Chapter 6 discusses the behavior of firms which can take the form of sole proprietorships, partnerships or corporations. A corporation is unlike a sole proprietorship or partnership in that the managers, including the chief executive officer (CEO), are usually somewhat removed from the owners. The following discussion provides more detail on the inner workings of a corporation.

How are corporations different from other types of firms? For one thing, owners of the corporation are liable only for a limited amount of any losses the corporation incurs. For example, if the corporation runs losses for several years and cannot repay all its debts, the owners do not have to sell their cars or give up their houses to pay the lenders. At most, the owners lose the value of their share of ownership in the firm. This feature of a corporation is called limited liability. Limiting the liability of the owners of a corporation reduces the risks of the owners and makes owning shares of a corporation more attractive.

A corporation pays a tax on its profits—called the corporate income tax—that is separate from the personal income tax paid by the owners. The corporation pays out part of its profits to the owners of the corporation and can use the remaining profits to expand the firm by buying additional capital, equipment, or even other firms. This payout to the owners is called a dividend.

Owners of a corporation own stock—certificates of ownership—in the corporation. The owners elect a board of directors, which is supposed to watch over the management of the corporation and look out for the owners’ interests. Owners can sell the stock in a stock market, such as the New York Stock Exchange. The corporation can exist long after the original owners and their heirs are deceased. If a corporation is doing well, it can live on and on.

The CEO and the other managers of a corporation make many of the day-to-day decisions about hiring workers or buying equipment. Big decisions, such as a major expansion or a downsizing, are usually made with the board of directors closely involved. Bigger decisions, such as mergers with other firms, require the vote of the owners. A host of important issues that pertain to the relationships between the managers and the owners of corporations fall under the heading corporate governance. Do the managers have the interests of the owners in mind? Or do the managers look out for their own interest, perhaps trying to get their friends on the board of directors, thereby getting more generous salaries or benefits such as a corporate jet?

These are difficult questions. When economists study such questions, they emphasize the principal-agent relationship that distinguishes sharply between the owners of the firm and the managers of the firm. The managers are viewed as agents for the owners; the owners are viewed as the principals who want the agents to carry out certain actions. In general, the job of an agent is to carry out the wishes of the principal. But in situations where the principal (the owner) does not have much information about the actions of the agents (the managers), difficult governance issues arise. One of the difficulties is finding ways to give the managers incentives to make decisions in the interest of the owners. One approach is to give the managers a share of the corporation so that they share in the firm’s profits. Such an approach is called profit sharing and has been used frequently. In some cases, profit sharing is extended to all workers of a firm, not only the managers, in order to give the workers incentives to improve the profitability of the firm.

How Many Firms Are There?

In the United States about 80 percent of all businesses—about 15 million firms—are sole proprietorships and partnerships. Most of them are small businesses; the sales of all of them together are only about one-seventh of total sales in the United States. You probably have never heard of most of these firms except for the ones that are located in your local community. Most are tiny in comparison with the 500 largest corporations, such as GM, IBM, and 3M, which sell products in countries all over the world.

There are about 3.5 million corporations in the United States but most of these are also relatively small, with less than $1 million in revenues, on average. There are only about 14,000 corporations with revenues greater than $50 million per year. The 500 largest of these—frequently called the Fortune 500 after a list Fortune magazine publishes each year—have revenues ranging from $168 billion for number one—General Motors—to about $3 billion for number 500—Vencor, a health-care firm in Louisville, Kentucky. Although there are fewer large firms than small firms, the large firms account for most of the sales of goods and services. Revenues of the 14,000 largest corporations together amount to about $6 trillion, while revenues of the 15 million proprietorships and partnerships total about $1 trillion.