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2018 | OriginalPaper | Buchkapitel

3. Marketing Ability, Personal Wealth, and Capital-Hiring-Labour

verfasst von : Weiying Zhang

Erschienen in: The Origin of the Capitalist Firm

Verlag: Springer Singapore

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Abstract

The purpose of Chap. 2 was to demonstrate the optimal assignment of principalship between the marketing member and the producing member. It has been shown that assigning principalship to the marketing member is optimal because marketing activities dominate uncertainty, and because the marketing member’s behaviour is more difficult to monitor. This provides a rationale for the asymmetric relationship within the firm between the entrepreneur (or management) and workers; that is, the former holds authority over the latter and the latter agree to obey that authority within some limits.

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Vorheriges Kapitel Marketing, Producing, Monitoring and the Assignment of Principalship

Nächstes Kapitel A General Equilibrium Entrepreneurial Model of the Firm

The argument will be strengthened rather than weakened if it takes physical forms.

We shall assume that \(\theta \) is drawn from a common distribution which is known to all individuals in the economy.

“Capitalist” is loosely used in the text since we assume that personal wealth is continously distributed between zero and a large amount. The reader can easily understand its different meaning in the different context.

This assumption can be replaced by a riskless interest rate.

In reality, for some occupations such as lawyer, teacher, medical doctor and so on, a certificate is needed; but for entrepreneur, it is not. We conjecture that the reason for this difference is that entrepreneurial ability is much more difficult to observe than other ability.

Note that although we use the term “perfect capital market”, we exclude consumption borrowing.

Non-negative consumption can be replaced with minimum subsistence without affecting the argument. In addition, the analysis can be carried over to limited liability by replacing the total wealth with equity share (one may like to call ULNGC itself “limited liability”.).

This might be the source of the long-running debate over what the profit is.

Limited liability is the underlying assumption of most agency-type models on capital markets; e.g., see Stiglitz and Weiss (1981) credit-rationing model, Eswaran and Kotwal (1989) capital-hiring-labour model, among others.

A passive capitalist does not need to lend capital and sell labour to the same entrepreneur.

In an earlier version of this chapter, we modelled both the labour market (the choice of workers) and the capital market (the choice of lenders). We found the marginal benefit of modeling more than one is little more than making the description more like reality.

Therefore they do not care about which entrepreneur they should match with. Alternatively, we can assume that the lowest return of the firm (in the worst state) is not less than labour cost.

The assumption of the wage being paid prior to production is equivalent to workers delegating their choice of match to passive capitalists. In reality, workers normally have priority when the entrepreneur cannot pay all contractual payments, even if they are paid at the end of the period. An interesting question is why workers have priority in most cases.

It is convenient to refer to K simply as “capital”. If k is physical investment, w is wage per worker and l is the number of workers, \( K=k+wl. \) We implicitly assume that the entrepreneur always chooses an optimal combination of k and l. In addition, K can be a variable.

Zero return can be replaced by a positive return as long as it is smaller than the total cost.

Recall that we have normalized marketing ability to be distributed between zero and one.

In the following analysis, we normalize wage to zero for convenience.

In the literature, the assumption is called “maximum equity participation” (MEP) (e.g., Gale and Hellwig 1985).

We assume that \(\delta _K\) is big enough that the individual prefers to lend out his asset rather than hold it when he chooses to be a worker. If this is not the case, we replace \(\delta _K(1+r)\) with 1.

Here we assume that the individual faces the same expected probability of success of the potential borrowers regardless of whether he is lending out excess funds (when he himself is also an entrepreneur) or lending out all funds (when he chooses to be a worker).

One may like to argue that the distribution of ability and the distribution of personal wealth is positively correlated either because of dynamic effects (today’s wealthy people are yesterday’s successful businessmen) or because the wealthier people have better opportunities for good education. If this is the case, wealth itself signals ability.

Since \(\theta ^{*}\) is dependent on \(\delta _K\), an outsider must base his judgment of an would-be entrepreneur’s \(\theta ^{*}\) on the \(\delta _K\) in the latter’s expectation (that is, to know person A’s \(\theta ^{*}\), an outsider has to know A’s expectation of his potential borrower’s probability of success if he chooses to be a worker). But given that the only available information is personal wealth, rational expectations imply that the outsider will hold the same expectation of all would-be entrepreneurs’ \( \delta _K\)s. In the following, we shall make this assumption.

These would-be entrepreneurs do not depend on external funds, and are “selected” by workers.

In the following analysis, for concreteness, we assume that marketing ability is uniformly distributed among population.

In the previous analysis, we have implicitly assumed the existence of these groups; otherwise, we should replace \(\delta _K(1+r)\) with 1. Since we have assumed that workers are paid before production, we shall not make a distinction mathematically between the second and the third groups.

The following arguments about changes in the interest rate also apply to changes in wages.

In the present model, this upper-bound is an interest rate \(\overline{r}\) (or wage \(\overline{w}\)) at which only those with the highest marketing ability \((\theta =1)\) can be indifferent between being entrepreneurs and being workers and all others strictly prefer being workers, that is, \( f(K, L)-(1+\overline{r})(K-W_0)-\overline{w}L-\overline{w}\equiv 0\). This requirement is too strong to hold in reality.

Since, given capital investment, one’s demand for borrowing is decreasing with initial personal wealth, this means the interest rate charged to a borrower is an increasing function of the borrowing amount.

Technically we shall assume that the particular individual’s expected return on lending and expected wage from being a passive capitalist worker are given.

The Stiglitz–Weiss model is based on asymmetric information between borrowers and lenders about the risk quality of investment projects. They argue that because of the adverse selection problem and the moral hazard problem, the investment projects become riskier as the interest rate increases; and hence an increase in the interest rate may decrease rather than increase the total expected return to lenders (under limited liability). This provides the incentive for the lenders to ration credit rather than raise the interest rate when there is an excess demand for loanable funds.

The argument is as follows. The probability of default is a decreasing function of the entrepreneur’s work effort. Since an increase in the interest rate not only decreases the range of realization of states over which the entrepreneur is the residual claimant, but also decreases his marginal return in that range, the entrepreneur will work less hard following the interest rate increase. As a result, the probability of default increases. For the lender, this effect may more than offset the direct increases of return when good states occur.

In fact, these two arguments can be incorporated into our model simply by assuming that the distribution funtion \(\Psi (y)\) of the return is a function of marketing ability \(\theta \), work effort a as well as a parameter of riskness \(\alpha \): \(\Psi (y;\theta , a,\alpha )\). If we assume that \(\Psi (.)\) satisfies the first-order stochastic condition over \(\theta \) and a, and \(\alpha \) is the mean-preserving parameter (that is, a higher \( \alpha \) represents higher riskness), we can show that: (i) the critical marketing ability is an increasing function of \(W_0\), r; (ii) the optimal effort is increasing with \(W_0\), but decreasing with r (given marginal disutility of effort increases); (iii) the choice of \(\alpha \) increases in r.

In the two-state case, this simply means that the probability of success is increasing with marketing ability.

The effect on the probability of bankruptcy of higher debt has already been taken into account by the lenders.

Theoretically credit-rationing can be interpreted as that the borrower has to pay an extremely high interest rate so that even if the best state occurs, the return cannot cover the cost.

We have assumed that they are independent.

e.g., see Ross (1977), Grossman and Hart (1982), Diamond (1984) and Gale and Hellwig (1985).

Of course, a death sentence in case of bankruptcy could be helpful in preventing low ability people from being entrepreneurs!

Titel: Marketing Ability, Personal Wealth, and Capital-Hiring-Labour
verfasst von: Weiying Zhang
Verlag: Springer Singapore
Buch: The Origin of the Capitalist Firm
Print ISBN: 978-981-10-0220-5

Electronic ISBN: 978-981-10-0221-2

Copyright-Jahr: 2018
DOI: https://doi.org/10.1007/978-981-10-0221-2_3