Citizen Economists » economic distortion

The Market Distortion of Corporations

Simon Grey — Fri, 17 Jun 2011 20:10:27 +0000

I’ve been meaning to write this post for nearly a month, but I didn’t feel like getting around to it until I saw this post by OneSTDV:

In general, the mainstream Right views corporations as unassailable edifices of the free market. They triumphantly brag about shopping at big chain stores and express indifference towards corporate influence. Yet, the reactionary Right doesn’t quite share this position or at least shares a tempered optimism towards the benefits of corporate dominance. In my opinion, the mainstream’s defiance regarding criticism of big corporations is part of their frustrating adherence to the proposition nation. Instead of espousing a straightforward nationalistic and traditionalist conception of America, mainstream conservatives use proxy indicators, such as guns, religion, libertarianism, and corporatism, to illustrate their right-wing bona fides.

I used to defend corporations as the cornerstone of the free market until I was introduced to the reality of corporations by the Austrian school of economics. Wikipedia provides an excellent summary of why corporations are ill-equipped to serve as the bastions of the free market:

A corporation is a legal entity that is created under the laws of a state designed to establish the entity as a separate legal entity having its own privileges and liabilities distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter (i.e. by an ad hoc act passed by a parliament or legislature). Most jurisdictions now allow the creation of new corporations through registration.

An important (but not universal) contemporary feature of a corporation is limited liability. If a corporation fails, shareholders normally only stand to lose their investment and employees will lose their jobs, but neither will be further liable for debts that remain owing to the corporation’s creditors.

The important thing to take away from this is that corporations are government-defined entities. The only reason corporations exist is because businessmen decided to cozy up to the government, which is not exactly the free market in action. As such, corporations serve as a market distortion in a variety of ways.

In the first place, the existence of the corporation shifts moral hazard from business owners to consumers, which effectively means that consumers bear the market risk that rightly belongs to corporations. This can be seen in the area of business contracts, most notably sales contracts. Without going into highly technical details, English common law dictated that consumers have the right to expect explicit and implicit guarantees of performance and safety for whatever product they bought. If a consumer buys a product that doesn’t perform, or a product that causes injury during intended use, the producer would be liable to the consumer for failure to perform or for incurring damage. If a producer made an incredibly shoddy product, he could go completely bankrupt.

The possibility of personal bankruptcy helped to ensure that producers manufactured products that met a basic level of quality. The formation of the corporation limited this incentive in that business owners no longer bore unlimited liability for their products. This shift, then, meant that business owners could make products that were “riskier,” in the sense that they could manufacture products that were more dangerous or liable to underperform without having to face the risk of personal bankruptcy. As such, the invention of the corporation has had the effect of shifting moral hazard from businesses to consumers, which is effectively a type of subsidy and a virtual tax.

A second effect of the abstract legal entity of the corporation is that it created a paradigm wherein people began to think that corporations pay taxes. In fact, there has never been a point in history where abstract legal entities have paid taxes. Only people can pay taxes, but there are some who think that corporations can pay taxes simply because those in the legal system have at one point argued that a corporation is a type of person. This has led to incredibly muddled tax policy, which has been discussed in detail prior on this blog.

In the third place, corporations require increasing government intervention into the market. This is due to the inherent subsidy of corporate status. All subsidies impose some sort of negative externality, which leads to negative market distortions. In this case, the status of corporation does not discourage risky production as much as it should, which leads to corporations making either shoddier or more dangerous products.

Consumers demand, quite legitimately, that the government fix this problem. Since governments are generally allergic to owning their mistakes, and are generally desirous of increasing their power, they seize this opportunity to regulate businesses in order to ensure that they meet production quality and safety standards.

Incidentally, the worker side of the equation deserves discussion as well. Not only does corporate status limit a producer’s liability to consumers, it also limits its liability to workers as well. Corporations can, to a limited extent, ignore the safety of their workers because they do not bear personal liability for whatever harm befalls them in the course of normal work. The poor working conditions of the industrial revolution can therefore, to a very limited extent, be blamed on the corporate status of businesses.

Anyway, the history of the corporate entity has shown that the original distortion has led to many, many more distortions, always in the name of correcting some “market” flaw.

Finally, note that corporations have had the effect of transferring power and wealth to those who are already wealthy. There is no debating the fact that many corporations suckle at the government’s teat. This should not be surprising, given that the only reason corporations exist is because businessmen went to the government to ask for special market privileges. As such, those who own corporations have been seeking, since day one, to use the government to make them wealthier, and to help them beat the market.

At this point, then, it should be obvious that corporations are not, and indeed have never been, the free market’s friend. In fact, corporations are as free market as the government that grants and defines their continued existence. Corporations are an inherent market distortion, and should be recognized as such.

The Irrationality of Unemployment Insurance

J.D. Seagraves — Thu, 02 Apr 2009 11:16:10 +0000

In ECON 101, we are taught the concept of “structural unemployment.” Government economists say that structural unemployment, which refers to the segment of the work force unemployed due to “structural change” in the economy, is unavoidable. Therefore, a good 3-5 percent of Americans can be out of work and the government will still say we have “full employment.”

In truth, “structural unemployment” is created by the misallocation of financial resources resulting from the Federal Reserve’s fiat-money central banking regime and other government interventions into the economy, most notably minimum wage laws. Under a gold standard and laissez-faire, there would be real full employment. But of the myriad cockamamie government intrusions into the market unnecessarily causing unemployment, one that deserves special focus amid the current economic depression is unemployment insurance.

From Textbooks to Real Life

Let’s make this personal. I have a younger brother, of whom I’m very proud, who decided to start his life over in Medford, Oregon, 2,300 miles away from his home in South East Michigan. Moving out there with nothing more than he could fit in his car, he quickly got a sales job at Circuit City. A few weeks later, he was promoted to a management position. That was a little over six months ago now.

Now, as you know if you keep up with the business press, Circuit City declared bankruptcy a while back and is now on the verge of being forced into liquidation. Many of the firm’s stores have been closed, but my brother’s in Medford, OR is still open—for now. If they are shut down, then my brother will receive 80 percent of his wages for a full year as part of Oregon’s unemployment insurance program. The only catch: he can’t find another job in the meantime.

Now who in their right mind would want to find a new job given this scenario? Imagine your boss coming in and telling you he has to cut your pay by 10 percent—but the good news is, you only have to work one day a week. Ninety percent of your pay for 20 percent as much work would seem like a pretty good deal, wouldn’t it? How about 80 percent of your pay for zero percent as much work? Who would screw up a sweetheart deal like that by going out and finding a new job?

Disincentivizing Work

Theoretically, of course, my brother could find a job that offered him higher pay. In that case, he might be smart to take it. But when a company goes bankrupt, one of the factors contributing to their insolvency is that they were paying inefficient employees too much money. My brother is a great salesman, but he’s undoubtedly the exception to the rule. After all, if Circuit City were paying their employees the “right” amount, they wouldn’t be going under. If they were overpaying by, oh say 20 percent, then their former workers from Oregon would have a hard time finding new jobs that paid them as much as they’ll receive just for staying home and doing nothing. Where is the incentive to find work?

This mismatch of incentives doesn’t apply only to firms that have gone belly-up, either. Even employees who are laid off have generally been paid too much: if their marginal utility was higher than the wage they were being paid, then the company would have kept them—so of course they’re going to have to take a pay cut to find another job! Why, then, does the government incentivize not finding a lower-paying job?

President-elect Barack Obama, of course, wants to extend unemployment benefits across the nation (and who knows, maybe the world, too). This is obviously a prescription for extended mass unemployment and a deepening of the current depression. If the government must intervene, and apparently it must, then the concept of “wage insurance” makes a lot more sense.

Wage Insurance: An Alternative Idea

Wage insurance is a program whereby displaced workers receive benefits—but only once they find a new job. For example, if a factory worker who had been making $20 per hour were laid off and got a job at a convenience store for $10 an hour, wage insurance would make up part (or all) of the $10 differential between his previous wage rate and his new, lower wage rate. Over time, this benefit would be scaled back as the worker learned new skills that would presumably result in salary increases.

Now as you can see, unemployment insurance incentivizes not finding a job, while wage insurance incentivizes actually procuring employment. Which one do you think would do more to get us out of recession? Even better, unlike unemployment insurance which could never be handled by the free market (due to its incentivizing of bad behavior), wage insurance could be: workers could pay optional insurance premiums for individualized wage-insurance policies. Insurers would be happy to underwrite these moral hazard-free contracts.

Contrast this to our current situation: productive workers are forced to sacrifice their earnings through reduced wages and higher taxes to subsidize the unproductive and non-working. Only the government could set up such a perversely counterproductive and destructive scenario and call that which ails us—over-regulation—a miracle cure.