Incentives, cooperation and the nature of the firm (1)
In capitalist countries, most firms are privately owned. Owners risk their wealth on the success of the business. If the firm is successful and earns profits, these financial gains go to the owners. Conversely, if the firm suffers losses, the owners must bear the consequences. Because the owners receive what remains after the revenue of the firm is used to pay the contractual costs, they are called residual amiantus.
In a market economy, the property right of owners to the residual income of the firm plays a very important role: it provides owners with a strong incentive to organize and structure their business in a manner that will keep the cost of producing output low (relative to its value). The wealth of these residual claimants is directly influenced by the success or failure of the firm. Thus, they have both the authority and a strong incentive to see that resources under their direction are used efficiently and directed toward production do goods that are valued more highly than their costs.
In principle, all production could be accomplished solely through contracting. For example, a builder might have a house built by contracting with one person to pour the concrete, another to construct the wooden part of the house, a third to install the roofing, a fourth to do the electrical wiring, and so on. No employees would have to be involved in such a project. More commonly though, goods and services are produced with some combination of contracting and the use of team production by employees of a firm.
Why do firms use team production? If contracting alone is used to produce some- thing, the producer must, for each project, (1) determine what needs to be produced and how, given the circumstances, current technology, and prices, (2) search out reliable suppliers, and (3) negotiate and enforce the contracts. The entrepreneur who wants to produce by this method must have specialized knowledge in a variety of areas and must devote a great deal of time and effort to the planning and contracting processes. Not many people have the expertise or the time to perform all these tasks by themselves except on a small scale. Team production for certain tasks can be more practical and less costly.
Accordingly, a builder with multiple projects is likely to hire knowledgeable, experienced workers to plan the construction process, purchase materials, and build the structures. The builder will then contract with others to obtain materials and more specialized labor services.
Competition among firms for investment funds and customers
Even without direct control of their corporation, stockholders (and the investment advisers, pension fund managers, and others hired to help them) have an incentive to monitor the corporation’s management in order to anticipate problems and search for constructive changes. Investors who are the first to spot a profitable new management strategy can buy stock early, before others realize the opportunity, and bid the price up. A rising stock price is both a signal of approval to good managers and an incentive to manage the corporation well. Conversely, when managers’ decisions are contrary to the interests of stockholders, the opposite occurs: the stock price will fall. Knowing that stock prices can plummet motivates stockholders (along with professional managers of stock holdings) to be the first to spot a problem with the company. This way they can dump their stock before everyone else does, and thus prior to the share price falling. Some investment firms even specialize in selling shares “short” (writing contracts to deliver shares of the stock later, when they expect the stock price to be lower than its current level) if they believe a company is overvalued on the market. So managers get constant feedback via stock price changes, which can be just as important as current profits to stockholders and boards of directors.
Similarly, consumers have an incentive to monitor the quality and price of the firm’s output. No one forces them to buy the corporation’s product, so if other firms supply superior products or offer lower prices, consumers can take their business elsewhere. Because investors are free to buy and sell the company’s shares and customers to buy its products or those of other firms, the ability of managers to benefit personally at the expense of either customers or stockholders is limited. While some managers are still able to enrich themselves at stockholders’ expense, at least temporarily, the recent cases of corporations like Tyco and Enron show that their actions tend to catch up with them.