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The Economics of an Unusual Firm

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Minarchist Posted: Sun, Mar 18 2012 11:49 PM

Suppose there is an electric utility company in a town. The manager is elected for 5 year terms by the popular vote of all adults (who are also the customers) living in the town. At the time that the candidates for the office of manager register as candidates prior to the elections, they each must declare their desired annual salary for the 5 years of their term, should they be elected. The winner of the election is then legally entitled to collect that salary out of any profits - if there are no profits, then the manager receives no salary. The manager of the utility, during his tenure, acts as the owner with fulls rights to dispense with the property as he pleases - i.e. he sets prices for electricity, collects the revenues, hires and pays employees, invests in new equipment, makes repairs, etc.

The de facto owner of the property (the manager) has an incentive to make profits, and has the ability to calculate economically.

A problem may be that the manager has an incentive to sacrifice the long-term viability of the company for short-term profits - to ensure that he earns his full salary, and there are no shareholders or others with a counterbalancing interest in the long-term viability of the firm.

However, because his salary is fixed before-hand, this is limited: i.e. he has no incentive to earn more profits during his tenure than he needs to pay himself his salary.

To limit this shortsightedness further, perhaps the manager could be barred from contracting debts whose maturity extends beyond his tenure, and/or perhaps part of his salary could be payable as a pension whose value is fixed in proportion to the future profits (or lack thereof) of the plant after the manager's tenure ends?

For those of you more familiar with different models of corporate governance than I, can you think of any other ways to make this firm more efficient, more viable, while keeping the basic structure of the elected manager in place?

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For those of you more familiar with different models of corporate governance than I, can you think of any other ways to make this firm more efficient, more viable, while keeping the basic structure of the elected manager in place?

What is the context here? Is this a stateless society or based on what we have today? If you are basing this on today's model I think that you are focused on the wrong problem to solve if you are worried about efficiency.

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Merlin replied on Mon, Mar 19 2012 4:55 AM

I see what you aim at here, but I think this would not work. For the kind of firm you postulate, the shortsightedness issue can only be solved at the cost of barring good decision-making.

First, if managers have a fixed salary, it still does not mean that they face no incentive to squander the capital of the firm. Some third party may approach them and ask to sell them company property at depressed prices, a service for which they will be recompensed. The manager is thus able to increase his income at the expense of the owners and fixing the salary does little or nothing to change that.

I’d even say that this would be counter-productive: a manager that would be able to get additional income out of the company could afford to ask for a lower salary (even zero), and he’d win the election. Thus, the elections would favor the most rapacious managers.

Second, limiting debt maturity to match tenure also will not do. What would keep a manager from taking on a huge amount of debt, be it only short-term? If the company goes bankrupt the day he leaves office, when the enormous debt comes due, what does he care? This rule too would seem to fail in its task.

Now, there could be ways to limit the incentive of the manager to behave in a short-sighted manner but, to repeat myself, only at the cost of removing the chance of ever seeing good management. You can turn the manager into a beaurocrat that merely follows some plan (say, an annual budged voted in a ‘referendum’), but this would set the company towards slow disintegration. Perhaps that would be better than the immediate disintegration that leaving free reign to a selfish manager could do, but it would still be no solution.

The solution is to break the institution that keeps this company alive: make ownership transferable. Once the owners can trade their shares, the incentive of the manager changes at once. If he does something that hurts the capital value of the company, share prices will plummet, and he’ll likely loose his job. It would take us too far to study the entire structure of changes that this ‘reform’ would bring, so let us only state that making ownership transferable creates an internal  market  for capital for the firm, and that market can be used to both judge the manager’s performance and to radically change his incentives. I see no other way.

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