Prof: Think back
to–this is meeting six. It’s about the rise of the
joint stock corporation. The joint stock corporation is,
without doubt, the most important institution
in the world economy today. Its only rival might be states
or governments, but it is just a massively
important thing. The question of how it got here
and why it takes the form it does is our topic today.
Let’s begin with Adam Smith.
Would somebody–would one of
you guys go up there and get that on slide one slideshow and
I’ll rejoin it when we get there?
Adam Smith, in talking about
the invisible hand, is also at length to say that
the productive use of the division of labor kicks in only
when you get big markets, only where market scale
justifies an elaborate division of labor and a large investment
of capital, do you get the benefits of
capitalism, really. In tiny markets where you’re
making, for example,
clothing for others in a village of a thousand,
the possibility of a sophisticated manufacturing
–somebody who knows this stuff
please do this. Navigator.
Get it into navigator and then
onto slide one and play slideshow and we’re set.
So Smith talks about scale of
markets, and the great limitation on
scale of markets until the early 1800s was the poor quality of
land transportation. Ocean transportation had by
that time gotten pretty good. Sailing ships had gotten better
and better in the three or four hundred years before 1800,
and steamships had improved that.
But–I’m going to skip some
slides– but the great interior of all
the continents still relied on transportation systems,
none of which were superior to a horse.
The cheapest form of
transportation was canal shipping where the motor power
was essentially a horse on a draw path next to the canal.
Then beginning in the 1820s and
accelerating decade after decade into the 1860s,
the railroad took over. For the first time ever one
could move freight vastly faster than a horse,
and vastly cheaper than any previous means of
transportation. The cities grew up initially at
the intersection of ocean shipping, coastwise shipping,
and canals. They grew up because there was
always an economic advantage to being at the junction point
between the main systems of transportation.
Rail took this and raised it by
many powers. The American Rail Network,
this is a simplified map Rand McNally from 1944,
and it’s about passenger rail. The real density of the U.S.
rail network is about five
times what this suggests. That density created exactly
what Adam Smith contemplated: a gigantic market where the
division of labor could be refined to a much higher level
than ever before. One result of that–this is a
contemporary map of greater New York, and the coloring is
dollars of earned income per square mile.
The densest places,
right around in here, reach past ten billion such
dollars per square mile. The great cities of the world
are invariably ones today which enjoy powerful rail
transportation, generally supplemented by water
transportation. But rail, and New York’s
extraordinary advantage as a gateway to the interior of the
United States, by water first up through the
Hudson and then across the Erie Canal to the Great Lakes,
and then beginning with the 1840s, a fabulous deepwater
harbor for shipments to the rest of the world connected by rail
to the entire continent. The double challenge faced by
railroads, two things, one they were very
expensive to build, so finance capital,
raising large amounts of money in order to construct railways,
was one challenge. In some senses,
an even greater challenge was actually running a railroad.
It turns out that railroads get
inordinately complicated after they get big.
When they are one section of
about forty or fifty miles, railroads are actually not very
complicated things to run. But when they get to be
hundreds or even thousands of miles, the logistics of
management get extremely challenging.
So you have two challenges;
one is finance, the other is operations.
Let’s start with operations.
In the nineteenth century train
collisions occurred at rates varying from about 400 to 1,000
a year in the U.S., and they were often ugly,
and they reflected the challenge of management.
This is a simple one section
rail that operated in the 1840s and 1850s between Boston and
Worcester, Massachusetts. Almost all the railroads built
just one track. The question was:
How do you run trains back and forth between these two cities
without collisions? The solution,
it’s in Chandler, that these people had was to
instruct the engineers of the trains beginning at the two end
cities to proceed to Framingham, and one turns–and each take a
right turn so to speak– and sit there until the other
train is in view. After the other train is in
view and stopped, proceed to the end of your
journey. Pretty simple management.
And that railroad had only
about fifty employees. It was four trips a day,
and a very simple thing. Characteristic of capitalism is
that people are not content with small success.
Therefore, they try to string
together many short railroads on the theory that average cost
will decline as scale of operation increases.
The New York Central System,
which was the glitziest of all the railways at its peak,
it’s peak coming roughly from the period of World War I to the
end of World War II, this railroad was created by
splicing together dozens of little railroads.
The Mohawk and Hudson ran
between Schenectady and Albany, and it was the kernel from
which this was formed. It’s one aggregation after
another, and the construction of that
marvelous terminal in midtown Manhattan which we’re all
familiar with, and ultimately,
after the thing reaches the end of its competitive lifecycle,
and the New York Central Railroad was essentially at the
end of its competitive lifecycle by the 1950s.
It was there because?
What was hard on railroads?
What was hard on passenger
railroads? Long haul passenger railroads?
This is a soft pitch, guys.
Student: Introduced the
highway system. Prof: Highway system.
And on freight,
what was the big competitor over land?
highway. Prof: Okay,
so the interstate highway system with trucking and
ultimately de-regulated trucking which was much more efficient,
the competitive position of railroads seemed to be terminal.
And the Pennsylvania Railroad
and the New York Central were combined in a bankruptcy
proceeding in 1968 to form The Penn-Central System,
which soon went bankrupt, and it went bankrupt because
the two managements hated each other,
and each did as little as possible to help the other
succeed. The–this idea of a mortal
lifecycle of the corporation is one which comes up again and
again. A week from today we’ll do the
Polaroid Corporation which begins as a brilliant innovative
firm and ends up playing defense against other more brilliant,
more innovative firms, only a generation and a half
after it began. What really happens with
railroads if you don’t know how to run them,
and the early railroads nobody knew how to run,
was that as the railroad scope or scale got larger,
average costs actually went up. The reason they went up was
that you had to build a mammoth bureaucracy to run the thing.
The Pennsylvania Railroad got
to 50,000 employees fast. The challenge of how to
organize that large workforce became severe.
The first cut was spatial,
without the kind of surveillance and information
technology we have today, they had the telegraph fairly
early on and that’s all they had.
The control over a massive
network– this is The New York Central
System– meant that they cut the system
into sections and created a set of authorities within each such
section. The ones I’ve drawn here in red
are merely illustrative. Then there was a division of
function. There were people who worried
about railroad cars. There were people who worried
about track. There were people who dealt
with passengers, others with freight,
finance, cost accounting, human resources,
and so on. So you have all these
functional stripes– all this is Chandler,
and I’m just simplifying what he says–
these functional stripes, and then you’ve got the
geographic sections, and the question becomes,
what do you with the intersections?
The fundamental administrative
question was, do you let the functional
groups boss the geographic groups around,
or do you let the geographic groups boss the functional
groups around? What ended up happening was
this pattern, which ultimately gives priority
to the geographic groups. It creates enormous power at
the top in general management. And the top people in American
railroad, who were very well compensated, often took on
ownership stakes, and were true big shots.
The functional people operated
as staff to them; the people who did accounting,
the people who did finance, the people who did
and rolling stock and so on. Then there were several tiers
of specific managers, superintendents with
responsibility for geographic areas,
and they too had functionally divided staff–
people to worry about the rolling stock,
the track, the construction, etc.–and the pivotal decision
makers were always the people with a geographic focus.
They were the ones who had to
take all the factors, all the functions together,
and make the thing work. They became the first general
managers of the modern description that MBAs are
training for. It’s essentially the origin of
the managerially operated joint stock corporation.
The Europeans used a different
pattern, which gave priority to the functions,
and by and large, the American system worked
better. Now why are European trains so
much better than American trains today?
Okay, yeah socialism is part of
it. Please elaborate;
let’s get from one word to ten. We got a mic?
Student: People seem to
be more comfortable in states in the Eurozone with diverting
taxpayer money to public project,
such as infrastructure. Prof: Okay,
this is particularly true of continental Europe I think.
Where the trains have become,
in many, not quite all cases, publicly operated systems.
There’s another reason,
there’s a historical reason. Student: The price of
gasoline. Prof: Price of gasoline,
that’s another point. I hadn’t actually connected the
dots. Gasoline there is roughly two
or three times what it is here, so passenger train for short
and middle sized runs makes a lot of sense.
Big historical event, yes?
Student: They didn’t
really have–the interstate highway kind of bloomed.
Prof: Say again?
Student: Like they
didn’t have like a highway system or
I think–well some of them did. I mean the German Autobahn was
pretty impressive, even if the Nazis built it,
it was pretty good highway. What I’m fishing for here is
World War II. World War II destroyed the
European rail system, and because it was destroyed,
and because of the U.S. Marshal Fund,
which paid for an awful lot of reconstruction,
they started more or less from scratch and made the thing work.
We had this higgledy-piggledy
remnant of a previous period, and never really made the
investment by socialism or capitalism.
The challenge of finance was
equally important, perhaps more important.
projects that involved high capital investment were funded
locally. People made investments within
small circles, within one city,
within the people who lived next–
the zone where people living next to a canal or a segment of
a canal would, in effect, buy bonds and
finance the thing. Railroads were catastrophically
expensive, they sucked up vast amounts of capital,
and so a device as in this bridge, the Eads Bridge in St.
Louis over the Mississippi,
there were hundreds, even thousands of terrifically
expensive construction projects to be financed.
The mechanism chosen was the
joint stock corporation. The forms of funding were of
two main kinds, I’m going to get to some detail
in a minute. One were railroad bonds where
people in effect loaned money to the railroads and achieved a
predictable income, relatively predictable income,
from that investment in debt. The other was the joint stock,
where you bought into the equity of the company and became
a partial owner. This is a world railroad grid,
and I’d like you to just in passing notice the very uneven
density of it, and the fairly strong
correlation between the density of the railroad grid and the
wealth of the place. The railroads were both cause
and effect of capitalist development.
Where there were railroads,
there was capitalist development, where capitalist
development, railroads. And colonialism had odd effects.
Africa’s railway system got
developed not so much to create internal markets as to get goods
quickly and efficiently out for shipment to the metropolitan
power, which controlled the
colonization. Now a chart, the dreaded chart.
And here we have on the
vertical dimension three major forms of ownership.
Indeed, these are the three
most important forms of ownership.
Proprietorship means outright
ownership. You just own it, end of story.
Partnership means what it says,
and interestingly, and for reasons you’ll probably
figure out by the end of the hour if you don’t know it
already, partnerships tend to be used in
a certain kind of company. It’s a company where the value
of the firm consists largely in the talent of its employees so
that the big consulting firms, the big investment banks,
the big law firms, all take the form of
partnerships and they are– and that actually changes and
one of the HBS cases you’re getting is the one where Goldman
Sachs ceases to be a partnership and becomes a company.
And of course third,
the joint stock corporation. Then we look at each of these
with the five considerations across the top in mind.
One is, what’s the
accountability chain here? How do we keep people doing
their job? How do we see the difference
between a job well done and a job poorly done?
The second is the role of
ownership and the third is liability.
Every one of these is a huge
factor in understanding this. The fourth is liquidity.
If I own something or a part of
something, how easy is it for me to sell out?
to what extent can we start with something small and grow
something enormous? The three forms vary
importantly in each of these five dimensions,
and I’m afraid I’m going to walk you through them.
The chain of accountability in
a proprietorship is pretty simple.
I own it, I run it,
I’m the boss. I hire and fire the employees,
I make the business decisions, I don’t submit plans to anyone
else, I just do it. In a very small enterprise,
that has its advantages. In a partnership things are
more complicated. The trouble with a partnership
is this: Every partner has a right to participate in
management, and I can’t admit a new partner
without the consent of the other partners.
Now the work around for this is
the hybrid form, which creates a general partner
who runs it, and then a bunch of limited
investment partners who participate passively,
and lots and lots of things take that hybrid form.
The pure partnership is very
awkward. You’ve got to talk to everybody
all the time; it’s like being married to a
room full of people at once. What a nightmare!
the chain of accountability is very different,
and it looks like this. You’ve got investors over here;
you’ve got capital markets with brokerages, stock exchanges,
and such like; then you’ve got a board of
directors, then top management, then layers of other
management, and then layer upon layer of regular employees.
And the chain of accountability
is the white line. I’ve made this one a little
crooked because it is a little crooked.
How many of you own a stock in
a specific company? Not–can we get a mic down to
this gentleman here with the olive colored shirt please?
Is it a publicly traded company?
Prof: Name it please.
Student: It’s called
Sasol; it’s a South African oil
company. Prof: Okay,
and you take an active role in running the company?
Prof: Do you like
everything the management does? Student: No.
Prof: Why don’t you fix
it then? Student: Because I
don’t own enough shares to make a difference.
and if you called up the CEO and said,
“I don’t like what you’re doing,” how would you
imagine the conversation would run?
Student: Very short.
Prof: It would be short
and what would his suggestion–his not indecent
suggestion be? Student: Pound sand.
Student: Pound sand.
pound sand or sell the damn stock.
You don’t like it, get out.
The characteristically weak
control that investors have here puts enormous importance on the
exit option. Indeed, the exit option becomes
dominant. And in day trading,
for example, what people are doing is owning
companies for very short periods,
owning tiny slices of companies for very short periods,
and exercising no influence or accountability but just,
“I don’t like it, I’m gone,”
or, “I believe the price is
going to fall, I’ll short the stock and get
out.” What you’ve created here is a
brilliant device for scooping up small amounts of investment from
a large amount of people, a large number of people,
so that with a joint stock corporation you can have
thousands, tens of thousands,
hundreds of thousands of investors.
They don’t know each other,
they don’t talk to each other by and large,
only the large institutional investors track the company’s
behavior with any care, the specific fundamentals of
the company, and the distancing–think about
proprietorship, where the boss is in the shop;
and partnership, where the owners are the
partners who actually do it. We’ve come a long way from that
with the joint stock corporation, and it’s an
extremely efficient device for raising money in that way.
The internal operation,
on the other hand, is complex.
You’ve got market mechanisms of
exchange outside the firm, but inside the firm you’ve got
to manage people, you’ve got to incent them,
motivate them to do what needs doing for the firm.
The board of directors plays a
symbolically central role in all this because they pick top
management, and top management is
accountable to them, at least in theory.
If you think about the recent
crisis in American capitalism, a lot of it has to do with the
fact that boards have failed, sometimes catastrophically,
to exercise any real accountability on top
management. The characteristic problem,
which I’ve mentioned to you a couple of times,
about the firm is so-called principal agency;
I hire you to do something, and you go off and do it or
not. For example,
let’s suppose I run something as simple as a bar and I hire
you–I’m not there in the evening and I hire you to run
the bar. I give you an hourly wage,
and I let you keep your tips, what might occur to you as a
way to maximize your income at my expense?
Student: Free drinks.
Prof: Free-who said it?
Free drinks or the very deep
pour; you order a scotch,
I pour you a double. You save the $5 and give me $2
of it. The characteristic of this
situation is that you have–what’s your advantage over
me in scamming me this way? Student: I keep the
tips. Prof: You keep the tips.
But how do you manage to get
away with it? If you called me up and said
I’m going to do this, I’d say you’re fired.
But you get away with it.
Student: You’re not
there. Prof: I’m not there.
You have the eyes and ears on
the scene, and I don’t. You’re the agent.
You have so-called information
asymmetry, you know a lot more than I do
about what you’re doing, and so the characteristic
problem for people trying to manage inside the box,
inside the firm, is to keep others for whom–
for whose achievements or malfeasance they’re
accountable– to keep them motivated and
honest. The role of ownership;
the sole proprietor runs the thing, simple as that.
they are all there except if you have the general partner,
but in general, say in a law firm they are all
involved, they will typically create an
executive committee and maybe a managing partner,
but pushed to shove in a disagreement about the firm,
they are all part of management. You make them that because they
are your assets. In a good law firm the real
assets are the lawyers. In the corporation the
ownership role is, as we saw a few minutes ago,
strongly attenuated. Now in actual fact there are
cases where stockholders rise up against management and throw the
board out and with a new board throw the management out.
It does happen, it’s just rare.
And it’s rare because the
transaction costs, just the time and effort
required to organize the shareholders,
is quite extreme. Stocks;
this is a 1998 tabulation of the percentage of U.S.
households by income strata,
higher in yellow and lowest in green, who directly or
indirectly own companies. The gist is just what you would
think it would be. You have a majority of people
with six figure incomes, and you’ve got to inflate a
little bit here from 1998 to now,
people with relatively high incomes are predominantly owners
of companies. The rate of ownership scales
down with income, which makes quite a lot
intuitive sense, but most of the stock is held
in very small parcels. And the putting together
of–forget a majority–putting together enough to be noticed,
which begins at about 5%, is a major task.
with a proprietorship, if you do a harm to someone
else, a tort ,as lawyers say; if you sell someone a
contaminated bottle of drinking water, they can sue you without
limit. If your proprietorship is worth
$100,000, and you’ve also got a home
worth $300,000, and savings worth another
$100,000 to make $500,000, they can go after all of that.
There is no protection against
lawsuits in the proprietorship form.
With partnerships things are as
bad or worse. Let’s suppose Tim here and I
are partners, and Tim for reasons known only
to himself, creates a catastrophic train
wreck on the line between New Haven and New York one day and
does it in the name of our proprietorship,
maybe we’re in the business of something for trains.
And I’m on vacation in Europe,
and Tim calls me up and says, “We’ve killed 110 people,
things are really a little bleak.”
My problem then,
of course I’m sorry for Tim, I’m sorry that Tim will suffer
from this; but I’m even sorrier about me
because the principle of joint and several liability applies to
partnerships so that the litigant can choose among the
partners and go after all the deepest pockets.
That is a really major flaw in
the ownership structure design from the individual point of
view. The most striking single thing
about the joint stock corporation is that it has
limited liability. By limited liability we mean if
you own 100 shares and they have a value of $7 a piece,
there’s $700 worth of capital, the most you can lose is that
$700 no matter what the firm does.
The firm could blow up the
Atlantic coast and your liability would be limited to
the $700 which would be, in effect, you can lose all of
your investment but you can’t do worse.
Now that’s a hell of a deal,
that’s an enormously attractive deal,
and if you think about the purpose of the joint stock
corporation it’s easy to understand.
It’s easy to understand because
we want people to make investments over something they
can’t control and can’t really see inside very clearly.
Now we will–I’ll ask you
before the term is over to have a look at a quarterly filing by
a company so you get to see about what investors can see.
If you can’t control it and
have no very powerful surveillance over its behavior
you wouldn’t want to invest in it unless you were granted
relief from liability, and that’s exactly the design.
There was 100 years ago a race
to the bottom among the American states in how generously they
treat corporations under the law.
The reigning champion among
American states for corporate law is Delaware.
Delaware corporations abound
everywhere, and in particular,
in places that aren’t Delaware or even close,
because these provisions are tightest from the corporate
point of view. Liquidity;
proprietorships are hard to sell.
In fact, often it’s impossible
to really get the value out of them when you sell them outside
the family. Often, in fact,
with say retailing, the value of the firm is
substantially the goodwill toward the owner the customers
have. When the owner sells it to
somebody else the value may go to zero,
although I was just–I had a boat in the marina on Lake
Champlain for a long time and I got tired and more tired of the
management of the marina; lazy, grasping,
unreliable, and I was talking to somebody on the phone
yesterday and they said, “You know there are new
owners up there,” and I thought:
Hazzah! I may take my boat back.
The proprietorship is a very
delicate creature. The partnership is worse.
Let’s suppose that all of us
are the partners of Wiggin & Dana law firm in New Haven.
We’re all partners,
except Morgan here, and Morgan is a brilliant
student just finishing the Yale school and I’m his advocate.
I say Morgan I’m going to make
you a partner. What do I have to do to make
that happen? In theory, there are ways to
shortcut this, but in theory I have to get the
consent of all of you. And then suppose I say,
“I’m tired and old and I want out.
I’m going to sell Jim Alexander
my partnership,” and Jim Alexander is generous
enough to offer me a large sum of money for that partnership.
Can I just send all of you a
memo about Jim now being a partner?
No, you’ve all got to approve
it. The illiquidity of the
partnership as a result is notorious.
The corporation is designed for
liquidity. You don’t even ever have to see
the physical stock certificates, they are just electronic bits.
The time it takes to sell
securities is that. And the transaction costs are
extremely low compared to the other two.
can we make this thing big or not?
The answer here is in data,
these are–can you read this from the back?
There are about 18 million
proprietorships in the country; a million and a third
partnerships, five million corporations,
and their average gross revenue per year are these numbers.
The standard story of a
proprietorship is the dry cleaner on the corner who makes
$1,000 a week and feels good about it.
These are actually gross
revenues not net. What that means is that the
actual take home may be pretty small.
The ratios are suggestive of
scalability. The joint stock corporation is
made to get big. There are several subtypes of
corporation, but probably the most profound
threshold for corporations is the public offering,
the initial public offering. When you take a firm from
private to public, that is when you,
for example, an S corporation is a very
private kind; you can only have 75
shareholders, you get some tax breaks,
but you can’t market your shares to a wide public.
When you go public–Jim you’ve
been through that, going public with a company,
is that right? Jim Alexander: Yes.
Prof: Is there a mic for
Jim? What’s the process?
This is Spinnaker Exploration.
You have to interest various investment bankers in
your, quote, story, unquote, as they call it.
You eventually choose a group
of people that you feel comfortable with and who feel
comfortable with you, you convert their analysts to
thinking you have good prospects,
you draw up a prospectus, which is both a selling,
and most importantly, a legal document describing–
ostensibly describing to the investors the principle risks
and potential returns of the investment.
You make sure that you have
what’s viewed as a good lawyer helping you with that,
a lawyer with a good reputation, make sure that you
have audited financials by a firm of the highest reputation,
and then eventually when the timing is right you go around
the country for several weeks talking to prospective
institutional investors because retail investors at most retail
firms won’t buy with the smart money,
which is deemed to be institutional,
it’s not buying. Typically you end up with a
group situation where maybe 20% to 40% of your company is sold
in the IPO, new money coming in which
typically pay down debt, and you end up with 200 to 500
shareholders whom you then have to keep happy,
at least for the first year or else bad things happen to you.
The gigantic corporation is the
most productive, not the most creative
necessarily, but the most productive player in the
economy. As you can see here,
nearly 90% of all the business done in the American economy is
done by corporations so that the–
an analysis of American capitalism or world capitalism
which neglects the joint stock corporation neglects the most
important player. We will be focused on those,
ones like the Pennsylvania Railroad here,
as we go forward.