Are Corporations Necessary?

Division of labor results in specialization. This was clearly established by Adam Smith more than 200 years ago and has been a central tenet of the modern capitalist economic system. We are all specialists. We depend on others for most of the goods and services that we need. For over a 150 years now, corporations have been the primary mechanism by which we have had access to these. Corporations made sense in the past. By pooling together large sums of money and bringing together people working towards a common purpose, corporations could lower the cost of providing us with what we (think we) need. Changes resulting from industrialization helped this process along. National markets became possible and cost effective to serve. International trade progressively became easier as international linkages increased and strengthened and the cost of transportation and communication steadily fell. Firms could become larger and larger in size and thus service their customers with ever greater cost effectiveness.

However, a funny thing has happened. The same factors which helped spur the rise of corporations kept developing and today increasingly favor alternative forms of business association. Transportation and communication links steadily strengthened, became cheaper and more importantly became more personal. National markets were woven more tightly together as internal trade barriers were eliminated. WTO was envisioned as a means of lowering barriers for corporations. It has had the effect of also doing the same for looser associations and individuals.

However, it is still difficult to answer whether corporations can be done away with entirely. It is now certainly possible to for smaller firms to compete successfully against larger ones in many areas of the economy. Many but not all. In some areas (like petrochemicals) size definitely matters and here larger corporations have a definite advantage. Even in these areas, there are niches where further development is possible and smaller, looser organizations are often better equipped to tackle such areas. Certainly, corporations as they have evolved have imposed liabilities on societies and individuals which are only now becoming apparent. But if corporations are to be done away with, what can replace them. To that, there is no easy answer.

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Why Corporations?

In the current series of posts regarding corporations, I have asked the question do we need corporations? In exploring this question, I then looked why the need for corporations arose in the first place. Related to this is the question of what advantages and disadvantages accrue from having corporations.

Consider two things. Most products and services today require a complex interplay of multiple factors. Corporations are also essentially large groupings of people come together for a common purpose. So in order to bring a product or service to market various tasks need to be performed. In the past, the cost of doing those tasks internally was lower than having them done from the outside. This was a major advantage to forming a corporation. However, while the costs are lower, nevertheless they are present. Also, accounting systems do not capture all the costs of internal transactions. Often, the costs that are not quantized are inherently difficult (and in the past were almost certainly impossible) to do so. So corporations incur costs when going about their business. Some of those costs are quantified by accounting systems. Others are at best estimated and still others are ignored altogether.

Globalization has greatly increased the complexity of doing business. Advances in transportation and communication technologies and a concomitant reduction in the cost of the same has resulted in long, complex supply chains that are nevertheless able to supply technically advanced products at ever reducing real costs. Corporations have taken full advantage of these trends. However these same trends have also lessened the traditional advantages of corporations. If a particular product can be manufactured overseas, what prevents it from being designed overseas as well? The question then becomes can we do away with corporations altogether?

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Why Did Corporations Arise?

If we want to explore the question do we need corporations, we need to at the very least look at the origin. Why did the need for corporations arise in the first place? Corporations are a fairly recent invention. Most economic interactions in the past featured individuals and not corporations. Even the oldest of these creatures are at most a few centuries old.

The need for corporations arose due to a combination of increasing costs, risk and complexity. The combination of these factors meant that it started to become too risky for any individual to engage in transactions particularly foreign ones. The answer was to find some mechanism with which to share the risks with others. This also meant that the rewards associated with the successful completion of the project needed to be shared as well and a mechanism for that also had to be developed. This was the beginnings of corporations.

The start of industrialization provided a big boost to corporations. Industrialization enabled new, mechanized, faster processes. At the same time, it increased the rewards of meeting a market need by steadily and drastically lowering local and international transportation and communication costs. This meant that increasingly people needed to work together in larger groups to accomplish a common purpose. This provided a major impetus to formalize this arrangement; in other words, the modern corporation was born.

The new entity adopted a command and control mechanism because at that time, this was the most efficient way of lowering transactional costs. The problems of managing a large group of people focused on a common goal had first been encountered by the development of professional armed forces and the solutions these had come up with were adapted in a civilian setting. The structure thus formed has proven to be remarkably durable. It has been adopted and adapted worldwide and still continues to thrive despite major recent technological, political and social developments. The question thus arises: has this structure become anachronistic or is it still relevant to the needs of the future?

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Do We Need Corporations?

Corporation are an important facet of our existence. We depend on corporations for nearly all the goods and services that we consume. More than any welfare system, corporations envelop us from cradle to grave. The academic discipline of Business Administration emerged as a result of the rise and increasing importance of corporations. Today, it is virtually impossible to advance in an established firm without having a Business Administration degree. Corporations are so embedded into our economic system that the vast majority of trade in the world occurs within and between corporations.

Whenever there is a debate about the global economic system, there is always this unspoken assumptions that corporations are necessary, indeed vital and permanent. Individual corporations may come and go but as a system, corporations will always be there. So perhaps it is pertinent to ask do we need corporations?

The question posed above actually embeds several questions in itself. The most important of these questions is what set of circumstances are most propitious for corporations? Other questions that arise are why did the need for corporations arise in the first place?  The particular form of corporations that generally exists today has remained unchanged for several decades now. This persistence has occurred despite major political, economic and social changes in the local and global environment within which corporations are embedded and within which they operate. Is this form still the most appropriate in today's environment? If yes, will it remain so in the future? What kind of economic structure is most appropriate for today and tomorrow's environment?

I believe that these are important questions that very few people are asking. The answers are not clear but they are bound to be multi-faceted and complex. This is an exploration that needs to be taken for the sake of our future. In future posts, I will try to explore each of these ideas in greater depth.

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The Guild System

One of the many effects of industrialization was the decline and disappearance of guilds. Guilds could be found in all parts of the world during the pre-industrial era. In earlier eras, they served an important role in preserving and transmitting knowledge of their statecraft over the years. This was a necessary steps for much of history since political structures were rarely durable. In those empires that lasted for long periods of time (e.g. Rome and China), there were long periods of turbulence within the empire. Guilds were a source of stability and protection in such times. It was primarily because of guilds that rulers in many parts of the world were able to construct grandiose structures. Since the guild system was designed to preserve knowledge and transmit it to the next generation, they were inherently conservative. This was fine before industrialization since changes came slowly and practices could persist relatively unchanged for centuries.

However, with industrialization came change at an ever accelerating pace. The inherent conservativeness of guilds became obstructive to new ways of thinking and doing things that were now required. The incentive to operate outside the guild system became greater and opportunities to do so became easier. These factors among others caused guilds to decline in importance and over time they were eventually banned in most countries.

However, has the guild system actually disappeared or has it morphed into new shapes and forms? While the basic purpose of guilds was to preserve and transmit knowledge, they were also an important control mechanism. Guilds could control who entered the system and who did not. They also controlled the means by which knowledge transfer could take place as well as the kinds of knowledge that were preserved and transferred. In other words, guilds helped to enforce and transmit an orthodoxy of thought. The question is that has this basic purpose disappeared in the modern era? If anything, control of knowledge - the kind of knowledge and the mechanism of knowledge transfer - has become even more important. In that sense, guilds have not only not disappeared, they are in fact thriving as never before!

Are Markets Moral?

A market based economy is an amazing system to behold. It is capable of taking inputs that are often available at irregular intervals and converts them into outputs that are dependably available all year round. And it does this generally at an affordable price for a majority of consumers. It is no wonder that economists generally love the market mechanism and view it with a wonder which sometimes approaches awe.

Is it a moral system? Economists by and large view interventions into the market as distortions that prevent an optimal allocation of resources. Taking this argument to its logical conclusion implies that society should not attempt to intervene in any manner for any good or service. No society past or present has been willing to do this. doing this implies that services like prostitution and goods like drugs be allowed free operation. The market system as a system makes absolutely no value judgement on any activity. Instead different societies make their individual value judgements on different goods and services on offer. Inevitably these value judgements distort the free operation of the market and thereby prevent an optimal allocation of resources.

There is also a large grey area where it is not clear if there should be an intervention in the free operation of the market. Most financial services for example tend to fall into such an area. The problem is that many if not most financial products have now become so complex that understanding them is essentially beyond the grasp of any reasonably educated, reasonably intelligent person. This is where moral values come into play. Should such products be peddled to persons who will be unable to understand what they are getting into? Keep in mind that one of the assumptions behind economist's model of the free market is equality (or at least parity) of information between the buyer and the seller. In turn, equality (or parity) of information implies an equal (or roughly similar) understanding of what the information means. However such an assumption is not necessary for a market economy to work. Remember that the market system by itself makes no value judgements. No good, service, action, information etc. is inherently right or wrong, good or bad from the system's point of view. Such judgements have to be imposed by the people who live within the particular economic structure. So should complex financial products be sold to people who have no idea what they are buying? The system by itself will not prevent anyone from doing so. The classic defense of such actions is that no one is forcing people to buy such products as well. This is true enough but this argument simply highlights the amoral nature of a market based system.

So markets are amoral. They make no value judgements. Neither do they by themselves impose any. This is what makes a market based system so seductive and at the same time so dangerous.

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Are Firms Entrepreneurial?

Most firms and business people are in my view rent seekers rather than entrepreneurs. This statement ofcourse immediately begs the question: what is the difference? According to Investopedia, rent seekers are organizations or people which use "their resources to obtain an economic gain from others without reciprocating any benefits back to society through wealth creation." Entrepreneurs by contrast are risk takers who obtain an economic gain from other but in return they give something of value back. The free market economic system depends on entities being entrepreneurial. This way new products, service and ideas percolate through the economy enriching all of us in the process.

However, what happens when entities within an economy start engaging in rent seeking behavior instead of entrepreneurial behavior? Instead of developing new products or new kinds of services, such entities increasingly seek to lock in the advantages that originally gave them the edge over their competitors. The net result is that consumers are saddled with increasingly higher prices and less advanced products and services. Often these effects take hold gradually. Consumers are then like the proverbial frog in a pot which is gradually brought to a boil. As the change in temperature is slow, the frog does not realize about the increasing danger and is thus cooked alive. Similarly, when entities start engaging in rent seeking behavior, the products and services that their consumers buy gradually deteriorate in quality. Without realizing it, the expectations of their consumers gradually diminish. What would have once been considered low quality becomes routine and what used to be routine now becomes a mark of quality. Why don't consumers realize what is going on? There are various types of rent seeking activities many of which are often difficult to distinguish from entrepreneurial ones. In any case, the change in behavior is seldom sudden but instead takes place over a period (sometimes a very long period) of time.

There are many examples of rent seeking behavior in the corporate world. Virtually the entire car industry has engaged in such behavior for much of its existence. In the 1950s and 60s, the emphasis was on producing flashy cars with tail fins and spikes and other such accoutrements. Technological development such as developing new kinds of engine technology or even improving the existing technology was a very low priority. Many manufacturers did not even seek the kind of production efficiencies that would result in increasing quality and lowering costs. Most of such companies were the industry's market leaders. Those companies that were more entrepreneurial and sought out the production efficiencies eventually usurped the pole position occupied the market leaders.

In another example, General Motors was one of the first companies to develop an all electric car back in the 1990s. What happened next is a beautiful example of rent seeking. The company not only abandoned the technology it had developed, it also recalled all the cars it had made and physically destroyed them. This despite the consumers pleading to be allowed to keep these cars.

Oil companies are another case of firms engaged in rent seeking behavior. All of them are aware that there is a finite supply of the commodity. At some point, viable alternatives will need to be developed. All of them devote far more resources to marketing and public relations than to developing alternatives to oil - a step that is going to be necessary for them to remain relevant in a post oil world.

Even technology companies which are supposed to be highly entrepreneurial and operating in a fast changing environment behave in rent seeking ways. The rush to patent and copyright software tools, algorithms and protocols is an example of this.

Economic theory insists that such behavior is unsustainable in the long run. Most business people also subscribe to a similar view. Why then would any organization, much less a profit seeking one, engage in activities that are essentially rent seeking in nature? One answer is that successful rent seeking activities act as toll gates. They will generate steady and usually large sums of money for very little effort. Another effect of successful rent seeking is that competition is stymied or at least dampened for a period of time. This allows for extra-ordinary profits which can sometimes border (or even be) monopolistic. Rent seeking activities can also be encouraged by sometimes strong network effects. Many industries have a winner take most characteristic. Once one company has established itself and taken advantage of network effects, it can be very hard to dislodge. This increases the inducement to do rent seeking. Furthermore, we must keep in mind that truly entrepreneurial activities are very hard to do on a consistent basis. They are also risky with an uncertain payoff. Rent seeking on the other hand is much easier to do with a more certain payoff. Most managers specially in public companies are evaluated on a yearly or even a quarterly basis. By the time any negative effects of rent seeking become evident, an individual manager will have moved on or retired. It is thus not surprising that organizations specially as they grow larger would engage in rent seeking activities.

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