Institutional Bias, Risk, and Workers' Risk Aversion

By Doucouliagos, Chris | Journal of Economic Issues, December 1995 | Go to article overview

Institutional Bias, Risk, and Workers' Risk Aversion


Doucouliagos, Chris, Journal of Economic Issues


The collapse of central planning in Central and Eastern Europe has brought greater attention to labor-managed firms (LMFs) as alternatives to both Soviet-type enterprises and conventional capitalist firms. LMFs are firms where labor either holds positions of power or is the ultimate decision-making body. LMFs are democratic organizations; decision making is based on the democratic principle of one person, one vote. This differs sharply from decision making within conventional capitalist enterprises, where decision making is based on the undemocratic principle of one share, one vote.(1) LMFs are both owned and controlled by workers. Capital-managed firms (CMFs) are firms where labor holds little or no ownership and exercises no control (the dominant species), or where labor nominally owns the firm, but where control is vested in managerial elites (as is often the case with Employee Stock [or Share] Ownership Plans). Workers associated with LMFs are commonly referred to as members, while workers associated with CMFs are known as employees [see Ellerman 1990 for a fuller exposition].(2)

An often-cited, and quite popular, explanation for the dearth of LMFs is workers' risk aversion. Risk-averse workers are said to prefer the contractually fixed remuneration granted under employee status to the income fluctuations associated with membership with LMFs [see Meade 1972; Buck 1982; Drago 1986; Fanning and McCarthy 1986; Conte 1986; Ben-Ner 1988; Dreze 1993]. Thus, risk aversion shapes organizational design; workers are said to reveal a preference for organizations that insulate them from market fluctuations.

LMFs are generally believed to be a more risky option for workers. However, this paper argues that while some risks are intrinsic to the nature of entrepreneurship, other risks associated with alternative organization structures are correlated with the prevailing institutional arrangements and entrepreneurial climate. Further, while risk aversion is a natural behavioral trait, the degree of risk aversion is also shaped by the prevailing institutions. All societies develop a set of institutions that reinforce the status quo. The prevailing institutions reinforce the reproduction of CMFs and hinder the formation of LMFs. This institutional bias, rather than market fluctuations, may be the main driving force behind the actual and perceived risks associated with LMFs and workers' risk aversion against LMFs. Institutional reform is thus vital to both reducing risk and the degree of worker risk aversion, and hence to the development of democratically managed firms.

Income and Risk in the LMF and CMF

To aid exposition, assume that workers face the choice of one of two organizational modes: either membership status (association with LMFs) or employee status (employment in CMFs).(3) Both of these options can be assumed to be equally technically and allocatively efficient. There are three reasons for this. First, this assumption is valid for exposition purposes. This paper argues that even if LMFs are equally efficient as CMFs, they may be scarce because of institutional bias; the formation of LMFs is limited for other than efficiency considerations. Second, there are sound theoretical arguments in favor of this proposition. Third, there is ample evidence to support it.

The mainstream economics view of workers' enterprises draws on the Ward-Vanek-Meade model [from Ward 1958; Vanek 1970; Meade 1972], which generates a number of inefficiencies and "perversities" associated with labor-management. This model assumes that members of a LMF maximize revenue per worker (an average) while the CMF maximizes total profit. Thus, for example, as product price increases, the CMF expands output and employment, while the LMF reduces employment in order to increase revenue per existing worker even further. It is surprising that many authors continue to subscribe to this model, given that there are thousands of successful LMFs, that there is no evidence for this sort of perverse behavior, and that the model assumes that workers will retrench each other when market conditions improve! …

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