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The economics of social enterprises
An interpretative framework
Carlo Borzaga and Ermanno Tortia
During the last decade, entrepreneurial non-profit organizations and social enterprises have rapidly expanded and become a focus of research in Europe, the US, and many other countries (Anheier and Salamon 1992; Borzaga and Defourny 2001; Anheier and Ben-Ner 2003; Borzaga and Spear 2004; Nyssens 2006; United Nations Development Programme 2008). The process of defining the key features of social enterprises has been advanced by legislation introduced in the UK during 2004 and in Italy during 2005.1 Given these important developments in the social and legal domains, a coherent theoretical framework is needed to account for the economic nature and effects of social enterprises.
This framework cannot ignore the history of producersā associations, cooperatives, and not-for-profit organizations with an entrepreneurial character, since social activism has played an important role in creating entrepreneurial ventures with social goals (Stryjan 2004; Borzaga and Ianes 2006; Ianes and Tortia forthcoming). For example, worker cooperatives have often been created with the aim of reducing unemployment through the open door and of improving job stability through employment protection. Better working conditions and a more inclusive organizational model can also favour the moral development of the membership through closer, non-hierarchical, and more transparent relations between the main patrons of the organizationāworkers, users/clients, and managers. In a similar fashion, non-profit organizations have been developed in order to alleviate social problems that for-profit firms and public agencies are unable to manage.
Furthermore, over the last decades cooperatives and non-profits have spread in systems characterized by high levels of social capital based on trust and embeddedness. In these contexts, a process of cumulative causation has occurred as social ties have been reinforced through the influence of organizations in which private and self-seeking objectives are weaker, and intrinsic and other-regarding motivations assume a prominent role (Jones and Kato 2007). This exemplifies the way in which culture and institutions co-evolve, since social ties based on trust and personal relations favour the establishment social enterprises, while the operations of social enterprises reinforce the process of accumulating social capital (Borzaga et al. forthcoming).
Our framework draws upon recent developments in the theories of the firm, institutional evolution, and motivational complexity to explain the crucial changes in ownership rights and governance rules that have been necessary both to implement the new entrepreneurial form of the social enterprise and to meet the needs and motivations expressed by the actors involved. As a first step, a satisfactory theory needs to overcome the limitations imposed by the conventional conception of the firm. These limitations consist of an inability to adequately account for institutional and organizational variety, mainly because of orthodox assumptions about self-interested motivations and profit-maximization on the one hand and of a static approach to institutional and cultural changes on the other (Borzaga and Tortia 2007). This problem is equally true for both the neoclassical and the new institutionalist schools of thought.
Second, to explain the economic nature of social enterprises it is necessary to assume that individuals are characterized by motivational complexity. Self-interested preferences interact with relational, procedural, and intrinsic aspects of human behaviour (Ben-Ner and Putterman 1998). A realistic portrayal of human agency starts from the analysis of predispositions and habits in a manner similar to the classical institutionalist and evolutionary schools (Hodgson 2006). Third, it is necessary to move beyond a conception of economic systems as divided into two main sectors: for-profit firms and public agencies. The intermediate area between these two sectors is often labelled the āthird sectorā and is populated mainly by not-for-profit organizations, a growing variety of which have an entrepreneurial character (Weisbrod 1977, 1988; Hansmann 1996). Finally, the conventional assumption that investor-owned firms are universally the most efficient is untenable, since at least in some industries non-investor-owned organizations have become widespread.2 During the last two decades, entrepreneurial non-profits have increasingly provided services with a quasi-public and meritorious character.
Starting from these observations, an adequate theoretical account of social enterprises requires an innovative conception of the firm in which profit maximization is no longer an essential condition. While altruism and social objectives have conventionally been studied outside the realm of production carried out by firms, an alternative approach is to consider firms as complex organizations that must coordinate different actors in the economic pursuit of production through the implementation of suitable governance structures. According to this approach, the economic and institutional nature of firms does not necessarily entail the private appropriation of net surpluses. A new account of the firm can help explain the existence of entrepreneurial organizations that conventional economics views as altruistic, but not productive.
This chapter begins by identifying the limitations of the new institutionalist and orthodox approaches for understanding cooperatives and not-for-profit enterprises. It argues that the behavioural approach to the study of economics, which focuses on individual habits and motivations (Nelson and Winter 1982), and the evolutionary approach, which focuses on organizational routines and institutional change (Hodgson 1993, 2006), offer a better basis for understanding the emergence and role of social enterprises. The chapter proposes a simple frame work for understanding the tendency of social enterprises to satisfy needs rather than to pursue purely economic objectives.
In the second part of the chapter, an examination of non-traditional entrepreneurial forms, mainly cooperative firms3 and non-profit organizations, highlights the features that they have in common with social enterprises in terms of their limited profit motive and forms of governance. Starting from a critical understanding of the history and theory of cooperatives and non-profits, a systematic framework is then defined and elaborated. It builds upon an analysis of the institutional factors and organizational routines shaping the evolution of social enterprises and argues that this institutional evolution has been driven mainly by social objectives rather than production efficiency, with economic and monetary factors playing an instrumental role in the overall production process. Investor-owned firms, by contrast, seek to achieve the economic objectives of maximizing their surplus and increasing their market value.
The orthodox approach
The orthodox approach focuses exclusively on cooperative firms. It was initiated by Ward (1958), who studied how cooperatives react to market stimuli by comparing worker-run with for-profit enterprises, and it was further developed by Furubotn and Pejovich (1970), who examined the issue of undercapitalization from an intertemporal perspective. This approach starts from the assumption that workers in self-managed firms maximize in the short run the average income per head net of operating costs. It predicts perverse supply behaviour in equilibrium since worker-members will equate average and marginal income. These optimality conditions imply an incentive to lay off part of the membership in good economic conditions, when prices increase, and the existence of a negatively sloped supply curve.
This claim of perverse supply behaviour did not withstand empirical tests (Bonin et al. 1987, 1993), though some results do show that cooperatives are characterized by a more rigid supply curve than for-profit firms4 due to their tendency to protect the stability of jobs by considering labour fixed in the short run. Hence, employment in cooperatives responds more weakly to variations in the demand for products than in profit-maximizing firms.5 Another important finding is that undercapitalization tends to occur in cooperative firms due to their inefficient allocation of self-financed capital funds.6
The orthodox approach has several limitations. First, it focuses exclusively on worker cooperatives, disregarding the existence of other forms of cooperative enterprises. Second, the hypothesis of the maximization of per-member income in cooperatives versus the maximization of total profits in investor-owned firms oversimplifies the behaviour of cooperatives because it excludes other important factors influencing the degree of x-efficiency (Leibenstein 1966). In particular, it neglects non-monetary objectives, the importance of job stability, the possibility of satisfying common and collective needs,7 and the involvement and self-realization of members. A second set of factors neglected by the orthodox approach is the ability of cooperatives to increase employment, output, and wages in the presence of market imperfections, such as the welfare losses caused by monopoly in the output market and monopsony in the input market. The historical record shows that cooperative firms tend to be formed in contexts characterized by a market power concentration. Cooperatives of producers, consumers, workers, and borrowers can be interpreted as institutional responses to market concentration, since they all increase supply and input prices while reducing output prices.
The orthodox approach concludes that cooperatives are less efficient than investor-owned firms, both in their static and in their dynamic (intertemporal) behaviour. This conclusion, however, relies upon the faulty procedure of evaluating cooperative firms exclusively based on their ability to maximize average income per member. Several studies have argued that this approach is reductionist due to its methodological individualism and its narrow focus on the institutional features of investor-owned firms. Consequently, this approach disregards the specific features of cooperative institutions that can support efficiency through participation and non-self-interested motivations, rather than through hierarchy and monetary incentives (Borzaga and Tortia 2005; Zamagni 2005).
The new institutionalist approach
Hansmann (1988, 1996) explains the existence of non-profit organizations and cooperative firms based on their relative ability to reduce transaction costs in the presence of market and contract failures. Hansmannās model represents a new synthesis and a complement to many previous findings concerning cooperatives and non-profits since it fosters an understanding of the process of creation and diffusion of all ownership formsāinvestor-owned, cooperative, and non-profitā in market economies. Organizations that survive in the market are those able to minimize the sum total of costs connected with their operation. Costs are divided into two categories: contract costs, which concern all actors entering into contractual relation with the organization without controlling it, and ownership costs, which are born by the organizationās patrons. Control is assigned to the stakeholder (or patron, in Hansmannās terminology) that has the most strategic role in making firm-specific investments. In other words, the owners risk the greatest economic loss deriving from market exchanges in cases of negative economic results or of morally hazardous (opportunistic) behaviour by the other classes of patrons. The costs of the operation of the market derive from market power ex ante (monopoly and monopsony), market power ex post (lock-in), and asymmetric information, while the costs of ownership are due to agency relations that induce costs of controlling employees and managers, decision-making processes, and risk taking by entrepreneurs. Given N different classes of patrons interacting with the firm, it is efficient to assign ownership8 to the class that is able to minimize the sum total of costs:
where CP is the ownership costs for the j class of patrons, and CCi is the contractual costs undergone by all the other classes of stakeholders. Competitive pressure on the market will make the minimization hypothesis effective.
According to this model, cooperatives can be more efficient than investor-owned firms in three cases. First, when capital is not the strategic factor of production, i.e. when other patrons such as producers, workers, or borrowers make the most specific investments and incur the highest risk of losing the value of the invested resources. Professional partnerships are a useful example, since they are characterized by highly specialized competences, while the physical capital utilized is usually general purpose. Second, cooperatives are more efficient when market power is concentrated in both the factor and output markets. Third, and for Hansmann the most crucial, cooperatives are more efficient when their memberships have homogeneous preferences, since the similarity of interests and objectives favours the implementation of organizational forms based on participation and mutuality, and decreases control costs. In this case, cooperative firms are often more efficient than investor-owned organizations, since they are better able to reduce agency costs of managers and workers and to increase organizational x-efficiency. Conversely, a crucial limitation is the higher collective decision-making costs of cooperatives when their memberships are heterogeneous. This usually occurs when a cooperative grows larger and its members become more differentiated with unequal endowments in terms of financial wealth or human capital, and they thus develop different objectives. This is true even if the division of labour and economies of scale allow the reduction of costs, since the crucial aspect is the higher decision-making costs incurred by cooperatives relative to investor-owned firms. Not all cooperatives suffer from this limitation in the same way, but the problem potentially exists whenever membersā interests are not highly aligned with one other.
In Hansmannās model, non-profit firms originate in the context of asymmetric information when none of the stakeholders is able to minimize costs. Since control by a specific group of agents would entail the possibility of exploiting asymmetric information and other contractual imperfections, ownership is entirely excluded, positive residuals are devoted to the development of the firmās activities, and the organization is managed by professionals who operate according to a statutory social mission. However, insofar as they cannot be sold and do not maximize profits, non-profit organizations are less efficient than investor-owned firms because they lack the necessary incentives to reduce costs in order to maximize efficiency. Like cooperatives, non-profit organizations are seen as an effective solution to severe market failures, but they will inevitably disappear when markets are perfected, i.e. when competition increases and regulation improves. Hence, non-profits are considered by Hansmann to be transitional organizational forms that spread mainly during the initial stages of market development, when imperfections are too pronounced to allow competition to deliver its beneficial effects.9
Hansmannās model obscures three important aspects of non-profits: the public benefits and meritorious nature of their activities, the high relational intensity that characterizes their operation, and the quasi-public nature of the services they deliver. These three attributes locate non-profits in an intermediate position between the public and for-profit sector...
