What does the Escondido Framework have to offer the Renewing Capitalism project?

The Escondido Framework suggests that most of the other analyses that the Renewing Capitalism project is considering are starting from the wrong place.  Most reflect traditional understandings of the firm which attribute to the company  the possibility of its own moral purpose and also based around the classical assumption (or perhaps neo-classical assumption) of the primacy of the shareholder. The Framework suggests that individuals working within the company provide it with whatever moral purpose it adopts and determine its responsibilities – particularly those embodied in the phrase “corporate social responsibility”.  The Framework provides a basis for challenging the view that the objective of the company is maximising shareholder value but also provides an alternative to the stakeholder theory challenges to the primacy of the shareholder.

In addition, the Framework challenges one of the underlying assumptions around most of these analyses, that there is something unique about the commercial company, arguing that the challenges of renewing capitalism and making capitalism “responsible” are shared by public sector bodies and the third sector. In doing so, it should firstly remove the sense of guilt often directed towards the private sector and occasionally felt by people working within it and secondly draw public and third sector enterprises into the spotlight alongside the private sector. In terms of suggesting prescriptions for “Renewing Capitalism”, it points towards the importance of looking at the influences on individuals who have the privilege to manage organisational units and, subject to understanding the potential unintended adverse consequences, argues that there is proper role for public policy in shaping the markets with which enterprises from all sectors engage.

The Escondido Framework starts from the assumption that the company (in common with many other forms of organisation) is defined by its interfaces with the various market places in which it operates, in the simplest form the markets for labour, raw materials, capital and finished goods or services. These are, in effect, its boundaries.  And while there are differences between markets, in essence they all reflect an exchange between two parties for mutual benefit – the employee receives payment and other non-financial rewards for his labour; the supplier of raw materials payment for the goods provided; the supplier of funds either interest or dividends and the prospect of capital growth for forgoing use of those funds for his own short term benefit; and the customer goods or services in exchange for payment.  The Framework also reflects the view that being a party to the exchange does not of itself mean that the other party has a “stake” in the company or “own” it in any absolute sense.  There may be a contractual relationship between the party and the company which reflects the terms of the exchange and provides structure for enforcement but essentially this is a mutually beneficial relationship in which both parties have duties to deliver their side of the bargain.

The Framework starts with the theory of the firm originated by Coase and refined by Williamson that the hierarchical organisation within the company reflects the potential for greater efficiency arising from organising economic activity with within the organisation compared to through a collection of transactions between independent actors as a result of market failure. Essentially, the purpose of the company is to deliver the outcomes that may not be feasible by means of a set of separate market transactions or only achievable at much greater cost.

Within the Framework, there is no assumption that any of the providers to the company – of labour, raw materials, capital or revenue – any superior rights or claims over the company, in traditional parlance, “ownership”. Legal devices may be put in place by the state, or may exist in the form of contractual agreements that provide these other parties with rights, for example: in the form of wages and employment rights; to payment for goods at a particular point in time; to payment of interest or dividends; and to return of capital under prescribed terms and with differing degrees of confidence. The contracts and legal frameworks may also define mechanisms under which these other parties may enforce these rights, but enforcement is also be a function of other considerations that reflect market conditions rather than the law, for example: what alternatives are available to a workforce with a specific set of skills and ties to a particular geography; what other customers are available for the raw materials, and how much  are they willing to pay; what will other prospective providers of capital pay for these shares or bonds, and how easily can we replace the existing board and executive team; and how often do customers in consumer markets consider, let alone read terms and conditions (cf. how few customers noticed Gamestation’s insertion of an “immortal soul” clause in its online terms and conditions on 1 April 2010).

The Framework suggests that the company can be considered as a “virtual space”, existing between these market interfaces.  The location and shape of each of the market interfaces reflects what economists think of as the demand function and marketing academics describe as indifference curves, i.e. how customers make trade-offs between the various attributes of a product. These are also shaped by the competition that the company faces: when recruiting from a limited pool of skilled employees; for sourcing scarce raw materials; seeking funding from a limited capital market, or seeking the custom of consumers who can buy from other companies or who may be able to substitute one item for other goods. Remove the competition and the market interface or boundary moves outwards, increasing the volume of the “virtual space” available to the company. Improve the operating efficiency within the company or secure a competitive advantage over other participants in one of the markets concerned and the volume of the “virtual space” will also increase.

At any particular point in time, for any particular product or service it sells, these interfaces will be brought together, or resolved, at a single virtual point at which of each of the providers is rewarded at prices that are, all things considered, satisfactory to them. In perfect market equilibrium, all prices would be at market clearing levels, no-one would realise economic rents, and there would one point at which the interfaces would be resolved.  No self-respecting economist has ever viewed the perfect market paradigm as anything other than a useful benchmark for understanding a world which is dynamic and virtually always distant from the paradigm, and in this the Escondido Framework is no different. In reality, the “virtual space” is just that, an available set of points at which the price levels may be resolved. Depending on the scale of the external market failures that allow for the internal organisation of economic activity to generate greater efficiency, there is potential for the management of the company to elect where to set prices and where on the indifference curves to locate the marketing proposition to each of the other parties (suppliers or labour, raw material, capital and custom), and how to allocate the economic surplus that the absolute volume of the “virtual space” represents.

It should be no surprise that managers, as the organisers of the economic activity within the enterprise, will manage the “virtual space” to their own advantage. Agency theory was developed to explain why owners lost control of enterprises when they employed managers – or more accurately ceased to be the managers themselves. Managers may exploit their “virtual space” in different ways, either to serve their own immediate interests or, more strategically, in the long term interests of the company, thereby securing their own position in the longer term (although the coincidence of the individual’s longer term interest and that of the company is limited by the human working lifespan, our potential for boredom and our tendency to discount the future).  Managers themselves may not always be honest enough with themselves about which they are doing, and outside observers, including non-executive directors and investment analysts, may struggle to distinguish one behaviour from another, or see through the surrounding rhetoric.

Managers may use the volume of the “virtual space” to provide themselves with a quiet life, by satisficing, that is to say satisfying the company’s providers but not striving to generate greater efficiency (which, as explained above for those who have an appetite for engaging with the conceptualisation of the company as “virtual space”, has the effect of the increasing the volume inside the space and set of available resolution points by pushing out the market interfaces). This is only one of many options. They may also exploit it by paying themselves exorbitant salaries, at least in the short term. They may use the surpluses that will accumulate on the balance sheet if not distributed to shareholders by engaging in vanity projects: a prestige HQ building, investments with unsupportable business cases, or overpriced and strategically dubious acquisitions. They may use it on activities that are legitimated by being labelled relationship marketing, government and corporate affairs, or even corporate social responsibility, but are at their heart the personal interests of the chief executive and his immediate colleagues: culture or sport at Covent Garden, St Andrews or the Emirates; support for a cause or political party by lobbying, think tank subscriptions or declared donations; or support of donations to a favoured charity or social or environmental cause.

Alternatively they may elect to use the discretion that the volume of the “virtual space” provides by selecting a “resolution point” for the interfaces with external markets that will help to secure the long term future of the company, and probably by implication their own  position. This could include setting prices sufficiently low or quality sufficiently high to deter competitors or drive them out of business. It might include increasing the investment in a workforce to secure future availability of skilled employees or a loyal cadre who will be harder for others to lure away, including setting hefty salaries for the  company’s marzipan layer (even if this also creates a rationale for levering up the salaries of those at the top of the cake too).  It may involve investing in labour saving equipment beyond the level implied by a static view of the available return on capital in order to anticipate any future adverse changes in the labour market. It might include integrating upstream to secure future supplies of raw materials. It might also include returning a higher level of dividends to shareholders than  market conditions require, in order to remove the possibility of a shareholder revolt against  the board or to pre-empt a hostile bid that might  displace  the  management team. It can also include engaging in corporate social responsibility projects that, rather being indulgence of personal whim as suggested for some such projects earlier, will enhance the standing of the company with wider society and governments.

The Escondido Framework model of the company as a “virtual space” bounded by its market interfaces has so far been present in simple form, as though the company deals with only four markets: labour, raw materials, capital funds, and customers.  This simple company can be visualised as a tetrahedron with flat sides. The market interfaces of the simplest form of company can be conceived as flat triangular planes, with linear trade-offs between the attributes of the factors in the market exchange, for example: for labour, skills versus terms of employment versus wage rate; for  raw materials, some measure of quality versus some measure of service level such as lead time or guaranteed availability versus price ; for capital funding, risk versus timing versus level of return; and for customers, a measure of quality versus measure of service level versus price.

Most companies are more complex than the tetrahedron visualisation suggests. They are bounded by many more market interfaces. These interfaces are multidimensional and not linear. And  whilst many of the dimensions of these interfaces are conventionally ” economic”, in the sense that they use money as currency, some have non-financial dimensions, denominated in  the currencies of political influence and even physical sanction or force.

Most of us struggle to visualise in more than three dimensions. This creates a challenge when trying to create a visual metaphor for the company, which generally operates in many markets.  It also creates a challenge when describing of the market interfaces bounding the company, since these have many dimensions, with trade-off functions that are anything but linear. For example, the typical company creates its output from many different raw materials; buys in services that vary from waste removal to legal advice; employs various different groups of staff and on different contractual bases; looks for the capital to facilitate its operations from multiple sources – trade credit, bank overdraft, short term loans, bond finance, mortgages on fixed assets, and possibly multiple classes of equity finance; may sell through a variety of intermediaries as well as to end users.

Companies are also subject to other boundaries, not generally recognised as marketplaces, but nonetheless behaving like markets, provided that the currency of exchange is extended to include political influence and power. This particularly surrounds their relationship with government and the wider society that they operate in. Many of these are obvious: the licensing of the merchant companies that opened up trade with the Americas, Asia and Africa; the regulatory regimes surrounding industries such as utilities, transport and healthcare; restrictions on retail trading on Sundays; limits on the freedom to publish or broadcast, whether to protect those holding power within the state, or to protect the innocence of minors, or celebrities from the prurient gaze of a star struck public; legislation to protect employees, the public and the  environment. Companies work  hard to influence these wider audiences, to adjust the shape of the regulations they face, to influence decisions that have a bearing on when, where and how they operate, and to secure financial  advantages that may arise in  the form of lower taxes or subsidies either to the their direct operation or upstream and downstream in the supply chain. The medium of exchange, or currency, is sometimes cash, or at least something to which a financial value can be directly attributed, and sometimes political – lobbying, PR and influence – and sometimes both (cf Section 106 agreements in UK planning). In some circumstances the medium of exchange in these other markets may include the use of force: in general in the developed world only in response to force being exerted by other parties (cf the recourse to private security in response to “direct action” protests against the action of companies in extractive industries); but in earlier centuries and outside the developed world commercial companies themselves have employed force rather than political persuasion or cash to support commercial ends.

The notional topology of the market interfaces is also more complex than those of the readily visualisable simple company employing one class of labour, converting one class of raw material, with investment capital of a single type, and selling to a single customer segment, with linear trade-offs being made by the other parties in each case. Far from being linear trade-offs with only three attributes considered by the other party (for example, price, product  quality  and service level), the trade-offs are likely to be non-linear (ie 1 unit of Attribute A not being readily substitutable by 1 unit of Attribute B at all points along the indifference curve between them), and there may be many more attributes under consideration (price, quantity discounts, credit terms, styling, weight, energy efficiency, ease of use, complementarity with other products, ease of maintenance, total cost of ownership, lead times, warranty and potentially many more).

The existence of this complexity should not distract from the Escondido Framework’s way of looking at the company. It is the something that marketing staff address all the time when thinking about product features, pricing and communication with the customer; that procurement teams consider when sourcing product; HR departments are thinking about when considering recruitment and strategies for remuneration and benefits; and finance directors address when considering the shape of the balance sheet, dividend policy, and investor relations. Their colleagues in corporate and governmental affairs departments examine how best to influence government and regulators and the PR and CSR teams work on ways for create a sympathetic attitude towards the company and its operations among the general public.  The job of the top management of the company is to make all this work consistently, so that the position that the company selects on each of the market interfaces complements all the others.  The way that a Unilever positions itself against each of the market interfaces will be very different to how a hi tech start-up should behave.

The Escondido Framework applies not only to the private sector company but equally to public sector organisations, to mutuals and to charities. It can also be extended to the lower level operational units.  Organisations exist when an objective is achieved more efficiently and effectively by moving the operation inside a hierarchical structure (for this purpose, the definition of hierarchy includes very flat structures like partnerships as well as steep sided pyramids) because the conditions required to organise activity through a series of market transactions either do not apply or only apply imperfectly.  The difference between the public sector and third sector bodies and private companies is the absence of potentially tradable risk capital.  But this does not mean that they do not require capital in order to fulfil their purposes and that their managements do not have to think about how they position themselves against a variety of market interfaces.  As chairman of an NHS hospital and trustee of a large medical research charity, I see very comparable challenges in terms of the strategy of the organisations towards staff, suppliers, funding sources, and end users to those I faced in my private sector career. And the managers in these sectors are no less vulnerable to the temptations to exploit and abuse the “virtual space” that they operate within if they are successful in pushing out boundaries surrounding their organisations.

So how does this view of the company, whether in the private sector with share capital or a public or third sector organisation, contribute to thinking about how to “renew capitalism”?  It neutralises some of the normative perspectives about the primacy of the interests of any particular group that the company interacts with. It focuses attention on the role of managers – those who determine the point of resolution between the market interfaces (which in turn is a function of where on each of the market interfaces –in their turn, a function of the indifference curves of the other parties to the transactions – the company chooses to locate itself).  If we want companies to behave differently, we have to think about the levers available to us either to move the market interfaces that bound the “virtual space” or to influence behaviour of managers.  Individuals can move the market interfaces by the way that they choose to transact with the company – effectively reframing the attributes that we look for and express in our personal exchanges with them (for example, as consumers by placing greater value as consumers on responsibly sourced products, or as suppliers ).  Governments can move other market interfaces (as broadly defined by the Escondido Framework), whether through regulation or tax policy.  Individuals, whether individually or in groups, and governments also have levers to affect the behaviour of managers, whether through moral suasion, adjusting incentives or (cf. recent Swiss referendum on a measure to limit the salary range within any company) by direct regulation.

Good governance has its place in “renewing capitalism” or securing “responsible capitalism”, but the perceived excesses and deficiencies that have triggered the establishment of the Renewing Capitalism project and its many predecessors demonstrate that despite all the debate over the past thirty years there is more to be done on this front.  The key to progress on this front may be to change the way that we, and those engaged in corporate governance, understand the working of companies and markets, along the lines of the Escondido Framework, particularly in challenging the theoretical primacy of the shareholder and tackling head on the conflicts of interest that face managers.

©Tom Hayhoe

November 2013

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