WHY HAS THE LABOR-MANAGED

FIRM FAILED
Svetozar Pejovich
Introduction
The end ofthe totalitarian socialist rule has created an institutional
vacuum in Eastern Europe and the former Soviet Union. The transition process we are witnessing in that region is, in effect, the search
for a new set of institutions? We still do not know as much about
the process of institutional change itself, about who should change
the rules and under what circumstances the rules ought to be
changed.2 The transition process in Eastern Europe is, therefore, a
gift from heaven for social engineers. And they have responded to
this gift by flooding the intellectual and political markets with models, ideas, and proposals for the development of new institutional
arrangements in the region.
Industrial democracy is an umbrella for all the different forms of
labor participation in the management of business firms. A striking
feature of industrial democracy is that it has failed to emerge spontaneously. It has also failed to perform successfully whenever and
wherever imposed by fiat, Codetermination in Germany, the labormanaged economy in former Yugoslavia, and various labor participatow schemes in some West European and South American countries
are good examples.
Cute Journal, Vol. 12, No. 2 (Fall 1992). Copyright Cato Institute. All rights
reserved.
The author is Professor of Economics at Texas A & M University. He wishes to
thank Louis De Alessi, Enrico Colombatto, Jose Mencinger, John H. Moore, and Jim
Dorn for their helpful comments. He also wishes to thank the Earhart Foundation and
the Lynde and Harry Bradley Foundation for supporting his research on the economics
of property rights in Eastern Europe.
are usually defined as the legal, regulatory, and custom-made arrangements for repeated human interactionsthat is, institutions are the rules of the game
whose major function is the predictability of behavior,
5
Douglass North and members of the Public Choice School have contributed most to
our understanding of the process ofinstitutional change,

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CATO JOURNAL

It would be, however, a mistake to underestimate the survival

power of the concept of industrial democracy. Labor participation
in the management of business enterprises offers too many opportunities for social engineering and satisfies too many ideological preferences to be discarded on account of its poor real world performance.
This is especially true in Eastern Europe and the former Soviet
Union where the end of the communist rule could not and indeed
did not put an end to all the communist institutions and legacies.
Thus, the search for new rules of the game in that region provides
the supporters of industrial democracy with an opportunity to be
heard (Vanek 1990). And their chances to be heard are likely to grow
as free-market policies fail to produce quick returns,
This paper concentrates on a specific type of industrial democracy:
the labor-managed firm. The support for the labor-managed firm
comes from several sources: (1) the old communitarian tradition in
most East European countries; (2) the collectivist mode of thinking
in that regiona legacy of the communist rule; (3) labor leaders and
social democrats in Western Europe; and (4) a handful of academic
supporters in the West, such as Jacques Dreze, Henryk Flakierski,
James Meade, Jan Svejnar, and Jaroslav Vanek. Also, some current
proposals for privatizing state firms in Russia, Serbia, Slovenia, and
Poland contain strong elements of labor-participation in
management.
In a free society people get what they want to pay for. And that
applies to all the differentmethods for organizing production. Investors in private-property, free-market economies are free to write any
kind of agreement with their contractual partners. Indeed, we
observe a large number of different types of business firms in the
West. All those firms have emerged voluntarily and survived competition from other types of business organizations.
Dreze (1976), Meade (1974), Prasnikar and Svejnar (1990), and
Vanek (1990), among others, have asserted that the labor-managed
firm is or could be an efficient method of organizing production. Yet,
this type ofbusiness organization has failed to appear on a significant
scale in free-market, private-property economies. An implication is
that the value of labor participation to the employees of business
firms is worth less than the costs to their contractual partners of
providing it. By failing to specify the property and contracting rights
within which the labor-managed firm exists, Vanek and others have
ignored the effects of negative incentives and high transaction costs
on its ability to survive in competitive markets.
The purpose of this paper is to show how the bundle of property
rights in the labor-managed firm creates two behavioral variables
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LABOR-MANAGED FIRM

that are specific to that bundle of rights (and of no significance in

the private-property, free-market economy). Those two variables are
the key to explaining the inefficiency of investment decisions by
labor-managed firms.

Property Rights and the Labor-Managed Firm

The Yugoslav experience and academic research have shown that,
like all other type ofbusiness enterprises, labor-managed firms could
differ from each other in terms of their internal rules and organizations. However, the bundle of property rights within which any type
of organization exists is the key to analyzing how it functions. It is,
therefore, necessary to identify the basic bundle of rights which sets
the labor-managed firm apart from other types of business enterprises. This bundle of property rights is characterized by the following five features:
1. The employees govern the firm. The employees are decisionmakers in their respective firms. We assume that the firms
decisionmaking structure, chosen by either its employees or
the state (on their behalf), takes into account preferences of the
median worker.
2. The employees have claims on thefirms cashflows. This right
says that the employees of the labor-managed firm are responsible for all the financial and legal obligations of the firm as well
as the allocation of the firms residual to any purpose (i.e., the
wage fund, investment fund, reserve fund) that is not explicitly
forbidden by law.
3. The employees rights specUied under (1) and (2) are not transferable. The right of ownership3 in (1) and (2) would, in effect,
allow the employees to sell both their right to govern the firm
as well as their residual claims on the expected future cash
flows of the firm. The labor-managed firm would then turn into
a private-ownership firm.
4. The employees rights spectfied under (1) and (2) are contingent
on their employment with that firm. A workers claim on his
share of the residual terminates when he leaves the firm. To
extend his non-tradeable claims on the firms cash flows beyond
that time would be costly to implement and monitor. It would
also impose a rising burden on the firms future costs of production. This specific right makes the employees lime horizon (the
Transferability of assets at mutually agreed prices is a critical component of the right
of ownership.

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CATO JOURNAL

expected length of stay with their firm) a critical variable in the

labor-managed firms choice of investment projects.
According to Eirik Furubotn (1976), the time horizon of the
employees of the labor-managed firm is rather short, It is also
likely to fall short of the employees expected termination dates.
First, an important implication of the rights specified under
(2) and (3) above is that the employees cannot diversify their
portfolio of non-tradeable claims on the firms cash flows. Thus,
we should expect to observe a conservative bias in the firms
decisions that have future consequences. An important paper
on the codetermining firm in Germany (Benelli, Loderer, and
Lys 1987) confirms this proposition. Second, hiring younger
workers could easily shrink the employees time horizon. A 45year-old worker has, in general, a shorter work horizon than a
younger man. However, his time horizon with the firm is likely
to be longer than that of a younger man who hopes to move up
by moving around.
5. The labor-managedfirm has no ownership in its capital assets.
The employees determine the use of capital assets held by their
firm; however, they only hold non-tradeable claims on the firms
cash flows while they work for that firm.
Research has shown that the bundle ofrights specified under
(1) (5) above creates some negative incentives and positive
transaction costs that are responsible for the inefficiency of
investment decisions by labor-managed firms (Jensen and
Meckling 1979, Milovanovich 1990, Pejovich 1990). To alleviate those effects, some writers have proposed various immunizing stratagems (Flakierski 1989, pp. 6770) which either ignore
transaction costs of making, maintaining and enforcing those
changes, or tend to privatize labor-managed firms, or both.
-

The Labor-Managed Firm and

Investment Decisions
The labor-managed firm can acquire capital assets through a state
agency, by renting them from others, and by issuing debt claims.
Also, the employees can allocate a part of the residual into the firms
investment fund.
Acquiring capital through a state agency has many efficiency implications, It takes an act of faith to assume that the social welfare
function exists, that the state knows it, that the state is going to do
something about it, and that the state will be willing to relinquish
its control over the assets given to enterprises. There is no empirical
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LABOR-MANAGED FIRM

evidence to support this type of naive expectations about the behavior of any government (Brunner 1987).
The rental option for acquiring capital assets has two major problems. First, a number of intangible productive assets, such as the
firms investment in the distribution systems, the design of products,
and training of the labor force, cannot be rented. Second, the rental
of durable productive assets is a costly method of acquiring capital
assets.4
Given its bundle ofproperty rights, the labor-managed firms main
sources for acquiring capital assets are then the claims of debt-owners, and the personal contributions of the employees. The former
are pure financial claims. As for the latter, since the employees have
no ownership claims on the firms capital assets, they cannot have
claims on the monies they give to the firm to purchase new assets.
The employees only hold non-tradeable claims on the firms return
from those assets, and even that for only as long as they stay with
the firm.
External Financing of Investments by the Labor-Managed Finn
The sources of external funds could be state and/or bank loans,
sale of bonds, interfirm borrowing, and perhaps some other monies.
This paper concentrates on the effects of bank credit on investment
decisions by labor-managed firms, Other external sources of funds
would be subject to similar incentives.
The employees benefits from investmentsfinanced by bank loans.
The employees of the labor-managed firm have non-transferable
claims on the stream of annual returns (B) from any specific investment (I) made by their firms. This property right creates incentives
for the employees to transfer the firms cash flows from the future
to the present. The employees can run down inventories, fail to
replace capital assets, under-invest in the maintenance of capital
goods, vote themselves large pension benefits with no funding provisions, grant themselves large severance payments, sell long-term
bonds with no sinking-fund provisions, and so on. To alleviate the
effects of those incentives, the government has to invest resources
in enacting, maintaining, and enforcing a number of constraints on
the property and contracting rights of the employees. Examples are
4
The obvious agency costs of the rental arrangement are those associated with the
reduced incentives for the user to maintain the assets properly, to guard it from theft,
and the increased incentives to misuse it. The magnitude of these costs along with
the monitoring and bonding costs that would be incurred in the effort to control them
explains why rental or leasing ofmost durable production goods is not observed. It is
simply a more costly contracting arrangement (Jensen and Meckling 1979, p. 480).

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the depreciation rules for capital assets, the rules for maintaining
and repairing physical assets, the rules for severance payments, and
so on. An important consequence of those constraints is that they
require a costly bureaucracy that is specific to the labor-managed
firm.5
Two implications of the employees non-tradeable claims on the
firms cash flows are the following. (1) The employees do not view
equivalent-present value projects as being equalthose projects
whose returns occur more quickly are preferred to those with even
flows, and the latter are preferred to investments whose yields are
bunched in later periods. (2) The absence of financial markets means
that the rate of interest does not express the present prices of capital
goods relative to their current costs ofproduction; it merely measures
a cost of investment,
An employees benefits from any specific investment (I) are limited
to the annual returns (B)from that investment over the employees
expected stay with the firm (t).The time horizon of the median
member of the collective or whatever the decisionmaking group
happens to be is then a critical factor in choosing investment projects
in the labor-managed firm. In comparison, the time horizon of an
investor in the private-property, free-market economy is irrelevant
because the flow of benefits over the productive life of his assets is
available to him in one lump sum.
The employees costs from investments financed by bank loans.
The employees cost of any specific investment (I) financed by bank
credit is the series of payments (C) to the bank over the employees
time horizon (t). Given the rate of interest, the firms annual payments
Fhat is exactly what happened in Yugoslavia, the only country that has experimented
with this system on a large scale and over a period oftime
5 long enough to provide us
with a strong data base. Prasnikar and Svejnar (1990, p. ) missed the point when they
tried to separate a theoretical construct of the labor-managed firm from the Yugoslav
experience: The strong influence of the League of Communists, the Communist-oriented trade unions and the various government authorities suggests that one ought to
examine seriously the extent to which the behavior ofYugoslav firms resembles that
of a proto-typical socialist enterprise rather than that of a labor-managed firm. The
labor-managed firm needs the political monopoly to protect it from competing methods
of organizing production, and the economy needs the self-management bureaucracy
to protect it from the employees incentives to eat up theiT firms.

The employees benefits could nlso be expressed in terms of their present values as
follows:
JV

[B(.J + IY 1]/i(1 + Vt

where PV is the present value of the flow of returns (B) from a specific investment (I)
over the employees time horizon (t). PV equals the true present value only when U)
is equal to or greater than the expected life of that investment. This paper focuses on
annual returns and costs. It is a simpler approach that has no effect on our results.
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LABOR-MANAGED FIRM

depend on the length of time over which the loan has to be repaid
(n). The length ofbank loan is an item in the contractthat is negotiated
between the borrower and the lender. It is then important to identify
the borrowers and the lenders incentives with respect to (it),
Suppose the labor-managed firm secures an investment loan that
has to be paid back to the lending bank over a period of time (n) If
the time horizon of the firms employees (t) were equal to or greater
than the length of that loan (n), the current group of workers would
bear the entire costs of investment (I). However, if the employees

time horizon fell short of the length of loan, a pan of the total cost
of investment (I) would be shifted to the next generation of workers
in the same firm.
The employees of the labor-managed firm have then incentives
to seek investment loans with as lengthy repayment schedules as
the banks are willing to go along with, and to negotiate agreements
to pay only interest on investment loans over the current employees
time horizon,
The employees annual costs of any specific investment (I)
financed by bank credit is then
_L

CI

(1+i)~
where (n) is the length of bank loan.

The choice of investment projects by labor-managedfirms. The

employees benefits from an investment project are the expected
returns (B) over their time horizon. The employees~costs from that
same investment are the annual payments to the bank (C) over their
time horizon. It follows that the investment decision of the labormanaged firm depends on the relationship between these two flows.
To simplify discussion, we assume that both flows are uniform over
the employees time horizon.7 Then,
111

B>I
<

_L

(1+i)~1

Since the ]ength of loan (it) is determined contractually between

the lender and borrower of investment funds, it is possible to adjust
(n) so that
n.

(1+l)a*

Uneven flows of (B) and (C) could generate different technical solutions but they
would not change the effects of the bundle of property rights in the labor-managed

firm on the employees incentives in choosing investment projects.

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The equality (3) shows the minimum (n ) required to make a specific

investmentproject acceptable to the employees ofthe labor-managed
firm. The investment decision of the labor-managed firm then
depends on the ability of its manager to negotiate a loan that, at the
minimum, has to be repaid over a period of time that makes the flow
of returns from an investment equal to its production costs times the
flow of income over (n ) years from $1 now. Whatever the rate of
interest, the length of bank credit (it) is a significant, perhaps the
most significant, variable in the firms choice of investments.8
In comparison, the decisionmakers time horizon and the length
of bank loan play no role in the choice of investment projects in the
private-property, free-market economy.
Changes in the length of bank credit and their implications. Let
us now look at the effects of changes in the length of bank loans on
the efficiency of investment decisions by self-managed firms.
The employees of a labor-managed firm are looking at an asset
that costs $1,000,000, has a productive life of 15 years, and promises
to yield $118,326 per year over a period of 15 years. At the market
rate of interest of 10 percent, the present value of that asset is
$900,000, and the investment is clearly inefficient. However, suppose that the manager of the firm is able to borrow $1,000,000 from
the bank on a 20 year loan at 10 percent. A private-ownership firm
would still turn the project down, but the labor-managed firm would
not. The employees annual payments to the bank would be $117,460
per year, while their annual benefits are $118,326. As long as the
employees time horizon is 15 years or less, the employees would
have $866 each and every year to divide among themselves. So they
would make an inefficient investment. The costs shifted to the next
generation of workers (including those current employees whose
time horizon exceeds 15 years) would equal annual payments of
$117,460 per year over the last five years of the contract. If the
employees time horizon were, say, 12 years, the costs shifted to
the next generation of workers would be $117,460 per year for the
remaining eight years, and so on,
If the length of loan is 19.57 years, the firms annual payments
(C) to the bank would be equal to annual returns (B) from that investment. However, a 20 year loan gives the employees an additional
$866 per year over their time horizon with the firm, It means that
Our results are contrary to those Meade (1972), Vanek (1970, 1977), andother advocates
of the labor-managed firm who consider the market (clearing) rate of interest to be a
critical variable that assures the system of the efficiency of externally financed
investmeats.

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LABOR-MANAGED FIRM

TABLE I
RELATION BETWEEN THE LENGTH OF LOAN AND REWARDS
OFFERED

Length of Loan
19.56 years

Benefits (B)

Costs

(C)

BenefitsCosts

$118,326

$118,326

20

118,326

117,460

866

21
22
23
24
25

118,326
118,326
118,326
118,326
118,326

115,624
114,005
112,572
111,300
110,168

2,702
4,321
5,754
7,026
8,158

the manager of the firm has incentives to offer some people at the
bank an equivalent of up to $866 per year in cash or specific goods
in exchange for a 20 year loan. And he would have incentives to offer
even better rewards for longer loans. Table 1 shows how changes in
the length of loan increase the amount of money the manager can
use to seek a good contract.
Suppose the time horizon of the employees is 10 years, and the
firm has three investment projects under consideration. The productive life of each project and their respective annual streams ofbenefits
per $1 are shown in Table 2, columns (1) and (2). Column (3) shows
the minimum length of bank loan (n) that makes the flow of annual
TABLE 2
PROPERTY RIGHTS AND THE INVESTMENT DECISION

Life of Asset

Benefits (B)

Minimum
Length of Loan(n)

10 years
15
20

$146
.118
.106

12.12 years
19.73
30.13

benefits equal to the employees annual costs from those investments. At a 10 percent rate of interest, a private-property firm would
clearly turn all three projects down because the present value of
each project at the 10 percent rate of interest is 90 cents. However,
ifthe manager of the labor-managed firm were able to negotiate bank
loans in excess of (n) years the employees would find all three
investments acceptable.
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CATO JOURNAL

Internal Financing of Investment by the Labor-Managed Firm

The employees non-tradeable claims on the firms cash flows create two wealth- increasing options for them. The employees can take
the firms residual out as wages and invest in assets they would own.
The employees can also leave a part of the residual with the firm
for investment in new capital assets in which they would hold nontradeable claims contingent on employment by the firm.
Property rights differences between those two options have been
researched in some detail (Pejovich 1969, Furubotn and Pejovich
1970, Jensen and Meckling 1979). The major results ofthat research
are summarized here in order to complete our discussion on investment decisions of the labor-managed firm.
The employees have the right of ownership in the assets they
purchase as individuals. They can trade those assets, give them away,
will them to their heirs, or do anything else that is not explicitly
forbidden by law. On the other hand, the employees have only nontradeable claims on the firms year-to-year cash flows contingent on
employment. That is, they have claims on neither the amount of the
residual they leave with the firm for purchase of new productive
assets nor the year-to-year returns from those assets once they leave
the firm,
The employees cost of any specific investment (I) financed from
the firms residual is the sum total of annuities (y) they could have
received over the period (t) by taking the amount equal to (I) out as
income and saving their respective shares at (i) rate of interest. The
annuity per $1 is

t
i(1+i)

(1 + i)~

4
1

The employees benefits from the same investment (I) financed from
the firms residual is the flow of returns (B) over their time horizon
(t).
For the employees to be indifferent between internally financed
investments and their own individual savings, the former must earn
the rate of return (r ) equal to (y) in (4); that is, the required rate of
return (r) for internally financed investments must be equal to the
annuity from one dollar at the rate (I) over the employees time
horizon (t).The rate of return (r ) is the rate of interest (i) adjusted
The assumption is that the two investment alternatives are alike with respect to risk
level and liquidity. It is a simplifying assumption that has no effect on the results of
our analysis in the paper.

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LABOR-MANAGED FIRM

for the incentives effects of property rights in the labor-managed

firm:
r*

i(i +
(1 + iY

(5)

The rates of return that would make the employees indifferent

between investments that are internally financed and their own private investments could be easily calculated. At a 10 percent interest
rate and time horizons of 1, 5, 10, and 15 years, they are 110 percent,
26 percent, 16 percent, and 13 percent, respectively.0 Given the
firms schedule of investment opportunities, the difference between
the market rate of interest (i) and the required rate ofreturn (r) must
result in an inefficient level of sellfinanced investment by labormanaged firms.

Conclusion
This paper describes the prevailing property rights in the labormanaged firm, identifies incentives and transaction costs that are
specific to that bundle ofproperty rights, and analyzes the effects of
those incentives and transaction costs on the employees investment
decisions. Reminding those who advocate labor participation in the
management of business firms that institutions mailer, Jensen and
Meckling (1979, p. 480) wrote,
Ignoring the agency costs ofalternative contractual forms in comparing two systems where the only difference between the two is the
contractual form allowed is unlikely to shed light on the major

issues. But Dreze, as well as most others writing on the topic, does
exactly this.

The analysis of this paper shows that the length of bank credit
(or any other financial claim) and the employees time horizon are
the two critical variables for the employees choice of investments,
And those two variables are specific to the bundle of property rights
in the labor-managed firm,
With respect to externally financed investments, the analysis
shows that when the length of bank credit exceeds the employees
time horizon and the employees time horizon falls short of the proAsin the case of externally financed investments, equivalent-return projects which
pay off quickly would be favored relative to those whose payoffs occur later in the
future.
When the employees time horizon is greater than the productive life of assets, the
relationship between (0 and (a) would determine whether an inefficient investment
is chosen.
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CATO JOURNAL

ductive life of assets, the labor-managed firm has incentives to

finance inefficient investment projects. The fact that the labor-managed firm has not emerged voluntarily on a significant scale in private-property, free-market economies is evidence that the market
for business organizations considers the length of bank credit to
be greater than the employees time horizon, the employees time
horizon to be shorter than the productive life of assets, and the
lenders incentives insufficient to offset the employees incentives
to seek loans in excess of their time horizon.
The labor-managed firm would avoid making inefficient investments only if the prevailing incentives and transaction costs pushed
the employees toward equalizing the length of bank credits with the
expected life of capital goods to be purchased with those credits.
For that to happen, several conditions have to be satisfied, First,
the employees of the labor-managed firm must have incentives to
negotiate contracts that would equalize the length of bank credits
with the life of assets to be purchased with those credits. It is clear
from the analysis in this paper that the employees do not have such
incentives. Second, the cost of information to the lender about the
expected life of capital goods, including intangible assets, must be
low relative to that of the borrower. However, the absence of tradeable claims in financial markets raises the lenders information costs
about both the productivity as well as the life expectancy of capital
goods to be financed by loans. Finally, the lender must have strong
incentives to incur the cost of negotiating contracts that would equalize the length of his loans with the life of assets to be purchased
with those loans. There are many possible types of lending institutions, such as private-ownership banks, labor-managed banks, various financial institutions, government agencies, and specialized
super banks, The analysis of all those types of lenders and their
incentives is beyond the scope ofthis paper. It is, however, difficult
to envisage a bundle of rights in all those lending institutions that
would create incentives and transaction costs sufficient to change
this papers conclusions.

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