3 May 2018

Introduction The corporation is the most important of modern economic institutions. The nineteenth century saw the emergence of business organisations with many employees and differing shareholders. Mostly, in the first instance, railroads and railways: bank and resource companies followed. And subsequently the manufacturing corporations which came to dominate the industrial scene in the twentieth century. (Hannah,1976) When Fortune produced its first list of the world’s largest corporations in 1956, nine of the top ten were manufacturing companies – three in automobiles, three in steel. (Table 1) Table 1: Sales ($m) Profits ($m) 1 General Motors 12,443.3 1,189.5 2 Exxon Mobil 6,272.4 709.3 3 Ford Motor 5,594.0 437.0 4 U.S. Steel 4,097.7 370.1 5 Chrysler 3,466.2 100.1 6 General Electric 3,095.4 200.9 7 Esmark 2,404.1 22.9 8 Bethlehem Steel 2,096.6 180.2 9 Armour 1,967.7 10.1 10 DuPont 1,909.2 431.6 Source: Fortune (1956) The nexus of contracts The rise of such corporations led economists to give belated attention to the theory of the firm. Credit for founding this branch of knowledge is generally given to Ronald Coase, whose 1937 article (based, he later explained, on ideas put forward five years earlier when he was only twenty-one) remains seminal. (Coase, 1937, 1991)   Transactions costs were central to Coase’s argument. The boundaries of the firm were defined by the relative costs of two methods of co-ordination: markets and the price mechanism versus central direction, and management hierarchies. Companies such as General Motors and du Pont – companies featured in Alfred Chandler’s magisterial account (1962) of the rise of the diversified manufacturing corporations – appeared to have extensive need of hierarchy, with extensive horizontal diversification and vertical integration. Oliver Williamson (1975) greatly extended the Coaseian framework, emphasising the importance of idiosyncratic investments which were specific to the needs of a particular product – including both physical equipment and acquired skills. If the manufacture of a part required specialist tooling and knowledge, then the related functions would take place within an integrated firm. This firm was ‘a nexus of contracts’. (Jensen and Meckling (1976), Easterbrook and Fischel (1989, 1993)).   This idea was present from the very beginnings of the modern corporation in the legal doctrine of corporate personality – people dealing with the firm transacted with a corporate entity, not the individuals who represented the organisation. From an economic perspective, the firm was at the centre of a web of legal agreements, with employees, suppliers, customers and lenders. What of the position of shareholders? Legal agreements can never be sufficiently comprehensive to cope with all eventualities. Much of what is contracted is implicit, and the courts may identify and enforce implicit terms: but much remains to be resolved by hierarchy. Grossman and Hart (1986) Hart (1989) characterised the ‘owner’ within the nexus of contracts as the person who determines the indeterminate elements of inevitably incomplete contracts.   The shareholders, residual claimants to revenues and assets, and at least in theory collectively possessed of the power to enforce their will, fulfilled this role of arbitrators of whatever was not spelled out contractually. Thus the problem of management is essentially reducible to the specification and resolution of principal-agent problems. And in the classic text of Milgrom and Roberts, this principal-agent problem explains the central issue of organisational design. Thus ‘although delegating authority to those with the information needed to make good decisions is an important part of good organisation design, it is of little use unless the decision makers share the organisation’s objectives. We have already mentioned incentives as a way to align individual and organisational objectives….. incentives and delegated authority are complements: each makes the other more valuable’. (Milgrom and Roberts, 1992, p.17). The contract is a device for creating incentives such that the individual (with local knowledge unavailable to persons more senior in the hierarchy) will act as if the objectives of the organisation (and, by extension of the previous argument, the shareholders) were his or her own. The scale of the twentieth-century corporation made inevitable the separation of such shareholder ‘ownership’ from control. This issue had been noted even before Coase and Chandler, famously by Berle and Means (1932)   Such separation generated an additional principal agent problem: that of the shareholder ‘owners’ as principal and the executive managers as agent. The emphasis in Jensen and Meckling’s 1976 article on the need to align these interests, by designing appropriate incentive schemes proved highly influential, not least because its conclusions were so congenial to the executive managers themselves. Over the following decades explosive growth in the use of stock options was associated with explosive growth in the levels of executive remuneration. Milton Friedman’s (1970) article ‘The Social Responsibility of Business is to Maximise its Profits’ may be one of the most cited articles ever published in the New York Times. Friedman’s assertion followed naturally from the identification of shareholders as ‘owners’ and managers as ‘stewards’, and that article may be seen as a precursor of the era of ‘shareholder value’. Jack Welch of General Electric is widely credited with inaugurating that era in a speech at the Pierre Hotel in New York soon after he took over as that company’s CEO. (Welch, 1982) Welch did not in fact use the phrase ‘shareholder value’, but it become more and more widely heard in the two decades that followed. Only in 2009, some years into retirement, would Welch describe shareholder value as ‘the dumbest idea in the world’. (Welch, 2009). The core model of the modern firm, then, visualises it as a cascade of principal-agent problems.   That model was the logical culmination of what had earlier been described (though with a degree of scepticism which had increased over time) as ‘scientific management’. Shareholders–owners, too busy and too numerous to manage the business themselves, contract with executives to run the business. These executive functions include determination of the appropriate scope of the firm, integrating idiosyncratic activities within the overall common organisational structure, and contracting in competitive markets where there are multiple potential suppliers of homogenous inputs. Internal organisation requires decentralisation