Knowledge And Decisions

If the management is doing well, but could do better, it is not even necessary for the residual claimants to know that in order for something to happen. If some alternative management knows it, the prospective residual claims under that alternative management are greater than existing claims under existing management. The alternative management can afford to pay existing residual claimants more than their claims are worth under existing conditions in order to buy control of the corporation, improve its efficiency, and make larger residual claims in the future. In other words, one corporation “takes over” another by buying up the less efficient corporation’s stock at prices that represent more than its current value to stockholders, because the more efficient management can earn more with the same plant, equipment, and employees. Through competitive bidding for a controlling share of stocks, knowledge is effectively applied by those who have it — other managements — even though the initial owners might have been insufficiently knowledgeable to realize that the executives initially in charge were not getting the most out of the resources of the firm. Looking at this from the point of view of the efficiency of the economy as a whole, corporations are monitored not only by existing residual claimants but by prospective residual claimants as well — each with the incentive of self-interest, eliminating the need for additional (and endless) layers of monitors.

Viewed in retrospect, residual claims are not very significant as a percentage of national income (about 10 percent) or as a return on investment (about 10 percent per annum). As a percentage of the selling price of goods, residual claims can be quite trivial. Supermarkets average about a penny profit on a dollar’s worth of groceries, and only the huge volume of business they do every day makes this add up to a profitable operation. It is not as a retrospective sum that residual claims have a major impact on the economy. It is as a prospective incentive that it profoundly affects behavior and the efficiency of production. If residual claimants were guaranteed in advance the very same sums which they end up earning, the whole economic system would function differently. With everyone in the economic system essentially on guaranteed salaries, the monitoring problems would be massive.

THE PHYSICAL FALLACY

From the discussion so far, it may be apparent that a given physical object has a value that varies greatly according to the location of that object in time and space, and according to the risks associated with it. Otherwise people would not go to the trouble and expense of transporting things, or insuring them, or buying them on credit with interest charges. Indeed, no exchanges of goods (for other goods or for money) would ever take place, unless the same physical things had different values to different people. Yet the opposite view — that a given physical object is always a given value — has had a profound effect on human history. Over the centuries, highly diverse consequences have followed from a belief in the invariable value of a physical object — a belief that can be characterized as “the physical fallacy.”

In medieval times, the physical fallacy led to the doctrine that an object had a “just price” based upon objective costs incurred by the producer and not upon the subjective valuation of the consumer. Any other price was considered morally sinful and as something that should be legally prohibited.⁶ A special case of the “just price” was the medieval prohibition on usury, which has not wholly disappeared, even in the modern world. Because the “same” sum of money was returned as borrowed, it was considered cheating to require additional payments (interest). But the whole transaction was made precisely because the same sum of money did not have the same value at different times. A borrower who could save enough to repay a loan by a given time could instead have waited until that same time and used those same savings for whatever purpose for which the loan was used. That he preferred having the loan immediately — that is, preferred money at one time over the same sum at another time — was the whole point of borrowing. Both the “just price” doctrine and the usury prohibition refused to recognize differences in value due solely to location in time or space. Both were among the earliest and most persistent forms of the physical fallacy.