Peter Radford on corporations

Most theories of the firm within economics pick up the narrative with the existence of the corporation as a given. They then bend over backwards to retro-fit this highly centralized pseudo economy into the larger free market narrative preferred in all major textbooks. In so doing they blithely ignore Alfred Chandler’s famous explanation for the rise of modern business organization, which he argued became possible “only when the hand of management proved be more efficient than the invisible hand of market forces”.

Chandler, being a historian rather than an economist, was more interested in reality than in hypotheticals. He understood and tried to explain the actual landscape of large-scale business. I have always wondered what would have happened to economics had it absorbed the true gist of the challenge issued by Coase in 1937. The impudence of that challenge has never been fully understood. Coase asked simply: “why do firms exist?”. After all if market forces are as supreme as the textbooks tell us, there is no room for business organization at all. We ought be able to accomplish all our transacting through a web of contracts in the open marketplace.

Indeed the most common response of economists to the challenge represented by business organization is to argue that a business organization is simply such a web of contracts. In this view we can continue to ignore any oddities of business organization since it is indistinguishable from the market. In this view the firm exists at a “nexus of contracts” and has no special attributes that cannot be negotiated and contracted for in the marketplace.

Except this is not true....

The key to understanding corporations is to separate the economics from everything else. We need to do this because the economics, as expressed in various theories of the firm, are usually entirely idealized and bear no resemblance to reality. Economists, as usual, love to theorize about things that don’t exist but which they wished did exist....

Corporations, far from being products of the free market, are actually franchises of the state. They are sub-contracted jurisdictions.

To be a corporation is to possess a charter from the state. That charter brings privileges not available to non-corporations. The most notable privilege is that the corporation is recognized as a distinct legal entity separate from any “natural” person who may be associated with it. And because the corporation is brought into existence prior to it being populated or animated by any natural person, it is not owned by any of them. It is unowned. In this sense it is akin to a nation state, the church, most universities, and, at least here in the US, most towns, It would be odd to describe any of those bodies as being owned by the people who animate them. Yet we routinely talk of firms being owned by stockholders. It is this misattribution of ownership that leads most economists astray in their theorizing...

Peter Radford explain why this is important and what problems misunderstanding engenders.

The Radford Free Press
Who “Owns” a Corporation?
Corporations Cont’dPeter Radford

Cecchetti & Schoenholtz — Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

Money and Banking

Moral Hazard: A Primer
Stephen G. Cecchetti, Professor of International Economics at the Brandeis International Business School, and Kermit L. Schoenholtz, Professor of Management Practice in the Department of Economics of New York University’s Leonard N. Stern School of Business

Cecchetti & Schoenholtz are the authors of Money, Banking and Financial Markets.

Noah Smith — An Econ Test Question We Shouldn't Get Wrong

Transaction costs. 

This is a big one to miss. Econometric models generally ignore it for tractability even though Ronald Coase receive the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for pointing it out in his work on the firm.

Bloomberg View
An Econ Test Question We Shouldn't Get Wrong
Noah Smith | Bloomberg View columnist

Rumplestatskin — Everything I was Afraid to Ask about Bitcoin but Did

Bitcoin, transaction cost, reversibility, trust.

Naked Capitalism
Everything I was Afraid to Ask about Bitcoin but Did
Rumplestatskin, a professional economist with a background in property development, environmental economics research and economic regulation.

John Carney — Ronald Coase and the nature of shadow banking

John Carney interprets Ronald Coase's insights about transaction cost with respect to finance rather than industry and commerce.

CNBC NetNet
Ronald Coase and the nature of shadow banking

John Carney | Senior Editor

Peter Radford — Some thoughts on economics

My instinctive entry point into economics is through business....
Economics as it exists today in its mainstream form is of no use whatever to anyone seeking to understand the reality of business. Our extant theories of the firm are failures in that they attempt to see the world through a neoclassical lens whilst that lens obscures anything remotely real from view in an effort to retain the equilibrating perfection of the closed system envisaged by Walras. The contradiction between the pursuit of equilibrium explanations and the open ended nature of the real world defeats neoclassicism at the starting gate and dooms it to subsequent nonsensical irrelevance....

In this context I have to attribute a great honor to the Arrow-Debreu effort to complete the Walrasian episode. Arrow-Debreu deserves our constant indebtedness. It shows, definitively, how the Walrasian tradition cannot be an explanation for a real economy. It achieves completion by imposing such horrendously, and obviously, unreal constraints on itself that it proves Walras wrong. It is thus great science. It is the falsification of a tradition shown to be worthless.

On another matter: mainstream economists have never adequately, in my opinion, responded to Coase’s challenge of 1937. He asked simply: if markets do what classical economists and their followers say they do, why do firms exist? They ought not. That they do suggests something is very wrong at the heart of orthodox thinking. So I add the ‘Coase conundrum’ to Arrow-Debreu as adding weight to the critique. Mainstream economics is alchemy....

Asymmetrical information is another challenge to orthodoxy that is too often ignored. Information about things is patchy in the real world. Very patchy. It is non-existent with regard to the medium and long term future. Yet this never deters the neoclassical theorists. They march along as if asymmetry was an inconvenience that can be assumed away for simplicity’s sake, rather than a dagger in the heart of their work....

Uncertainty and complexity characterize the real world. Certainty and simplicity characterize neoclassical economics. Hence it irrelevance. It is complicated though, as Arrow-Debreu shows. It has to be. Its epicycles weigh it down. But no amount of clever formalism can turn unreality into reality, just as lead is pretty tough to turn into gold. This doesn’t mean that neoclassical economist aren’t very bright. They are. They have to be to to tend to those epicycles. Newton, after all, spent more time on alchemy than on recognizable physics. No indeed, they are very bright. Just wrong. 

Real-World Economics Review Blog

Some thoughts on economics
Peter Radford

This is a seminal article. Not much that we haven't said hundreds of time on this blog and in the comments, but Peter Radford ties it together very nicely — concise, precise and clear.

Note also that what is said about economics, order and entropy wrt to management also applies wrt to governing, and as Norbert Weinberg observes in naming cybernetics. It's also the basis of general system theory developed by economist Kenneth Boulding and others from related fields who understood the fundamental role of information in imposing order and overcoming entropy. See A Curriculum for Cybernetics and Systems Theory by Alan B. Scrivener for a summary of the basics.

Why don't conventional economists read this stuff, or if they do, why don't they use it?

Where I would quibble with Radford is over his assertion,

"The substitution of labor for capital or vice versa tells us that neither if fundamental. The energy and skill are. Energy and knowledge deployed to order resources for subsequent disordering. That’s the economic process." 

Is he forgetting that capital goods are also produced by labor? Labor is basic until capital goods can produce capital goods and innovate while doing so. That level of AI is still  in the dream stage of development, and even then it seems that knowledge workers will still be required in the Age of Artificial Intelligence.