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Corporations continued

Summary:
From Peter Radford The key to understanding corporations is to separate the economics from everything else.  We need to do this because the economics, as expressed in various theories of the firm, are usually entirely idealized and bear no resemblance to reality.  Economists, as usual, love to theorize about things that don’t exist but which they wished did exist. But that may just be me being dismissively judgmental. Corporations, far from being products of the free market, are actually franchises of the state.  They are sub-contracted jurisdictions. To be a corporation is to possess a charter from the state.  That charter brings privileges not available to non-corporations. The most notable privilege is that the corporation is recognized as a distinct legal entity separate from any

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from Peter Radford

The key to understanding corporations is to separate the economics from everything else.  We need to do this because the economics, as expressed in various theories of the firm, are usually entirely idealized and bear no resemblance to reality.  Economists, as usual, love to theorize about things that don’t exist but which they wished did exist.

But that may just be me being dismissively judgmental.

Corporations, far from being products of the free market, are actually franchises of the state.  They are sub-contracted jurisdictions.

To be a corporation is to possess a charter from the state.  That charter brings privileges not available to non-corporations. The most notable privilege is that the corporation is recognized as a distinct legal entity separate from any “natural” person who may be associated with it.  And because the corporation is brought into existence prior to it being populated or animated by any natural person, it is not owned by any of them.  It is unowned.  In this sense it is akin to a nation state, the church, most universities, and, at least here in the US, most towns,  It would be odd to describe any of those bodies as being owned by the people who animate them.  Yet we routinely talk of firms being owned by stockholders. It is this misattribution of ownership that leads most economists astray in their theorizing.

The advantages that the privileges of being a corporation bring have long been recognized.  The ancient Romans set up corporations for business purposes for exactly the same reasons we do nowadays:  it makes the joint ownership and management of property for short term business purposes much more efficient than alternatives such as the traditional partnership.  

When a partner leaves a partnership, the remaining partners are obliged to pay out the leaving person’s share of the accumulated resources of the partnership.  This can often strain the organization to breaking point.  In a corporation, anyone withdrawing their financial support simply sells their share to someone else.  It is not the responsibility of the corporation to pay out anything.  The organization persists, and its shareholders are temporary.  This is obviously attractive for any business activity that requires long term investment or complex financing.  Hence the sudden rise of corporations in the business sphere after industrialization.

Prior to that the corporate form was found most often in ecclesiastical or educational settings.  Back in Medieval times it was mostly the church and then the universities who operated under a charter.  A typical bishopric was chartered.  It would be nonsensical to speak of the Bishop owning the bishopric.  Each bishop was simply the temporary custodian of what was a long term, if not perpetual, entity.

It was this clear separation of the assets of the corporation from the people animating it that  was the most advantageous aspect of a charter.  The bishopric, university, or town could own, manage, and buy or sell property in its own name.  They were all regarded as being legal “persons” for such property owning purposes.  This is the origin of the legal personhood that has become so controversial in our modern era.  And those entities were all granted this privilege, and advantage, because they all were assumed to be producing a public benefit.  A benefit that was normally stated in their founding charter as the reason for being given a charter in the first place.

So the original corporations were a hybrid organizational form.  Neither entirely public nor entirely private they were designed to produce public goods using private financing. The quid pro quo being that the private financiers could make a profit as long as the public good was provided as chartered.

It is because of this hybrid design that the theories of the firm found in mainstream economics textbooks totally miss the point.  Capitalists adopted the corporate form because of its property owning advantages over the partnership form.  It was a more efficient vehicle for the concentration of the large amounts of cash needed to undertake the risky activities of long distance trade or industrial production.  Yes, the corporate form economizes on transaction costs, but that is a radical understatement: without the corporate form those transaction costs are permanently prohibitive to the activity.  No sufficient amount of complex contracting — as found in the so-called “nexus of contracts” theory of the firm — is possible in a marketplace.  Not even in an information dense marketplace such we experience on the digital age. And within the walls of the corporation central planning dominates activity.

It is the market that is the anomaly for the organization of production, not the business firm.  In particular not the business firm organized as a corporation.

It is also this dependence of the corporation on the state for its legitimacy that has been the source of friction throughout the industrial era and up to today. The tension between contractor and sub-contractor has ebbed and flowed with both sides claiming victory at different points in history.

The first big break for the corporation here in the US came as far back as 1819 when the original trustees of Dartmouth — which was then not the college we know it as today — challenged the state’s interference in its internal organization.  The US Supreme Court ruled in favor of Dartmouth by asserting that the original charter was a contract and thus could not be violated by the state’s attempted legislation to upend it.  This was the confirmation of corporations having the very property rights that was to be so attractive to later capitalists.  Prior to this, and particularly in the UK, industrialization was still taking place in either family-run or partnership-run organizations.  After the Dartmouth decision the corporate form was dusted off from its Medieval shelf and re-purposed for industry.  With its property rights settled and on a firm footing the corporation became the obvious vehicle for business.

Recent controversy is less about these property rights than it is about civil rights.  The most contentious examples being the frequent use of the Fourteenth Amendment to extend the rights of business.  This is the Constitutional amendment designed to protect former slaves from discrimination, but its overwhelming use in the Supreme Court has been to extend the civil rights of business.  It is this much more fractious attribution of “personhood” to corporations that has gained so much attention, especially since the Citizens United case a few years back.  By granting corporations freedom of speech, which was surely never on the minds of the Founders writing the Constitution, the Supreme Court carried the notion of civil rights further than ever before and, by extension, twisted the American electoral system even further away from any pretense of democracy.

The Founders were all intimately aware of the corporate from of organization because most of the original colonies were established under corporate charters from the state in England.  Indeed when they were searching for a basis for their new nation they adopted the chartered corporation as their model, with “we the people” being the sovereign conferring legitimacy on the charter, now called a constitution, and all the usual trappings of corporate existence — by-laws, methods for limiting the charter, etc simply transferred over.  The US is itself a giant corporation in this view.

Th Citizen’s United case, and the subsequent Holly Lobby case a few years later, the latter extending religious freedoms to corporations, demonstrate the confusion the law has with corporations.

On the one hand the law states that the corporation is its own entity, unowned but with ownership rights separate from those people animating it.  This is the property rights tradition of law.  On the other hand, at its convenience, the  law has looked past that separate entity and attributed the rights of the people within the firm to the firm itself.  This is the civil rights tradition of law.  All the modern controversy extends from this latter tradition.

The Supreme Court oscillates between these two traditions. Sometimes treating corporations as mere associations of people, in which case it attributes personal rights to the aggregate of those people i.e. the corporation, and other times protecting that same association from the downside of personal property problems stemming from corporate failure i.e. by creating and then extending limited liability rights that natural persons do not have.

So the tension between the state and its offshoot corporations persists and is magnified by troubling inconsistencies in the attribution of which rights belong with the privileges that corporations are given in their charters.

If corporations want the privileges that give them their transaction cost advantage, then they ought sacrifice their appetite for civil rights.  Or the other way around.  Until they do they will incur the anger and hostility of many more commentators than otherwise.

The aggressive assertion of corporate rights, especially those that allow business to interfere in the legislative process, is detrimental to democracy.  Those of us who seek to defend democracy from the oligarchs need to remind ourselves of the franchisee status of corporations.  They exist to provide public goods — even if those goods are produced with private means they are public because they flow from the corporate form of organization.  Regulating business to this end is entirely legitimate and not at all an interference in the so-called free market.  Corporations are sub-contractors of state authority.  They have franchised privileges that give them advantages over other types of organizations.  The regulatory “cost” of adhering to their chartered course is actually not a burden: it is the price for those advantages.  It is the market price for their very legitimacy.

And the contradictions between reality and theory will continue to befuddle economists of all ideological ilks.

But clearing that up would ruin our fun, wouldn’t it?

Peter Radford
Peter Radford is publisher of The Radford Free Press, worked as an analyst for banks over fifteen years and has degrees from the London School of Economics and Harvard Business School.

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