Incomplete Contracts and Public Hierarchies .

1. Fondazione Nitti, Acquafredda, Maratea Aprile 2012 Incomplete Contractsand Public Hierarchies. Ugo Pagano

2. Incomplete contracts and Public Hierarchies:outline. 1. Independent Units and Complete Contracts. 2. Independent Units and Incomplete Contracts: the power of third parties 3. Dependent Units and Integrated Governance. 4. The double role of hierarchy: local vs. central, super-ordinate vs. subordinate. 5. Co-operating as partners.

4. Independent Units and Complete Contracts • Much Economics and Law have emphasized the role of contracts among independent units as the best way to organize the interactions among the agents. • This view has been challenged for both the interaction within and between the private and the public sphere. • In both spheres ex-ante contract offer a limited tool to foster cooperation. • This point has been recently made also for contracts among different levels of government and interaction between them and private units.

5. OECD From Linking Regions and CentralGovernments p. 66

7. The Traditional approach:Pure EconomicsandPure Law. • The separation of both disciplines from ethics went together with the separation between law and economics. • Pure economics concentrates on the internal consistency (equilibrium) and “efficiency” of the decentralized decisions of maximizing individuals. • Pure law concentrated on the validity of laws, that is the internal consistency (equilibrium?) of legal systems that were assumed to stem from a single authority or from a single grundnorm. The two disciplines seemed to live into separate pure Nirvanas and, besides their purities, only a formal analogy seemed to relate them. But there were also some hidden relations between the two Nirvanas…..

8. Two related Nirvanas? • Pure Economics assumes well defined and complete rights that are exchanged and enforced by a third party. Thus the Economic Nirvanarequires a Legal Nirvana. • Pure Law assumes that the legal ordering could be completed and made consistent by a single agent or on the basis of a set of basic norms without limitations due to bounded rationality, cognitive ability, failure of collective action and other limits due to the scarcity of resources. In other words the Legal Nirvanarequires an Economic Nirvana.

9. Coase: the fall from the Economic Nirvana. • Coase observed that in the world of pure economics all decisions were coordinated by prices at zero costs. • In this world firms would not exist. We would live in what became later the world of the “Coase theorem”. • In the world of the Coase theorem all possible externalities, including those related to economies and diseconomies to scale would have been internalized by market transactions. • Firms, state regulation and other arrangements can only appear in a word where no alternative institution is available at zero costs. There is noEconomic Nirvana: all institutions are costly.

10. Fuller: the fallfrom the Legal Nirvana. • Fuller defined law as the enterprise to subject to rules human behaviour. • This enterprise is too costly to be carried out by a centralized ordering. • The costs of Law can and are in fact decreased by decentralizing its enterprise to a plurality of orderings. • Unions, Churches and Universities have their internal orderings. Firms themselves can also be seen as private orderings. There is noLegal Nirvana:completeness, unity and consistency can possibly be the aim of a legal ordering but they cannot be taken for granted.

11. GM-Fisher Body: an hold-up story? • Much literature sees the reason for the existence and growth of firms in common ownership of machines and plants which avoids hold-up problems. • A typical example, given in this literature, is the GM-Fisher Body vertical integration when Fisher-Body was holding-up GM which wanted to expand production facilities • Fisher increased its short-term profit by failingto make the investments required by GM in a plant located near GM productionfacilities in Flint, Michigan.

12. Top management with a judicial function. GM growth required the adjudication of the responsibilities among individuals cooperating in production. Example: Kettering vs. the production production and the failure of the copper-cooled (air-cooled) engine. The role of Alfred Sloan: - Separation between top management and management of division - No horse trading in the central offices. - Top management with a “judicial function” adjudicating rewards and liabilities.

13. Top management with a judicial function. GM growth required the adjudication of the responsibilities among individuals cooperating in production. Example: Kettering vs. the production production and the failure of the copper-cooled (air-cooled) engine. The role of Alfred Sloan: - Separation between top management and management of division - No horse trading in the central offices. - Top management with a “judicial function” adjudicating rewards and liabilities.

14. A different interpretation. • The transition from open body to closed body. • Road-holding: fit between car body and engine. • Unlike airplanes and boats, the body and engine of the car became co-specific. • Unified liability towards customers and internal adjudications of liabilities. • Sloan’s “internalization” of the judicial function.

15. Esempi di soluzioni all’italiana: UCIMU A: http://www.ucimu.it/associazione/ potete leggere: UCIMU-SISTEMI PER PRODURRE è l'associazione dei costruttori italiani di macchine utensili, robot, automazione e di prodotti a questi ausiliari (CN, utensili, componenti, accessori).Rappresentante ufficiale della categoria, UCIMU-SISTEMI PER PRODURRE conta oggi oltre duecento imprese associate cui va ascritto più del 70% del made in Italy di settore.Il valore e la tradizione delle aziende aderenti, espressione di uno dei settori che maggiormente determinano l'intera filiera manifatturiera, insieme alla competenza della struttura associativa, fanno di UCIMU una delle realtà più autorevoli del Sistema Confindustria.

16. Esempi di soluzione all’italiana: il parmigiano Question: Parmesan vs Parmigiano Whatis the DifferenceBetweenParmesan and Parmigiano-Reggiano? Answer: Due toItalian D.O.C. lawsthatprotect the names and recipesofcertaincheeses, a cheesecannotbecalled Parmigiano-Reggiano unlessitismadeusing a specificrecipe and production methodwithin the provincesof Parma, Reggio-Emilia, Modena, and specificregions in the provincesof Bologna and Mantua. da: http://cheese.about.com/od/cheesebasics/f/parm_parmigiano.htm

17. GM vs. Parmigiano Observe that the relation is different: In the case of GM the office which does the marketing and guarantees the overall quality of the product is super-ordinate to the different departments producing different cars and functions. In the case of ICIMU and of Parmigiano the opposite is true. The producers control the association which guarantees the common trade-mark and other facilities. The provider of the central facility is not necessarily super-ordinate with respect to the local units. This is an important point when one considers the analogy between central and local government.

18. Coase’s Journey Costly decentralized market transactions. The firm as centralization of market transaction

19. Fuller’s Journey Costly centralized public orderings. The firm as decentralization of public orderings

20. A joint Coase-Fuller Journey? Costly decentralized market transactions. Costly centralized public orderings. The firm as as centralization of market transaction and as decentralization of public orderings

21. The firm as one of the many examples of private ordering Fuller: the firm as a decentralization of the public ordering Coase: the firm as a centralization of market transactions Coase Fuller However, for us what is relevant is that many different forms, such as GM, UCIMU etc. are possible and they involve some form of governance departing from a word of independent agents and centralized public markets. Universities, Unions, Town, Communities, the parmigiano association and GM are all examples of these forms of governance and the distribution of power among units providing central and local goods is largely indeterminate.

22. From butter milk to Swiss cheese • In a famous passage, quoted by Coase in his 1937 article on Nature of the Firm (p. 35), Denis Robertson (1928) observed how in the market economy firms can be seen as "islands of conscious power in this ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk". • In the New Property Rights approach the memory of the butter and the buttermilk has faded away . Its place has been taken by some sort of Swiss cheese where holes of incomplete contracts are open in a desert of perfectly working and costless markets.

23. The economic consequences of Justice • In a Coase-theorem world with zero transaction costsattributing the rights to a particular individual has no “economic” consequences. In any case rights will flow to the individual who values them the most. We are in a Legal and Economic Nirvana where judges can ignore the economic consequences of their decisions. • In a world with positive transactions the decisions of the judges have economic consequences because rights will not necessarily flow efficiently to the individuals who value them the most. According to Posner (and to much classical Chicago, law and economics) in this case judges should allocate rights, according to criteria of economic efficiency to the individuals who value them the most.

24. Judges as wealth maximizers? • According to Posner, Judges, aware of the economic consequences of their actions should behave like quasi-markets attributing the rights to the individuals who in a world of zero transaction costs would have acquired them. • They apply the Kaldor criterion according to an allocation is efficient if the gainers could have compensated the losers. • Relation between Kaldor criterion and Pareto principle. • He claims that this is consistent with an intuitive view of justice. If avoiding some damages is very costly for some agents and not costly for the others, the latter are guilty for the damages.

25. The Cathedral framework. • Contractual incompleteness does not imply that everything should be decided at the outset on the basis of future negotiations, unfettered by some form of third party judiciary. • In the Cathedral, when ex-ante exchanges have been impossible, ex-post negotiations can still be supervised by courts. • In Calabresi’s framework, when high transactions make it impossible to have ex-ante property exchanges, it is still possible to apply liability rules and courts’ supervision of ex-post transactions.

26. Il Problema della specificità Il grado di specificità di una risorsa é data dalla percentuale del suo valore che viene persa nella sua riallocazione agli altri usi. Parenti stretti: Specificità, Liquidità e Irreversibilità. Trasformazione Fondamentale: Gli investimenti specifici implicano che che si ha concorrenza ex-ante e monopolio ex-post. Questo ci porta a distinguere la letteratura in due filoni: Branca del monopolio (Monopolio alternativa sincronica alla concorrenza) Branca dell’efficienza (Monopolio prosecuzione diacronica della concorrenza).

27. Transazioni efficienti in casi di diverse ipotesi di comportamento

28. 3 (+1) Columns for the Cathedral. • Property rules (low transaction costs). • Liability rules (intermediate transaction costs) • Negligence rules and criminal law (high transaction costs or inalienable assets). • Another Column: Private orderings and corporate governance. Both Calabresi and Williamson involve a fundamental transformation that makes monopoly and competition two different stages of the same relations.

29. Calabresi’s Fundamental Transformation: Because of the high number of possible accidents, negotiations occur after individuals have “disinvested” in specific accidents. Ex-Ante Competition Ex-Post Bilateral Monopoly Ex-Post Transactions under Courts Supervision.

30. Williamsons’s Fundamental Transformation: Because of the high number of possible events, negotiations occur after individuals have invested in specific assets. Ex-Ante Competition Ex-Post Bilateral Monopoly Ex-Post Transactions under Firms’ Governance.

31. The Fundamental Differences. • Unlike accidental disinvestments, specific investments are more likely to involve a voluntary choice of the counterpart and of the third party endowed with judicial power. • In cases like car accidents, the ex-post relation lasts only for the time of readdressing the specific damage. There are no gains from continued cooperation and no incentive of private third parties to make second-order specific investments in the verification of the specific (dis)investments. • The private agents making verification investments can set up governance structures and become residual claimants for the extra-return on (first order) specific investments which are due to they “second-order investments” in the building of appropriate private orderings.

32. Ex-ante contractual Incompleteness Calabresi and Williamson Ex-post Verification Capabilities. Calabresi Williamson Public orderings. Independent Agents. Fuller-Coase Emergence of the Firm. Private Orderings. Employed Agents

33. Same-Sex Marriage in the Cathedral In Calabresi’s Cathedral a Fuller-Coase marriage can be easily celebrated. The firm appears as a centralization of market transactions and a decentralization of the public ordering which arises when co-specific investments make it desirable a system of joint liabilities. The main feature of the firm is not a common property of non-human assets. Its main characteristic is a system of common liabilities and of centralized power which, inter alia, allows an internalization of a Calabresi-type judicial function.

34. Corporations vs. Partneships. Characteristics of the corporation: • Limited Liability. • Centralization of Control. • Perpetual Life. • Liquid market for shares. • Legal Personality and Capital lock-in: A corporation's assets belong to the corporation and not to its equity investors. As a result, those assets cannot be unilaterally withdrawn from the firm by either its shareholders, or the creditors of its shareholders. By contrast in a partnership: anyone of the investors can unilaterally demand the partnership be dissolved and the value of its assets distributed back to the partners

35. The corporation as half legal person (Iwai). Unlike the State, the modern corporation is a person and a thing at the same time: it can be sold and bought like a thing it can own things like a human person. Two extreme cases: • concentration of ownership and take-over (thing). • acquisition of its own shares and self-ownership (person). Useful flexibility of legal positions defining the corporation.

36. From State Organ to Free Incorporation. • In Roman Times the State (SPQR) was well defined legal person. • Legal Pluralism and legal personae in the middle age. • Nation States and the unification of legal personae. • Incorporation under state authorization (chartered corporation: 31 December 1600, East Company). • Free incorporation (in 1889 the State of New Jersey permitted incorporation for all lawful purposes - a movement which all the other the States quickly had to follow)

37. The evolution of the corporation • The corporation evolved from a process of concentration of ownership along Coasian lines which involved an huge centralization of market transactions. • The centralization could not have been by mortal legal person but involved the creation of immortal legal fictions. • This last process evolved along Fullerian lines and implied an evident decentralization of the public ordering. • From an historical point of view the evolution was different in the US and Britain. Corporation started as non-profit organization, engaged in the construction of infrastructure in the

38. The Law-Economics Marriage Remember that in Calabresi’s Cathedral a Fuller-Coase marriage can be easily celebrated. The firm can be seen as a child of the marriage embodying the genes of both parents: a centralization of market transactions a decentralization of the public ordering The main feature of the firm is not a common property of non-human assets but a system of common liabilities and of centralized power which, inter alia, allows an internalization of a Calabresi-type judicial function.

39. The usual view of the degenerate child • Many economists (such as Demsetz) have seen the corporation as generated by high transaction costs: they make it convenient to centralize contracts in the corporations. • However, the corporation is seen as degenerate child of the market: its powerful incentives are lost and manager’s incentives are not aligned with the goals of shareholders. • Remedies: incentives, such as stock-options, could re-align managers’ incentives with the interest of the corporation.

40. Posner: advantages of the degenerate child • The business corporation ended up by having a legal personhood similar to that of other public organizations. • It had an inner dynamism superior to other organizations whose personalities were restricted to a territory (national states and their bodies) or to a specific mission (universities), or which required faith in particular beliefs (churches). • The business corporation has no territorial limitation, no specific mission, and no faith constraining its opportunities.

41. Posner: disadvantages of the degenerate child • However, territory, mission and faith do not simply constrain personalities; they also define their identities. • This may be particularly important in the case of non-mortal legal persons. In spite of their non-mortality, these can only live if some mortal individuals identify with them. • This identification is much easier if the non-mortal person has a well-defined identity. In the case of Posner the corporation stems from a decentralization of legal personality to a half-person that can be sold and bought on the market. The bench marks for degenerate child are the public bodies that generated it.

42. Degenerate parents! • If the corporation was generated by costly markets and/or by costly centralized orderings, there are no perfect parents. • Degenerate parents generated degenerate children. • There is no perfect bench-mark to which the corporation should be compared. We are always comparing imperfect solutions..........

43. Knowledge and Land Enclosures. • While industrial capitalism was preceded by the enclosure of lands, intellectual monopoly capitalism has been made possible by the enclosure of ideas in privately owned fields. • Land enclosures may have even prevented the over-exploitation of a resource being depleted by overcrowding (but there is some evidence against this thesis) . • No similar claim can be made for the case of intellectual enclosures. The fields of knowledge are not subject to overcrowding. By contrast, the access to knowledge is seriously limited by the fields privatized by others, the agents are forced are forced specialize in narrow fields is likely and suffer a dramatic squeeze of investment opportunities.

44. Global Patents and Investments.

45. Dynamics of Intellectual MonopolyCapitalism • While the some countries and firms may gain from intellectual protectionism, the overall restriction of investment opportunities generates a dynamic process shown in the preceding figure. • In this figure, we can observe a total world increase of investments for about five years after the TRIPs but, after this initial phase, a continuous decline starting in 1999 and culminating with the recent global financial crisis. • The interactions between productive forces and production relations is likely to have produced two different dynamics of Intellectual Monopoly Capitalism, the first characterizing the roaring nineties and the second the much less glamorous first decade of the new millennium.

46. The Birth of the InstitutionsofIntellectual MonopolyCapitalism. • The first phase (1990-1999) marked the expansion of the so-called knowledge economy. • In the new world under American dominance, internet and computers – to whose development military and public research had substantially contributed – became cheaply and often freely available, opening up numerous new technological possibilities for the entire world economy. • However, the technological generosity of the US did not last for long. The 1994 Marrakesh agreements marked the beginning of a new era of the world economy where few giant firms could own a disproportionate share of the global knowledge. • The creation of the WTO, with the associated 1994 TRIPs agreements, marked a structural break in the world economy that saw the birth of the institutions of intellectual monopoly capitalism.

47. The roaringninties. • The second half of the nineties could enjoy the past fruits of public investment in knowledge as well as the incentives of knowledge privatization. • The public availability of information and communication technology and the possibility of acquiring new secure private intellectual property rightsopened numerous investment opportunities. • The reinforcement of private intellectual property rights happened on a virgin territory that had just been fertilized by the ICT innovations which had been made publically available to everybody. The incentives of intellectual monopoly were strong while its blocking effects were weak.

48. The depressedbeginningof the newmillemnium • With the end of the nineties, the new gold-rush towards the acquisition of intellectual property rights (coupled by a decline of public investment in knowledge) started to have negative effects on investment opportunities and the blocking effects of intellectual monopoly became stronger than its incentive effects. • This substantial decrease in investments, in turn, explains the existence of global imbalances better than the hypothesis of a "saving glut", on which much emphasis has been placed to explain the 2008 financial crisis. • The “famine” of good productive investment opportunities, coupled with poor financial regulations, produced a flood of easy money that became both a cause and an effect of the housing bubble and of the following subprime crisis.

49. Financial Timesof March 6 2009 “Our impression is that Opel has not freed itself from GM’s influence and that it is not being serious about becoming more autonomous as a business,” the insider said, confirming that both Mr. Guttenberg and Ms Merkel were losing patience with the companies. Berlin has refused to assist Opel without cast-iron guarantees that the money will not flow to GM or be lost in the wake of a GM insolvency. Officials say Opel’s restructuring suggestions so far have failed to provide this guarantee. The government suspects GM has provided some of Opel’s patents as collateral to the US Treasury in exchange for financial assistance. Berlin therefore doubts Opel would be shielded against an GM insolvency.”

50. Allied Security Trust Patent pools and pre-emptive patenting have created a situation in which only some large interconnected firms are able to limit the damage caused by intellectual monopoly and, in particular, by patent trolls. Recently, 11 firms, including Sun Microsystems, Motorola, Hewlet-Packard, Verizon Communications, Cisco Systems, Google and Ericsson, have become members of AST (Allied Security Trust), a joint trust which is a patent holding company that helps protect members against patent infringement lawsuits. Allied Security Trust (2010) claims that: AST operates under a “catch and release” model that is unique among defensive patent organizations. AST members purchase patents for defensive purposes, secure the necessary licenses to ensure freedom of operation, and then return the patents to the marketplace for sale. These sale proceeds help to reimburse AST members for their investment in acquiring a license. Under the rules of Trust, AST or its affiliated companies seek to sell all acquired patents within one year of the date of acquisition.