Sunday 22 May 2011

Who should own human-capital based firms?

At the Freakonomics blog the question is asked Why Can’t Law Firms Go Public? They writes,
The personal injury law firm Jacoby & Meyers (known for its TV commercials) is suing to overturn state laws in New York, New Jersey and Connecticut that prohibit non-attorneys from owning stakes in law firms. From The Wall Street Journal:
The firm, which has more than 60 lawyers and specializes in personal-injury cases, claims that the restrictions have hurt its ability to raise capital to cover technology and expansion costs, and have hampered it in providing affordable legal services to its working-class clients.

U.S. law firms typically are owned by their senior-most lawyers, called partners. The structure was designed to ensure that all the principals of the business were accountable for the firm’s work and that of their fellow partners.

The ban on law firms accepting nonlawyer investors is nationwide, with the exception of Washington, D.C., under ethics rules established largely by state supreme courts. Violations of the rules can lead to disbarment.

The restriction on investors is decades old and stems from even older strictures against lawyers sharing fees with nonlawyers, for fear that might compromise their professional independence.
Firms like lawyers and doctors and accountants are by and large partnerships and, obvious, the major asset of these firms is the human capital of the partners and the others who work at these firms. The question that arises is, Is ownership by the human capital optimal for such firms?

The answer offered by this paper is, it depends. In particular it depends on the heterogeneity of the human capital involved in the firm. For firms with a homogeneous set of human capital, ownership by the human capital can be optimal. The more heterogeneous the human capital becomes the more likely is ownership by outside investors.

The argument as to why this is so is based on the "reference point" approach to the theory of the firm. The argument therefore is based on the ideas of aggrievement and shading. Think of a firm which involve both human and physical capital but where, like a law firm, the human capital is the most important. Giving ownership to the human capital make sense since the these workers can cause much grater efficiency losses for the firm should they become aggrieved than the owner of the physical capital could. Remember the physical capital is unimportant to the production of the firm.

But as the relative importance of physical capital increases the efficiency losses the owner of this capital can cause also increases and at some point they will become so large as to make giving him ownership of the firm optimal.

If you think of the owner of the physical capital as a second type of human capital then ownership of the firm should go to whichever human capital can cause the greatest efficiency loses. But as Oliver Hart has argued human capital only firms are inherently unstable. Some non-human capital is needed to "glue" the firm together.

Thus heterogeneous human capital only firms are unlikely to remain intact and so either firms must have significant non-human capital involved, the owner of which may be the owner of the firm, or they consist of only homogeneous human capital.

So we see why law firms which expand to involve human capital other than just lawyer may wish to seek investors. Labour-ownership may no longer be optimal when the firms human capital becomes heterogeneous.

No comments: