The predominance of the capitalist-managed firm (henceforth KMF) over the labor-managed firm (henceforth LMF) is a striking feature of western economies, given Paul Samuelson’s (1957) equivalence between capital hiring labor or labor hiring capital. In an interview in Juncture (2014), Thomas Piketty claimed that revisiting property relationships and involving workers in the ownership and management of their company was complementary to other measures, such as a wealth tax in fighting rising levels of inequality. In a similar vein, Joseph Blasi, Richard Freeman, and Douglas Kruse (2013) argue in support of more profit sharing and employee ownership. Questions of equity and democracy aside, many authors (e.g., Bowles 2012; Kandel and Lazear 1992; Klein 1987; Kruse 1992) have put forth efficiency arguments for expanding democratic and return rights for employees. The inability to specify complete labor contracts gives rise to socially costly monitoring expenses faced by the KMF, unable to meet welfare enhancing combinations of higher pay and higher effort by its employees relative to the LMF (Bowles and Gintis 1993a).

Proponents of LMFs, however, face an analytical dilemma since, if the LMF is superior, then why does the LMF not thrive in a competitive environment (Dow 1993)? Moving beyond existing arguments on wealth and credit constraints or risk aversion on behalf of employees to explain the prevalence of the KMF over the LMF, we engage in a new argument put forth by Jason Schwartz (2012). The question of the largely absent LMF is not so much why LMF do not thrive in market economies, but why so few are started to begin with. In Schwartz’s (2012) account, the organizational form of an LMF is a public good, the benefits (among them, residual claimancy, job security, and participation in decision-making) of which are shared between workers. To explain the absence of LMFs, we should, first and foremost, study possible collective action problems in the start-up phase. We follow an institutionalist perspective, arguing that our economy is not the natural result of automatic market forces, but a product of collective action that shaped institutions and power relationships. Following William Dugger (1987, 92-93), the focus of institutionalism is on national, democratic planning that explains their reticence on worker ownership, despite the promise of more democratic decision-making at the work floor: “Separate worker ownership of the individual production facilities making up the interdependent and interrelated industrial system will not provide the needed overall coordination and planning … So if worker ownership/participation at the micro level, so to speak, were combined with some kind of democratically integrating and coordinating process at a higher level, institutionalists might be more supportive.” Our proposed instrument of start-up subsidies can be used as such a macro-economic tool that promotes worker ownership.

In this article, we set out to formalize and expand upon this insight, offering a game theory analytical framework to judge both whether and what kind of government intervention is desirable. In the first section, we contrast the LMF to the KMF, defining a firm in which both control and return rights rest with labor as in the LMF, while the same rights rest with the suppliers of equity finance or owners of its physical assets in the KMF. In the second section, we discuss a number of market failures in the KMF and the mechanisms through which the LMF may be able to overcome them. In the third section, we provide a short overview of existing explanations for the absence of LMF, and engage in the argument that the absence of LMFs is due to its organizational structure being a public good for the prospective workers. In the fourth section, we present this argument in an analytic framework using the extensive form from game theory. We discuss the policy implications in the fifth section. To address collective action problems in the start-up phase of the LMF, both standardization and start-up subsidies reduce the costs of setting-up LMFs and overcome the prevalent collective action problems.

Defining the LMF Along the Axes of Control and Return Rights

Gregory Dow and Louis Putterman (1996) define the organizational structure of a firm by asking the question: Which party controls the firm? In a pure KMF, control rests with the suppliers of equity finance or owners of its physical assets. By contrast, in the pure LMF, suppliers of non-managerial and managerial labor share formal control rights. Besides the right to control the use of an asset, there is also the right to the returns of the firm. According to Avner Ben-Ner and Derek Jones (1995, 532-533), on one hand, owning a firm means “determining the objectives of an organization, the positions people occupy, the functions of these positions, who occupies them and how their occupants are induced to carry out their functions’.”¹ On the other hand, it entails enjoying the “financial and physical payoffs generated from the operation of the organization … distributed as profits, wages, working conditions, or through output quality and price.” Beyond what they refer to as the “conventional firm,” which we label KMF, three major “shades of grey” exists: (i) firms that share profits, (ii) firms with employee-share ownership programs (ESOP), and (iii) firms organized as (producer) cooperatives (i.e., LMFs). Differences between firms in the same product market may exist when moving east or south in Table 1, yet as John Pencavel (2012) argues, there may be an argument for complementarity between both dimensions, suggesting that a south-eastern movement may affect the firm’s operation the most, as it is the interaction between both dimensions that matters. Control rights may thus be more effective on the performance of a firm if coupled with return rights, and vice versa.

An excellent and more thorough analysis of the differences in the legal structure of the conventional firm and a worker cooperative is provided by David Ellerman (1984), who distinguishes voting rights (control), profit rights (returns), and net-book value rights. Ellerman’s proposal is that voting rights and profit rights should be personal, non-marketable, and non-transferable — i.e., rights attached to membership gained through working in the cooperative — while net-book value rights are property rights. A worker who leaves the cooperative will lose his/her personal rights, but maintains his/her accumulated share in the net-book value of the cooperative. For instance, investments funded by retained net earnings are an implicit equity of the workers and increase the net-book value, registered in internal accounts, as done by the highly successful Mondragon cooperatives in Spain. Using this framework, Ellerman shows the main shortcomings of existing intermediate forms of ownership (some of them are listed in Table 1). In employee-owned firms, where voting rights are issued proportional to share ownership, the effect is that managers and other high earning employees have more voting power. Profit-sharing schemes and ESOPs also lead to unequal outcomes, where shares are distributed proportionally to pay and “ESOPs are usually established by corporate managers or owners interested in the tax benefits and not particularly interested in transferring any power or control to the employees” (Ellerman 1984, 886). This finding is corroborated in Patrick Rooney (1988), who found very low worker participation in (majority) employee-owned firms.

In the analysis that follows, we restrict ourselves to the two extremes in both corners: the LMF (with both full control and return rights for employees) and the KMF (with no control and return rights for employees). The LMF makes up only a small share of firms in western economies. Although figures differ across studies, largely because of different definitions,² Fathi Fakhfakh, Virginie Pérotin, and Mónica Gago (2009) report 1,900 worker cooperatives in France in 2008, representing only around 0.2 percent of all firms at that time. Cooperatives UK (2013) counted just 497 worker-owned cooperative businesses, with around 84,000 members (for firm entry of LMFs in the UK, see Podivinsky and Stewart 2007). Data for the United States show only 223 worker cooperatives with an average of eleven employees each, concentrated mainly in arts, media, and books industries (Artz and Kim 2011). Schwartz (2012) argues that this number is negligible, as in 2009 almost 553,000 new firms started their operations in the Unites States. Countries with relatively large cooperative sectors are Spain and Italy. Spain had 16,800 worker cooperatives in 2011 and nearly 80 percent of them were in the service and construction sector, covering roughly 200,000 worker members (CECOP 2012). Italy has around 31,400 production cooperatives in 2008 (Zanotti 2012), leading Europe in number and share of the cooperative worker sector. Overall, however, the picture is that the LMF is a marginal phenomenon.

Market Failures in the KMF

Although the KMF is the predominant organizational structure of firms throughout the western world, Samuel Bowles and Herbert Gintis (1993a) show that the KMF is troubled by a range of market failures and that, even under highly competitive conditions, the LMF may allocate resources more efficiently than the KMF. Market failures arise from the fact that exchange on the labor market is contested. Viewing labor contracts not as “solved political problems” (Bowles and Gintis 1993b, 86), but through the lens of contested exchange, gives rise to a number of market failures. Contrary to the costless enforcement of contracts in a Walrasian ideal-type market, in reality the terms of exchange in the labor market are endogenously determined by costly monitoring technologies and sanctioning mechanisms imposed by employers. To induce effort in employees, labor markets, for instance, depend on the contingent renewal of contracts — renewal being a function of effort exerted in the earlier period. Theoretically, the LMF faces different incentive structures that are better able to align labor time and labor effort, possibly overcoming many of the market failures present in the KMF. In this section, we provide an overview of market failures in the KMF and show how the LMF may overcome these, concluding with a short overview of empirical studies into productivity differences between both organizational forms.

In inducing effort, the capitalist entrepreneur is indifferent to expenditure on monitoring or on wages, concerned only with ensuring it is not possible to achieve further net gains in worker productivity through additional expenses on either instrument. Employees, on the other hand, will strongly prefer the use of the wage incentive because monitoring is socially costly, whereas higher wages entail just a redistribution of income from the employer to the employee. This market failure, in which the KMF uses “too many monitoring resources and not enough wage incentives” (Bowles and Gintis 1995, 574), is overcome in the LMF through the wage incentive effect. All other things being equal, to elicit the same work effort, the LMF will make more use of the wage incentive and less of the socially costly monitoring incentive.

Related to this market failure, monitoring technologies available to the LMF can be more effective compared to those in the KMF. While the KMF will usually resort to costly management control and all kinds of (electronic) monitoring devices, the LMF can rely more on mutual monitoring. Due to this mutual monitoring effect, the LMF benefits from an almost costless system of more “horizontal” monitoring, internalizing the positive externalities from individual decisions to cooperate in interdependent tasks (Kruse 1992, 25), reinforced by peer pressure as a more effective type of co-monitoring (Kandal and Lazear 1992). Horizontal monitoring may often be more effective than “vertical” monitoring in hierarchical organizations, possibly overcoming principal-agent type of incentive problems.

Another market failure arises when the KMF alienates workers from their job. The reasoning here is that lower worker motivation stems from the exclusion from decision-making and ownership of the fruits of one’s labor. The participation effect in an LMF is due to control rights for employees that affect company performance (Klein 1987, 320). Less alienation is experienced either because simply being an owner increases commitment and satisfaction, or because control rights increase worker commitment and thereby company performance. Likewise, Jon Pierce, Stephen Rubenfeld, and Susan Morgan (1991, 134) relate the employee ownership of a firm to motivation, which increases due to “the impact of ownership on instrumentality and expectancy perceptions, valence, cooperative behavior, work group norms, and peer pressure …, through experienced meaningfulness of work and experienced responsibility for work outcomes.” A related extrinsic productivity argument in the LMF concerns the residual claimancy effect, whereby effort increases as workers are aware that higher effort translates into higher profits which, in turn, are shared among employees in the LMF. Therefore, control and return rights in an LMF may increase worker commitment both through intrinsic and extrinsic mechanisms.

Bowles and Gintis (1993a) give two more examples of market failures that persist in the KMF. They show that there are Pareto-improving combinations of management pay and risk-taking which are not feasible given the manager’s degree of risk aversion if the residual claimant owner hires a manager more risk-averse than himself/herself. Furthermore, in their analysis of the principal-agent relationship between a lender and a borrower as a residual claimant, there are Pareto-improving combinations of interest rates and risk-taking that are not within reach of the KMF.

Other market failures, concerning the inability to specify complete labor contracts, relate to the hold-up problem. While the firm and the worker may be willing to invest in firm-specific assets before negotiating wages, the risk of being held up may discourage the investor from making these investments, leading to underinvestment in worker skills (Grout 1984; Tirole 1986). Douglas Kruse (1992) argues that the LMF may be able to overcome some of these hold-up problems in the KMF. Turnover may be lower in the LMF through identification with the firm or through valuation of the stronger link between compensation and work effort, thus making investment in firm-specific assets more likely. As Cecilia Navarra and Ermanno Tortia (2014) suggest, stronger employment stability in LMFs allows for greater wage flexibility compared to the KMF, where workers prefer rigid wages as they are less informed about the (potentially risky or opportunistic) investment decisions of the employer that may underlie arguments for cuts in labor costs. This latter job security argument is also evoked in a different argument, claiming that outsider-shareholders, when maximizing their income, will be eager to sell their shares at above-market prices in case of a takeover, whereas employee-shareholders have a more longrun perspective, taking into account their own employment, especially when they consider the takeover as hostile. Finally, efficiency may also improve if employees in the LMF are more willing to share information, increasing operational productivity and easing innovation. Furthermore, technical change may be welcomed among employees in an LMF, as technological change will be a major driver of labor income in the LMF compared to the KMF in which it may pose a threat to existing jobs.

A large body of literature has empirically tested the hypothesized advantages of the LMF over the KMF, most recently by Blasi, Freeman, and Kruse (2013, ch. 5) for the USA. Certain studies focus on the effects of different combinations of control or return rights within KMFs (see Table 1), seeking to find out whether these configurations influence firm performance. Michael Conte and Jan Svejnar (1988) show that a large and positive productivity effect exists through participation in decision-making, with moderate levels of indirect worker ownership positively affecting productivity. José Bayo-Moriones, Pedro Gailea-Salvatierra, and Javier Merino-Díaz de Cerio (2003) find no significant performance differences between the LMF and KMF in Spanish manufacturing, yet show that introducing participation rights generates positive outcomes both for the LMF and KMF. Fakhfakh, Pérotin and Gago (2012) demonstrate that French labor-managed firms are as (or even more) productive than their capitalist counterparts, using inputs more efficiently. If a KMF were to transform to an LMF, using the latter’s industry-specific technologies production would be likely to increase. However, even if most studies would report favorable outcomes for the LMF compared to KMF, they still face the problem relating to the few observations for LMFs relative to the ubiquity of KMFs in the same sectors. Before one can measure the performance of LMFs relative to KMFs, it is necessary to investigate why, among the many new firms started each year, so few LMFs are launched.

What Inhibits the Emergence of LMFs?

If employees in the LMF use more effective monitoring technologies, are more involved in their firm (either as co-owner of the firm, or being aware that higher effort will translate into higher profits to be shared in the firm), and LMFs spend less on monitoring and more on wages, then we would expect LMFs to thrive in a competitive environment. The very low incidence of LMF in western economies, however, have led authors to doubt the blessings of the LMF. A large body of literature has offered a multiplicity of accounts of why LMFs fail. Gregory Dow (2001) categorizes these explanations along five major lines: (i) asset ownership, claiming workers have weak incentives to maintain rented assets in their LMFs; (ii) work incentives, claiming that, as effort in a team is largely unobservable, vertical monitoring will be more effective; (iii) wealth and credit rationing, claiming workers tend to be poor and face adverse selection problems on the market for credit; (iv) risk aversion, claiming workers are generally more risk averse than investors; and finally (v) collective choice, arguing workers in a democratic firm will have problems reaching collective decisions. Paul Susman and Geoffrey Schneider (2008) argue that LMFs fail due to institutional barriers, both domestic and international. Preferential domestic treatment of multinational corporations and international trade agreements that favor non-cooperative firms may give KMFs comparative institutional advantages that are not easily accessible to LMFs.

With the exception of the wealth and credit rationing argument and the institutional argument, all of the above arguments follow a “Panglossian” logic, asserting that “that what is, must be optimal” (George 1997). As Schwartz (2012) argues, explanations of the absence of the LMF revolving around these arguments hold that, even given market failures in the KMF, LMFs perform even worse. The first question to be answered is rather why so few LMFs are started to begin with. Given 553,000 new firms in the United States in 2009 — of which a large fraction will undoubtedly fail — only a handful at most are started as worker cooperatives, so what explains why so few LMFs are formed?

Among the arguments defying such a Panglossian logic, Bowles and Gintis (1993a) discuss the largely absent LMF by posing three constraints on its operation. First, a democratic capacity constraint inhibits new LMFs from forming, claiming workers are not attuned to democratic rule of the firm and face high costs on learning how to govern the firm democratically, preventing a workforce from becoming experienced with democratic management. In the same vein, Donald A.R. George (1997) argues that economic theory departs from an exogenous preference structure, while preferences about the organization of the work place may be endogenous, shaped by experiences. Louis Putterman (1993, 130) similarly speaks of endogeneity of preferences, claiming that “the desire [for control rights] may be non-existent or weak if workers are socialized into the expectation of subordination on the job and are conditioned to viewing work as an acceptable sacrifice making possible increased consumption during leisure time.” Second, Bowles and Gintis pose an economic environment constraint, where path dependency in an economy with many (few) LMFs increases the likelihood of more (fewer) LMFs to start. Once a “critical mass” of LMFs in an economy is reached, one may expect new ones to form more easily. Third, akin to Dow’s wealth and credit rationing argument, the wealth inequality constraint claims that workers are often asset-poor and unable to borrow large sums to purchase firm stock with limited collateral (if any). Furthermore, while the worker in a KMF can diversify his/her assets, and thereby risk, the employee of an LMF concentrates both his/her returns from work and savings in a single asset. Uncertainty about the returns and prospects for the firm may prevent a risk-averse worker from sharing in its ownership.

Schwartz (2012, 266) dismisses the wealth inequality constraint by stating that there is no “evident reason that they [LFM] are less creditworthy than capital-managed firms,” as past examples have shown incidences of self-financed takeovers by workers (e.g., United Airlines), while (union) pension funds may have assets exceeding the value of firms employing these (union) workers. As pension funds manage deferred wages of workers, trade unions might consider using pension fund money to buy capital shares (hence decision-making) in companies on behalf of the workers.

While the LMF may outperform the KMF, in its core, “a labor-managed firm is a public good” (Schwartz 2012, 267) that faces collective action problems inhibiting its emergence and giving rise to free-riding behavior. Schwartz describes the collective action problem of starting an LMF as follows:

Due to the public-good nature of its organizational structure, each has the “incentive to contribute less than or none of the share required to generate the optimal amount of the good on the pattern of an n-person prisoner’s dilemma” (Schwartz 2012, 283). In Schwartz’s account, in line with Bowles and Gintis’s economic environment constraint, this collective action problem is both reinforced and exacerbated by unfamiliarity with LMFs by workers and investors:

This final argument we apply in the section that follows in order to analyze why so few LMFs are started. We present this argument in an analytical framework that enables us to formulate policy proposals for addressing these specific collective action problems in the start-up phase of the LMF.

The Collective Action Problem in Starting an LMF

We interpret the governance of an LMF as a public good or club good, with higher job security, participation in decision-making and shared residual claimancy as benefits for workers. In the case of pure public goods, whereby exclusion is by definition not possible, the resulting Cournot-Nash equilibrium in which individual contributions are conditional upon others’ contributions is characterized by under-provision. However, in our case, exclusion is feasible, likening the provision of governance to the provision of a club good. As the supposed benefits of the LMF accrue only to those workers subscribing to the LMF, public economics literature claims that such club goods generally face no market failures when compared to some of the collective action problems prevalent in the provision of pure public goods. Indeed, early theories on club goods (especially Buchanan 1965) viewed these as types of cooperatives that “coordinated action by members to maximize the welfare of the group” (Sandler and Tschirhart 1997).

In so far as handbooks of public economics literature deal with the process of setting up a club good (see Hindriks and Myles 2013, ch. 7), they assume that there is a profit maximizing entrepreneur who starts a firm and demands fees (a fixed membership fee or a two-part tariff with additional user fees) of clients to make use of the facilities (e.g., a fitness center). Our question enters the point where the entrepreneur decides whether to organize such a club along the lines of an LMF or to start a conventional KMF. Vicky Barham et al. (1997) show that in a decentralized process without the assumption of coordination (i.e., without an entrepreneurial agent), any ad hoc club formation process would give rise to multiple equilibria, taking the form of a so-called coordination game. Such coordination problems may hinder voluntary participation in setting up a club good. Workers may be able to realize mutual gains by forming an LMF, but only by making mutually consistent choices. Free-riding on the contributions of others (Olson 1965), or hold-ups because actors await others to take the lead, may give rise to inaction.

Using a payoff matrix, we will specify the constraints on starting an LMF. We assume that the coordination game, resulting from the voluntary nature of starting the LMF, can only be overcome by a single or small subset of entrepreneurial workers, taking it upon themselves to form an LMF by coming to a mutually satisfactory agreement about how to set up and manage a business.³ For any prospective entrepreneur, however, we must first ask the question: Why this entrepreneur would not set up a KMF instead and capture the full returns to entrepreneurship instead of sharing them with fellow workers (Figure 1)? If the entrepreneur has reasons to prefer the LMF above a KMF, in a subsequent second stage, the prospective members must prefer to join the LMF above an outside wage offer.

We make use of a highly stylized payoff matrix, as used in game theory where players can either cooperate (C) or defect (D), with either a KMF entrepreneur/owner who employs L workers, or an entrepreneur who forms an LMF with L workers joining as members (see Table 2). So among the L+1 persons, there is at least one entrepreneurial type who is the natural candidate to take the lead, either to start a KMF or an LMF. We abstract from capital or assume that, in the short run, capital is fixed. Table 2 presents the payoff matrix.

There is a cost F to start or set up a firm, differentiated by type of firm, which can be either an LMF (superscript L) or a conventional KMF (superscript K). These start or set-up cost can be interpreted broadly, not primarily in monetary expenditures, but mostly in (over)time not being compensated in terms of money or the monetary equivalent of worries and psychological cost to set up a new business. Profits are given by π, again differentiated for the LMF and KMF. Profits in an LMF (π^L) are shared equally among members, where it must be taken into account that, instead of wages, as in the KMF, the income of members of the LMF is their equal share in the profits. Of course, the decision of E is influenced by the choice of L to defect or cooperate, and vice versa. A Nash equilibrium is obtained if both decisions are mutually compatible. In other words, if E cooperates, then L defects, and if L defects, then E cooperates. A dominant strategy arises when one choice is better than another for one player, no matter the choice made by the other. Figure 1 translates the payoff matrix of Table 2 into the extensive form representation of the game. The extensive game form allows for deriving the conditions under which an equilibrium outcome is likely to evolve.

The Labor-Managed Firm: Permanent or Start-Up Subsidies?

All authors

Loek Groot & Daan van der Linde

https://doi.org/10.1080/00213624.2017.1391592

Published online:

21 December 2017

Figure 1. Extensive Form, Entrepreneur (E) Moves First

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Our point of departure is the collective action problem highlighted by Schwartz (2012): namely, the failure of workers deciding collectively to start up a new LMF or to turn the existing KMF into an LMF. We will show that when there is an entrepreneurial agent prepared to launch an LMF, the best strategy for the workers is to defect in the start-up phase. Backward induction allows us to find the subgame perfect Nash equilibrium. As it is natural to assume E to be the first mover, we first ask what L would do, conditional upon cooperation or defection by E. Anticipating L’s conditional choices, E will determine his/her best strategy. Throughout, we assume the participation of an entrepreneurial agent to be essential for the emergence of the LMF, implying that with the defection of E, the formation of an LMF would suffer from a coordination game, as explained above. We, therefore, rule out the possibility of emergence of an LMF in which L cooperates, while E defects.

Figure 1 depicts E as the first mover. By backward induction, E will choose his/her optimal strategy, depending on the choices of L in the second stage. If E chooses to cooperate, L will choose to defect because c is always higher than a₂. If E defects, then the emergence of an LMF is ruled out, so L is forced to defect. Therefore, if the entrepreneur is the first mover, to defect is a dominant strategy for the workers. Backward induction now implies that E anticipates that L will defect and will choose to start an LMF only if b≥e is met, which we will label as the LMF constraint (LMFC):

From an efficiency point of view, the LMF constraint turns out to be unduly stringent on the proliferation of LMFs (see Figure 2). Summarizing, if E cooperates, L will defect since for L to defect is a dominant strategy, and if L defects, E will cooperate only if the LMF constraint is met. So (E cooperates, L defect) is a Nash equilibrium subject only to the LMF constraint. We now turn to determining whether the emergence of LFMs are (in)efficient. The added value V̄ per capita in the LMF and KMF can be defined as:

The Labor-Managed Firm: Permanent or Start-Up Subsidies?

All authors

Loek Groot & Daan van der Linde

https://doi.org/10.1080/00213624.2017.1391592

Published online:

21 December 2017

Figure 2. The LMFC and EC

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The efficiency condition (EC) for the LMF requires V̄^L>V̄K, or in terms of profits of the LMF:

In other words, the efficiency condition (EC) states that profits of the LMF must, at least, be as high as the KMF’s profits, the difference in start-up costs, and the wage bill of the KMF.

Figure 2 graphically presents the LMF constraint (LMFC), with a slope of L +1, and the efficiency condition, with a slope of 1. The shaded area above EC and below LMFC shows that possibly efficient LMFs exist that are not formed due to the LMF constraint not being met. The intersection point (W-(F^L-F^K),(L+1)W) can be derived by equating the right-hand side (RHS) of EC to LMFC. To the left of the vertical line through the intersection point, the LMF constraint is too lax since firms that do not pass EC might still pass the LMF entrepreneurial constraint. In case of normal profits in KMFs, so π^K≥W+F^K, the area left of the vertical line at π^K=W+F^K can be disregarded. The market failure of the non-emergence of LMF, despite being more efficient, is represented by the shaded area in between the lines EC and LMFC and the vertical line. To give a numerical example, for W =10; L=5; F^K=10; F^L=15; π^K=26; π^L;=153, EC is passed with flying colors (or in terms of added value per capita, V̄^K=11 and V̄^L=23), but the LMF constraint is still not met (the payoff for the LMF entrepreneur (π^L/(L+l))-F^L=10.5, while for the KMF entrepreneur it is (π^K−F^L=16).

Before we go on to consider the role of start-up subsidies in alleviating the collective action problem, note that this simple framework can easily accommodate some salient empirical findings concerning LMFs. First, many real world LMFs predominantly emerged from employee buyouts of a KMF in financial dire straits (notable examples include Weirton Steel in the United States and Tower Colliery in Scotland). In terms of LMFC, this causes π^K to be low or even negative. If, for simplicity, we assume a single time period, π^K also represent the net present value of a KMF. If this term becomes zero, the LMFC results in:

In other words, the earnings of the entrepreneur in an LMF only have to be high enough to compensate for the extra start-up costs (and be higher than W), with F^L the start-up cost to transform the firm into an LMF and F^K the start-up cost of a new KMF. Graphically, this corresponds to a point on the y-axis above the point of intersection of LMFC and the y-axis. If the net revenues of the new LMF are insufficient to make up for the difference in start-up cost and to pay members the going “wage” W, it does not meet the EC condition and bankruptcy is to be preferred.

Second, some historical examples of LMFs are shown to be initiated by spiritually inspired entrepreneurs, of which the founder of the Mondragon cooperatives, priest José María Arizmendiarrieta, serves as the paradigmatic example. In terms of our framework, although LMFC is binding in a non-spiritual sense, it may not be relevant for the spiritual leader (to include this effect requires the use of utility functions which take into account warm-glow considerations) (Andreoni 1990). It corresponds to a lower experienced F^L, which causes a downward shift of LMFC, thus increasing the likelihood that an LMF is formed.

Finally, conditions are relaxed as soon E is comprised of two or more individuals (so in the cooperative row for E, F^L is shared by the number of E), which is in line with the observation that many LMFs are initiated by a couple or a trio as a subset of the new partnership. In terms of LMFC, varying E and assuming the total number remains fixed to L +1:

Thus, the slope of LMFC’ (the dashed line in Figure 2) is equal to LMFC, but the intercept might become negative (if F^K>F^L/F), which increases the probability of the emergence of inefficient LMFs. Intuitively, the cooperating founders are sharing the burden F^L, but the new LMF is not generating enough benefits to pay all members the going wage W and to compensate for the higher start-up costs. Interestingly, it is easy to derive the required number for E such that line LMFC’ intersects the EC line exactly at the point (W+F^K, (L+1)W+F^L) by equating the RHS of EC and LMFC’, to impose π^K=W+F^K, and to solve for E, which gives E =L+1. So, only when all workers are prepared to shoulder the start-up cost of the LMF, giving rise to the fully cooperative LMF+ in Figure 1, then just at the long-run equilibrium where JT π^K=W+F^K, the entrepreneurial LMF constraint is not more binding than the efficiency constraint. However, the extensive game form where the entrepreneur is the first mover has shown that to defect is a dominant strategy for L, so the outcome that all prospective members of the LMF will join right from the beginning is highly unlikely. Therefore, we turn to the instrument of start-up subsidies to address the problem of non-emerging LMFs, despite their being more efficient than KMFs.

Start-Up Subsidies

We proceed by considering the role of a start-up subsidy for the LMF. Obviously, granting subsidies without any conditions with respect to real participation in the start-up of the LMF will further strengthen free-riding incentives, because one’s share in the subsidy can be cashed in while free-riding. We, therefore, assume that the subsidy is shared only among those who are involved in setting up the LMF, which may either be only E, or E and L together, again excluding the emergence of LMFs without the involvement of E As with the start-up cost, the term “subsidy” has to be interpreted broadly, so not only (over)time being compensated in terms of money, but also the free or subsidized provision of services in the form of expertise, provision of standardized forms to start an LMF, legal help and council – in sum, anything that might help or ease the start-up of an LMF.⁴ We first analyze the case where the subsidy S is a fixed sum.

As Table 3 shows, the subsidy changes the payoffs. The interesting question is to what extent the subsidy relaxes the LMF constraint and how high the subsidy should be (or, if S is variable, what form it should take)? For notational convenience, we use the subscript S in the conditions for the subsidized case. As a reminder, the outcome of the unsubsidized case was that the Nash equilibrium of L defects and E cooperates holds if the LMF constraint is met, otherwise the status quo of the KMF is maintained.

To achieve a level-playing field, suppose the subsidy is pitched at the difference in start-up cost of an LMF and a KMF, so that S=F^L–F^K. Using the payoff matrix of Table 3, to defect is still the dominant strategy for L (if E cooperates, L defects because c>a₂ and if E defects, L defects because we ruled out the emergence of an LMF without entrepreneurial input). Again, anticipating defection by L, E will start the LMF only if the subsidized LMF constraint is met:

Substitution of S=F^L−F^K into the RHS gives π^L≥(L+1)π^K, which compared to the original LMF constraint π^L≥(L+1)[π^K+(F^L−F^K)] implies a relaxation on required LMF profits of (L+l) times the subsidy S. Graphically, the LMFC line shifts down and now runs through the origin, again with a slope of L+1. By equating the RHS of LMFC_S and EC, the intersection point occurs at π^K=W+(F^L−F^K)/L, which is in between π^K=W and π^K=W+F^K. So, at the long-run equilibrium where π^K=W+F^K, the subsidized LMF constraint is still more binding than EC. Naturally, an even higher subsidy further relaxes the LMF constraint (shifting it further downwards), but at the same time increases the danger of emergence of inefficient LMFs. This leads to the question: What must be the level of S, such that the subsidized LMF constraint and EC intersect exactly at the long-run equilibrium where π^K=W+F^K? Inserting π^K=W+F^K into LMFC_S and EC and solving for S gives the firm-size subsidy S^L=LF^L/(L+1), so that the larger the LMF firm, the closer the required subsidy is to the full start-up costs F. Note that for S≥F, the full cooperative LMF⁺ (so both E and but the LMF constraint is still not met cooperate) is ensured if EC is met. Intuitively, the subsidy is now so high, given that the subsidy is targeted to those who join in the start-up stage, that L (because a₂≥C) also wants to join the LMF right from the start-up phase. The disadvantage is the emergence of inefficient LMFs, which is more likely to happen if in the relevant range around π^K=W+F^K the LMFC_S line is below the EC line.

Finally, when an LMF is at least as efficient as a KMF, is there a subsidy that incentivizes the entrepreneur to start an LMF, irrespective ofL to cooperate or defect? This requires devising a subsidy that sets the efficiency condition EC equal to LMFC_S :

Solving for S* gives:

The information required to provide this subsidy is not only the firm size and the start-up costs of an LMF as in the firm-size subsidy S^L above, but also the profits in a KMF, the wages paid in a KMF and the start-up costs of a KMF. Using more information, if available, allows for a more efficient subsidy. Note that in the competitive long-run equilibrium, with π^K=W+F^K, S*=S^L.⁵ As Figure 2 shows, the provision of subsidies helps the formation of LMFs that are more efficient than KMF, for example, for firms where π^K=W+F^K the subsidy eliminates the collective action problem and causes a new LMF to emerge. However, in the area where π^K<W+F^K and (L+1)W+F^L<π^L<(L+1)(W+FL), the subsidy can lead to the emergence of inefficient LMFs — that is, where due to the subsidy the LMFC_s constraint is passed, but not the EC constraint. Using our numerical example, for S*=S^L=12.5 and W=10; L=5; F^K=10; F^L=15; ΠK=15, for the rangeπ^L=(45; 75), the LMFC_S is met, but not EC.

Justifying Start-Up Subsidies for LMFs

If market failures prevail in the KMF and are serious enough, while the LMF has properties that may be conducive to attenuate or solve them, there is an argument for public intervention. We have elaborated on a major problem of LMFs: namely, that it is plagued by a collective action problem in the start-up phase that can be solved by providing a start-up subsidy. As the burden of proof is on the side of LMF proponents, we present a more general argument to support our claim that government intervention, if any, should concentrate on providing subsidies to help start up new LMFs. Following James Meade (1972), we relate these arguments to the observation that LMFs will respond differently to exogenous (demand) shocks than KMFs.

A major difference between an LMF and a KMF relates to shocks in demand for their output. While higher demand results in expanding employment in KMFs, it reduces employment in the LMF (the so-called Illyrian firm, or the firm that is assumed to maximize income per worker;⁶ see Ohnishi 2012), coupled with higher average earnings (Meade 1972, 407-408). A KMF, located in an industry with increasing demand and so a higher product price, will attract more workers at the prevailing wage level W up until the point that the marginal product of labor is again equal to W.⁷ An LMF, situated in the same industry, will not have an incentive to expand employment because the rise in the marginal product of labor will be less than the rise in average earnings of its members. This insight is empirically corroborated by Gabriel Burdin and Andres Dean (2009) as well as John Pencavel (2014). A KMF system can thus rely more on expansion and contraction within existing firms, while an LMF system must rely more on the free entry of new firms. These same mechanisms are at work if competition is monopolistic. Meade (1972, 411) notes the importance of free entry by arguing that “in the co-operative system this situation is ultimately restored only by the free entry of new firms into any industry which has become exceptionally lucrative as a result of a rise in its selling prices. It is thus clear that the competitive pressures of free entry play a much more important role in a cooperative than they do in an entrepreneurial system.”

Conclusion and Discussion

While standard neoclassical economic theory assert indifference between capital hiring labor and labor hiring capital, the majority of firms in western economies are organized along a structure of control and return rights held by equity finance or owners of its physical assets. We showed that, in an economy characterized by contested exchange, this type of organization faces a number of market failures where firms, in which control and return rights reside with labor, may be more efficient. We presented a number of standing arguments that explain the absence of LMFs, yet argue that, before studying why LMFs may fail in the economy, we should ask the question: Why so few LMFs are started to begin with? We followed Schwartz’s (2012) argument that the LMF constitutes a public good or club good (if excludable to its members) and faces severe collective action problems in its start-up phase, inhibiting its emergence. By exploring this notion in a game theoretical framework, we were able to explain some salient features of existing LMFs and contribute to understanding of why so few LMFs are started.

Arguing from an efficiency perspective, public intervention is desirable. We argued that government intervention should aim at the start-up phase of LMFs. Governments may either actively subsidize LMFs in the form of monetary payments to initiators of these cooperatives, or may seek to lower the nonmonetary entry barriers for LMF firms by providing standardized forms, legal counselling, and other in-kind services. We noted the importance of free entry of firms in an economy for many LMFs and concluded that subsidies may be able to relax constraints and induce cooperation.

Ultimately, one may ask why the start-up of an LMF has to be subsidized, but not a KMF in the same sector. This is indeed a legitimate question and the burden of proof here resides on the side of proponents of the subsidy. In particular, they have to show that the market failures inherent in some types of KMF and efficiency and other gains of the LMF are such that these subsidies are justified. Meade (1972, 927) claims that “it may well be the case that the merits of participation should be so highly prized as to make the encouragement of such institutions a major objective of governmental policy.” Furthermore, LMF subsidies may only be warranted in those sectors of the economy where the case can be convincingly made that LMFs are more productive than their capitalist counterparts. We do expect that, even with a full-blown subsidy scheme, not all new firms will be LMFs. An innovative entrepreneur with a highly profitable business plan would be wise to start a KMF rather than an LMF since in the former he/she is the only residual claimant of (monopolistic) profits, while in the latter the value of the innovation has to be shared. For many other business, where normal profits are expected, an LMF above a KMF is to be preferred if the efficiency constraint can be met. An avenue for further research is to investigate the political, cultural, and institutional conditions required to launch a full-fledged system of subsidies for LMFs.