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Does the Economy Need Corporations?

People can enter into business partnerships without formally incorporating. Does society need corporations for a functional economy? Professor Robert Miller explains that as the economy grew with the industrial revolution, businesses needed a way to operate and raise capital on a large scale. The corporate form allows investors, large and small, to contribute money while relieving them of managerial responsibilities and liability. https://youtube.com/watch?v=jCm8_dN32-U


A corporation is a way of organizing human activity that is not possible under the common law. So under the common law, if people wanted to go into business together, they could agree among themselves that they would go into business, that I would contribute this, that you would contribute that, that we would agree to split the profits and losses this way or that, the decisions would be made in one way or another. We could enter into a contract as complicated as we wanted to govern our relationship. And this is called a common law partnership. The thing we could not do, however, under the common law was to affect our relationships with third parties. Unless of course they consented, but in many cases they would not consent. So if we were going to borrow money, our partnership, from a bank, the default rule under the common law is that all the partners would be liable to the bank for the repayment of the money. If our partnership is involved in running a business, and we committed tort against somebody else, our delivery driver runs over a pedestrian or we cause a fire and burn down someone's house, the common law rule was that all the partners are jointly and severally liable for the tort, just like they would be if they were individuals who committed the tort. In a pre-industrial economy where businesses were basically small, where the amount of capital you needed to run a business was relatively small, these rules worked just fine. But then the industrial revolution happens. And the economy begins to change primarily because of changes in technology, both scientific technology, how you work with chemicals and metals and so on, but also in economic technology of how we're going to organize businesses. Things begin to change and we get new forms of economic activity. Think of a railroad that require immense amounts of capital to engage in. To run a railroad, you have to buy land or rights of way to lay your tracks over for hundreds and hundreds of miles. And then you have to lay those tracks and then you have to buy locomotives and you have to buy train cars that the locomotives will haul and you have to buy lots and lots of coal. And you have to have hundreds of employees and you need to have all of these employees before your first train runs before you can charge your first customer for anything. You need an immense amount of capital to get this business off the ground. And then the problem is this, you can't raise that much capital from a small number of wealthy people. They just don't have that much money. Maybe they could fund one railroad, but they can't fund the railroad and the shipping company and other railroad and so on. If you want to raise that much capital, you need to raise capital by raising relatively small amounts of money from a relatively large number of people. And then the problem gets very serious because most people are not willing to invest a small amount of money and end up personally liable for all the harms a railroad can cause. Moreover, once you have a large number of investors investing in the same business, it turns out that most of them are not interested in participating in the day to day management of the business. Now who would sign up to invest a small amount of money in a business in which they have no interest in participating on a day to day basis, but where they can end up personally liable for the gigantic harms a large business could cause? That's not going to happen. So if you were going to be able to fund those types of very large forms of economic activity, heavy industry, railroad, shipping companies, you need a form of legal organization in which large numbers of people can invest in which they do not have to take an active role running the business and in which they will not be personally liable for the harms the business causes. They can lose everything they've invested, but no more. That way of organizing economic activity is called a corporation.

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