Knowledge And Decisions

The typical business enterprise buys or rents its inputs for a fixed price, and sells the resulting output for whatever price emerges in the market, earning a residual claim loosely referred to as “profit,” though often discovered to be a loss. Strict economists point out that much of what is conventionally called “profit,” especially in a small, owner-operated business, is nothing more than wages received in a variable form. Even a successful owner-operated business — and the bankruptcy rate is high — often pays no more under the name “profits” than the proprietor would have earned for the same amount of work for someone else who paid him under the name of “wages.” To determine what the enterprise itself is earning, it would be necessary to deduct the wages for the proprietor’s work and the interest he could have earned elsewhere on the money he has invested in the business. By this economists’ standard, many successful small businesses are making no profit at all. In many cases the residual claim after such deductions would be negative, so that the owner operator is in effect paying for the privilege of being his own boss.

In a large corporate business, the executives are in fact paid salaries under the name of salaries, and the residual claimants are the stockholders. If the residual claim is positive, the tax collectors also share in it, though if it is negative, they do not. (“Win and the government wins with you; lose and you lose alone.”) Both the friends and critics of private business tend to refer to them as “profit-making” enterprises. But this is the fallacy of defining a process by its hoped-for results, rather than by its actual characteristics. A similar fallacy occurs in discussions of the “cooling off” period under a labor injunction, “public interest” law firms, “sensitivity training,” and “quality, integrated education.” What the actual business process involves is the payment of some people at fixed rates (employees, executives, bondholders) and others in residual claims (stockholders and sometimes tax collectors). Viewed in retrospect, the particular method of payment means little. A given fixed amount can always be made equivalent to some given variable amount, with appropriate discount or premium for time and/or risk. Indeed, different methods of payment can be mixed, as when employees have profit-sharing plans and executives are paid partly in stocks, or when investors have some mixture of stocks and bonds. It is only when viewed prospectively that the method of payment has socially significant effects.

Residual claims set in motion different behavior patterns from fixed claims. Whoever has the legal title to the residual claim has an incentive to make that residual — the difference between production costs and consumer value — as great as possible. The same thing, from a social point of view, is that the residual claimant has an incentive to supply what is desired by consumers at the least sacrifice of inputs used for things desired by other consumers. To the residual claimant, these social consequences of his behavior are secondary at best. But from the point of view of the economy at large, this behavior pattern that grows out of the attempt to maximize residual claims is crucial, and whether the residual claim turns out in fact to be large or small, or even positive or negative, is secondary.

The role of the residual claims method of payment is especially important in situations where multiple inputs and numerous persons are used, raising the cost of monitoring individual performances. It is always possible to hire people to watch other people, but how conscientiously they will watch and report is as problematical as the original behavior that requires watching. Hiring more monitors to monitor the first set of monitors merely raises the same question on a new level rather than providing an answer. While the residual claimants cannot monitor the process, they can easily monitor the results. They know whether the residual claims of one organization are greater or less than another — and this provides incentives for each organization to monitor its own performances so as to keep costs low and therefore the residual claims high. How they achieve this result is of little interest to the residual claimant. In a broader social point of view, it means that the need for knowledge in the system is minimized, because the ultimate monitors can effectively monitor results without needing to know the specific techniques or conscientiousness of those who directly produce the results. The residual claims method of payment creates a set of monitors who do not need to be monitored themselves, because they have the incentive of self-interest to see that residual claims are maximized.