Firm.doc

Firm-Nexus of ContractOliver Hart treated firm as establishing contractual relations with employees, suppliers, customers, creditors and other constituencies. Firm is an aggregate of different individual input owners coordinating together to provide goods or services. In detail, employees offer human capital resource; creditors provide debt capital; shareholders provide equity capital, bear the risk of losses and monitor the performance of management; and managerial group detect employees performance and coordinate the activities of all input. Stephen M. Bainbridge, The New Corporate Governance in Theory and Practice, Oxford University Press, p29 All participants are linked to the centre, so called the “nexus”, not the individuals each other. The rights and obligations of various input owners are established through contracts. Gavin Kelly and John Parkingson, The Conceptual Foundations of the Company: A Pluralist Approach, The Political Economy of the Company, Hart Publishing Parkinson, p114According to the nexus of contracts, it is argued that except for shareholders, workers, bondholders, even local communities can protect their interests by contracting for the right to veto future proposed by management,” ibid, p118 because they are the fixed claimants. And the reason for why shareholders cannot protected under contracts that is alleged by some scholars will be discussed later.According to Ronald Coases classical thinking, “outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transaction is substituted the entrepreneur/coordinator, who directs production.” Renald, Coase, The Nature of the Firm, The Economic Nature of the Firm, Cambridge Press (third edition), P87 In the contractual model, individuals could transact the input resources they owned by contract. The central authority figure in the relationship can coordinate activities more efficiently than individual input providers. It means that the firm refers to both outside and inside environment, and the situation is divided into two directions, transaction cost and team production.Transaction CostIn impersonal and arms-length market, the transaction is not costless. Transaction cost theory aims to minimize the cost in market transaction and govern the relationships between the parties to the firm through different kinds of contracts. See Kelly and Parkinson, P120 Under the circumstance of market, individual input owner transact themselves with the firm. Therefore, any individual owner owns each factor of production hired by the firm, but no one owns the totality. Even shareholders only own the residual claim on the firms assets and earnings, not the firm itself. So no individual has authority to intervene other constituencies in the process of contract and how to use the input resources in the firm. All people are bounded together by a complex web of contractual relationships. See Bainbridge, p32However, compared with the contract in external market transaction, there will be a more efficient approach to govern the employees. Generally, it is inefficient to instruct every single employees routine behavior through contracts. Instead, employees could be directed through internal management. It means that the party who gets the authority can instruct employees directly. In detail, the board of director is conferred the authority by shareholders to make decisions about how to dispose the input resources and distribute the interest in corporate governance. Then managers will get the authority to execute their decision and require employees what and how to do. In transaction cost theory, the main question is which factor might increase the transaction cost. It is contended that asset specificity is the most important element which influences the transaction cost. If the resource is generic which is fully redeployable, the transaction will only occur on the basis of spot market. However, if it is firm-specific investment, the situation is totally converse. It means that resource owner undertake investment which creates value and will retain most of its value only within a given firm. Due to the problems in asset specificity, like longevity of the asset, uncertainty and complexity of the transaction, it is costly and impossible to write a “complete contract” which contains all accidental scenarios. The hierarchical governance arrangement is introduced in this situation, the firm-specific resources will be governed depending on the degree of difficulty in redeploying assets to other uses. Margaret M. Blair, Firm-Specific Human Capital and Theories of the Firm, Business, Economics and Regulatory Policy Working Paper No. 167848, Georgetown University Law Center That is to say, that the input owner whose resource is the most difficult to substitute and redeploy, will be given the most right, like shareholders. Their investment is seen as the most difficult to replace, and they bear the most serious risk. Therefore, shareholders hold the senior position in the firm that they can authorize the board of director the control right. Although they cannot interfere the decision and operation in the board of director, shareholders have voting right to veto the decision made by the board of director or dismiss the member of board of director.In addition, “when two contracting parties each make investments that are specific to their relationship, either party can attempt to expropriate the returns from those investments by threating to “hold-up” the other party in the enterprise.” Therefore, two parties will integrate their operations vertically and bargain in the contract to cater their own returns. Therefore, these constituencies could get safeguard through contractual provisions imposing financial penalties for breach and full integration within the firm. See Kelly and Parkinson Shareholders firm-specific investment is different. It is the only group whose firms residual right is open-ended and at the most risk. Because of the complexity of management decisions and the unpredictable future circumstances, shareholders return is not fixed and uncertained. Therefore the protection through contract and vertical integration is not enough to ensure shareholders interest.Employees who provide firm-specific human capital share the similar status with shareholders. They provided the technology, personnel and methods that cannot be altered or imitated easily and have to work within specific team and firm. Their skills might be solely valuable in specific firm and with specific team members. Employee also could expropriate their skills and knowledge from the firm in the hold-up situation to threaten the firm. However, if they withdraw their specific human capital, the contract will be terminated that will not produce any further interest within the relationship. Meanwhile, the firm-specific skills might be no worth in other firms. See BlairTeam productionDifferent from Coases market transaction insight that markets do not operate costlessly and is applied by firm to form contract, Alchian and Demsetz contended that the firm could get comparative advantage of organizing resources through team productivity. It means that the input owners will increase productivity by team cooperation. Armen A. Alchian and Harold Demsetz, Production, Information Cost and Economic Organization, American Economic Review, 1972 (62), p173 According to the classical theory, firm used to be seen as having power to settle issues by fiat, authority or disciplinary. However, in team production, the inputs do not belong to one person. Each individual input owner could transact through ordinary market contracts without any other limitation or exclusion. Employee is free to terminate and refuse the contract with employer, and vice versa. Therefore, to speak, the process of managing, directing or managing workers is continual renegotiation of contracts on terms that both parties have to accept the conditions. ibid, p174 So it is said that “the centralized contractual agent in a team productive process-not some superior authoritarian directive or disciplinary power.” See Alchian and Demstz, p174In order to stimulate the cooperation among input owners, metering the productivity and rewards is the vital issue. No matter whether the productivity will arise the rewards to resources, or the rewards will affect the productivity. The rewarding and output should be relatively correlated together. Therefore, how to meter the reward and output efficiently in team production will be the technological problem. Team production is production in which “(1) several types of resources are used and (2) the product is not a sum of separable outputs of each cooperating resource and (3) not all resources used in tam production belong to one person.” ibid, p176 It is not the simple accumulation of separable individual productivity. In order to avoid shirking, it is necessary to detect and monitor the team members performance. Market competition among team members would be an approach to determine the membership and rewards. There is no specific manager, team leader in the decentralized control system. And the inside employers will be threatened by outside competitors who could provide higher input for lower rewards. It seems that shirking will eliminate automatically without any monitoring cost. Nonetheless, the individualized market competition is not effective control, due to two reasons. First, new challengers must know how they will be relatively more competent and offer much more input than the team members they replaced. Second, in order to obtain the position in the team, new challengers have to sacrifice some amount of share of rewards or promise to produce more. However, the shirking is still possible as existed inputs owners, because what he bears is still less than the total reduction of team output. ibid, p179Someone specialized as a monitor to check the input performance of team members will reduce shirking. The monitor is given title to distribute the net earnings of the team and payments to other inputs. Meanwhile the team monitor will receive the residual product above prescribed amounts which are agreed by other input owners. It is also an incentive to avoid monitors shirking rather than market competition. The person who receives the residual rewards will measure output performance, apportion rewards and detect or estimate their marginal productivity. The monitor has the authority to revise or even terminate input owners contract without any termination of contract with other team members, so that it will discipline team members behavior and reduce shirking. The residual claimant-monitor of the team is concluded as the person who is the residual claimant, to observe input behavior, the central party to all contracts with input owners, to alter the membership of the team and also to has the right to sell his central contractual residual status. ibidWith the development of technology, the joint use of equipment which refers to the interactions between workers, has become widespread. Hence, the centralized managing behavior of input owners will reduce the complexity and difficulty in measurement of marginal productivity. The situations about shirking and monitoring team productivity are different depending on the types of firms. Here, it will be divided into profit-sharing firms, partnership and corporations.Within profit-sharing firms, the monitor who hires, fires, changes, promotes and renegotiates will get the residual value of firm. It could be simply treated that team monitor will have much more bonus than other input owners. Under this circumstance, profit-sharing is based on the collective productivity of all team members, losses from central monitor shirking would exceed the output gains from other team members effort. Consequently, the extent of reducing shirking is correlated to the size of profit-sharing firm. The smaller the optimal team size is, the stronger the incentive to reduce shirking will be, because the average interest and loss will be distributed to team members. And in smaller group, profit-sharing incentive will also push self-policing among team members.Partnership will be more appropriate to team production in artistic or professional intellectual skills that the behavior is difficult to monitor and estimate. However, because the partners share a commo