The Property Rights Theory of the Firm
Property rights theory emphasizes the role of property rights in providing appropriate incentives to independent agents. Alchian and Demsetz (1972) followed this reasoning to propose a theory of the firm based on the efficient allocation of property rights. They view the firm as a central contracting party that governs team production. The problem with team production is one of asymmetric information. The effort put forth by each individual is private information, but it would be essential to make an efficient (and fair) distribution of the collective output. With no information about each team member level of effort, the typical solution would be to split the output in equal shares. But this solution leads to suboptimal incentives. Some members of the team, knowing they will get an equal share on the output, will prefer to take it easy. Shirking contributes to obtain suboptimal production levels due to this free rider problem. Every member of the team prefers team effort to be high but individual effort to be low.
To avoid this problem some type of monitoring has to be implemented. Mutual monitoring is a possibility for small teams. However, when the size of the team is large there is also an incentive to free ride on monitoring and, therefore, mutual monitoring becomes ineffective. The traditional capitalist firm solves this problem by specializing monitoring and providing appropriate incentives to monitor team production. The entrepreneur is viewed as a central controlling authority which monitors the individual contribution of each member and can take corrective actions (as firing inefficient members). Here comes the classic question: who watches the watchmen? To ensure appropriate incentives, this specialized controller will receive the residual benefits of the firm. These benefits are twofold and correspond to the allocation of property rights on profits and firm assets to the entrepreneur:
- Profit: team members are granted fixed payments and the difference between the team's output and these payments is a residual that is awarded to the specialized controller, i.e. the entrepreneur.
- Firm value: any increase in the value of the firm (goodwill) will be also awarded to the controller.
Thus, the theory provides an explanation for the efficiency of the traditional capitalist firm. However, it finds difficulties in explaining monitoring and incentive schemes in modern large corporations. In these firms, monitoring is exerted by hired managers who are not the owners of the firm or the entrepreneur. In any case, the theory still explains why the person in charge of a team should participate more on the output of the team than the team members.
To avoid this problem some type of monitoring has to be implemented. Mutual monitoring is a possibility for small teams. However, when the size of the team is large there is also an incentive to free ride on monitoring and, therefore, mutual monitoring becomes ineffective. The traditional capitalist firm solves this problem by specializing monitoring and providing appropriate incentives to monitor team production. The entrepreneur is viewed as a central controlling authority which monitors the individual contribution of each member and can take corrective actions (as firing inefficient members). Here comes the classic question: who watches the watchmen? To ensure appropriate incentives, this specialized controller will receive the residual benefits of the firm. These benefits are twofold and correspond to the allocation of property rights on profits and firm assets to the entrepreneur:
- Profit: team members are granted fixed payments and the difference between the team's output and these payments is a residual that is awarded to the specialized controller, i.e. the entrepreneur.
- Firm value: any increase in the value of the firm (goodwill) will be also awarded to the controller.
Thus, the theory provides an explanation for the efficiency of the traditional capitalist firm. However, it finds difficulties in explaining monitoring and incentive schemes in modern large corporations. In these firms, monitoring is exerted by hired managers who are not the owners of the firm or the entrepreneur. In any case, the theory still explains why the person in charge of a team should participate more on the output of the team than the team members.