Knowledge & ownership

At the Stumbling and Mumbling blog Chris Dillow raises the interesting issue of Knowledge & ownership. He writes,

The thing is, part of the case for worker ownership is that it is a means of using dispersed, fragmentary knowledge. Workers sometimes (often?) know better than bosses how to cut waste or improve efficiency. Giving them ownership might therefore be a means of improving efficiency.
There are two principles here we should make explicit.
First, ownership should, ideally, flow to where there is knowledge. Not all ownership forms achieve this. For example, customer ownership did not stop Equitable Life collapsing, in part because customers didn’t really know what the hell it was doing. Similarly, shareholders’ failure to stop banks going bust wasn’t just a problem of collective action - it was that they didn’t know what banks were doing.
Second, ownership must entail real power.

Dillow is right in that workers may well have more information that bosses about the actual workings of a firm. But does this mean they need to be given ownership? In some cases the answer would be yes. We see worker ownership in the form of partnerships in areas where knowledge is important, lawyers and doctors being two obvious examples. But can the idea be applied more widely or are labour-owned firms likely to remain small partnership like institutions? Consider the paper Brynjolfsson (1994).

The Brynjolfsson (1994) model considers an entrepreneur who has some expertise needed to run a firm. No value can be created without both the knowledge asset of the entrepreneur and the physical assets of the firm. He assumes that no comprehensive contract can be written between the entrepreneur and the firm. If the entrepreneur does not own the firm, then if he makes an investment in effort and creates value, he can be subject to hold-up by the other party since he needs the firm’s physical assets. If the entrepreneur owns the firm then clearly the hold-up problem ceases to exist. The most obvious interpretation of Brynjolfsson model is as a model of a labour-owned firm. Brynjolfsson argues that it is optimal to give the entrepreneur ownership of the physical assets of the firm since he has information that is essential to its productivity. This result is obviously just an application of Hart and Moore’s proposition that an agent who is ‘indispensable’ to an asset should own it. Here, firms are owned by the indispensable human capital, or more normally by a small section of the human capital, e.g. a partnership.

Labour-owned firms are therefore one way to form a human capital-intensive firm but the shortcomings of such organisations are obvious: lack of access to capital, inadequate risk pooling, investment problems, older workers wanting a shorter pay-back period than younger workers, are membership rights tradable and if so under what conditions, new members would have to purchase ‘equity’ in the business from retiring ones, borrowing to cover such a purchase could be a problem for younger would-be members, etc.

Brynjolfsson (1994, p. 1654) also sees advantages in firms being small when information is important in production. In his view, smaller firms have an advantage in providing incentives both because it is easier to separate out the contributions made by each individual, and thus to reward each individual accordingly, and because it is more likely that agents in small firms have a stronger incentive to make non-contractible contributions. Small firms therefore have an advantage over larger ones in situations in which it is important to provide incentives for the application of information in ways that cannot be easily foreseen and incorporated into a contract. Brynjolfsson (1994, footnote 12) goes further by noting that the stronger, output-based incentives for the noncontractible actions in smaller firms will not only induce higher effort overall, but, in multidimensional models, also induce less effort on actions that do not enhance output. Note that what we mainly see in terms of labour-owned firms are small firms. Outside of some of the accounting firms, partnerships and other worker-owned firms are generally small.

But even if knowledge is important to production, firms can change in response to this without a change in ownership. Rajan and Zingales (2003, p. 87) argue that we are in fact seeing a new ‘kinder, gentler firm’. This is in response to the increase in the importance of human capital, along with increased competition and access to finance, all of which have increased the worker’s importance and improved the outside options for workers, thereby changing the balance of power within firms. Rajan and Zingales (2003, p. 87) also argue that the biggest challenge for the owners and management today is to manage in an environment of much reduced authority. Today, authority has to be gained by persuading workers that the workplace is an attractive one and one that they would hate to lose. To do this, management has to ensure that work is enriching, that responsibilities are handed down, and that rich bonds develop not only among workers but also between workers and management.

Another example is Cowen and Parker (1997) who make a similar point about the changes to organisational structures that the new economy is bringing about. For them:

Information as a factor of production is making old functional structures and methods of organisation and planning redundant in many areas of business. The successful use of knowledge involves not only its generation, but also its mobilisation and integration, requiring a change in the way it is handled and processed. (Cowen and Parker, 1997, p. 12)

Organisational change, according to Cowen and Parker, is the consequence of the increasing need to make use of market principles within the firm and the growing importance of human capital. They note that as far as a firm’s labour force is concerned, the emphasis has now shifted towards encouraging knowledge acquisition, skills and adaptability since these are seen as critical in maintaining a competitive advantage. (Cowen and Parker, 1997, p. 32). Firms are obliged to rely more on market-based mechanisms as the most efficient way of processing and transmitting information and giving the firm the flexibility but also the focus it requires. Companies are decentralising their management systems as a way of coping with the uncertainty and pace of change in their markets. The aim is to ensure that those with the required knowledge and right incentives are the ones making the decisions and taking responsibility for the outcomes. Cowen and Parker (1997, pp. 25–8) emphasise how advances in ICTs underlie the capacity to combine the advantages of this organisational flexibility with mass production.

The point of all this is that the efficient use of (tacit) knowledge may not require a change in ownership. This is for two related reasons: 1) worker ownership may require the firm to be small, large worker-owned firm may create more problems than they solve. You do have to ask why are they so rare. 2) there are other ways to deal with (tacit) knowledge within a firm which don't require changes in ownership.

References:

• BRYNJOLFSSON, E. (1994). Information assets, technology, and organization. Management Science, 40, 12, pp. 1645–62.
• COWEN, T. and PARKER, D. (1997). Markets in the Firm: A Market-Process Approach to Management. London: Institute of Economic Affairs.
• RAJAN, R. G. and ZINGALES, L. (2003). Saving Capitalism From the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity. New York: Crown Business.