Economic power and firm performance

Cooperation between human capital and material capital

Wealth creation is the main topic of economic and social development. At the beginning of the establishment of economic science, economists focused on the problem of creating social welfare. However, the crux of the problem is that the allocation of social income underlies the research on social income creation. Since it is reasonable that income should be distributed among the class who created it, the main problem that challenges economic research is the inconsistency between wealth creation and income distribution. In the development of economic history, mercantilism first proposed the concept that wealth is created from circulation, which meets the need of business capital ideology. Physiocrats hold that wealth is created from agriculture, while landlords, handicraftsmen, and the aristocracy do not create any type of wealth. From William Petty to Adam Smith, as economics gradually formed a scientific system, the labor theory of value prevailed, emphasizing that effort created wealth during the production process. Until the emergence of subjective price theory, the concept of value and wealth creation acquiesced to market and price. Factors, such as land, labor, and capital used in the production process, are contributing factors in wealth creation. The firm’s income should be distributed among the owners of these factors. Unfortunately, prevailing neoclassical economic theory did not find consensus on price theory and distribution theory among economists.

For capitalist classical firms, Marx (1911) holds that the capitalist exploits the worker’s surplus value. For modern firms, the theory of corporate governance argues that as a result of information asymmetry between the manager and the shareholder, the capital owner’s profit will be encroached upon as the manager tries to maximize their own profit, which is the fundamental problem of the firm. The corporate governance structure is designed to protect monetary capital profit from erosion. To encourage manager’s behavior not to veer too far from the shareholders’ interests, some extra profit that traditionally belonged to monetary capital should be given to the manager. The question is: Why has the investor’s status changed so dramatically from exploiter to victim? In the traditional theory of economics, capital is a factor that enjoys the firm’s residual claim at the cost of assuming managerial risk. Capital’s exclusive control on profit is guaranteed by the capital owner’s power. According to Galbraith’s (1983) theory of power distribution, in any society, power is always combined with the most irreplaceable factor of production, and the agent who supplies such factors will enjoy the firm’s residual income. In feudal society, land is the most important factor of production. The landlord is the supplier of this factor of production; thus, the landlord benefits from the rent. In a capitalist economy, capital takes the place of land, becomes the most important factor of production, and the residual claim of the firm transfers to the capitalist. In the present era of information knowledge, due to industry and technology advancements, there is an increasing demand for knowledge. Specialized knowledge is more complex and has become a main factor of production in promoting economic growth and enhancing productivity. Spontaneously, workers who possess such knowledge and skills enjoy power corresponding to their knowledge and skills. Capitalized human resources enjoy the firm’s residual claim as a result of the changes in capital structure.

We hold that material capital lost its dominance because of the changes in power structure related to material capital and human capital. Power structure is a state of interaction while profit is the driving source of interaction. If the structure of benefit distribution meets the power structure, a steady state is reached among economic subjects. Changes in power structure, as a result of changes in the resource endowments structure, incur modulations in bilateral behavior. Thus, benefit adjustment is reached, and new resource distribution and cooperation structures emerge under the motive of pursuing maximum profit. These efforts, in turn, influence the power structure until the new steady state is reached.

For classical firms, disparity in income status between material capital and human capital reflects the market bargaining power of both parties. The workers choose to sell cheap labor for two reasons: the social environment at the time and the prevailing mode of production at the time require primitive and pure labor that is abundant. If advanced production technology is so complicated that high-quality labor is required, the cooperation process between both parties will focus on wage negotiation and include residual claims.

It is impossible for material capital to maintain the exclusive advantages of profits without the use of advanced modes of production. Ricardo (1891) notes that accompanying economic growth, the share of rent will become increasingly large. Malthus, Winch and James (1992) predict that the wage of labors can only maintain their standard of living. A fact of modern economic growth is that rent as a proportion of revenue decreases while the economy grows rapidly; wage rates and labor income increase as the economy grows. When the power of material capital is strong enough that workers have little strength to resist, competition among material capital intensifies, and the result is that capital continues to adopt new technology to raise productivity. Mincer (1974) argues that accumulation of material capital will enhance the marginal products of human capital. It is a powerful stimulus for ordinary workers to realize the high income of the managerial class and the highly skilled, and workers will continually invest in themselves in terms of knowledge, intelligence, and skills. During this process, capital utilization and output will improve at the same time.

Compared with material capital, human capital characteristics differ from those of property rights. The advancement of human capital’s status in the firm results in the re-distribution of the corporate right of control between them. The most important feature of human capital is that it is inseparable from the owner. Because of its inseparability, human capital is weak in terms of information display capability and cannot be mortgaged or transferred. The wide diversity of human capital implies its heterogeneity and the ease with which it can be hidden, which leads to monopolization of human capital. Thus, human capital is difficult to measure. When human capital and material capital cooperate with each other, the failure of the firm means the owner of human capital will lose their property gains but will not lose the property itself. Hence the promise of material capital is reliable while human capital can easily avoid the risk of business failure. Under the property rights system, with limited liability, the owner of material capital transfers its right of management and administration while reserving the right of supervision in the use of capital. Some scholars argue that the trend of human capital investment leverages specialization and the team dynamic (Fang, 1997). Therefore, human capital can be mortgaged and considered a stakeholder.

The differences between the two described views originate from the difference between two concepts in firm theory:6 the specificity and exclusiveness of assets. The specificity of assets implies that the rent of assets may be possessed in future cooperation; that is the risk of being trapped. The exclusive nature of assets reflects bargaining power and increases the bargaining chips for future cooperation. However, this is not the case in reality. For human capital with an exclusive nature, the threat of leaving the firm is unbelievable threat because human capital has specificity in nature at the same time. Intrinsically, the monopoly of transaction exists in the specificity and exclusively of assets to varying degrees. The discussion on the specificity and exclusively of human capital adds vagueness to the characteristics of human capital. From the results, the two points of views are different because they have a different understanding of risk. If the risk compensates for the fixed payment resulting from a lack of ex-post income, in an economic society where currency is the ultimate means of payment, material capital is the ultimate risk unless a credible promise can be made using human capital, for example, power license; the loss of reputation becomes significant. If the risk is understood as the uncertainty of future earnings, both material capital and human capital cannot achieve the goal of risk aversion. Material capital can exit more easily due to the monetization and securitization of the material capital, while human capital cannot easily do so because of its nature of specificity.

Human capital’s property rights characteristics and the changes of supply and demand in the market led to the transformation of the classical capitalist firm to a modern firm. This likely indicates that the property structure and the contract of modern firms are more effective. In reality, proprietorship and modern firms co-exist, which implies that the owner of material capital accepts the new property structure and the new interest distribution structure based on the weighing of the pros and cons. In other words, the formation of power of different components based on a relatively stable power structure is a result of the negotiation on both parties. The firm’s residual income is a mixture of risk compensation brought by the external market circumstances and the return of management functions caused by capital mobility. There are no clear-cut and reasonable standards to evaluate the contributions and the income of both sides. If you do have to find such a standard, the factor markets that provide a reference for both sides to sign a contract after negotiation are a good example; marginal revenue reflects the contribution of the production factors, the amount of which determines the remuneration of factors of production.

Similar to our analysis on the firm’s pricing mechanism in the previous section, there are two problems in the method to determine the firm member’s income according to market prices. The first problem is that the market is not perfectly competitive. Coase (1995) argues that because a higher market transaction cost is required to judge the performance of different parties’ products, firms use transaction contracts. Second, the total amount to be allocated between both parties is greater than the sum of the contribution of all the factors (otherwise, there would be no cooperation), and there is no way to prove that the benefits of cooperation equal the marginal product of one side when there are no other opportunities for cooperation. A price higher than the market price can only be used as a participation constraint. In fact, the enterprise system is considered to be the chief culprit of the imbalance in interest distribution because, subjectively speaking, the price in the market is never satisfactory. From the point of view of supply and demand, when the potential supply of human capital exceeds the potential supply of material capital, human capital’s negotiation strength is insufficient because its weakening scarcities results in diminishing income distribution. On the contrary, as the supply of material capital increases, the relative scarcity of the firm’s human capital becomes increasingly obvious, and human capital has the ability to ask for more return. Thus, the distribution structure of the firm’s residual income changes naturally.

The power structure and the distribution of firm’s revenue

The firm’s income will ultimately be distributed among its participants, including the investors, the management, and the employees. According to neoclassical economics firm theory, the income of the factors of production is determined by their marginal productivity. The total income created by the firm is distributed among all factors of production. If there is excessive profit or loss, the equilibrium distribution under perfect competition is guaranteed by the entry and exit of new firms. This is what market-deciding theory tells us. If the firm is considered a different resource allocation mechanism compared with the market, the firm has its own income distribution mechanism for the factors of production, which is different from market price. We assume that the firm’s distribution criteria are settled as the firm’s contract is signed. A majority of the managers and employees must obey the stipulations of the contract if they want to participate in certain business activity. The premise of such obedience is that the economic power of these individuals is much weaker than that of the firm’s owners.

Within a firm, economic power is related to the key resources that the participants of the firm hold. If an individual possesses the resources necessary for the firm’s development, the more important and irreplaceable these resources, the greater the negotiating power of an individual. The result of the game is a larger share of the income distribution. According to enterprise contract theory, the firm’s contract is determined by bargaining among participants before the contract is signed. The income distribution among these contractors depends on their negotiating power. Such examples in real life are not hard to find, particularly in North America and Europe where the market economy is more mature. Successful CEOs always ask the board for a relative high salary. The reason why these CEOs have such negotiating power is that they control the key resources that are vital for the firm’s development. The negotiation power is the external expression of economic power during the contract negotiation process. Conversely, why are migrant workers’ wages so low and often defaulted on by their employer? The main reason is that migrant workers lack organizations such as unions. Thus, an individual migrant worker has no capability to negotiate with the capitalist leading to unfair distribution of income between migrant workers and the capitalist. Recently, under the state’s intervention, migrant worker’s residual claim has increased along with their negotiating power.

In a Nash bargaining model, the power of negotiation is actually the participant’s economic power formed by the amount of capital owned, the criticality of that capital, the leadership of the business organization, and the ability to obtain non-public information. These factors determine the influence and control of different players during the bargaining process. It reveals the influence and control of different players during the bargaining process. We denote the negotiation power of one-side as i, where 0(, p2, p„), where

Рь Pi' "> Pn denote resource vectors. Though an implicit form of г is not given, there is no doubt that negotiation power increases as different components of power rises, so we assume t is an increasing function of p,-.

Assume both parties have a starting point, namely Д = (д°, t>°), it indicates that when the two parties cannot reach an agreement, one party can receive payoff д°, while the other party can receive payoff v°, which are the two player’s retained earnings. Let S be the set of all possible payoff vectors (/i, v) reached by negotiation or bargaining between two parties, (д°, u°) e S, and we have the following two assumptions.

Assumption 1: Pareto-efficient frontier of the bargaining result S, is a concave curve h defined on a closed interval [д, д], and there exists Д e [^д, д J with Д >Д°, и = /?(д)> t>°. This assumption indicates that the participants’ utility can be increased by negotiation.

Assumption 2: The set of all weak Pareto-efficient payoff^, u)is closed.

The pair (S, d) which satisfies assumption 1 and assumption 2 is defined as a Nash bargaining problem. Following the two assumptions above and the axiomatic assumptions of Nash bargaining problem, for every т e (0,1), the solution to Nash bargaining problem is a unique solution of the following optimization problem.

Suppose each party’s negotiation power is represented by X and T2 respectively, and T| + T2 = 1. We denote the firm’s output, under the cooperation of players as (p((p> 0), (p=p + v. If participants fail to cooperate with each other, then the retained income is ф(ф > 0), = д° + u°. If the two parties choose to cooperate with each other, the ultimate distribution ratio of income must satisfy the solution to Nash bargaining problem. Differentiating / = (д -Д°)Г (и- и0) Т with respect to д, we obtain an expression of д and r.

By the first order condition = 0 above, we obtain


This shows that two parties’ ratio of gross income is equal to the ratio of their negotiation power. In other words, power as represented by the negotiation power determines income distribution.

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