Inside the Capitalist Firm An Evolutionary Theory of the Principal Agent-Relation Malcolm Dunn Potsdam Economic Studies | 1 Potsdam Economic Studies Potsdam Economic Studies | 1 Malcolm Dunn Inside the Capitalist Firm An Evolutionary Theory of the Principal Agent-Relation Potsdam University Press Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available in the Internet at http://dnb.de. Potsdam University Press 2013 http://verlag.ub.uni-potsdam.de/ Am Neuen Palais 10, 14469 Potsdam Tel.:+49 (0)331 977 2533/ Fax: 2292 E-Mail: [email protected] The monograph series Potsdam Economic Studies is edited by Prof. Dr. Malcolm Dunn. ISSN (print) 2196-8691 ISSN (online) 2196-9302 The document is protected by copyright. Layout and typography: Thomas Graf, Martin Anselm Meyerhoff, wissen.satz Print: docupoint GmbH Magdeburg First published German-language edition Dunn, Malcolm H.: Die Unternehmung als ein soziales System : ein sozialwissenschaftlicher Beitrag zur neuen Mikroökonomie / von Malcolm H. Dunn. - Berlin : Duncker und Humblot, 1998. - 363 S. ISBN 3-428-07852-7 © Duncker & Humblot 1998 Habilitationsthesis Darmstadt 1992 ISBN 987-3-86956-247-6 Simultaneously published online at the Institutional Repository of the University of Potsdam: URL http://pub.ub.uni-potsdam.de/volltexte/2013/6515/ URN um:nbn:de:kobv:517-opus-65151 http://nbn-resolving.de/urn:nbn:de:kobv:517-opus-65151 To Elizabeth Dunn Preface to the English Edition This book deals with the inner life of the capitalist firm. There we find numer- ous conflicts, the most important of which concerns the individual employment relationship. As everyone knows, employees are out to earn as high an income as possible and to avoid doing work that entails physical and psychological wear and tear. Their superiors, on the other hand, pursue the interest of the firm, which consists in lowering the wage costs per unit. The best way to do so is to maximize the amount of work to be performed at a given wage level. So it is no surprise that employees and their superiors often disagree on what constitutes ‘fair pay’ and a ‘reasonable work load’. Just as certain, however, is the fact that employees and their superiors depend on each other to achieve their own re- spective interest. Employees need money, so they need somebody who reckons to profit by hiring them and paying them wages. Managers supervise a labor process that requires the employees to work, for which the firm has agreed to pay them. The antagonistic relationship between the employees and the manag- ers representing the firm is thus founded on their mutual dependence. Because quitting a job or firing an employee carries both, costs and risks, both parties are generally interested in longer-term employment, despite their awareness that the everyday life of the firm constantly gives rise to conflicts that present diffi- culties for all involved. How do employees and their superiors deal with these conflicts? This question is of both practical and theoretical significance. Within economic theory, the principal-agent theory analyzes social interactions in which one actor attempts to motivate another actor to act on his or her behalf. The problem is that even on the basis of a contractual agreement both sides have opportunities to pur- sue their respective interest at the cost of the other, since the actual behavior of the actors cannot be sufficiently supervised. In other words, contracts are only vii rarely comprehensive and precise enough to eliminate the possibility of ‘oppor- tunistic’ behavior. The particularity of the principal-agent theory concerns the manner in which this concept is applied to the employment relationship within the capitalist firm. It makes sense to identify the manager representing the interests of the capitalist firm as the ‘principal’ who issues orders that are to be followed by the employee, the ‘agent’. But it is not at all self-evident that the employee, the agent, should possess a greater amount of information and thus an advantage over the princi- pal. This is an indirect sign of the standpoint to which the principal-agent the- ory is primarily committed: Its purpose is to support the firm and its managers in finding ways and means to influence the behavior of the employees, such that the latter – ideally – act on behalf of their superior. All the techniques and strategies developed and problematized by the principal-agent approach – e.g., increased supervision and the threat of punishment on the one hand, positive incentives such as performance-based pay, improved career opportunities and the creation of a ‘corporate identity’ on the other hand – are guided by the in- terest of the firm, not by that of the employees. And yet, nowhere in the prin- cipal-agent model do we find the assumption that superiors possess a greater amount of information that they can use at the cost of the employee; nor do we find studies that address the question of how an employee can better achieve his or her aims vis-à-vis the principal. The principal-agent theory takes up the perspective of the firm, but not, howev- er, by simply ignoring the well-being of the agent. On the contrary, in all prin- cipal-agent models the ‘optimum’ is a state in which both sides, principal and agent, maximize their utility under given conditions. Hence the principal-agent theory seeks to develop strategies that can turn an inherently antagonistic rela- tionship into a social optimum that takes account of the interests of both sides. Is that not a logical contradiction? Perhaps! The empirical observation that employ- ees generally do not regard their superiors as the ‘opponent’, but rather identify with ‘their’ firm and show ‘pride’ in their work, seems to validate the claim that the inner life of the firm is not only marked by antagonisms, but also by a kind of harmony between the employees and ‘their’ firm. However we might assess the intention of the principal-agent theory and this empirical identification of workers with their employers, what is certain is that viii the concrete actions of the actors involved cannot be sufficiently explained by pointing to the latent economic conflicts between employees and their superi- ors. It is obvious that their social interactions depend on how they perceive and evaluate the employment relationship, including factors such as working condi- tions, the level of pay, etc. Yet, an explanation of this kind cannot be expected from the principal-agent theory. Shirking, to take just one example, is treated by the principal-agent theory as if it were a ‘fact’ and not a moral judgment de- serving explanation. A positive theory of the employment relationship cannot be content to interpret individual behavior as the result of the maximization of utility functions and other conditions, nor can it assume that a uniform amount of information has been ‘asymmetrically’ distributed between the actors, as if there could be any objectively given ‘amount’ of information that could then be distributed unevenly. As much as we must abstract and simplify a great deal in order to share the interest of principal-agent models, they contribute nothing (or very little) to an explanation of the actual conflicts within the firm. Here we have come to what the purpose of this book is and what it is not. To begin, managers will search here in vain for tips on how they can better ‘lead’ their employees. Economists expecting a scientific study on the individual employment relationship, one that derives a social optimum in the sense of a (Nash) equilibrium, will be disap- pointed as well. The purpose of this book is to better understand the actual social interactions within the firm, but without evaluating them normatively. In order to do so, this study not only raises new questions, such as what shirking is really all about, but it will also address and re-examine a number of ‘old’ ques- tions in the theory of the firm. For example, economists have long discussed the issue of whether the primary aim of the capitalist firm is to make a profit, a maximum profit, an adequate profit, or some other goal. There is also contro- versy over whether the assumption of bounded rationality can be viewed as a substitute for the traditional notion of rationality. Another question is whether the production process primarily represents a technically defined ‘input-out- put’ relation, or whether production must be understood as a social process that cannot be illustrated by a production function. Or to take one last example: Is the existence of the firm really owed to a calculation of transaction costs, be- cause hierarchical organizations avoid the costs of transactions on the market? ix Is there really a dichotomy between ‘markets and hierarchies’, as the Nobel lau- reate Ronald Coase claimed in his legendary essay on the nature of the firm? These and other questions surrounding the theory of the firm are treated in de- tail, though the focus of the book concerns individual behavioral patterns and the resulting interactions between the actors in the firm. Why do employees in- crease or decrease their performance? When and why are employees discontent with their working conditions? Do ‘contented’ employees perform better than ‘discontented’ employees? Under what conditions do managers evaluate the be- havior of their employees as ‘shirking’? Clearly, the treatment of these questions goes far beyond the narrow understanding of traditional economics. Alongside economics, therefore, the study also draws upon and evaluates the relevant so- ciological, political, and above all, psychological research. To the accusation that this study is not an economic investigation in the true sense of the term, I can only respond that this depends entirely on what we understand by ‘economics’.