* Towards a Political Theory of the Firm Zingales, Luigi, 2017

Question 1

CONTEXT

Answer 1

• In a list combining both corporate and government revenues for 2015, ten companies appear in the
  largest 30 entities in the world
• All ten of these companies had annual revenue higher than the governments of Switzerland, Norway,
  and Russia
• Yet in contemporary economics, the commonly prevailing view of the firm ignores all these elements of
  politics and power; the firm is a simple “nexus of contracts”, with no objectives or life separate from
  those of its contracting parties (a veil to achieve personal goals)
• Author argues that this view certainly does not accurately describe giant global corporations that
  facilitated a massive concentration of economic (and political) power in the hands of a few people, who
  are hardly accountable to anyone (hostile takeovers nearly disappeared, activist investors are under
  political pressure)
• Companies have large security forces, public relations offices and resources (political influence),
  lacking only the direct power to wage war and the legal power of detaining people
• In the essay, the author argues this is a threat to “the functioning of the free market economy and to the
  economic prosperity it can generate, and a threat to democracy as well”

Question 2

FROM ADAM SMITH TO THE NEOCLASSICAL
THEORY OF THE FIRM

Answer 2

• Author argues that concerns like his were present in Adam Smith’s work, then they were neutralized, and then they were reborn to a
  certain extent
• Adam Smith had a negative view of corporations due to their monopolistic behaviour
• Example – The East India Company – a 15-year monopoly right that lasted 233 years is a harsh reminder of how dangerous the
  commingling of economic and political power can be
• The East India Company would lobby and pay bribes to keep monopoly power. When by 1764, it had become the de facto ruler of Bengal,
  where it established a monopoly in grain trading and prohibited local traders and dealers from “hoarding” rice, 10m people died of starvation
  when drought struck. It also caused the two “opium wars”.
• The next step was the Gilded Age (19th century):
• Incorporation became a right of citizens
• However, the rise in economies of scale during the Second Industrial Revolution contributed to ensuring corporations’ market power
• The more an economy becomes winner-take-all, the bigger the incentives to corrupt the political system to gain a small, but often decisive,
  advantage. As a result, industrial titans were at the same time the greatest corruptors.
• Tillman Act in 1907 and Clayton Act in 1914 started to limit corporate influence, then other
  legislations broke corporate power further, and as a result the US entered the second part of 20th
  century with a less-concentrated economy – Zingales calls this period “The power of competition
  and takeovers”
• Such views prevailed:
• Competitive selection process eliminates much (if not all) managerial discretion
• Managerial discretion can be constrained by the pressure of the corporate control market
  → a publicly traded firm that is being run inefficiently represents an arbitrage opportunity. A raider can buy the firm, fix the inefficiency, resell the firm
  or continue to operate it, and make money.
• Moving attention more away from the “power” aspect towards the more technological one
• Neoclassical economists argued that in a world with perfect competition and no transactions costs,
  firms are nothing more than isoquant maps
• However, it turns out that even in a perfectly competitive environment, corporations are powerless
  only if there is perfect contractibility/full disclosure
• The incomplete contract paradigm: in “neoclassical framework”, only one set of transactions is described well – when
  there are many producers of similar quality products and many potential customers. Many transactions do not fit this
  specification.
• Most contracts are incomplete, in the sense that they will not fully specify the division of surplus in every possible
  contingency (too costly/ unanticipated contingency); the incompleteness creates room for bargaining affected by the
  following factors:
• Which party has the ownership
• Availability of alternatives
• Institutional environment
• In this setting, what is often specified is who has the right to make decisions when unspecified contingencies arise, which
  in turn will influence strategic bargaining over the surplus
  *Neoclassical framework - Buyers attempt to maximize their gains from getting goods, and they do
  this by increasing their purchases of a good until what they gain from an extra unit is just balanced by
  what they have to give up to obtain it.
• Emphasizing the incomplete nature of contracts and rules, the theory of incomplete contracts
  creates scope for lobbying, rent seeking, and power grabbing, i.e., there is plentiful of space for
  economic actors to exert pressure on the regulatory, judiciary, and political system to grab a larger
  share of these rents
• In a world where cash bribes are illegal and relatively rare, firms need other means to lobby and
  pressure the political and regulatory world, e.g. the (implicit) promise of future career
  opportunities → the credibility (and thus the effectiveness) of such promises strongly depends
  upon the current and future economic power of a firm
• If the ability to influence the political power increases with economic power, so does the need to do
  so, because the greater the market power a firm has, the greater the fear of expropriation by
  the political power. Hence, the risk of what Zingales calls the “Medici vicious circle.”

Question 3

THE INCREASING MARKET POWER OF US
FIRMS

Answer 3

• In the last two decades, more than 75% of US industries experienced an increase in concentration levels. During this time,
  the size of the average publicly listed US company tripled in market capitalisation: from $1.2 billion to $3.7 billion in
  2016.
• 2 trends can explain this:
• Reduction in the rate of birth of new firms
• Very high level of merger activity
• Evidence of larger share of profits in the value added (from 2% in 2984 to 6% in 2014) + empirical evidence that the share
  of profits and industry concentration are related → likely, the market power has increased
• Possible explanations:
• Network externalities: situations in which an increase in usage leads to a direct increase in value for other users
• Winner-take-all industries: the proliferation of information-intensive goods that have high fixed and low- marginal costs; if
  you add market power effects, the momentum toward concentration might be irresistible
• Reduced antitrust enforcement

Question 4

POLITICAL POWER OF FIRMS

Answer 4

• Market power gives corporations a comparative advantage at the influence game: the greater their market power, the more
  effective they are at obtaining what they want from the political system.
• Moreover, the more effective they are at obtaining what they want from the political system, the greater their market power
  will be, because they can block competitors and entrench themselves → risk of a Medici vicious circle.
  “Medici vicious circle” - which economic and political power reinforce each other, threatening both free markets and
  democracy.
• Zingales argues that in the last three decades in the US, the power of corporations to shape the rules of the game has
  become stronger for three main reasons:
• The size and market share of companies has increased → lower competition; corporations are more powerful vis-à-vis consumers’
  interest
• The size and complexity of regulation has increased → makes it easier for vested interests to tilt the playing field to their advantage
• There has been a demise of the antibusiness ideology that previously prevailed among Democrats, and this has reduced the costs of
  being perceived as too friendly to the interests of big business for both parties.

Question 5

TOWARDS A POLITICAL THEORY OF THE FIRM

Answer 5

• The ideal state of affairs is a “goldilocks” balance between the power of the state and the power of firms
  “Goldilocks balance” is characterized by an economy which is neither too heated (inflationary) nor in recessionary state.
• Other states are problematic:
• If the state is too weak to enforce property rights, then firms will either resort to enforcing these rights by themselves (through private
  violence) or collapse
• If a state is too strong, rather than enforcing property rights it will be tempted to expropriate from firms
• When firms are too weak vis-à-vis the state, they risk being expropriated, if not formally (with a transfer of property rights to the
  government), then substantially (when the state demands a large portion of the returns to any investment)
• But when firms are too strong vis-à-vis the state, they may shape the definition of property rights and its enforcement in their own
  interest and not in the interest of the public at large
• The feasibility of a “goldilocks” equilibrium depends upon a mixture of institutional and economic characteristics

Question 6

INSTITUTIONAL CHARACTERISTICS

Answer 6

• If the main source of political power in a country is brute force (autocratic approach), then “goldilocks” balance is less
  likely than if power is based on social consensus (democratic approach)
• Mechanisms in the formation of the democratic consensus:
• The world of the media; can be influenced by the political power (through censorship, ownership, subsidies, and leaks) and by the
  economic power (through advertising, direct ownership, financing, and access to information). It is equally important that they are
  (mostly) not affected by government censorship and corporate censorship.
• Electoral process, shaped both by the electoral law and by the rules for campaign financing. A mixture of limitations on private
  donations, matched to some extent by public financing, is an attempt to find a balance.
• Ideology: in some countries, political legitimisation is linked to a formal election process; in other countries, governments formed in
  different ways are nonetheless regarded as legitimate. Ideology is also based on perceptions of the relative benefits of being dominated
  by economic interests
• The prosecutorial and judiciary powers: differ in their degree of independence from the political and the economic powers and in
  their prevalent ideology

Question 7

ECONOMIC CHARACTERISTICS

Answer 7

• Company’s ability to make credible long-term promises (for example, future employment opportunities for politicians
  and regulators), which is highly dependent upon a company’s long-term survival probability
• The grip a company has on the market for specific human capital (for example, how many potential employers of nuclear
  engineers there are)
• A company’s ability to wrap its self-interest in a bigger, noble, idea (for example, Fannie Mae and the goal that every
  American should be able to borrow to purchase a house)
• Control that a company has through its image in society by way of employment, data ownership, media ownership,
  advertising, research funding, and other methods
• All of these factors are positively influenced by firm’s size and level of concentration within a market
• What matters here it is not just product market concentration, but in general all concentration of economic power. The main
  employer in a town or jurisdiction is very politically influential, even if the firm sells in a competitive market outside that
  town

Question 8

REMARKS, PRACTICAL IMPLICATIONS

Answer 8

• The possibility and extent of Medici vicious circle depends upon several non-market factors:
• Main source of political power (closest to a perfect balance today – Scandinavian countries; on the extremes we have North Korea and
  East India Company)
• Conditions of the media market
• Independence of the prosecutorial and judiciary power
• Campaign financing laws
• Dominant ideology
• How to limit the risks from huge modern corporations?
• Increased transparency of corporate activities
• Improvements in corporate democracy
• Better rules against revolving doors and more attention to the risk of capture of scientists and economists by corporate interests
• More aggressive use of the antitrust authority
• Attention to the functioning and the independence of the media market
• Single most important – broader public awareness