This is “Types of Firms”, section 9.1 from the book Beginning Economic Analysis (v. 1.0).
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There are four varieties of firms created in law, although these types have several subtypes. At one end is the proprietorshipA firm is owned by a single individual (the proprietor) or a family., which is a firm owned by a single individual (the proprietor) or perhaps by a family. The family farm and many “mom-and-pop” restaurants and convenience stores are operated proprietorships. Debts accrued by the proprietorship are the personal responsibility of the proprietor. Legal and accounting firms are often organized as partnershipsFirms owned by several individuals who share profits as well as liabilities of the firm according to a specified formula that varies by the relative contribution and potential cost of each partner.. Partnerships are firms owned by several individuals who share profits as well as liabilities of the firm according to a specified formula that varies by the relative contribution and potential cost of each partner in the firm. Thus, if a partner in a law firm steals a client’s money and disappears, the other partners may be responsible for absorbing some portion of the loss. In contrast, a corporationA single entity owned by shareholders. is treated legally as a single entity owned by shareholders. Like a person, a corporation can incur debt and is therefore responsible for repayment. This stands in contrast to a partnership where particular individuals may be liable for debts incurred. Hence, when the energy trader company Enron collapsed, the Enron shareholders lost the value of their stock; however, they were not responsible for repaying the debt that the corporation had incurred. Moreover, company executives are also not financially responsible for debts of the corporation, provided they act prudentially. If a meteor strikes a manufacturer and destroys the corporation, the executives are not responsible for the damage or for the loans that may not be repaid as a result. On the other hand, executives are not permitted to break the law, as was the case with corporate officers at Archer Daniels Midland, the large agricultural firm who colluded to fix the price of lysine and were subsequently fined and jailed for their misdeeds, as was the corporation.
Corporations who shield company executives and shareholders from fines and punishments are said to offer “limited liability.” So why would anyone in his or her right mind organize a firm as a proprietorship or a partnership? The explanation is that it is costly to incorporate businesses—about $1,000 per year at the time of this writing—and corporations are taxed, so that many small businesses find it less costly to be organized as proprietorships. Moreover, it may not be possible for a family-owned corporation to borrow money to open a restaurant; for example, potential lenders may fear not being repaid in the event of bankruptcy, so they insist that owners accept some personal liability. So why are professional groups organized as partnerships and not as corporations? The short answer is that a large variety of hybrid, organizational forms exist instead. The distinctions are blurred, and organizations like “Chapter S Corporations” and “Limited Liability Partnerships” offer the advantages of partnerships (including avoidance of taxation) and corporations. The disadvantages of these hybrids are the larger legal fees and greater restrictions on ownership and freedom to operate that exist in certain states and regions.
Usually proprietorships are smaller than partnerships, and partnerships are smaller than corporations, though there are some very large partnerships (e.g., the Big Four accounting firms) as well as some tiny corporations. The fourth kind of firm may be of any size. It is distinguished primarily by its source of revenue and not by how it is internally organized. The nonprofit firmFirm that is prohibited from distributing a profit to its owners. is prohibited from distributing a profit to its owners. Religious organizations, academic associations, environmental groups, most zoos, industry associations, lobbying groups, many hospitals, credit unions (a type of bank), labor unions, private universities, and charities are all organized as nonprofit corporations. The major advantage of nonprofit firms is their tax-free status. In exchange for avoiding taxes, nonprofits must be engaged in government-approved activities, suggesting that nonprofits operate for the social benefit of some segment of society. So why can’t you establish your own nonprofit that operates for your personal benefit in order to avoid taxes? Generally, you alone isn’t enough of a socially worthy purpose to meet the requirements to form a nonprofit.Certainly some of the nonprofit religious organizations created by televangelists suggest that the nonprofit established for the benefit of a single individual isn’t too far-fetched. Moreover, you can’t establish a nonprofit for a worthy goal and not serve that goal but just pay yourself all the money the corporation raises, because nonprofits are prohibited from overpaying their managers. Overpaying the manager means not serving the worthy corporate goal as well as possible. Finally, commercial activities of nonprofits are taxable. Thus, when the nonprofit zoo sells stuffed animals in the gift shop, generally the zoo collects sales tax and is potentially subject to corporate taxes.
The modern corporation is a surprisingly recent invention. Prior to World War I, companies were typically organized as a pyramid with a president at the top and vice presidents who reported to him at the next lower level, and so on. In a pyramid, there is a well-defined chain of command, and no one is ever below two distinct managers of the same level. The problem with a pyramid is that two retail stores that want to coordinate have to contact their managers, and possibly their manager’s managers, and so on up the pyramid until a common manager is reached. There are circumstances where such rigid decision making is unwieldy, and the larger the operation of a corporation, the more unwieldy it gets.
Four companies—Sears, DuPont, General Motors, and Standard Oil of New Jersey (Exxon)—found that the pyramid didn’t work well for them. Sears found that its separate businesses of retail stores and mail order required a mix of shared inputs (purchased goods) but distinct marketing and warehousing of these goods. Consequently, retail stores and mail order needed to be separate business units, but the purchasing unit has to service both of them. Similarly, DuPont’s military business (e.g., explosives) and consumer chemicals were very different operations serving different customers yet often selling the same products so that again the inputs needed to be centrally produced and to coordinate with two separate corporate divisions. General Motors’s many car divisions are “friendly rivals,” in which technology and parts are shared across the divisions, but the divisions compete in marketing their cars to consumers. Again, technology can’t be housed under just one division, but instead is common to all. Finally, Standard Oil of New Jersey was attempting to create a company that managed oil products from oil exploration all the way through to pumping gasoline into automobile gas tanks. With such varied operations all over the globe, Standard Oil of New Jersey required extensive coordination and found that the old business model needed to be replaced. These four companies independently invented the modern corporation, which is organized into separate business units. These business units run as semiautonomous companies themselves, with one business unit purchasing inputs at a negotiated price from another unit and selling outputs to a third unit. The study of the internal organization of firms and its ramifications for competitiveness is fascinating but beyond the scope of this book.If you want to know more about organization theory, I happily recommend Competitive Solutions: The Strategist’s Toolkit, by R. Preston McAfee, Princeton: Princeton University Press, 2002.