Partnership as Experimentation

JLEO, V35 N3 455 Partnership as Experimentation Cihan Artunç* Middlebury College Timothy W. Guinnane** Yale University What is the relationship between the legal organization of business firms and economic development? The rules for business enterprises affect firm longevity and capital accumulation. Partnerships do not exist independent of their members. The enterprise can be dissolved at any moment if a partner dies or withdraws. The corporation, on the other hand, exists separately from its owners and has locked-in capital (Blair and Stout 2005; Stout 2005; Dari-Mattiacci et al. 2017). An influential literature *Department of Economics, Middlebury College. Email: **Department of Economics, Yale University. Email: . This article is supported by the National Science Foundation under the grant NSF SES 1559273. We thank Naomi Lamoreaux, Jean-Laurent Rosenthal, Seven Ağir, Shameel Ahmad, Lint Barrage, Price Fishback, Amanda Gregg, Timur Kuran, Jakob Schneebacher, Gabriella Santangelo, Christopher Udry, and seminar participants at Harvard Business School, Yale University, and the World Economic History Congress 2015 for comments and suggestions. Laura D. Taylor provided excellent research assistance. The staff of Yale University Lillian Goldman Law Library, Bibliothèque nationale de France, and the British Library helped in locating sources. We also thank Roger Bilboul and David Lisbona for kindly sharing some of their private collection. An earlier draft of this article was circulated under the title “Enterprise Forms and Partnership Survival in Egypt between 1910 and 1949.” The Journal of Law, Economics, and Organization, Vol. 35, No. 3 doi:10.1093/jleo/ewz007 Advance Access published May 27, 2019 ß The Author(s) 2019. Published by Oxford University Press on behalf of Yale University. All rights reserved. For permissions, please email: Recent research disputes the view that the joint-stock corporation played a crucial role in historical economic development, but retains the idea that the costless firm dissolution implicit in non-corporate forms deterred investment. A multi-armed bandit model demonstrates the benefits of costless dissolution in an environment where potential business partners are not fully informed. Experimentation creates a spike in dissolution rates early in firms’ lives, as less productive matches break down and agents look for better matches. Many of the better matches adopt the corporate form, whose higher dissolution cost functions as a commitment device. We test the model’s predictions using firm-level data on 12,000 enterprises established in Egypt between 1910 and 1949. The partnership reflected a trade-off between committing to a partner and sorting into potentially better matches, fostering the formation of more productive enterprises (JEL D21, D22, L26, N15, O16). 456 The Journal of Law, Economics, & Organization, V35 N3 views the corporate form as critical in Europe’s and the United States’ successful industrialization (e.g., Chandler 1977; Cochran 1977). These works argue that because they are at-will, partnerships could not undertake large-scale, long-term investment. The corporate form’s role is held to be especially significant for emerging economies and late industrializers. Countries that had high barriers to incorporation, the argument goes, made it difficult to mobilize capital beyond the relatively modest personal wealth of individuals (Owen 1991; Kuran 2011). Recent research disputes the idea of a universally superior corporate form, but still views costless dissolution as a disadvantage to partnerships (Lamoreaux and Rosenthal 2005; Guinnane et al. 2007). Partnerships, however, were long the dominant form of multi-owner enterprises, even after the corporation became easy to create. We propose a novel interpretation of the partnership’s popularity: its costless dissolution encourages beneficial experimentation. We formalize the problem with a theory of company formation and dissolution, then provide empirical evidence consistent with the model’s predictions. This empirical exercise rests on a novel firm- and owner-level dataset composed of some 12,000 partnerships and corporations established in Egypt between 1910 and 1949. Our data allow us to make two distinct empirical contributions. First, because we have information on owners and their history in earlier enterprises, we can focus on the implications of owner matches for firm success. Second, the existing literature on firm dynamics pertains to recent experience in developed countries. The Egyptian data make a rare contribution to the literature on firms in developing countries. Most data on firms have limitations; they might be restricted to manufacturing establishments (e.g., Lee and Mukoyama 2015), exclude firms with self-employed owners (the recent literature that relies on the US Longitudinal Business Database, e.g., Decker et al. 2014), or miss certain legal forms such as single proprietorships (Guinnane and Martı́nez-Rodrı́guez 2018). Our Egyptian dataset lacks sole proprietorships, but does include firms from across the economy, including those run by the self-employed. Extensive robustness checks demonstrate that other data issues do not drive our main results. In our theoretical model, costless dissolution allows entrepreneurs to experiment with different partners until they sort into matches with the “right” partner. Only 75% of Egyptian partnerships in our data lasted at least 2 years, compared to 96% of corporations. For many ventures, high dissolution cost from the start would have locked partners into unproductive ventures or deterred formation of ventures in the first place. For other partners whose joint productivity is sufficiently high, however, the partnership’s ease of dissolution discourages larger investment and cooperation because agents can deviate from investment plans, dissolve the firm, and re-match with a new partner. The corporation’s lock-in feature offers these firms an option to commit. Partnership as Experimentation 457 This article thus provides a new way to think about enterprise form adoption and firm longevity by taking seriously the trade-off between experimentation and commitment. We start with a model based on a multi-armed bandit framework. Agents match to one another to produce some surplus in each period. Match success rate depends on the match quality, which the partners do not observe but on which they share a common prior. The enterprise’s observed success rate informs the partners of the actual match quality. If partners share pessimistic posteriors, they dissolve the firm and move on to new partners. If partners believe the match quality is sufficiently high, they remain in their current match and provide increased investment or effort to the firm. At this point, however, the ease of dissolution becomes a hindrance because it encourages each partner to free ride on the other’s effort and then re-match. Thus, partnerships that surviv (...truncated)