16 June 2011

The Market Distortion of Corporations

I’ve been meaning to write this post for nearly a month, but I didn’t feel like getting around to it until I saw this post by OneSTDV:
In general, the mainstream Right views corporations as unassailable edifices of the free market. They triumphantly brag about shopping at big chain stores and express indifference towards corporate influence. Yet, the reactionary Right doesn't quite share this position or at least shares a tempered optimism towards the benefits of corporate dominance. In my opinion, the mainstream's defiance regarding criticism of big corporations is part of their frustrating adherence to the proposition nation. Instead of espousing a straightforward nationalistic and traditionalist conception of America, mainstream conservatives use proxy indicators, such as guns, religion, libertarianism, and corporatism, to illustrate their right-wing bona fides.
I used to defend corporations as the cornerstone of the free market until I was introduced to the reality of corporations by the Austrian school of economics.  Wikipedia provides an excellent summary of why corporations are ill-equipped to serve as the bastions of the free market:
A corporation is a legal entity that is created under the laws of a state designed to establish the entity as a separate legal entity having its own privileges and liabilities distinct from those of its members.  There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter (i.e. by an ad hoc act passed by a parliament or legislature). Most jurisdictions now allow the creation of new corporations through registration.
An important (but not universal) contemporary feature of a corporation is limited liability. If a corporation fails, shareholders normally only stand to lose their investment and employees will lose their jobs, but neither will be further liable for debts that remain owing to the corporation's creditors.
The important thing to take away from this is that corporations are government-defined entities.  The only reason corporations exist is because businessmen decided to cozy up to the government, which is not exactly the free market in action.  As such, corporations serve as a market distortion in a variety of ways.

In the first place, the existence of the corporation shifts moral hazard from business owners to consumers, which effectively means that consumers bear the market risk that rightly belongs to corporations.  This can be seen in the area of business contracts, most notably sales contracts.  Without going into highly technical details, English common law dictated that consumers have the right to expect explicit and implicit guarantees of performance and safety for whatever product they bought.  If a consumer buys a product that doesn’t perform, or a product that causes injury during intended use, the producer would be liable to the consumer for failure to perform or for incurring damage.  If a producer made an incredibly shoddy product, he could go completely bankrupt.

The possibility of personal bankruptcy helped to ensure that producers manufactured products that met a basic level of quality.  The formation of the corporation limited this incentive in that business owners no longer bore unlimited liability for their products.  This shift, then, meant that business owners could make products that were “riskier,” in the sense that they could manufacture products that were more dangerous or liable to underperform without having to face the risk of personal bankruptcy.  As such, the invention of the corporation has had the effect of shifting moral hazard from businesses to consumers, which is effectively a type of subsidy and a virtual tax.

A second effect of the abstract legal entity of the corporation is that it created a paradigm wherein people began to think that corporations pay taxes.  In fact, there has never been a point in history where abstract legal entities have paid taxes.  Only people can pay taxes, but there are some who think that corporations can pay taxes simply because those in the legal system have at one point argued that a corporation is a type of person.  This has led to incredibly muddled tax policy, which has been discussed in detail prior on this blog.

In the third place, corporations require increasing government intervention into the market.  This is due to the inherent subsidy of corporate status.  All subsidies impose some sort of negative externality, which leads to negative market distortions.  In this case, the status of corporation does not discourage risky production as much as it should, which leads to corporations making either shoddier or more dangerous products. 

Consumers demand, quite legitimately, that the government fix this problem.  Since governments are generally allergic to owning their mistakes, and are generally desirous of increasing their power, they seize this opportunity to regulate businesses in order to ensure that they meet production quality and safety standards.

Incidentally, the worker side of the equation deserves discussion as well.  Not only does corporate status limit a producer’s liability to consumers, it also limits its liability to workers as well.  Corporations can, to a limited extent, ignore the safety of their workers because they do not bear personal liability for whatever harm befalls them in the course of normal work. The poor working conditions of the industrial revolution can therefore, to a very limited extent, be blamed on the corporate status of businesses.

Anyway, the history of the corporate entity has shown that the original distortion has led to many, many more distortions, always in the name of correcting some “market” flaw.

Finally, note that corporations have had the effect of transferring power and wealth to those who are already wealthy.  There is no debating the fact that many corporations suckle at the government’s teat.  This should not be surprising, given that the only reason corporations exist is because businessmen went to the government to ask for special market privileges.  As such, those who own corporations have been seeking, since day one, to use the government to make them wealthier, and to help them beat the market.

At this point, then, it should be obvious that corporations are not, and indeed have never been, the free market’s friend.  In fact, corporations are as free market as the government that grants and defines their continued existence.  Corporations are an inherent market distortion, and should be recognized as such.

6 comments:

  1. The trouble with this argument is that, without liability limitation, it will be virtually impossible to secure investment for a new business venture.

    Let's say you hear about a company that's just invented a universal panimmunity treatment...anybody who takes their shot once a year will be guaranteed to never get sick from anything. And this business needs money to build some infrastructure. You know...make the drug, ship it to doctors, that sort of thing. So they seek out investors. And, seeing as how you know how much people hate to get sick, you decide that this kind of thing represents a lot of potential profits, and is a good place to park some of your spare cash.

    But there's a problem, see. One of the shipping clerks has a pin-up calendar hung in the loading dock. And since it's raining outside, a few of the women up in the marketing department decide to hang out in the loading bay instead of in front of the building, when they go out on a cigarette break. And one of them gets offended. And screams "sexual harassment!". And hires a lawyer.

    A year or so later, after all the massive media outrage and the lawsuits and counter-suits, you're sitting back, wondering wistfully what it would be like to live in a world where people didn't have to get sick, and people-not-getting-sick also made you personally richer.

    Here we have two choices. _With_ limited corporate liability, your wistful notions and sorrow at the loss of your investment are the end of the story. _Without_ limited corporate liability, you also have to cope with the fact that the aggrieved Marketing harridan's lawyer is now showing up at your door with an eviction notice.

    She owns your house now, you see, because even as a _passive investor_ in the business, you are _personally liable_ for anything that _any employee_ of the business does during the course of their employment.

    The guy who hung the calendar will probably be standing behind you in line at the homeless shelter, of course. But the guy who hired someone with such a poor sense of business etiquette? The guy who neglected to tell the women of the marketing department not to smoke their cigarettes in the loading dock? The guy who hired a woman so high-strung that she'd sue everybody she could into destitution over a pin-up calendar? Unless they also bought stock in the business, they're just fine. Unemployed, of course, but free to keep all their accumulated property.

    Is that the legal regime you want to live under?

    Limited corporate liability is a protection for investors against the ravages of rapacious lawyers. Disincentivizing defective products is what competitors are for.

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  2. @Matt- you said “without liability limitation, it will be virtually impossible to secure investment for a new business venture.” How did people in time immemorial ever manage to conduct business without chartering a corporation?

    As to your hypothetical company, please note that one can invest in a business without owning it (they’re called bonds).

    And the example of a sexual harassment lawsuit where a female worker confiscates one’s house because some dockworker posted a pin-up calendar is simply specious. Yes, it is true that you can, as a part-owner of a company, be held personally liable for that. However, if traditional common law were applied to this scenario in lieu of the laws governing corporate status, your liability for the pin-up calendar would be quite limited, especially if you had no direct knowledge of it, and even more so if the pin-up calendar was posted in violation of company policy.

    Furthermore, your scenario is irrelevant to the discussion at hand. I am not advocating a repeal of corporate status. I am simply noting that corporate status is simply a form of government interference that produces a market distortion. Defending corporations, or, more accurately, the corporate status, is not a way to show one’s free market bona fides.

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  3. A second effect of the abstract legal entity of the corporation is that it created a paradigm wherein people began to think that corporations pay taxes.... This has led to incredibly muddled tax policy, which has been discussed in detail prior on this blog.

    Point me there, I'm curious. I always thought double taxation of corporate income was an approximately fair way of getting a little back from the corporations in return for the advantages the veil gives them. I don't know much about this.

    As to Austrians on corporations, point me there too. Are we talking about Röpke or Hayek or someone? I know those guys by name but I know little of substance.

    How does the Austrian School (not just economists from Austria, I guess) feel about the way Austria itself has its economy organized, with the government-business chamber, the government-labor chamber, etc.? It all struck me as very anti-competitive once, but I don't rush to judgement so much any more.

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  4. @Olave- The problem with the double taxation argument is that corporations are fictional entities incapable of doing anything. It is people that do things, and, in this case, it is people that pay taxes. The costs of taxes can be shifted to shareholders (in that it cuts into their profits), consumers (in that the prices of goods are higher), employees (in that their wages are lower), or some combination of the three. It's impossible to tell for certain who pays how much, but at the end of the day, some person(s) is paying the taxes. The idea that an abstract legal entity somehow pays taxes is absurd on its face.

    As to Austrians on corporations, I'm referring to a Mises daily I read several months ago. I don't remember the title or even the author, and I'm too lazy to look for it, but the argument was essentially that corporations are legal constructs created by the government, and it traced the history and origins of the corporate status. My conclusions are drawn from this observation, and may not necessarily reflect the views of the Austrian school per se. I apologize for not having been more clear in my qualifications of the Austrian stance in the post.

    I have no idea how the Austrian school feels about the way Austria has its economy organized. I'm not particularly interested in economic analysis of specific European countries, so I can't say that I'm all that concerned about it.

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  5. The costs of taxes can be shifted to shareholders (in that it cuts into their profits), consumers (in that the prices of goods are higher), employees (in that their wages are lower), or some combination of the three. It's impossible to tell for certain who pays how much, but at the end of the day, some person(s) is paying the taxes.

    True. It is my assumption that it is the double-taxers' assumption that the cost is born largely by the shareholders, and that's only good and right because they don't run the corporation, they just own it. Sort of like absentee landlords or something. People don't really think things like that through.

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  6. People don't really think things like that through.

    People don't really think many things through at all. That's why corporate taxes is a sticky issue for many. They simply don't realize that taxes come out of some person's wallet. As such, there are plenty of people who advocate policies that do not accomplish what people intend for them to accomplish.

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