Firms and Incentives under Socialism

 *Note: this is a repost from an earlier defunct blog of mine that I'm posting here for 'archival' reasons.

In my last post, I made the case against the heuristic 'market socialist' pricing mechanism that Fred Taylor and other market socialists have argued could salvage socialism from the inherent impossibility of the rational allocation of resources. One aspect of market socialist theory, however, I left mostly unaddressed, and that's the socialist theory of firms. I referred, at the end of my post, to the problems of incentives under a socialist arrangement, and a future post on the matter; this is that post. I associate most of the 'incentives questions' relating to socialism with the definition of the firm, its ownership, and the relative status of its participants. In particular, I think the Coasean theory of the firm is the best model for firms, is the most consistent with observed reality, and ultimately vindicates the free market approach to firms rather than the socialist approach, as the former best aligns incentives to maximize well-being, while the latter clearly does not.

A firm is defined as a joint enterprise between individuals (or, of course, other firms) for the purpose of producing goods or services. Ronald Coase's theory of firms basically posited that firms exist (as opposed to all economic decision-making, negotiation, and contracts being done between unincorporated individuals) because of transaction costs. Coase's theory of firms informed his eponymous theorem, which holds that, absent transaction costs, regardless of the initial allocation of resources, ownership of resources will, simply through the process of exchange, tend toward reallocation in which everything is owned by whoever values it most. Of course, the reality of transaction costs largely shapes both the structure of the market (the size and other characteristics of firms, such as ownership distribution) and how resources get reallocated through exchange on the market.

But to avoid further digression, let's return to the issue of production. The free market approach to production is simple: any firm can own anything anyone else is willing to sell to them (including factors of production, like land or natural resources), and any individuals can voluntarily join together to form any type of firm based on any mutually consensual arrangement, distributing ownership and revenue however they may agree to. In other words, the free market approach is, well, free. It imposes no legal restrictions on the formation, modification, activity, or dissolution of firms as long as long all activity is consensual for all participants. A firm bay buy, sell, hire, and fire as it pleases. Indeed, one may note that nothing necessitates that firm should even exist in a free market setting. One need not incorporate in order to participate in any kind of economic activity; inasmuch as firms arise, it is a spontaneous phenomenon.

The socialist model of the firm (I will, as in my last post, use Jossa and Cuomo as my reference here), however, imposes certain legal restrictions on what firms may or may not do. Firms are not, in this model, permitted to hire employees. All laborers, rather, have an ownership stake in the firm. It is implied (though of course this condition could in theory be relaxed) that the ownership stake is equal for all employees. There are no shareholders in the socialist model for the firm: all excess revenue (if it is not appropriated by the state, that is) is distributed equally among members of the co-op. In the socialist model of production, all decision-making is conducted democratically, either directly or indirectly (that is, either by direct vote or by managers elected by the employees).

A key restriction on this arrangement is that employees, despite automatically having an ownership stake, cannot sell this stake - that is, their vote on initiatives or the election of managers - or the income associated with it (the excess revenue, if it is distributed equally among its members) to anyone either outside or within the co-op. But is this restriction actually in the interests of the worker? Is it in the interest of the members of the co-op in general? Even if all co-op members share an equal interest in the success of the co-op, they do not share equal knowledge relevant to decision-making. Indeed, most socialists accept the managerial positions would be necessary for effective coordination in a commune or co-op beyond the smallest size. The managers may be elected, but the acknowledgement of the benefits of delegation constitutes a concession that some members will be better decision-makers than others (otherwise managers may just as well be chosen from among the workers at random as elected). A worker might choose to give his vote in initiatives or elections to another worker he believed to be more informed than he himself is on the issue subject to the vote. There are, of course, selfish reasons for a worker to seek to judiciously give away his vote, and selfish reasons for a worker who believes himself well-informed to accept it: this donation would (if the workers are accurate in their perception of each other's relative competence) improve the likelihood of good decision-making, increasing output, and improving the well-being of both workers, as well as all other workers in the co-op; indeed, increasing output and/or reducing cost of production would also be to the benefit of society generally.

But how can a worker be confident that the other worker to whom he's considering delegating his vote is actually more competent to vote on a policy or the appointment of a manager? Is it simply a question of judging his character? Well, if we relax the restrictions imposed on co-workers still further and permit them to sell their votes to each other, then a hapless worker who had no idea what or who to vote for may be more confident that another worker is genuinely more competent if the latter is willing to pay for his vote. Indeed, the selling worker might even sell part of (or all of) the future surplus revenue he would earn as a member of the co-op to the buyer. If it is true that 'incentives matter,' as the mantra goes, then someone who is willing to stake his own wealth on a decision will tend to make a better decision than someone who isn't. The buyer of the vote now has a much stronger incentive to accurately assess and present how competent he on the matter subject to a vote. Assuming workers are living above subsistence level and have disposable income with which they might buy each other's votes, then from this premise alone (that workers willing to bet financially on their competence by buying others' votes and potentially the future income concomitant with their stake in the co-op will tend to vote more competently on average), votes - and ownership over future surplus revenue - will tend aggregate in the hands of workers who are most competent. This is because, inasmuch as they vote more competently than others, their surplus income will tend to grow larger, allowing them to buy still more votes. This concentration may continue to the point where ownership of co-ops tends to be concentrated in the hands of a few or even one member.

Is this process, however, deleterious? No, quite the opposite: the vote-buying workers are willing to pay the seller <i>more </i>than the current value of future surplus income the seller would otherwise earn for two reasons: 1) the vote itself gives the buyer greater ability to improve the productivity of the co-op, thereby increasing his own income as a worker above what it would be if he didn't buy the vote, and 2) because, simply by buying the vote and using it more judiciously, he will increase the expected surplus revenue per worker, meaning the amount he will reap from the seller's erstwhile future allotted surplus income will be higher than what the seller would have reaped if he had kept his vote. The buyer therefore values the seller's vote more than the seller does, and can, in a sense, use it more productively. This gives him a reason to pay the buyer an amount equal to or greater than the current value of the future income stream, and enables him to still generate a profit from the exchange. Both parties benefit, as do the other members of the co-op (the increase in productivity raises everyone's income) and society in general, which enjoys lower prices from the reduced cost of production resulting from the better policies which in turn result from the more judicious exercise of voting shares by the buyers of votes.

But we might relax our restrictions on the freedom of economic decision-making even further: we can allow workers to sell their stake in the co-op to outsiders. Now, one might argue that outsiders have less of an incentive to see the co-op's productivity increase; in fact, competitors could even buy votes in a co-opt to impose bad policy decisions on it to sabotage it for their own benefit. This, however, can be remedies by selling votes in the company to outsiders only concomitantly with proportional future income flows. This means even the outsider buying votes from co-op members will have a vested interest in sound management of the co-op. Of course, workers will still have a stronger interest in the performance of the co-op than outsiders. This may lead workers to sell votes (and concomitant surplus incomes) to other workers at a discount relative to outsiders. This practice begins to resemble the practice observed in capitalist economies of employers offering employees (especially managerial ones whose decisions may significantly impact performance and therefore whose incentives it behooves the firm to align more strongly with the firm's productivity) stock options.

At this point, it should be clear that our vote buyers - internal and external - are beginning to look like investor-owners. Indeed, those workers who are successful at buying up votes and using them to improve the productivity of their companies (perhaps even merely by doing a better job of assessing the abilities of potential managers) may find themselves increasingly specialized not in whatever business their co-op is in, but in the business of determining how to improve the management of co-ops (or even simply identifying which co-ops are better managed than others) - in other words, they may become professional investors. Our co-op, of course, is now no longer a co-op, but a corporation owned by investors rather than workers (though there will tend to be some overlap between the two).

 The issue of entry and exit poses yet another problem for the robustness of the socialist model of the firm. If one co-op is generating less revenue than another, workers at the former may be willing to leave their co-op to work at the more successful one; but the more successful co-op may only be willing to hire them if they are willing to forego future surplus revenue and the ability to vote on co-op decisions. Restricting such hiring is to the detriment of everyone: the worker at the less successful co-op must continue to earn a lower income, and his willingness to switch co-ops indicates that he values a higher, fixed salary more than a lower or uncertain future revenue stream and his vote in his less successful co-op (and likely rationally: one cannot eat a vote in a failing co-op). The exchange is Pareto optimal. Both parties benefit; and yet, a consequence of allowing this to occur would be the gradual erosion worker ownership of co-ops (we might now merely say 'firms') as more and more workers trade in their voting shares and surplus income flows at less successful co-ops for wages at more successful co-ops.

The conclusion we reach is that, if employees are permitted to make their own economic decisions, such as the selling or buying of ownership stakes and concomitant revenue flows, and firms are permitted to make their own economic decisions regarding the buying and selling of goods or services to or from other firms (and the buying of ownership stakes and revenue flows from other firms), the 'democratic', co-operative nature of the firms will naturally change, tending toward the corporate structure we observe in capitalist economies. And, more importantly, this tendency does note require any exploitation whatsoever (exploitation defined rather loosely as inducing someone to participate in an arrangement that is deleterious to him). Rather, firms and employees will often find it to be <i>in their interest</i> to make these decisions (e.g., the buying or selling of equity) that will cause the transition toward corporate ownership. Moreover, these economic decisions will not merely often be to the benefit the immediate participants, but will tend to be Pareto efficient as well - that is will have no non-negative impact on anyone else.

Finally, specialization and the division of labor (something Marx perhaps correctly identifies as necessarily undermining egalitarian socialism) will tend to recreate the income and wealth inequality one observes in capitalism, if one only allows co-ops to freely bargain with other co-ops for goods and services. A factory co-op might hire a trucking co-op to transport its goods to the market; it may hire a janitorial co-op to keep the factory clean; it may even purchase insurance from an insurance co-op, or pay a banking co-op that specializes in assessing credit-worthiness to supply it with credit. All of these financial services - insurance, accounting, credit, etc. - would have as much a reason to exist under a socialist system as a capitalist one: risk will still exist; surplus revenue (whoever owns it) will still exist, and will still be more productively used by lending it out that stuffing it under mattresses. And a result of this co-op specialization will be the tendency of revenues of various co-ops to diverge toward their marginal productivity, determined by the supply and demand of the skills necessary to provide whatever goods and services they render. Even if one attempts to suppress intra-firm wage inequality, firms will emerge that are specialized to the point that minimizes the relative burden of transaction costs (referring again to Coase's theory of firms), yielding a setting in which considerable inter-firm income inequality exists. Of course, this divergence from the egalitarian socialist model is not a pernicious development that ought to be suppressed, but a salutary one that (again, if one accepts that people are motivated by material incentives, something socialists seem to readily accept, else there would be no capitalists) will induce people to use their skills most productively, maximizing the material well-being of society in general.

To summarize, if a socialist model of the firm can be established in a community (even in a decentralized manner), it can only possibly be maintained by suppressing, by force, the right of individuals and firms to make mutually consensual exchanges that have a net positive value both to participants in the exchange and to society in general. By suppressing such free economic decision making, the imposition of the socialist model on existing firms imposes a discordance between decision-making and incentives that is neither efficient, in that it disincentivizes the optimal allocation of resources for social welfare, nor fair, in that it systematically allocates control over the making of decisions to individuals beyond the extent of their investment in the consequences, while depriving others of control over decisions that is proportional to their stake in the consequences.

The tendency of ownership to concentrate, unequally, in the hands of investors rather than equally among workers requires no exploitation or manipulation of workers. All it requires is that people respond to material incentives, and have the freedom to engage in voluntary exchange. This thought experiment has, in essence, been an illustration of the Coase Theorem. Not all workers value their co-op voting rights equally; this is rational, because not all voters will use those voting rights with equal productivity. Differences in how productively one can exercise one's influence over economic decision-making leads to this difference in valuation, which in turn means that rational agents will tend to buy or sell voting rights and future surplus incomes (which ultimately become what we would call profit) until voting shares and claims to profits are reallocated to those that most believe they can can influence firm decision-making in a manner that increases productivity, or at least accurately assess the quality of management and allocate their wealth where it will be used most productively. And if one accepts a second premise - that those that are willing to stake their own wealth or income on a decision, that have the strongest material incentive to make the right decision, will tend to make such decisions more soundly than those that aren't willing to stake their own wealth on it - then this reallocation is beneficial not just to the investors who buy up votes and profit claims, nor even merely to the workers who are able to sell their votes and claims to profits for more than they would be worth if the exchange did not take place, but the public benefits from the improved productivity of its industries (and if one rejects this second premise, then vote-buyers will fail to accumulate the surplus wealth necessary to erode cooperative ownership). Nor is this reallocation unfair, as it is merely the result of workers voluntarily selling something they rationally value less to someone who rationally values it more because the latter can make more productive use of it than the former.

Per Coase theorem, even if one starts with a socialist allocation of ownership of the means of production, once one resolves to allow free exchange, the process of exchange will tend to reallocate ownership to those that value it most and and can use it most productively, which on balance improves the material well-being of society. What this means is that even a decentralized socialist framework can be maintained only by the (rather illiberal) suppression by force of the freedom of individuals and co-ops to engage in mutually beneficial, Pareto efficient acts of voluntary exchange with one another, resulting in a less prosperous society.