Unit 6 The firm and its employees

6.3 Other people’s money: The separation of ownership and control

Owners, managers, and employees have a common interest in the firm’s success. They would all suffer if it failed. But they have conflicting interests about how to distribute the proceeds of the firm’s success among themselves in the form of wages, managerial salaries, and owners’ profits. And they may disagree about conditions of work, managerial perks, and who makes key decisions.

capital goods
The durable and costly non-labour inputs used in production (such as machinery and buildings). They do not include some essential inputs (such as air, water, and knowledge) that are used in production at zero cost to the user.
asset
An asset is something that is owned, and has value.
residual claimant
The person who receives the income left over from a firm or other project after the payment of all contractual costs (for example, the cost of hiring workers and paying taxes).

The firm’s profits legally belong to the people who own the firm’s capital goods and other assets. The owners direct other members of the firm to take actions that contribute to the firm’s profits. This, in turn, will increase the value of the firm’s assets.

Profits depend on three things:

  • costs of acquiring the inputs to production (raw materials, labour, energy, and capital goods)
  • output of goods and services (how much the inputs produce)
  • revenues from selling the output.
\[\text{profit} = \text{sales revenue} - \text{input costs}\]

The owners take whatever remains after revenues are used to pay employees, managers, suppliers, creditors, and taxes. Profit is the residual. It is what’s left of the revenues after these payments. So the owners are called residual claimants. Managers (unless they are also owners) are not residual claimants. Neither are employees.

This division of revenue has an important implication. If revenues increase because managers or other employees do their job well, the owners will benefit, but the employees will not (unless they receive a promotion, bonus, or salary increase).

In small enterprises, the owners may also be the managers who take operational and strategic decisions. For example, consider a restaurant owned by a sole proprietor, who decides on the menu, hours of operation, marketing strategies, choice of suppliers, and the size and compensation of the workforce. The owner-manager will usually try to maximize the profits of the enterprise by providing the kinds of food and ambience that people want, at competitive prices.

share
Shares are financial assets that can be bought and sold, giving their owners (the shareholders) shared ownership of the assets of a firm, and therefore a right to receive a corresponding share of the firm’s profit.
separation of ownership and control
The attribute of some firms by which managers are a separate group from the owners.

Large corporations usually have many owners, most of whom play no part in the management. The owners are individuals and institutions (such as pension funds) that own the shares issued by the firm. By selling shares to the general public, a firm can raise capital to finance its growth, leaving strategic and operational decisions to a relatively small group of specialized managers.

These decisions include what, where, and how to manufacture the firm’s products, and how much to pay workers and managers. The senior management decides how much of the profit is distributed to shareholders in the form of dividends, and how much is retained to finance growth. Of course, shareholders also benefit from the firm’s growth because they own part of the value of the firm, which increases as it grows.

When managers decide on the use of other people’s funds, this is referred to as the separation of ownership and control. And it results in a potential conflict of interest.

The owners receive the profits while the managers receive salaries, so it is not always in the interest of managers to maximize profits. They may choose to take actions that benefit themselves, at the expense of the owners. Perhaps they will spend as much as possible on their company credit card, or their own salaries, or seek to increase their power and prestige through empire-building, even if that is not in the interests of shareholders.

Even single owners of firms are not required to maximize profits. Restaurant owners can choose menus they personally like, or waiters who are their friends. But unlike managers, when they lose profits as a result, the cost comes directly out of their pocket (because they are the residual claimant).

In the eighteenth century, Adam Smith observed that senior managers tended to serve their own interests, rather than those of shareholders:

[B]eing the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a [firm managed by its owners] frequently watch over their own … Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. (The Wealth of Nations, 1776)

The modern firm did not exist in Smith’s time, but Smith understood the problems raised by the separation of ownership and control. There are two ways that owners can incentivize managers to serve their interests. Firstly, they can design contracts so that managerial compensation depends on the firm’s share price. Secondly, the board of directors, who represent the shareholders and typically have a substantial share in the firm themselves, can monitor managerial performance. The board has the authority to dismiss managers, and shareholders in turn have the right to replace members of the board. The shareholders of large companies rarely exercise this authority, partly because they are a large and diverse group that cannot easily get together to decide something. Shareholders face a kind of free-rider problem: they can enjoy the benefits of the firm’s success whether or not they contribute to it. But occasionally a shareholder with a large stake in a firm may lead a shareholder revolt to change or influence senior management.

free rider, free riding, free ride
Someone who benefits from the contributions of others to some cooperative project without contributing themselves is said to be free riding, or to be a free rider.

When we model the firm as an actor, we assume that it maximizes profits. This is a simplification, but a reasonable one for most purposes:

  • Owners have a strong interest in profit maximization: It is the basis of their wealth.
  • Market competition penalizes or eliminates firms that do not make substantial profits for their owners: Units 1 and 2 show that this process helps to explain the continuous technological revolution.

Question 6.4 Choose the correct answer(s)

Read the following statements about the separation of ownership and control, and choose the correct option(s).

  • When the ownership and control of a firm is separated, the managers become the residual claimants.
  • Managers always work to maximize the firm’s profit.
  • One way to address the problem associated with the separation of ownership and control is to have the board of directors monitor managerial performance.
  • It is effective for shareholders to monitor the performance of the management, in a firm owned by a large number of shareholders.
  • The shareholders are the residual claimants.
  • Managers may choose to take actions that provide benefits for themselves at the expense of the owners.
  • The board of directors has the authority to dismiss managers, which can incentivize managers to serve the owner’s interests.
  • When there are many shareholders, there is not only a coordination problem but also a free-rider problem, where every shareholder relies on others to do the costly monitoring (and hence no monitoring is undertaken as a result).