"The limited liability corporation has stoked debate and controversy as surely as it has generated wealth. Norman Barry investigates the twenty first century corporation and its antecedents."
The limited liability corporation is perhaps the greatest invention of modern capitalism – but it has never been without its critics or its scandals. Over a century ago, Gilbert and Sullivan wrote the above lines in response to the Companies Act of 1862, which made it easy to set up a limited liability corporation – and as a consequence, a great many went bankrupt.
Though not all firms are corporations, all corporations are firms. As Ronald Coase pointed out in an article in 1937, the rationale for the market was that people could exchange by multilateral contracting. But this involves heavy transaction costs (the expense of doing business) and is inefficient. The firm, however, operates by the bilateral contract and reduces these costs. When you join the corporation you lose your liberty and have to do whatever the company says. Even though the firm emerges from the market it does not operate exactly by market methods.
This has produced great prosperity but has never been without its enemies. As early as 1776 Adam Smith stated a preference for owner-managed enterprises, reckoning that the joint stock company could not succeed. It was difficult, he thought, to imagine that employees would do what the owners (shareholders) wanted just because they were paid a wage. Smith expected them to cheat.
Smith thus discovered the ”agency” problem. The owners are the principals and the employees the agents. But how do we align their interests? All of the great scandals of the past few years are new versions of this. From Enron to WorldCom, we have seen examples of employees running off with company money.