The Corporation

Growth, Diversification and Mergers

Dennis Mueller

• Publisher: Taylor & Francis
• Year: 2003
• Print ISBN: 9780415271356
• eBook ISBN: 9781134487653
• Edition: 2
• Topic: Business
• Subtopic: Business General
• Index: Business

This book reviews the theory of the firm and the large modern corporation. Examining the process of entrepreneurial capitalism in which firms come into existence, then managerial capitalism and the changing motives of management in corporations - The Corporation is a thorough and thoughtful account. Of interest to students and academics in the area

1: Introduction

Adam Smith’s famous discussion of the organization of production in a pin factory articulated the advantages of the division of labor, and the economic gains from specialization and large production. But Smith expressed considerable skepticism concerning the relative efficiency of that particular form of business organization we now name the corporation, in which ownership and control are separated (1937, p. 700). Yet, it has been this organizational form that has come to dominate the business landscape in both Smith’s own homeland and in most other Anglo-Saxon countries – a development that the Scottish sage could scarcely have imagined.

Large corporations exist, of course, in all of the highly developed countries of the world and in many of the developing ones. Outside of the Anglo-Saxon countries, however, control and ownership are usually combined. We shall devote considerable space in this book to discussing these differences across countries and examining their consequences for corporate performance (see, in particular, Chapters 6 and 7).

The extent of the development of the corporate form in the United States is revealed in Table 1.1. In 1998, there were 4,849,000 corporations in the United States – roughly one for every 60 Americans. Moreover, as a group they accounted for nearly 90 percent of business receipts in 1998, a fraction that is up from 2/3rds in 1945.¹ Table 1.1 also reveals how the nature of economic activity in the United States evolved over the last century. While the number of corporations in the manufacturing sector in 1998 was a little more than three times the figure in 1920, the number of corporations in the service sector increased hundred fold over the same period.

Not only do corporations as a group account for a large fraction of economic activity, but the largest of these also take on a scale that makes the word “firm” seem a misnomer. In the year 2000, Wal-Mart had 1,244,000 employees, which made it roughly the same size as the Salt Lake City/Ogden Utah metropolitan area (see Table 1.2). Exxon, the largest company in the world, had sales of more than $200 billion.

The twentieth century might well be called “the century of the automobile,” given both the economic importance of the automobile industry and the impact of its spread on other industries, on the way people organize their lives, on the environment, and so on. Table 1.2 reveals that the economic importance of this industry remains significant at the close of the twentieth century. Eight of the ten largest corporations in the world in the year 2000 were either manufacturers of automobiles or refiners of petroleum. Wal-Mart, the giant variety store chain, and General Electric were the only two corporations in the top ten that were neither in, nor heavily dependent upon, the automobile industry.²

Table 1.1 Number of US corporations, by industrial division: 1920–98 (thousands)

Sources: Historical Statistics, Colonial Times to 1970, Part II, p. 914. Table titled “Number of Corporations, by Industrial Division: 1916 to 1970.” Statistical Abstract of the United States, 1984, 1995, 2001, tables 890, 854, and 719, respectively.

Notes

a Includes inactive corporations.

b Includes nonallocable corporations (about 25).

c Includes private utilities.

Of the 100 largest corporations of the world, 37 have their corporate headquarters in the United States. Although this is a larger figure than for any other country, it clearly indicates that large corporations are to be found all around the globe. For this reason, we shall devote considerably more space in this volume to the characteristics of corporations and corporate governance institutions outside of the United States than was the case in its predecessor (Mueller, 1987).

As the title of this book suggests, its focus is upon the activities of large corporations. Virtually all corporations start out as small firms, however, and so before examining the characteristics and activities of large corporations, we shall focus upon the characteristics and origins of small firms. Essentially, two different accounts exist in the literature for why firms come into existence. One sees them as institutions for minimizing transaction costs, the other as a vehicle for bringing innovations into existence. These two, quite different accounts of the origins of firms are examined in Chapters 3 and 4.

In Chapter 5, we focus upon the managers of large corporations and ask what their objectives are likely to be. As we shall see, quite a number of different hypotheses have been put forward to account for the behavior of professional managers in addition to the standard, textbook assumption that they maximize the profits of their firm.

Table 1.2 The 100 largest corporations in the world, 2000

Source: Fortune Global 500, Fortune Magazine, July 2001.

In the literature dealing with the “Anglo-Saxon corporation” there are only two main actors, the managers who run the firm, and the shareholders who own it. Even in Anglo-Saxon countries there are sometimes additional actors of importance, like banks, however, and in non-Anglo Saxon countries banks, other firms, and the state often substitute for the individual shareholder. In Chapter 6, we discuss the objectives of these other actors. We also describe the different corporate governance systems that exist around the world, and look at some evidence regarding their impacts on corporate performance.

One of the important activities of corporations that might be affected by corporate governance structures and managerial goals is investment in capital equipment. This activity is the focal point of Chapter 7. Mergers and acquisitions can be thought of as another form of investment. In light of their importance for understanding the behavior of large corporations, and the size of the literature that examines them, two chapters are devoted to mergers. Chapter 8 reviews the various hypotheses that have been put forward regarding the causes of mergers. Chapter 9 examines their effects on company performance and social welfare. A brief chapter brings the book to a close.

The “profit motive” is widely believed to be the driving force behind all economic activity in market economies. Although we shall have cause to question whether it is the sole driving force motivating corporate decisions, no one including me, would deny the importance of profits as both a measure of company performance and a goal of its owners and managers. Therefore, we begin our excursion in the next chapter by discussing exactly what profits are and how they come about.

2: The nature of profits

The driving force behind the competitive process is often referred to as “the profit motive.” Although every first-year student of economics knows that “profits are the difference between revenues and costs,” many do not understand why such residuals exist, and why the competitive process tends to drive them to zero. Since we shall devote considerable attention to the workings of the competitive process in a modern capitalist economy, it is useful to pause briefly at this juncture to examine the peculiar characteristics of profits. Our discussion draws heavily on the ideas of one of the great Chicago economists Frank Knight.

Uncertainty and profit

Definition. Profit is the residual that exists after all contractual and potentially contractual costs have been met.

In discussing why profits exist, Knight (1921) made the important distinction between risk and uncertainty. Both words describe situations in which the future is not known with perfect certainty. But in situations that only involve risk, one is able to calculate the probabilities of the different possible unknown future events occurring. For example, the probability of two ones coming up when one throws a pair of dice is 1/36, the probability of a one and a two coming up is 1/18, and so on. It is thus possible to calculate exactly the probability that someone will throw “snake eyes” or a seven on a given roll of the dice. Thus, someone with a lot of money could in principle sell insurance to dice rollers at a casino at a price equal to the amount of money at stake times the probability of it being lost. If a lot of dice rollers bought this insurance, the insurer would break even.

Of course, there is no reason for someone to go into the insurance business if they just break even, and the types of people who frequent casinos are typically risktakers who would not be interested in buying insurance if it were available. (Even at casinos some insurance gets sold, however. If a blackjack dealer has an ace showing, the other players can insure against the concealed card’s being a ten or a face card.)

In the commercial world, there are many activities that occur with sufficient frequency that probabilities of various events occurring can be calculated and insurance sold. Oil tankers make thousands of trips each year, and from their experience, the probability of one running aground can be calculated. An oil tanker company can thus buy insurance against one of its tankers having an accident. Now suppose that a very large tanker company chooses not to purchase insurance against possible losses from accidents involving its tankers. Full protection against all losses would have cost it $100 million. It has a lucky year with no losses whatsoever. For the year its income statement looks like that in Table 2.1. As in all income statements, revenues and expenses must be equal.

Table 2.1 Income statement of Small Spill Tanker Company (in $ millions)

The entry “Surplus” on the expense side is a sort of fudge factor that ensures that this equality will hold. Had revenues equaled 9,000, surplus would have been set equal to −900. If revenues had been 11,000, surplus would have equaled 1,100.

It is tempting to call this surplus a profit, and this is probably what Small Spill’s accountant would call it. But this surplus would not be an economic profit by our definition above. Wages, fuel, and interest are all contractual expenses. The $100 million in insurance is a potentially contractual expense. Had Small Spill bought insurance its contractual expenses would have just equaled its revenues. Its economic profits in the oil tanker business for this year are zero. Had its revenues been 11,000, we would say that its economic profits were 1,000.¹

Suppose, however, that it had not been possible to buy insurance. Small Spill is delivering to Country X that is at war with Y . It runs the danger that Y ’s submarines will sink its tankers. No insurance company is willing to insure it against the possibility of such losses. Neither it nor any other company has had enough experience in such situations to be able to calculate the probabilities of its tankers getting sunk. Here, Small Spill faces a situation involving genuine uncertainty, and its surplus of 100, if it again should be lucky, should be defined as a profit.

In a world in which no uncertainty exists, in which all unknown events have known probability distributions so that they only involve risk, the free entry and exit of firms should drive all profits down to zero. Wherever entrepreneurs anticipated positive residuals after all contractual and potentially contractual costs had been met, including insurance against all risks, entry would occur and profits would decline. Where negative residuals were anticipated, exit would occur until profits rose to zero.

This uncertainty-based theory of profits provides us with both an ex ante and an ex post theory of profits. Ex ante profits explain the entry and exit decisions of agents. The concept of ex post profits solves the accountant’s adding-up problem. Ex post the difference between revenues and contractual or potentially contractual costs just balances the expenditure and revenue sides of the firm’s income statement.

Mobility and profit

Knight, and many who have followed him, emphasized the willingness to bear uncertainty among those who took up the entrepreneurial role. But there is another way to look at entrepreneurship in a theory that makes profit depend on uncertainty. The flip side of uncertainty is information. The person who knows that she will roll a seven – she knows that the dice are loaded – takes no chance. Thus, an alternative way of viewing entrepreneurs than as people with a penchant for taking chances is to view them as people w...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Acknowledgments
• 1: Introduction
• 2: The nature of profits
• 3: The nature of the firm
• 4: The Schumpeterian firm
• 5: The managerial corporation
• 6: Corporate governance
• 7: Investment
• 8: The determinants of mergers
• 9: The effects of mergers
• 10: Conclusion
• Notes
• References