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Monopoly, Externalities and Non-Profit Maximising Firms

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Monopoly, Externalities and Non-Profit Maximising Firms MONOPOLY, EXTERNALITIES AND NON-PROFIT MAXIMISING FIRMS David Kelsey¤ Frank Milne Department of Economics Department of Economics The University of Birmingham, England Queens University, Canada. 13th December 2001 Abstract This paper provides a theory of a monopolist in general equilibrium. We assume that the …rm’s decisions are based on the preferences of shareholders and/or other stakeholders. We show that the monopolist will charge less than the pro…t-maximising price, since shareholders su¤er part of the cost of a price rise if they are also consumers. If price discrimination is possible, the resulting equilibrium will be Pareto e¢cient. We use the model to examine the e¤ects of increasing stakeholder representation in …rms. A related result shows that a non-pro…t …rm will produce fewer negative externalities. Address for Correspondence David Kelsey, Department of Economics, The University of Birmingham, Birmingham, B15 2TT, ENGLAND. Keywords, Monopoly, stakeholder, externality, co-operative, hold-up. JEL Classi…cation: D52, D70, L20. ¤We would like to thank John Fender, Chiaki Hara, Norman Ireland, Les Reinhorn, John Roberts, John Roemer, Colin Rowat and Willy Spanjers and Erkan Yalcin and participants in seminars at the Universities of Birmingham, Durham, Heidelberg, Mannheim and Queens, the Public Economic Theory conference at the University of Warwick, July 2000, and the EEA congress, Lausanne 2001 for comments and suggestions. 1 1 INTRODUCTION 1.1 Background Traditionally it has been assumed that …rms maximise pro…ts. However this assump- tion should be justi…ed. In the presence of market distortions, it is not typically the case that owners will wish …rms to maximise pro…ts. The usual justi…cation for pro…t maximisation is the Fisher Separation Theorem (see Milne (1974), Milne (1981)), which says that if there are no externalities, the …rm has no market power and …nancial markets are complete, all shareholders will wish to maximise the value of the …rm. This result does not apply if there are externalities between the …rm and its shareholders. In this case, shareholders will not just care about the …rm’s decisions via their e¤ect on shareholder wealth but will also care about direct (exter- nality) e¤ects of the …rm’s decisions upon their utility. For instance, the shareholder who lives near a factory with a smoking chimney, will want less production than the pro…t maximising level and less production than a shareholder who lives further away. Thus we see both disagreement between shareholders and deviations from pro…t maximisation. Although we use pollution as an example of an externality, it is not the most important one. Another is the dislike that many people have from investing in …rms which behave in socially irresponsible ways, such as supporting repressive regimes or damaging the environment. Alternatively the externality could be interpreted as private bene…ts of control, perquisites (see Jensen & Meckling (1976)) or other services not captured by market variables. These are the externalities discussed most often in the corporate control literature. We suspect that these are important factors in proxy …ghts and takeover contests. Other examples are the …rm-speci…c investments that are provided by members of the control group (see section 7.2). If there is imperfect competition, the Fisher Separation Theorem breaks down in two ways. Firstly, in general, there will be disagreement between di¤erent share- holders about the policy of the …rm. Secondly, typically, no shareholder will wish to maximise pro…ts. The Fisher Separation Theorem does not apply if there is imper- fect competition, since in that case, a change in the …rm’s production plan will a¤ect 2 prices as well as shareholders’ wealth. Hence typically the old budget set will not be a proper subset of the new one and no unambiguous comparisons can be made. 1.2 Modelling Firm’s Decisions In this paper, we consider an economy with monopoly or externalities. As we argue above, there is a strong case against assuming pro…t maximisation when markets are distorted. However, it is not clear what the alternative should be. At present there is no widely accepted economic model of the internal decision-making of …rms. To resolve this, in the present paper, we propose a relatively general model of the …rm. Despite the generality, our model is able to make a number of predictions concerning equilibrium behaviour and to throw some light on policy questions. The …rm is modelled as a collection of individuals, each of whom is maximising his/her utility. Firms’ decisions are made by a process of aggregating the preferences of a group of decision-makers within the …rm.1 One approach, which has been used in the past, is to model decisions as being made by a majority vote of shareholders, see for instance Hart & Moore (1996) or Renstrom & Yalcin (1997). If the …rms’ choice is one-dimensional (e.g. price), it will be determined by the median shareholders’ preference. However one can object to shareholder voting models by arguing that, in practice, management have more in‡uence than shareholders. To model this, we assume that the …rm’s decisions are made by a group of individuals, which we shall refer to as the control group. For example, the control group could consist of the shareholders and senior management. As another example, consider a …rm with no shareholders, but is a partnership. This case is common in legal, accounting, …nance and professional …rms, where the …rm produces services that are a function of human capital and individual and team e¤ort. However, to preserve generality, we shall not explicitly describe the criteria for membership of the control group. At present there is no widely accepted theory of the internal structure of the …rm 1Examples of such procedures would be the Nash bargaining solution used by Hart & Moore (1990), alternating o¤ers bargaining, de DeMeza & Lockwood (1998), Bolton & Xu (1999) or the voting models used by De Marzo (1993), Kelsey & Milne (1996) and Sadanand & Williamson (1991). 3 (for recent surveys of the governance literature see Shleifer & Vishny (1997), Allen & Gale (2000) and Tirole (2001)). For this reason we use an abstract model. We make, what we believe to be the mild assumption, that the …rm’s procedures respect unanimous preferences within the control group. Such rules would include, inter alia, those which give a major role for management. Note that many familiar forms of governance can be seen as special cases, for instance producer cooperatives, consumer cooperatives, including worker representatives on the board (as in Germany) and many types of non-pro…t organisation. In a discussion of …rm structures, Hansmann (1996) provides many examples of …rms that are cooperatives, partnerships and non-corporate forms. Some are complex non-pro…t forms, where the services provided appear to require more subtle forms of organisation than the simple corporate form assumed in basic text books. It follows that any general model of the …rm should be ‡exible in abstracting from details that are speci…c to particular situations and should deal instead with the abstract decision-making process. Some theories of the …rm use bargaining models to determine the relative power of di¤erent individuals. By varying the bargaining game, it is possible to induce di¤erent outcomes to the management-control mechanism or game. Although some of these games have some semblance to reality, we feel they are highly stylized. We prefer to abstract from the details of the bargaining process and simply assume that whatever the bargaining or management game, the process leads to an e¢cient outcome. If one believes that in certain situations, that the outcome is ine¢cient, then it would be important to explain the source of the ine¢ciency. One could think of our model as the outcome of a process to design an e¢cient mechanism. If this is infeasible then we are dealing with ine¢cient mechanisms. As we are dealing with an open theoretical question, we simply by-pass it by assuming an e¢cient mechanism exists and explore the consequences of that assumption. We brie‡y discuss how our results would be a¤ected by ine¢cient mechanisms in the conclusion, (see also Tirole (1999)). Another major point of this paper is to emphasize the connection between tradi- tional public economics concerns and the theory of the …rm. We can think of the …rm 4 as an entity which provides local public goods, e.g. pro…ts and private bene…ts of control to shareholders and/or employees (see Holmstrom (1998)). This establishes a connection between our model of a …rm and the theory of a public project in an economy with symmetric information and real or pecuniary externalities. Finally, observe that our model does not deal with asymmetric information or competing oligopolistic …rms. To incorporate asymmetric information we would re- quire a general equilibrium model with asymmetric information. Such models exist (see Prescott & Townsend (2000)) but address the issues in terms of competitive clubs. Oligopolistic models require additional assumptions to ensure existence, and introduce the possibility of collusion or strategic behaviour across …rms or coalitions of control groups. These extensions are beyond the scope of the present paper. 1.3 Monopoly and Externalities As argued above, in the presence of market distortions, shareholder unanimity cannot be guaranteed. However it is still the case that there are decisions on which all mem- bers of the control group will agree. Firstly we show that, under some assumptions, for any plan which is not productively e¢cient, there will be some production plan which is unanimously preferred. Hence the equilibrium will be productively e¢cient.
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