecasts quickly find themselves unable to secure any further resources for investment and eventually exit the market. The second perspective is that of the capitalist, the owner of the firm. Ownership can also be thought of as a factor of production—what Rothbard , pp. Because the owner delegates certain functions to managers, a central focus of the theory of the firm becomes the problem of corporate governance: How do suppliers of capital structure their arrangements with managers in a way that maximizes their returns?
This article argues that the most interesting problems in the theory of the firm relate to the intersection between the entrepreneurial function and the capitalist function. Indeed, as Mises argued, the driving force behind the market economy is a particular type of entrepreneur, the capitalist-entrepreneur, who risks his money capital in anticipation of future, uncertain, returns. Moreover, as discussed below, the entrepreneur is nearly always also a capitalist, and the capitalist is also an entrepreneur.
Dump these inputs into a black box, stir them up, and one got outputs of products and profits. Today, theory sees the firm as more, as a management structure.
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If those relationships are dysfunctional, the firm is more likely to stumble. Coase was the first to explain that the boundaries of the organization depend not only on the productive technology, but on the costs of transacting business. The market mechanism entails certain costs: discovering the relevant prices, negotiating and enforcing contracts, and so on. However, internal organization brings other kinds of transaction costs, namely problems of information flow, incentives, monitoring, and performance evaluation.
The boundary of the firm, then, is determined by the tradeoff, at the margin, between the relative transaction costs of external and internal exchange.
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In this sense, firm boundaries depend not only on technology, but on organizational considerations; that is, on the costs and benefits of various contracting alternatives. Economic organization, both internal and external, imposes costs because complex contracts are usually incomplete. The transaction-cost literature makes much of the distinction between complete and incomplete contracts.
A complete contract specifies a course of action, a decision, or terms of trade contingent on every possible future state of affairs. In textbook models of competitive general equilibrium, all contracts are assumed to be complete. The future is not known with certainty, but the probability distributions of all possible future events are known. The Coasian approach relaxes this assumption and holds that complete, contingent contracts are not always feasible.
In simple transactions—for instance, procurement of an off-the-shelf component—uncertainty may be relatively unimportant, and spot-market contracting works well. For more complex transactions, such as the purchase and installation of specialized equipment, the underlying agreements will typically be incomplete—the contract will provide remedies for only some possible future contingencies. Another is an implicit contract—an agreement that while unstated, is presumably understood by all sides. Suppose an upstream supplier tailors its equipment to service a particular customer.
After the equipment is in place, the customer may demand a lower price, knowing that the salvage value of the specialized equipment is lower than the net payment it offers. Anticipating this possibility, the supplier will be unwilling to install the custom machinery without protection for such a contingency, even if the specialized technology would make the relationship more profitable for both sides.
One way to safeguard rents accruing to specific assets is vertical or lateral integration, where a merger eliminates any adversarial interests. Less extreme options include long-term contracts Joskow , , , , partial ownership agreements Pisano, Russo, and Teece ; Pisano , or agreements for both parties to invest in offsetting relationship-specific investments Heide and John Overall, parties may employ several governance structures. The Coasian literature tries to match the appropriate governance structure with the particular characteristics of the transaction.
There is some debate within the Austrian literature about whether the basic Coasian approach is compatible with Austrian economics. Some Austrian economists have suggested that the Coasian framework may be too narrow, too squarely in the general-equilibrium tradition to deal adequately with Austrian concerns Boudreaux and Holcombe ; Langlois Here the emphasis is on monitoring and incentives in an exogenously determined agency relationship. Stated differently, one can adopt an essentially Coasian perspective without abandoning the Knightian or Austrian view of the entrepreneur as an uncertainty-bearing, innovating decision-maker.
Entrepreneurship represents the bearing of uncertainty. Economic calculation is the tool entrepreneurs use to assess costs and expected future benefits. Consider each in turn. Entrepreneurship Entrepreneurship, in the Misesian sense, is the act of bearing uncertainty. In an ever-changing world, decisions must be made based on expectations of future events. Because production takes time, resources must be invested before the returns on those investments are realized.
If the forecast of future returns is inaccurate, the expected profits will turn out to be losses. This is, of course, true not only of financial investors, but of all human actors. If the future were known with certainty, man would not act, since his action would not change the future. Thus, all purposeful human action carries some risk that the means chosen will not bring about the desired end. In this sense, all human actors are entrepreneurs.
Austrians tend to focus on this kind of pure entrepreneurship, the entrepreneurial aspect of all human behavior. In doing so, however, they often overlook a particular case of entrepreneurship, the driving force behind the structure of production: the capitalist-entrepreneur, who risks his money capital in anticipation of future events. The simplest case is that of the arbitrageur, who discovers a discrepancy in present prices that can be exploited for financial gain.
In a more typical case, the entrepreneur is alert to a new product or a superior production process and steps in to fill this market gap before others. According to this criticism, mere alertness to a profit opportunity is not sufficient for earning profits. To reap financial gain, the entrepreneur must invest resources to realize the discovered profit opportunity.
Moreover, excepting the few cases where buying low and selling high are nearly instantaneous say, electronic trading of currencies or commodity futures , even arbitrage transactions require some time to complete. The selling price may fall before the arbitrageur has made his sale, and thus even the pure arbitrageur faces some probability of loss. Entrepreneurs either earn profits or break even, but it is unclear how they suffer losses. Kirzner , p. Mistaken actions by entrepreneurs mean that they have misread the market, possibly pushing price and output constellations in directions not equilibrative.
Misreading market conditions leads to losses only if the entrepreneur has invested resources in a project based on this misreading. It is the failure to anticipate future market conditions correctly that causes the loss. It seems obscure to describe this as erroneous discovery, rather than unsuccessful uncertainty bearing.
But the most important case of entrepreneurship, the driving force in shaping the actual structure and patterns of production in the market economy, are the capitalist-entrepreneurs, the ones who commit and risk their capital in deciding when, what, and how much to produce. The capitalists, too, are far more subject to actual monetary losses than are the laborers. Rothbard , p.
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It is the capitalist-entrepreneurs who control the allocation of capital to the various branches of industry. It is clear from this formulation that the capitalist-entrepreneur must own property. He cannot invest without prior ownership of financial capital. As Yu , p. Entrepreneurs require complementary factors of production, he argues, which are coordinated within the firm. Economic Calculation All entrepreneurs, particularly capitalist-entrepreneurs, use economic calculation as their primary decisionmaking tool.
By economic calculation we simply mean the use of present prices and anticipated future prices to compare present costs with expected future benefits. In this way, the entrepreneur decides what goods and services should be produced, and what methods of production should be used to produce them. To make this selection, the entrepreneur must be able to weigh the costs and expected benefits of various courses of action. The need for economic calculation places ultimate limits on the size of the organization Klein Indeed, many writers have recognized the connections between the socialist calculation debate and the problems of internal organization Montias ; Williamson The mainstream literature on the firm focuses mostly on the costs of market exchange, and much less on the costs of governing internal exchange.
The new research has yet to produce a fully satisfactory explanation of the limits to firm size Williamson , chap. Rothbard , pp. Rothbard argued that the need for monetary calculation in terms of actual prices not only explains the failures of central planning under socialism, but places an upper bound on firm size. It is 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.
To have such markets, factors of production must be privately owned. 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. The same problem affects a firm owning multiple stages of production. A large, integrated firm is typically organized into semi-autonomous profit centers, each specializing in a particular final or intermediate product. The central management of the firm uses the implicit incomes of the business units, as reflected in statements of divisional profit and loss, to allocate physical and financial capital across the divisions.
To compute divisional profits and losses, the firm needs an economically meaningful transfer price for all internally transferred goods and services. If there is an external market for the component, the firm can use that market price as the transfer price. Without a market price, however, the transfer price must be estimated, either on a cost-plus basis or by bargaining between the buying and selling divisions Gabor ; Eccles and White ; King Such estimated transfer prices contain less information than actual market prices.
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.
Usually, however, the costs from the loss of calculation will likely exceed the costs of external governance. Our thesis adds that the costs of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear, so that the free-market optimum will always stop well short not only of One Big Firm throughout the world market but also of any disappearance of specific markets and hence of economic calculation in that product or resource. First, all else equal, firms able to use market-based transfer prices should eventually outperform firms using administered or negotiated transfer prices.
Second, innovation should be particularly difficult in industries where few of the relevant manufacturing capabilities exist in the market Langlois and Robertson Because innovating firms are more likely to be using unique intermediate goods and production processes, innovation carries with its benefits the cost of more severe internal distortions. Economic calculation is then another obstacle the innovator must overcome. Third, the allocation of overhead or fixed cost across divisions will be particularly problematic.
If an input is essentially indivisible or nonexcludable , then there is no way to compute the opportunity cost of just the portion of the input used by a particular division see Rogerson , for a discussion of these problems. It is here that this most important form of entrepreneurship takes place. Of course, in the traditional, production-function theory of the firm, capital markets do little but supply financial capital to managers, who can get as much capital as they wish at the going market price.
In a more sophisticated understanding, managers do not decide how much capital they want; capitalists decide where capital should be allocated. In doing so, they provide essential discipline to the plant-level manager, whom Mises , p. Managers may thus be able to use those resources to benefit themselves, rather than the capitalist.
A Systemic Failure of Corporate Governance: Lessons from the On-going Financial Crisis
The problem of managerial discretion—what we now call the principal-agent problem—occupies much current research in the theory of the firm. Under what conditions can managers exercise discretionary behavior? Without effective rules, what actions will managers choose? Berle and Means argued that the modern firm is run not by its owners, the share-holders, but by salaried managers, whose interests are different from those of shareholders and include executive perks, prestige, and similar rewards. If the corporation is diffusely held, no individual shareholder has sufficient motivation to engage in costly monitoring managerial decisions, and therefore discretion will flourish at the expense of the market value of the firm.
However, Berle and Means did not consider how owners might limit this discretion ex ante, without the need for detailed ex post monitoring. Agency theory—now the standard language of corporate finance—addresses these problems.
enter site As developed by Jensen and Meckling , Fama , Fama and Jensen , and Jensen , agency theory studies the design of ex-ante incentive-compatible mechanisms to reduce agency costs in the face of potential moral hazard malfeasance by agents. Agency costs are defined by Jensen and Meckling , p. Owners of corporations shareholders use a variety of control or governance mechanisms to limit the managerial discretion described by Berle and Means.
Internally, owners may establish a board of directors to oversee the actions of managers. Finally, they can rely on competition within the firm for top-level management positions—what Fama calls the internal market for managers—to limit the discretionary behavior of top-level management.
Competition in the product market, for example, assures that firms whose managers engage in too much discretionary behavior will fail, costing the managers their jobs. In countries where universal banking is permitted, large equity holders such as banks can exercise considerable influence over managerial behavior. When managers engage in discretionary behavior, the share price of the firm falls, and this invites takeover and subsequent replacement of incumbent management. Therefore, while managers may hold considerable autonomy over the day-to-day operations of the firm, the stock market places strict limits on their behavior.
It is true, Mises acknowledges, that the salaried managers of a corporation hold considerable autonomy over the day-to-day operations of the firm. Mises , p. The market socialists, he argued, fail to understand that the main task performed by a market system is not the pricing of consumer goods, but the allocation of financial capital among the various branches of industry. By focusing on production and pricing decisions within a given structure of capital, the socialists ignore the vital role of capital markets.
What should be the basis of an Austrian theory of corporate governance? This section suggests four areas that Austrians should address: 1 the concept of the firm as an investment; 2 the relationship between internal and external capital markets; 3 comparative corporate governance; and 4 financiers as entrepreneurs. Firms as Investments Because the owner, and not the manager, is the ultimate decisionmaker, the Austrian theory of the firm should comprise two elements: a theory of investment corporate finance , and a theory of how investors provide incentives for managers to use these resources efficiently corporate governance.
In microeconomics textbooks, by contrast, what the capital investors give to the firm is treated as just another factor of production. In the ownership perspective, as developed by Gabor and Pearce , , Vickers , , Moroney , and others, the firm is viewed as an investment. The services of the top-level manager are thus treated as a cost, while the investor is considered the residual claimant.
Also note that because the capitalist bears the risk that the investment will fail, upon investing the capitalist has become an entrepreneur. Furthermore, to the extent that the entrepreneur as Kirznerian discoverer hires himself out to the capitalist as a salaried manager, his compensation is not entrepreneurial profit; it is a cost to the owner of the firm Rothbard , p.
This has significant implications for firm behavior. First, the firm will not always expand output to the point where marginal revenue equals marginal cost. For if the firm is earning positive net returns at its current level of output, instead of increasing output until marginal net returns fall to zero, the firm could simply take those returns and employ them elsewhere, either to set up a new firm in the same industry or to diversify into a new industry Gabor and Pearce , p. The efficient scale of production is determined by outside investment opportunities, not simply the marginal returns from producing a single output.
Indeed, it is easy to show that under fairly weak assumptions, the output level that maximizes the profit rate is less than the output level that maximizes the level of profit. As long as the money capital requirement is increasing in output, the output level that maximizes the profit rate—profit divided by the money capital required to finance that output level—is less than the output level that maximizes profit.
Significantly, for internal accounting purposes, firms are typically structured such that the goal of any operating unit is to maximize the return on its invested capital. Reece and Cool studied of the largest U. These subunits are commonly evaluated according to a return-on-investment ROI criterion, such as the ratio of accounting net income generated by the investment center divided by total assets invested in the investment center.
The point is that individual divisions are being evaluated on the same basis as the corporation itself—namely, what kind of return is being generated on the financial resources invested. Second, the firm-as-investment concept relates closely to an emerging literature on merger as a form of firm-level investment Bittlingmayer ; Andrade and Stafford Once managers have acquired financial resources from capitalists, these managers have some discretion over how to invest those resources.
Merger may be a different form of investment; Andrade and Stafford find, for example, that mergers in particular industries tend to be clustered over time, while rankings of non-merger forms of investment by industry tend to remain constant. This suggests that merger activity is encouraged by specific industry or policy shocks, like deregulation, the emergence of junk-bond financing, and increased foreign competition Mitchell and Mulherin Nonetheless, mergers will be evaluated by the returns they generate, just like any other investment. Capital markets allocate resources between stand alone, single-product firms.
In the diversified, multidivisional firm, by contrast, resources are allocated internally, as the entrepreneur distributes funds among profit-center divisions.
According to the internal capital markets theory, diversified firms arise when limits in the capital market permit internal management to allocate and manage funds more efficiently than the external capital market. These efficiencies may come from several sources. First, the central headquarters of the firm HQ typically has access to information unavailable to external parties, which it extracts through its own internal auditing and reporting procedures Williamson , pp.
Third, HQ can also intervene selectively, making marginal changes to divisional operating procedures, whereas the external market can discipline a division only by raising or lowering the share price of the entire firm. Fourth, HQ has residual rights of control that providers of outside finance do not have, making it easier to redeploy the assets of poorly performing divisions Gertner, Scharfstein, and Stein Hence there would be no speculative bubbles or waves. Bhide uses the internal capital markets framework to explain both the conglomerate merger wave of the s and the divestitures of the s, regarding these developments as responses to changes in the relative efficiencies of internal and external finance.
For instance, corporate refocusing can be explained as a consequence of the rise of takeover by tender offer rather than proxy contest, the emergence of new financial techniques and instruments like leveraged buyouts and high-yield bonds, and the appearance of takeover and breakup specialists, like Kohlberg Kravis Roberts, which themselves performed many functions of the conglomerate HQ Williamson Furthermore, the emergence of the conglomerate in the s can itself be traced to the emergence of the M-form corporation.
Because the multidivisional structure treats business units as semi-independent profit or investment centers, it is much easier for an M-form corporation to expand via acquisition than it is for the older unitary structure. New acquisitions can be integrated smoothly when they can preserve much of their internal structure and retain control over day-to-day operations.
In this sense, the conglomerate could emerge only after the multidivisional structure had been diffused widely throughout the corporate sector. Internal capital market advantages, then, explain why diversification can increase the value of the firm.
During the s, entrepreneurs took advantage of financial-market imperfections many due to regulatory interference to form large, highly diversified firms Hubbard and Palia ; Klein b. They also benefited from government spending in high-technology and other defense-related businesses, which were particularly suited for acquisition. In the two subsequent decades, financial-market performance improved, reducing the internal capital market advantages of conglomerate firms. This situation, in turn, implies strict limits to firm size, even for large conglomerates.
The argument for the efficiency of internal capital markets is that compared with outside investors, the entrepreneur can extract additional information about divisional requirements and performance. To evaluate the merit of a proposed investment, the central management of a diversified conglomerate still relies on market prices to calculate expected money benefits and cost. Internal accounting does not substitute for money prices; it merely uses the information contained in prices in a particular way. So under those conditions we would expect an increase in M-form corporations, allocating resources via internal capital markets.
During the s, that is exactly what we observed. Correctly understood, the internal capital markets hypothesis does not state that internal capital markets supplant financial markets. Either by signing into your account or linking your membership details before your order is placed. Your points will be added to your account once your order is shipped. Click on the cover image above to read some pages of this book! An effective system of corporate governance has both internal and external aspects that have to be sufficiently responsive if governance is to succeed. In this book, Ahmed Naciri examines these two core aspects or the latest buzzword in business and management theory.
Internal aspects include ownership structure, the board of directors and committees, internal control, risk management, transparency and financial reporting. This book aim is to fill up the gap by using a systemic approach and giving a global picture of the corporate governance theoretical foundations, mainly by putting the emphasis on its double dimension: internal and external.
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