Basic Economics

  Like limited liability, the separation of ownership and management is a key characteristic of corporations. It is also a key target of critics of corporations. Many have argued that a “separation of ownership and control” permits corporate managements to run these enterprises in their own interests, at the expense of the interests of the stockholders. Certainly the massive and highly publicized corporate scandals of the early twenty-first century confirm the potential for fraud and abuse. However, since fraud and abuse have also occurred in non-corporate enterprises, including both democratic and totalitarian governments, as well as in the United Nations and in non-profit charities, it is not clear whether the limited liability corporation is any more prone to such things than other kinds of organizations, or any less subject to the detection and punishment of those who commit crimes.

  Complaints about the separation of ownership and control often overlook the fact that owners of a corporation’s stock do not necessarily want the time-consuming responsibilities that go with control. Many people want the rewards of investing without the headaches of managing. This is especially obvious in the case of large stockholders, whose investments would be sufficient for them to start their own businesses, if they wanted management responsibilities. The corporate form enables those who simply want to invest their money, without taking on the burdens of running a business, to have institutions which permit them to do that, leaving the task of monitoring the honesty of existing management to regulatory and law enforcement institutions, and the monitoring of management efficiency to the competition of the marketplace.

  Outside investment specialists are always on the lookout for companies whose management efficiency they expect to be able to improve by buying enough stock to take over these corporations and run them differently. This threat has been sufficiently felt by many managements to get them to lobby state governments to pass laws impeding this process. But these outside investors have both the incentives and the expertise available to evaluate a corporation’s efficiency better than most of the rank-and-file stockholders can.

  Complaints that corporations are “undemocratic” miss the point that stockholders may not want them to be democratic and neither may consumers, despite the efforts of people who call themselves “consumer advocates” to promote laws that would force corporations to cede management controls to either stockholders or to outsiders who proclaim themselves representatives of the public interest. The very reason for the existence of any business enterprise is that those who run such enterprises know how to perform the functions necessary to the organization’s survival and well-being better than outsiders with no financial stake—and with no expertise being required for calling themselves “consumer advocates” or “public interest” organizations. Significantly, attempts by various activists to create greater stockholder input into such things as the compensation of chief executive officers have been opposed by mutual funds holding corporate stock.{234} These mutual funds do not want their huge investments in corporations jeopardized by people whose track record, skills and agendas are unlikely to serve the purposes of corporations.

  The economic fate of a corporation, like that of other business enterprises, is ultimately controlled by innumerable individual consumers. But most consumers may be no more interested in taking on management responsibility than stockholders are. Nor is it enough that those consumers who don’t want to be bothered don’t have to be. The very existence of enhanced powers for non-management individuals to have a say in the running of a corporation would force other consumers and stockholders to either take time to represent their own views and interests in this process or risk having people with other agendas over-ride their interests and interfere with the management of the enterprise, without these outsiders having to pay any price for being wrong.

  Different countries have different laws regarding the legal rights of corporate stockholders—and very different results. According to a professor of law who has specialized in the study of business organizations, writing in the Wall Street Journal:

  American corporate law severely limits shareholders’ rights. So does Japanese, German and French corporate law. In contrast, the United Kingdom seems a paradise for shareholders. In the U.K., shareholders can call a meeting to remove the board of directors at any time. They can pass resolutions telling boards to take certain actions, they are entitled to vote on dividends and CEO pay, and they can force a board to accept a hostile takeover bid the board would prefer to reject.{235}

  How does the economic performance of British corporations compare with that of corporations in other countries? According to the British magazine The Economist, 13 of the world’s 30 largest corporations are American, 6 are Japanese, and 3 each are German and French. Only one is British and another is half owned by Britons. Even a small country like the Netherlands has a larger share of the world’s largest corporations.{236} Whatever the psychic benefits of stockholder participation in corporate decisions in Britain, its track record of business benefits is unimpressive.

  Questions about the role of corporations, as such, are very different from questions about what particular corporations do in particular circumstances. The people who manage corporations run the gamut, from the wisest to the most foolish and from the most honest to the most dishonest, as do people in other institutions and activities—including people who choose to call themselves “consumer advocates” or members of “public interest” organizations or advocates of “shareholder democracy.”

  Executive Compensation

  The average compensation package of chief executive officers of corporations large enough to be listed in the Standard & Poor’s Index was $10 million a year in 2010.{237} While that is much more than most people make, it is also much less than is made by any number of professional athletes and entertainers, not to mention financiers.

  Some critics have claimed that corporate executives, and especially chief executive officers (CEOs), have been overly generously rewarded by boards of directors carelessly spending the stockholders’ money. However, this belief can be tested by comparing the pay of CEOs of public corporations, owned by many stockholders, with the pay of CEOs of corporations owned by a small number of large financial institutions. In the latter case, financiers with their own money at stake set the salaries of CEOs—and it is precisely these kinds of corporations which set the highest salaries for CEOs.{238} Since it is their own money, financiers have no incentive to over-pay, but neither do they have any reason to be penny-wise and pound-foolish when hiring someone to manage a corporation in which they have billions of dollars at stake. Nor do they need to fear the adverse reactions of numerous stockholders who may be susceptible to complaints in the media that corporate executives are paid too much.

  What has provoked special outcries are the severance packages in the millions of dollars for executives who are let go because of their own failures. However, no one finds it strange that some divorces cost much more than the original wedding cost or that one spouse or the other can end up being rewarded for being impossible to live with. In the corporate world, it is especially important to end a relationship quickly, even at a cost of millions of dollars for a “golden parachute,” because keeping a failing CEO on can cost a company billions through the bad decisions that the CEO can continue to make. Delays over the firing of a CEO, whether these are delays within the company or within the courts, can easily cost far more than the golden parachute.

  MONOPOLIES AND CARTELS

  Although much of the discussion in previous chapters has been about the way free competitive markets function, competitive free markets are not the only kinds of markets, nor are government-imposed price controls or central planning the only interferences with the operations of such markets. Monopolies, oligopolies, and cartels also produce economic results very different from those of a free market.

  A monopoly means literally one seller. However, a small number of sellers—an “oligopoly,” as economists call it—may cooperate
with one another, either explicitly or tacitly, in setting prices and so produce results similar to those of a monopoly. Where there is a formal organization in an industry to set prices and output—a cartel—its results can also be somewhat like those of a monopoly, even though there may be numerous sellers in the cartel. Although these various kinds of non-competitive industries differ among themselves, their generally detrimental effects have led to laws and government policies designed to prevent or counter these negative effects. Sometimes this government intervention takes the form of direct regulation of the prices and policies of non-competing firms in industries where there is little or no competition. In other cases, government prohibits particular practices without attempting to micro-manage the companies involved. The first and most fundamental question, however, is: How are monopolistic firms detrimental to the economy?

  Sometimes one company produces the total output of a given good or service in a region or a country. For many years, each local telephone company in the United States was a monopoly in its region of the country and that remains true in some other countries. For about half a century before World War II, the Aluminum Company of America (Alcoa) produced all the virgin ingot aluminum in the United States. Such situations are unusual, but they are important enough to deserve some serious attention.

  Most big businesses are not monopolies and not all monopolies are big business. In the days before the automobile and the railroad, a general store in an isolated rural community could easily be the only store for miles around, and was as much of a monopoly as any corporation on the Fortune 500 list, even though the general store was usually an enterprise of very modest size. Conversely, today even multi-billion-dollar nationwide grocery chains like Safeway or Kroger have too many competitors to be able to set prices on the goods they sell the way a monopolist would set prices on those goods.

  Monopoly Prices vs. Competitive Prices

  Just as we can understand the function of prices better after we have seen what happens when prices are not allowed to function freely, so we can understand the role of competition in the economy better after we contrast what happens in competitive markets with what happens in markets that are not competitive.

  Take something as simple as apple juice. How do consumers know that the price they are being charged for apple juice is not far above the cost of producing it and distributing it, including a return on investment sufficient to keep those investments being made? After all, most people do not grow apples, much less process them into juice and then bottle the juice, transport and store it, so they have no idea how much any or all of this costs. Competition in the marketplace makes it unnecessary to know. Those few people who do know such things, and who are in the business of making investments, have every incentive to invest wherever there are higher rates of return and to reduce their investments where the rates of return are lower or negative. If the price of apple juice is higher than necessary to compensate for the costs incurred in producing it, then higher rates of profit will be made—and will attract ever more investment into this industry until the competition of additional producers drives prices down to a level that just compensates the costs with the same average rate of return on similar investments available elsewhere in the economy.

  Only then will the in-flow of investments from other sectors of the economy stop, with the incentives for these in-flows now being gone. If, however, there were a monopoly in producing apple juice, the situation would be very different. Chances are that monopoly prices would remain at levels higher than necessary to compensate for the costs and efforts that go into producing apple juice, including paying a rate of return on capital sufficient to attract the capital required. The monopolist would earn a rate of return higher than necessary to attract the capital required. But with no competing company to produce competing output to drive down prices, the monopolist could continue to make profits above and beyond what is necessary to attract investment.

  Many people object to the fact that a monopolist can charge higher prices than a competitive business could. But the ability to transfer money from other members of the society to itself is not the sole harm done by a monopoly. From the standpoint of the economy as a whole, these internal transfers do not change the total wealth of the society, even though such transfers redistribute wealth in a manner that may be considered objectionable. What adversely affects the total wealth in the economy as a whole is the effect of a monopoly on the allocation of scarce resources which have alternative uses.

  When a monopoly charges a higher price than it could charge if it had competition, consumers tend to buy less of the product than they would at a lower competitive price. In short, a monopolist produces less output than a competitive industry would produce with the same available resources, technology and cost conditions. The monopolist stops short at a point where consumers are still willing to pay enough to cover the cost of production (including a normal rate of profit) of more output.

  In terms of the allocation of resources which have alternative uses, the net result is that some resources which could have been used to produce more apple juice instead go into producing other things elsewhere in the economy, even if those other things are not as valuable as the apple juice that could and would have been produced in a free competitive market. In short, the economy’s resources are used inefficiently when there is monopoly, because these resources would be transferred from more valued uses to less valued uses.

  Fortunately, monopolies are very hard to maintain without laws to protect the monopolistic firms from competition. The ceaseless search of investors for the highest rates of return virtually ensures that such investments will flood into whatever segment of the economy is earning higher profits, until the rate of profit in that segment is driven down by the increased competition caused by that flood of investment. It is like water seeking its own level. But, just as dams can prevent water from finding its own level, so government intervention can prevent a monopoly’s profit rate from being reduced by competition.

  In centuries past, government permission was required to open businesses in many parts of the economy, especially in Europe and Asia, and monopoly rights were granted to various business owners, who either paid the government directly for these rights or bribed officials who had the power to grant such rights, or both. However, by the end of the eighteenth century, the development of economics had reached the point where increasingly large numbers of people understood how this was detrimental to society as a whole and counter-pressures developed toward freeing the economy from monopolies and government control. Monopolies have therefore become much rarer, at least at the national level, though restrictions on competition remain common in many cities where restrictive licensing laws limit how many taxis are allowed to operate, causing fares to be artificially higher than necessary and cabs less available than they would be in a free market.

  Again, the loss is not simply that of the individual consumers. The economy as a whole loses when people who are perfectly willing to drive taxis at fares that consumers are willing to pay are nevertheless prevented from doing so by artificial restrictions on the number of taxi licenses issued, and thus either do some other work of lesser value or remain unemployed. If the alternative work were of greater value, and were compensated accordingly, then such people would never have been potential taxi drivers in the first place.

  From the standpoint of the economy as a whole, monopolistic pricing means that consumers of a monopolist’s product are foregoing the use of scarce resources which would have a higher value to them than in alternative uses. That is the inefficiency which causes the economy as a whole to have less wealth under monopoly than it would have under free competition. It is sometimes said that a monopolist “restricts output,” but this is not the intent, nor is the monopolist the one who restricts output. The monopolist would love to have the consumers buy more at its inflated price, but the consumers stop short of the amount that they would buy at a lower price under free competit
ion. It is the monopolist’s higher price which causes the consumers to restrict their own purchases and therefore causes the monopolist to restrict production to what can be sold. But the monopolist may be advertising heavily to try to persuade consumers to buy more.

  Similar principles apply to a cartel—that is, a group of businesses which agree among themselves to charge higher prices or otherwise avoid competing with one another. In theory, a cartel could operate collectively the same as a monopoly. In practice, however, individual members of cartels tend to cheat on one another secretly—lowering the cartel price to some customers, in order to take business away from other members of the cartel. When this practice becomes widespread, the cartel becomes irrelevant, whether or not it formally ceases to exist.

  When railroads were formed in the nineteenth century, they often had competing lines between major cities, such as Chicago and New York. These were called “trunk lines,” as distinguished from “branch lines” leading from the trunk lines to smaller communities that might be served by only one railroad each. This led to monopoly prices on the branch lines and prices so competitive on the trunk lines that the cost of shipping freight a long distance on a trunk line was often cheaper than shipping it a shorter distance on a branch line. More important, from the railroads’ point of view, the trunk line prices were so low as to jeopardize profits. In order to deal with this problem, the railroads got together to form a cartel:

  These cartels kept breaking down. . . The cost of sending a train from here to there is largely independent of how much freight it carries. Therefore, above a break-even point, each additional ton of freight yields nearly pure profit. Sooner or later, the temptation to offer secret rebates to shippers in order to capture this profitable-at-any-price traffic would become irresistible. Once the secret rebates started, price wars soon followed and the cartel would collapse.{239}