High human capital and worker-owned firms

In a recent paper in the Journal of the Knowledge Economy I argued, via a simple model of the firm based on the reference point approach to the firm, that having a firm based on a homogeneous group of human capital leads to a different organisational form than that of a firm which involves a heterogeneous group of human capital.

To illustrate this idea I considered the ownership structure of professional sports teams. Heterogeneity in playing talent—playing talent being the human capital here—and thus in earning potential is a disincentive to the formation of a worker cooperative, an organisation which normally involves (rough) equality in payment,  since those players with the greatest earning potential, the largest outside options, will transfer away from the cooperative to maximise their income stream. Thus, a worker-owned team would have few, if any, star players, a handicap in the winner-takes-all world of professional sports.

But this argument could be applied to any worker-owned firm in which their is a range of worker ability. My argument would mean that the given a relatively flat compensation structure high ability workers would be more likely to leave a worker-owned firm.

In a new paper in the latest issue of the Economic Journal Gabriel Burdín argues that Equality Under Threat by the Talented: Evidence from Worker-Managed Firms.

The abstract of the paper reads:

Does workplace democracy engender greater pay equality? Are high-ability individuals more likely to quit egalitarian organisational regimes? The article revisits this long-standing issue by analysing the interplay between compensation structure and quit behaviour in the distinct yet underexplored institutional setting of worker-managed firms. The analysis is based on novel administrative data sources, which allow constructing a simple ordinal measure of the workers' ability type. The article's key findings are that worker-managed firms have a more compressed compensation structure than conventional firms, and high-ability members are more likely than other members to exit. (Emphasis added.)

Thus Burdin finds what you would expect, high-ability workers (players) are more likely to exit worker-owned firms (teams) leaving such firms (teams) at a disadvantage compared to employee based firms.

Are cooperatives more productive than investor-owned firrms?

An often asked, if not often answered question. Well now there is an article that sets out to answer the question, at least for the case of Portugal.

Natália P. Monteiro and Odd Rune Straume have a new working paper, "Are cooperatives more productive than investor-owned firms? Cross-industry evidence from Portugal".

And the answer is that cooperatives are less productive than investor-owned firms.

The abstract reads:

We analyse empirically whether cooperatives and investor-owned firms differ in terms of productive efficiency. Using rich Portuguese panel data covering a wide range of industries, we apply two different empirical approaches to estimate potential differences in total factor productivity between the two groups of  firms. The results from our benchmark random-effects model show that cooperatives are significantly less productive, on average, than investor-owned firms. This conclusion is to a large extent confirmed by the results from System-GMM estimations. The lower productivity of cooperatives applies to a wide spectrum of industries. In six out of thirteen industries, cooperatives are outperformed by investor-owned firms in all empirical specifications considered, while there is no industry in which cooperatives are consistently found to be the more productive type of firm.

Of course it has been argued that an investor-owned firm is a particular type of producer cooperative; a capital (or lenders’) cooperative.

In their analysis Monteiro and Straume combine all forms of cooperatives but the basic results don't change when they look at particular types of cooperatives within a given industry. That is, productive efficiency of cooperatives versus investor-owned firms is not particularly related to cooperative type.

Investor-owned firms as cooperatives

Having written a couple of posts recently on cooperatives, see here and here, I thought to compare cooperatives with investor-owned firms, the main form of firm in the economy. While investor-owned firms dominate the economy what is not often realised is that they can be seen as a form of producer cooperative. This argument is due to Henry Hansmann, "Ownership of the Firm", Journal of Law, Economics, & Organization, Vol. 4, No. 2. (Autumn, 1988), pp. 267-304.

Hansmann begins by noting that

In the discussion that follows it will be helpful to have a term to comprise all persons who transact with a firm, either as purchasers of the firm's products or as suppliers to the firm of some factor of production, including capital. Such persons—whether they are individuals or other firms—will be referred to here collectively as the firm's "patrons."

Most firms are owned by persons who are also patrons. This is conspicuously true of producer and consumer cooperatives.

He then notes that this is also true of the standard business firm, which is owned by persons who lend capital to the firm. In fact, Hansmann argues, the standard investor-owned firm is in a sense nothing more than a special type of producer cooperative—a lenders' cooperative, or capital cooperative.

To show this Hansmann starts by looking at the structure of a typical producer cooperative.

A representative example is a dairy farmers' cheese cooperative, in which a cheese factory is owned by the farmers who provide the raw milk for the cheese. The firm pays the members a predetermined price for their milk on the occasion of each sale. (In keeping with conventional usage, the term "member" will be used here to refer to the patron-owners of cooperatives.) This price is usually set low enough so that the cooperative is almost certain to make a profit from its operations. Then, at the end of the year, profits that have been earned from the manufacture and sale of the cheese are distributed pro rata among the members according to the amount of milk they have sold to the cooperative during the year. Voting rights are held only by those who sell milk to the firm, either on the basis of one-member-one-vote or with votes apportioned according to the volume of milk each member sells to the firm. Some or all of the members may have capital invested in the firm. In principle, however, this is unnecessary: the firm could borrow all of the capital it needs. In any case, even where members invest in the firm, those investments typically take the form of preferred stock that carries no voting rights and is limited to a stated maximum rate of dividends. Upon liquidation of the firm, the net asset value—which may derive from retained earnings or from increases in the value of rights held by the firm—is divided pro rata among the members, usually according to some measure of the relative value of their cumulative patronage.

In short, ownership rights are held exclusively by virtue of the fact, and to the extent, that one sells milk to the firm. On the other hand, not all farmers who sell milk to the firm need be owners; the firm may purchase some portion of its milk from nonmembers, who are simply paid a fixed price and do not participate in net earnings or control. (Consumer cooperatives are set up similarly, with net earnings and votes apportioned according to the amounts that a member purchases from the firm.)

Now what of the standard business firm?

A business corporation is also organized in this fashion, except that it is owned not by persons who supply the firm with some commodity, such as milk, but rather by some or all of the persons who lend capital to the firm. To see the analogy clearly, it helps to characterize the transactions in a business corporation in somewhat stylized terms: The members each lend the firm a given sum. For this they are paid a fixed interest rate, set low enough so that the firm has a reasonable likelihood of running at a profit. Then at regular intervals, or upon liquidation, the firm's net earnings (after all contractual expenses, including wages and the cost of materials as well as the fixed interest rate on the capital borrowed from the members, have been paid) are distributed pro rata among the lender-members according to the amount they have lent. The firm may also have lenders who are not members. These lenders, commonly banks or bondholders, simply receive a fixed market interest rate and have no share in profits or participation in control.

As it is, in a business corporation the interest rate that is paid to lender- members (that is, shareholders) is generally set at zero for the sake of convenience. Moreover, the loans from members are not arranged annually or for other fixed periods, but rather are perpetual; the principal can generally be withdrawn only upon dissolution of the firm. In the typical cooperative, by contrast, members generally remain free to vary their volume of transactions with the firm over time, and even to terminate their patronage altogether. This distinction is not, however, fundamental. Investor-owned firms can be, and sometimes are, structured so that the amount of capital invested by each member can be redeemed at specified intervals or even (as in a simple partnership) at will. Conversely, cooperatives can be, and often are, structured so that members have a long-term commitment to remain patrons. Electricity generation and transmission cooperatives, for example, commonly insist that their members (which are local electricity distribution cooperatives) enter into requirements contracts that run for thirty-five years.

Indeed, we can view business corporation statutes as simply specialized versions of the more general cooperative corporation statutes. In principle, there is no need to have separate business corporation statutes at all; business corporations could just as well be organized under a well-drafted general cooperative corporation statute. Presumably we have separate statutes for business corporations simply because it is convenient to have a form that is specialized for the most common form of cooperative—the lenders' cooperative—and to signal more clearly to interested parties just what type of cooperative they are dealing with. (All quotes, Hansmann 1988: 270-2. Footnotes deleted.)

So the standard business firm can be seen as a form of cooperative, a capital cooperative. Not that it is often thought of in this way.

Worker (and other) cooperatives

As I have posted before on when worker cooperative may be a viable governance structure, and when they won't be, I thought I would take a look at just how large a force they are in the economy. Data is a bit hard to get but I did come across this from the US Federation of Worker Cooperatives

Though we lack comprehensive data on the nature and scope of worker cooperatives in the U.S., researchers and practitioners conservatively estimate that there are over 350 democratic workplaces in the United States, employing over 5,000 people and generating over $500 million in annual revenues.

Given the size of the US economy, 5000 people is not many.

However if you look at all cooperatives things look a bit different. The International Co-operative Alliance states that there are

30,000 co-operatives [which] provide more than 2 million jobs

Of course cooperatives being big employers is nothing new for New Zealand given the size of Fonterra (17,300 employees as at 2012). But to put this into perspective Wal-Mart alone employs around 2.2 million people world-wide.

Why not worker control?

This question is asked by everyones third favourite Marxist Chris Dillow at his Stumbling and Mumbling blog. Chris writes,

"Workplace autonomy plays an important causal role in determining well-being" conclude Alex Coad and Martin Binder in a new paper. This is consistent with research by Alois Stutzer which shows that procedural utility matters; people care not just about outcomes but about having in having control, which is why the self-employed tend to be happier than employees.

This implies that a government that is concerned to increase happiness - as David Cameron claims to be - should have as one of its aims a rise in worker control of the workplace.

The first question you may ask is, If workers control is so great why does it need government help? If it really can out perform other governance structures it should be able to dominate these other structures without any government help. In fact doing so would prove that it is a better form of governance. A second question to ask is Why, if worker cooperative are so great, are there so many conversions to investor ownership?

But let me give an answer to Chris based on my paper Simple Models of a Human-Capital-Based Firm: a Reference Point Approach which is forthcoming in the Journal of the Knowledge Economy. The abstract of the paper reads,

One important feature of the knowledge economy is the increased importance placed on human capital, especially when dealing with the firm. We apply the reference point approach to contracts to the modelling of a human-capital-based firm. First, a model of firm scope is offered which argues that the organisation of a human-capital-based firm depends on the “types” of human capital involved. Having a firm based on a homogeneous group of human capital leads to a different organisational form than that of a firm which involves a heterogeneous group of human capital. Second, a simple model of a human-capital-based firm is discussed. Three organisational forms are considered: an investor-owned firm, a labour-owned firm and a market transaction involving the use of an independent contractor. Results are given that show when each of these forms is optimal. The effects of a firm’s size and scope on organisation are considered as is the question of why are there conversions from worker to investor ownership.

My basic argument is that worker control can work when the labour force is homogeneous but is less likely to work when the labour force is more heterogeneous. Let me illustrate the idea with an example from the conclusion of the paper. One place you may expect to see labour ownership is in situations where the skills of the work force is the major, if not the only, source of value added. An example of this is pirates. I write,

The labour-owned firm is more likely to be formed when the human capital is relatively homogeneous in its characteristics and faces a common set of incentives. The pirate example at the beginning of the paper is an (unusual) example of this

In the introduction to the paper I say,

To illustrate how having a firm based on knowledge workers—human capital—rather than physical capital can change the structure of the firm, consider the example of pirates (a human-capital-based firm) versus privateers (a more physical-capital-based firm).

Lesson (2009) argued that given the economic environment and incentives faced by pirates a “worker cooperative” type organisational form was found to be viable for “pirate firms” (ships), but as he also notes one size does not fit all and thus worker-owned firms are unlikely to be an exploitable organisational form for all firms, in all situations. Leeson’s point about different economic contexts resulting in different organisational forms for firms can be illustrated by comparing the organisational form of the privateers with that of pirates and considering the role that non-human capital (or the lack of it) plays in determining that form.

An important difference between privateers and pirates is that although they both practised maritime plunder, privateers were state-sanctioned. That is governments would commission privateers to attack and seize enemy nations’ merchant shipping during times of war.The most obvious piece of non-human(physical in this case)capital for both pirates and privateers was their ship. The role of investors in providing this capital was important to the organisational form that the pirates and privateers developed. Pirates had no investors; they simply stole the capital they needed. Privateers, on the other hand, as legal enterprises could not just go out and steal the capital they required; they needed external financiers to supply their capital requirements. This difference in capital supply resulted in very different organisational forms, the privateers having a more autocratic management system than pirates. Pirate crews were equal contributors and part owners of the firm they worked for. Having no need for investors, pirates did not need to develop mechanisms to protect the interests of the firm’s financiers as the privateers needed to do. This meant that incentive problems could be dealt with by developing a worker-owned firm with the crew (usually) sharing equally in “profit” and electing their leaders and having power dispersed among multiple members of the crew such as the captain and the quartermaster. In contrast, the privateer had investors and a management system designed to protect their investments. The investors appointed privateer captains and developed an organisational scheme that in some important respects mirrored the managerial organisation of (also investor backed) merchant ships.

Chris's point seems to be that we would be happier and more productive if we were pirates.

Well may be not I argue. In the conclusion I go on to say,

Another (more usual) example of a human-capital based “firm”, but one where labour-owned firms are seldom, if ever, found, is that of the professional sports team. The models developed above can explain this. Here we have a situation where human capital,talent at playing a particular sport, is the basis for the “firm” but ownership by the human capital, the players, is extremely rare since a worker-owned team would be at a disadvantage relative to a player-as-employee-based team.

Heterogeneity in playing talent—playing talent being the human capital here—and thus in earning potential is a disincentive to the formation of a worker cooperative, an organisation which normally involves (rough) equality in payment, 25 since those players with the greatest earning potential, the largest outside options, will transfer away from the cooperative to maximise their income stream. Thus,a worker-owned team would have few, if any, star players, a handicap in the winner-takes-all world of professional sports.

Another issue for a cooperative sports team is that while the star players may leave the team too soon, the “average players” may stay too long. The average players will have smaller outside options and thus less incentive to leave but as they are also owners of the team it would be more difficult to get rid of those who are not performing. It would be easier for an employee-based team to remove under performing players as they are not owners of the firm.

Also, to the degree that exit barriers are entry barriers, a worker-owned organisation is at a disadvantage. Such an organisation could hinder rapid transfers between clubs. Problems with transfers could arise, for example, if the conditions under which a player can exit the team have to be negotiated with the remaining player-owners at the time of exit. Or the remaining owners may be unable or unwilling to buy out the exiting player—under a “right of first refusal” or “right of first offer” scheme—or any of them could veto an incoming replacement player-owner. Also, there is the question of the value of a player’s interest in the team as well as the question of the time period over which an agreed upon value would be paid. These costs make exit more difficult than it would be under an employment contract and thus tend to lock-in the player-owner to the team. Such lock-in is a disincentive to forming, or joining, a labour-owned firm, especially for the best players. Many of these problems can, to a degree, be contracted around but this imposes additional negotiation costs at the time of entry into the team, which again is a disincentive to forming a worker-owned team. Utilising a worker-owned organisation would result in additional haggling costs, either ex ante or ex post, relative to a player-as-employee team.

Put simply, an employee can leave an organisation more quickly and easily than an owner and in the case of professional sports, transfers between teams, or at least a credible threat to transfer, are particularly valuable to the best players. Therefore, a player-owned team would be at a competitive disadvantage compared to teams comprised of employee players.

In the model in the section “a simple model of a human-capital based firm”, an independent contractor contract implies giving control over production decisions (choice of the widget in the model) to the consultant which in the sports team example would mean giving control to the players. This would create at least some of the same problems as player ownership. If the consultant’s (player’s) contract restricted the amount of control that players have, then it’s not clear what the effective difference between the independent contractor contract and an employee contract would be.

An alternative interpretation of the results in the paper is to say that they show that organisational form depends, in part, on the relative mix of the inputs used in production. For a largely human-capital-based firm, some form of labour-ownership may be feasible while for a firm with a greater (relative) use of non-human capital, a capital owned organisation is more likely. If you increase the relative importance of the non-human capital compared to the human capital, i.e. increase the amount of non-human capital the knowledge worker needs to be productive, you increase the ability of the non-human capital owner to "shade" and thus his ability to impose welfare losses. What we see is that when the firm is homogeneous in its inputs, in the sense that they consist largely of the efforts of the knowledge worker some form of worker-owned organisation is feasible. But as the relative importance of the non-human capital increases the firms begins to look more “traditional” in its input mix and thus begins to look more traditional in its organisational form in that a capital-owned firm becomes increasingly likely. If you are a computer scientist using a PC to design small business accounting software, then your firm being a partnership is feasible whereas if you are writing software for a super-computer you are more likely to be an employee of whoever owns/rents the computer.

So the argument which is based around the "reference point" approach to the theory of the firm suggests that when a firm's human capital is homogeneous, and thus there is little reason for "shading", worker ownership may work but when the human capital becomes heterogeneous or non-human capital starts to play a big role in the production of the firm, investor ownership becomes more likely.

I would suggest that the general thrust of my argument is similar to that of Henry Hansmann's discussion of worker cooperatives and why we see so few of them. Hansmann, for example writes,

[t]he most striking evidence of the high costs of collective decision making [for employee-owned firms] is the scarcity of employee-owned firms in which there are substantial differences among employees who participate in ownership. Most typically, employee-owned firms all do extremely similar work and are of essentially equivalent status within the firm. Rarely do they have substantially different types or levels of skills, and rarely is there much hierarchical authority among them.

and

[t]he preceding evidence implies that employee ownership works best where the employee-owners are so homogeneous that any decision made by the firm will affect them roughly equally, or where, though the employees differ in ways that cause the burdens and benefits of some decisions to be shared unequally, there is an objective and widely accepted basis for making those decisions. That is, employee ownership is most viable where either no important conflicts of interest exist among the employee-owners, or some simple and uncontroversial means is available to resolve the conflicts that are present