A Team Production Theory of Corporate Law

1. A Team Production Theory ofCorporate Law Margaret Blair & Lynn Stout - 1999

2. Principal-Agent Model • Explanation of public corporation ownership • Shareholders (principal) own corporation and hire officers (agents) • Goal of corporation is to increase shareholder wealth • Corporation law is used to reduce “agency costs” and maintain faithfulness of directors/officers (agents) to the principals • E. Fama, Agency Problems and the Theory of the Firm (1980) • Advocated the separation of ‘management’ and ‘risk bearing’ roles • Used insights provided by Alchian and Demsetz (1972) to establish agent and principal roles

3. Production, Information Costs, and Economic Organization • Published in 1972 in AER • Armen A. Alchian (University of California, Los Angeles) • Harold Demsetz (University of California, Los Angeles) • What makes a team? • The use of several resource types • The product does not equal a sum of individual contributions • Not all resources used by the team belong to one person • Think about two people lifting a 100lb box • Does each person lift 50lbs? • Does one lift 75lb and the other 25lb?

4. Production, Information Costs, and Economic Organization • Shirking: A problem with the a team • Fixed by using a “Monitor” • Residual claimant • Observe input behavior • Central party common to all contracts • Ability to alter team membership • Ability to sell these rights (ownership) • When does a team become a firm? • When it is possible to increase production through a team • When it is economical to estimate marginal productivity via observation

5. A Team Production Theory ofCorporate Law • Blair and Stout (1999) refute application of Principal-Agent Model and corollary that corporations’ primary goal is to maximize shareholder wealth • Model applies to firms in general, but provides no special insights into public corporations • Team Production Approach • Where a productive activity requires the combined investment and coordinated effort of two or more individuals or groups • Issues occur in form of ex ante (agreement) shirking and ex post (agreement) opportunism

6. A Team Production Theory ofCorporate Law • Issues occurring under Team Production Approach circumvented by corporate law as a “Mediating Hierarchy” • Formation of Public Corporation provides a hierarchy existing outside original production team • All team members “agree to give up control rights over the output from the enterprise and over their firm-specific inputs” (i.e. to a BoD) • No single team member is a “principal” having right of control • Solves three primary issues with Team Production Approach: • Convoluted information-gathering and decision-making • Shirking and opportunism via principal-agent contracts • Disputes between team members regarding allocation of duties and rewards

7. A Team Production Theory ofCorporate Law • A public corporation is not simply a “bundle of assets” under common ownership, but rather a complex collection of agreements between team members working together for mutual gain: “A nexus of firm-specific investments.” • Control over assets and outputs are mutually given up in order to reduce shirking and rent-hoarding via implementation of an internal mediating hierarchy

8. A Team Production Theory ofCorporate Law

9. Keeping Directors Faithful • Influences of Corporate Law and Culture • Directors motived to do well if they want to maintain their positions • Directors also motivated by desire to maintain reputations • Corporate law limits ability of directors to serve their own interests • Directors unable to appropriate corporate assets beyond established compensation • Assumption exists that if directors cannot serve their own interests, they will serve the interests of their firm (Is this a valid assumption?) • Corporate culture motivates directors to serve as fair trustees of firm • Serves role of benevolent/trusted mediator implied in all contract theory

10. Mediating Hierarchy Theory • May only be a “second-best” solution to relegation of asset and firm output control • Given certain constrains, a board of directors may offer substantial reduction in inefficiencies and rent loss • Mediating Hierarchy Theory expands on legal view of corporation as a “nexus of contracts” (explicit and implicit) • Highlights importance of team production dynamics within public firms • Establishes tools to understand political nature of a corporation • Explains role of BoD in determining firm focus on employees/shareholders