The Stakeholders in the Modern Corporation Tolouse December

The Stakeholders in the Modern Corporation Tolouse, December 17 2014 Stakeholders conflicts and corporate assets. Fabio Landini Università Bocconi Ugo Pagano Università di Siena and Central European University

(Meta-)Complementarities • Stakeholders conflicts can give raise to concentrated ownership and organized workers (US) or to dispersed ownership and disorganized workers (EU). • A model of “conflictual complementarities” shows how these two possible property rights arrangements can emerge as equilibria of the game played by the different stakeholders. • Different corporate assets are developed under the two arrangements. Each arrangements saves on those resources that because of they specificity and monitoring attributes are particularly costly under each system of corporate rights. • A model of “synergic complementarities” between corporate rights and assets is used to show the cases in which multiple organizational arrangements are possible. • The two complementarities are therefore linked together by metacomplementarities, characterizing each system of corporate governance.

Stake-Holders Conflicts Two complementarities: Conflictual Complementarities Varieties of Capitalism Synergic complementarities Fitting Corporate Assets

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Dispersed varieties of capitalism Capitalist diversify their interests by holding shares in different firms. Workers do not concentrate their interests by the means of political action. Unions and Social-Democracy are weak. Managerial hierarchies and firms’ size are not limited by the owners’ interests to control the firm. Managers have strong incentives to invest in firms’ specific and difficult to monitor skills. Dispersed owners and disorganized workers do not have the same incentives.

Concentrated varieties of capitalism Capitalist concentrate their interests by having single families owning relevant percentages of shares in each firm. Workers cannot concentrate their interests by concentrating property. They react by the means of costly political action forming centralized unions Managerial hierarchies and firms’ size are limited by the owners’ concentrated ownership and strong unions. Managers have little incentive to invest in difficult to monitor and firmspecific skills. These corporate assets are more likely to be developed by other stakeholders as owners and workers who have strong rights on the organization.

Conflictual Complementarities: different stake-hoders interactions Dispersed ownership Concentrated ownership Managers M Disorganized workers’ interests Organized workers’ interests

Synergic complementarities: stakeholders rights and firms’ technical assets Specificity and Monitoring Characteristics of Assets : : Property Rights and Organizational Form The most specific and difficult to monitor agents can save the greatest amount of agency costs when they control the organization. The agents controlling the organization will tend to become the most specific and difficult to monitor

A model of conflicting complementarities Three types of (representative) agents: owners (o), managers (m) and workers (w) A firm is a private ordering characterized by a well-defined structure of authority relations according to which o exercise authority over m, who in turn exercise authority over w. In domain O two main alternatives are available: high concentration of property rights (OH) and low concentration of property rights (OL), i. e. O ={OH, OL} In domain W agent w can choose between two distinct options: high concentration of their interests (WH) and low concentration of their interests (WL), i. e. W ={WH, WL} Managers m are assumed to have no class organizations that defend her interests in society but it has different welfare in the different settings.

Owners Second order jural relations Power of i Liability of j Disability of i Immunity of j Upstream Managers Downstream Workers

Table of organizations Owner Worker (w) (o) High Concentration (WH) Low Concentration (WL) upstream: o’s power m’s liability downstream: m’s inability w’s immunity downstream: m’s power w’s liability upstream: o’s inability m’s immunity downstream: m’s inability w’s immunity downstream: m’s power w’s liability High Concentration (OH) Low Concentration (OL)

Agents objective functions • uo(O, W)= πo(O, W, t) + ζo(O)+ zo(O, W) • um(O, W)= b + ζm(O, W)+ zm(O, W) • uw(O, W)= s+ ζw(W)+ zw(O, W) + cw(W) (1) ( 2) (3) • πo(O, W, t), b and s are the agents’ economic returns of o, m w All profits go to o but change with corporate technical assets t. For the moment t is given and study how decisions are taken for a given t • ζo(O), ζm(O, W), ζw(W) freedom functions of o, m, w • zo(O, W), zm(O, W), zw(O, W) organizational rents extractions function of o, m, w • cw(W), for cw(WH) = cw > 0 and cw(WL) = 0, is w’s cost of collective action

Freedom Functions: ζo(O), ζm(O, W), ζw(W) Power p: a continuum in the interval [-1, 1], where p = -1 stands for full liability to the power of others and p = 1 stands for full exercise of power on others ζ(p) : ζ(1)= ζ, ζ(-1)=-ζ ζ(0)=0, where ζ represents the benefit (cost) associated with the exercise (lack) of choice freedom. ζ(0) represents even power. Owners ζo(O)= ζ if O = OH = 0 if O = OL Workers ζw(W)= 0 if W=WH -ζ if W=WL upstream Managers downstream Manager degree of choice

Organizational rents extractions functions 1) (OH, WL) concentrated owners, dispersed workers: o and m can exploit their position of relative power to extract organizational rents from w. By selecting working conditions that are more favorable to o than to w, in fact, m can transfer resources from labor to capital while obtaining a partial compensation for their service. 2) (OL, WH) dispersed owners, concentrated workers: w can exploit their immunity position to offer m a collusion agreement that goes in the opposite direction, i. e. it makes m to transfer resources from capital to labor in exchange for a due compensation. By doing so m can improve upon their position and partially compensate for the lack of downstream power. 3) (OH, WH) concentrated owners, concentrated workers: rents’ managers disappear. Management is worse off with respect to all the other possible combinations. 4) (OL, WL) dispersed owners, dispersed workers: organizational rents can be extracted by managers. In this case, m can enjoy both upstream immunity and downstream power. Management is better off with respect to all the other possible combinations.

Organizational rent extraction functions zu(L, j)= πL, j(t) = the upstream rent extracted from capital (for j = H, L) zd = s – ζ downward rent extracted from labor Under combination (OL, WL), we assume that m can extract only a fraction ε of the upstream and downstream rents, where ε > 0 is a measure of m’s decisional authority.

Politics Business Varieties On the basis of the above assumptions, the conflictual interaction between o and w can be represented in game theoretic form by the triplet Γ ={I, Θ, u}, where I = {o, w} is the set of players, Θ = O × W is the set of strategy profiles and u = {uo(θ, t), uw(θ)} for θ Θ is the vector function of the players’ payoff, Definition 1. A politics-business arrangement in game Γ corresponds to a pure strategy profile , where θo O and θw W is the pure strategy adopted by players o and w, respectively. To every politics-business arrangement corresponds a specific way to resolve the conflict between workers and owners. In particular, game Γ offers a representation of four distinct arrangements, namely {OH, WH}, {OH, WL}, {OL, WH} and {OL, WL}. Definition 2. A politics-business arrangement is a politics-business variety if the corresponding pure strategy profile is a Nash equilibrium of game Γ. Only {OH, WH} and {OL, WL} qualify as politics-business varieties.

Table of pay-offs: owners, workers and managers Owner Worker (w) (o) High Concentration (WH) Low Concentration (WL) πH, H(t) + ζ , s – cw πH, L (t) + ζ +(s – ζ) /2 , 0 High Concentration (OH) [ b – ζ ] [ b + (s – ζ) /2 ] Low Concentration (OL) 0 , s + πL, H(t) /2 – cw πL, L(t) (1 – ε) , (s – ζ)(1 – ε) [ b + πL, H(t) /2 ] [ b + ζ + ε (πL, L(t) + s – ζ)]

Proposition 1 Suppose ζ <s, ζ <b (freedom benefits smaller than economic returns) and s >cw (workers payments greater than the cost of collective action) Then: a) for any t, {OL, WH} and {OH, WL} are never politics-business varieties; b) for any: or for any : where {OH, WH} is the only politics-busines variety; c) Two politics business-varieties exist if : namely {OH, WH} and {OL, WL}. and

A model of synergic complementarities • Proposition 1 suggests that, for any type of technology, {OH, WL} and {OL, WH} are never politics-business varieties. On the contrary, for sufficiently high levels of πL, L(t) and cw, both {OH, WH} and {OL, WL} are politics-business varieties. • Hence, in what follows we consider only combinations {OH, WH} and {OL, WL} and focus on the space of parameters in which both are politics-business varieties. • To simplify the notation, let us define a new domain P = {PH, PL}, where PH =(OH, WH) and PL =(OL, WL) denote a politics-business variety characterized respectively by a high and low degree of interest concentration. • On this basis, we will define a variety of capitalism as a pair (P, t), where t stands for the features of technology. Technological corporate assets and ownership arrangements are characterized by synergic complemetarities

Agency costs • Three types of production factor: capital (K), managerial knowledge (M), and labour (E), where E stands for work effort. • K is supplied by owners (o), M is supplied by managers (m) and E is supplied by workers (w). • Standard production function: Q(K, M, E). • Under PH, m is both exposed to the power of o and unable to exercise authority over w and requires some additional compensation x to make specific investments in managerial knowledge. • Under PL the immunity of m may scare shareholders, who may find it difficult to get rid of opportunistic managers. To invest, they may thus ask for the inclusion of some additional safeguards, which we assume to take an extra-return y on their investments. A similar argument applies to workers which we assume to require the same extra-return y on their human capital investment. • Under PH, the agency costs y are saved while under PL the agency costs x are saved. The immunity and powers (involved by the different varieties of capitalism) themselves work as safeguards.

Politics Business Structures and Technologies We denote with r, b and s the prices of respectively K, M and E. b and r are the agency costs to be paid for m and for o and w On this basis, we write the firm’s profit under PH as follows: πH, H (K, M, E) = Q(K, M, E) – [r K + (b + x) M + s E] (A) P T Similarly, we write the firm’s profit under PL as follows: πL, L (K, M, E) = Q(K, M, E) – [(r + y) K + b M + (s + y) E] (B) PH can prevail if, given the factors currently employed, πH, H ≥ πL, L, or: (K+E)y ≥ Mx or (K+E)/M ≥ x/y (C) T P PL can prevail if, given the factors currently employed, πH, H ≥ πL, L, or: (K+E)y ≤ Mx or (K+E)/M ≤ x/y (D)

Varieties of Capitalism as Organizational Equilibria Let: (KH , MH , EH) = argmax πH, H (K, M, E) (K L , M L, E L) = argmax π L, L (K, M, E) (8) (9) Definition 3. The variety (PH , t. H) constitutes a concentrated OE for the set of values for which the degree of interest concentration PH maximizes profit under the prevailing technology t. H and, in turn, the factors intensity t. H maximizes profit given degree of interest concentration PH. This occurs when the following holds: t. H = (KH+EH)/MH ≥ x/y (10) Definition 4. The variety (PL , t. L) constitutes a dispersed OE for the set of values for which the degree of interest concentration PL maximizes profit under the prevailing technology t. L and, in turn, the factors intensity t. L maximizes profit given degree of interest concentration PL. This occurs when the following holds: t. L = (KL+EL)/ML ≤ x/y (11)

Proposition 2. (a) Multiple OEs exist when the following condition is satisfied: t. H = (KH+EH)/MH ≥ x/y ≥ (KL+EL)/ML = t. L (12) i. e. , when both condition (10) and (11) are satisfied. (b) A unique concentrated OE exists if: t. H = (KH+EH)/MH ≥ (KL+EL)/ML = t. L ≥ x/y (13) i. e. , when condition (10) is satisfied but not condition (11) (c) A unique dispersed OE exists if: x/y ≥ t. H = (KH+EH)/MH ≥ (KL+EL)/ML = t. L (14) i. e. , when condition (11) is satisfied but not condition (10). Multiple equilibria exist as long as the ratio between the two additional costs x and y falls within the close interval defined by t. H and t. L. This condition is more likely to be satisfied, the greater the elasticity of substitution among production factors.

Proposition 3 Suppose that both concentrated (PH , t. H) and dispersed (PL , t. L) OE exist. Then: a) If , where then (PH , t. H) and (PL , t. L) are not mutually Pareto comparable; b) If , then (PL , t. L) is Pareto superior; c) The greater m’s decisional authority ε, the smaller the set of parameters for which (PL , t. L) is Pareto superior; d) For any t, the two disequilibria characterized by asymmetric concentration of class interests are never Pareto superior.

Intuition behind proposition 3 • Managers are always better off under equilibrium (PL , t. L) as opposed to (PH , t. H), where the combination of both upstream immunity and downstream power enables them to extract large organizational rents. This in turn implies that equilibrium (PH , t. H) can never be Pareto superior. • For workers, the superiority of one of the two equilibria depends instead on two components, namely m’s decisional authority ε and the cost of collective action cw. Whenever m’s authority is sufficiently low and the cost of collective action is sufficiently high, workers are better off under equilibrium (PL , t. L). In these cases the cost of being subject to m’s power is more than off-set by the possibility to avoid the collective action problem associated with interest concentration. For the set of parameters in which both (PH , t. H) and (PL , t. L) are equilibria this condition is always satisfied, so that workers always prefer equilibrium (PL , t. L). • It follows that the Pareto superiority of the dispersed equilibrium rests on the utility gained by owners, and in particular on the value of the firm’s profit

The evolution of the American variety of capitalism Stakeholders Conflicts • At the time of the second industrial revolution, thanks to two major revolutionary conflicts (independence war and secession war), the US had already fought successfully against the old European aristocracy and the slave-owning American farmers of the South. • The development of large firms happened in the framework of a strong democracy. Large block holdings, present in more than one firm, were seen with suspicion by early antitrust authorities, (Sherman and Clayton acts). Pyramids were dismantled by F. D. Roosevelt by the means of appropriate fiscal policies. • This “exceptional” early dispersion of capitalist interests made it less important to concentrate workers’ interests in strong unions and in social democratic parties. A dispersed equilibrium emerged. 26

The evolution of the American variety of capitalism Corporate Assets The American dispersed equilibrium has encouraged investment in human skills of professional managers, the diversification of ownership, and the concentration of large amounts of capital in corporations. By contrast, it has provided only very mild incentives for the human capital of owners and workers. The absence of family control (Berle and Means) and the extension of managerial hierarchies have allowed the growth of large firms. In turn the characteristics of the technical and productive assets have reinforced the institutional stability of the American model. 27

Evolutionary roots of the European varieties Stakeholders conflicts • The European countries (with possible exception of Switzerland) followed a different path: at the time of the second industrial revolution, their societies were hierarchical and still permeated by aristocratic privileges. • No democratic authority could limit the concentration of the power of the capitalist dynasties occurring with the second industrial revolution. • A social-democratic reaction concentrated also workers’ interest and a concentrated equilibrium emerged in all these countries. 28

Evolutionary roots of the European varieties Corporate Assets • This distribution of rights entailed a stronger incentive for owners (and theirs) to invest in the human capital necessary to run firms while, at the same time, employment protection creates conditions favourable to firm-specific investments also for some workers. • By contrast, investments in the human capital of professional managers is discouraged. Family control and limited managerial hierarchies have also limited the size of the firms. • Also the technology, favoured by the European forms of corporate governance, reinforces in turn the distribution of rights characterizing these systems: ‘concentrated’ owners and workers have a vested interest in finding the political safeguards that protect their investments in physical and human capital associated with this technology. 29

The British Metamorphosis (I): from concentrated equilibrium to disequilibrium. • At the time of the second industrial revolution, aristocratic influence, early unionization and a deep sense of class division made Britain a typical case of concentrated equilibrium. • However, transmission and division of inheritance, coupled with the international role of the city produced a dispersion of property. • In seventies the UK was characterized by a situation of "institutional disequilibrium" where the traditionally well -organized British unions were not matched by a countervailing centralization of firms' ownership. 30

The British Metamorphosis (II): from disequilibrium to dispersed equilibrium. • This institutional disequilibrium coincided with a crisis of the British economy. For some time, "continental solutions" (such as pyramids and cross-share holding on one side and some "responsible" centralization of union's activity on the other) seemed to have a chance to prevail (Franks, Mayer, Rossi 2005). • These "continental solutions" were, however, opposed by the city. Eventually the Thatcher government made a sharp move towards a dispersed type of institutional equilibrium, characterised by strong limitations of unions' activities and by a (much advertised) shareholder popular capitalism. • These arrangements have not been substantially reversed by 31 the subsequent Labour Party governments.

Switzerland: an Alpine America? • There are remarkable similarities between U. S. and Switzerland. Both countries came to an early tolerance of religious and ethnic diversity. The "cement of society" relied more on shared values and ways of life than on ethnic or religious homogeneity. • Also Switzerland achieved an early definitive exit from aristocratic privileges (in 1847). Swiss feudal ties were traditionally weak. The peasants were difficult to dominate because they were often far away on the Alpine pastures and because they were well trained in military activities (serving, often, as the most valuable mercenaries all around Europe). • Like the U. S. , at the time of the second industrial revolution, Switzerland had a robust democracy and satisfied the conditions to realize a “dispersed equilibrium”. 32

Conclusion • Conflictual complementarities among share holders favor different ownership arrangements which are characterized by synergic complementarities with technical assets. • Legal origins theory cannot explain why Britain has moved from one system to the other and why a civil law country, such as Switzerland, shares so many features of the American system. By contrast, conflictual and synergic complementarities can explain both the strong inertia and the sporadic changes that characterize the different corporate systems • Even if interlocking (meta-)complementarities involve a considerable inertia, existing arrangements can be upset by the emergence of novel dimensions of stakeholder conflicts.