Учебный год 22-23 / Firms, Contracts, and Financial Structure

control rights over the asset. In reality, the owners of a company—particularly a large one—often cannot run the company themselves on a day-to-day basis and so they delegate power to a board of directors and to managers. This delegation creates potential conflicts of interest, which will be the subject of Chapters 6–8. In particular, managers may have their own reasons for merging, which have little to do with profit: for example, they may wish to build a bigger empire. Thus, some mergers may be carried out that do not increase value (for the companies concerned).

Even though there are important differences between the owner-managed and large company cases, the main insights of the property rights approach continue to be relevant. It is still useful to think of a large company as consisting of nonhuman assets. It is also helpful to analyses a merger in terms of a change in residual control rights. Prior to a merger, some residual control rights are delegated to the board of the acquiring company and some to the board of the company that is to be acquired; after the merger, all the residual control rights are delegated (in the first instance) to the board of the acquiring company. An interesting topic for further research is to extend the model of Chapter 2 to the case of public companies.

Just as the shareholders of a public company delegate power to the board of directors and managers, so top managers delegate power to subordinates, who delegate power to their subordinates, and so on down the line. It is hard to make sense of this process in a comprehensive contracting world, because even the concept of authority is difficult to define. What does it mean to put someone ‘in charge’ of an action or decision if all actions can be specified in a contract? Thus, the incomplete contracting framework is a natural one for studying authority.

An interesting recent paper that analyses authority from an incomplete contracting perspective is Aghion and Tirole (1995). These authors make a distinction between real authority and formal (legal) authority.73 They argue that someone with superior information may have effective power, even though he does not have legal power, because those with legal power—owners—may follow his suggestions. In fact, it may be in the interest of

73 This distinction has also been made in the sociology and organization behaviour literature; see Weber (1968: 215) and Barnard (1938: 164–5).

owners to create an asymmetry of information, so that subordinates can wield power, and can thereby be rewarded for making relationship-specific investments. The cost of such an arrangement is that the subordinates will sometimes take actions that are not in the interest of the owner. Aghion and Tirole use these ideas to develop a theory of information acquisition and the optimal span of control within the firm.74

4.Residual Control versus Residual Income

I have emphasized the connection between ownership and residual control rights. However, it is often argued that a key characteristic of ownership is that the owner of an asset is entitled to the residual income from that asset. I now consider the relationship between these two concepts.

A problem that one faces when discussing the notion of residual income is that in many contexts it is not well defined. For example, if two parties enter into a profit-sharing agreement, whereby party A receives log(π+1) and party B receives π−log(π+1), where π is total profit, then who is the residual income (or profit) claimant? The answer is that both parties are. Given that profit-sharing contracts are not in principle costly to write if profits are verifiable (and it is unclear how residual income is to be allocated if profits are not verifiable), the conclusion

74Delegated authority or control can be seen as an intermediate form of authority lying somewhere between no control (the employee case) and full control (the owner case). There are other kinds of intermediate control or ownership. If firm A buys firm B and converts it into a wholly owned subsidiary, then it is often argued that the managers of firm B have more control and authority (‘independence’) than if firm A merges with firm B. Similarly, if firm A enters into a long-term contract, whereby B rents or leases some assets from A (possibly owning others itself), then the managers of B probably have more authority than if they are employees of A, but less authority than if they are owners. Among other things, B's managers may be able to decide who works with the assets they have leased from A, even if they cannot make physical alterations to these assets. (One of the assets may be the company name, in which case one has something close to a franchising arrangement.) The literature has by and large not used the property rights approach to analyse intermediate forms of ownership, but this is an interesting topic for future research. For papers that make some progress in this direction, see Holmstrom and Tirole (1991) (on the comparison of the U-form and M-form structures within firms) and Burkart et al. (1994).

is that residual income may not be a very robust or interesting theoretical concept. (For more on this, see Hart 1988.)75

In practice, complicated profit-sharing agreements are often not written, and some party (or set of parties) can be identified as the residual claimant for a particular asset. The question then arises, will this party also hold the residual control rights? The answer is, not necessarily: residual income and residual control do not have to be bundled together on a one-to-one basis. One example is given by publicly traded companies that have several classes of shares with different voting rights (so the ratio of income rights to control rights varies across investors)—such an arrangement is rare in the USA and UK but common in many other countries. A second example is given by joint ventures, where it sometimes happens that two parties share control 50 : 50 but have differential profit shares. A third example is given by any situation where a manager or worker is on a profit-based incentive or bonus scheme: the employee is in some sense a residual claimant, but may not have any voting rights.

The above examples are somewhat special. I now present some theoretical arguments as to why in many cases one might expect the holder of residual control rights to have significant residual income rights, that is, why residual control and residual income should often go together.

First, if residual income and residual control are separated, then this creates a hold-up problem. Assume that M1 has the control rights for asset a1 and M2 has most of the income rights (where income is verifiable). Then M1 will have little incentive to develop an idea for a profitable new use of a1 since most of the gains go to M2. Similarly, M2 has little incentive to develop an idea for operating a1 more efficiently since she must negotiate with M1 for the right to implement the idea. To put it simply, control rights and income rights are highly complementary and so,

75The same difficulty does not arise regarding the definition of residual control rights. Residual control rights are not divisible in the same way as residual income rights. For example, if there are two parties and one asset, then it is reasonable to suppose that one party or the other has residual control rights: it would be difficult if not impossible to

allocate 80 per cent of the residual control rights to party A and 20 per cent to party B. (However, see Ch. 4 for a discussion of more flexible ownership arrangements.)

widget sales by virtue of his possession of the residual control rights.80

Chapter 8 will provide another reason why residual income and residual control rights should be bundled together. It will be shown that unbundling residual income rights from residual control rights can lead to inefficiencies in the market for corporate control. In particular, unbundling—that is, a departure from one share–one vote—may allow a management team with high private benefits but low total value to win a take-over contest against a management team that has low private benefits, but that creates higher value for shareholders overall.

The above results can be used to understand an idea briefly mentioned in Chapter 1. I noted there that it is often assumed—particularly in the industrial organization literature—that profit-sharing is easier within a single firm than between independent firms. I observed that it is hard to make sense of this idea in a comprehensive contracting world, since the independent firms could always write a profit-sharing contract. However, in an incomplete contracting world, those who possess residual rights of control may end up receiving the firm's profit, given their power to direct profit to themselves. As a result, if firm A buys firm B the owner-manager of A may receive both A and B's profit; that is, profit-sharing may occur. In contrast, when the firms are separate, B's profit may be diverted to the owner-manager of B; that is, whatever any profit-sharing agreement may say, profit-sharing will not actually occur.

5.The Effects of Reputation

Nothing so far has been said about the effects of reputation. This is restrictive since it is often argued that reputation can overcome many of the problems of opportunism identified in this book. For example, if one takes the static model of Chapter 2 and repeats it infinitely often, then the first-best can be achieved if the interest

80In a similar vein, Williamson (1985) has argued that the owner of a firm can divert profit to herself by manipulating the accounting system. Williamson uses this idea to explain why incentive schemes within a firm will be low-powered and incentive schemes between firms will be high-powered.

rate is not too high. One way to do this is for the parties to agree in advance to co-operate, with this outcome being sustained by the threat that if one party deviates the other party will refuse to trade with it any more.81

There are two reasons why reputation has been put to one side, in spite of its obvious importance. First, as discussed in Chapter 1, in a first-best world firms don't matter at all, since the optimum can be sustained under any organizational form. Thus, to develop a theory of the firm, one must analyse a situation where the first-best cannot be guaranteed, i.e. where reputational forces are not strong enough to eliminate all problems of opportunism. As a first step, therefore, it does not seem unreasonable to consider the static model of Chapter 2, where reputation plays no role at all.

Second, it is not clear that—even in an infinitely repeated relationship—reputation will eliminate all the problems of opportunism that have been described. In some cases, although the trade is repeated, it is reasonable to suppose that the parties' relationship-specific investments are made only once. However, this means that the gains from breaching a co-operative agreement are sizeable even if a breach marks the end of the relationship. The point is that the deviating party gets a huge one-time gain from expropriating the other party's specific investment. Thus, it may be the case that the repeated version of the model exhibits problems of opportunism similar to those of the static model.82

In spite of these comments, I believe that the general issue of the influence of reputation on organizational form is a fascinating one. An interesting recent analysis is Halonen (1994) (see also Garvey 1991). Halonen considers the infinitely repeated version of the static model of Chapter 2, where the relationship-specific investment is made each period. She finds that for one range of parameters repetition makes joint ownership of assets optimal. (Joint ownership is never optimal in the static model of Chapter 2.) The reason is that joint ownership, by maximizing hold-up problems, minimizes the parties' payoffs if co-operation breaks down and therefore makes it easier to sustain cooperation. In

81This is a well-known result from game theory; see e.g. Fudenberg and Tirole (1991: ch. 5).

82To be more precise, a very low interest rate may be necessary to support the co-operative outcome. For a formal analysis of a situation like this, see Thomas and Worrall (1994).

contrast, for a second range of parameters she finds that the basic results of the static model apply; that is, either nonintegration or (some type of) integration is optimal. However, integration is less likely to be optimal in a repeated relationship than in the static case.

6.Investments in Physical Capital

The model of Chapter 2 supposes that all investments are investments in human capital. What this means is that, if M1 invests i, this creates a return from operating a1 and a2 of R(i), but only if M1 is a party to the transaction. In effect, M1 is acquiring an asset-specific skill that is not transferable to others in his absence.

In practice, the return from many investments is embodied, at least partially, in a piece of physical capital rather than in the human capital of the person making the investment. The main ideas of the property rights approach generalize to the case where investments are embodied in physical capital, but some of the details change. In particular, it is no longer clear that strictly complementary assets should be owned together or that joint ownership is never optimal.

It will be useful to illustrate this point. Suppose there is a single asset a* and two agents M1 and M2 who can each increase the asset's value. For simplicity, take the investments to be discrete: M1 can make an investment that costs i and increases the value of a* by R; and M2 can make an investment that costs î and increases the value of a* by . (As in Chapter 2, increases in value and investment expenditures are observable but not verifiable.) Assume that each investment is embodied entirely in the physical capital, i.e. that once the investment is made neither M1 nor M2 is

83 Even though the investments are embodied in physical capital, it does not follow that the investments are themselves physical. They may represent the efforts taken by M1 and M2 at date 0 to make a* more profitable (e.g., to increase the size of the market for a*'s product). The difference from Chapter 2 is that it is now supposed that the increases in value, R or , can be enjoyed at date 1 in the absence of M1 or M2.