The Modern Firm, Corporate Governance and Investment (2009)

The Modern Firm, Corporate Governance and Investment

NEW PERSPECTIVES ON THE MODERN CORPORATION Series Editor: Jonathan Michie, Director, Department for Continuing Education and President, Kellogg College, University of Oxford, UK The modern corporation has a far-reaching influence on our lives in an increasingly globalized economy. This series will provide an invaluable forum for the publication of high-quality works of scholarship covering the areas of: ● ●

● ● ● ●

corporate governance and corporate responsibility, including environmental sustainability human resource management and other management practices, and the relationship of these to organizational outcomes and corporate performance industrial economics, organizational behaviour, innovation and competitiveness outsourcing, offshoring, joint ventures and strategic alliances different ownership forms, including social enterprise and employee ownership intellectual property and the learning economy, including knowledge transfer and information exchange.

Titles in the series include: Corporate Governance, Organization and the Firm Co-operation and Outsourcing in the Global Economy Edited by Mario Morroni The Modern Firm, Corporate Governance and Investment Edited by Per-Olof Bjuggren and Dennis C. Mueller

The Modern Firm, Corporate Governance and Investment Edited by

Per-Olof Bjuggren Jönköping International Business School, Sweden

Dennis C. Mueller University of Vienna, Austria

NEW PERSPECTIVES ON THE MODERN CORPORATION

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Per-Olof Bjuggren and Dennis C. Mueller 2009 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2009922767

ISBN 978 1 84844 225 2 Printed and bound by MPG Books Group, UK

Contents List of contributors Preface 1

Introduction: the modern firm, corporate governance and investment Per-Olof Bjuggren and Dennis C. Mueller

PART I 2 3

5 6

7

8

11 43

THE THEORY OF THE FIRM FROM AN ORGANIZATIONAL PERSPECTIVE

A contractual perspective of the firm with an application to the maritime industry Per-Olof Bjuggren and Johanna Palmberg The use of managerial authority in the knowledge economy Kirsten Foss Competence and learning in the experimentally organized economy Gunnar Eliasson and Åsa Eliasson

PART III

1

KEY ISSUES

Opening the black box of firm and market organization: antitrust Oliver E. Williamson The corporation: an economic enigma Dennis C. Mueller

PART II

4

vii viii

63 82

104

INVESTMENTS AND THE LEGAL ENVIRONMENT

Corporate governance and investments in Scandinavia – ownership concentration and dual-class equity structure Johan E. Eklund The cost of legal uncertainty: the impact of insecure property rights on cost of capital Per-Olof Bjuggren and Johan E. Eklund v

139

167

vi

9

Contents

The stock market, the market for corporate control and the theory of the firm: legal and economic perspectives and implications for public policy Simon Deakin and Ajit Singh

PART IV

10 11

12

13 14 15

THE BOARD, MANAGEMENT RELATIONS AND OWNERSHIP STRUCTURE

Institutional ownership and dividends Daniel Wiberg Contracting around ownership: shareholder agreements in France Camille Madelon and Steen Thomsen Board governance of family firms and business groups with a unique regional dataset Lluís Bru and Rafel Crespí Better firm performance with employees on the board? R. Øystein Strøm The determinants of German corporate governance ratings Wolfgang Drobetz, Klaus Gugler and Simone Hirschvogl Top management, education and networking Mogens Dilling-Hansen, Erik Strøjer Madsen and Valdemar Smith

Index

185

225

253

292 323 361 382

401

Contributors Per-Olof Bjuggren, Jönköping International Business School, Sweden Lluís Bru, Universitat de les Iles Balears, Spain Rafel Crespí, Universitat de les Iles Balears, Spain Simon Deakin, The Faculty of Law, Cambridge University, UK Mogens Dilling-Hansen, School of Economics and Management, University of Aarhus, Denmark Wolfgang Drobetz, Department of Corporate Finance, University of Basel, Switzerland Johan E. Eklund, Jönköping International Business School, Sweden Åsa Eliasson, IBMP CNRS Strasbourg and Vitigen GmbH, Siebeldingen, Germany Gunnar Eliasson, KTH, Stockholm Kirsten Foss, Copenhagen Business School, Denmark Klaus Gugler, Department of Economics, University of Vienna, Austria Simone Hirschvogl, Department of Economics, University of Vienna, Austria Camille Madelon, HEC School of Management, Paris, France Erik Strøjer Madsen, Department of Economic, Aarhus School of Business, Denmark Dennis C. Mueller, University of Vienna, Austria Johanna Palmberg, Jönköping International Business School, Sweden Ajit Singh, Queen’s College, Cambridge University, UK Valdemar Smith, Centre for Industrial Economics, University of Copenhagen, Denmark R. Øystein Strøm, Østfold University College, Norway Steen Thomsen, Copenhagen Business School, Denmark Daniel Wiberg, Jönköping International Business School, Sweden Oliver E. Williamson, University of California, Berkeley, USA

vii

Preface This book is a collection of papers from two workshops held in Jönköping, Sweden, in 2006 and 2007. The theme of the workshop in 2006 was ‘Corporate Governance and Investment’ in a wide sense. Topics of papers could be: to describe and analyse the ownership and corporate governance structure of a given country; to make a comparative analysis of governance structures in different countries; to study corporate governance and performance in different types of firms (for example, family and non-family owned firms); to explain the levels of investment of companies; and to draw policy implications about how capital markets might be altered to improve the allocation of capital and the overall performance of companies. The workshop arranged in Jönköping was one in a series of annual meetings of a European Corporate Governance Network. The network’s first meeting was at Cambridge University (UK) in 1998 by initiative of Professor Dennis C. Mueller and Professor Alan Hughes. Since then several meetings have been organized. The 2006 workshop in Jönköping was the seventh. The second workshop, held in Jönköping in September 2007, was the first of its kind inspired by the emerging literature on the economics of the firm. The background to the workshop was the revolutionary development of the theory of the firm that has taken place during the last 35 years. In spite of all the progress in the field, traces of the new developments in microeconomic and industrial organization textbooks are scant. The comments made by Ronald Coase in 1971 at an NBER meeting about a non-existent treatment of organization of economic activities within and between firms in industrial organization textbooks are still valid. But in other ways the situation today is quite different from 35 years ago. At the same NBER meeting Coase also commented upon his celebrated article from 1937 (‘The Nature of the Firm’) with the words ‘much cited and little used’. This comment turned out to be a truthful description of the situation in 1971, but not true for the rest of the 1970s. In the same year as the NBER meeting (1971) Oliver E. Williamson published a seminal article in the American Economic Review, which was the start of a large number of books and articles that, like Coase, centred on the importance of transaction costs in analyses of economic organizations. A new field of transaction cost economics emerged. Some other articles from which new fields of research have emanated viii

Preface

ix

were also published in the 1970s. The team production and the property rights perspective introduced by Alchian and Demsetz (1972) and the corporate governance perspective in Jensen and Meckling (1976) have been especially influential. From the 1980s the evolutionary theory of the firm presented by Nelson and Winter (1982) and the new property rights approach by Grossman and Hart (1986) have reshaped research in a similar fashion. These and other branches of the growing tree of the theory of the firm were the sources of inspiration for the workshop on ‘The Economics of the Modern Firm’. The output from the two workshops is merged in this book under the title The Modern Firm, Corporate Governance and Investment. To merge contributions from the two workshops makes sense given the close connection between the topics and papers presented at the workshops. For example, several papers at the second workshop were on corporate governance. In all, 14 papers from the two workshops have been selected, nine from the second workshop and five from the first. The keynote addresses of Oliver E. Williamson and Dennis C. Mueller at the second workshop are the first two chapters after the introduction. The participants at the workshops and the referees of the different articles in this book have helped to improve the contents. We thank them for their questions and comments. The workshops and the preparation of this book were financed by Sparbankstiftelsen Alfa, Torsten and Ragnar Söderberg´s foundation and CESIS (Center of Excellence for Science and Innovation Studies). We are grateful for their support that allowed us to engage in this research. We are also indebted to Ibteesam Hossain and Maria Eriksson for excellent research assistance with this book.

1.

Introduction: the modern firm, corporate governance and investment Per-Olof Bjuggren and Dennis C. Mueller

The book is organized into four parts. Part I contains overviews of the theory of the firm. Part II is devoted to firms and organization of economic activities. Part III deals with how the institutional framework of an economy affects investments made by firms. Part IV looks at the impact of ownership structure and board composition on firm performance.

I.

OVERVIEWS

Part I contains two overviews of the theory of the firm from different perspectives. ‘Opening the black box of firm and market organization: antitrust’ by Oliver E. Williamson presents an overview of the characteristics of the transaction cost approach to the study of economic organization. The antitrust implications of this new view of economic organization are also considered. Thus, this chapter reviews both the positive and normative aspects of Williamson’s theory of the firm, and offers a contractual view of economic organization. The black box of the firm is opened in the sense that the governance attributes that distinguish the firm from the market are outlined. The market of the ‘pure vanilla’ type (spot contract character) found in most textbooks is complemented by the contractual deviations that can be characterized as hybrids of market and firm. The new explanations of antitrust phenomena provided by transaction cost analysis are discussed. Instead of solely focusing on market power aspects of vertical market relations, pricing practices and horizontal and conglomerate mergers, a transaction cost analysis provides a broader picture by also including cost-reducing explanations. Williamson shows how these alternative explanations gradually have been recognized by US antitrust authorities. ‘The corporation: an economic enigma’ by Dennis C. Mueller looks 1

2

The modern firm, corporate governance and investment

at how the view on the corporate form of business has changed amongst economists since Adam Smith. The chapter addresses the key issue in corporate governance about efficiency implications of ownership and control in corporations. An overview is provided on how economists’ views of the corporation and its performance had changed over time. The early economists such as Adam Smith, John Stuart Mill and Alfred Marshall offered descriptions of corporate behaviour based on their observations of how companies function. Berle and Mean’s book The Modern Corporation and Private Property from 1932 is also based on observations that are supported by an impressive amount of descriptive data. The neoclassical view emerging during the 1930s and 1940s represents a different way of doing research on the firm and corporate form. For pedagogical and simplifying reasons the firm is looked upon as a profit maximizing entity. The managerial challenge of this neoclassical view and the ongoing debate between these two schools of thoughts are then discussed. One way to resolve the conflict between these two views is to look at the return on investments. Such studies have been done recently and show that investment efficiency has actually improved since the 1990s in some countries like the United States. Possible explanations are disciplining takeovers, increased product competition due to globalization and the growth of institutional shareholding.

II.

ORGANIZATION OF ECONOMIC ACTIVITIES

In Part II, chapters studying the firm from an economic organization perspective are found. The first chapter, by Per-Olof Bjuggren and Johanna Palmberg, (entitled ‘A contractual perspective on the firm with application to the maritime industry’) introduces a contractual model of the firm and applies it to explain how the maritime sector is organized. The capacity of the firm as a legal person to enter into contracts with suppliers of goods and services, customers and creditors is highlighted. It is argued that mutual dependency is what determines the character of contractual relations. The employment contract and ownership of assets in adjacent vertical stages enables the firm to supplant price as coordination mechanism in the production of goods and services. The maritime industry offers a rich flora of contractual relations due to differing degrees of mutual dependence between shipper and carrier. Both the firm and the freight contract are analysed from a contractual perspective. A contractual explanation is also offered for the phenomenon of third-party management. A second chapter, by Kirsten Foss, (entitled ‘Authority in the knowledge economy’) takes a closer look at authority relations between employer and

Introduction

3

employees. In transaction cost economics, it is claimed that the possibility to use authority as a mode of coordination is what primarily characterizes firms. Authority is a key concept in the theory of the firm, and Foss throws light upon it. She claims that the emerging knowledge economy makes it necessary to take a closer look at the different dimensions of the authority concept in order to understand ongoing changes in economic organization. From a review of authority in the economic literature, the conditions under which it is efficient to use authority for coordination, contract enforcement, and dispute resolution are identified. Finally, how these conditions have to be adapted to an emerging knowledge economy is discussed. The third chapter, by Gunnar and Åsa Eliasson, (entitled ‘Competence and learning in the experimentally organized economy’) offers a new evolutionary perspective on how firms emerge and disappear. The authors picture an economy with boundedly rational and myopic actors who try to take advantage of perceived business opportunities. Success is to a large extent dependent on the interaction of actors in so called competence blocs. In a successful competence bloc, customers, innovators, entrepreneurs, financiers, exit markets and industrialists interact efficiently in the sense of minimizing the cost of keeping losers on for too long and losing the winners. The customer has a key function in a bloc by being the ultimate arbiter of value. In the experimentally organized economy that Gunnar and Åsa Eliasson envision, economic organization and ‘the firm’ are a result of how the competence bloc is structured. Efficient ways to organize the relations between the actors in a bloc will be rewarded by increasing returns, which make the organization viable.

III.

IMPORTANCE OF THE INSTITUTIONAL ENVIRONMENT

Part III consists of chapters dealing with investment and legal environment. Johan Eklund’s contribution (entitled ‘Corporate governance and investment in Scandinavia – ownership concentration and dual-class equity structure’) looks at how ownership structure affects investment performance in the different Scandinavian countries. As a measure of investment performance, the marginal q developed by Dennis Mueller and Elisabeth Reardon is used. From legal and political perspectives the Scandinavian countries are rather similar. But there are still distinctive differences in separation of ownership and control through the use of dual-class shares. Sweden has the highest fraction of listed firms that use dual-class shares, while Norway has the lowest fraction. The implications of these differences on investment performance are investigated. It turns out that in Norway

4

The modern firm, corporate governance and investment

the marginal q estimate indicates overall efficient investment performance among the listed firms, while the estimate for Swedish and Danish firms indicates over-investment – marginal returns on investment are lower than costs of capital. A non-linear effect of ownership concentration in Scandinavian firms is also found, implying a positive but marginally decreasing effect of ownership concentration on investment returns. In a second chapter (‘The cost of legal uncertainty: the impact of insecure property rights on cost of capital) Per-Olof Bjuggren and Johan Eklund study how institutional risk influences the required return on international investments. Institutional risk due to weak property rights and investor right protection represents a non-diversifiable risk to international investors, as these rights are fairly stable over time. Hence investors are likely to demand a risk premium in those countries where these rights are weak. The required return on investment in such countries will accordingly be higher. The capital asset pricing model (CAPM) is used to test for the importance of taking institutional risk into consideration, and to find out the risk premium associated with institutional risk. It turns out that the explanatory power of the CAPM is considerably increased if such a risk is taken into account. Furthermore, the risk premium due to institutional risk is found to be significantly higher for developing than for developed countries. A third chapter, by Simon Deakin and Ajit Singh, (‘The stock market, the market for corporate control and the theory of the firm: legal and economic perspectives and implications for public policy’) takes up the question of how important an active market for corporate control is for economic efficiency. The authors have severe doubts about whether hostile takeovers have positive effects on efficiency and growth in developed countries. Their discussion of the pros and cons of a market for corporate control starts with the observation that shareholders do not ‘own a company’ in the sense of being entitled to ‘a particular segment or portion of the company’s assets, at least while it is a going concern’. Furthermore, directors’ fiduciary interests of loyalty and care are owed to the company. Even though in practice it is foremost the interests of the shareholders that are catered to, other stakeholders’ interests are to a differing degree also recognized. This is especially the case in civil law systems. It is argued that it cannot be taken for granted that company law and articles of association that serve as obstacles to takeovers are at the expense of economic efficiency. Two strands of thought in the economic literature are referred to in Deakin and Singh’s economic analysis; On one hand, there is the principal– agent view of the market for corporate control that is used in financial economics. On the other hand, there is a more antitrust oriented analysis used

Introduction

5

in industrial organization. The views of these schools differ. While financial economists have focused on takeovers and mergers as a mechanism to discipline managers, industrial economists also stress their negative effects on the overall economy. Balancing different views of efficiency implications, Deakin and Singh come to the conclusion that hostile takeovers are likely to harm the prospects for growth in developing and transition economies.

IV.

OWNERSHIP STRUCTURE, BOARD COMPOSITION AND FIRM PERFORMANCE

Part IV contains chapters that examine how the composition of the board, management relations and ownership structure affect firm performance. A first chapter by Daniel Wiberg (‘Institutional ownership and dividends’) studies the relationship between institutional ownership and dividends. Wiberg wants to see both whether there is a positive relation between institutional ownership and dividends, and whether there are more rational reasons than ‘short-termism’ for explaining such a relation. Swedish data are used to test the hypotheses. The Swedish institutional framework is interesting as there is widespread use of dual-class shares and the tax rules make dividends more attractive to institutional than to other ownership categories. Through the use of dual-class shares, ownership can be separated from control, leading to pronounced agency problems. One way to overcome these agency problems is to insist on dividends. If such a relationship exists it implies that dividends are higher in firms with greater separation between ownership and control due to dual-class shares. Wiberg finds this to be the case, and that institutional ownership has a positive impact on dividend growth. Camille Madelon and Steen Thomsen (‘Contracting around ownership: shareholder agreements in France’) use data from large, French listed firms to examine the effects and determinants of shareholder agreements. These agreements represent a way to contract around the official ownership structure. While the relationship between observable formal ownership and behaviour/performance has been extensively studied, there has been no study of the relationship between real ownership structure (considering contracts between shareholders as well) and behaviour/performance. Madelon and Thomsens’s study is one of the first steps towards ‘filling this void’. It is an explorative study that analyses agreements from a transaction cost approach view. The costs and benefits of acquiring control through contracting amongst shareholders are compared with the alternative of outright ownership. Several theoretical propositions are derived that consider ownership and industry characteristics and network ties as

6

The modern firm, corporate governance and investment

explanations as to why contractual agreements are chosen. Propositions about the impact of shareholders’ agreements on economic performance are also derived. ‘Board governance of family firms and business groups with a unique regional dataset’, by Lluís Bru and Rafel Crespi, is both a methodological paper about how to empirically study family business and a description of what family businesses look like in the Balearic region of Spain. They have managed to trace family ownership and management by use of the Spanish ‘two-surnames’ system. This system has two features. Married women usually do not change their name and newborns have both the father’s and the mother’s surname. This surname system has made it possible to trace both ownership and involvement in boards and management by family members. Besides family companies, it has been possible to trace business groups under the control of associated families. The importance of family firms and groups in the Balearic economy and the characteristics of the diversification patterns of family business groups are described. Reidar Øystein Strøm (‘Better firm performance with employees on the board?’) uses data from Norwegian listed firms to analyse how co-determination affects performance. He distinguishes between direct and indirect effects of employee directors. In the theoretical literature both positive and negative effects of employee directors on performance are envisioned. Employee directors might contribute to positive performance by bringing more information about how the firm functions and enhancing the incentives to invest in firm-specific human capital. On the other side, owners’ and employees’ interests might not be aligned, producing a negative effect on performance. Most empirical studies find a negative impact on performance. Strøm takes the analysis one step further by taking account of the reactions of the shareholders to anticipated negative effects of employee directors. By adjusting the composition of the board and the financial leverage of the firm, these negative effects can be counteracted. This indirect effect is taken into consideration in a simultaneous equations framework. A three-stage least squares methodology with fixed effect is used to estimate both the direct and indirect effects. Even though indirect endogenous effects are taken into account, the results of the empirical analysis show a negative impact of employees on the board. Wolfgang Drobetz, Klaus Gugler and Simone Hirschvogl (‘The determinants of German corporate governance ratings’) analyse corporate governance rating in Germany. As in many other European countries, Germany has since 2002 had a Corporate Governance Code of a ‘comply or explain’ kind. Instead of assessing the impact of code fulfilment on performance of firms, Drobetz, Gugler and Hirschvogl choose to analyse the determinants of corporate governance rating. One advantage with this approach is that

Introduction

7

an endogeneity problem due to self-selection is avoided. The analysis is to a large extent based on the assumption that there is a positive relation between firm performance and a high corporate governance rating. The determinants of performance studied are ownership concentration, the size of the supervisory board, choice of strict accounting rules, and the use of an option-based remuneration plan. Ownership concentration is hypothesized to be non-linearly related to ratings. The rationale is that it is only at high levels of ownership concentration that the entrenchment effect of ownership is balanced by the rewards associated with better performance. For the other determinants, a negative effect is found for board size, stricter accounting rules are positively related to performance, and stock-option schemes have a positive relation to rating. All the hypotheses are corroborated in the empirical analysis based on survey data from 91 German firms. Mogens Dilling-Hansen, Erik Strøjer Madsen and Valdemar Smith (‘Top management, education and networking’) use Danish data to study how management can benefit from networking. Networking takes place through board participation by top management. They look at network ties between firms linked by ownership and between independent firms. The former ties are labelled internal ties while the latter are called external ties. Networking through external ties can increase the top management’s knowledge of the competitive and technological environment of the firm. It can also facilitate collusion. Networking can then be expected to improve performance. Networking of an internal character can improve the control of subsidiaries. The extent to which networking will have a positive influence on performance can be expected to be dependent on education. An empirical analysis of a large sample of Danish firms finds a significant positive effect of internal network activities on firm performance, and that education implies a positive attitude towards networking. No other significant relationships can be traced.

PART I

Key issues

2.

Opening the black box of firm and market organization: antitrust* Oliver E. Williamson The task of linking concepts with observations demands a great deal of detailed knowledge of the realities of economic life. – Tjalling Koopmans

Opening the black box of firm and market organization and examining the mechanisms inside is a defining characteristic of the transaction cost approach to the study of economic organization (Arrow, 1987, 1999; Dixit, 1996; Kreps, 1990). But questions remain. Do the details matter for a wide range of phenomena or only a few? Which, among the endless number of details that could be recorded, have conceptual and operational significance? What, if any, are the public policy ramifications? My responses to these queries are that the details matter for a wide range of phenomena, that many relevant details are uncovered by examining economic organization through the focused lens of contract/governance,1 and that public policy toward business has been a beneficiary. Antitrust applications are developed here. Regulatory applications are examined elsewhere (Williamson, 2007a). I begin with a statement of the crisis in antitrust as of 1970. A synopsis of the microanalytic setup is then sketched in Section 2. The paradigm problem for transaction cost economics is the intermediate product market transaction, as described in Section 3. Antitrust applications are developed in Sections 4–8. Concluding remarks follow and there is an Appendix on the antecedents on which transaction cost economics builds.

1.

THE CRISIS IN ANTITRUST

Victor Fuchs opens his foreword to the National Bureau of Economic Research 50th anniversary volume, Policy Issues and Research Opportunities in Industrial Organization, with the query ‘Whither industrial organization?’, to which he opines that ‘all is not well with this once flourishing field’ 11

12

Key issues

(1972, p. xv). Of the various answers that could be advanced to explain this decline, the ones to which I attach the greatest weight are the all-purpose reliance by industrial organization economists (and others) on a black box theory of the firm and a plain vanilla theory of markets. Because the firm was described as a production function that transformed inputs into outputs according to the laws of technology, non-technological or nonprice theoretic explanations for reshaping the boundary of the firm were thought to be deeply problematic. Contractual deviations from simple market exchange were likewise regarded as suspect. Since economists were dismissive of the possibility that the internal organization of transactions had important economizing consequences,2 vertical integration and other organizational practices that lacked a ‘physical or technical aspect’ were presumed to have the purpose of increasing the ‘market power of the firms involved rather than reduction in cost’ (Bain, 1968, p. 381). Vertical market restrictions (and other deviations from simple market exchange) were also regarded as deeply problematic. As the then head of the Antitrust Division of the US Department of Justice put it, ‘I approach customer and territorial restrictions not hospitably in the common law tradition, but inhospitably in the tradition of antitrust.’3 Indeed, some protectionist antitrust enforcement officials regarded prospective efficiency gains from a merger to be anticompetitive because less efficient rivals would be disadvantaged.4 Such upside-down reasoning encouraged respondents to merger litigation to disclaim that any efficiency benefits would accrue.5 Ronald Coase summarized the prevailing state of disarray as follows: ‘If an economist finds something – a business practice of one sort or other – that he does not understand, he looks for a monopoly explanation. As in this field we are very ignorant, the number of ununderstandable practices tends to be rather large, and the reliance on monopoly explanation, frequent’ (1972, p. 67). An altogether different lens through which to examine complex contracting and economic organization would be needed to break the grip of such convoluted thinking. As described in Section 2, the lens of contract/ governance describes firms and markets as governance structures, the different mechanisms of which matter in efficiency respects. An economics of organization takes shape in the process as monopoly is reduced to an important but special case.

Opening the black box of firm and market organization

2.

THE MICROANALYTICS: A SYNOPSIS

2.1

General

13

As Herbert Simon observes (1984, p. 40): In the physical sciences, when errors of measurement and other noise are found to be of the same order of magnitude as the phenomena under study the response is not to try to squeeze more information out of the data by statistical means; it is instead to find techniques for observing the phenomena at a higher level of resolution. The corresponding strategy for economics is obvious: to secure new kinds of data at the micro level.

Inasmuch, however, as the social sciences are ‘hypercomplex’ (Wilson, 1998, p. 183; Simon, 1957, p. 89), the details proliferate. Where precisely do the relevant microanalytics reside? That will vary with the phenomena to be investigated and the lens through which the phenomena are viewed. 2.2

The Rudiments6

Rather than operate out of the neoclassical lens of choice (with emphasis on prices and output, supply and demand, in relation to which organization is held to be unimportant), transaction cost economics works out of the lens of contract/governance. The building blocks are transactions and governance structures and the efficient alignment thereof, whereupon organization is not only important but is susceptible to analysis.7 In addition to simple market exchange (contract as legal rules), provision is made for hybrid contracting (contract as framework, for which continuity of the exchange relationship is important) and hierarchy, each of which is described as an alternative mode of governance. Note that the decision to use one mode of governance rather than another depends on the transactions for which governance support is required. Hitherto neglected transaction costs take their place in the analytical firmament. If both transactions and governance structures differ, then the relevant microanalytics for describing both of these will need to be worked out. Herbert Simon’s advice, to little discernible effect, that ‘Nothing is more fundamental in setting our research agenda and informing our research methods than our view of the nature of the human beings whose behavior we are studying’ (1985, p. 303) is pertinent in this connection. Cognitive competence is especially relevant, but so too is the manner in which selfinterest is described. If, for example, human actors possess the cognitive ability to implement comprehensive contingent claims contracting, then we are in the

14

Key issues

world of Arrow–Debreu and, in such a contractual world, organization is unimportant. If instead the list of six assumptions that are made by Drew Fudenberg, Bengt Holmstrom and Paul Milgrom (1990) apply, then we are in a world where a sequence of short-term contracts can implement an optimal long-term contract.8 More generally, the point is this: different assumptions about cognition lead into different theories of contract and organization (and the same holds for descriptions of self-interest (Williamson, 1985, pp. 64–7)). Transaction cost economics describes both cognition and self-interest in a two-part way. Specifically, cognition combines bounded rationality with feasible foresight while self-interest joins benign behavior with opportunism. Thus all complex contracts are unavoidably incomplete (by reason of bounded rationality) yet human actors are assumed to have the capacity to look ahead, recognize hazards, work out the mechanisms, and, albeit imperfectly, factor the ramifications back into the ex ante contractual design (which is a manifestation of feasible foresight). Also, most human actors will do what they agree to and some will do more most of the time (benign behavior), but outliers for which the stakes are great will elicit defection and/or posturing (which are manifestations of opportunism) with the purpose of inducing renegotiation. Whether contractual incompleteness (bounded rationality) and defection hazards (opportunism) pose serious governance issues depends on the attributes of transactions. Transactions for which continuity of the exchange relationship is important and for which coordinated adaptations are needed to restore efficiency are those for which the efficacy of simple market exchange breaks down. Behavioral attributes in combination with transactional attributes thus underpin the need for added governance supports (or not) – where governance is defined as the means by which to infuse order, thereby to mitigate conflict and realize mutual gain. The three attributes of transactions that are especially important for preserving continuity by implementing coordinated adaptations are asset specificity (which is a measure of bilateral dependency, to which maladaptation hazards accrue), uncertainty (the disturbances, small and great, to which transactions are subject), and the frequency with which transactions recur, which has a bearing on both reputation effects (in the market) and private ordering mechanisms (within firms). Governance structures are described as discrete structural syndromes of attributes that differ in their adaptive capacities, of which two types are distinguished: autonomous adaptation to changes in relative prices as described by Friedrich Hayek (1945) and coordinated adaptations of a conscious, deliberate, purposeful kind as described by Chester Barnard (1938). Incentive intensity, decision and administrative control instruments, and

Opening the black box of firm and market organization

15

contract law regimes are the defining attributes with respect to which governance structures are described. As discussed in Section 3, the three main modes of governance for organizing intermediate product market transactions are market, hybrid, and hierarchy. Interestingly, but not surprisingly, spot markets and hierarchies are polar opposites – in that spot markets are characterized by high-powered incentives, negligible administrative control, and a legal rules contract law regime, thereby to support autonomous adaptation, whereas hierarchies use low-powered incentives and hands-on administrative control, and settle internal disputes administratively under a forbearance law regime9 in support of coordinated adaptation. Hybrid contracting is located between market and hierarchy in all three attributes and in both adaptation respects and thus can be thought of as a compromise mode. The discriminating alignment hypothesis provides the predictive link between transactions and governance structures – to wit, transactions, which differ in their attributes, are aligned with governance structures, which differ in their costs and competences, so as to effect a transaction cost economizing match.

3.

TRANSACTIONS IN THE INTERMEDIATE PRODUCT MARKET: THE PARADIGM TRANSACTION

The intermediate product market transaction (or in more mundane terms, the make-or-buy or outsourcing decision) is the obvious paradigmatic transaction for transaction cost economics for two reasons. First, this is the transaction to which Coase referred in pointing up a lapse in economic theory in 1937: ‘The purpose of this paper is to bridge what appears to be a gap in economic theory between the assumption (made for some purposes) that resources are allocated by means of the price mechanism and the assumption (made for other purposes) that this allocation is dependent on . . . [hierarchical mechanisms]. We have to explain the basis on which, in practice, this choice between alternatives is effected’ (Coase, 1937, p. 389). Secondly, intermediate product market transactions are simpler than are labor market, capital market, and final product market transactions because they are less beset with asymmetries of information, budget, legal talent, risk aversion, and the like. The simple contractual schema, as described herein, focuses on the intermediate product market transaction but applies (with variation) to the study of transactions more generally. Thus assume that a firm can make or buy a component and assume

16

Key issues A (unassisted market) h=0 B (unrelieved hazard) s=0 C (credible commitment) h>0 market safeguard s>0 administrative

D (integration)

Figure 2.1

Simple contractual schema

further that the component can be supplied by either a general purpose technology or a special purpose technology. Letting k be a measure of asset specificity, the transactions in Figure 2.1 that use the general purpose technology are ones for which k 5 0. In this case, no specific assets are involved and the parties are essentially faceless. Transactions that use the special purpose technology are those for which k . 0. Such transactions give rise to bilateral dependencies, in that the assets cannot be redeployed to alternative uses and users without loss of productive value. The parties therefore have incentives to promote continuity, thereby to safeguard specific investments. Let s denote the magnitude of any such safeguards, which include penalties, information disclosure and verification procedures, specialized dispute resolution (such as arbitration) and, ultimately, integration of the two stages under unified ownership. An s 5 0 condition is one for which no safeguards are provided; a decision to provide safeguards is reflected by an s . 0 result. Node A in Figure 2.1 corresponds to the ideal transaction in law and economics: there being an absence of dependency, governance is accomplished through competition and, in the event of disputes, by court awarded damages. Node B poses unrelieved contractual hazards, in that specialized investments are exposed (k . 0) for which no safeguards (s 5 0) have been provided. Such hazards will be recognized by farsighted players, who will price out the implied risks.10 Confronted with the added costs of these hazards, buyers have the incentive to mitigate the hazards (in

Opening the black box of firm and market organization

17

cost-effective degree), which is to say that node B is an inefficient mode of governance for ongoing (as against episodic) supply purposes. Added contractual supports (s . 0) are provided at Nodes C and D. Node C governance corresponds to what Karl Llewellyn referred to as contract as framework, as distinguished from contract as legal rules, where the former better preserves continuity of the transaction through ‘a framework highly adjustable, a framework which almost never accurately describes real working relations, but which affords a rough indication around which such relations vary, an occasional guide in cases of doubt, and a norm of ultimate appeal when the relations cease in fact to work’ (1931, pp. 736–7). This is the aforementioned hybrid transaction where credible contracting mechanisms are introduced in support of cooperative adaptation. Such hybrids are not, however, ‘indefinitely elastic. As disturbances become highly consequential, . . . an incentive to defect [arises]. The general proposition here is that when the “lawful” gains to be had by insistence upon literal enforcement exceed the discounted value of continuing the exchange relationship, defection from the [cooperative] spirit of the contract can be anticipated’ (Williamson, 1991a, p. 273). Benjamin Klein subsequently describes ‘the self-enforcing range’ similarly: if and as ‘changes in market conditions move outside the self-enforcing range, . . . the one-time gain from breach [will] exceed the private sanction’ (1996, p. 449). But this is not the end of the governance story. As the expected maladaptation costs of hybrid contracting progressively mount, best efforts to craft cost-effective credible commitments notwithstanding, transaction cost economics predicts that transactions will be removed from the hybrid and organized under unified ownership (vertical integration). Inasmuch as added bureaucratic costs accrue upon taking a transaction out of the market and organizing it internally, hierarchy is usefully thought of as the organization form of last resort: try markets, try hybrids, and have recourse to the firm (Node D) only when all else fails. Node D governance (hierarchy) involves (1) unified ownership of successive stages, (2) coordinated adaptation at the interfaces by the application of routines (to manage disturbances in degree) and by the use of hierarchy (to manage disturbances in kind), (3) internal dispute resolution for settling disputes that cannot be resolved by the parties by appealing these to a common ‘boss’, and (4) the aforementioned bureaucratic cost burdens. Transaction cost economics thus predicts that generic (k 5 0) transactions will be assigned to Node A (the market mode, where continuity is of no importance and disputes are settled in court), more complex transactions (k . 0) to Node C (the hybrid mode, where continuity matters and adaptations are accomplished under the more elastic concept of contract as framework), that very complex transactions (k . . 0) will be taken

18

Key issues

out of the market and organized within hierarchy at Node D, and that few transactions (mistakes or adventitious transactions) will be located at inefficient Node B. What is furthermore noteworthy is that empirical tests of the predictions of the theory have ensued and have been broadly corroborative. Indeed, ‘despite what almost 30 years ago may have appeared to be insurmountable obstacles to acquiring the relevant data [which are often primary data of a microanalytic kind], today transaction cost economics stands on a remarkably broad empirical foundation’ (Geyskens, Steenkamp and Kumar, 2006, p. 531). This applies, moreover, not merely to the tests of the paradigm problem of vertical integration but to a vast variety of other phenomena that are interpreted as variations on a theme (Macher and Richman, 2006). There is no gainsaying that transaction cost economics has been much more influential because of the empirical work that it has engendered (Whinston, 2001).

4.

APPLICATIONS TO ANTITRUST: GENERAL

The over-reaching excesses of monopoly reasoning during the 1960s contained the seeds of their own destruction. Confronted with escalating implausibility, Supreme Court Justice Potter Stewart, in a dissenting opinion, observed that the ‘sole consistency that I can find is that in [merger] litigation under Section 7, the Government always wins.’ 11 Alarmist excesses of monopoly reasoning eventually elicited a series of challenges – to include both allocative efficiency and transaction cost reasoning,12 where the latter made express provision for economies of organization, the myopic quality of entry barrier reasoning was confronted with remediableness considerations, nonstandard and unfamiliar contracting practices that had been declared to be anticompetitive under the inhospitality tradition were re-examined and found, often, to serve credible contracting purposes, and selective appeal to zero transaction costs was supplanted by an insistence that positive transaction costs be recognized wheresoever they may reside.13 Antitrust scholars from the ‘Chicago School’ (Stigler, 1968; Demsetz, 1974; Posner, 1976; Bork, 1978) receive and deserve much of the credit, but transaction cost economics was also a contributing factor. Thus whereas ‘the Chicago School focused on explaining why vertical integration and nonstandard vertical contracts did not create or enhance market power . . . transaction cost economics focused on why these vertical arrangements emerged as cost-reducing responses to certain transactional characteristics’ (Joskow, 1991, p. 56; emphasis added). Without such an affirmative rationale,

Opening the black box of firm and market organization

19

it is hard to believe that the Chicago critique of antitrust policies regarding vertical arrangements would have had as much influence, especially among professional economists and antitrust scholars, . . . for [whom] the theoretical and empirical work in transaction cost economics . . . demonstrated that previously suspect vertical arrangements often could be explained as contractual and organizational responses motivated by a desire to reduce the cost of transacting. (Joskow, 1991, p. 57)

As between critiques of wrong-headed reasoning and explanations for the practices in question for which the mechanisms have been expressly worked out, the latter is the more demanding. Interestingly, Timothy Muris, during his term as chair of the Federal Trade Commission, held that much of the New Institutional Economics ‘literature has significant potential to improve antitrust analysis and policy. In particular, . . . [the transaction cost branch has] focused on demystifying the “black box” firm and on clarifying important determinants of vertical relationships’ (2003, p. 15). Opening the black box and acquiring an understanding of the mechanisms inside has had an impact, moreover, on practice: The most impressive recent competition policy work I have seen reflects the NIE’s teachings about the appropriate approach to antitrust analysis. Much of the FTC’s best work follows the tenets of the NIE and reflects careful, factbased analyses that properly account for institutions and all relevant theories, not just market structures and [monopoly] power theories. (Muris, 2003, p. 11; emphasis in original)14

A comprehensive examination of the applications of transaction cost economics to antitrust is beyond the scope of this chapter. My purpose is merely to illustrate the ways in which examining the microanalytics of complex contract and economic organization through the lens of contract/ governance has served to alter and deepen our understanding of many antitrust related phenomena. I successively examine applications to vertical market relations, price theoretic issues, credible contracting, and the modern corporation.

5.

VERTICAL MARKET RELATIONS

Lateral integration into components, backward into raw materials, and forward into distribution are successively examined. The analysis throughout tracks the logic of the simple contractual schema – in that the move from market to hybrid to hierarchy is predicted as asset specificity and outlier disturbances increase. Asset specificity refinements − as among

20

Key issues

physical, human, site, dedicated, and brand name capital – are also consequential. With respect, for example, to mobile physical assets (such as specialized dies), it may be possible for the specialized investments to be made by the buyer, who relieves bilateral dependency by assigning the specialized dies to the winning bidder for the duration of the supply contract and repossessing and reassigning these to a successor if the original bidder does not win the renewal contract.15 The need for unified ownership is also relieved by the use of credible commitments to support hybrid contracting – as with exchange agreements, or for organizing distribution through a large number of geographically dispersed outlets by franchising rather than by forward integration (although there is also merit in dual distribution). As, however, asset specificity and disturbances increase, unified ownership is predicted. 5.1

Lateral Integration

Economies are commonly ascribed to the integration of successive stages in the ‘technological core’, an example of which is the unified ownership of iron- and steel-making stages by reason of thermal economies (Bain, 1968, p. 381). By contrast, lateral integration into components that lack such a ‘physical or technical aspect’ is (under technological reasoning) believed to be deeply problematic. As discussed above, monopoly purpose and effect were commonly ascribed to these. Transaction cost economics disputes such reasoning. All that is implied by thermal economies (or, more generally, by the physical or technical aspects to which Bain refers) is that the two stages be located adjacent to each other. The governance issue is whether the exchange of product across these co-located stages should be mediated by market or by hierarchy. Unless contractual problems are projected, there is no reason why each stage could not be independently owned and the two stages joined by an interfirm contract. If, therefore, co-located stages are integrated, that is because transaction cost economies are thereby realized: unified ownership relieves the contractual hazards that would otherwise arise between independent, site-specific trading entities. But there is more: transaction cost economics also selectively offers an economizing interpretation for transactions that lack the ‘physical or technical aspects’ to which Bain refers. As discussed in Section 3 above, the outsourcing of separable components of a non-site-specific kind is the paradigm problem on which transaction cost economics is based and to which empirical tests were first applied (Monteverde and Teece, 1982; Masten, 1984).16 The upshot is that the same comparative contractual logic applies to the organization of asset-specific transactions of all kinds,

Opening the black box of firm and market organization

21

site-specific or not. The contrast with earlier antitrust predilections is stark.17 5.2

Raw Materials Procurement

Except perhaps for very atypical cases, an efficiency case for vertical integration backward into raw materials is believed to be rare if not nonexistent. Surely the lesson of the Ford Motor Company’s ‘fully integrated behemoth at River Rouge, supplied by an empire that included ore lands, coal mines, 700,000 acres of timberland, sawmills, blast furnaces, a glass works and coal boats, and a railroad’ (Livesay, 1979, p. 175) is that this was vertical integration run amok. Exactly right: maybe comprehensive vertical integration has the appearance of being an engineer’s dream, but it is not an economic ideal. As John Stuckey’s examination of backward integration from the refining into the raw materials stage in the Australian aluminum industry reveals, the transactional details matter. Bauxite ore, it turns out, is not a uniform mineral but, instead, is ‘a heterogeneous commodity, . . . [where] the ore in any deposit has unique chemical and physical properties’ (Stuckey, 1983, p. 290). That is consequential: the cost difference of processing a mixedhydrate bauxite, which is efficiently processed with a high-temperature technology, in a low-temperature refinery instead, comes to almost 100 percent (Stuckey, 1983, pp. 53–4). Other details also matter. Bauxite storage covers are needed for some ores and not for others (p. 49); residue processing costs vary greatly (p. 53); and air pollution equipment is tailored to the attributes of the bauxite (p. 60). Moreover, although smelting is less idiosyncratic, there is, nevertheless, an ‘art part of smelting’, which is upset if the aluminum supply is varied (p. 63). Not every refinery, however, is dependent on a specific bauxite deposit. Thus, whereas most of the above described economies are realized by specializing the characteristics of a local refinery to a local bauxite deposit (as in Australia), the same cannot be said for remotely located refineries, as in Japan, where a general purpose refinery that can process bauxite ores procured on the world market has countervailing advantages. Interestingly, regulatory concerns sometimes get in the way of backward integration – an example of which is the bilateral dependency that sometimes arises between fuel source and operating stages in electricity generation by coal-burning generators (Joskow, 1987). Lest utilities ‘integrate backward into coal production to shift profits from a regulated to an unregulated activity, the regulatory process has discouraged this’ (Joskow, 1987, p. 284, n. 17). As with bauxite, ‘The type of coal that a generating unit is designed to

22

Key issues

burn affects its construction and its design thermal efficiency’ (Joskow, 1987, p. 284). In some regions, as in the Eastern United States, coal of relatively uniform quality is available from a large number of small nearby mines; in other regions, as in the West, deposits are large and coal quality variation among mines and the distances for shipment are great (1987, p. 284). ‘Mine mouth’ generating plants of specific design are often observed for the latter. More generally, comparative contractual reasoning predicts that longer-term and more nuanced contracts will be observed for the West than in the East, which is borne out by the data: ‘as relationship-specific investments become more important, the parties . . . find it advantageous to rely on longer-term contracts that specify the terms and conditions of repeated transactions ex ante, rather than relying on repeated bargaining’ (Joskow, 1987, p. 296). 5.3

Forward into Distribution

A huge franchising literature in economics and marketing examines the decision of whether producers should own some or much of their distribution system or contract with others to manage the distribution of goods and services instead. In the event of the latter, vertical market restrictions often apply, a common purpose being to protect the network against brand name devaluation (Klein and Leffler, 1981). Many economizing issues are posed by forward integration into marketing and the uses of vertical market restrictions, of which asset specificity (especially in the form of brand name capital) is only one. Transaction cost reasoning nevertheless plays a central role in the marketing decision (Coughlan et al., 2005) as to which contractual mode to choose and, if the market, whether contractual restrictions should be imposed. Contrary to the ‘inhospitality tradition’ in antitrust,18 vertical market restrictions will yield social benefits if the requisite transaction cost pre-conditions are satisfied.

6.

PRICE THEORETIC ISSUES

6.1

Price Discrimination

The price theoretic argument in favor of price discrimination (especially perfect price discrimination) is that discrimination permits parties whose valuation is below a uniform monopoly price but above marginal costs to buy the good or service in question, as a result of which allocative efficiency benefits accrue. A problem with the argument is that perfect

Opening the black box of firm and market organization

23

price discrimination assumes that the transaction costs of discovering true customer valuations and of policing against arbitrage are zero, which are heroic assumptions. Upon taking the costs of discovering price valuations and enforcing arbitrage restrictions into account, it can be shown that costly price discrimination can lead to both private benefits (monopoly profits increase) and social losses (Williamson, 1975, pp. 11–13).19 6.2

Robinson-Patman

Transaction cost economics also has a bearing on the Robinson-Patman Act, which has been interpreted as an effort ‘to deprive a large buyer of [discounts] except to the extent that a lower price could be justified by reason of a seller’s diminished costs due to quantity manufacture, delivery, or sale, or by reason of the seller’s good faith effort to meet a competitor’s equally low price.’ 20 The concern, plainly, is that large buyers will use their muscle to extract better deals from suppliers, as a result of which smaller buyers will be disadvantaged. To this, however, should be added the possibility that different buyers are prepared to offer different contractual supports for the same good or service. With reference to Figure 2.1, suppose that a supplier uses specialized assets to produce the same good or service for two buyers. Assume that one of the buyers refuses to offer contractual safeguards while the other does offer safeguards. These two correspond to Node B and Node C contracting, respectively. Plainly, the supplier will sell on better terms to the Node C buyer than to the Node B buyer. The upshot is that quantity and meeting competition considerations do not exhaust the legitimate reasons for offering lower prices to some buyers than to others. Application of the lens of contract/governance, as against all-purpose reliance on textbook micro theory, serves to uncover these additional purposes. 6.3

Predatory Pricing

Transaction cost economics disputes the merits of the marginal cost pricing test for predatory pricing, as advanced by Philip Areeda and Donald Turner (1975), in two respects. First, although marginal cost pricing can be thought of as a hypothetical ideal (second best considerations aside), such an ideal is a deceptive standard if the measurement of marginal costs invites accounting manipulation and deceit in the courtroom. Additionally, Areeda and Turner apply the same marginal cost pricing test to price reductions of both continuing and temporary kinds – which is to say that they make no provision for strategic price reductions: now it’s there, now

24

Key issues

it isn’t, depending on whether a new entrant has appeared or been vanquished. That is unwarranted, since the welfare benefits of temporary price cuts are at best small and could easily be net negative. Here as elsewhere, however, objections to a proposed criterion do not, alone, carry the day. There is an obligation to advance a superior feasible alternative. The output test proposed in Williamson (1977) has three advantages over the marginal cost pricing test: (1) repositioning, (2) measurement, and (3) contingent versus continuing responses. Repositioning makes allowance for the possibility that parties to which predatory pricing rules apply will adapt (reposition) in relationship to them. Areeda and Turner ignore this incentive, yet it is noteworthy that their test has inferior repositioning properties in comparison with the output test. Output, moreover, is much easier to measure than is marginal cost. And the output test expressly favors continuing over contingent supply – now it’s here, now it isn’t, depending on whether an entrant has appeared or perished – by the established firm. The upshot is that transaction cost considerations are very relevant for uncovering the efficiency ramifications of two price theoretic tests for predation. 6.4

Over-searching

The market for gem-quality uncut diamonds employs two nonstandard contracting practices that are puzzling at best and are easily interpreted as efforts by de Beers to exercise muscle in its dealings with the buyers of uncut diamonds. The two trading restrictions in question are the ‘all-or-none’ and ‘in-or-out’ trading rules. Inasmuch as de Beers had market power in the supply of uncut diamonds, these trading rules were believed to have the muscular purpose of extracting profit from diamond cutters. Although the web of cooperative practices among diamond cutters in New York (Richman, 2006) might be interpreted as collusive, the de Beers trading rules applied to a global market. Consider therefore the possibility raised by Roy Kenney and Benjamin Klein (1983) that these rules have efficiency purposes. Whereas uncut diamonds are classified into more than two thousand categories, significant quality variation in the stones evidently remains. How can such a market be organized so as to reduce the oversearching costs that would be incurred if buyers were to evaluate every stone, or at least every grouping of stones, offered by de Beers? The combination of all-or-none with in-or-out trading rules arguably serves to reduce over-searching.21 The all-or-none trading rule requires that a buyer accept the entire grouping of diamonds assembled by de Beers (a ‘sight’) or none at all. Buyers are thereby denied the opportunity to pick and choose among

Opening the black box of firm and market organization

25

individual diamonds, yet nonetheless have the incentive to inspect each sight very carefully. Refusal to accept a sight would signal that the sight was over-priced – but no more. Suppose now that an in-or-out trading rule is added. The decision to refuse a sight now has much more serious ramifications. To be sure, a refusal could indicate that a particular sight is egregiously over-priced. More likely, however, it reflects a succession of bad experiences. It is a public declaration that de Beers is not to be trusted. In effect, a disaffected buyer announces that the expected net profit of dealing with de Beers under these constrained trading rules is negative. Such an announcement has a chilling effect on the market. Buyers who were earlier prepared to make casual sight inspections are now advised that there are added trading hazards. Everyone is put on notice that a confidence has been violated and is warned to inspect more carefully. On this interpretation, the in-or-out trading rule is a way of encouraging buyers to regard the procurement of diamonds not as independent trading events but as a related series of trades. If, overall, things can be expected to ‘average out’, then it is not essential that the payment made for value received corresponds exactly on each sight. In the face of systematic under-realizations of value, however, buyers will be induced to quit. If, as a consequence, the system is moved from a high to a low trust trading culture, then the costs of marketing diamonds increase. That is an adverse outcome to the system which de Beers has strong incentives to avoid. Accordingly, in a regime where both all-or-none and in-or-out trading rules apply, de Beers will take greater care to present sights such that the legitimate expectations of buyers will be achieved. The combined rules thus infuse greater integrity of trade.

7.

CREDIBLE COMMITMENTS

Although credible contracting is the core purpose served by hybrid modes of governance, such a purpose was slow to register in antitrust enforcement – mainly because of the monopoly predisposition with which nonstandard and unfamiliar contracting practices were viewed. But whereas ‘traditional market power theories [were so predisposed], . . . TCE can [frequently] . . . illuminate the meaning of facts – particularly in the context of complex contractual relations – that cannot otherwise be explained, or worse, are explained incorrectly’ (Muris, 2003, p. 18). Credible commitment reasoning (of a Node C versus Node B kind) has been applied to a wide range of contractual practices – including franchise restrictions, exchange agreements, take-or-pay agreements, and a host of other nonstandard contracting practices (Masten, 1996). Exchange agreements are an especially

26

Key issues

interesting illustration of opening the black box and interpreting the purposes served by the mechanisms inside.22 Petroleum exchanges have puzzled economists for a very long time and have been routinely challenged in antitrust cases and investigations of the petroleum industry. The 1973 case brought by the United States Federal Trade Commission against the largest petroleum firms maintained that exchanges were instrumental in maintaining a web of interdependencies among major firms, thereby helping to effect an oligopolistic outcome in an industry that was relatively unconcentrated on normal market structure criteria.23 A later study, The State of Competition in the Canadian Petroleum Industry, likewise held that exchanges were objectionable.24 The Canadian Study, moreover, produced documents – contracts, internal company memoranda, letters, and the like – as well as deposition testimony to support its views that exchanges are devices for extending and perfecting monopoly among the leading petroleum firms.25 Such evidence on the details and purposes of contracting is usually confidential and hence unavailable. But detailed knowledge is clearly germane – and often essential – to a correct assessment of the transaction cost features of a contract. Engineers, managers, and lawyers in the major petroleum companies all had a benign interpretation of exchanges. If X has a surplus of product in region A and a deficit in region B while Y has a surplus of product in region B and a deficit in region A, and if both wish to market their product in both areas, then the exchange of product will save on cross-hauling. That, however, omits another possibility: why not create a central market into which each firm can report its surpluses and deficits and procure in an anonymous rather than bilateral way? Petroleum industry engineers, managers, and lawyers found this query unsettling, yet the critical issue that needs to be faced is why bilateral exchange rather than simple market exchange? The Canadian Study lists four objections to exchanges, the first two of which I will pass over here (but see Williamson (1985, p. 148)). The other two are more intriguing: competition is impaired by conditioning supply on the payment of an ‘entry fee’ (pp. 53–4) and by exchange agreements that impose limits on growth and supplementary supply (pp. 51–2). The antitrust concerns posed by the entry fee are supported by the following documentation and interpretation (pp. 52–3; emphasis added): Evidence of an understanding that a fee relating to investment was required for acceptance into the industry can be found in the following quotation from Gulf: ‘We do believe that the oil industry generally, although grudgingly, will allow a participant who has paid his ante, to play the game; the ante in this game being the capital for refining, distributing and selling products.’ (Document #71248, undated, Gulf)

Opening the black box of firm and market organization

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The significance of the quotation lies equally in the notion that an ‘entry fee’ was required and in the notion that the industry set the rules of the ‘game.’ The meaning of the ‘entry fee’ as well as the rules of the ‘game’ as understood by the industry can be found in the actual dealings between companies where the explicit mention of an ‘entry fee’ arises. These cases demonstrate the rules that were being applied – the rules to which Gulf was referring. Companies which had not paid an ‘entry fee,’ that is, companies which had not made a sufficient investment in refining capacity or in marketing distribution facilities would either not be supplied or would be penalized in the terms of the supply agreement.

Once a comparative contractual perspective is adopted, a different interpretation of these practices presents itself. So as to keep the comparison simple, suppose that there are two would-be buyers and that each places an order for a significant and identical amount of product for delivery over the same time interval with the same supplier. The buyers differ, however, in that one of the buyers is prepared to create a safeguard to deter premature termination while the other is not. It is elementary that the seller will charge a higher (Node B) price to the latter. But wherein do exchange agreements relate to such trades? Given that the amount of product to be supplied is significant, and assuming that the supply interval is long and that the surplus/deficit geographic relations described above apply, then buyers and sellers so situated will find that an exchange agreement between them not only saves on cross-hauling costs but, additionally, provides a reciprocal credible commitment – in that termination by one party is deterred by the expectation that it will be answered in kind. Especially if both parties to the exchange agreement experience correlated disturbances, in which event both will want to adapt similarly, exchange agreements have good adaptation and security properties. Assuming that each party to such a supply agreement constructs and maintains a larger plant than it otherwise would, the specific investments made by these firms take the form of ‘dedicated assets’ – large incremental additions to plant, the output from which is earmarked for a specific buyer – as secured by an exchange agreement. Little wonder that petroleum firms will contract on better terms with other petroleum firms that have ‘paid the ante’ to ‘play the game’ than they will with buyers whose purchases are unsecured. Consider therefore the use of growth and supplementary supply restraints, an example of which is the Imperial–Shell exchange agreement, under which Imperial supplied product to Shell in the Maritimes and received product from Shell in Montreal (p. 51): The agreement between Imperial and Shell, originally signed in 1963, was renegotiated in 1967. In July 1972, Imperial did this because Shell had been growing too rapidly in the Maritimes. In 1971–72, Imperial had expressed its dissatisfaction with the agreement because of Shell’s marketing policies. Shell noted:

28

Key issues ‘[Imperial’s] present attitude is that we have built a market with their facilities, we are aggressive and threatening them all the time, and they are not going to help and in fact get as tough as possible with us.’ (Document #23633, undated, Shell)

Specifically, Imperial renewed the agreement with Shell only after imposing a price penalty if expansion were to exceed ‘normal growth rates’ and furthermore stipulated that ‘Shell would not generally be allowed to obtain product from third party sources’ to service the Maritimes (p. 52; emphasis added). The Canadian Study notes that Gulf Oil also took the position that rivals receiving product under exchange agreements should be restrained to normal growth: ‘Processing agreements (and exchange agreements) should be entered into only after considering the overall economics of the Corporation and should be geared to providing competitors with volumes required for the normal growth only.’ 26 It furthermore sought and secured assurances that product supplied by Gulf would be used only by the recipient and would not be diverted to other regions or made available to other parties (p. 59). Limits on ‘normal growth’ and prohibitions on ‘third parties’ could well have anticompetitive purpose and were so regarded by the Canadian Study. Examined, however, through the lens of contract/governance, it is also possible that these same restrictions had the purpose and effect of preserving symmetrical incentives between the parties to exchange agreements, thereby allowing them to reach Node C credible commitments. Without use restrictions, bilateral dependence could become unbalanced. Also, symmetry could be placed under strain if one party was to grow ‘in excess of normal’ – in which event it might be prepared to construct its own plant and scuttle the exchange agreement. Marketing restraints that help to forestall such outcomes encourage parties to participate in exchanges that might otherwise be unacceptable. To be sure, credibility benefits that are valued by the parties may not be equally valued by society. Such restraints may in some cases have both market power and secure transaction purposes. My purpose is merely to emphasize that, whereas the Canadian Study viewed these entirely in a one-sided (monopoly) way, the perspective of credible contracting adds another. To repeat, transaction cost economics can sometimes ‘illuminate the meaning of facts [and words] – particularly in the context of complex contractual relations – that otherwise cannot be explained, or worse, are explained incorrectly’ (Muris, 2003, p. 14).27

Opening the black box of firm and market organization

8.

29

THE MODERN CORPORATION

The lens of contract/governance applies to the modern corporation in numerous ways: limits to firm size, scaling up, divisionalization, horizontal merger, conglomerate mergers, corporate governance, Japanese outsourcing practices, disequilibrium forms of organization, and the list goes on. My discussion here is restricted to limits to firm size, scaling up (to include corporate governance), and horizontal and conglomerate mergers.28 8.1

Limits to Firm Size

The puzzle of firm size was posed by Frank Knight in 1921 when he observed that the ‘diminishing returns to management is a subject often referred to in economic literature, but in regard to which there is a dearth of scientific discussion’ (Knight, 1965, p. 286, n. 1). He elaborated in 1933 as follows (1965, p. xxxi; emphasis added): The relation between efficiency and size of firm is one of the most serious problems of theory, being, in contrast with the relation for a plant, largely a matter of personality and historical accident rather than of intelligible general principles. But the question is peculiarly vital, because the possibility of monopoly gain offers a powerful incentive to continuous and unlimited expansion of the firm, which force must be offset by some equally powerful one making for decreased efficiency.

Tracy Lewis’s later remarks that large established firms will always realize greater value from inputs than small potential entrants are apposite (1983, p. 1092; emphasis added): The reason is that the leader can at least use the input exactly as the entrant would have used it, and earn the same profits as the entrant. But typically, the leader can improve on this by coordinating production from his new and existing inputs. Hence the new input will be valued more by the dominant firm.

If the dominant firm can use the input in exactly the same way as the entrant, then the larger firm can do everything the smaller firm could. If it can improve on the input usage, it can do more. Applied to vertical integration, the parallel argument is that the acquisition of an independent component supplier is always preferred to outsourcing because the combined firm will never do worse (by reason of replication) and will sometimes do more if the acquiring stage always but only intervenes when expected net gains can be projected (by reason of selective intervention). The puzzle of firm size thus reduces to this: what are the obstacles to the implementation of replication and selective intervention? As I discuss

30

Key issues

elsewhere (Williamson, 1985, Chapter 6), promises to replicate and selectively intervene are not costlessly enforceable. An acquired supplier can neither trust the acquirer to do the accounting (on which the supplier’s net receipts are calculated) in an unbiased way nor trust the acquirer to intervene always but only for good cause; and the acquirer cannot trust the supply stage to operate the plant and equipment (now owned by the acquirer) with unchanged due care and to adapt appropriately to autonomous disturbances. The upshot is that neither replication nor selective intervention can be implemented without cost, as a result of which the governance mechanisms of markets and hierarchies differ in kind (Williamson, 1991a). The recurrent point to which I call special attention, however, is this: the bureaucratic burdens of integration are discerned only upon opening the black box and examining the microanalytics. 8.2

Scaling Up

Solow observes that ‘The very complexity of real life . . . [is what] makes simple models so necessary’ (2001, p. 111). The object of a simple model is to capture the essence, thereby to explain hitherto puzzling practices and make predictions that are subjected to empirical testing. But simple models can also be ‘tested’ with respect to scaling up. Does repeated application of the basic mechanism out of which the simple model works yield a result that recognizably describes the phenomenon in question? The test of scaling up is often ignored (possibly out of awareness that scaling up cannot be done) or is sometimes scanted (possibly in the belief that scaling up can be accomplished easily). The influential paper by Michael Jensen and William Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure’ (1976), is an exception. The authors work out of a simplified setup where an entrepreneur (100 percent owner-manager) sells off a fraction of the equity of the firm, as a result of which his incentive intensity is reduced and efficacious monitoring arises as a response. What the authors are really interested in, however, is not entrepreneurial firms but the ‘modern corporation whose managers own little or no equity’ (1976, p. 356). Although the latter project was beyond the scope of their paper, they expressed belief that ‘our approach can be applied to this case . . . [These issues] remain to be worked out in detail and will be included in a future paper’ (1976, p. 356).29 Alas, Jensen and Meckling never produced the follow-up paper, but many others have since examined the efficacy of the board of directors as monitor in the large corporation where the ownership is diffuse. The jury is still out, but I ascertain that serious obstacles stand in the way of acquiring the relevant information to support vigilant monitoring and, furthermore,

Opening the black box of firm and market organization

31

contend that the advisability of assigning the role of vigilant monitor to the board of directors is extremely problematic (Williamson, 2007b). In that event, corporate governance does not scale up from the entrepreneurial firm to the diffusely owned modern corporation. Scaling-up issues relevant to the modern corporation are also posed by the theory of the firm as team production (Alchian and Demsetz, 1972) and the theory of the firm as governance structure. The theory of team production works through technological nonseparability, which Alchian and Demsetz illustrate with the example of manual freight loading: ‘Two men jointly lift heavy cargo into trucks. Solely by observing the total weight loaded per day, it is impossible to determine each person’s marginal productivity’ (1972, p. 779). Accordingly, rather than each person being paid his (unmeasurable) marginal product, such activities are organized cooperatively, with a team whose members are paid as a team and are monitored by a boss lest they engage in shirking. This is instructive, but does technological nonseparability scale up to explain the modern corporation? One possibility is that the large corporation is a vast, indecomposable whole, in which event everything is connected with everything else and the model of technological nonseparability goes through. Another possibility is that, as Simon describes in ‘The Architecture of Complexity’ (1962), large hierarchical systems evolve from nearly decomposable subsystems – within which subsystems interactions are extensive and between which they are attenuated.30 Simon’s examination of social, biological, physical, and symbolic systems as well as the logic of complexity supports the proposition that decomposability ‘is one of the central structural schemes that the architect of complexity uses’ (1962, p. 468). Inasmuch as such decomposability relieves the condition of technological nonseparability on which Alchian and Demsetz rely, scaling up from small groups to which nonseparability applies (such as manual freight loading and, possibly, groups as large as the symphony orchestra) does not extend to the decision to join a series of technologically separable stages, thereby to form the modern corporation. So how does that transaction cost economics setup fare in scaling-up respects? Does successive application of the make-or-buy decision, as it is applied to individual transactions, scale up to describe something that approximates a multi-stage firm? Note in this connection that transaction cost economics assumes that the transactions of interest are those that take place between technologically separable stages. This is the ‘boundary of the firm’ issue as described elsewhere (Williamson, 1985, pp. 96–8). Upon taking the technological ‘core’ as given (possibly as derived from site specific investments, of which thermal economies are an example (see Section 5.1 above)), attention is focused on a series of separable make-or-buy decisions

32

Key issues

− backward, forward, and lateral – to ascertain which should be outsourced and which should be incorporated within the ownership boundary of the firm. So described, the firm is the inclusive set of transactions for which the decision is to make rather than buy – which does appear to implement scaling up, or at least is a promising start (Williamson, 1985, pp. 96–8).31 8.3

Horizontal Mergers

My initial inclination was to regard oligopoly to be outside the scope of transaction cost reasoning, mainly because I had become accustomed to thinking about oligopoly in terms of the prevailing structure–conduct– performance paradigm, where concentration ratios and barriers to entry were the coin of the realm. Upon viewing oligopoly as a cartel problem, however, its contractual nature is immediately evident. Consider in this connection the claim that monopoly and oligopoly are nearly indistinguishable in competitive respects.32 Such a claim fails to make allowance for (1) the advantages of hierarchy (within a monopoly) as compared with interfirm contracting (among oligopolists) for dispute settlement and coordinating purposes and (2) the differential incentives and the related propensity to cheat that distinguish internal from interfirm organization. Examining the cartel as a five-stage contracting process – contract specification, joint gain agreement, implementation under uncertainty, monitoring contract execution, and penalizing contract violations – is instructive. As discussed elsewhere (Williamson, 1975, pp. 238–44), oligopolies differ in their ‘complexity’ in all five of these contractual respects. Simple oligopolies – where numbers are few and products are homogeneous, shares are easy to agree upon, disturbances are small, price and output are public knowledge, and penalties for violations are assuredly meted out – will surely recognize their interdependence and behave accordingly. As, however, deviations from these simple conditions arise, cartel contracts become progressively more complex and undergo slippage and fracture during contract execution. Interestingly, even in the 1870s and 1880s, when express collusion was not unlawful, repeated efforts by the railroads to curb competitive pricing – first by informal alliances, then by managed federations – were undone by cheating.33 When the railroads ‘found to their sorrow that they could not rely on the intelligence and good faith of railroad executives’ to manage the cartels (Chandler, 1977, p. 141), they gave up on interfirm agreements and turned to merger. Contractual reasoning is thus instructive in making oligopoly–monopoly comparisons. Because, however, the predictions of the contractual approach to oligopoly are very similar to many other oligopoly theories, empirical research on oligopoly has been little affected.

Opening the black box of firm and market organization

8.4

33

Conglomerates

The conglomerate form of organization was a matter of grave concern in the 1960s, especially among those with populist predilections, of which H.M. Blake (1973) was one. According to Blake, the anticompetitive hazards of conglomerate mergers, in potential competition and other respects, were ‘so widespread that [these] might appropriately be described as having an effect upon the economic system as a whole – in every line of commerce in every section of the country’ (1973, p. 567). So regarded, the conglomerate was a menace. Can a contractual approach to conglomerate diversification help to inform the issues? The basic proposition is this: whereas vertical integration is viewed as taking transactions out of the intermediate product market and organizing them internally, the conglomerate can be interpreted as taking transactions out of the capital market and organizing them internally. So described, the conglomerate experiences a breadth for depth tradeoff in managing capital market transactions. The argument relies on part in the distinction between centralized (unitary or U-form) and decentralized (multidivisional or M-form) corporations, as developed by Alfred Chandler (1962) and interpreted in efficiency terms in Williamson (1970). Specifically, the conglomerate can be understood as a logical outgrowth of the divisionalized strategy for organizing complex economic affairs. Thus, once the merits of the M-form structure for managing separable, albeit related, lines of business (such as different automobile brands or different chemical divisions) were recognized and digested, its extension to manage less closely related activities was natural, although that is not to say that the management of diversification is without problems of its own. The basic M-form logic, whereby strategic resource allocation and oversight are assigned to the general office and operating decisions are the responsibility of the operating divisions, nevertheless carries over. To the degree to which conglomerates employ the M-form logic (as against the go-go conglomerates of the 1960s) and possess deep knowledge (as compared with the capital market) within a large but delimited set of diversified investment opportunities, then the indicia for an efficient resource allocation interpretation of the conglomerate take shape.34 Plainly, however, not all conglomerates qualify to be so described.

9.

CONCLUSIONS

Opening the black box of firm and market organization is accomplished by taking transaction cost economizing to be the main case, in relation to

34

Key issues

which adaptations (of autonomous and coordinated kinds) are especially important, and examining economic organization through the lens of contract. The transaction is made the basic unit of analysis and governance is the means by which to infuse order. In conformity with Simon’s advice that our research agenda and research methods are shaped by our description of human actors, the cognitive and self-interestedness attributes of human actors that bear on contracting are expressly identified, after which the ramifications of human actors as these relate to the key attributes of both transactions and governance structures are worked out. Aligning transactions, which differ in their attributes, with governance structures, which differ in their cost and competence, so as to effect a transaction cost economizing outcome is where the predictive content resides. The key features of the foregoing are these: (1)

(2)

(3)

(4)

The lens of contract/governance is an instructive way by which to open the black box of firm and market organization and examine the mechanisms inside. This project subscribes to Jon Elster’s dictum that ‘explanations in the social sciences should be organized around (partial) mechanisms rather than (general) theories’ (1994, p. 75; emphasis omitted). Especially relevant to public policy analysis is that nonstandard contractual practices and organizational structures that were believed to be anticompetitive when examined through the lens of price theory are often revealed to serve efficiency purposes as well or instead. Subsequent uses of the lens of contract/governance to examine complex contract and economic organization reveal that many ‘superficially disconnected and diverse phenomena . . . [are] manifestations of a more fundamental and relatively simple structure’ (Friedman, 1953, p. 33).35

Such applications notwithstanding, many conceptual, empirical, and public policy challenges await.

NOTES *

1.

This is the first of two papers dealing with ‘opening up the black box’. This paper deals with applications to antitrust. The other paper describes applications to regulation (Williamson, 2007a). The introduction and Section 2 of this chapter overlap with Section 1 of Williamson (2007a). The importance of a focused lens is crucial. The distinction here is between promising but sprawling concepts that invite ex post rationalizations for any outcome whatsoever (which is a chronic problem with vaguely defined concepts – of which ‘power’ is one (March, 1966)). A focused lens both delimits the set of factors that can be invoked to explain

Opening the black box of firm and market organization

2.

3. 4.

5. 6. 7. 8.

9. 10.

11. 12. 13. 14.

35

complex phenomena and reveals the mechanisms through which these factors work. The promising but vague concept of transaction costs which Coase introduced in his 1937 article, ‘The Nature of the Firm’, remained in a state of disuse 35 years later (Coase, 1972, p. 63) precisely because the key ideas had not been operationalized (Coase, 1992, p. 718). As Harold Demsetz observes, it is ‘a mistake to confuse the firm of [neoclassical] economic theory with its real-world namesake. The chief mission of neoclassical economics is to understand how the price system coordinates the use of resources, not the inner workings of real firms’ (1983, p. 377). The quotation is attributed to Donald Turner by Stanley Robinson (1968), p. 29. The Federal Trade Commission’s opinion in Foremost Dairies states that the necessary proof of violation of Section 7 ‘consists of types of evidence showing that the acquiring firm possesses significant market power in some markets or that its overall organization gives it a decisive advantage in efficiency over its smaller rivals’ (In re Foremost Dairies, Inc., 60 FTC, 944, 1084 (1962), emphasis added). See Williamson (1985, pp. 366–7) for an elaboration upon the convoluted status of antitrust enforcement during the 1960s. This terse summary is elaborated elsewhere (Williamson, 1985, 1991a, 2002, 2005). The intellectual antecedents are set out in the Appendix. R.C.O. Matthews describes the New Institutional Economics (with emphasis on transaction cost economics) in precisely these terms in his Presidential Address to the Royal Economic Society (1986, p. 903). Because I judge several of the listed six assumptions to be implausible (Williamson, 1991b, pp.172–6), I take the lesson of Fudenberg et al. (1990) (which is an intellectual tour de force) to be that a sequentially optimal contract is infeasible. Especially problematic are their assumptions of three-way costless knowledge of public outcomes (by principal, agent, and arbiter) and common knowledge of both technology and preferences over action-payment streams. If and as the attainment of logical consistency (in theory) yields infeasibility (in practice), applied economists will understandably be chary of the operational significance of the theory. For a discussion of contract law regimes as these relate to governance, see Williamson (1991a). Note that the price that a supplier will bid to supply under Node C conditions will be less than the price that will be bid at Node B. That is because the added security features at Node C serve to reduce the contractual hazard, as compared with Node B, so the contractual hazard premium will be lowered. One implication is that suppliers do not need to petition buyers to provide safeguards. Because buyers will receive goods and services on better terms (lower price) when added security is provided, buyers have the incentive to offer credible commitments. United States v. Von’s Grocery Co., 384 U.S. 270, 301 (1966) (Stewart, J., dissenting). As, for example, in ‘Economies as an antitrust defense: the welfare tradeoffs’ (Williamson, 1968). This is an insistent theme in Coase (1960, 1964, 1972). Stephen Stockum’s summary of Muris’s position is as follows (2002, p. 60): Muris describes his economic approach as neither Chicago School nor PostChicago, but rather ‘New Institutional Economics’, which combines theory with a study of real world institutions, . . . [is] heavily empirical, . . . [and provides relief from economic ideology in favor of] more practical discussions of how economic analysts can contribute to rational enforcement of the antitrust laws.

15. 16. 17.

This relieves problems of valuing such dies if they are owned by the supplier, although user-cost abuses of dies become a concern if the buyer owns them. For discussions, see Williamson (1979, 1987). Thus whereas industrial organization specialists and the Antitrust Merger Guidelines once advised that an antitrust issue is posed should a firm with a 20 percent market share acquire a 5 or 10 percent share in any industry from which it buys or to which it

36

18. 19. 20. 21. 22. 23. 24.

25. 26. 27. 28. 29.

30.

31. 32. 33. 34.

Key issues sells (Stigler, 1955, p. 183), transaction cost economics counsels that the attributes of the transaction tell us a lot more about the purposes of integration, especially for such small market shares. To be sure, vertical integration sometimes serves strategic purposes. As Alfred Marshall observed, if, in a small country, spinning and weaving were joined, ‘the monopoly so established will be much harder to shake than would either half of it separately’ (1920, p. 495). Bain warned that vertical integration can be used as a means by which to ‘disadvantage, weaken, eliminate, or exclude non-integrated competitors’ (1968, pp. 360–62). And Stigler advised that integration ‘becomes a possible weapon for the exclusion of new rivals by increasing the capital requirements for entry into the combined integrated production processes’ (1955, p. 224). I do not disagree. Because, however, strategic entry deterrence is so easy to invoke, those who would make such claims should describe the details of the underlying mechanisms and explain when we should expect alleged adverse effects to rise to the level of public policy significance. For a discussion of both the Jurisdictional Statement and the Brief for the United States in United States v. Arnold, Schwinn & Co., 388 U.S. 365 (1967), see Williamson (1979; 1985, pp. 183–9). Applied welfare economics apparatus is used to display these two effects. The tradeoffs had gone unnoticed, however, until positive transaction costs were expressly introduced into the calculus. FTC v. Morton Salt Co., 334 U.S. 37 (1948); emphasis added. The remainder of this subsection is based on Williamson (1996, pp. 77–8). The remainder of this subsection is based on Williamson (1985, pp. 197–201). FTC v. Exxon et al. Docket No. 8934 (1973). Robert J. Bertrand, Q.C., Director of Investigation and Research, Combines Investigation Act, coordinated the eight-volume study, The State of Competition in the Canadian Petroleum Industry (Quebec, 1981). All references in this chapter are to Vol. V, The Refining Sector. That study will hereinafter be referred to as the Canadian Study. Page numbers here and below that do not name the source all refer to Vol. V of the Canadian Study (see note 24, above). The Canadian Study (p. 59) identifies the source as Document #73814, January 1972. Muris (2003, pp. 15–23) discusses a variety of other applications of transaction cost economics to complex contracting. Also see Joskow (2002). For discussions of divisionalization, see Williamson (1970, 1985, Chapter 11); for Japanese economic organization, Williamson (1985, pp. 120–123); for corporate governance, Williamson (1988, 2007b); for disequilibrium contracting, Williamson (1991a). Other examples where scaling-up tensions are posed include Thomas Schelling’s treatment of the evolution of segregation in the ‘self-forming neighborhood’ (Schelling, 1978, pp. 147–55), the expansive uses sometimes made of the so-called paradox of voting (Williamson and Sargent, 1967), and the move from project financing to composite financing in the modern corporation (Williamson, 1988). ‘The loose . . . coupling of subsystems . . . [means that] each subsystem [is] independent of the exact timing of the operation of the others. If subsystem B depends upon subsystem A only for a certain substance, then B can be made independent of fluctuations on A’s production by maintaining a buffer inventory’ (Simon, 1977, p. 255). In consideration of the difficulties and importance of scaling up, it is judicious to hold theories of the modern corporation for which scaling up has not been demonstrated in public policy abeyance. John Kenneth Galbraith took the position that ‘the firm, in tacit collaboration with other firms in the industry, has wholly sufficient power to set and maintain prices’ (1967, p. 200). Note that while the courts tolerated collusion, they refused to enforce price setting agreements. There is an additional contractual wrinkle, in that conglomerates once posed an acquisition threat to underperforming firms, including firms that had allowed their debt–equity

Opening the black box of firm and market organization

35.

37

ratio to fall below the optimal level (Williamson, 1988). Leveraged buyout specialists such as Kohlberg-Kravis-Roberts are precisely attuned to such opportunities and have since taken over many of these takeover functions. In the spirit of pluralism, we will benefit from any theory that deepens our understanding of complex phenomena and satisfies the precepts of pragmatic methodology (Williamson, 2007c).

REFERENCES Alchian, A. and H. Demsetz (1972), ‘Production, Information Costs, and Economic Organization’, American Economic Review, 62 (December), 777–95. Areeda, P. and D.F. Turner (1975), ‘Predatory Pricing and Related Practices Under Section 2 of the Sherman Act’, Harvard Law Review, 88 (February), 697–733. Arrow, K. (1987), ‘Reflections on the Essays’, in George Feiwel (ed.), Arrow and the Foundations of the Theory of Economic Policy, New York: NYU Press, pp. 727–34. Arrow, K. (1999). ‘Forward’, in Glenn Carroll and David Teece (eds), Firms, Markets, and Hierarchies, New York: Oxford University Press, pp. vii–viii. Bain, J. (1968), Industrial Organization, 2nd edn, New York: John Wiley and Sons. Barnard, C. (1938), The Functions of the Executive, Cambridge, MA: Harvard University Press (15th printing, 1962). Blake, H.M. (1973), ‘Conglomerate Mergers and the Antitrust Laws’, Columbia Law Review, 73 (March), 555–92. Bork, R.H. (1978), The Antitrust Paradox: A Policy at War With Itself, New York: Basic Books. Chandler, A.D. (1962), Strategy and Structure, Cambridge, MA: MIT Press. Chandler, A.D. (1977), The Visible Hand: The Managerial Revolution in American Business, Cambridge, MA: Harvard University Press. Coase, R. (1937), ‘The Nature of the Firm’, Economica, N.S., 4, 386–405. Coase, R. (1960), ‘The Problem of Social Cost’, Journal of Law and Economics, 3 (October), 1–44. Coase, R. (1964), ‘The Regulated Industries: Discussion’, American Economic Review, 54 (May), 194–7. Coase, R. (1972). ‘Industrial Organization: A Proposal for Research’, in V.R. Fuchs (ed.), Policy Issues and Research Opportunities in Industrial Organization, New York: National Bureau of Economic Research, pp. 59–73. Coase, R. (1992), ‘The Institutional Structure of Production’, American Economic Review, 82 (September), 713–19. Coughlan, A., E. Anderson, L. Stern, and A.El-Ansary (2005), Marketing Channels, 7th edn, Upper Saddle River, NJ: Pearson/Prentice Hall. Demsetz, H. (1974), ‘Two Systems of Belief About Monopoly’, in V. Fuchs (ed.), Policy Issues and Research Opportunities in Industrial Organization, New York: National Bureau of Economic Research. Demsetz, H. (1983), ‘The Structure of Ownership and the Theory of the Firm’, Journal of Law and Economics, 26 (June): 375–90. Dixit, A. (1996), The Making of Economic Policy: A Transaction Cost Politics Perspective, Cambridge, MA: MIT Press. Elster, J. (1994), ‘Arguing and Bargaining in Two Constituent Assemblies’,

38

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unpublished manuscript, remarks given at the University of California, Berkeley. Friedman, M. (1953), Essays in Positive Economics, Chicago: University of Chicago Press. Fuchs, V. (ed.) (1972), Policy Issues and Research Opportunities in Industrial Organization, New York: Columbia University Press. Fudenberg, D., B. Holmstrom and P. Milgrom (1990), ‘Short-Term Contracts and Long-Term Agency Relationships’, Journal of Economic Theory, 51 (June), 1–31. Galbraith, J.K. (1967), The New Industrial State, Boston: Houghton-Mifflin Company. Geyskens, I., J.B.E.M. Steenkamp and N. Kumar (2006). ‘Make, Buy, or Ally: A Meta-analysis of Transaction Cost Theory’, Academy of Management Journal, 49 (3), 519–43. Hayek, F. (1945), ‘The Use of Knowledge in Society’, American Economic Review, 35 (September), 519–30. Jensen, M. and W. Meckling. (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure’, Journal of Financial Economics, 3 (October), 305–60. Joskow, P. (1987), ‘Contract Duration and Relationship-Specific Investments’, American Economic Review, 77 (1), 168–85. Joskow, P. (1991), ‘The Role of Transaction Cost Economics in Antitrust and Public Utility Regulatory Policies’, Journal of Law, Economics, and Organization, 7 (March), 53–83. Joskow, P. (2002), ‘Transaction Cost Economics, Antitrust Rules and Remedies’, Journal of Law, Economics and Organization, 18 (1), 95–116. Kenney, R. and B. Klein (1983), ‘The Economics of Block Booking’, Journal of Law and Economics, 26 (October), 497–540. Klein, B. (1996), ‘Why Hold-Ups Occur: The Self Enforcing Range of Contractual Relationships’, Economic Inquiry, 34 (3), 444–63. Klein, B. and K. Leffler (1981), ‘The Role of Market Forces in Assuring Contractual Performance’, Journal of Political Economy, 89 (August), 615–41. Knight, F. (1965), Risk, Uncertainty, and Profit, New York: Harper & Row, Publishers, Inc. Kreps, D. (1990), A Course in Microeconomic Theory, Princeton, NJ: Princeton University Press. Lewis, T. (1983), ‘Preemption, Divestiture, and Forward Contracting in a Market Dominated by a Single Firm’, American Economic Review, 73 (December), 1092–1101. Livesay, H.C. (1979), American Made: Men Who Shaped the American Economy, Boston: Little, Brown. Llewellyn, K.N. (1931), ‘What Price Contract? An Essay in Perspective’, Yale Law Journal, 40, 704–51. Macher, J.T. and B. Richman (2006), ‘Transaction Cost Economics: A Review and Assessment of the Empirical Literature’, unpublished manuscript. March, J.G. (1966), ‘The Power of Power’, in David Easton (ed.), Varieties of Political Theory, Englewood Cliffs, NJ: Prentice-Hall, pp. 39–70. Marshall, A. (1920), Principles of Economics, 8th edn, New York: Macmillan and Co., Ltd. Masten, S. (1984). ‘The Organization of Production: Evidence from the Aerospace Industry’, Journal of Law and Economics, 27 (October), 403–18.

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Masten, S. (1996), Case Studies in Contracting and Organization, New York: Oxford University Press. Matthews, R.C.O. (1986), ‘The Economics of Institutions and the Sources of Economic Growth’, Economic Journal, 96 (December), 903–18. Monteverde, K. and D. Teece (1982), ‘Supplier Switching Costs and Vertical Integration in the Automobile Industry’, Bell Journal of Economics, 13 (Spring), 206–13. Muris, T. (2003), ‘Improving the Economic Foundations of Competition Policy’, George Mason Law Review, 12 (1), 1–30. Posner, R. (1976), Antitrust Law, Chicago: University of Chicago Press. Richman, B. (2006), ‘How Communities Create Economic Advantage: Jewish Diamond Merchants in New York’, Law and Social Inquiry, 31 (2), 383–420. Robinson, S. (1968), ‘Comment’, New York State Bar Association, Antitrust Symposium. Schelling, T. (1978), Micromotives and Macrobehavior, New York: Norton. Simon, H. (1957), Models of Man, New York: John Wiley & Sons. Simon, H. (1962), ‘The Architecture of Complexity’, Proceedings of the American Philosophical Society, 106 (December), 467–82. Simon, H. (1977), Models of Discovery, Boston: D. Reidel Publishing Co. Simon, H. (1984), ‘On the Behavioral and Rational Foundations of Economic Dynamics’, Journal of Economic Behavior and Organization, 5 (March), 35–56. Simon, H. (1985), ‘Human Nature in Politics: The Dialogue of Psychology with Political Science’, American Political Science Review, 79 (2), 293–304. Solow, R. (2001), ‘A Native Informant Speaks’, Journal of Economic Methodology, 8 (March), 111–12. Stigler, G. (1955), ‘Mergers and Preventive Antitrust Policy’, University of Pennsylvania Law Review, 104, 176–85. Stigler, G. (1968), The Organization of Industry, Homewood, IL: Richard D. Irwin. Stockum, S. (2002), ‘An Economist’s Margin Notes: The Antitrust Writings of Timothy Muris’, Antitrust (Spring), 60. Stuckey, J. (1983), Vertical Integration and Joint Ventures in the Aluminum Industry, Cambridge, MA: Harvard University Press. Whinston, M. (2001), ‘Assessing Property Rights and Transaction-Cost Theories of the Firm’, American Economic Review, 91 (2), 184–99. Williamson, O.E. (1968), ‘Economies as an Antitrust Defense: The Welfare Tradeoffs’, American Economic Review, 58 (March), 18–35. Williamson, O.E. (1970), Corporate Control and Business Behavior, Englewood Cliffs, NJ: Prentice-Hall. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1977), ‘Predatory Pricing: A Strategic and Welfare Analysis’, Yale Law Journal, 87 (December), 284–340. Williamson, O.E. (1979), ‘Assessing Vertical Market Restrictions’, University of Pennsylvania Law Review, 127 (April), 953–93. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1987), ‘Vertical Integration’, in J. Eatwell et al. (eds), The New Palgrave Dictionary of Economics, Vol. IV, London: Macmillan, pp. 807– 12.

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Williamson, O.E. (1988), ‘Corporate Finance and Corporate Governance’, Journal of Finance, 43 (July), 567–91. Williamson, O.E. (1991a), ‘Comparative Economic Organization: The Analysis of Discrete Structural Alternatives’, Administrative Science Quarterly, 36 (June), 269–96. Williamson, O.E. (1991b), ‘Economic Institutions: Spontaneous and Intentional Governance’, Journal of Law, Economics, and Organization, 7 (Special Issue): 159–87. Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford University Press. Williamson, O.E. (2002), ‘The Theory of the Firm as Governance Structure: From Choice to Contract’, Journal of Economic Perspectives, 16 (Summer), 171–95. Williamson, O.E. (2005), ‘The Economics of Governance’, American Economic Review, 95 (2), 1–18. Williamson, O.E. (2007a), ‘Opening the Black Box of Firm and Market Organization: Regulation’, working paper, University of California, Berkeley. Williamson, O.E. (2007b), ‘Corporate Boards of Directors: In Principle and In Practice’, Journal of Law, Economics, and Organization, 24 (October), 247–72. Williamson, O.E. (2007c), ‘Pragmatic Methodology’, working paper, University of California, Berkeley. Williamson, O.E. and T. Sargent (1967), ‘Social Choice: A Probabilistic Approach’, The Economic Journal, 77 (308), 797–813. Wilson, E.O. (1998), Consilience, New York: Alfred Knopf.

Opening the black box of firm and market organization

APPENDIX 2.1

41

INTELLECTUAL ANTECEDENTS TO THE LENS OF CONTRACT/ GOVERNANCE

The comparative contractual approach to economic organization is inspired by a series of key ideas, many of which first surfaced in the 1930s (or thereabouts). Of special importance are these: (1)

(2) (3) (4) (5)

(6)

(7)

(8)

The organization of economic activity as among firms, markets, and other modes of governance should be derived rather than taken as given (Coase, 1937). Such a derivation should make explicit allowance for positive transaction costs (Coase, 1937, 1960). Unstated assumptions about the nature of the human beings whose behavior we are studying should be revealed (Simon, 1957, 1985). The unit of analysis should be named, of which the transaction is a candidate (Commons, 1932), and dimensionalized. Moving beyond the economics of simple market exchange, ongoing contractual relations should also be brought under scrutiny – with emphasis on the triple of conflict, mutuality, and order (Commons, 1932). Provision also needs to be made for the contract law differences between modes. Simple market exchange (to which the concept of contract as legal rules applies) gives way to long-term contracting (to which the more elastic concept of contract as framework (Llewellyn, 1931) applies) and to hierarchy (whereby internal organization becomes its own court of ultimate appeal). The central problem of economic organization to which transaction cost consequences accrue is that of adaptation, of which two kinds are distinguished: autonomous adaptations (Hayek, 1945) and coordinated adaptations (Barnard, 1938). Going beyond the neoclassical lens of choice, complex economic organization is also usefully examined through the lens of contract/ governance, where the latter implements the proposition that ‘mutuality of advantage from voluntary exchange . . . is the most fundamental of all understandings in economics’ (Buchanan, 2001, p. 29).

References Barnard, C. (1938), The Functions of the Executive, Cambridge, MA: Harvard University Press. Buchanan, J. (2001), ‘Game Theory, Mathematics and Economics’, Journal of Economic Methodology, 8 (March), 27–32.

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Key issues

Coase, R. (1937), ‘The Nature of the Firm’, Economica, N.S., 4, 386–405. Coase, R. (1960), ‘The Problem of Social Cost’, Journal of Law and Economics, 3, (October), 1–44. Commons, J. (1932), ‘The Problem of Correlating Law, Economics, and Ethics’, Wisconsin Law Review, 8, 3–26. Hayek, F. (1945), ‘The Use of Knowledge in Society’, American Economic Review, 35 (September), 519–30. Llewellyn, K.N. (1931), ‘What Price Contract? An Essay in Perspective’, Yale Law Journal, 40, 704–51. Simon, H. (1957), Models of Man, New York: John Wiley & Sons. Simon, H. (1985), ‘Human Nature in Politics: The Dialogue of Psychology with Political Science’, American Political Science Review, 79 (2), 293–304.

3.

The corporation: an economic enigma Dennis C. Mueller

The Anglo-Saxon version of corporate organization – widely dispersed ownership, and professional managers with small ownership stakes – has been somewhat of an enigma throughout its 200 or so year history. Some economists have thought it to be an inefficient organizational structure; others have proclaimed its superiority over all other ways to organize business activity. The performance of US corporations during the 1970s and 1980s seemed to confirm the judgments of the corporate form’s critics. One market after another was lost to companies from Japan or Europe. Articles and books appeared proclaiming the ‘German model’ or the ‘Japanese model’ superior to the Anglo-Saxon model.1 One student of American capitalism even predicted ‘the eclipse of the public corporation’ (Jensen, 1989). The impressive performance of the United States’ economy during the 1990s, alongside the stumbling performances of the Japanese and the German and some other European economies, has led some to now claim that it is the Anglo-Saxon model which is superior and toward which all others must converge.2 In this chapter I review some of the arguments and evidence regarding the efficiency of the corporate form. I shall argue that one reason for the different views of economists about corporations is that they tend to see what they want to see. Although most of the evidence cited seems to support the position of the critics of the corporate form, I shall close the chapter with the suggestion that developments over the last decade or two have altered the environments in which corporations operate in such a way as to justify the efficiency claims of their defenders. I begin, appropriately enough, with Adam Smith.

1.

THE EARLY ECONOMISTS

Corporations, or joint stock companies as they were commonly called at the end of the 18th century, were relatively rare when Adam Smith wrote 43

44

Key issues

The Wealth of Nations. But Smith had seen enough of them to offer the following observations: The directors of such companies . . . being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company . . . It is upon this account that joint stock companies for foreign trade have . . . very seldom succeeded without an exclusive privilege; and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it. (1776, p. 700)

John Stuart Mill regarded this conclusion as ‘one of those overstatements of a true principle, often met with in Adam Smith’ (1885, p. 140). Nevertheless, he also thought the principle to be true. After discussing the advantages of joint stock companies, Mill took up ‘the other side of the question’. [I]ndividual management has also very great advantage over joint stock. The chief of these is the much keener interest of the managers in the success of the undertaking. The administration of a joint stock association is, in the main, administration by hired servants. Even . . . the board of directors, who are supposed to superintend the management . . . have no pecuniary interest in the good working of the concern beyond the shares they individually hold, which are always a very small part of the capital of the association, and in general but a small part of the fortunes of the directors themselves; and the part they take in the management usually divides their time with many other occupations, of as great or greater importance to their own interest; the business being the principal concern of no one except those who are hired to carry it on. But experience shows, and proverbs, the expression of popular experience, attest, how inferior is the quality of hired servants, compared with the ministration of those personally interested in the work, and how indispensable, when hired service must be employed, is ‘the master’s eye’ to watch over it. (Mill, 1885, pp. 138–9)

Smith and Mill were, of course, giants in the development of economics. That each had a brilliant mind goes without saying. But their genius stemmed not only from their capacity to reason. Each was also a keen observer of people and institutions. Each could draw generalizations from what he saw that others would recognize to be true upon hearing. Another good example of this is Smith’s statement that ‘People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some

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contrivance to raise prices’ (1776, p. 128). As with his statements about corporations, what is particularly interesting about this famous passage is that it is not a proposition about what businessmen under certain assumptions will do. It is a statement about what they do do. Smith’s classic treatise is not a series of hypotheses about how individuals and markets will behave, but rather a treasure chest of observations of how they do behave. Alfred Marshall was first and foremost a keen observer of the world of business. He, too, had some doubts about the efficiency of joint stock companies. In a section entitled ‘Temptations of joint stock companies to excessive enlargement of scope’ in Industry and Trade (1923), Marshall notes that ‘unfortunately many [outside directors] are unable to give the large time and energy needed for obtaining a thorough mastery of the affairs of the companies for which they are responsible’ (p. 321). The slack thereby created can lead to ‘excessive enlargement of scope’, because company managers ‘cannot always approach a proposal for enlarging an existing department, or starting a new one, without some bias’ (p. 322). Nevertheless, he was much less concerned about the potential inefficiencies of the corporate form than Smith and Mill, for he judged there to be a countervailing development that protected the ‘powerless’ position of the shareholders. It is a strong proof of the marvellous growth in recent times of a spirit of honesty and uprightness in commercial matters, that the leading officers of great public companies yield as little as they do to the vast temptations to fraud which lie in their way . . . There is every reason to hope that the progress of trade morality will continue . . . (Marshall, 1920, p. 253)

The founders of neoclassical economics on the western side of the Atlantic were also sanguine in their views about the newly emerging corporations and trusts formed through merger. Anticipating the reasoning underlying transaction costs economics and the ‘new learning’ in industrial organization by 80 years, they deduced that Darwinian competition could be relied upon to select only the most efficient combinations of assets.3 The next landmark in our intellectual history is The Modern Corporation and Private Property. As with many of the arguments contained in The Wealth of Nations, much that Berle and Means (1932) wrote about the corporation was known at the time they wrote. But they combined their thesis with an exhaustive history of the evolution of the corporate legal form, and amassed data demonstrating the extent of the separation of ownership from control, and the rise in aggregate concentration that had occurred in the first third of the 20th century. If the dangers of dispersed

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shareownership forewarned by Smith and Mill were real, Berle and Means’s book suggested that the United States had much to fear. The bulk of The Modern Corporation and Private Property must have been written in the late 1920s, and thus the book cannot be construed as an account of the collapse of 1929. But the timing of the book’s publication could not have been better. The arguments put forward by Berle and Means about the potential for managerial abuse of discretion created by the separation of ownership and control resonated with the thunder of falling stock prices and profits. The handful of examples of abuse of managerial power in the book were duplicated and dwarfed by the accounts appearing daily in the business press.4 The modern corporation appeared to have fulfilled the worst fears of Smith and Mill, and dashed the hopes of Marshall. The Victorian noblesse oblige that Marshall saw protecting shareholders as late as 1920 had by 1930 vanished, at least in the United States.

2.

THE ‘MARGINALIST’ CONTROVERSIES

With the publication of The Modern Corporation, the Great Crash and its aftermath of revelations of misuse of position by managers, the issue of corporate efficiency could not be ignored, or so it would seem. But most economists did ignore it.5 For by the 1930s the neoclassical revolution, in which Alfred Marshall had played such an important part, had triumphed. When a new issue arose, the economist would no longer turn to his firsthand knowledge of the relevant facts and institutions for addressing this issue, or lacking first-hand knowledge proceed to gather it. The economist’s first reaction would now be to turn to one of the models he had used to analyze similar problems in the past. The neoclassical models had proved themselves to be insightful analytic tools for laying bare the basic elements of certain economic problems. To achieve their pedagogic potential they needed to be kept simple, however, and so it was often the case that individuals were assumed to choose a single instrument (for example, price) to achieve a single goal (profit). Thus, although the managerial corporation was by the 1930s the dominant economic institution of Western capitalism, the firm (entrepreneur) remained the main business actor in the economics literature, and it (he) maximized profit. The 1930s were difficult for mainstream economics to digest. Much seemed to be happening that the newly developed neoclassical models could not explain. Keynes’s response is the most famous reaction, of course. But attacks on the micro front were also afoot. A number of economists were troubled by the failure of prices to fall to eliminate significant amounts of excess supply. Gardiner Means (1935) attempted to account for this with

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the thesis that large corporations in oligopolistic markets enjoyed considerable freedom to administer prices independently of market forces. Hall and Hitch were struck by interview evidence that revealed a gross inconsistency between ‘the way in which business men decide what price to charge for their products and what output to produce’ and the behavior assumed in neoclassical models (1939, p. 12). They concluded that the evidence ‘casts doubt on the general applicability of the conventional analysis of price and output policy in terms of marginal cost and marginal revenue, and suggests a mode of entrepreneurial behavior which current economic doctrine tends to ignore’ (p. 12). They offered as an alternative to marginal analysis a ‘full cost’ or mark-up model of pricing. Richard Lester was left with ‘grave doubts as to the validity of conventional marginal theory and the assumptions on which it rests’ from answers given by 58 entrepreneurs from the South to a questionnaire circulated in the mid-1940s (1946, p. 81). Kaplan et al. (1958) conducted interviews of chief executives in the late 1940s and mid-1950s and uncovered a variety of objectives and rules of thumb for setting prices that did not resemble marginal cost equals marginal revenue. Thus, evidence gathered over two decades and two countries on how managers actually do set prices directly contradicted the assumptions upon which most economic modeling of pricing was at that time, and is today, based. Not surprisingly these challenges to the mainstream view were vigorously repelled (Machlup, 1946, 1947; Kahn, 1959).6 What is interesting is that the defenders of the neoclassical model offered neither contradictory interview and questionnaire evidence to support their positions nor empirical evidence that would allow one to reject one hypothesis and not the other. Rather the argument was made that it was not important that individuals consciously maximize as posited in economic models, but that they act as if they did. Examples from the interview/questionnaire evidence or from everyday life were then used to suggest that the data, indeed, would sustain, if systematically garnered, the neoclassical model. Although the direct rejoinders to the attacks on marginalist pricing models did not present data to support their positions, others did. Among these, the most famous perhaps is George Stigler’s (1947) demolition of the Hall–Hitch–Sweezy kinked-demand schedule explanation of price rigidity in the 1930s. Stigler argued quite correctly that a kink should only exist for oligopolies, and thus that the relationship between price changes and concentration or number of sellers should be U-shaped. Only oligopolies should change price less frequently than profit maximization would imply. Stigler presented data on numbers of price changes in markets with different numbers of firms that dramatically rejected the U-shape prediction. The number of price changes in a market increased directly with the

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number of sellers. In the two markets with one seller, aluminum and nickel, there were respectively two and zero price changes between June of 1929 and May of 1937.7 It is difficult to believe that, in a decade as unusual as the 1930s, the demand for a basic industrial product like nickel did not shift sufficiently to induce at least one change in the profit-maximizing price for this monopolist, especially since the coefficient of variation of output for this industry was the sixth largest of the 21 industries Stigler examined. The Stigler results, while destroying the kinked-demand schedule hypothesis, raised the puzzling question of why price rigidity increases with concentration, and Stigler admitted ‘that the neoclassical theory does not provide a satisfactory explanation for this extraordinary rigidity of monopoly prices’ (1947, p. 428). The lesson drawn by the profession from Stigler’s paper was, however, only that the data had rejected the challenges to neoclassical theory offered by Hall and Hitch (1939) and Sweezy (1939). That the data were equally inconsistent with what neoclassical theory predicted was ignored. In the mid-1940s one would not have had to cast about far to find a hypothesis that fit these results, however. Gardiner Means’s administered price hypothesis argued that large corporations held prices constant for long periods in markets dominated by a ‘relatively small number of concerns’ (National Resources Committee, 1939, p. 143, as quoted in Scherer, 1980, p. 350). That George Stigler would not immediately seize upon the administered price hypothesis to explain his results is not surprising. Indeed, a generation later he and James Kindahl (1970) were to publish a major empirical study that claimed to refute the administered price thesis. In fact, the price rigidities that were observed could be reconciled with ‘traditional theory’ if the latter was appropriately modified by additional assumptions regarding long-term contracts and transaction costs (Stigler and Kindahl, 1973, p. 719). Both Means (1972) and Leonard Weiss (1977) followed with empirical studies that they claimed were consistent with the administered price thesis. Many additional studies examined the flexibility of prices. I shall not dwell on this literature,8 but merely assert that the work of that period did not produce a resounding victory for the marginalist model in any standard form. But the profession proceeded ahead as if it did.

3.

THE MANAGERIALIST CHALLENGE

The attacks on economic orthodoxy just discussed all questioned the implications of profits maximization with regards to pricing decisions. In the 1950s and 1960s studies appeared that directly questioned the profits maximization assumption and neoclassical predictions regarding decisions

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other than price. William Baumol (1959, 1966) hypothesized that managers maximized sales; Oliver Williamson (1963) added staff and emoluments to the managers’ objective function; Robin Marris (1963, 1964), the growth of the firm. Cyert and March (1963) posited four objectives in addition to profits pursued by the firm. Most fundamentally, Herbert Simon (1957, 1959) argued that managers did not maximize any objective function at all; they satisficed. What needs to be stressed about these examples is that they all stemmed from observations about how managers and corporations actually behave. Simon’s satisficing hypothesis originated from his work in psychology and his study of organizational behavior. His colleagues, Cyert and March, built on Simon’s behavioralist approach and set out to describe the decision-making processes in actual, large corporations rather than to model an ideal, representative firm. To do so they constructed programming models of actual corporate decision structures. Williamson, a student of Simon, was also seeking a more realistic description of the ‘managerial preference function’ than existed at that time. Baumol’s hypothesis arose from observations about the importance of sales to managers as an index of the health of their firm, and as a source of status (1966, pp. 44–8). Marris launches his study with a lengthy review of the literature on organizational behavior, which dwells on motivation, compensation formulae and the like.9 Thus each was seeking to model in a more accurate way the behavior of managers as they had actually observed it, or as they had come to understand it from reading a literature that came from outside of economics. These challenges to economic orthodoxy were dismissed with arguments similar to those used to repel the attacks against marginalist price theory (Baldwin, 1964; Peterson, 1965; Machlup, 1967). In 1970 William Baumol and colleagues published estimates of rates of return on reinvested cash flows during the 1950s and 1960s ranging from 2 to 6 percent. These returns were significantly below both the returns shareholders were earning over this period and the returns Baumol et al. estimated on new debt and equity issues. They corroborated the hypothesis that managers not subject to the discipline of external capital markets would, relative to what was optimal for their shareholders, overinvest their internal cash flows. As with every study that seemingly contradicts the conventional wisdom in economics, the Baumol et al. results were immediately challenged, and several additional studies followed.10 In one of these Henry Grabowski and I brought in a life-cycle hypothesis (1975). Mature firms in industries with mature technologies earned significantly lower returns than young firms in industries with newer technologies. Our results also cast light on another paradoxical finding in the literature – the seemingly ‘irrational’ preference of shareholders for dividends over retained earnings.

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For our sample, it was only the shareholders of mature companies earning relatively low returns on investment who preferred dividends to retentions. The preference for dividends tended to disappear for firms earning high returns on investment. Shareholders were not so irrational after all. In the late 1960s Dale Jorgenson and Calvin Siebert (1968) developed and tested a neoclassical theory of investment. The key determinant of investment for the shareholder-wealth-maximizing firm was the Modigliani and Miller cost of capital. Cash flow had no place in a neoclassical investment equation.11 Of course Jorgenson was right. But cash flow did belong in the investment equation for the managerial firm, since it was this source of capital over which managers could exercise the most discretion. Although the neoclassical cost of capital invariably outperformed cash flow in Jorgenson’s articles, other studies (Elliot, 1973; Grabowski and Mueller, 1972) continued to find that cash flow was superior to measures of the neoclassical cost of capital. Thus, a pattern of empirical results was visible in the 1970s that was fully consistent with a managerial discretion/size-growth maximization hypothesis about the corporation. The greater a corporation’s cash flow, the more it spent on capital equipment and R&D; reinvested cash flows earned relatively low rates of return; mature corporations earned lower returns than young companies or those with new technologies; the market priced the shares of mature firms in a way that implied a preference for greater dividends and less reinvested cash flows. At the same time evidence was accumulating to suggest that the conglomerate merger wave of the 1960s had reduced corporate efficiency. The wealth of the shareholders of acquiring firms steadily declined relative to other shareholders as the market learned more and more about the conglomerate mergers.12 But this pattern of evidence either went unnoticed or, if it was discerned, failed to dislodge the view that managers maximized profits or shareholder wealth. The managerial theories joined the mark-up pricing models that had preceded them as valiant but futile attempts to replace the simplistic view of managerial decision making that characterized the neoclassical model of the firm. It should be noted that this outcome is not peculiar to the field of industrial organization. Robert Frank (1985) focuses on the inadequacy of neoclassical theory in explaining wage patterns within firms, but notes also, citing Mayer (1972), that ‘the evidence for [a] relationship [between income and savings] is so strong and so consistent that it would appear difficult for proponents of the permanent income and life-cycle [saving] theories to continue to insist that savings rates are unrelated to income. Yet these claims persist in all major undergraduate and graduate texts in macroeconomics’ (Frank, 1985, p. 160). Thus, despite a broad consensus among economists that hypotheses should be formulated in such a way

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that they can be ‘rejected by the data’, no empirical evidence is ever deemed strong enough to reject a hypothesis that assumes that agents maximize one of the standard behavioral objectives, that is, in the case of the firm, profits or shareholder wealth, or at least so it seemed up into the 1970s.

4.

CONSTRAINTS ON MANAGERIAL DISCRETION

In trying to explain why managers maximize profits or shareholder wealth, economists have offered essentially five different arguments. Four rely on the existence of a particular market. 4.1

Product Market Competition

The most obvious way to curb managerial discretion and force managers to maximize profits is to ensure that product markets are perfectly competitive. If managers have to maximize profits simply so that their company survives, they will maximize profits. 4.2

An Efficient Capital Market

It should be obvious to potential shareholders that the incentives managers have to maximize shareholder wealth are attenuated if the managers own only a fraction of a company’s shares. If the capital market is efficient, it will recognize when an owner-manager first announces a sale of shares that the owner-manager will engage in more on-the-job consumption following the sale – purchase more staff and emoluments, pursue growth to a greater degree, and so on. The assumption of capital market efficiency implies that the share price drops immediately upon the sale’s announcement to reflect the manager’s additional on-the-job consumption. All of the agency costs from a separation of ownership and control are thus borne by the original owner-manager and s/he therefore has an incentive to minimize these costs.13 4.3

The Market for Managers

Eugene Fama (1980) has claimed that agency problems are eliminated through the workings of the market for managers. Managers will wish to develop a reputation for maximizing profits (not engaging in on-the-job consumption) to improve their chances for promotion within the firm that they currently work for, and to generate attractive job offers from other companies.

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4.4

Key issues

The Market for Corporate Control

Robin Marris (1963, 1964) hypothesized that the constraint upon growthmaximizing managers which prevented them from ignoring shareholders’ interests entirely was the threat of takeover by outsiders if the share price fell too low, and subsequent loss of job. Henry Manne (1965) coined the term ‘market-for-corporate-control’ and claimed that it tended to solve the agency problems created by the separation of ownership and control. 4.5

Principal–Agent Contracts

The fifth constraint on managerial discretion emphasized in the literature comes through the incentives built into the manager’s compensation contract. The principal, that is, the shareholder, is assumed to be concerned only with his wealth or the utility of his wealth. The agent gets utility from his wealth and disutility from the effort expended on behalf of the principal. One or both may be risk averse. The principal cannot fully monitor the agent and thus must try to induce the agent to maximize the principal’s wealth or utility by incorporating the proper incentives into the employment contract. The optimal contract typically does not maximize shareholder wealth, because it needs to insure the agent from some of the risks of the company.

5.

HOW STRONG ARE THE CONSTRAINTS?

In this section, I briefly question each of the hypothesized constraints on managerial discretion put forward in the previous section. 5.1

Product Market Competition

Few industrial organization economists believe that all or even most markets are perfectly competitive. Neither Microsoft’s nor Coca-Cola’s managers need lie awake at night worrying about whether their firm can survive the intense competition it faces. 5.2

An Efficient Capital Market

The initial share offerings of most companies occur when they are young and small. The main concern of potential buyers of these shares at that time is not over managers’ on-the-job consumption, but whether the young firm will survive. If it does, and if it grows big, a day will come when its

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managers can engage in on-the-job consumption at their shareholders’ expense. But by this time the company will most likely have ceased issuing shares. It presses the assumption of rational expectations on the part of the capital market very hard to assume that a possible share price drop upon the initial sale of a company’s shares in anticipation of managerial on-thejob consumption in the distant future can curb this activity. 5.3

The Market for Managers

The market for managers seems more likely to be an effective disciplinary force for middle managers than for senior managers, at least for large companies. Once a manager has become CEO or president of a BP or a General Electric their next job is likely to be hitting golf balls. Should they choose to engage in a little on-the-job consumption or empire-building they are unlikely to worry about the effects on their future employment activities. Potential agency problems with respect to the top managers of large corporations are unlikely to disappear because of the market for managers. 5.4

The Market for Corporate Control

If a corporation has a potential market value of $100 billion and a current market value of $80 billion, then a potential gain exists from taking over the company and replacing the current managers to realize the company’s potential value. If the managers of the undervalued firm are unwilling to sell out through a friendly merger, a tender offer must be made. This would require raising $40 billion at the current share price, and even more considering that a premium will have to be paid to acquire at least 50 percent of the shares. Few potential bidders have that amount of money, and it may be difficult to raise from banks if the assets of the potential target cannot be quickly turned into cash once control is gained. 5.5

Principal–Agent Contracts

The basic problem with the principal–agent incentive contract story is that we do not observe managerial compensation contracts with the characteristics that this story implies. If the shareholders were to design an incentive contract to mitigate the principal–agent problem, they would tie managerial compensation to some combination of reported profits and share price, as perhaps with stock bonuses. The measure of profits or share price in the contract would be some estimate of the increase in profits or share price caused by the managers. Compensation contracts typically reward managers, however, with stock options and bonuses that

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go up with general market swings. A wise shareholder would also retain the authority to fire the manager for poor performance, for example, by giving managers only nonvoting shares. However, if nonvoting shares are issued, they typically go to the shareholders. Increasingly popular among managers in recent years have been multiple-vote, super shares. Perhaps, the clearest evidence of the failure of managerial compensation contracts to provide proper incentives to managers has been the practice following the drop in stock prices at the end of the late 1990s bull market of revaluing mangerial stock options downward. Why the discrepancy between theory and fact? It arises because the fundamental premise of the principal–agent model, in the case of the shareholder and manager, is false. Shareholders do not write the contracts that define managerial compensation, and do not hire and fire managers. To a considerable degree managers select themselves and design their own contracts (Vancil, 1987; Bebchuk and Fried, 2004).

6.

DEVELOPMENTS OVER THE LAST TWENTY YEARS

In 1993 Elizabeth Reardon and I published a study in which we estimated marginal qs (ratios of returns on investment to costs of capital) for 699 companies over the period end of 1969 to end of 1988. A firm which maximizes its shareholders’ wealth should have a marginal q equal to or slightly greater than 1. Our estimates were less than 1 for eight out of ten companies. The median estimated marginal q was 0.71. Cumulated over the 19-year period, the 699 companies have collectively destroyed roughly $1 trillion by investing in projects with returns less than their costs of capital. General Motors alone, with a marginal q of 0.48 destroyed around $150 billion. These figures vividly reveal the significant agency problems in US corporations that existed during the 1970s and part of the 1980s with respect to investment policies. Shareholders in the 699 large companies in our sample would have been $1 trillion richer if the managers of these companies had invested in the way that economics textbooks say they do. Others observed the poor performance of US corporations and commented upon it at the time. As late as 1983, in a survey of the merger literature with Richard Ruback, Michael Jensen requested more ‘knowledge of this enormously productive social invention: the corporation’ (Jensen and Ruback, 1983, p. 47). By 1989, Jensen had acquired the requested knowledge and predicted that the inefficiencies of the corporation with ownership and control separated were so significant that it was destined

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to disappear. A more rapid conversion had not taken place since Paul journeyed to Damascus. Even as Jensen was predicting the corporation’s demise, however, developments were taking place that would enhance its efficiency. Many economists refer to a merger wave of the 1980s in the United States. Compared with merger activity in the 1990s, that of the 1980s was barely a ripple. It is legitimate, however, to speak of a wave of hostile takeovers in the mid to late 1980s. Tender offers, of which hostile takeovers are an important part, rose to 25 percent of all mergers during this period, a figure never before or since seen (Gugler et al., 2007). Moreover, many of the hostile takeovers were headline-grabbing takeovers of major US companies. The business and popular press was filled with stories about them, and they even became the subject for a popular movie, Wall Street. For the first time in US history, the takeover constraint that Marris and Manne had postulated existed began to have some real teeth. Managers reacted. Unprofitable and unrelated divisions were sold off. Managers began buying back their companies’ shares rather than undertaking bad investments or mergers. Terms like ‘back to core competences’, ‘downsizing’ and ‘shareholder value’ began to fall from managers’ lips. Managers’ concerns about shareholder wealth changed radically following the hostile merger activity of the 1980s. The constraint on managers from product market competition can also be said to have increased in recent years due to globalization. Forty years ago a US corporation needed to worry only about the response of other US companies to an innovation or price change. Today, Schumpeter’s gale of creative destruction storms over the innovator from around the world. A third development that has increased constraints on managers is the growth of institutional shareholdings. In 1950, only one in ten shares was held by a pension fund, mutual fund, or some other institutional shareholder. By the mid-1990s the figure was one in two (Friedman, 1996). The managers of these institutional portfolios are full-time stockholders who appear to be increasingly willing to intervene to block a merger or other management decision that the portfolio managers believe will lower share price. These developments have had a noticeable impact on the investment performance of US companies. Estimates of marginal q for the United States over the period 1985–2000 yield a mean of 1.02, a dramatic improvement over the 1970–88 period (Gugler et al., 2004). Thus, at a point in time when many economists are finally beginning to acknowledge the existence of agency problems and to take them seriously, institutional changes may be making them less important.

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7.

Key issues

AN END TO MANAGERIAL DISCRETION?

Despite the institutional developments discussed in the previous section, and the much better investment performance of US companies, it may still be too early to declare all managerial discretion issues to be totally resolved. The study that reported the 1.02 estimate for the 1985–2000 period in the United States reported much lower figures for Continental European and Latin American countries. Thus, even if agency problems seem to have become less important in the United States and some other Anglo-Saxon countries, they appear to be alive and well in many other countries. The first phrase that comes to mind when trying to describe the merger wave of the late 1990s is not ‘back to core competences’ or ‘downsizing’. The merger wave looked to be fueled by soaring stock prices much like all other waves. And, as in other merger waves, the shareholders of the acquiring companies appear to have suffered substantial losses (Gugler et al., 2007; Moeller et al., 2005). This wave also illustrated that institutional shareholders are not as powerful a check on managers as some think. They appear to have been just as swept up by the euphoria of the bull market, and just as willing to believe the various ‘theories’ about why this or that merger will generate synergies – theories which, as with other merger waves, have not received a lot of empirical support. Finally, it must be noted that managerial salaries continue to climb to unprecedented heights despite all the attention that they have received.

NOTES 1. 2. 3. 4. 5.

6. 7. 8. 9. 10. 11.

See Gilson and Roe (1993), and Charkham (1994). See Hansmann and Kraakman (2000). See in particular the quote of John Bates Clark in Letwin (1965, p. 74) and Stigler (1950, p. 76). On these see Galbraith (1972). When not ignoring it, the economist would often ridicule it. As late as 1982, at a conference held ostensibly to ‘celebrate’ the fiftieth anniversary of the publication of The Modern Corporation and Private Property, the tenor and tone of the papers reveals that many came not to praise the book but to bury it (see special issue of Journal of Law and Economics, June 1983). Douglass North’s (1983) comment is a nice exception. Friedman’s (1953) and Becker’s (1962) famous essays could also be cited here. Stigler’s initial findings have been substantiated in several other studies; for example, Simon (1969); Primeaux and Bomball (1974); and Primeaux and Smith (1976). For a survey, see Scherer (1980, pp. 350–62), and a more recent re-examination (Carlton, 1986). I also know from personal conversations with him that his thinking on these matters has been importantly influenced by personal experiences with a firm in his family. This literature is reviewed in Mueller (2003a, pp. 145–8). The pioneering study of the role of cash flow in an investment equation is of course

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12. 13.

57

that of Kuh and Meyer (1957). Although they interpret the strong performance of cash flow in their investment equations as consistent with the profits maximization hypothesis, cash flow enters their list of possible explanatory variables not as a result of the application of the marginal analysis, but because ‘by far the most outstanding aspect of . . . direct inquiries [about the determinants of investment] is their virtual unanimity in finding that internal liquidity considerations and a strong preference for internal financing are prime factors in determining the volume of investment’ (p. 17). The third of the three reasons they give for the strong preference for internal funds is ‘the hierarchical structure and motivations of corporate management which make outside financing asymmetrically risky for the established or in-group’ (pp. 17–18). See the extensive references in my surveys (Mueller, 1977, 2003b, pp. 163–70). See Jensen and Meckling (1976).

REFERENCES Baldwin, W.L. (1964), ‘The Motives of Managers, Environmental Restraints, and the Theory of Managerial Enterprise’, Quarterly Journal of Economics, 78 (May), 236–58. Baumol, W.J. (1959), Business Behavior, Value and Growth, New York: Macmillan; 2nd edn, 1966. Baumol, W.J., P. Heim, B.G. Malkiel and R.E. Quandt (1970), ‘Earnings Retention, New Capital and the Growth of the Firm’, Review of Economics and Statistics, 52, (Nov.), 345–55. Bebchuk, L. and J. Fried (2004), Pay Without Performance, Cambridge, MA: Harvard University Press. Becker, G.S. (1962), ‘Irrational Behavior and Economic Theory’, Journal of Political Economy, 70, (Feb.), 1–13. Berle, A.A. and G.C. Means (1932), The Modern Corporation and Private Property, New York: Commerce Clearing House; rev. edn, New York: Harcourt, Brace, Jovanovich, 1968. Carlton, D.W. (1986), ‘The Rigidity of Prices’, American Economic Review, 76, (Sept.), 637–58. Charkham, J.P. (1994), Keeping Good Company, Oxford: Oxford University Press. Cyert, R.M. and J.G. March (1963), A Behavioral Theory of the Firm, Englewood Cliffs, NJ: Prentice-Hall. Elliot, J.W. (1973), ‘Theories of Corporate Investment Behavior: Revisited’, American Economic Review, 63 (March), 195–207. Fama, E.F. (1980), ‘Agency Problems and the Theory of the Firm’, Journal of Political Economy, 88 (April), 288–307. Frank, R.H. (1985), Choosing the Right Pond, Oxford: Oxford University Press. Friedman, B.M. (1996), ‘Economic Implications of Changing Share Ownership’ Journal of Portfolio Management, 2 (3), 59–70. Friedman, M. (1953), ‘The Methodology of Positive Economics’, in Essays in Positive Economics, Chicago, IL: University of Chicago Press, 3–43. Galbraith, J.K. (1961), The Great Crash, 1929, Boston, MA: Houghton Mifflin, 3rd edn, 1972. Gilson, R.J. and M.J. Roe (1993), ‘Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization’, The Yale Law Journal, 102 (4), 871–906.

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Grabowski, H.G. and D.C. Mueller (1972), ‘Managerial and Stockholder Welfare Models of Firm Expenditures’, Review of Economics and Statistics, 54, Feb, 9–24. Grabowski, H.G. and D.C. Mueller (1975), ‘Life-Cycle Effects on Corporate Returns on Retentions’, Review of Economics and Statistics, 57, Nov, 400–409. Gugler, K., D.C. Mueller and B.B. Yurtoglu (2004), ‘Corporate Governance and the Returns on Investment’, Journal of Law and Economics, 47 (Oct.), 598–633. Gugler, K., D.C. Mueller and B.B. Yurtoglu (2007), ‘The Determinants of Merger Waves’, mimeo, University of Vienna. Hall, R.L. and C.J. Hitch (1939), ‘Price Theory of Business Behaviour’, Oxford Economic Papers, os-2 (1), 12–45. Hansmann H. and R. Kraakman (2000), ‘The Essential Role of Organizational Law’, Yale Law Journal, 110 (3), Dec, 387–440. Jensen, M.C. (1989), ‘The Eclipse of the Public Corporation’, Harvard Business Review, (Sept./Oct.), 61–74. Jensen, M.C. and W.H. Meckling (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure’, Journal of Financial Economics, 3 (4), 305–60. Jensen, M.C. and R.S. Ruback (1983), ‘The Market for Corporate Control’, Journal of Financial Economics, 11 (April), 5–50. Jorgenson, D.W. and C.D. Siebert (1968), ‘A Comparison of Alternative Theories of Corporate Investment Behavior’, American Economic Review, 58 (4), 681–712. Journal of Law and Economics (1983), Special Issue, June. Kahn, A.E. (1959), ‘Pricing Objectives in Large Corporations: Comment’, American Economic Review, 49 (4), 670–80. Kaplan, A.D.H., J.D. Dirlam and R.F. Lanzillotti (1958), Pricing in Big Business. A Case Study Approach, Washington, DC: Brookings Institution, 128–9. Kuh, E. and J.R. Meyer (1957), The Investment Decision, Cambridge, MA: Harvard University Press. Lester, R.A. (1946), ‘Shortcomings of Marginal Analysis for Wage–Employment Problems’, American Economic Review, 36 (1), 63–82. Letwin, W. (1965), Law and Economic Policy in America, New York: Random House. Machlup, F. (1946), ‘Marginal Analysis and Empirical Research’, American Economic Review, 36 (Sept.), 519–54. Machlup, F. (1947), ‘Rejoinder to an Antimarginalist’, American Economic Review, 37 (1), 148–54. Machlup, F. (1967), ‘Theories of the Firm: Marginalist, Behavioral, Managerial’, American Economic Review, 57 (March), 1–33. Manne, H.G. (1965), ‘Mergers and the Market for Corporate Control’, Journal of Political Economy, 73 (April), 110–20. Marris, R. (1963), ‘A Model of the “Managerial” Enterprise’, Quarterly Journal of Economics, 77 (May), 185–209. Marris, R. (1964), The Economic Theory of Managerial Capitalism, Glencoe: Free Press. Marshall, A. (1920), Principles of Economics, 8th edn, London: Macmillan. Marshall, A. (1923), Industry and Trade, 4th edn, London: Macmillan. Mayer, T. (1972), Permanent Income, Wealth and Consumption, Berkeley, CA: University of California Press. Means, G.C. (1935), Industrial Prices and Their Relative Inflexibility, Washington, DC: U.S. Senate Document 13, 74th Congress, 1st Session.

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Means, G.C. (1972), ‘The Administered Price Thesis Reconfirmed’, American Economic Review, 62 (June), 292–306. Mill, J.S. (1885), Principles of Political Economy, 9th edn, London: Longmans, Green and Co.; first published 1848. Moeller, S.B., F.P. Schlingemann and R.M. Stulz (2005), ‘Wealth Destruction on a Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave’, Journal of Finance, 60 (2), 757–82. Mueller, D.C. (1977), ‘The Effects of Conglomerate Mergers: A Survey of the Empirical Evidence’, Journal of Banking and Finance, 1, December, 315–47. Mueller, D.C. (2003a), The Corporation – Investment, Mergers, and Growth, London: Routledge, 2003. Mueller, D.C. (2003b), ‘The Finance Literature on Mergers: A Critical Survey’, in M. Waterson (ed.), Competition, Monopoly and Corporate Governance, Essays in Honour of Keith Cowling, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 161–205. Mueller, D.C. and E. Reardon (1993), ‘Rates of Return on Corporate Investment’, Southern Economic Journal, 60 (Oct.), 430–53. National Resources Committee (1939), The Structure of the American Economy, Part I, Washington, DC: National Resources Committee. North, D.C. (1983), ‘Comment on Stigler and Friedland: The Literature of Economics: The Case of Berle and Means’, Journal of Law and Economics, 26 (2), 269–71. Peterson, S. (1965), ‘Corporate Control and Capitalism’, Quarterly Journal of Economics, 79 (Feb.), 1–24. Primeaux, W.J. Jr. and M.R. Bomball (1974), ‘A Reexamination of the Kinky Oligopoly Demand Curve’, Journal of Political Economy, 82 (4), 851–62. Primeaux, W.J. Jr. and M.C. Smith (1976), ‘Pricing Patterns and the Kinky Demand Curve’, Journal of Law and Economics, 19 (1), 189–99. Scherer, F.M. (1980), Industrial Market Structure and Economic Performance, 2nd edn, Chicago, IL: Rand McNally. Simon, H.A. (1957), ‘The Compensation of Executives’, Sociometry, 20 (March), 32–5. Simon, H.A. (1959), ‘Theories of Decision Making in Economics and Behavioral Science’, American Economic Review, 49 (June), 253–83. Simon, J.L. (1969), ‘A Further Test of the Kinky Oligopoly Demand Curve’, American Economic Review, 59 (5), 971–5. Smith, A. (1776), The Wealth of Nations, reprinted New York: Random House, 1937. Stigler, G.J. (1947), ‘The Kinky Oligopoly Demand Curve and Rigid Prices’, Journal of Political Economy, 55 (5), 432–49; reprinted in G.J. Stigler and K.E. Boulding (eds), 1952, Readings in Price Theory, Chicago, IL: Irwin, 410– 39. Stigler, G.J. (1950), ‘Monopoly and Oligopoly by Merger’, American Economic Review, 40 (2) (May), 23–34; reprinted in R.B. Heflebower and G.W. Stocking (eds), 1958, Readings in Industrial Organization and Public Policy, Homewood, IL: Irwin, 69–80. Stigler, G.J. and J.K. Kindahl (1970), The Behavior of Industrial Prices, New York: Columbia University Press. Stigler, G.J. and J.K. Kindahl (1973), ‘Industrial Prices, as Administered by Dr. Means’, American Economic Review, 63 (4), 717–21.

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Sweezy, P.M. (1939), ‘Demand Under Conditions of Oligopoly’, Journal of Political Economy, 47 (4), 568–73. Vancil, R.F. (1987), Passing the Baton, Boston, MA: Harvard Business School. Weiss, L.W. (1977), ‘Stigler, Kindahl, and Means on “Administered Prices”’, American Economic Review, 67 (Sept.), 610–19. Williamson, O.E. (1963), ‘Management Discretion and Business Behavior’, American Economic Review, 53 (Dec.), 1032–57.

PART II

The theory of the firm from an organizational perspective

4. A contractual perspective of the firm with an application to the maritime industry Per-Olof Bjuggren and Johanna Palmberg* 1.

INTRODUCTION

In 1776 Adam Smith developed a theory for markets as the coordinating device in an economy. However, economic activities are not only coordinated through the price mechanism of the market but are also guided by firms within which the production of goods and services takes place. In contrast to markets the firm is not so well developed in economic theory. This is reflected, for example, in basic economic textbooks that usually assume the firm as something exogenously given that need not be explained or analyzed. After acknowledging the existence of firms, textbooks quickly turn to the market and analyze its importance for a well-functioning economy.1 However, since the early 1970s there has been rapidly expanding research on the theory of the firm, largely inspired by an article dating back to 1937 about the nature of the firm written by the Nobel laureate, Ronald H. Coase. However, it took more than thirty years for researchers to draw inspiration from the ideas put forward by Coase. In the 1970s (primarily) Oliver E. Williamson continued along the line of research that Coase had outlined. Since then theories of the firm have been a new expanding area of research in economics. In this chapter, a contractual perspective on the firm is used, with the concept of institution being an important cornerstone, and a synthesis of different contractual perspectives on the firm as the coordinating institution within the maritime industry. This chapter recognizes the fact that the firm itself can enter into contracts with other firms and physical persons. In a competitive environment there is a strong tendency for the most cost-efficient composition of contracts within a given institutional environment to survive (see, for example, Fama and Jensen, 1983). We will apply such a contractual view. In addition to the production costs (remuneration to suppliers of different kinds 63

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The theory of the firm from an organizational perspective

of inputs such as labor and capital services) these costs include information costs and the costs for negotiating and monitoring contracts. In line with transaction cost economics, we consider all transactions to be costly. These transaction costs can then be used to explain market structures as well as firms and other institutions (see, for example, Chapter 2 in this volume). The focus in this chapter is on the relationship between contracts and transaction characteristics. The maritime industry offers an interesting area of research for economists. Different theories developed within the fields of financial economics, institutional economics, corporate governance and industrial organization can be applied with good analytical results. A quick glance through the volumes of Maritime Policy and Management illustrates this. Furthermore, the maritime industry is interesting for contract theory since all different types of contracts ranging from spot contracts to vertical integration are used in the industry. Also, the organization of the shipping company is affected by third-party management which in its extreme form separates ownership from control. In the early 1990s an article by Stephen Pirrong demonstrated how transaction cost analysis could be applied in the analysis of contracting practices in maritime transport (Pirrong, 1993). We extend Pirrong’s analysis by applying transaction cost analysis both to the freight contract and to the firm. The idea behind this chapter originates from a larger research project on the Swedish shipping industry (see Johansson et al., 2006).2 Therefore the Swedish maritime industry is used for illustration. The maritime industry is a truly global industry; the Swedish ship-owners and their counterparts all act on international markets. Hence, characteristics valid for Sweden also apply to larger shipping nations. Section 2 of the chapter starts with a presentation of our contractual view of the firm, with maritime illustrations, and Section 3 offers a brief presentation of maritime transport and the different types of firms that operate in the market. A closer look at different contractual compositions that characterize maritime transport firms with transaction cost and institutional explanations is presented in Section 4, and Section 5 concludes the chapter.

2.

A CONTRACTUAL PERSPECTIVE ON THE FIRM

In neoclassical economics the firm is often treated as a ‘black box’, but viewing the firm as a ‘nexus of contracts’ (Jensen and Meckling, 1976; Ståhl, 1976) results in a much richer analysis of market processes and the allocation of resources in an economy. In this section the firm is discussed from a contractual perspective. First, an overview of the relation between specialization and productivity and the need for coordination

A contractual perspective of the firm Increased productivity by division of labour (specialization)

Figure 4.1

Mutual dependence

Coordination required

65 Institutional solutions

Specialization and institutions

and institutions (Section 2.1) is presented. Section 2.2 discusses the firm as a contractual entity in depth. Section 2.3 concludes with an analysis of the relation between contracts, markets and firms. 2.1

Specialization and Institutions

In an analysis of the organization of an industry, specialization is a crucial concept since it fosters increased productivity. This is an important message of the first chapter of Adam Smith’s Wealth of Nations (1776). With the help of the famous pin factory example, Smith demonstrates in detail how productivity is increased by specialization. However, specialization implies increased mutual dependence and hence production must be organized in a fashion that solves this mutual dependency. In Figure 4.1 this is expressed as demands on proper institutional solutions created by the coordination problem caused by mutual dependence due to specialization. (Institutions are thereby defined as rules for individual interactions/cooperation.) Firms and markets are alternative institutional solutions to the coordination problem. We will start by looking at the firm as an institutional arrangement to solve the coordination problem caused by factor specialization. 2.2

The Firm as a Nexus of Contracts

An important feature of a firm is that it is a legal entity and can, just like a physical person, enter into binding agreements (contracts) with other physical and legal persons (see Ståhl, 1976). From this perspective the firm can be seen as a ‘nexus of contracts’ that coordinates financial investors, suppliers of intermediate goods, services and labor, and customers in the production of goods and services. Figure 4.2 shows the firm from such a contractual perspective. The production factors human capital (H) and physical capital (K) can serve as a starting point in a description of this contractual view of the firm. These are the independent variables commonly used in production functions such as Cobb–Douglas and CES. The firm can choose either to own or to rent its physical capital. Ownership implies property rights

66

The theory of the firm from an organizational perspective Shareholders

Suppliers of raw material and goods Suppliers of human capital services

The firm as a production unit and a nexus of contracts

Creditors Users/ customers

Suppliers of physical capital services = Guaranteed contracts

Figure 4.2

= Residual contract

The firm as a nexus of contracts

with an exclusive right to use physical capital and the return from its use. Furthermore, private property right is associated with an exclusive right to transfer the property right through an agreement (contract) to another person. A rental agreement implies a much more limited scope for decisions about the use of the physical asset. In the maritime sector the most important physical capital is the vessel. Both ownership and rental agreements and combinations of these two alternatives are common amongst ship-owners. For labor there is a choice between an employment contract and hiring of a consultant. An employment contract is much more open than a contract with a consultant with regard to use of labor. The employment contract makes it possible to use a hierarchical type of decision making regarding the use of human capital, and thereby provides an opportunity to replace the price mechanism of the market with administrative decisions about resources allocation (see, for example, Coase, 1937; Masten, 1988). One could say that the invisible hand of the market is replaced by the visible hand of an organization. In the shipping industry a wide range of contracts with labor can be found. A phenomenon of special interest that will be discussed in more detail below is the so-called third-party ship management, where the owners of physical capital, the vessel, hire parts of or all labor and management services from another company. (See Section 4.1 for further discussion.) A firm’s financial contractual relations have governance implications.

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67

The shareholders are considered the owners of the firm. Their contractual relation with the firm is characterized by a claim on the residual that remains when all other contractual obligations of the firm have been met. (They are residual claimants.) The return on their investment is therefore directly related to how well the firm is managed. This dependency makes it important to have a mechanism through which shareholders can control how the corporation acts as a legal person. In most cases it is the board of directors and the CEO who, on behalf of the firm, enter into binding contracts with, for example, suppliers, employees and customers. It is thus logical (understandable) that the shareholders directly or indirectly choose who will have these positions.3 On the financial side of the firm there are also lenders (investors) with fixed claims contracts (banks and bondholders). In contrast to the shareholders they have specified claims on the firm in terms of mortgage plans, maturity and interest claims. If the firm cannot meet these fixed claims it can be forced into liquidation/bankruptcy. The remuneration that lenders and also suppliers can get is then dependent on the value of assets to entities other than the bankrupted (liquidating) corporation. Fungible assets with a well-functioning second-hand market are valuable to others and can therefore serve as collaterals for loans. Consequently firms that have such assets can to a larger extent than other firms use loans as a source of finance (see Williamson, 1988). In the maritime sector the vessel is in most cases a fungible asset. There are well-functioning second-hand markets for vessels. The number of alternative carriers and customers for carrier services is for some types of vessels large enough to make the second-hand market competitive (Stopford, 1997). Finally, we turn our attention to the firm’s contractual relation with suppliers and customers (contracts to be found on the input and output sides of the firm in Figure 4.2). Value added chains, vertical integration and supplier-specific/customer-specific specialization are important concepts here.4 A value added chain shows the different stages in the processing of a raw material to final consumer product; for example, from axe to loaf, from stone to house, from iron ore to car. In a value added chain there are several technologically separate stages. Between all these stages it is possible to envisage transport by ship that brings the output of one stage to a succeeding stage. Just as a number of different contractual relations can be found by the supplier and user in a value added chain, an equally rich flora of contracts is found for the shipping of raw materials, intermediate goods and consumer goods. If the automotive industry is taken as an example, shipping can enter into the value added chain in different stages of the processing of raw material

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such as iron ore and steel in the manufacturing of a car for sale to a final customer. Raw material such as iron ore might have to be transported by a dry bulk carrier to a steel mill. Different automotive parts made of steel might have to be transported over the sea in containers to the car manufacturer. The ready-made cars in turn have (if exported) to be shipped in specially designed vessels to other countries. 2.3

Contracts, Markets and Firms

What is especially important from a contractual perspective is whether there are assets whose productive value is dependent on uninterrupted transactions between a specific supplier and customer.5 As indicated in Figure 4.1 it is usually specialization of assets that is the source of the mutual dependence. Here, it is important to note the problems of sunk costs and quasirents associated with investment in transaction-specific assets. A bilateral dependence evolves immediately after the investment has been made and there is no alternative equally attractive transaction partner within a specific price span. Klein et al. (1978) call this span the ‘appropriable quasirent’ as it amounts to the part of the value of a specialized investment that can be taken away without a change of employment of the factor.6 A rational supplier or customer is not prepared to make an investment in an asset of a transaction-specific character without at least some guarantee in the form of a long-term contract with a price that makes the investment profitable. But, as pointed out by Williamson (1985), it is sometimes difficult to construct such a long-term contract sufficiently watertight in terms of no loopholes and at the same time sufficiently flexible to allow for changed circumstances. This is especially the case if uncertainty and complexity characterize the business in which the supplier and the customer are engaged. Both of the requirements ‘water tightness’ and flexibility have to be met if the long-term contract is to serve as a perfect institutional solution to the problem of mutual dependence. But the rationality of human beings sets, as noted by Williamson (1975, 1985 and 1996), a limit to what can be achieved in terms of ‘water tightness’ and flexibility (the assumption of bounded rationality). In a complex world, contracts are therefore bound to be more or less incomplete with loopholes that invite opportunistic behavior.7 In transactions between firms with different owners there are conflicting profit incentives in contract negotiations. While the supplier has a profit incentive to obtain as high a price as possible, the customer’s profit incentive is to get as low a price as possible. The conflicting profit incentives make transactions costly if an appropriable quasi-rent due to asset specificity exists. Hence, a long-term contract could be preferred to a spot contract and, if the transactional problems are severe, vertical integration

A contractual perspective of the firm

69

(joint ownership) could be the most cost-efficient solution. At the same time the strong (high-powered) incentives of independent firms to minimize cost have to be factored in when the decision to vertically integrate is contemplated. The cost minimization incentive is likely to be less powered for a salaried manager than for an owner-manager (see Williamson, 1985, and Chapter 2 in this volume). With vertical integration, transaction costs may be avoided, as the incentives are different in a firm and in the market. An employee-manager of a division X, which supplies inputs to a division Y within the same firm, will not be rewarded if she/he engages in costly negotiations that increase the profit of division X at the expense of division Y and at the expense of the overall profit of the firm. Instead the manager runs the risk of being fired. Within the firm it is behavior of co-operation and not costly rival behavior that will be rewarded. The structure of vertical integration can take different paths, as can be seen in the structure of shipping services in relation to cars and car manufacturers. For instance in cases such as that of container traffic there might be a need of vertical integration forward with terminals in ports and train carriers in order to secure smooth transport of parts to the car manufacturer. If, for example, parts of a car produced in Asia are transported on a larger container vessel for assembly on the American East Coast there might be the problem that the vessel cannot pass through the Panama Canal. Consequently, the vessel has to go through a Californian port and land transport might have to be used over the continent from west to east. In order to speed up the handling in the port, special equipment might be needed and it may thus be more efficient to use special railway wagons. These are so-called dedicated assets that have to be available when the vessel arrives.8 Vertical integration with terminals and wagons is therefore an attractive solution (see Midore et al., 2005). In other cases, such as oil tankers, there has instead been a trend of vertical disintegration (see Veenstra and De la Fosse, 2006). To summarize, a contractual relation depends on the nature of the asset invested in. If assets are designed in one way or another to complement each other, it is unlikely that the coordination of the use of assets in successive stages of a supply chain will be left to an atomistic market. Some safeguard is needed in order to make transactions efficient in such cases. Vertical integration is one solution where the assets are controlled under the same ownership. In other cases it will be sufficient to have some hybrid contractual solutions aligning the interests of supplier and customer.9 Without any safeguard the conflicting profit incentives of supplier and customer are a source of costly transactional problems. Mutual dependence means that the interest of the supplier to increase revenue through

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The theory of the firm from an organizational perspective

a higher price and the reverse interest of the customer to decrease cost through a lower price will lead to clashes. If there are no alternative transaction partners to turn to, conflicts will have to be solved within a continuing transactional relation. Otherwise costly investments will lose value. The vertical integration of container carriers can be explained in this way. Terminals and wagons are dedicated assets that are necessary for keeping down the costs of the vessels at ports (see Midore et al., 2005).

3.

CHARACTERISTICS OF MARITIME TRANSPORT – MARKET AND FIRMS

The maritime sector offers a wide spectrum of institutional arrangements, which makes it an interesting field for contractual research. Economists with a background in financial economics, institutional economics and corporate governance will find contracts and organizational solutions a prospective area for empirical research. This section gives an overview of the rich contractual and organizational pattern that can be found in the maritime sector.10 Moreover, it attempts to give a transaction economics explanation for the wide array of institutional arrangements in that sector. 3.1

The Freight Market

The maritime sector can roughly be divided into four types of markets (see Figure 4.3). First there is tramp shipping. The tramp market is trafficked primarily by tankers and bulk carriers. In this market, spot contracts and forward contracts are the most commonly used contracts. Long-time charters are also used but they are less common. The bulk market is diversified with respect to various types of cargo, such as coal, ore, grain, and forest products. Some of these products demand specially constructed (designed) vessels; this implies that the ship-owner becomes more specialized and more vulnerable to long-term changes in the market structure. Magirou et al. (1992) give an excellent review of the freight market. A second market is liner shipping. The goods shipped in this market are higher up in the value added chain and are often transported in containers and various types of ro-ro vessels. In this market the shipper–client relationship is more long-term than in tramp shipping. Moreover, vertical integration forward in the logistic chain is found in the form of ownership of terminals in ports and special train wagons. Some of the goods have to be delivered just in time, which increases the mutual dependence of the assets in these later stages of the logistic chain. Another contractual difference between the tramp and liner markets is that the freight contract in

A contractual perspective of the firm

71

Ship-owners

Tramp market Perfect competition

Liner shipping Markets are often cartelized

Ferry traffic

Special cargo shipping Long-term contracts

Bulk

Tank

General cargo

Standard cargo (Container-, ro-ro vessels)

Spot contracts or time charters (forward contracts)

Source:

Johansson et al. (2006) based on Magirou et al. (1992).

Figure 4.3

Structure of the freight market

the tramp market is focused on the vessel whereas in the liner market the contract is focused on the transport. There are differences also in terms of the market structure between the tramp and the liner market. The tramp market is characterized by (almost) perfect competition. Sea transport is supplied by ship-owners and bought by charterers. In contrast to the tramp market the liner market is to a large extent cartelized. Groups of shippers come together in so-called liner conferences in order to negotiate prices and to supply sea transport to different trades. The ship-owners therefore have to compete on factors other than price such as service and times of transport. Due to containerization the liner conferences have declined in importance to the pricing strategy. A third shipping market is the ferry/cruise market. A strong parallel can be drawn between this market and the aircraft industry. A certain route is used. Terminals and other dedicated assets have to be invested in. However, the assets (the vessels) are not transaction specific to a specific route. They can rather easily be transferred to another ferry route. Finally there is special cargo shipping, to which car carriers and forest sea transport belong. Special shipping is characterized by long-term customer adaptation; usually the COA (contract of affreightment) is applied. Swedish ship-owners mainly operate within the tramp market or special cargo shipping. These vessels are designed for goods that are processed so far that they are downstream near the end of the value added chain. The receiver of the good is a retailer selling a good to the final consumer. Here, we find long-term contracts and vertical integration.11

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3.2

The theory of the firm from an organizational perspective

The Freight Contract

The shipping industry is characterized by at least four types of market structures, ranging from almost perfect competition on the tramp market to cartelization on the liner market. The different types of markets also use different types of freight contracts. This section focuses on the bulk market. (The other types of markets are to a larger extent characterized by long-term freight contracts.) In principle there are three types of freight contracts used in the bulk market: (i) the voyager charter, (ii) the time charter and (iii) the contract of affreightment (COA). The time span and the intensity in the contract between the shipper and the carrier depend partly on the type of freight contract and partly on the extent to which the carrier uses the same shipper (Pirrong, 1993). The voyager charter implies that the shipper transports a single cargo or a series of shipments during a given time period. This freight contract has the shortest time span. The charter is directed at the vessel, which means that the ship-owner transports one cargo from one port to another. The contract is traded on the spot market and ceases, in normal cases, directly after the cargo has been discharged at the port. The time charter, on the other hand, is used by a carrier who wants to carry out the transport process on their own. The time charter implies that the carrier exercises command over the vessel for a specified time period. The charterer is responsible not only for the commercial operation of the vessel but also for the variable costs of the vessel such as port charges, canal dues, costs for loading and discharging, stowing, and so on. The ship-owner is, on the other hand, responsible for the maintenance and the nautical operation of the vessel and for the fixed costs of the vessel, interest on equity, depreciations, and so on (Gorton et al., 1989; Johansson et al., 2006). The third type of freight contract is the COA. This is a long-term contract spanning between 3–4 years and 15 years. The COA implies that it is only the vessel that is leased. The charterer is responsible for the crew, insurance, maintenance, inspections, and all variable costs. The contract is often detailed and specifies the type of cargo, minimum and maximum volumes carried over specific time periods, destination and origin ports, and so on (Pirrong, 1993). 3.3

The Shipping Company

The organization of the shipping company is decided by factors such as type of shipping activities, type of market on which the company operates, and the size of the company. The structure of a company operating on the spot market differs from the structure of a liner shipping company. A

A contractual perspective of the firm

Liner department – Operational department – Freight booking – Freight office and accounting – Reloading – Marketing/sales

73

Tramp department – Affreightment – Calculation – Operational department The shipping company

Administrative department – Financial and accounting – Personnel department – Law – IT –‘Ship management’ – External and internal information

Source:

Technological department – Construction – Operating – Inspection – Maintenance – Commissariat service

Based on Nya Sjöfartens Bok, 2006 (2005).

Figure 4.4

Business structure of a large shipping firm

shipping company operating on the tramp market has, in general, only two departments: administrative and technical. Shipping companies that timecharter their vessels for shorter time periods also have an affreightment department. The liner shipping company has the largest administrative department, with many employees and agents across the globe. Smaller shipping companies usually have a small administrative department and it is common that the onboard crew takes many of the decisions regarding the firm (Nya Sjöfartens Bok, 2006). Figure 4.4 shows how a shipping company can be organized. It is only the larger shipping companies that have all the different departments displayed in the figure. In general, the shipping company operates on either the liner market or the spot market. Smaller shipping companies purchase administrative and technical services instead of providing them internally in the company, as shown in the figure. The liner department is responsible for all the regular traffic that the shipping company controls. The business is carried out both from the head office and from subsidiaries. In addition, the liner shipping company purchases services from shipping agencies (brokers) in ports where it is not located. The tramp department is responsible for all the vessels that are leased on the open spot market. That is, the department is responsible both for the chartering and for the commercial operation of the vessels. It is also responsible for the purchasing and the selling of vessels. The administrative department is, in the ideal case, dynamic and well able to follow the fast development that characterizes the shipping industry. In general, one can say that the larger the shipping company the more of the administrative services are handled

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internally in the company; smaller shipping companies purchase various administrative services to a larger extent (Nya Sjöfartens Bok, 2006).

4.

THE ECONOMIC ORGANIZATION OF MARITIME TRANSPORT AND MARITIME FIRMS FROM A CONTRACTUAL PERSPECTIVE

A general finding is thus that the contractual relation seems to depend on the good’s place in the value added chain. Raw material is transported according to spot contracts. In these markets perfect competition can be recognized. When we go further up the value chain and come closer to the final consumer good, the contractual relations exhibit more of a long-term character and asset specificity explanations can be found. The distinction between firm and market also varies in an interesting way. Third-party management is a phenomenon that illustrates the fact that labor (the crew) is not tied to the asset (the vessel) to the same extent as in other industries. Instead, it is possible to have an arm’s-length relation between labor and capital to an extent not found in other industries. 4.1

Third-party Ship Management

Third-party management is a denomination for a complete separation of ownership and control in maritime transport. That is, a professional management company manages ships owned by another company. In our contractual model (see Figure 4.2) it is at its extreme the same as breaking up the firm into two halves. Ownership and financing of physical capital are put in one company that contracts with another company for the supply of human capital services and other inputs necessary for the production of maritime transport services. There is no employment relation connecting capital ownership and labor. The ship-owner cannot influence the use of the ship through fiat. A contract between two separate firms decides how the use of capital and labor shall be coordinated. Contract (market) has replaced the firm as a coordination mechanism. In the extreme case, a ship-management company takes over all the activities outlined in Section 3.3 (Figure 4.4). Mitroussi (2003) describes it thus: once a ship owner assigns activities, like crewing, technical and freight management, insurance, accounting, chartering, provisions, bunkering operations and sale and purchase of a vessel, in essence he or she gives up, together with the full management, control of his assets to third parties with no ownership rights in them. (p. 81)

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However, in practice ship managers seldom go to this extreme. In another study Mitroussi (2004) shows that in the majority of cases the firms assign crewing, technical management, service, accounting and operations to independent managers. The extreme division of ownership and control indicates that the asset specificity in the relationship between capital and labor is not large. The crew of a tanker, a bulk carrier or a container ship can serve equally efficiently on vessels owned by different firms. In line with Williamson (1996, Chapter 3), the high-powered incentives in an arm’s-length (market) relation can be used and the price for transport services is in most cases given. With a given price, cost minimization becomes important. A ship-management company has higher-powered incentives to minimize cost than an employee. Furthermore, as also noted by Williamson (1996, Chapter 3, p. 66), ‘markets can sometimes aggregate demands to advantage, and thereby realize economies of scale and scope’. The possibilities to reap economies of scale and scope are mentioned by Panayides and Cullinance (2002) as the main rationale for use of thirdparty management. The ship-management companies are usually subsidiaries of larger shipowners. The knowledge and the experience from operating vessels thereby remain within the company. Important customers of the ship-management firms are large multinational oil and manufacturing companies that have built up their own fleet. The rationale behind owning a fleet is lower costs of transport as well as the possibility to control the supply of sea transport. Furthermore, the cost of letting a ship-management company operate the vessel is often lower than the cost of developing a department within the existing company. It is also common that the ship-owner purchases management services in order to learn how to operate a vessel (Nya Sjöfartens Bok, 2006; Branch, 1988). 4.2

A Wide Array of Contracts in Maritime Transport

The prevalence of the diversity of contracts in maritime transport cannot fully be explained by the types of asset specificity enumerated in Williamson (1985), for example, site, physical asset and human asset specificity. Vessels, in general, are not built to serve a specific shipper (customer), with the exception of vessels used in special shipping. Most of the vessels used in bulk shipping are, as pointed out by Pirrong (1993), not customer-specific in the same sense as site specificity and asset specificity. Furthermore, the use of third-party management indicates that human asset specificity is not as important as in other industries. Instead time and space considerations give rise to what Masten et al. (1991) call ‘temporal specificities’ and Pirrong (1993) claims that this type of specificity is common in bulk

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shipping. Temporal specificities are, according to Pirrong, the explanation as to why some contracts are more commonly used at some freight markets than at others. Appropriable quasi-rents exist because ‘delays in shipment cause great harm on the shipper and the carrier’s next best cargo shipping opportunity is sufficiently distant’ (Pirrong, 1993, p. 942). This temporal specificity can be costly to handle in spot market transactions. Some type of safeguard represented by a long-term contract or other type of binding between shipper and carrier has to be imposed. In markets where forward and time contracts are common a second type of specificity can arise due to the time span of the contract, namely contractual specificities. These arise in the vacuum after the expiration of the contract when all other vessels and cargos are engaged in other freight contracts. During this time period, when all other shippers and carriers are tied up in other contracts, the previously contractually related carrier and shipper are in a bilateral monopoly situation. The transaction costs of entering into a new agreement then increase considerably and there are incentives for strategic behavior. The cost of contractual specificities can, however, be mitigated by an increasing number of contracts that expire repetitively. Both the shipper and the carrier then have a number of potential new partners. Costs associated with forward contracting, such as cost of lower flexibility and the cost of opportunistic behavior, increase with the time span of the contract, whereas contractual specificities lead to longer freight contracts and vertical integration (Pirrong, 1993). In freight markets where specialized vessels are common, for example, for car transports and wooden products, the probability of long-term gaps between expiration dates of different short- and medium-term contracts is high. From a transaction costs perspective the shipper can then gain by buying its own vessel, that is, be independent of ship-owners. Long-term contracts are yet another way of reducing the transaction cost. Temporal and contractual specificities do determine the design of the freight contract. Spot contracts are used at markets where temporal specificities lack importance, whereas long-term freight contracts and vertical integration exist on markets associated with significant temporal specificities caused by ‘i) market thinness, ii) the unavailability of supplies of the shipped commodity from non-firm specific resources, or iii) efficiencies arising from the use of specialized tonnage’ (Pirrong, 1993, p. 951). In Table 4.1 the different types of bulk markets are analyzed from a contractual perspective. Spot contracts should be used when there is no temporal specificity apparent, that is, when there is a no in each of the three boxes following each commodity respectively. Accordingly spot contracts are used for freights for commodities such as grain, oil (post-1973), fertilizers and

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Table 4.1

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Contracting practices in bulk shipping

Commodity

Firm-specific Specialized supplies vessels

Thin market

Typical contract

Grain Oil post-1973 Oil pre-1973 Thermal coal pre1980 Thermal coal post-1980

No No Yes No

No No No No

No No No No

Spot Spot MTC or VI Spot

Yes

Yes/No

No

Coking coal

Yes

Yes/No

–

Fertilizer Scrap Iron ore Great Lakes ore Wood chips Lumber Cement Bauxite Liquified natural gas Autos

No No Yes Yes Yes Yes Yes Yes Yes

No No Yes Yes Yes Yes Yes Yes Yes

No No Yes Yes Yes Yes Yes Yes Yes

LTCOA for large ships, MTC for others LTCOA for large ships, MTC for others Spot Spot LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI

Yes

Yes

Yes

LTCOA or VI

Note: LTCOA 5 long-term contracting, VI 5 vertical integration, Spot 5 spot chartering, and MTC 5 medium term chartering. Source:

Adopted from Pirrong (1993, p. 974).

scrap, transported with general vessels, in thick markets and without firmspecific supply. Various kinds of time charters are used when the market is characterized by firm-specific supplies, specialized vessels or thin market. In these markets both time specificities and contractual specificities are significant. Freight market characteristics can change over time; for example, the characteristics of the market for oil shipping changed considerably during the late 1970s, from forward contracts and time charter (MTC or VI) into spot contracts.12 This change displays the major role that temporal specificities play in contracting practices. Also, the change in contracting practices took place when firm specificity became less important. Before 1973 most of the contracting with crude oil producers consisted of forward

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and time charters. At this time the crude oil producers in the Middle East, West Africa, and Indonesia supplied the major oil refiners – British Petroleum, Exxon, Gulf, Mobil, Royal Dutch Shell, Socal and Texaco – with crude oil on equity contracts or preference agreements. These market conditions resulted in temporal specificities. At the same time there was an excess supply of tankers which mitigated contractual specificities. During the 1970s political as well as economical changes took place in countries belonging to the Organization of Petroleum Exporting Countries (OPEC). These changes resulted in a drastic reduction in the use of forward contracts and time charters. The process, towards spot contracts, was supported by the development of spot oil markets in the Netherlands, the US and the UK. To summarize, the above reasoning demonstrates that firm specificities can create temporal specificities which in turn give rise to the use of forward contracts, time charters and vertical integration. The increased use of spot contracts increased the flexibility, which lowered the transaction costs of spot contracting.

5.

CONCLUDING REMARKS AND DISCUSSION

This chapter presents a contractual perspective of the firm that highlights the function of the firm as a common contracting partner to suppliers, customers, labor, capital and financiers. The nature of contracts concluded is in our model dependent on the degree of mutual dependency. A high degree of mutual dependency requires safeguards that can be provided in the form of long-term contracts, an employment relation or joint ownership of assets in different stages of a value added chain. The maritime industry is analyzed from a contractual perspective with special focus on the link between the carrier and the shipper. We present a synthesis of different contractual perspectives on the firm as a coordinating institution. The maritime industry is interesting due to the wide variation of contracts used, ranging from spot contracts, forward contracts and time charters to vertical integration. It is also interesting that in comparing different freight markets there is a large variation going from one extreme to another. The tramp market is characterized by (almost) perfect competition whereas the liner market is characterized by cartels. In general there are three types of freight contracts, the spot contract, the time-voyager and the contract of affreightment (COA). The choice of contract depends not only on the position of the commodities in the value added chain but also on the existence of temporal specificities. The spot contract is used on tramp markets mainly for raw material such as oil and

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grain where no temporal specificities prevail. Commodities higher up in the value added chain are most often transported with forward contracts or time charters. In addition, these markets are characterized by temporal specificities due to political and economic changes in the contract practices over time, such as in the shipping of oil. This example highlights the fact that firm specificities can create temporal specificities which induce the use of forward contracts and time charters in an industry that due to its characteristics normally should apply spot contracts. The existence of third-party ship management in the maritime industry is also an interesting phenomenon. It sheds light on complete separation of ownership and control. In this case the relation between physical and human capital is regulated by a contract. This in turn indicates that there is a relatively low degree of asset specificity regarding capital and labor in the maritime sector. When third-party management is applied, the allocation of resources is replaced by a contract. There is also a strong relation between commodity specialization and firm structure. For example, firms operating mainly on the spot market are usually smaller whereas firms on the liner and ferry markets usually are relatively large. The existence of temporal specificities therefore affects both the firm structure and the design of the freight contract.

NOTES * 1. 2. 3. 4.

5. 6.

7.

Corresponding author. However, it is a plain vanilla theory of markets. No attention is paid to differing contractual aspects of markets (see Williamson, Chapter 2 in this volume). The report has benefited from excellent comments and branch-specific knowledge supplied by P.A. Sjöberger, Swedish Shipowners’ Association. In many cases CEO, chairman and largest shareholder can be one and the same person. Value added chains can be used to show the different stages in shipping. For example the Swedish shipping companies Broström AB and Wallenius AB use comprehensive freight contracts that include several steps in the supply chain. Instead of buying these services from other logistic firms the ship-owners develop them internally in the company (Johansson et al., 2006). Williamson (1985, 1996 and Chapter 2 in this volume) uses the term ‘asset specificity’ in his description of such a dependency. Klein et al. (1978) make a distinction between use and user when defining an appropriable quasi-rent. While the concept quasi-rent according to them refers to how much the value of an asset in current use exceeds the value of an asset in its best alternative use, appropriable quasi-rent denotes the difference in value in relation to what the next highest valuing user is prepared to pay for the service of the asset. According to Williamson (1975, 1985, 1996) bounded rationality refers to the limited capacity of the human mind to conceive and evaluate all alternatives pertinent to a decision. Opportunistic behavior in turn means to give false or self-disbelieved promises about the future or self-interest seeking with guile; to include calculated efforts to mislead, deceive, obfuscate, and otherwise confuse.

80 8. 9. 10. 11. 12.

The theory of the firm from an organizational perspective According to Williamson (1996, p. 105) dedicated assets are ‘discrete investments in general purpose plant that are made at the behest of a particular customer’. By hybrid one means ‘Long-term contractual relations that preserve autonomy but provide added transaction-specific safeguards, compared with the market’ (Williamson, 1996, p. 378). Section 3 is based on Johansson et al. (2006). See for example the Swedish companies Wallenius Wilhelmsen Line and SCA. The following discussion is based on Pirrong (1993).

REFERENCES Branch, A.E. (1988), Economics of Shipping Practice and Management, 2nd edn, Chapman & Hall, London. Coase, R.H. (1937), ‘The Nature of the Firm’, Economica N.S. 4:386–405, reprinted in O.E. Williamson and S. Winter (eds) (1991), The Nature of the Firm: Origins, Evolution, and Development, New York: Oxford University Press, pp. 18–33. Fama, E.F. and Jensen, M.C. (1983), ‘Separation of Ownership and Control’, Journal of Law and Economics, 26:301–26. Gorton, L, Ihre, R. and Sandevärn, A. (1989), Befraktning, edition 3–1, Liber Hermods, Läsprodukter AB, Halmstad. Jensen, M. and Meckling, W. (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure’, Journal of Financial Economics, 3:305–60. Johansson, B., Karlsson C., and Palmberg, J. (2006), Den svenska sjöfartsnäringens ekonomiska och geografiska nätverk och kluster, Institutet för Näringslivsanalys, http://www.ihh.hj.se/doc/3707. Klein, B., Crawford, R.A. and Alchian, A.A. (1978), ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Process’, Journal of Law and Economics, 21:297–326. Magirou, E., Psaraftis, H.N. and Christodoulakis, M.N. (1992), ‘Quantitative Methods in Shipping: A Survey of Current Use and Future Trends’, Centre for Economic Research, Athens University of Economics and Business, Report no. E115. Masten, S. (1988), ‘A Legal Basis for the Firm’, Journal of Law, Economics, and Organization, 4:181–98. Masten, S., Meehan Jr., J. and Snyder, E. (1991), ‘The Cost of Organization’, Journal of Law, Economics, and Organization, 7:1–22. Midore, R., Musso E. and Parola, F. (2005), ‘Maritime Liner Shipping and the Stevedoring Industry: Market Structure and Competition Strategies’, Maritime Policy and Management, 32:89–106. Mitroussi, K. (2003), ‘Third Party Ship Management: The Case of Separation of Ownership and Management in the Shipping Context’, Maritime Policy and Management, 30:77–90. Mitroussi, K. (2004), ‘The Ship Owners’ Stance on Third Party Ship Management: An Empirical Study’, Maritime Policy and Management, 31:31–45. Nya Sjöfartens Bok, 2006 (2005), Svensk sjöfartstidningsförlag, Nr 23, 16 December. Panayides, P.M. and Cullinane, K.P.B. (2002), ‘The Vertical Disintegration of Ship Management: Choice Criteria for Third Party Selection and Evaluation’, Maritime Policy and Management, 29:45–64.

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Pirrong, S.C. (1993), ‘Contracting Practices in Bulk Shipping Markets: A Transaction Cost Explanation’, Journal of Law and Economics, 36(2):937–76. Smith, A. (1776), The Wealth of Nations, reprinted with a foreword by A. Skinner (1976), Harmondsworth: Penguin Books. Stopford, M. (1997), Maritime Economics, 2nd edn, Routledge Taylor and Francis Group, London. Ståhl, I. (1976), ‘Ägande och makt i företagen – ett debattinlägg’, Ekonomisk Debatt, nr 1. Veenstra, A.W. and De la Fosse, S. (2006), ‘Contributions to Maritime Economics – Zenon S. Zannetos, the Theory of Oil Tankship Rates’, Maritime Policy and Management, 33:61–73. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1988), ‘Corporate Finance and Corporate Governance’, Journal of Finance, 43:567–91. Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford University Press.

5.

The use of managerial authority in the knowledge economy Kirsten Foss

1.

INTRODUCTION

This chapter contributes to the ongoing debate in diverse literatures, including management, sociology and economics, on the issue of the use of authority. The debate has re-surfaced with the focus on the emerging knowledge economy. In that debate a number of management academics and sociologists have argued that authority relations will strongly diminish in importance or at least change significantly in character.1 More specifically, these writers have argued that the exercise of authority is, if not outright impossible, at least not efficient and will be substituted by different means of organizing the production of knowledge intensive goods and services. More discretion will be granted to knowledge workers and this will result in an eruption of the hierarchical structures of organizations. Such predictions are a serious concern for those theories, notably transaction cost theories (Coase, 1937; Williamson, 1985) and property rights theory (Hart and Moore, 1990; Hart, 1995, 1996), that place emphasis on authority relations as the mode of coordination that primarily characterizes firms. Thus, explanations of the existence and boundaries of firms that rely on authority are challenged. Part of the reason behind the prediction of the decline of the importance of authority relations is the assertion that firms will experience a tension between the exercise of authority by superiors based on their position in the hierarchy and the exercise of authority by knowledge workers based on their great expertise in certain areas. As superiors come to lack information about the tasks that are carried out by knowledge workers, and as knowledge workers gain bargaining power because of their control of crucial information, the economic importance of the authority of the position in a hierarchy will diminish. However, this claim is based on a much too narrow conception of what it means to exercise the authority of the position. Orders are merely one way of exercising authority; superiors may, for example, also define goals, set restrictions for employees regarding the use of firm resources, or implement 82

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83

various restrictions (N. Foss, 2001). If all such uses of authority decline in importance as means of coordinating activities in firms, we should be able to find an economic rationale for this. However, in order to do so we must first understand the economic rationale for the use of authority as a means of coordinating economic activities in order to discover whether the conditions for the use of such authority have changed. In this chapter I provide efficiency explanations for the use of different forms of authority in firms and argue that we may expect the use of different types of authority of the office in conjunction with experts who may possess authority based on their expertise. The questions to be addressed in this chapter are the following: ● ● ●

2.

Can the use of authority co-exist with the delegation of discretion within a contract? If so, what factors can change the use of authority relative to the use of market contracts as a means of organizing productive activities? Is it likely that a move from the capital intensive to the knowledge intensive economy will change the relative use of authority?

WHAT IS AUTHORITY?

The concept of authority is closely linked to the sociological literature on bureaucracy (for example, Weber, 1946, 1947) and organization and behavioral theories, usually drawing on sociology and psychology, present a number of interpretations of authority (Simon, 1951; Blau, 1956; Thompson, 1956; Grandori, 2001). It would be a hopeless task to present a full review and critical evaluation of the multitude of definitions and ideas regarding the concept of authority. For the purpose of this chapter the concept of authority as defined by Barnard (1938) and Simon (1951, 1991) serves as a starting point for the development of the terminology adopted here. Both Simon and Barnard employ the concept of ‘willingness to obey’ (Simon, 1951, p. 126). Simon (1951) defines authority as obtaining when a ‘boss’ is permitted by a ‘worker’ to select actions, A0 , A, where A is the set of the worker’s possible behaviors. More or less authority is then defined as making the set A0 larger or smaller. Simon develops a model (specifically, a multi-stage game in the context of an incomplete contract with ex post governance), where, in the first period, the prospective worker decides whether to accept employment or not. In this period, none of the parties know which actions will be optimal, given circumstances. In the next period, the relevant circumstances as well as the costs and benefits associated with the various possible tasks are revealed to the boss. The boss then directs the worker to

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a task, which – for the latter to accept it – must lie within his or her ‘zone of acceptance’. An important feature of authority thus is that the authority of a superior is constrained by the subordinate’s acceptance of it. ‘A subordinate may be said to accept authority’, Simon (1951, p. 22) explains, ‘. . . whenever he permits his behavior to be guided by a decision reached by another, irrespective of his own judgment as to the merits of that decision.’ Simon’s use of the notion of authority is akin to that of Coase (1937), who defines an authority relation as ‘one whereby the factor, for a certain remuneration (which may be fixed or fluctuating), agrees to obey the directions of an entrepreneur within certain limits. The essence of the contract is that it should only state the limits to the powers of the entrepreneur. Within these limits, he can therefore direct the other factors of production’ (idem, p. 242). Coase (1937), Bernard (1938), and Simon (1951) all linked the notion of authority to entering into an employment contract. Others, however, have argued that an employment relation is not a necessary condition for the use of authority (Alchian and Demsetz, 1972; Cheung, 1983).

3.

AUTHORITY IN FIRMS AND MARKETS

Many contributions to the understanding of authority share the – sometimes implicit – assumption that if complete contingent markets existed, price coordination would suffice. This was indeed Coase’s point of departure in ‘The Nature of the Firm’ where he posed the question, ‘Why do firms exist?’ The reason for the existence of firms is that there are costs of using the price mechanism and that ‘[t]he most obvious cost of “organizing” production through the price mechanism is that of discovering what the relevant prices are’ (Coase, 1937, p. 21). When there are high transaction costs firms pose an alternative to markets as a means of achieving coordination, because the firm allows for the use of authority as a means of allocating resources comparable to bargaining and contracting in markets. In parts of the economic literature, authority has been linked to the employment contract (Coase, 1937; Simon, 1951; Williamson, 1985) and firm coordination is seen as different from market coordination due to the use of employment contracts. According to Coase an employment contract is preferred: ‘owing to the difficulty of forecasting, the longer the period of the contract is for the supply of the commodity or service, the less possible, and indeed, the less desirable it is for the person purchasing to specify what the other contracting party is expected to do’ (Coase, 1937, p. 21). Thus, the employment contract is a long-term contract for an unspecified labor

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service. Managed direction of resources substitute for price direction of resources when parties to transactions realize that contingencies of different sorts may in an unpredictable manner disrupt the choice of action or the timing and sequencing of interdependent activities (see Wernerfelt, 1997).2 However, there are also costs of using authority (that is, managed direction) which define the efficient limits for the use of authority. In an economy characterized by uncertainty with respect to the actions that need to be taken, the main costs of using authority stem from the ‘increasing opportunity costs due to the failure of entrepreneurs to make the best use of the factor of production’ (Coase, 1937, p. 23). According to Coase (1937), the costs of losses through mistakes will increase with an increase in the spatial distribution of transactions organized, in the dissimilarity of the transactions, and in the probability of changes in the relevant prices. As more transactions are organized by an entrepreneur, it would appear that the transactions would tend to be either different in kind or in different places. (p. 25)3

Managers, in other words, have limited capacity to ‘discover the relevant prices’ and this increases mistakes as more dissimilar transactions are organized in a firm. Simon (1951) also links firms and authority to the use of the employment contract. Like Coase, he perceives of the employment contract as a contract for unspecified labor services. Uncertainty also constitutes the essence in the explanation provided by Simon (1951) of the use of employment contracts and authority as a means of coordination. The employment contract grants the right to the employer to postpone the decision about what services to demand from the employee until he obtains the relevant information on which to base the decision. However, limits to the use of authority are not due to managerial mistakes, as in Coase, but to the differences in costs of fulfilling the participation constraints of an employee and an independent contractor. Therefore the use of authority is efficient only when contractual adaptation is critical to one party while the other party is nearly indifferent as to the actions he carries out. The Coase–Simon view compares adaptations to uncertainty by means of authority and by means of re-contracting among independent agents. Authority differs from bargaining power in that authority is voluntarily granted by one party to another on the basis of efficiency considerations. This clear-cut distinction between bargaining power and authority is not present in later developments of the concept of authority within property rights theory as defined by, for example, Hart (1991, 1995). This theory is based on the assumption that the main problem of coordination is that of

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providing the right incentives for investing in situations where there are high costs of describing the relevant investments to be made and the output to be delivered. This kind of transaction cost makes it impossible for the contracting parties to use a third party (courts) as a means of enforcing original promises, thus creating a situation where the parties expect recontracting over the created surplus. Firms represent an efficient choice of enforcement of contracts because of the bargaining power they posses in the re-contracting situation. For example, Hart defines the firm as the physical assets over which a legitimate owner has formal residual user rights. Having residual user rights over assets provides the firm with a bargaining power that is different from that which characterizes transactions that take place between individual owners of assets. The limits to the use of authority depend on the parties’ incentives to invest in non-contractible assets when ownership of assets is centralized as in firms and when it is dispersed as in markets. The property rights theory shares its strong focus on incentive alignment as the central coordination issue with agency theory. Both assume that the best uses of resources are already known and that the problem of coordination arises due to asymmetric information on some relevant aspects relating to the contractual execution. In principal–agency literature asymmetric information introduces the need for different contractual designs, of which some may include ‘authority’. In the work of Alchian and Demsetz (1972) teamwork creates one of the situations in which the use of authority serves the purpose of improving the efficient use of labor inputs for given ends. With teamwork it is costly to separate the contribution of each participant, creating incentives for moral hazard. The solution to such a team problem is to set up an organization (but not necessary a firm) which will economize on metering costs so as to better allocate rewards in accord with the effort delivered. A monitor specialized in metering effort is granted by the members of the team the authority (or right) to alter membership of the team in order to improve incentives for work effort.4 Thus, specialization advantages in monitoring and more advanced incentive schemes than those that can be devised for re-contracting between independent individuals (with definite time horizons) help overcome incentive problems. Authority in this conception is based on a granted right (as in Coase and Simon) but it is not necessarily related to the use of employment contracts, nor is it granted because of the need to adapt to unforeseen changes. These ideas are similar to those of Cheung (1983), who emphasizes that there is a wide spectrum of contracts, ranging from pure spot market contracts to order contracts, from piece rate contracts to employment contracts. All contracts, with the sole exception of pure spot market contracts, include some instructions or restrictions or are accompanied by orders.

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As Coase (1937) did, Cheung (1983) stresses the cost of discovering the relevant prices as the reason for this wide spectrum of contracts. However, the reasons he provides as to why prices are substituted by other means of coordination differ somewhat from those of Coase (1937), since he stresses the cost of measuring the relevant attributes of goods and services as the main reason for lack of complete contingent contracts. According to Cheung, such measurement costs are likely to be high ‘[i]f the activities performed by an input owner change frequently [and] if these activities vary greatly’ (Cheung, 1970, p. 7). Moreover, it may simply be too costly to separate the contribution of each party to the production of a consumer good. In other words, measurement costs may cause team problems. In contractual relations characterized by high measurement costs, ‘it tends to be more economical to forgo any direct measurement of these activities and substitute another measurement to serve as a proxy’ (ibid.). For example, instead of contracting for the use of a secretary to type a certain letter at a certain place at a certain time, one may contract for the unspecified labor service of the secretary for a given period of time and a given pay per time period. However, when a price for each job to be done by the secretary cannot be specified, the contract needs to be supplemented by directions/ instructions (or orders). The relation between remuneration of the input and the valued attributes of the output may be more or less imprecise and therefore require more or less instructions.5 We should, according to Cheung, expect an extensive use of orders where measurement costs makes it efficient to use flat wages rather than payments that more fully reflect the contribution of the subordinate to the quality of the final consumer good. The principal–agency literature on firms (Cheung, 1970; Alchian and Demsetz, 1972) emphasizes that orders and restrictions are not unique to the employment relation and the exercise of authority not confined to firms. Nor does it view differences in bargaining power as discriminating firms (or employment contracts) from markets. This point of view is most clearly expressed in Alchian and Demsetz (1972), who claim that ‘[i]t is common to see the firm characterized by the power to settle issues by fiat, by authority, or by disciplinary actions superior to that available in the conventional market. This is a delusion’ (p. 72). An employer has, in their opinion, no different means at his disposal for punishing disobedience than individual contractors have. According to this view every single instance of the exercise of authority is based either on implicit agreements or on the bargaining power of the parties in the relation. The conclusion one may derive from Cheung (1970) and Alchian and Demsetz (1972) is that authority exists in the same form and to the same degree in markets and in firms. This view is contrasted by those who emphasize the differences in the legal conditions that support the private exercise of authority (as

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enforcement of contracts) within firms compared with the use of market contracts (Williamson, 1985; Masten, 1991; Vandenberghe and Siegers, 2000). First, employment law requires that orders or instructions are carried out, restrictions implemented by an employer are respected and disputes about their merits and legitimacy are settled after the completion of the order. Williamson (1985), for example, describes firms as their own ultimate court of appeal. Second, the rights of the employer to monitor and sanction actions differ in employment and market contracts (Masten 1991). The extended right to monitor employees complements the functioning of authority as a means of solving disputes. For example, an employer may have better access to knowledge of relation-specific non-contractible investments than courts. Thus, although restrictions, directions and orders can be found in market contracts, they differ from employment contracts in the legal frame that supports the contracts. Market contracts do not provide one of the parties with the formal (and legally supported) right to make decisions without the consent of the other party. Adaptations can be made if there is no conflict of interest between the parties or a verifiable mechanism (such as elevator clauses) of contractual adjustment is agreed on in the contract.6 That is, measurement costs explain why contracts contain more stipulations than just the price and the item. However, only uncertainty or partly unpredictable volatility makes it necessary to use managerial discretion to make ex post adaptation of these instructions and stipulations. 3.1

Formal and Real Authority

The notion of authority as supported by firm governance structure does not imply that firms (or more precisely managers) are always able to exercise the authority they are legally entitled to exercise. That is, employees may exercise discretion and avoid the restrictions, instructions and orders issued by managers. This introduces a distinction between formal and real authority (Aghion and Tirole, 1997, p. 1). Whenever there is a legally recognized employment relation we find formal authority in the sense of an attribute that is attached to the role of an employer (for example, Weber uses the notion of bureaucratic authority or authority of the office). The employment relation supports the use of authority of the position (formal authority) but formal authority does not necessarily convey real authority which is ‘an effective control over decisions, on its holder’ (Aghion and Tirole, 1997, p. 1).7 That is, employees may exercise discretion within the authority relationship. Discretion can broadly be defined as the ability of an agent to control or consume resources over which he/she does not have formal ownership. Discretion includes instances where an agent behaves morally hazardously

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or exerts influence indirectly or where peers in a group voluntarily agree to have their points of view represented by a group member or to have conflicts resolved by one member of the group.8 The exercise of discretion by employees does not fully preclude their recognition of the formal authority granted to an employer through employment law. For example, an employee may recognize the legitimacy of the formal authority relation with a superior and be willing to accept the limits within which the superior can direct the actions of the subordinate, while not fulfilling the agreement when given specific directions in areas where he is not subject to effective control. Also, the employee may recognize the legitimacy of the formal authority relation and the specific ways in which the authority is exercised, while spending resources on altering the guidance to which he is subject to by influencing superiors to change the way in which the authority is carried out. Employees’ ability to exercise discretion depends on the employer’s costs of monitoring and on their bargaining power. For example, a knowledge worker’s technical competences and expertise may be an important constraint on the ability of the employer to exercise his formal authority – this is the assertion that seems to underlie the prediction that knowledge workers are less likely to be subject to the authority of office and more likely to possess discretion or authority themselves due to their specific qualifications. Authority and discretion may be delegated to one employee or a group of employees. Delegated (or formal) discretion can be defined as instances where an agent is delegated the rights by a superior to allocate resources (including his own labor services) to those ends he desires without the formal approval of an owner or employer.9 Delegated authority is to be distinguished from delegated discretion by the fact that the discretion does not include formal rights to direct the actions of other members of the firm. Both delegated authority and delegated discretion are limited by the formal rights of a superior to overrule the decisions made by a subordinate (Baker et al., 1999) as well as by the real discretion exercised by lower-level employees. Delegation of discretion and authority is a means of overcoming the inefficiencies that stem from centralized decision making (Jensen and Meckling, 1992). In the Coase–Simon–Cheung view it is implicitly assumed that the superior receives the relevant information and has the relevant knowledge to make use of the information by ordering the subordinate to carry out a specified action. With such a narrow conception of authority there is no room for the use of dispersed knowledge or information that rests with employees within the employment relation. Thus, the use of centralized decision making by an authority becomes inefficient in a knowledge economy where employees or subordinates (at least at certain

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points in time) have the relevant information or the relevant knowledge that makes them superior in using the information. However, Simon (1991, p. 31) himself pointed out four decades after his paper on authority, ‘[a]uthority in organizations is not used exclusively, or even mainly, to command specific actions.’ Instead, he explains, it is a command that takes the form of a result to be produced, a principle to be applied, or goal constraints, so that ‘[o]nly the end goal has been supplied by the command, and not the method of reaching it.’10 The concept of authority introduced by Simon (1991) sets focus on the many ways in which contractual relations can be altered ex post contracting. Moreover, the definition allows for the delegation of discretion to subordinates with respect to their choice of actions. Authority on the part of the superior may then be interpreted as the right to unilaterally change the degree of delegation ex post contract agreement and to veto decisions made by the subordinate (see also Aghion and Tirole, 1997; Baker et al., 1999). It does not alter the economic rationale for formal authority if it is broadened from the narrow focus on orders to encompass situations where the superior ex post contracting vetoes decisions or implements restrictions that prevent the subordinate from picking the actions most preferred by him. In accordance with Coase and Simon, formal authority still serves the overall purpose of achieving coordination of productive activities in a setting where it is economically efficient for the parties to adapt the contractual relation to unpredictable changes in contractual circumstances. Adaptation must be costly to obtain through re-negotiations or by means of contingent plans (Coase, 1937). Given the above, I put forward the following definition of authority. Authority is a formal right granted to a superior to use managerial judgment to unilaterally decide on changes or maintenance of aspects of the term of contract ex post contracting irrespective of the contracting party’s judgment as to the merits of that decision. In employment relations the formal right to exercise authority is supported by labor law.

4.

CAUSES OF CHANGE IN THE RELATIVE USE OF AUTHORITY

4.1

The Use of Authority from an Incentive Perspective

The tension between real and formal authority is center stage in some of the writings on the diminishing importance of authority compared with, for example, market contracts (or hybrids such as collaborative arrangements supported by, for example, norms (Grandori, 2001)). Two different types of

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arguments support this idea. First, a move toward the knowledge economy may be expected to increase the relative importance of investments in knowledge assets compared with investments in capital. With this change, employers’ costs of monitoring and bargaining with knowledge workers over the actions to be chosen may increase. In turn, this leads to increased costs from moral hazard (Jensen and Meckling, 1992) and from bargaining in all transactions dealing with knowledge workers. Also, investments in knowledge assets and allocation of bargaining power change endogenously (Hart, 1995). That is, in order to create efficient incentives for knowledge workers to invest in knowledge assets we should expect a reallocation of the real authority that follows from ownership of co-specialized physical assets from managers to knowledge workers. If we hold everything but the discretion and costs of bargaining with employees constant we should expect the benefit function from the use of formal authority to move downward, causing a relative decrease in the use of formal authority. However, there are also factors that can offset this move. For example, increased investments in knowledge assets may create more assets specificity, which in turn raises costs of market contracting and introduces a need for private courts that can handle the specific types of conflicts that arise in incomplete contract situations (Williamson, 1985). Thus increasing knowledge workers’ discretion (or authority) does not necessarily imply more market transactions. However, the formal authority of the employer may to a lesser extent be accompanied by real authority. A second type of argument focuses on how information is differently dispersed in the knowledge economy compared to the capital intensive one. Grandori (2001), for example, has forcefully stated that changes in the distribution of information may cause ‘authority [as a centralized decisionmaking system] to fail in all its forms’ (p. 257). Along with the differently dispersed knowledge, the choice set of actions available to knowledge workers may become much greater than that available to workers in the capital intensive economy. In such a situation it may be too costly for a central manager to be informed about the entire choice sets of an employee. Knowledge workers then become better able to select actions that create joint value than the employer. However, the employer may interpret the employees’ choices as morally hazardous when they do not benefit the employer and he may not allow these choices although they maximize the joint satisfaction function. If as Simon (1951) argues the employee cannot make the employer commit to choose actions that maximize their joint satisfaction function, the use of authority becomes inefficient. For a given level of uncertainty (variance) employees will demand a higher compensation (compared with the compensation they get from market transactions) in order to meet their participation constraints.11 The increased costs of

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meeting employee participation constraints raise the costs of using authority relative to market contracting. Thus, the diminished use of authority in a knowledge economy should be attributed to an increased conflict of interests leaving little scope for the use of authority that satisfies the participation constraints of both the employer and the employee. A limited scope within which the participation constraints of both employee and employer are fulfilled may also arise if changes in work content produce a wider gap between the preferences of the knowledge workers and those of their employers (with no changes in the size of the choice set). For example, it may well be the case that knowledge workers to a greater extent prefer to work on projects that add to their general (non-relation-specific) stock of human capital, whereas an employer to an increasing extent wants employees to work on projects that mainly build relation-specific experience. Two mechanisms can ease the problem. One is to introduce differentiated pay for activities in accordance with the merits to the employer and the costs to the employee. It has in fact been argued that in the knowledge economy we see an increasing use of high-powered incentives within firms. Of course this re-introduces the issue raised by Coase (1937), Cheung (1983) and others of the costs of discovering the relevant prices. Another mechanism is for the firm to delegate some discretion to knowledge workers and build a reputation for allowing the employee to select actions that maximize the joint satisfaction function (Aghion and Tirole, 1997).12 The reputation has to be robust to evolving changes in the pay-off to the employer and employee of emerging actions (see, for example, Kreps, 1990). The recognition of firms as legal entities and the legal protection of corporate identity are factors that ease the use of reputation mechanisms as a means of private enforcement of implicit promises within firms as compared with across spot markets. Thus, increased distribution of knowledge and the accompanying need for delegation need not result in a relative diminished use of formal authority. However, as delegation of discretion introduces costs in the form of moral hazard, there will have to be limits to the delegation that takes place within firms. The optimal delegation of discretion is, according to Jensen and Meckling (1992), one that balances ‘the costs of bad decisions owing to poor information and those owing to inconsistent objectives’ (p. 264). In order to constrain moral hazard, restrictions are often used in employment relations where assets have many different uses and where only a subset of these uses optimize the joint satisfaction function. This conclusion is in line with the work of Holmstrom and Milgrom (1994), Barzel (1989) and Holmstrom (1999), who argue that employers use restrictions in order to avoid costs of morally hazardous behavior when incentive payments are too costly to implement. Thus, the employer may replace direct monitoring

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of work effort by supervision of a set of constraints that the employer has imposed on the employee with respect to the use of the labor services and capital assets (Barzel, 1989). However, since contracting takes place in a dynamic setting in which new opportunities for value creation and for moral hazard arise, the constraints and restrictions may need to be changed over time. The employment contract ensures that the employer has the formal rights to make these changes unilaterally, thereby saving contracting costs. Thus, an increased need for delegation need not imply a diminished role for authority. To sum up: writers on the knowledge economy have emphasized the importance of increasing misalignment of preferences between employer and employee or the relative increase in employees’ ability to discover valuecreating actions which in turn should diminish the relative importance of the use of authority. However, there is no reason to assume that there is a diminished need for the role of formal authority as supported by a firm governance structure. It may still be efficient to use authority supported by firm governance to solve conflicts of interest in situations of incomplete contracting (as argued by Williamson, 1985) and to support the building of a credible reputation for delegating discretion. Moreover, delegation of discretion within an employment contract allows for different types of monitoring compared with market contracts, making it easier to counter moral hazard within the firm governance structure. Finally, the firm governance structure allows for a flexible adaptation of constraints to delegation as employers have the right to make these decisions unilaterally. The above discussion has centered on how incentive issues influence the relative use of authority in the knowledge economy holding the nature of the coordination problem constant. However, it is also possible that the nature of the coordination problem changes with a move from a physical capital to a knowledge intensive economy. In the following, I make use of an example of a coordination problem that arises between a marketing and a product development function in order to illustrate how changes in the nature of the coordination problem influence the relative costs and benefits of the use of authority under different conditions of dispersion of information and knowledge between an employer and two employees. For the moment I leave aside the discussion of the incentive issues, thus taking common goals as the standard assumption throughout the example. 4.2

The Use of Authority from a Production Coordination Perspective

The coordination problem consists in carrying out a product development project. Two employees (in marketing and product development respectively) and a manager are engaged in the project. The choice set for

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the marketing employee contains two different product concepts and the choice set for the product developer contains two different technical solutions. The coordination problem is that of selecting the concept and the technological solution that under the prevailing contingencies generate the greatest revenue to the firm (which in this example is the choice that maximizes joint value). The contingencies facing the firm consist of the values (which enter as parameters in the revenue function) for the state of customer preferences and for the state of technological knowledge. Both customer preferences and technological knowledge can change over time. The way in which the coordination problem can be solved depends on the nature of interdependencies and on the distribution of information and knowledge between the employer and the two employees. Information refers to information about a realized state and the solutions available, while knowledge refers to the ability to specify the revenue function and solve for the optimal solution. Either the superior or the two employees in the firm may posses information regarding the choice sets and the kind of states that have emerged. Moreover, either the superior or the subordinate or both may have the knowledge needed to select the optimal combination of product concept and technical solution, given the information available on customer preferences and technological knowledge. When the informational interdependencies between the choice of product concept and technical solution are complex, coordination requires that the decision maker has information about the contingencies and the solutions facing both design and product development. The coordination problem is characterized by decisiveness when decisions on product concept and technical solution can be made sequentially by different decision makers. For example, customer preferences may be decisive for the choice of product concept and for the choice of technique. This implies that the marketing employee (who selects product concepts) can make a decision without information about the state of technological knowledge or technical solutions. Moreover, he only needs to communicate his choice of concept to the employee in product development, who selects the technical solution on the basis of his investigation of the state of technological knowledge. Finally, the coordination problem can be characterized by complete independence, in which case the marketing employee only needs information about the state of consumer preferences and product concepts and the product development employee only needs information on the state of technological knowledge and technical solutions. Centralized authority in a setting of complex interdependencies The employer is the only one who can make the relevant decision if he is the one who possesses all relevant information of states and solutions

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available and the knowledge needed to use that information. Some ex ante communication of the information possessed by the employer will be necessary though, as employees will be unwilling to accept an employment contract unless it specifies the nature and limits of the choices that the employer can make (Simon, 1951). However, compared with the use of market contracting, which requires a more detailed specification of actions and instructions, the use of order in employment contracts may save some communication costs (Demsetz, 1995). If contingencies or the choice set of actions change, the benefits from the use of formal authority supported by firm governance structure to make adaptations increase, as more transaction costs are saved compared with carrying out the adaptation by means of spot market transactions (Coase, 1937).13 The arguments presented above indicate at least three important variables that may influence the relative use of centralized decision making (assuming there are no conflicts of interest). First, the costs of completing contracts over markets in the knowledge economy could have been reduced. For example, the introduction of IT technology in the knowledge economy and the embodiment of information needed for coordination, as well as the development of interface and measurement standards, are factors that reduce costs of re-contracting. However, these factors may influence firm internal costs of using centralized decision making to the same extent. Second, uncertainty may have been reduced. In the example above, this would be the case if the states of consumer preferences or technological knowledge did not change or if no new product concepts and solutions could be identified. However, a reduction in the level of uncertainty is contrary to what most writers on the knowledge economy assume. Finally, the costs to the central manager of obtaining relevant information and of using this may have increased. The latter falls in line with the arguments presented in much of the literature on the use of authority in the knowledge economy, where many writers argue that an increased dispersion of knowledge makes it increasingly difficult for the holder of formal (and centralized) authority to reach efficient decisions (see, for example, Minkler, 1993; Cowen and Parker, 1997; Hodgson, 1998; Radner, 2000). For example, an increase in specialization in production and knowledge in the knowledge economy results in more diverse types of transaction (in terms of choice sets, contingencies and sources of interdependencies) and this increases the costs to managers of ‘discovering the right prices’, resulting in a reduction of the efficient size of firms and an increase in the relative use of market transactions. Part of the confusion about the status of authority in a knowledge economy seems to arise because the use of authority is confused with highly centralized decision making. Indeed, the costs that arise due to the limited

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mental capacity of managers can be reduced if some discretion and authority is delegated to lower-level employees. Delegation has been mentioned in the organization literature as a means of improving decision making under uncertainty (Miller, 1992), economizing on principals’ opportunity costs (Salanié, 1997) and avoiding decision delays under circumstances of volatility and uncertainty (Thompson, 1956; Burns and Stalker, 1961; Mintzberg, 1983). The underlying idea is that delegation of discretion provides an efficient use of distributed knowledge in firms (Jensen and Meckling, 1992) that is costly to communicate to a central decision maker (Casson, 1994).14 Uncertainty, unpredictable volatility and some level of distributed knowledge and information create the conditions under which there is an economic rationale for the coexistence of authority and delegation of discretion within hierarchies. This conclusion is based on the assumption that the coordination problem is at least partly decomposable (Simon, 1962). One such situation arises if the coordination problem is characterized by decisiveness. Delegation in a setting of decisiveness, dispersed information and centrally or dispersed knowledge When the coordination problem is characterized by decisiveness it is possible to achieve the optimal solution with delegation of discretion to employees. The employer can delegate decisions to the employee who has the relevant information about states and solutions and the knowledge needed to make the choice. When marketing information is decisive for the coordination problem the marketing employee can make the decision and communicate it to the employer, having them select the optimal technique, or they can communicate their decision directly to the product development employee who has obtained information about the state of technology. The choice between centralized decision making and decentralized corporation (through markets or within the hierarchy) depends on the trade-off between benefits from specialization in decision making and costs of communicating to the employer the states and solutions that have been observed by marketing and product development. In cases where the design problem is not characterized by natural decisiveness, it may sometimes be efficient to have the employer impose decisiveness on problems by dispensing with the communication of the decision premises. As an example, the employer can choose to take customer preferences or technological knowledge as given and make that the ‘normal state’. Decisions will only be made in a consultative manner when the employer or the employee in a marketing department discovers an unusual state. In all other situations they will be made in a sequential manner. An even stricter way of imposing decisiveness is to restrict

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employees from all examination of states. In the latter case decisions are taken in a routine manner and the only role for a central authority is to monitor the adherence to and feasibility of this restriction. Restrictions on the delegation of discretion may be needed as long as there is some level of interdependence. Costs from delegation of discretion arise when knowledge workers do not possess all relevant knowledge. Employees’ exercise of discretion can produce spillover effects (that is, ‘externalities’) due to unintended consequences of the actions taken. These harmful spillover effects include coordination failures, such as scheduling problems, duplicative efforts (for example, of information gathering, R&D), cannibalization of product markets and other instances of decentralized actions being inconsistent with the firm’s overall aims, and so on. The use of authority to restrict harmful consequences is efficient if the employer is better able to form a judgment regarding what types of actions are appropriate. The employer defines constraints that only allow the knowledge workers to choose among actions he deems appropriate (Armstrong, 1994). In this way the employer prevents the knowledge worker choosing actions that he knows or believes to be infeasible. If the employer does not know where to set the restrictions ex ante to contracting, he may instead overrule or veto decisions made by the employee (as in, for example, Aghion and Tirole, 1997). That is, even with perfect alignment of incentives between employer and knowledge there is a role for employers as monitors and enforcers of restrictions. The use of restrictions and veto brings attention to the function of authority as a means of constraining ‘the method[s] of reaching’ an end goal, in Simon’s (1991) terminology. Under conditions of uncertainty where the choice set of the knowledge worker and interdependencies in decision change over time, constraints will have to be adjusted. Thus, the role of authority in a setting of distributed knowledge and uncertainty may well be that of unilaterally altering constraints on decisions made by lower-level knowledge workers and adjusting criteria for accepting or rejecting decisions made by such knowledge workers.15 The way in which delegation of discretion can ease the constraints on the use of authority in settings characterized by disperse information and knowledge move the focus from the discussion of authority versus market contracts to a discussion of centralized versus decentralized decisions within the employment relation. From the above it is clear that the role of the employer as one who solves coordination problems decreases as one moves from coordination problems characterized by interdependency to those characterized by (imposition of) decisiveness. Changes in production techniques can cause a shift in the nature of interdependencies. Moreover, it may have become more attractive to impose decisiveness on coordination problems with the move to the knowledge economy. This is the case

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if the costs of investigating states increase drastically compared with the benefit of reaching the optimal solution. However, a move away from the use of centralized authority toward more decentralized decisions may also be a consequence of a relative change in the importance of knowledge workers’ information about actions in the choice set and contingencies compared with employers’ knowledge of interdependencies. That is, some interdependencies are ignored or suppressed at the expense of achieving the optimal fit between subsets of the solution. The movement in the knowledge economy toward the design of modular products is an example of the latter. Firms imposed decisiveness on problem solving, dispensing with some interdependencies in the product design, and the interfaces that are specified ex post detailed product development constitute the natural state of the environment which is to be taken for granted in the choice of the specific design solutions.

5.

CONCLUSION: IS THE USE OF AUTHORITY DIMINISHING IN THE KNOWLEDGE ECONOMY?

The notion of authority is an important one in economics. In particular, it underlies important contemporary theories of economic organization (Williamson, 1985; Hart, 1995). Given this, it is surprising that so few fundamental discussions of the notion are to be found in the literature. This is problematic, because the notion of authority has recently been subject to much discussion in neighboring fields, such as sociology and business administration. Economists have had difficulties entering this discussion because of their relatively crude conception of authority, in which authority is seen as synonymous with either bargaining power or the use of ordered direction by a highly informed employer (Simon, 1951). However, the theory of economic organization is in no way necessarily limited to those notions of authority. Thus, the theory suggests other possible, yet complementary, understandings of authority, such as the unilateral right to set and change constraints on the activities of subordinates, overrule decisions made by subordinates, and implement and change reward systems. Seen in the light of this latter understanding of authority, it is not so apparent that authority will strongly decline in importance in the emerging knowledge economy, as asserted by a number of writers. Although knowledge workers may have more bargaining power and be more knowledgeable about the activities they carry out than ‘traditional’ industrial workers, they too will be subject to authority, as long as productive activities are characterized by uncertainty and measurement costs which make complete contracting

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prohibitively costly. It may be conjectured that under these circumstances delegation will be more widespread. However, because of differing preferences, asymmetric information and externalities in decision making, such delegation is likely to be circumscribed. The literature on authority points to several factors that can diminish the relative use of authority in the knowledge economy: ● ● ● ● ● ● ●

changes in the distribution or importance of information and knowledge held by employees and employers respectively less need for adaptation – more interface standards, more modular products, and so on increased complexity and diversity in transactions increased conflict in preferences over actions between employer and employee more bargaining power to employees less asset specificity greater importance of knowledge workers’ investments in knowledge compared with employers.

In order to fully answer the question of whether or not authority is diminishing in importance, one must empirically investigate how changing from the capital intensive to the knowledge intensive economy affects all of these variables.

NOTES 1.

2.

3. 4.

5. 6.

Some representative sources are Boisot (1998), Foss (2001), Ghoshal et al. (1995), Grandori (2001), Harrison and Leitch (2000), Hodgson (1998), Liebeskind et al. (1995), Matusik and Hill (1998), Minkler (1993), Vandenberghe and Siegers (2000), and Zucker (1991). For example, the employer can be ignorant about the best use of different labor services as in the case of innovative activities (N. Foss, 2001). Also, in cases of rather complex production or product innovations, it may be desirable to conduct a number of controlled experiments before one decides on what labor service is required for a certain task (K. Foss, 2001) Richardson (1972) has a very similar argument for the boundaries of firms Agency theory, a body of literature to which Alchian and Demsetz (1972) belongs, ascribes all contracting costs to the costs of observing variables. Monitoring denotes ‘measur[ing] output performance, apportioning rewards, observing the input behavior of inputs as means of detecting or estimating their marginal productivity and giving assignments or instruction in what to do and how to do it’ (Alchian and Demsetz, 1972, p. 782). However, the reason for the last kind of activity is left unexplained. Barzel (1989) argues that orders are used in conjunction with flat wages, not because employees lack information, but because they have no incentives to devise ways of exercising use rights over assets that would produce utility. In market contracts one party may allow the other party to make some specific type of

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7.

8.

9. 10.

11.

12.

13.

14.

15.

The theory of the firm from an organizational perspective decision ex post contracting. For example, a painter who enters a market contract with a customer may allow the customer to decide on the color and type of paint ex post contracting. This can be interpreted as an instance where the painter is indifferent between colors and types of paint to be used and therefore implicitly negotiates and accepts the order. Thompson (1956) distinguishes between authority and power as the basic means of obtaining obedience. He defines power as ‘the ability to determine the behavior of others, regardless of the bases of that ability’, and authority as ‘that type of power which goes with a position and is legitimated by the official norms’ (p. 290). For example, an employee or a group of employees may formally be delegated rights to decide, among themselves, on the use of resources that influence their decisions about how to carry out certain activities. I reserve the notion of delegation of authority to those instances where a superior has formal rights to influence the decisions made by subordinates, whereas I consider it an instance of delegation of discretion when a group of employees are to decide among themselves on the use of resources. The authorization to give well-defined orders under well-defined circumstances does not fall under the definition of discretion. In fairness to Simon, it should be noted that the more expansive notion of authority in the 1991 paper can be found already in Simon (1947). Thus, Simon’s views of authority did not change between 1951 and 1991. What arguably happened was that Simon in the 1951 paper developed a formal model of authority and that tractability of the formal analysis required that a relatively simple concept of authority be employed. In a reinterpretation of Simon (1951), one may consider restrictions on the subordinate as a means of reducing the set of actions that the employee has the discretion to choose at a given wage. The authority relation should then be preferred when it is efficient to allow the superior to postpone the decision about the preferred type of work activity and/or the preferred set of restrictions on the work activity. For example, Aghion and Tirole (1997) have investigated the use of authority in a setting in which the agent has asymmetric information about his expected private benefits from various projects. The principal may veto projects to protect him from the agent’s adverse selection of projects that reveals high private benefit to the agent and little or no benefit to the principal. However, in such situations the superior must be able to credibly commit to choose projects that do not generate negative expected benefits to the agent (see also Baker et al., 1999). The employment contract could be interpreted as providing a stock of labor services that within limits could be allocated to different uses by the direction of a manager in response to unforeseen contingencies (Coase, 1937; 1991). However, managers only need to bear the cost of carrying such a stock if they cannot appropriate the benefits of their knowledge as new contingencies emerge. Three factors may explain why they cannot sell their knowledge in markets. First, there is the well-known problem of information as a public good that, if revealed before the transaction, cannot be protected from capture (Arrow, 1962); second, negotiations may take longer time than direction by orders and, because of this, the opportunity for profitable action may be gone; and third, managers’ knowledge may be specific to particular transactions. Employers also grant discretion to employees for a number of other reasons, including improving motivation through ‘empowerment’ (Conger and Canungo, 1988), fostering learning by providing more room for local explorative efforts, and improving collective decision-making by letting more employees have an influence on decisions (Miller, 1992). However these reasons arise also if there is no uncertainty. The rather considerable literature on delegation in organizations (for example, Galbraith, 1974; Fama and Jensen, 1983; Jensen and Meckling, 1992) does not explain why delegation should be associated with the exercise of authority. Part of the reason may lie in the static nature of the analysis: all costs and benefits associated with delegation are given (hence, optimum delegation is known immediately to decision-makers), and there is no role for authority, except perhaps monitoring the use of delegated decision rights.

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REFERENCES Aghion, Philippe and Jean Tirole (1997), ‘Formal and Real Authority in Organizations’, Journal of Political Economy, 105: 1–29. Alchian, Armen and Harold Demsetz (1972), ‘Production, Information Costs, and Economic Organization’, American Economic Review, 62: 777–95. Armstrong, Mark (1994), ‘Delegation and Discretion’, Discussion Paper in Economics and Econometrics, Department of Economics, University of Southampton. Baker, George, Robert Gibbons and Kevin J. Murphy (1999), ‘Informal Authority in Organizations’, Journal of Law, Economics and Organization, 15: 56–73. Barnard, Chester I. (1938), The Function of the Executive, Cambridge, MA: Harvard University Press. Barzel, Yoram (1989), Economic Analysis of Property Rights, Cambridge: Cambridge University Press. Blau, Peter M. (1956), Bureaucracy in Modern Society, New York: Random House, Inc. Boisot, Max (1998), Knowledge Assets: Securing Competitive Advantage in the Information Economy, Oxford: Oxford University Press. Burns, Tom and G.M. Stalker (1961), The Management of Innovations, London: Tavistock Publications. Casson, Mark (1994), ‘Why are Firms Hierarchical?’, International Journal of the Economics of Business, 1: 47–76. Cheung, Stephen N.S. (1970), The Structure of a Contract and the Theory of a Non-exclusive Resource’, Journal of Law and Economics, 11: 49–70. Cheung, Stephen N.S. (1983), ‘The Contractual Nature of the Firm’, Journal of Law and Economics, 26: 1–22. Coase, Ronald H. (1937), ‘The Nature of the Firm’, in Nicolai J. Foss (ed.), (1999), The Theory of the Firm: Critical Perspectives in Business and Management, Vol. II. London: Routledge. Coase, Ronald H. (1991). ‘The Nature of the Firm: Origin, Meaning, Influence’, in Oliver E. Williamson and Sidney G. Winter (eds), The Nature of the Firm, Oxford: Oxford University Press. Conger, J. and R. Canungo (1998), ‘The Empowerment Process: Integrating Theory and Practice’, Academy of Management Review, 13: 471–82. Demsetz, Harold (1988), ‘The Theory of the Firm Revisited’, Journal of Law, Economics, and Organization, 4: 141–61. Demsetz, Harold (1991), ‘The Theory of the Firm Revisited’, in Oliver E. Williamson and Sidney G. Winter (eds), The Nature of the Firm, Oxford: Oxford University Press. Demsetz, Harold (1995), The Economics of the Business Firm: Seven Critical Commentaries, Cambridge: Cambridge University Press. Fama, E.F. and M.C. Jensen (1983), ‘Separation of Ownership and Control’, Journal of Law and Economics, 26: 301–25. Foss, Kirsten (2001), ‘Organizing Technological Interdependencies: A Coordination Perspective on the Firm’, Industrial and Corporate Change, 10 (1): 151–78. Foss, Nicolai J. (2001), ‘Coase versus Hayek: Authority and Firm Boundaries in the Knowledge Economy’, LINK Working Paper (downloadable from http:// www.cbs.dkllink).

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Galbraith, J.R. (1974), ‘Organization Design: An Information Processing View’, Interfaces, 4: 28–36. Ghoshal, Sumantra, Peter Moran and Luis Almeida-Costa (1995), ‘The Essence of the Mega Corporation: Shared Context, not Structural Hierarchy’, Journal of Institutional and Theoretical Economics, 151: 748–59. Grandori, Anna (2001), Organizations and Economic Behaviour, London: Routledge. Harrison, Richard T. and Claire M. Leitch (2000), ‘Learning and Organization in the Knowledge-Based Information Economy: Initial Findings from a Participatory Action Research Case Study’, British Journal of Management, 11: 103–19. Hart, Oliver (1991), ‘Incomplete Contracts and the Theory of the Firm’, in O.E. Williamson and S.G. Winter (eds), The Nature of the Firm: Origins, Evolution and Development, Oxford: Oxford University Press. Hart, Oliver (1995), Firms, Contracts, and Financial Structure, Oxford: Oxford University Press. Hart, Oliver (1996), ‘An Economist’s View of Authority’, Rationality and Society, 8: 371–86. Hart, Oliver and John Moore (1990), ‘Property Rights and the Nature of the Firm’, Journal of Political Economy, 98: 1119–58. Hodgson, Geoff (1998), Economics and Utopia, London: Routledge. Holmstrom, Bengt (1999), ‘The Firm as a Subeconomy’, Journal of Law, Economics, and Organization, 15: 74–102. Holmstrom, Bengt and Paul Milgrom (1994), ‘The Firm as an Incentive System’, American Economic Review, 84: 972–91. Jensen, Michael C. and William H. Meckling (1992), ‘Specific and General Knowledge and Organizational Structure’, in Lars Werin and Hans Wijkander (eds), Contract Economics, Oxford: Blackwell. Kreps, David (1990), ‘Corporate Culture and Economic Theory’, in James E. Alt and Kenneth A. Shepsle (eds), Perspectives on Positive Political Economy, Cambridge: Cambridge University Press. Liebeskind, Julia Porter, Amalya Lumerman Oliver, Lynne G. Zucker and Marilynn B. Brewer (1995), ‘Social Networks, Learning, and Flexibility: Sourcing Scientific Knowledge in New Biotechnology Firms’, Cambridge: NBER Working Paper No. W5320. Masten, Scott (1991), ‘A Legal Basis for the Firm’, in Oliver E. Williamson and Sidney G. Winter (eds), The Nature of the Firm: Origins, Evolution, and Development, Oxford: Oxford University Press. Matusik, Sharon F. and Charles W.L. Hill (1998), ‘The Utilization of Contingent Work, Knowledge Creation, and Competitive Advantage’, Academy of Management Review, 23: 680–97. Miller, Gary (1992), Managerial Dilemmas, Cambridge: Cambridge University Press. Minkler, Alanson P. (1993), ‘Knowledge and Internal Organization’, Journal of Economic Behavior and Organization, 21: 17–30. Mintzberg, Henry (1983), Structures in Five, Englewood Cliffs: Prentice-Hall. Simon, Herbert A. (1947), Administrative Behavior, New York: The Free Press. Simon, Herbert A. (1951), ‘A Formal Theory of the Employment Relationship’, in H.A. Simon (1982) (ed.), Models of Bounded Rationality, Cambridge: MIT Press.

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Simon, Herbert A. (1961), ‘The Architecture of Complexity’, Proceedings of the American Philosophical Society, 156: 467–82. Simon, Herbert A. (1991), ‘Organizations and Markets’, Journal of Economic Perspectives, 5: 25–44. Thompson, James D. (1956), ‘Authority and Power in “Identical” Organizations’ American Journal of Sociology, 62: 290–301. Vandenberghe, Ann-Sophie and Jacques Siegers (2000), ‘Employees versus Independent Contractors for the Exchange of Labor Services: Authority as Distinguishing Characteristic?’, Paper for 17th Annual Conference on the European Association of Law and Economics, Gent, 14–16 September. Weber, Max (1946), Essays in Sociology, translated and edited by H.H. Gerth and C.W. Mills, New York: Oxford University Press. Weber, Max (1947), The Theory of Economic and Social Organization, translated by A.M. Henderson and Talcott Parsons; edited by Talcott Parson, New York: Oxford University Press. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: The Free Press. Zucker, Lynne (1991), ‘Markets for Bureaucratic Authority and Control: Information Quality in Professions and Services’, Research in the Sociology of Organizations, 8: 157–90.

6.

Competence and learning in the experimentally organized economy1 Gunnar Eliasson and Åsa Eliasson

1.

INFORMATIONAL ASSUMPTIONS FOR A THEORY OF INDUSTRIAL DEVELOPMENT

The single most important empirical assumption in economic theory concerns the totality of all possible states the economy can be in. This universal state space of the model of the economy, or what we call the business opportunities space (Eliasson, 1990a) sets the limits both of what actors can do, and of how informed about their environment they can be. We introduce the knowledge based economy (Eliasson 1987b, 1990a, b; OECD, 1996), which establishes as a necessary assumption an economic opportunities space of immense complexity that is theoretically impossible to comprehend more than fractionally from any one place. Each actor understands only a miniscule fraction of the total opportunities space. Together, however, the understanding of all actors in the markets is much larger, but still only encompasses a fraction of the whole, and the tacitness of their knowledge or competence effectively restricts expansion of that understanding through collective coordination. Attempts to speed up exploration of the opportunities space through rivalrous competition in markets encounter rapidly escalating information and communications (transactions) costs in the short run. Such exploration, however, offers opportunities for learning and increases the number of creative encounters such that the opportunities space expands, and probably faster than it is being explored. Hence, we may all be growing increasingly ignorant of what is theoretically possible to know about. This information paradox, or what we will call the Särimner effect,2 is a fundamental, sustained and distinguishing property of the experimentally organized economy (EOE) and the rational basis for the existence of a competence bloc (Eliasson and Eliasson, 1996).

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1.1

105

The Grossly Ignorant Actor

Under these circumstances ‘boundedly rational’ (Simon, 1955) and myopic, bordering on grossly ignorant actors will constantly participate in a positive sum economic game, trying to orient themselves in the immense opportunities set, their success rates depending on their competence to discover and capture the new opportunities, constantly making more or less serious mistakes in the process (Day et al., 1974). Hence, each decision can be seen as a more or less well designed ‘economic experiment’ to be tested in the market in confrontation with all other actors. Both successful and mistaken experiments involve elements of learning and the creation of new combinations on which competitors can set up new economic experiments. Economic mistakes (to be defined below) then define the ultimate transactions cost (Eliasson and Eliasson, 2005). Economic mistakes escalate if actors intensify their exploration of the state space to capture larger profits, and the reason is the problem, recognized already by Wicksell (1923) and repeated by Arrow (1959), that it is difficult, and perhaps impossible, to model the simultaneous determination of structures (quantities or organizations) and prices. In the highly non-linear micro (firm) based macro model that we will refer to below as an approximation of the theory of the EOE, both quantities and prices become increasingly destabilized as actors are pushed on by market competition, and prices become increasingly unreliable signals to guide quantity adjustments towards a both unreachable and perhaps indeterminate equilibrium. The economy will constantly be in a ‘Heisenbergian flux’ (see also Eliasson, 1991a, and Eliasson et al., 2005). Since experimentation aimed at exploring and learning about state space also expands the opportunities space through learning and the creation of new opportunities (innovation), we have to reckon with the possibility that the total economic opportunities space is not only immense but also indeterminate at any point in time. Demsetz (1969) recognized this possibility when criticizing the neoclassical doctrine as being subject to a ‘Nirvana fallacy’ in the sense that the best of all worlds that the neoclassical economists can calculate within their model make them miss the possibility of even better worlds beyond their prior assumptions.3 One property of the EOE to be explained below also is that there always exist better allocations than the current one, meaning that the economy will always be operating (far) below its production frontiers.4 Referring to Demsetz, Kirzner (1997) observed that economies will always fall short of their potential, a potential, Kirzner argued, that could be approached with the help of discoverers/entrepreneurs.

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The Särimner Effect

The informational assumptions are a distinguishing feature of both the neoclassical model and the theory of the EOE. They are embodied in the state space assumed for the model. The assumptions of the neoclassical model are normally tailored such that (1) a unique optimum exists, (2) it can be identified and (3) it can be reached at zero or negligible transactions costs. Convexity assumptions of some sort, of course, have to be imposed to prevent the model economy from exploding or ceasing to exist altogether. The assumption of strict convexity and continuous derivatives ensures that a unique cost minimum, profit maximizing optimum exists.5 Finding it is always possible if the information and communications (transactions) costs needed are (assumed to be) zero or negligible. If transactions costs are large they will have to influence both the position and the existence of the optimum as conventionally defined. And in reality the transactions costs are very large (Eliasson et al., 1985, p. 53; Eliasson, 1990a, b; Bergholm and Jagren, 1985; Pousette and Lindberg, 1986; Wallis and North, 1986). The informational assumptions of the EOE are embodied in its state space or in what we call its business opportunities space. Initially it is assumed to be large and populated with grossly ignorant actors positioned somewhere inside it. The problem, however, is that it has to stay that way for ever for the theory of the EOE not to converge upon the neoclassical or WAD (Walras–Arrow–Debreu) model. Large transactions costs in the form of business mistakes that escalate the closer you get to a stationary process keep the operating domain of the EOE away from the optimum.6 This is, however, not sufficient for the economy to grow. For endogenous growth to occur this situation has to be for ever maintained and the actors kept grossly ignorant about circumstances that are critical for their business. This can be solved mathematically (Eliasson, 1990b, pp. 46 ff) by assuming the opportunities space to be initially sufficiently large, and that it grows from being explored through innovative discovery and learning. This establishes the positive sum game of the EOE that we call the Särimner effect, and the possibility (the paradox) that in a dynamic EOE actors may grow increasingly ignorant about what is important to them because the business opportunities space grows faster than it can be explored and learned about. In this experimentally organized economy (Eliasson, 1991a, 1996) economic growth will be shown to be moved by innovative project creation and competitive selection, or the Schumpeterian creative destruction process of Table 6.1.7 The capacity of the economic system to identify winners and carry them on to industrial scale production and distribution determines economic growth. Hence, the dynamic efficiency of selection becomes

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Table 6.1

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The four investment and divestment mechanisms of Schumpeterian creative destruction and economic growth

Innovative entry enforces (through competition) Reorganization Rationalization or Exit (shut down) Source: ‘Företagens, institutionernas och marknadernas roll i Sverige’, Appendix 6 in A. Lindbeck (ed.), Nya villkor för ekonomi och politik (SOU, 1993, p. 16) and G. Eliasson (1996, p. 45).

Table 6.2

Competence specification of the experimentally organized firm

Orientation 1. Sense of direction (business intuition) 2. Risk willing Selection/Flexibility 3. Efficient identification of mistakes 4. Effective correction of mistakes Operation/Efficiency 5. Efficient coordination 6. Efficient learning feedback to (1) Source:

Eliasson, G. (1996, p. 56).

critical for economic growth. The organization of efficient selection and the definition of efficiency in an EOE with no exogenous equilibrium are dealt with in competence bloc theory, of which the theory of the firm can be seen as a special case. Competence bloc theory is presented in this chapter as an integral part of the EOE. Access to the business opportunies space is regulated by institutions that determine the incentives for actors to look for business opportunities there and to compete. In fact, the competence of a firm or an actor is best characterized as in Table 6.2. 1.3 Competence Specification of the Firm in the EOE – the Tacit Dimension Table 6.2 represents a typical situation of a firm in reality and in the EOE (Eliasson, 1996, p. 56, 1998a, p. 87). First, no actor, including government,

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can survey the entire economic opportunities space from one point. The assumptions of the economic opportunities space make it impossible for each actor to be more than fractionally aware of its interior structures and contents and notably about what now and then may become critical for survival. Hence, business mistakes will be made by all actors all the time. Such business mistakes, however, also involve learning about the opportunities space and should be regarded as a normal cost for economic development, a transactions cost (Eliasson and Eliasson, 2005). One common form of learning is being confronted with a superior competitor and understanding that for better business solutions than one’s own are possible. Second, some actors may hit upon the absolutely best solution by chance, but they will never know, and nobody else will either. Hence, third, the economy will always be operating far below its production possibilities frontier, a violation of a standard assumption of neoclassical theory. In fact, such frontiers may even be indeterminate. Fourth, as a business actor you must always believe in your proposed business experiment. If not, you cannot act decisively and forcefully in dynamically competitive markets. Fifth, however, whatever you have invented, you know one thing with almost certainty: there will be many potential solutions that are much better. Therefore, sixth, you have to recognize that among your many competitors you cannot be alone with such a good idea as yours. The business firm has to act decisively and prematurely on the basis of the competent judgment of its top competent team (intuition, Eliasson, 1990a) before somebody else has acted successfully. Each new solution, therefore, has the character of a business experiment, and the competence of a business firm is well categorized in Table 6.2. The firm in the EOE needs a good business intuition (orientation), it needs to be able to identify and correct mistakes (flexibility) and it needs to be operationally efficient. This is a tall order and all three categories of competencies can neither be embodied in one individual nor be assumed to be more than fractionally communicable between participating actors. They are tacit in the sense of limited communicability (Eliasson, 1990a). This problem of multidimensionality and tacitness of competence characteristics is solved in practice through organization, coordination being achieved to the extent possible by the top competent team of the organization and/or through competition in markets (Eliasson, 1976, 1990a). As demonstrated by Coase (1937), the mix between hierarchy and market is determined by the relative transactions costs of coordination within and between hierarchies, tacitness being one factor pushing for market solutions, dynamic efficiency another (see below). The competence and behavioral characteristics of the firm follow directly from the assumptions made about the business opportunities space and the

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EOE. It is no coincidence, however, that development of this basic idea has grown upon us during many interactions with business firms (beginning with Eliasson (1976) and currently during a study in progress on the economics of health care (Å. Eliasson, 2007; Eliasson and Eliasson, 2007)) and frequent participation in internal firm educational programs with the purpose of relating the internal life of firms to their external economic environment. In such reality settings you are in a hopeless situation trying to explain how the mainstream neoclassical model can be of any use. 1.4

Macro Dynamics through Experimental Selection – Going from Micro to Macro

When something radically new is introduced, it almost always occurs through the launching of a new product, the establishment of a new division or through the entry of a new firm. A new product may be a complement to existing products or a substitute, in the latter case subjecting existing producers to competition and forcing them to reorganize and/ or rationalize, or die (exit). When a competitor introduces a radically new product, a firm often cannot cope with the new situation through reorganization, because it is staffed with the wrong human capital. It then has to contract or shut down, and possibly recruit new personnel to establish a new firm. The entry process, hence, is critical for long-term economic growth, pushing performance of the entire industry upwards through the four creation and selection mechanisms (‘investments and disinvestments’ of Table 6.1). But entry will not result in growth unless accompanied by a viable exit process.8 If superior entrants and successfully reorganizing firms (the ‘winners’) are supported by the market and allowed to force inferior firms to exit, growth will follow. Hence, the major information cost, again, is business mistakes in the form of ‘lost winners’ and the losses of inferior firms that are allowed to continue for too long.9 Under normal circumstances, therefore, an economy will be reasonably fully employed and the thrust of firm turnover will be to reallocate resources. Hence, the question of the employment contribution of new firm formation and self-employment is normally irrelevant, and if asked (as in Blanchflower, 2004) it has to be related to a well-defined unemployment situation.10 The optimum or the benchmark for efficiency measurements will be obtained by minimizing the cost of committing the two types of errors in Table 6.3a. Under the opportunities space assumption of the EOE there will always exist better allocations than the current one.11 This optimum, hence, does not exist under the assumptions of the EOE and a unique efficiency reference cannot be determined. With lost winners defining the

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Table 6.3a

The dominant selection problem

Error Type I: Losers kept too long Error Type II: Winners rejected Source:

G. Eliasson and Å. Eliasson (1996).

potential of the economic system not reached, optimum performance cannot be determined even theoretically, since the benchmark for determining efficiency cannot be identified. One aspect of efficiency, however, is to make sure that the customer, or demand, is a determining force in setting directions. The optimal organization of the economy, hence, is determined by a delicate balancing of decentralized incentives, information processing and competition in markets (Eliasson and Taymaz, 2000). For a successful economic outcome actors and resource providers have to be competently guided and disciplined by signals from the ultimate end users, the customers. The competence bloc performs those functions of guidance and resource provision.

2.

COMPETENCE BLOC THEORY

Critical competencies are tacit in the sense of being limitedly communicable12 (Eliasson, 1990a). While the nature of tacit knowledge cannot be represented analytically, it can be functionally defined. A competence bloc lists the minimum number of actors with such competence that are needed to successfully create, identify, select and commercialize new business ideas and to carry them on to industrial scale production and distribution, that is, to initiate and develop a new industry (Eliasson and Eliasson, 1996). This also confirms that the competence bloc has a pronounced end product or market definition, as distinct from a technical definition, making the customer the ultimate arbiter of economic value. 2.1

The Nature of Business Competence and the Efficiency of Project Selection

Competence bloc theory is structured around three nodes of actors; the customers, the technology suppliers and the commercializers. In between them there are three markets: the markets for products, innovations and factors of production (see Figure 6.1). The commercialization process in turn is intermediated through authority within hierarchies and through three types of asset markets – the venture capital market, the private

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1. Competent customers

2. Innovators (technology supply)

Markets for innovation

Commercializing agents 3. Entrepreneurs 4. Venture capitalists 5. Exit market agents 6. Industrialists

Source:

Strategic

Choose

Tactial

Coordinate

Operational

Manufacture and subcontract

Eliasson (2005a, p. 255).

Figure 6.1

Decision structure of the competence bloc

equity market and the market for strategic acquisitions – and through the regular stock markets. Trading in intangible knowledge assets, however, poses particular property rights problems that we come back to in Section 3 below. The different functions of the actors in the competence bloc can be identified as relay stations in the innovation, creation and commercialization processes and are needed as a minimum. Sometimes they are all internalized within one hierarchy or in a planned economy. This was almost the case for IBM during its heyday in the 1970s (Eliasson, 1996, pp. 175ff). IBM was then to a large extent its own customer in intermediate products. Normally, however, most functions are carried out by specialized actors in the market; call them firms. The determination of the mix between market and hierarchy within the competence bloc not only becomes a Coasian (1937) type dynamic theory of the firm but also determines the dynamic efficiency of the entire economy (Eliasson and Eliasson, 2005). The efficiency of project selection in terms of identifying and supporting (commercializing) winners and forcing the exit of losers, as intermediated through the competence bloc (first crudely sketched in Eliasson and Eliasson, 1996), determines the efficiency of resource allocation and growth through the Schumpeterian creative destruction process of Table 6.1. Efficient selection in the EOE is defined as the ‘minimizing’ of the economic incidence of two types of errors (Table 6.3a), that is, keeping losers on for too long and ‘losing the winners’. This minimization can, however, only be performed analytically if the business opportunities

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space of the model can be made fully transparent from at least one central point, all information and communications costs kept very small, and all winners identified. The presence of critical tacit and incommunicable knowledge in the decision process makes this theoretically impossible in the EOE. The optimal coordination of production has to be organized as an endogenously determined combination of hierarchies (firms) and markets. The limits of hierarchies are determined where the costs on the margin in the form of lost winners exceed the gains in coordination costs achieved through expanding the hierarchy. The mechanism behind this determination is simple. Centralizing knowledge at one point and ordering outcomes top-down through authority is limited (1) to the part of knowledge that can be coded as information and interpreted centrally at a determinable transactions cost and (2) by the reach of and power to impose authority (compare Simon, 1945; Williamson, 1975; Foss, Chapter 5 in this volume). If that centralization is extended to the parts of the total knowledge (probably the most important parts) that are tacit and not communicable to the intelligence center (the corporate headquarters) of the firm, an error bias in the central analysis will be introduced because some of it will be misinterpreted along the way, owing to a lack of receiver competence (Eliasson, 1976). This can be shown to reduce the total knowledge that enters each decision. Distributing tacit knowledge (or human or team embodied competencies) over the market, on the other hand, can be shown to maximize the exposure of each project to a competent evaluation, and minimize a transactions cost measure that includes an economic value of the loss of winners (Eliasson and Eliasson, 2005).13 Competence bloc theory, hence, is an organizational solution to the efficient allocation of tacit, human embodied competencies on business problems. If economic competence consists significantly of tacit knowledge, the same characteristics must also apply to consumer choices. If consumer choices are experience based ‘tacit knowledge’, exhibiting preferences for novelty, convergence on an exogenous optimum can in no way be guaranteed (Day, 1986b). The (also experience based) competence of all actors of the competence bloc to visualize the unpredictable change in consumer preferences, however, should to some extent keep the economic system from becoming erratic, as proposed by Georgescu-Roegen (1950) and modeled by Benhabib and Day (1981). The competence of the customers to appreciate quality and the competence of firms to produce new qualities go hand in hand. The perhaps most important quality demanded in an advanced market, furthermore, is product or quality variation.14 Only the customers can individually decide which variant they prefer. One critical function of the competence bloc,

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hence, is to make sure that customers’ preferences and competencies filter down to the actors in the competence bloc that create and select innovations. Customer receiver competence (Eliasson, 1990a) is decisive for the existence of a market. With no customer receiver competence for sophisticated products there will be no market for the same products. 2.2

The Actors in the Competence Bloc

First, the products created and chosen in the experimental process never get better than what customers (item 1 in Table 6.3b) are capable of appreciating and willing to pay for. The long-term direction of technical change, therefore, is always set by the customers. Sophisticated customers define a competitive advantage of a sophisticated industry.15 Without competent customers there are no sophisticated markets. This is so even though the innovator, entrepreneur or industrialist may take the initiative to launch a new sophisticated product. But quite often the customer takes the initiative. Technological development, therefore, requires a sophisticated customer base, capable of appreciating new products (Eliasson and Eliasson, 1996). The more advanced and radically new the product technologies, the more important customer quality becomes. In one sense, the customer analysis of competence bloc theory opens up the Keynesian macro demand schedule. But as you peek inside that ‘black box’ you will find that the customer dynamic of the competence bloc has little to do with Keynesian demand. The actors of the competence bloc contribute (commercial) competence in the technological choice process. They accept or reject products offered to them in the market, thereby signaling what they want. But customers may also be directly involved in some phases of the development of the product. This is normally the case when it comes to very advanced and complicated products such as military and commercial Table 6.3b 1.

Actors in the competence bloc

Competent and active customers

Technology supply 2. Innovators who integrate technologies in new ways Commercializion of technology 3. Entrepreneurs who identify profitable innovations 4. Competent venture capitalists who recognize and finance the entrepreneurs 5. Exit markets that facilitate ownership change 6. Industrialists who take successful innovations to industrial scale production Source:

G. Eliasson and Å. Eliasson (1996).

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airplanes (Eliasson, 1995, 2001b). This fact also serves as a rationale for competent purchasing and acquisitions, including public purchasing in areas where goods and services are supplied by public authorities. Second, technology supply is internationally available, but the capacity to receive it and make a business of it requires local competence. Part of this receiver competence (Eliasson, 1987b, 1990a, 1996, pp. 8, 14) is the ability to create new winning combinations of old and new technologies (innovation). A rich and varied supply of subcontractor (technology) services is part and parcel of the innovation process and the competence bloc. The innovation gate into the competence bloc (item 2 in Table 6.3b), hence, is served by many technologies, or technological systems to use the terminology of Carlsson (1995), that are integrated innovatively. Third, technology supply is not synonymous with industrial progress or growth. In between comes the competence to commercialize new technologies, a far more resource demanding activity than innovation. So between innovation supply and commercialization, representing the demand for innovations, we find the market for innovations in which winners and losers are sorted out (see Figure 6.1). The problem with new growth theory and evolutionary theory is that they do not distinguish between the innovator, the entrepreneur and the competent venture capitalist, and hence do not model that sorting process. Commercialization competence is experience based and, hence, more narrowly defined than the creative innovation supply process (Eliasson and Eliasson, 2005).16 As a consequence there will always (ex definitione) be a loss of winners along the way. By explicitly modeling the commercialization process we break the linearity between innovation supply and economic growth commonly entered as a prior assumption in the different versions of new growth theory and in evolutionary theory. We find that increasing supplies of technology do not lead to faster growth and that growth can be radically increased on a sustainable basis under improved commercialization at given technology supplies.17 First among the commercializing agents come the entrepreneurs. The task of the entrepreneur is to identify commercial winners among the suppliers of technically defined innovations and to get his/her choice of technology on a commercial footing.18 The understanding may be of a long-run nature, or more temporary in the sense that entrepreneurs may have to reconfigure their thoughts soon, or make a business mistake (see Table 6.2). The main thing is that the entrepreneur acts on the perceived economic opportunity (entre prendre in French). A brief sidestep here. New growth theory is a sub-branch of neoclassical theory and neoclassical theorists tend to order their assumptions such that entrepreneurship has no economic role beyond innovation or technology supply. Innovation supply, furthermore, is commonly represented

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as drawings from a lottery, the participation in which is free of charge. This process, furthermore, is staged within a rational expectations setting or as a stationary process such that the differences between ex ante plans and ex post outcomes cancel out in expectation over time as white noise. A stochastic exogenous equilibrium can be defined. On this the Swedish economic tradition, heralded by the Stockholm School economists, takes a contrary position, more in line with Austrian economics and us (see Eliasson, 1992, p. 256).19 The enormous and varied expanses of the business opportunities space of the EOE, which keeps opening up new vistas as a consequence of its exploration by the entrepreneurs, make the assumptions of the mainstream neoclassical model empirically unreasonable. The mathematical reason is that the underlying structures of the assumed stationary process change constantly, radically redefining the distributions.20 This means that the standard assumptions of statistical learning do not hold.21 Learning under item 6 in Table 6.2 becomes unreliable. The entrepreneur, however, rarely has resources of his own to move the business project forward. He, therefore, (fourth) needs funding from an industrially competent venture capitalist, that is, a provider of risk capital, capable of understanding innovators of radically new technology and able to identify business needs and provide context. The money is the least important thing. What matters (Eliasson and Eliasson, 1996; Eliasson, 1997b, 2005c) is the competence to understand and identify winners and, hence, provide reasonably priced equity funding.22 There is an asymmetry problem here that relates to the risk willingness item in Table 6.2. The entrepreneur believes s/he has understood the business situation (business intuition, item 1).23 S/he therefore considers the risks low and is willing to take them on. The outsider, for instance the venture capitalist, does not have the same insight, and therefore considers the same situation more, usually much more, uncertain. Implicit in this statement is that the industrially incompetent venture capitalist does not understand the project and, therefore, charges an unreasonable (to the entrepreneur) price for his/her services. The supply of industrially competent venture capitalists is extremely scarce (Eliasson, 1997b, 2005c). They constitute the critical link in the overall selection process and, if lacking in performance, this is liable to result in the ‘loss of winners’. The issue of competent venture capital has long been politically sensitive in some European countries since it signals the need for privately rich and industrially competent people to move new industry formation. Such signals run counter to political ambitions to even out income and wealth distributions. The low rate of new entry in continental European countries, including Sweden (Braunerhjelm, 1993), can have two explanations; low

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entrepreneurial competence or lack of competent venture capital. The argument in Sweden for a long time focused on the lack of entrepreneurial spirit. It was often heard from banking circles that there was plenty of money but very few good projects to invest in. The most credible explanation, however, (Eliasson and Eliasson, 1996; Eliasson, 2005c) has been lack of industrially competent bankers and venture capitalists. Without a rich variety of such financial competence, you will not see many entrepreneurs. Hence, the venture capitalist and his escape (exit) market (fifth) are the most important incentive supporting actors. With no understanding venture capitalists the price of new capital will be prohibitively high, or funding will not be forthcoming, and winners will be ‘lost’. With badly functioning exit markets the incentives for venture capitalists will be small and, hence, also for the entrepreneurs and the innovators. With the rapid securitization of the global financial system the markets for ownership or corporate control have gained in importance (Rybsczynski, 1993). New actors have emerged trading in risks and the exit markets have gained in sophistication and importance as private equity investors with the capacity to mobilize very large financial resources have entered the scene. In growing markets for strategic acquisitions small high technology firms and large industrial firms (item 6) are trading in knowledge assets. Sixth, and finally, therefore, when the selection process has run its course and a winner has been identified, a new type of industrial competence is needed to take the innovation on to industrial scale production and distribution. We cannot tell in advance what the formal role of the industrialist is (CEO, chairman of the board, an active owner, or other). He or she figures in the competence bloc on account of his or her capacity to contribute functional competence. The capacity to identify, select and move winners to industrial scale production is the most important growth promoting property of the competence bloc. It defines a competitive advantage of an economy. This innovative dynamic is what endogenizes growth in the theory of the EOE. Vertical completeness of the competence bloc, hence, is a necessary requirement for the viable incentive structures that guarantee increasing returns to a continued search for winners, that is, for new industry formation. The extreme diversity of the opportunities space of the EOE means that the competence needed to identify winners cannot be specified in advance. Hence, an efficient project identification and selection in the competence bloc requires that a large number of each type of actor in the competence bloc be present, so that if one actor does not understand there will be others who might. Such horizontal diversity in competence is a necessary condition for maximum exposure of each project to a competent

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evaluation. Vertical completeness and horizontal diversity make the competence bloc complete. Seeing to it that the competence blocs are complete must, therefore, be the prime task of industrial policy (Eliasson, 2000). None of the ‘pillars’ (the actors) of the competence bloc can be missing, or the whole incentive structure will fail to develop. In the EOE a premium is placed on flexibility. Actors all the time have to take premature decisions on scant and unreliable information. As a consequence they constantly commit more or less serious business mistakes and have to be prepared to change their minds constantly. Flexibility in the EOE is achieved in three ways. First, and most important, is to have the right business idea (item 1 in Table 6.2). Second, and decisive when you are on the wrong track, is early identification and correction of mistakes (items 3 and 4). Third, when the first two criteria fail, the competence bloc enforces flexibility through exit by withdrawing support. But this occurs only after the project has been exposed to a varied and maximum competent evaluation, thus minimizing the risk of losing a winner. The more widely distributed over the market the competence bloc, the more flexible the allocation process. When vertical completeness and sufficient horizontal variety have been achieved, critical mass has been reached. Then: (1) (2)

Increasing returns to continued search for resources prevail. The loss of winners is minimized. Competition among all actors in the competence bloc for the gains that otherwise will be lost as lost winners ensures that less competent actors exit.

The competence bloc will now function as an investment attractor such that new entry takes place in such a way that the competence bloc benefits from the new entrants, but (because of competition) only new entrants that contribute to the competence bloc enter and/or survive. The competence bloc then functions as an industrial spillover generator and will begin to develop endogenously through its internal momentum (critical mass). We have a positive sum game. These spillovers will diffuse along many paths and both further reinforce the internal development forces of the bloc and contribute serendipitously to other related and unrelated industries. Endogenous growth will occur (Eliasson, 1997a). 2.3

The Theory of the Firm Revisited

Compared with the internal project evaluation in a large firm, project evaluation over the competence bloc draws much larger direct transactions

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costs, since the evaluation is done in a distributed fashion involving many independent actors in the market. Narrowing down the evaluation to an internal procedure within a hierarchy, therefore, may lower direct transactions costs, but the more narrow evaluation also raises the risk of losing winners and therefore both raises total transactions costs and lowers the efficiency of project selection. Hence, a relevant analysis of the optimal organization of production has to include the loss of winners as a transactions cost (Eliasson and Eliasson, 2005).24 A large firm, such as IBM in the 1980s, internalized most of its competence bloc. For a long time IBM was unable to get out of its mainframe mentality due to lack of internal experience from the new industrial markets of distributed computing and came close to disaster during the last years of the 1980s, during its attempts to transform itself away from mainframe technology. Business history is full of near losses based on narrow-minded internal business judgment in large hierarchies, the only ones that can be identified (Eliasson, 1996). The contrary solution with all functions distributed over the market, however, has other problems, even though Fama (1980) argued that there was no need for an entrepreneur in economic theory, since the services of the entrepreneur could always be rented in the market. Most of economic literature and debate, furthermore, neglects the commercialization competence altogether and we have a neo-Schumpeterian literature that comes very close to neoclassical literature in presenting the firm or an industry as a direct linear R&D, technology supply and growth machine. And socialist thinking on the matter has been even more negligent in understanding any merit in the competitive functions of markets. Competence bloc theory has no role to play under the assumptions of the static general equilibrium (neoclassical) model in which all knowledge has the qualities of codable and communicable information that can be centralized to one place for a complete overview. Competence bloc theory, however, has a decisive role to play in project selection within and between hierarchies when tacit, non-codable knowledge embodied in individuals and hierarchies has to be mobilized within hierarchies and through markets. Once this has been said, we know that the nature and distribution of knowledge determine the ‘optimal’ combination of hierarchies and markets through which the total knowledge base can be mobilized for particular business problems. We have a dynamic version of Coase’s (1937) theory of the firm in which the hierarchical structure of markets is not only endogenized as an equilibrium property but also changes as a consequence of the constantly ongoing project selection in an experimentally organized economy. In that setting the critical task of the top competent team of a firm

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is to identify the best organizational structure for the particular business problem at hand (Eliasson, 1990a). Since that structure constantly changes, new organizational structures constantly have to be identified. This is not at all easy and management mistakes are constantly made. Hence, learning feedback (item 6 in Table 6.2) is limited. Such limited learning possibilities are typical of the theory of the EOE. It has also been a typical experience in the recent ongoing outsourcing business culture (Eliasson, 2005d). A systematic test of the limitations of business learning is presented in Eliasson (2005b) in which business planning and management methods during and between the three periods of post-World War II development are compared: (1) the pre-oil crisis steady state experience of 1969–75, (2) the post-oil crisis sobering-up through most of the 1990s and (3) the rapid emergence of globally distributed production from the mid 1990s, blurring the notion of the firm/hierarchy to be managed. In general, management experience did not carry over reliably between the periods, and business mistakes occurred on a grand scale during those transitions. Furthermore, distributed production and unstable hierarchies undermine the whole notion of the central authority of a corporate headquarters (Eliasson, 2005a, Chapter V). Top-down push-through of orders does not work when the hierarchy responds by changing its structure. This problem of endogenous hierarchies or organization poses the same analytical problem as that discussed already by Wicksell (1923), mentioned above, and provides a rational argument for integrating the theory of organization with that of allocation.25 Through the early 1990s Sweden featured an extreme concentration of historically grown and successful large-scale and international manufacturing companies. For decades this was considered synonymous with an equally rich endowment of business leadership competence that could be carried over from generation to generation (Eliasson, 1990b, 2005b). To some extent this was of course true, but this competence had been acquired in traditional mature industries that innovate slowly. The management of innovation in the new type of industries like biotech is radically different from that in mature industries such as engineering. Experience is that leadership competence acquired in traditional industries is of limited use in the radically new industries and sometimes outright dangerous to apply. The learning feedback (item 6 in Table 6.2) is correspondingly unreliable (Eliasson, 2005b). For some reason the large Swedish companies exhibited unusual organizational innovation capacity coming out of the oil crises of the 1970s and carrying Swedish manufacturing growth in the 1980s, but it was concluded in Andersson et al. (1993) that this was a story that no one should count on to be repeated. True enough. When Swedish industry entered the ‘New Economy’ of globally distributed production during the

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second half of the 1990s the giants began to stumble, presumably because the earlier management experience was not a reliable management guide into the future (Eliasson, 2005a). Presumptuous big business leaders who enter radically new businesses with an air of authority, therefore, may even be a negative factor for development. Hence, Swedish manufacturing industry perhaps no longer features the rich and varied competence blocs needed for the efficient project selection that worked well for decades but does not seem to work at all that well as we currently attempt to enter a radically New Economy.

3.

INSTITUTIONS, TRADE IN PROPERTY RIGHTS AND SOCIAL CAPITAL/COMPETENCE

Project selection over markets always involves trade in knowledge assets between actors in a competence bloc. Competence bloc theory explains those transactions explicitly, why large resources (transactions costs) are needed and why transactions competence is critical for dynamically efficient allocations in the theory of the EOE, but not in the mainstream neoclassical model. We therefore have to relate the competence bloc theory just introduced back into the economic environment of the EOE. 3.1

Institutions, Incentives and Competition

None of the economic dynamics discussed so far can occur without a minimum of supporting institutional infrastructure needed to establish the required tradability in knowledge assets. Institutions define incentives to act on business opportunities that fuel competition. In general, if complete contracts that define the transfer of ownership associated with trade cannot be formulated, trade will be correspondingly limited and undersupply will follow (Williamson, 1985). Resource allocation in the experimentally organized economy involves trade in intellectual property rights across the competence bloc, notably throughout the markets for venture capital, the exit markets and the markets for strategic acquisitions on its commercialization side. For the full macroeconomic growth potential of innovative project creation and selection in Table 6.1 to be realized, this trade will have to occur with a minimum of risks and transactions costs. For this to be realized property rights to these intellectual assets have to be well defined. Those property rights are not needed for the same transactions to be organized within a hierarchy. For all projects to be exposed to a maximum competent evaluation over the competence bloc, efficient property rights of this kind thus have to be in place. Only then will the relative

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superiority of the broad market exposure of competence on each project be fairly compared with the narrow exposure within a hierarchy, and the key factor will be the tradability of intangible knowledge in financial asset markets (Eliasson and Wihlborg, 2003). 3.2

Social Capital/Competence

Competence bloc theory has been shown to be needed to explain the efficiency of project selection in the EOE. Under the informational assumptions of the EOE, the selection and allocation processes supporting stable economic growth at the macro level become unpredictable and socially demanding at local micro levels. This suggests that the overriding welfare and policy concern should be to design institutions that support the ability of individuals to cope with environmental unpredictability and the exposure to arbitrary change that increases with economic efficiency and growth (Day, 1986a, 1993, notably p. 77; Eliasson, 1983, 1984). This suggests that what we call social capital should be defined in terms of how it supports individuals’ ability to cope (Eliasson, 2001a)26 and in doing so we also recognize that the support of social capital development becomes a critical part of both industrial and social policy, to be elaborated in another context (Eliasson, 2000, 2006b).

4.

ENDOGENOUS GROWTH THROUGH COMPETITION – THE DYNAMICS OF GOING FROM MICRO TO MACRO AND BACK

Endogenous growth in the theory of the EOE is explained with reference to the Schumpeterian creative destruction process of Table 6.1 and how it works in the Swedish micro-to-macro model (Eliasson, 1991a, 1996, p. 45). Competition there keeps the entrepreneurial and commercialization processes in motion and the Särimner innovation/learning effect keeps the investment opportunities space expanding to sustain growth. But competition has to be activated. It may be prohibited or regulated. Actors may enjoy monopoly conditions and earn more by colluding than competing. Incentives to compete are therefore not sufficient to activate competition. The rational foundation of endogenous growth through the Schumpeterian creative destruction process of Table 6.1, therefore, has to explain why each actor in a market of the EOE constantly has to innovate and improve its performance, or perish. The reason is that each actor lives in a constant state of fear of being overrun by new and old competition. The opportunities space or the Särimner effect combined with unrestricted

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Rate of returns (percent)

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55 50 45 40 35 30 25 20 15 10 5 0 –5 –10 –15 –20 –25

1990

1983

0

10

20 30 40 50 60 70 80 Cumulative capital stock (percent)

90

100

Note: The vertical columns show the position on the Salter curve of one firm, the width measuring its size in percent of total industry capital. Source: MOSES Database (1992) and updatings.

Figure 6.2a

Salter curve distribution of rates of return on total capital in Swedish manufacturing in 1983 and 1990

free entry keeps experimental exploration of the opportunities space active as a necessary means of survival. The rationale for this is that each actor is constantly challenged in the market, from above by superior (‘more profitable’) competitors that can pay more for factors of production or lower prices, and from below by inferior firms that have to innovate and leapfrog superior competitors to prevent them from competing them out of business. The Salter curves (1960) in Figures 6.2a and 6.2b illustrate how this endogenization of growth has been specified in the Swedish micro-to-macro model (Eliasson, 1977, 1985). The Salter curves rank firms (or divisions of large firms) in Swedish manufacturing industry in 1983 and 1990 by returns to capital and labor productivity. It is part of the micro database used to initiate simulations on the Swedish micro-to-macro model. The spread of the Salter distributions illustrate the great opportunities for improvement

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Labour productivity 650 600 550 500 450 400 350 300 250 1990

200 150

1983

100 50 0 0

10

20

30

40

50

60

70

80

90 100 Percent

Note: The columns indicate the same firm as in the previous figure, the size now being measured in percent of total employment. The shaded areas measure unused capacity for each firm. Source:

MosesDataBase (1992) and updatings.

Figure 6.2b

Salter curves of labor productivities in Swedish manufacturing in 1983 and 1990

in macro performance through reallocation of resources. This reallocation can be set in motion through competition. The firm is indicated by a column, its width measuring its size in percent of the total capital or the total employment of the firm population. This firm is challenging the less profitable or productive firms to the right, by being able to outbid them for resources. But these firms being challenged also challenge the firms to their left by attempting to leapfrog them through innovation and investment. The Salter curves in Figures 6.2a and 6.2b are snapshots at one point in time. At each point in time entrants wait behind the scene. New entrants on average exhibit lower performance than incumbents, but the spread is much wider. This is empirically well established. Hence, there will always be a few winners in the entry flow of firms that survive and grow into major players, provided the local commercialization competence is sufficient. The underperforming entrants are sooner or later competed out of business.

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The outcome for the firm indicated in Figure 6.2a in 1990 has been an improvement in profitability, but a loss in ranking. As a consequence the Salter curves ranking productivities in Figure 6.2b shift outward. Growth occurs. For this competitive process, spurred by fear, to be sustained and result in sustainable growth it is, of course, possible to introduce the standard stochastic innovation lottery that are commonly found in the new growth models. We have done that in the Swedish micro-to-macro model (Hanson, 1986, 1989; Taymaz, 1991), but a more satisfactory solution is to model the innovation process explicitly by making it possible for firms to learn to upgrade their productivity from superior competitors when exploring the opportunities space and to model creative encounters during that exploration which create new and superior combinations that in turn expand the opportunities space and open possibilities for others to discover and learn from, and so on. This Särimner creativity process has been based on the Ballot and Taymaz (1998) genetic learning mechanism in the model. The distributions that define innovation supplies will then be endogenously determined, explicitly derived and deterministic, and not entered as an assumed stochastic process as in Aghion and Howitt (1992, 1998), Pakes and Ericson (1998) and Nelson and Winter’s (1982) evolutionary model (on the last see in particular Winter, 1986). Competence bloc theory in combination with Ballot and Taymaz (1998) has made it possible to avoid the less satisfactory approach of modeling the source of economic development as draws of productivity gains in a given lottery (from a stationary distribution) that represents the combined outcome of innovators, entrepreneurs and venture capitalists, a lottery that does not even charge you for your participation and that is presumably organized by the state. Our approach is still a crude approximation of what we aim for, focusing on the role of industrially competent venture capital provision (Ballot et al., 2006), but it is sufficient to overcome the logical but false linearity between innovation supply (through the lottery) and economic growth27 that shortcircuits the commercialization process in new growth literature.

5.

ALLOCATION AND ECONOMIC GROWTH

The Schumpeterian creative destruction process of Table 6.1 does not guarantee macroeconomic growth. Destruction may dominate over creation for considerable time and with permanent long-term consequences. Reorganization of firms (item 2) might very well be guided by caution and mistaken perceptions and result in a general contraction of output among firms. The main thing is that institutions are organized such that

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winners are created and identified in the competence bloc and carried on to industrial scale production and distribution, while losers are pushed out. In the Swedish micro-to-macro model (Eliasson, 1991a), choice algorithms determine the decisions of individual firms in this respect. Since the competence bloc not only creates, identifies and selects winners but also supports winners by directing (financial) resources to them, this also illustrates the role of the competence bloc, not only as a creator and an identifier of winners but also as an organizer of the allocation of tacit, human embodied knowledge, and as a financial resource provider. Since all actors in the competence bloc embody a rich variety of tacit competencies, the competence bloc becomes an allocator of its own competence. The competence bloc becomes the core resource allocator in an EOE. 5.1

Technological Diffusion

The diffusion of new technology as directed by the competence bloc occurs along six distinct channels (Table 6.4): (1) when people with competence move over the labor market, (2) through the entry of new firms when people with competence leave established firms, (3) through mutual learning between subcontractors and the systems coordinator, (4) when a firm strategically acquires other firms to integrate their particular knowledge with its own competence base, (5) when competitors imitate the products of successful and leading firms (the ‘Japanese approach’), and (6) through organic growth of and learning in incumbent firms. Items 3 and 4 are particularly important for the advanced mature industrial economies. Some of them, but not all of them, have the capacity to develop and produce very advanced and technologically complex systems products such as aircraft, submarines and large trucks. Such products embody so many different technologies that change rapidly and so many Table 6.4

New technology is diffused

1. 2.

when people with competence move (labor market) through new establishment by people who leave other firms (innovation and entrepreneurship) 3. when subcontractors learn from the systems coordinating firm, and vice versa (competent purchasing) 4. through strategic acquisitions of small R&D intensive firms (strategic acquisitions) 5. when competitors learn from technological leaders (imitation) 6. through organic growth and learning in incumbent firms Source:

G. Eliasson (1995).

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specialist components that it is impossible to develop and produce them within one company. Both development and manufacturing have to be distributed over subcontractors in the market (Eliasson, 2001b). All actors have to understand how to operate as a sophisticated participant in the ‘whole’. Hence, mutual learning within such a systems product complex is an important part of the technological diffusion process of the very advanced economies.28 One observation can be made from a close study of Table 6.4: efficient diffusion of new technology requires effective market support, notably in the labor market (item 1 in Table 6.4) but also in the venture capital market and the markets for mergers and acquisitions (M&A) (Eliasson and Eliasson, 2005). Completeness of the competence bloc again becomes a critical requirement for the introduction of radically new technology. Efficient diffusion is also a necessary condition for spillovers and competence bloc development, but it is not sufficient. For new technology to be introduced in production receiver competence (Eliasson, 1987b, 1990a) is needed. Entrepreneurial and venture capital competencies are part of this, but the general and rapid introduction of new technology also requires a varied and competent labor force at all levels (workers, engineers, managers and executive people). 5.2

The Informational Assumptions Revisited

The distinguishing features of the theory of the EOE hinge on its informational assumptions. Under the assumptions of the EOE, tacit knowledge or competence in the sense of limited communicability can be shown to exist (Eliasson, 1990a). The coordination of actors guided by tacit competencies can never be perfect. It is costly, the largest cost being not resources used directly in information processing but the ‘profits lost’ when business mistakes are being committed.29 It also involves the selection and coordination of tacit competencies for the same coordination, a task that unavoidably leads to an infinite regress and no determinate best or optimum outcome (read exogenous equilibrium). A competence bloc, hence, can also be defined as an organization of institutions and actors with (tacit) competence such that incentives and competition contribute to as efficient an allocation of total resources as is possible. This includes the allocation of the tacit competencies embodied in the actors. Hence, under the informational assumptions of the EOE, the best possible allocation cannot be determined. There will always be unknown better allocations. This conclusion only requires our assumption of an immense, non-transparent business opportunities space, an assumption30 that places us, and the EOE, in the early Austrian tradition of Carl

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Menger (1871), who emphasized the ignorance of actors and the frequent incidence of business mistakes (Alter, 1990). It may be considered presumptuous to modify the standard informational assumptions of mainstream economic theory such that the allpowerful mathematical tool of calculus appears to be rendered useless. But there are good reasons. First, it is easy to quote a massive empirical evidence in favor of the assumptions of the EOE. Second, attempts to penetrate the inner mechanics of new growth models, such as Pakes and Ericson (1998), that are based on a Walrasian, Arrow and Debreu (1954) type equilibrium platform tell a story that is not less complex than the story of the EOE or the mathematics of its model approximation, MOSES. A possible objection might, however, be (third) that, even though not correct, the informational assumptions of the neoclassical model work well as a reasonable approximation and generate good predictions in the spirit of Friedman (1953). Of what? It is difficult to find good examples. However, fourth, a reasonable argument for being methodologically conservative is that one might as well keep the familiar mathematical tool box until someone has come up with something better (Clower, 1986).31 Now, that has been done and it appears that the properties of the theory of the EOE that are obtained after some marginal modifications of the assumptions of the WAD model require simulation mathematics in order to be satisfactorily investigated. Removing the devotion to calculus in economics would therefore help make way for the powerful simulation tool and more relevant economic theory, a prediction voiced about fifty years ago by Koopmans (1957, p. 174).

NOTES 1.

2.

This chapter merges the theory of the experimentally organized economy (EOE) (Eliasson, 1991a) with that of competence blocs (Eliasson and Eliasson, 1996). The theory of the EOE has grown out of many years of experimenting with the Swedish micro-to-macro model (Eliasson, 1977, 1991a; Albrecht et al., 1992, Ballot and Taymaz 1998) to the extent that the model should now be seen – as will be explained in the text – as a quantitative approximation of the theory of the EOE. As such the text is very empirical and based as well on several hundred interviews carried out by one of us, or the two of us together, and on analyses of data assembled for the model (see Albrecht et al., 1992). To keep the theory of the EOE and its model approximation in the sustainable Austrian/Schumpeterian state that distinguishes it from the standard neoclassical model, certain assumptions relating to the nature of the state space of the model (its size, complexity and heterogeneity) have to be made. From the pig in the Viking sagas that was eaten for supper in Valhalla, only to return the next day to be eaten again, and so on. The difference from the situation in Valhalla, which we make a point of, is that the opportunities space not only stays large; it grows from being explored. We are confronted with a positive sum game. By being concerned

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3. 4. 5. 6.

7.

8.

9.

10.

11.

The theory of the firm from an organizational perspective not only with the neoclassical problem of how to manage a given endowment of scarce resources but also with the Aristotelian problem of how resources are created, we face the positive sum game of the EOE that endogenizes growth (Eliasson, 1987a, p. 28f, 1990b, p. 46f). During the year 2007, when the 300th year birthday of the Swedish botanist Linnaeus was celebrated, it felt appropriate to mention (Frankelius, 2007) that Linnaeus, in his until now not translated (from Latin), but frequently quoted, main work Systema Naturae Sive Regna Tria Naturae Systematice Proposita Per Classes, Ordines, Genera & Species (Leyden, 1735), considered economics to be the greatest of all sciences. And his concern was to create economic value through exploration of, and discoveries in, nature. The Nirvana complex has a long history. In his Candide (1759) Voltaire poked fun at Leibnitz’s vision of the best of all worlds. Leibnitz, by the way, laid the foundation of the mathematics used by neoclassical economists today. To the extent that they can be determined. Hence, starting from any place, as long as you walk uphill you will eventually reach the peak. There are hundreds of mathematical algorithms that approximate that task in economic modeling. This feature of the EOE has been investigated on a quantitative micro-based macro model of the EOE in which structures and prices are simultaneously determined in an interactive fashion, using up transactions resources in the process. In static equilibrium that can only be achieved under very restrictive assumptions, notably zero transactions costs, duality prevails and prices reflect exactly quantities, and vice versa. The further away from ‘static equilibrium’, the more unreliable prices are as signals of future optimum quantities and the more frequent and larger the mistakes. If you push the economy closer to an approximate equilibrium the entire model structure is destabilized and eventually collapses (Eliasson 1991a; Eliasson et al., 2005). The theory of the EOE is not structured as a mathematical model. The micro assumptions, therefore, can only be linked to macro through verbal reasoning. The Swedish micro(firm)-to-macro model (Eliasson, 1991a), on the other hand, is a mathematical model that can be said to approximate the EOE. Common to both, and the source of endogenous growth, is the dynamic of the Schumpeterian creative destruction process of Table 6.1. In fact, the theory of the EOE was inspired by experimenting with that model (Eliasson, 1987a). This reasoning can be nicely illustrated using a Salter (1960) curve; see Figures 6.2a and b in Section 4, and Eliasson (1991a, 1996, p. 44f). This is also the way growth occurs in the Swedish micro-to-macro model (Eliasson, 1991a), which is based on empirically determined Salter curves and firms constantly shifting position on the Salter curves as they are induced by incentives and pushed by competition. Competence bloc theory explains how this competitive process can be organized differently and more efficiently. It is particularly important to observe that innovative entry subjects incumbent firms to competition and forces them to respond. Their response in the form of reorganization and rationalization may mean either expansion or contraction, depending upon incentives embodied in the institutions of the economy and the individual competence capital of firms. Growth through competitive experimental selection through innovative entry is explicitly modeled in the micro-based macro Model Of the Swedish Economic System (MOSES) (Eliasson, 1977, 1985, 1991a) in which learning costs through business mistakes are explicit. The early, simple expectations functions have been complemented with genetic learning mechanisms in Ballot and Taymaz (1998). Which may be a relevant situation for continental Europe where such a large number of people are prematurely retired, on sick leave or outright unemployed, but much less in the US where growth to a larger extent occurs through the reallocation of employed people (G. Eliasson, 2006a, b). This is the case in the Swedish micro-to-macro model (Eliasson, 1977, 1991a) which approximates the EOE. Whatever output trajectory over the long run that you simulate, you can be fairly sure that better outcomes exist.

Competence and learning in the experimentally organized economy 12. 13.

14. 15. 16. 17. 18.

19.

20.

21.

22. 23. 24.

25.

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Most definitions of tacit knowledge are much broader than this. For our purpose, however, this narrow definition is sufficient. A broader definition will only strengthen the empirical implications of our analysis. Note that this is the exact opposite conclusion to the standard view of the Walras– Arrow–Debreu model, in which the Walrasian superauctioneer is assumed to be capable of achieving a complete and costless central overview of the entire economic landscape, and to identify the one superior position of the economy that is there by assumption for instance as modeled by Malinvaud (1967). This constitutes a second information paradox of economics referred to earlier, namely that we are becoming less and less informed about what is becoming more and more important, namely the quality of inputs and outputs (Eliasson, 1990b, p. 16). As pointed out already by Burenstam-Linder (1961). Burenstam-Linder, however, carried out his argument in terms of static international trade theory and called it comparative advantage. On this Granstrand and Sjölander (1990a, b) observe that a broad internal technology base makes the firm more efficient in acquiring and implementing new complementary knowledge, for instance through the acquisition of innovative technology firms. This was a property of the Swedish micro-to-macro model as early as Eliasson (1979, 1981) when the property was ‘discovered’ as part of a crudely modeled commercialization process. This distinction between the innovator and the entrepreneur originated in Mises (1949). Schumpeter was not clear on this and often used the term innovator to signify what we mean by an entrepreneur. With our definition we do not need the third concept, the inventor, which Schumpeter frequently used to emphasize the technical dimensions of an innovation. Stationarity means that distributions have constant (over time) mean and variation. A stationary process will keep generating data such that the parameters of the statistically defined entrepreneur will eventually be known for sure with any precision desired. Besides being an absurd representation of ‘the entrepreneur’, it has been demonstrated that such statistical learning requires a hopelessly narrow specification of the state space, expressed as a stationary process, to allow any learning at all (Lindh, 1993). In a huge Las Vegas gaming hall à la Rothschild (1974) the analogy would be each actor rushing around between the one-armed bandits using his or her personal criteria to change console. Even though each bandit is governed by a particular stationary process for ever, the activity going on in the entire gaming hall (the ‘market’) cannot be approximated by a stationary process that does not change over time. Which are identical to those of rational expectations and efficient market theory. Antonov and Trofinov (1993) demonstrate how simple statistical learning through forecasting a non-linear environment with linear economic prediction models of a standard Keynesian or neoclassical type produces worse macroeconomic outcomes than the use of completely ad hoc individual experience-based relationships. The venture capitalists also contribute managerial, financing and marketing competence through their network, but this comes after the ‘understanding’. Such services are normally available in the market and, consequently, are less critical. Knight (1921) would say that the entrepreneur converted an uncertain situation into a situation of calculable risks. See also LeRoy and Singell (1987) and Eliasson (1990a). Even though the economic value of the loss of winners is indeterminate in the theory of the EOE. This is no problem in the neoclassical model in which business mistakes and loss of winners do not exist by assumption, with the possible exception of random losses in stochastic equilibrium models which are outright irrelevant in an industrial economics analysis. An anonymous referee pointed out that this problem of ‘seemingly endless reorganization’ and unpredictable market behavior has already been discussed by Ilinitch et al. (1996). It would, however, mean a new chapter to address also the problem of

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26.

27.

28. 29. 30.

31.

The theory of the firm from an organizational perspective ‘hypercompetition’ here. True, however, and in keeping with my argument, standard neoclassical theory has little to say on this. This is a more narrow definition of social capital than the broad, empirically difficult categories of Coleman (1988), Putnam (2000), Ritzen (2001) and Woolcock (2001). We are, in fact, much closer in definition to the abilities to cope that Wolfe and Haveman (2001) relate to educational capital. Which by accident has its origin in Schumpeter (1942). Schumpeter was a great admirer of Walras. He sometimes ‘pedagogically’ began his argument by making the innovator an exogenous disturber of the Walrasian equilibrium. By postulating that once successful the routine R&D/innovation department of a firm would then for ever make that firm the dominant player in its market, Schumpeter invoked the perennial problem of economies of scale in the Walrasian model. This corner solution troubled Marshall. He invented the concept of an ‘industrial district’ where the scale economies originated in the district as a whole rather than with individual firms. Romer (1986, 1990) formulated this mathematically in macro under the title of ‘new growth theory’, however without quoting Marshall. It is also obvious that as long as the distributed production system remains within the borders of a nation it offers a protective shield against foreign ‘competitive imitation’ (under item 5). In fact, accounting for the implicit cost of ‘lost profits’ is what distinguishes our model from the standard neoclassical model. For an interesting early discussion of this see Dahlman (1979). Note that Arrow and Debreu (1954), pioneering modern mathematical economics, carefully crafted their assumptions to avoid this result. There is no mention of Austrian economics and Hayek (1937, 1940, 1945), which, though by far the most penetrating treaties on information economics at the time, are not even quoted. In the discussion of Herbert Simon’s presentation at the conference on ‘The Dynamics of Market Economies’, organized by the IUI, 1983 (see Day and Eliasson, 1986, pp. 42ff).

BIBLIOGRAPHY Aghion, Philippe and Peter Howitt (1992), ‘A Model of Growth through Schumpeterian Creative Destruction’, Econometrica, 60 (2) (March), 323–51. Aghion, Philippe and Peter Howitt (1998), Endogenous Growth Theory. Cambridge, MA and London: The MIT Press. Albrecht, James W., Pontus Braunerhjelm, Gunnar Eliasson, Jörgen Nijlsson, Tomas Nordström and Erol Taymaz (1992), MOSES Database, Research Report No. 40, Stockholm: IUI. Alter, Max (1990), Carl Menger and the Origins of Austrian Economics, San Francisco and Oxford: Westview Press. Andersson, Thomas, Pontus Braunerhjelm, Bo Carlsson, Gunnar Eliasson, Stefan Fölster, Lars Jagrén, Eugenia Kazamaki Ottersten and Kent Rune Sjöholm (1993), Den långa vägen – Om den ekonomiska politikens begränsningar och möjligheter att föra Sverige ur 1990-talets kris, Stockholm: IUI. Antonov, M. and G. Trofinov (1993), ‘Learning through Short-Run Macroeconomic Forecasts in a Micro-to-Macro Model’, Journal of Economic Behavior and Organization, 21 (2), June. Arrow, Kenneth J. (1959), ‘Toward a Theory of Price Adjustment’, in M. Abramovitz et al., (eds), The Allocation of Economic Resources, Stanford, CA: Stanford University Press.

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Arrow, Kenneth J. and Gerard Debreu (1954), ‘Existence of Equilibrium for a Competitive Economy’, Econometrica, 22 (3) (July), 265–90. Ballot, Gérard and Erol Taymaz (1998), ‘Human Capital, Technological Lock-in and Evolutionary Dynamics’, in G. Eliasson and C. Green (eds), The Microeconomic Foundations of Economic Growth, Ann Arbor: The University of Michigan Press, Stockholm: City University Press. Ballot, Gerard, Gunnar Eliasson and Erol Taymaz (2006), ‘The Role of Commercialization Competence in Endogenous Economic Growth’, paper presented to the International J.A. Schumpeter Society 11th ISS Conference, Nice-Sophia Antipolis, 21–24 June. Benhabib, Jess and Richard H. Day (1981), ‘Erratic Accumulation’, Economics Letters 6:113–17. Bergholm, F. and L. Jagrén (1985), ‘Det utlandsinvesterande företaget – en empirisk studie’, in G. Eliasson, F. Bergholm, E.C. Horwitz and L. Jagrén, De Svenska Storföretagen – en studie av internationaliseringens konsekvenser för den svenska ekonomin, Stockholm: IUI. Blanchflower, David G. (2004), ‘Self-employment: More may not be Better’, Swedish Economic Policy Review, 11 (2) (Fall):15–94. Braunerhjelm, Pontus (1993), ‘Nyetablering och Småföretagande i Svensk Industri’, in Andersson et al. (1993), Chapter 4. Braunerhjelm, Pontus (ed.) (2001), Huvudkontoren flyttar ut, Stockholm: SNS förlag. Buigues, Pierre, and Alexi Jacquemin and Jean-Francois Marchipont (2000), Competitiveness and the Value of Intangible Assets, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Burenstam-Linder, S. (1961), An Essay on Trade and Transformation, Uppsala: Almqvist & Wiksell. Carlsson, Bo (ed.) (1989), Industrial Dynamics – Technological Organizational, and Structural Changes in Industries and Firms, Boston/Dordrecht/London: Kluwer Academic Publishers. Carlsson, Bo (ed.) (1995), Technological Systems and Economic Performance: The Case of Factory Automation, Boston/Dordrecht/London: Kluwer Academic Publishers. Carlsson, Bo (ed.) (1997), Technological Systems; Cases, Analyses, Comparisons, Boston/Dordrecht/London: Kluwer Academic Publishers. Clower, Robert W. (1986), ‘Discussion’, in Day, Richard H. and G. Eliasson (eds), The Dynamics of Market Economies, Stockholm: IUI, and Amsterdam: NorthHolland, pp. 42ff. Coase, R.H. (1937), ‘The Nature of the Firm’, Economica, New Series, IV (13–16) (Nov.), 386–405. Coleman, J.S. (1988), ‘Social Capital in the Creation of Human Capital’, American Journal of Sociology, 94, Suppl., S95–S120. Dahlman, C.J. (1979), ‘The Problem of Externality’, Journal of Law & Economics, 22 (1), 141–62. Dahmén, E. (1950), Svensk industriell företagarverksamhet (Entepreneurial Activity in Swedish Industry, 1919–39), Band 1 and 2, Stockholm: IUI. Also published in 1970 by the American Economic Association Translation Series under the title Entrepreneurial Activity and the Development of Swedish Industry, 1919–1939. Day, Richard H. (1986a), ‘Disequilibrium Economic Dynamics: A

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Post- Schumpeterian Contribution’, in R.H. Day and G. Eliasson (eds) (1986). Day, Richard H. (1986b), ‘On Endogenous Preferences and Adaptive Economizing’, in R.H. Day and G. Eliasson (eds) (1986). Day, Richard H. (1993), ‘Bounded Rationality and the Coevolution of Market and State’, in Day, Eliasson and Wihlborg (eds) (1993). Day, Richard H. and Gunnar Eliasson (eds) (1986), The Dynamics of Market Economies, Stockholm: IUI; Amsterdam: North-Holland. Day, Richard H., Gunnar Eliasson and Clas Wihlborg (eds) (1993), The Markets for Innovation, Ownership and Control, Stockholm: IUI; Amsterdam: NorthHolland. Day, Richard H., S. Morley and K.R. Smith (1974), ‘Myopic Optimizing and Rules of Thumb in a Micro-Model of Industrial Growth’, American Economic Review (March). Demsetz, H. (1969), ‘Information and Efficiency: Another Viewpoint’, Journal of Law and Economics, 12 (April), 1–22. Eliasson, Åsa (2007), ‘The Markets for Bioterror and Biodisaster Protection’, preliminary manuscript for the study, ‘The Markets for Security Products and Disaster Preparedness’, Stockholm: Swedish Academy of Engineering Sciences (IVA). Eliasson, Gunnar (1976), Business Economic Planning – Theory, Practice and Comparison, London, New York etc.: Wiley & Sons. Eliasson, Gunnar (1977), ‘Competition and Market Processes in a Simulation Model of the Swedish Economy’, American Economic Review, 67 (1), 277–81. Eliasson, Gunnar (1983), ‘On the Optimal Rate of Structural Adjustment’, in G. Eliasson, M. Sharefkin and B.-C. Ysander (eds) (1983), Policy Making in a Disorderly World Economy, Stockholm: IUI. Eliasson, Gunnar (1984), ‘Micro Heterogeneity of Firms and Stability of Growth’, Journal of Behavior and Economic Organization, 5 (3–4), (Sept.–Dec.), 249–98 (also in R.H. Day and G. Eliasson (eds), 1986). Eliasson, Gunnar (1985), The Firm and Financial Markets in the Swedish Micro-toMacro Model – Theory, Model and Verification, Stockholm: IUI. Eliasson, Gunnar (1987a), Technological Competition and Trade in the Experimentally Organized Economy, Research Report No. 32, Stockholm: IUI. Eliasson, Gunnar (1987b), ‘The Knowledge Base of an Industrial Economy’, in Eliasson and Ryan, The Human Factor in Economic and Technological Change, OECD Educational Monograph Series No. 3. Eliasson, Gunnar (1990a), ‘The Firm as a Competent Team’, Journal of Economic Behavior and Organization, 13 (3), 275–98. Eliasson, Gunnar (1990b), ‘The Knowledge-Based Information Economy’, in G. Eliasson et al. (1990), The Knowledge Based Information Economy, Stockholm: IUI, Chapter 1. Eliasson, Gunnar (1991a), ‘Modeling the Experimentally Organized Economy’, Journal of Economic Behavior and Organization, 16 (1–2), 153–82. Eliasson, Gunnar (1991b), ‘The International Firm: A Vehicle for Overcoming Barriers to Trade and a Global Intelligence Organization Diffusing the Notion of a Nation’, in L.-G. Mattson and B. Stymne (eds) (1991). Eliasson, Gunnar (1991c), ‘Financial Institutions in a European Market for Executive Competence’, in C. Wihlborg, M. Fratianni and T.D. Willett (eds) (1992). Eliasson, Gunnar (1992), ‘Business Competence, Organizational Learning, and Economic Growth: Establishing the Smith–Schumpeter–Wicksell (SSW)

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Connection’, in F.M. Scherer and M. Perlman (eds), Entrepreneurship, Technological Innovation, and Economic Growth. Studies in the Schumpeterian Tradition, Ann Arbor: The University of Michigan Press. Eliasson, Gunnar (1995), En teknologigenerator eller ett nationellt prestigeprojekt? – Exemplet svensk flygindustri (A technology generator or a national prestige project? – The Swedish aircraft industry), Stockholm: City University Press. Eliasson, Gunnar (1996), Firm Objectives, Controls and Organization – the Use of Information and the Transfer of Knowledge within the Firm, Boston/Dordrecht/ London: Kluwer Academic Publishers. Eliasson, Gunnar (1997a), ‘General Purpose Technologies, Industrial Competence Blocs and Economic Growth’, in B. Carlsson (ed.) (1997). Eliasson, Gunnar (1997b), ‘The Venture Capitalist as a Competent Outsider’, mimeo, INDEK, KTH, IEO R: 1997-06, Stockholm. Eliasson, Gunnar (1998a), ‘Competence Blocs and Industrial Policy in the Knowledge Based Economy’, OECD Science, Technology, Industrial (STI) Revue. Eliasson, Gunnar (2000), ‘Industrial Policy, Competence Blocs and the Role of Science in the Economic Development’, Journal of Evolutionary Economics, 10, 217–41. Eliasson, Gunnar (2001a), ‘The Role of Knowledge in Economic Growth’, in Helliwell, John (ed.) (2001). Eliasson, Gunnar (2001b), Advanced Purchasing, Spillovers, Innovative Pricing and Serendipitous Discovery, paper presented at the E.A.R.I.E. 2001 Conference in Dublin 30 Aug.–Sept. Eliasson, Gunnar (ed.), (2005a), The Birth, the Life and the Death of Firms – the Role of Entrepreneurship, Creative Destruction and Conservative Institutions in a Growing and Experimentally Organized Economy, Stockholm: The Ratio Institute. Eliasson, Gunnar (2005b), ‘The Nature of Economic Change and Management in a New Knowledge Based Information Economy’, Information Economics and Policy, 17, 428–56. Eliasson, Gunnar (2005c), ‘The Venture Capitalist as a Competent Outsider’, in G. Eliasson (2005a) Chapter 4. Eliasson, Gunnar (2005d), ‘Insourcing of Production from Foreign Subsidiaries or Subcontractors – an Empirical Study of Swedish Firms’, paper prepared for Invest in Sweden Agency (ISA), Stockholm; can be downloaded at www.isa.se/ kostnadellerkompetens. Eliasson, Gunnar (2006a), ‘From Employment to Entrepreneurship’, Journal of Industrial Relations, 48 (5), 633–56. Eliasson, Gunnar (2006b), ‘Policies for a New Entrepreneurial Economy’, paper presented to the International J.A. Schumpeter Society 11th ISS Conference, Nice-Sophia Antipolis, 21–24 June. Eliasson, Gunnar and Åsa Eliasson (1996), ‘The Biotechnological Competence Bloc’, Revue d’Economie Industrielle, 78 (4), 7–26. Eliasson, Gunnar and Åsa Eliasson (2005), ‘The Theory of the Firm and the Markets for Strategic Acquisitions’, in Cantner, U., Dinopoulos, E. and Lanzilotti, R.F. (eds), Entrepreneurship: The New Economy and Public Policy, Berlin, Heidelberg and New York: Springer. Eliasson, Gunnar and Åsa Eliasson (2007), ‘Competence in Health Care’, KTH, Stockholm, mimeo. Eliasson, Gunnar and Erol Taymaz (2000), ‘Institutions, Entrepreneurship, Economic Flexibility and Growth – Experiments on an Evolutionary Model’,

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in U. Cantner, H. Hanush and S. Klepper (eds) (2000), Economic Evolution, Learning and Complexity – Econometric, Experimental and Simulation Approaches, Heidelberg: Physica–Verlag. Eliasson, Gunnar and Clas Wihlborg (2003), ‘On the Macroeconomic Effects of Establishing Tradability in Weak Property Rights’, Journal of Evolutionary Economics, 13, 607–32. Eliasson, Gunnar, Fredrik Bergholm, Eva Christina Horwitz and Lars Jagrén (1985), De svenska storföretagen – en studie av internationaliseringens konsekvenser för den svenska ekonomin (The Giant Swedish Groups – a Study of the Consequences of Internationalization for the Swedish Economy), Stockholm: IUI. Eliasson, Gunnar, Dan Johansson and Erol Taymaz (2005), ‘Firm Turnover and the Rate of Growth’, in Eliasson (2005a), Chapter 6. Fama, E.F. (1980), ‘Agency Problems and the Theory of the Firm’, Journal of Political Economy, 88 (2) (April), 288–307. Frankelius, Per (2007), Linne i Nytt Ljus: Den första översättningen av Systema naturae samt ny analys av Linnes perspektiv (with a translation from Latin by Bertil Alden), Malmö: Liber. Friedman, M. (1953), ‘The Methodology of Positive Economics’, in M. Friedman (ed.), Essays in Positive Economics, Chicago, IL: The University of Chicago Press. Georgescu-Roegen, Nicholas (1950), ‘The Theory of Choice and the Constancy of Economic Laws’, The Quarterly Journal of Economics, 44, 125–38. Granstrand, Ove and S. Sjölander (1990a), ‘Managing Innovation in MultiTechnology Corporations’, Research Policy, 19 (1) (Feb.), 36–60. Granstrand, Ove and S. Sjölander (1990b), ‘The Acquisition of Technology and Small Firms by Large Firms’, Journal of Economic Behavior and Organization, 13 (3), 367–86. Hanson, K.A. (1986), ‘On New Firm Entry and Macro Stability’, in The Economics of Institutions and Markets, IUI Yearbook 1986–1987, Stockholm: Industriens Utredningsinstitut (IUI). Hanson, K.A. (1989), ‘Firm Entry’, in J.W. Albrecht et al., MOSES Code, Stockholm: Industriens Utredningsinstitut (IUI). Hayek, Friedrich A. von (1937), ‘Economics and Knowledge’, Economica, 4, 33–54. Hayek, Friedrich A. von (1940), ‘Socialist Calculation’, Economica, 7 (26), 125–49. Hayek, Friedrich A. von (1945), ‘The Use of Knowledge in Society’, American Economic Review, 35 (4) (Sept.), 519–31. Helliwell, John (ed.) (2001), The Contribution of Human and Social Capital to Sustained Economic Growth and Well-being, HRDC, Canada. Ilinitch, Anne, Richard D’Áveni and Arie Lewin (1996), ‘New Organizational Forms and Strategies for Managing in Hypercompetitive Environments’, Organization Science, 7 (3), Special Issue 4, Part 1 of 2: Hypercompetition (May–June), 211–20. Johansson, Dan (2001), ‘The Dynamics of Firm and Industry Growth – the Swedish Computing and Communications Industry’, Doctoral thesis, Department of the Organization and Management, KTH, Stockholm. Kirzner, Israel M. (1997), ‘Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach’, Journal of Economic Literature, 35 (1), 60–85. Knight, F. (1921), Risk, Uncertainty and Profit, Boston: Houghton-Mifflin.

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Koopmans, Tjalling C. (1957), Three Essays on the State of Economic Science, New York: McGraw Hill Book Company Inc. LeRoy, S.F. and L.D. Singell, Jr (1987), ‘Knight on Risk and Uncertainty’, Journal of Political Economy, 95 (2) (April), 394–406. Lindh, T. (1993), ‘Lessons from Learning to have Rational Expectations’, in R.H. Day, G. Eliasson, C.G. Wihlborg (eds), The Markets for Innovation, Ownership and Control, Stockholm: IUI; Amsterdam, London, New York, Tokyo: NorthHolland. Malinvaud, E. (1967), ‘Decentralized Procedures in Planning’, in E. Malinvaud and M.O.L. Bacharach (eds) (1967). Malinvaud, E. and M.O.L. Bacharach (eds) (1967), Activity Analysis in the Theory of Growth and Planning, London: Macmillan. Marshall, Alfred (1890), Principles of Economics. London: Macmillan. Marshall, Alfred (1919), Industry and Trade, London: Macmillan. Mattson, L.-G. and B. Stymne (eds) (1991), Corporate and Industry Strategies for Europe, Amsterdam: North-Holland. Menger, Carl (1871), Grundsätze der Volkswirtschaftslehre, Vienna: Wilhelm Braumüller. Mises, Ludwig von (1949), Human Action, Chicago: Contemporary Books. MOSES Database (1992), see Albrecht et al. (1992). Nelson, R.R. and Winter, S.G. (1982), An Evolutionary Theory of Economic Change, Cambridge, MA: Harvard University Press. Nyström, Kristina (2006), Entry and Exit in Swedish Industrial Sectors, Jönköping: Jönköping International Business School Dissertation Series No. 032. OECD (1996), The Knowledge Based Economy, Paris. Pakes, Ariel and Richard Ericson (1998), ‘Empirical Implications of Alternative Models of Firm Dynamics’, Journal of Economic Theory, 79 (1), 1–45. Pousette, Tomas and Thomas Lindberg (1986), ‘Tjänster i Produktionen och Produktionen av Tjänster’, in Eliasson, Gunnar, Bo Carlsson, Enrico Deiaco, Thomas Lindberg and Tomas Pousette, Kunskap, Information och Tjänster – en studie av svenska industriföretag, Stockholm: IUI Putnam, R. (2000), Bowling Alone: The Collapse and Revival of American Community, New York: Simon & Schuster. Ritzen, Jozef M. (2001), ‘Social Cohesion, Public Policy, and Economic Growth: Implications for OECD Countries’, in Helliwell (2001). Romer, P.M. (1986), ‘Increasing Returns and Long-Run Growth’, Journal of Political Economy, 94 (5) (Oct.), 1002–37. Romer, P.M. (1990), ‘Endogenous Technological Change’, Journal of Political Economy, 98, (5) pt. 2, S71–102. Rothschild, M. (1974), ‘A Two-Armed Bandit Theory of Market Pricing’, Journal of Economic Theory, 9 (2) (Oct.), 185–202. Rybsczynski, T.M. (1993), ‘Innovative Activity and Venture Financing: Access to Markets and Opportunities in Japan, the US and Europe’, in Day, Richard H., G. Eliasson and C. Wihlborg (eds) (1993), The Markets for Innovation, Ownership and Control, Stockholm: IUI, and Amsterdam: North-Holland. Salter, W.E.G. (1960), Productivity and Technical Change, Cambridge, MA: Cambridge University Press. Schumpeter, Joseph (1911) (English edition 1934), The Theory of Economic Development, Harvard Economic Studies, Vol. XLVI, Cambridge, MA: Harvard University Press.

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Schumpeter, Joseph (1942), Capitalism, Socialism and Democracy, New York: Harper & Row. Simon, Herbert A. (1945), Administrative Behavior, New York: Macmillan. Simon, Herbert A. (1955), ‘A Behavioral Model of Rational Choice’ Quarterly Journal of Economics, 69, 99–118. Smith, Adam (1776), An Inquiry into the Nature and Causes of the Wealthy of Nations, reprinted New York: Modern Library, 1937. Taymaz, Erol (1991), MOSES on PC: Manual, initialization, and calibration, Stockholm: IUI. Wallis, John and Douglass North (1986), ‘Measuring the Transaction Sector in the American Economy’, in Engerman, Stanley and Gallman (eds), Long Term Factors in American Economic Growth, Chicago: The University of Chicago Press. Walras, L. (1874), Elements d’économie politique pure. English translation of 1926 edition: Elements of Pure Economics, or the Theory of Social Wealth, London: Allen and Unwin, 1954. Wicksell, Knut (1923), ‘Realkapital och kapitalränta’, Ekononmisk Tidskrift, Häfte 5–6, 145–80. Wihlborg, C., M. Fratianni and T.D. Willett (eds) (1992), Financial Regulation and Monetary Arrangements after 1992, Amsterdam: Elsevier Science Publishers B.V. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications: A Study in the Economics of Internal Organization, New York: Free Press. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York/ London: The Free Press. Winter, S.G. (1986), ‘Schumpeterian Competition in Alternative Technological Regimes’, in Day, Richard H. and G. Eliasson (eds), The Dynamics of Market Economies, Stockholm: IUI, and Amsterdam: North-Holland, Chapter 8. Wolfe, Barbara and Robert Haveman (2001), ‘Accounting for the Social and NonMarket Benefits of Education’, in Helliwell (2001). Woolcock, Michael (2001), ‘The Place of Social Capital in Understanding Social and Economic Outcomes’, in Helliwell (2001).

PART III

Investments and the legal environment

7.

Corporate governance and investments in Scandinavia – ownership concentration and dual-class equity structure* Johan E. Eklund

1.

INTRODUCTION

In essence, the corporate governance system in a country is the institutional framework that supports the suppliers of finance to corporations and enables firms to raise substantial amounts of capital (Shleifer and Vishny, 1997).1 By protecting suppliers of capital and safeguarding property, sound governance systems facilitate mobilization and allocation of capital to useful investments. Corporate governance systems are of outmost importance for the allocation of capital to its highest value use. It can be argued that the corporate governance system in a country determines the speed of structural change and economic development by affecting allocation and reallocation of capital. Therefore the crucial question is whether the corporate governance system induces managers of corporations to make good value enhancing investments decisions, or not. In particular, the ownership concentration and composition appear to matter for firm performance, as shown by Morck et al. (1988).2 This chapter looks at corporate governance and the rate of return on corporate investments in Scandinavia. The structure of ownership and its effects on performance are examined. Taking an outsider’s view of Scandinavia, the corporate governance systems in the Scandinavian countries, Sweden, Finland, Norway and Denmark, arguably display more similarities than differences. The countries share a number of important features that unify them in comparison with other countries. It has, for example, been hypothesized that the common origin of the legal systems in Scandinavia is still reflected in the quality of corporate governance (La Porta et al., 1997). Furthermore, Scandinavian firms are typically controlled by a dominant owner and only a small minority of firms are characterized by dispersed ownership structure. Finally, the Scandinavian countries can also be said to have a common political orientation, with strong 139

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social democratic traditions (for example, Högfeldt, 2004), which, according to Roe (2003), matters for corporate governance. Such apparent homogeneity of the Scandinavian countries in combination with the importance of well functioning corporate governance systems motivates a comparison of corporate returns and ownership structure in Scandinavia. The purposes of this chapter are therefore the following. First, the returns on investments made by the largest firms in Scandinavia are assessed. Second, the effect of ownership structure on investment decisions is examined as a factor explaining variation in performance and in returns on investments. Finally, and perhaps most importantly, the chapter analyses how deviations from the one-share-one-vote principle affect this ownership– performance relationship. Outright expropriation of corporate assets and investor funds by managers is likely to be small in developed economies, such as the Scandinavian ones. Over-investment in pursuit of ends other than profit maximization and misallocation of assets is more likely to be a problem. The chapter is organized in six sections. Relevant literature on investments, corporate governance and ownership is reviewed in Section 2. In Section 3 the method is derived and the data are described. In Section 4, the return on corporate investments in Scandinavia is assessed. The fifth section examines how ownership and the extensive use of dual-class shares affect investment decisions. Section 6 provides the conclusions.

2.

CORPORATE CONTROL AND INVESTMENT

Neoclassical investment theory suggests that investments are expanded up to the point where the expected marginal rate of return equals the opportunity cost of capital. This condition would be satisfied in a friction-free world without any informational asymmetries, agency problems or transaction costs. Capital would flow automatically to the most efficient use and thereby guarantee that welfare is maximized. However, in the modern corporation, with its separation of owners and financiers from the management, there arises a set of agency problems that can cause investment decisions to deviate from what is predicted in neoclassical models (see Mueller (2003) for a review of investment theories). Berle and Means (1932) were the first to call attention to the potential agency costs.3 They argued that corporate ownership in large listed firms would become dispersed up to a point where professional managers would become unaccountable to the shareholders. Later, Jensen and Meckling (1976) provide a more theoretical underpinning to the linkages between agency costs and ownership structure. Jensen and Meckling analyse how the interests of utility maximizing owner-managers and minority shareholders

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diverge as ownership structure becomes more dispersed. Their basic argument is that the owner-manager will not bear the full cost of on-the-job consumption.4 Potential minority investors will realize this and subsequently the share price will reflect the divergence of interests between owner-managers and minority shareholders. Arguably the conflict of interests becomes more severe as the equity stake of owner-managers decreases. Jensen and Meckling (1976) argue that investors with high stakes will also have incentives to maximize firm value. This is referred to as the incentive effect. Hypothesis 1 is therefore: H1

Ownership concentration will improve investment performance.

In this view, agency costs increase as ownership is diluted and becomes dispersed. However, not all have seen the separation of ownership and control as a potential problem, where the counter-hypothesis is that control and ownership separation may improve allocation. Thorstein Veblen (1921), for example, argues that this separation would lead to the control being turned over from ‘monopoly’-seeking owners/businessmen to growth and efficiency-seeking management. Veblen claims for example that if industry were completely organized as a systemic whole, and were then managed by competent technicians with an eye single to maximum production of goods and services; instead of, as now, being manhandled by ignorant business men with an eye single to maximum profits; the resulting output of goods and services would doubtless exceed the current output by several hundred per cent. (Veblen, 1921)

Recognizing that owner-managers are also guided by utility maximization and not pure profit maximization, Demsetz (1983) argues that it is not clear that diffusion of ownership will automatically have a detrimental effect. In fact, it has been argued that as the stake of owner-managers increases, so does their ability to misallocate resources (Stulz, 1988). This effect is referred to as the entrenchment effect (see Morck et al., 1988, and Stulz, 1988). Morck et al. (1988) find a non-monotonic relationship between ownership and Tobin’s q. They find that performance initially increases with ownership concentration, then declines and finally increases again, which is consistent with an entrenchment effect. McConnell and Servaes (1990) find similar results.5 Expecting a managerial entrenchment effect leads to the second hypothesis: H2 Ownership concentration will have a non-linear effect on performance. The generality of the Berle and Means (1932) observation is, however, empirically challenged. Looking at ownership structure around the world,

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most corporations have concentrated ownership and are controlled by families (Morck et al., 2005; La Porta et al., 1999). Faccio and Lang (2002) study the ownership in Europe and find that corporations are predominantly controlled by families in continental Europe. This control is achieved without corresponding capital by means of primarily three different control enhancing mechanisms (CEM): vote-differentiation of shares, pyramid ownership and cross-holdings. This means that the division between what Berle and Means (1932) call ‘nominal ownership’ and the corporate control is further enhanced by separating the capital stake and the voting power, making it possible for a small group of investors, often the founding family, to maintain control of the firm. Burkart and Lee (2008) review the theoretical literature on oneshare-one-vote arguing that there are both positive and negative effects associated with dual-class shares. Adams and Ferreira (2008) review the empirical literature and find the empirical evidence inconclusive.6 Bebchuk et al. (1999), on the other hand, argue that these control mechanisms distort the incentives of the controlling owners and therefore potentially may cause a sharp increase in agency costs. When the incentives are distorted, this may potentially have a negative impact on the optimal choice of investments, scope of the firm and transferral of control. Separation of control rights and cash-flow rights not only alters the control structure of the corporation but also changes the incentives of owner-managers. An effect one can expect from the separation of cash-flow and control rights is that the positive incentive effect will be weakened whereas the entrenchment effect will be enhanced. From this, hypothesis 3 follows: H3 Control mechanisms such as dual-class equity structure will weaken the incentive and enhance the entrenchment effect. Using a market-to-book measure of Tobin’s q, Claessens et al. (2002) find evidence that is consistent with this hypothesis. They examine a large number of firms in East Asia and find that cash-flow rights are positively correlated with performance. However, control rights in excess of cashflow rights have a negative effect on firm value. A large number of studies also establish a link between ownership structure and concentration on the one hand and performance on the other. Countries with weaker investor protection tend to have a more concentrated ownership structure (see for example La Porta et al., 1997). In fact, the two most common ways of dealing with the agency aspects of corporate governance are, according to Shleifer and Vishny (1997), first, legal and regulatory protection of investor and minority rights, and second, large and concentrated owners.

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2.1

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Corporate Governance in Scandinavia

The corporate governance systems in Scandinavia have some unique features that change the prediction of the Jensen and Meckling model. Like most firms in continental Europe, the Scandinavian firms very often have controlling owners that have maintained their control even when their capital stake has declined and the firms have grown. Most European countries allow at least one of the three principal instruments for enhancing ownership control: cross-holdings, pyramid ownership and vote-differentiation (Söderström et al., 2003). In particular, the extensive use of vote-differentiated shares has had a substantial impact on the way in which the ownership structure has evolved in Scandinavia. In Norway about 14 percent of listed firms use dual-class shares, in Denmark and Finland more than 30 percent, and in Sweden it is as high as 55 percent (Bøhren and Ødegaard, 2006; Söderström et al., 2003). Many countries in Europe do not allow for dual-class share systems, so this is one of the prominent distinguishing features of the corporate governance systems in Scandinavia. The frequent use of dual-class shares, with strong separation of voting rights and equity claims, has produced very strong and stable ownership structures in Scandinavia (Högfeldt, 2004; Henrekson and Jakobsson, 2006). By using vote-differentiation, the founding families may retain control of firms even with a very small equity share. Most firms in Scandinavia have a single controlling owner and very few firms are characterized by dispersed ownership. Bennedsen and Nielsen (2005) report significant differences in the frequency of control mechanisms for a sample of 4096 European firms (see Table 7.1). Cronqvist and Nilsson (2003) examine a large sample of Swedish listed firms and find that controlling owners have a negative effect on Tobin’s average q. These controlling owners are also more likely to use control mechanisms. Maury and Pajuste (2004) examine a sample of Finnish firms and show that a more uniform distribution of votes among large block holders is positive for firm valuation. They also find that divergence between cash-flow rights and control rights have a negative effect on firm value. An additional consequence of the strong separation of ownership claims and control is that the so-called market for corporate control (Manne, 1965) virtually does not exist in Scandinavia. Successful hostile bids are therefore very rare. Supposed advantages of strong and stable owners provide the underpinning argument for the Scandinavian legislation that allows for votedifferentiation of share and pyramid ownership. In this chapter, ownership concentration is measured as the share of capital and votes controlled by the largest owner (CR1 & VR1) and the five largest owners (CR5 & VR5). About 40 percent of the firms in the aggregate Scandinavian sample

144

Investments and the legal environment

Table 7.1

Corporate control mechanisms in European countries Dual-class shares

Sweden Switzerland Finland Italy Denmark UK Ireland Austria Germany Norway France Belgium Portugal Spain European average Scandinavian average

0.62 0.52 0.44 0.43 0.29 0.25 0.25 0.23 0.19 0.11 0.03 0.00 0.00 0.00 0.24 0.37

Pyramid structures Cross-holdings 0.27 0.06 0.07 0.25 0.17 0.22 0.18 0.26 0.24 0.33 0.15 0.27 0.13 0.16 0.20 0.21

0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.01 0.03 0.02 0.00 0.00 0.00 0.00 0.01 0.01

Note: The figures represent the percentage of firms that use dual-class shares, pyramid structures and cross-holdings, respectively. Source:

Bennedsen and Nielsen (2005).

separate control and cash-flow rights; see Table 7.2. The ownership data have been collected from the annual reports for each firm. Ownership concentration is very high in Scandinavian listed firms, especially compared with those in the Anglo-Saxon countries. Demsetz and Lehn (1985) examine the ownership structure in 511 large US firms. They report that, on average, the five largest owners together hold 24.8 percent and the top 20 shareholders 37.7 percent. Frequently 20 percent is assumed to be more than enough to control a firm (Morck et al., 2005). La Porta et al. (1997) have hypothesized that the legal origin of a country determines the efficiency of the country’s financial system. Scandinavia can in this respect be regarded as being relatively homogeneous. Scandinavia has a long tradition of cooperation in drafting new legislation (Carsten, 1993). Interestingly, there are still important differences with respect to deviations from the one-share-one-vote principle. Denmark, Finland and Sweden all allow dual-class shares. In Norway deviations from the proportionality principle need government approval (Faccio and Lang, 2002).

Corporate governance and investments in Scandinavia

Table 7.2

145

Ownership concentration in Scandinavia (2004)

All firms

Capital share one owner, CR 1 Capital share five owners, CR 5 Voting rights one owner, VR 1 Voting rights five owners, VR 5

Mean

Std. dev.

Min

Max

No. firms Skewness

23.5

15.5

0.4

82.4

214

0.90

44.8

19.6

1.5

95.1

214

0.33

29.4

19.7

0.4

89.3

211

0.89

52.0

22.6

1.5

96.5

211

0.08

Mean

Std. dev.

Min

Max

23.5

13.7

2.9

60.4

90

0.70

47.4

19.0

9.4

93.8

90

0.43

35.8

20.3

4.6

89.3

88

0.73

64.8

19.8

18.6

96.5

87

−0.33

Mean

Std. dev.

Min

Max

23.2

16.7

0.4

82.4

124

1.01

42.9

19.9

1.5

95.1

124

0.32

23.2

16.7

0.4

82.4

124

1.01

42.9

19.9

1.5

95.1

124

0.32

Vote-differentiated firms

Capital share one owner, CR 1 Capital share five owners, CR 5 Voting rights one owner, VR 1 Voting rights five owners, VR 5

No. firms Skewness

Firms with one-share-one-vote

Capital share one owner, CR 1 Capital share five owners, CR 5 Voting rights one owner, VR 1 Voting rights five owners, VR 5

3.

No. firms Skewness

METHODOLOGY

This chapter applies a method developed by Mueller and Reardon (1993) to assess the rate of return on investments. The measure produced is a marginal version of Tobin’s q. Tobin’s q is defined as the market value of a firm over the replacement cost of its assets, which translates to the average return on total assets. The marginal version of Tobin’s q, on the

146

Investments and the legal environment

other hand, measures the return on investments, or the marginal return on capital relative to the cost of capital (Mueller, 2003). This is in effect a measure of what Tobin (1982) calls the ‘functional form’ of stock market efficiency.7 Marginal q is also a more appropriate measure of performance since average q contains infra-marginal returns.8 Marginal q can be derived from the simple insight that any investments should ex ante be evaluated against the discounted present value of future cash flows that the investment generates. Obviously, only projects that have a positive net present value should be carried out. Consider an investment, It, made by a firm in period t. This investment generates cash flows, CFt1j in j periods. The present value, PVt, of this cash flow is as follows: n

PVt 5 a CFt1j / (1 1 rt) j

(1)

j51

where rt is the discount rate. Note that the present value is the discounted expected value of future cash flows. This equation can be expressed in the following way, where it can be regarded as a quasi-permanent rate of return: PVt 5 Itit /rt

(2)

For investments to be efficient from a shareholder perspective the investment being considered must generate future cash flows which, discounted to the present value, equal or exceed the investment cost. The ratio i/r is essentially a marginal version of Tobin’s q (Mueller, 2003) which measures the return on a marginal investment, and will therefore henceforth be referred to as qm. Equation (2) can be rearranged and expressed as follows: PVt 5 it /rt 5 qm,t (3) It For investments to be meaningful, we must have that PVt $ It. This implies that qm $ 1. If firms are investing at qm 5 1, investments are efficient. This implies that there are no further profitable investment opportunities (see Figure 7.1). Whereas if qm , 1, firms are receiving a return on their investments that is less than the cost of capital, which can only be interpreted as over-investment and a managerial failure of some sort. At the end of period t the market value of a firm may be decomposed into the market value in period t 2 1 (Mt-1), the present value of investments made in period t (PVt), the change in market value of the old capital stock (dt), and an error term for the errors the market may make in its evaluation of the firm (mt).9 Mt ; Mt21 1 PVt 2 dtMt21 1 mt

(4)

Corporate governance and investments in Scandinavia

147

r, i

r

i q m > 1 > q m*

Figure 7.1

qm* = 1

q m< 1 < qm*

It

Marginal rate of return on capital, i, cost of capital, r, and marginal q

By replacing Mt-1 in equation (4) in each subsequent period, the following expression is obtained: n

n21

n

Mt1n 5 Mt21 1 a PVt1i 2 a dt1iMt1i 1 a mt1i i50

150

(5)

i50

In a single period, the error in the market’s evaluation of the firm can be substantial, assuming efficient markets: E (mt) 5 0 and E (mt, mt21) 5 0, which n implies E ( g i50mt1i) 5 0. Thus, as n grows the last term will approach zero. From equation (3) we get the following expression: n

n

a qm,t1iIt1i qm 5

i50

a PVt1i 5

n

i50 n

a It1i

a It1i

i50

i50

(6)

Using equation (5) this expression can be formulated in the following way: n

qm 5

(Mt1n 2 Mt21) n

n

a dt1iMt1i21 1

i50 n

a mt1i 2

i50 n

a It1i

a It1i

a It1i

i50

i50

i50

(7)

This can be used to calculate a weighted average qm for each firm.10 Assuming that qm and d both are constant over time and across firms, we can use equation (4) to estimate qm and d directly. Taking equation (4) and subtracting Mt-1 from both sides we get:

148

Investments and the legal environment

Mt 2 Mt21 5 2dMt21 1 qmIt 1 mt

(8)

Dividing by Mt-1 we normalize the equation and get the following relationship that can be empirically estimated: mt Mt 2 Mt21 It 5 2d 1 qm 1 Mt21 Mt21 Mt21

(9)

Mueller and Reardon’s (1993) methodology can be applied to test the agency hypotheses. In contrast to the average Tobin’s q, this method measures the marginal return on investments, which makes it more appropriate when testing the agency hypotheses. To study the effects of ownership structure or various institutional factors on investment decisions, measures of ownership may be added as interaction terms with It /Mt21 in equation (9). If interaction terms are added, the functional form will be: Y 5 a 1 b1X 1 b2XZ, and qm is the economic interpretation of the marginal effect, ⭸Y/⭸X 5 b1 1 b2Z. This method has been applied by Gugler and Yurtoglu (2003) and by Bjuggren et al. (2007). The equations estimated have the following functional form: Mt 2 Mt21 It It It 5 2d 1 b1 1 b2Z1 1 . . . 1 bi11Zi 1 ei Mt21 Mt21 Mt21 Mt21 (10) where the Z’s denote the explanatory variables. Thus, the marginal effect, qm, of equation (10) is: qm 5 b1 1 b2Z1 1 . . . 1 bi11Zi

(11)

The total market value of a firm is defined as the total number of outstanding shares times the share price at the end of year t, plus total debt. Investments are approximated as: I 5 After tax profit – Dividends 1 Depreciation 1 DEquity 1 DDebt1 R&D 1 Advertising & Marketing The market and accounting data have been collected from Compustat Global database.11 The firms included were listed at one of the four stock exchanges in Scandinavia (Copenhagen Stock Exchange in Denmark, Helsinki Stock Exchange in Finland, Oslo Stock Exchange in Norway and Stockholm Stock Exchange in Sweden) between 1998 or 1999 and 2005, in total 292 firms (2004 observations). All figures have been adjusted by

Corporate governance and investments in Scandinavia

149

harmonized consumer price indexes to 2005 constant prices. The indexes used have been compiled by Eurostat. Naturally, the standard caveats apply to the data. To use equation (7) to calculate qm, it is also necessary to determine the size of the deprecation rate d. That is, the rate at which the value of the firm’s assets is declining over time. According to Mueller and Reardon (1993), most estimates are around 10 percent. Naturally, the actual depreciation rate varies across firms and industries, depending on the durability of employed assets. Even within firms, we have reason to believe that the depreciation rate differs across the capital stock. Equation (9) has the advantage that no assumption regarding the size of d is necessary. In an empirical estimation of equation (9) the intercept (d) will capture the depreciation rate plus any systematic changes in market valuations of the stock of old capital. The estimated d has no bearing on the interpretation of qm.

4.

CORPORATE RETURN IN SCANDINAVIA

This study covers 292 large Scandinavian firms that are listed at one of the four stock exchanges. This accounts for about 40 percent of all listed firms. In 2004, the top 100 of these 292 firms (25 largest in each country) accounted for approximately 42 percent of the total stock market capitalization (33 percent of GDP).12 The firms approximately follow a rank–size distribution, where the second largest firm is about half the size of the largest.13 As a first step, equation (7) is used to calculate a qm for each individual firm. For Scandinavia, the estimated average marginal q, excluding the upper 95 percentile and the lower 5 percentile, is 1.19. This means that during the period 1999–2005 the Scandinavian firms had an average return on investments that was 19 percent above the cost of capital. However the median qm is 1.03, which implies a return that is 3 percent above cost of capital. Neither the average qm nor the median qm give any reason to believe that Scandinavian firms are under-performing. This is based on the assumption that the depreciation rate was 10 percent per annum. Equation (7) is sensitive to the choice of depreciation rate. Consequently, a more rapid deprecation will translate into a higher qm, all else equal. Investments as defined in this chapter can be negative. This will be the case if a firm is making losses that are larger in absolute terms than new equity and debt. It is not meaningful to ask what the returns on investment are if investments are negative. Nor does equation (7) make any sense when

150

Table 7.3

Investments and the legal environment

Cumulative distribution of marginal q

Denmark Range of qm qm ≥ 2.00 1.50 ≤ qm < 2.00 1.00 ≤ qm < 1.50 0.50 ≤ qm < 1.00 0.00 ≤ qm < 0.50 −0.50 ≤ qm < − 0.00 −1.00 ≤ qm < − 0.50 qm < − 1.00 Number of firms Number of qm ≥ 1 Number of qm < 1

1999

2000

2001

2002

2003

2004

2005

10 3 3 10 11 9 4 4 54 16 38

9 2 3 14 19 5 4 4 60 14 46

6 3 3 12 23 5 1 6 59 12 47

2 4 5 9 26 8 0 6 60 11 49

4 3 3 11 25 8 2 4 60 10 50

5 4 6 13 23 5 1 4 61 15 46

5 8 6 13 22 3 0 2 59 19 40

1999

2000

2001

2002

2003

2004

2005

20 5 9 8 3 3 0 3 51 34 17

17 1 6 11 13 3 3 4 58 24 34

9 9 2 17 10 4 2 5 58 20 38

11 5 9 16 8 1 3 5 58 25 33

13 5 10 15 8 1 1 6 59 28 31

12 4 16 11 9 1 2 4 59 32 27

15 4 22 9 3 1 2 3 59 41 18

1999

2000

2001

2002

2003

2004

2005

23 5 7 5 0 1 1 2 44 35 9

19 6 10 3 4 3 0 2 47 35 12

13 3 15 7 2 1 3 3 47 31 16

8 4 10 15 3 2 0 6 48 22 26

12 6 13 7 4 0 0 4 46 31 15

17 5 15 3 4 0 0 1 45 37 8

23 7 9 2 2 0 1 1 45 39 6

Finland Range of qm qm ≥ 2.00 1.50 ≤ qm < 2.00 1.00 ≤ qm < 1.50 0.50 ≤ qm < 1.00 0.00 ≤ qm < 0.50 −0.50 ≤ qm < − 0.00 −1.00 ≤ qm < − 0.50 qm < − 1.00 Number of firms Number of qm ≥ 1 Number of qm < 1 Norway Range of qm qm ≥ 2.00 1.50 ≤ qm < 2.00 1.00 ≤ qm < 1.50 0.50 ≤ qm < 1.00 0.00 ≤ qm < 0.50 −0.50 ≤ qm 3% equity), yet no majority owner; High concentration: existence of a majority owner; Low concentration: some large owners but the sum of large owners is lower than 10% 2 16.7% of voting rights. 3 Elisabeth Badinter, daughter of the founder, Marcel Bleustein-Blanchet. 4 Equally owned by Wendel and KKR.

Schneider 2006 Tacit renewal Between Schneider Electric Septem- of the contract and Axa (2) ber every year

Schneider 2002 Electric March (1)

and Wendel jointly own less than 33% of Legrand’s equity, or (2) one of the 2 parties individually owns less than 5% Tacit renewal of the contract every year

266

The board, management relations and ownership structure

Proposition 2 Shareholder agreements are more likely to be found in companies in which shareholders have a long-term interest (for example, families, corporations). The heterogeneity of goals of shareholders is well established in the management literature (for example, Bushee, 1998 and 2001; Verstegen Ryan and Schneider, 2002, 2003, for institutional investors; Thomsen and Pedersen, 2000, for a large range of owner identities). Prior research suggests that owners have different objectives and strategic preferences according to their identities (Bethel and Liebeskind, 1993; Hoskisson et al., 2002: Tihanyi et al., 2003; Gaspar et al., 2005). Our data indicate that shareholder agreements are more likely to be signed between owners who have non-financial objectives. By non-financial objectives, we mean objectives that are not strictly linked to the value maximization of the shareholders’ equity. They span personal and strategic objectives. For example founders’ families such as Pernod or Badinter (the founders’ children) may want to keep the culture and values of the founders alive in the firm. Corporations such as Kirin and Dentsu appear to have strategic reasons to surrender their external control rights. Kirin is the largest spirits company in Japan with a long tradition of joint ventures to access markets and technology. In the 1970s, it signed a joint venture with Seagram to distribute its whisky brands in Japan. Shortly after Seagram’s spirits division was sold to Pernod Ricard and Diageo in 2002, Kirin signed an agreement with the two companies to retain and acquire sales rights in Japan for the former Seagram portfolio’s brands. Thus Kirin’s equity share (3 percent) in Pernod Ricard seems to serve other purposes than financial returns, such as expanding in the non-beer business. Figuratively speaking, Pernod Ricard became part of the ‘keiretsu’. Similarly, it is hard to understand why Dentsu would assent to sign an agreement that strongly limits its controlling power over Publicis (when it has formally 18 percent of the equity) for purely financial reasons.4 Secondary data suggest that at the time of the agreement (2002) Dentsu was facing growth imperatives – just after its introduction on the stock market – and was struggling with a downward advertisement market in Japan. Two years before, Dentsu had made some diversification investments abroad, particularly in Bcom 3, a large US agency network. In 2002, it sold its dominant share in Bcom 3 to Publicis – officially to free up some cash – and signed what was described by the top management of the firms as a ‘strategic alliance’ or ‘business tie up’ with Publicis.5 Dentsu was probably agreeing to trade off control over Publicis for a business alliance that would possibly offset the slow growth of its Japanese activity and enhance its global offer of communication services.

Contracting around ownership

267

A slightly different logic applies to the Club Med agreement. Why would Accor set up a contract with several new institutional investors at the time when it exited from Club Med? Secondary data, notably press articles, suggest that Accor may have been pressured by the French government to find a ‘substitute’ owner that would replace Accor (as the reference owner) and thus protect Club Med from a takeover by foreign investors. Club Med is commonly considered one of the ‘national corporate jewels’ of France, one that needs to be protected against hostile bids. Another important non-financial objective – which we have not seen documented in previous research – is what we could call ‘preventive ownership’ or ‘preventive control’, which consists in preventing third parties from acquiring control. To be sure, preventive control is not equal to protection against takeovers. It is a way for corporate owners to prevent their direct competitors from expanding their footprint. For example, in the Club Med case, it is likely that Accor did not want a foreign competitor like Hilton to establish a strong position in the leisure business by taking over Club Med. Similarly, in the Publicis case, it was probably important for Dentsu to prevent Publicis from being acquired by competitors like WPP or Grey. In this case, control over management is less important than preemption over competitors. Hence, we make the following proposition: Proposition 3 Shareholder agreements are more likely to be found in companies in which owners have non-financial objectives (for example, strategic alliance interests for corporate owners, continuity for family ownership, ‘national protectionism’ for government owners, preemption – in contrast to investors who prefer to avoid the loss of flexibility). Our cases also suggest that the leading shareholder of the agreement, that is, the one initiating the agreement and managing the negotiation process, has a strong historical link with the firm and seeks to maintain this link. For example, in Publicis and Pernod Ricard, the leading negotiating shareholders are the founders’ families. We argue that they tried to maintain their historical control over the firm. As both firms grew over the years, they needed additional financial back-up and went public, with a strong share of the firm remaining in the founders’ hands (in 2000, the Badinter/ Bleustein-Blanchet family still had 40 percent of the firm’s equity; in 2001, 28 percent). Both shareholder agreements followed just after major external acquisitions (BCom 3 for Publicis in 2002; Allied Domecq for Pernod Ricard in 2006) suggesting that the founders’ families used the contracts to protect themselves against a loss of power in the new entity. The Legrand contract also indicates that the incumbent shareholders (the two private funds) sought to maintain their control of Legrand after

268

The board, management relations and ownership structure

the firm was introduced on the stock market. Initially, in 2002, at the time of the LBO, KKR and Wendel had signed a very detailed agreement on Legrand. Once they floated part of the equity, they were required to reveal their agreement, and thus turned to a simplified version. One of our interviewees told us very strongly that ‘[they] use shareholder agreements to maintain [their] power in the firm’. These cases suggest that when incumbent owners seek to maintain their power in the firm, the costs of contracting may be offset by the benefits of control. Thus: Proposition 4 Shareholder agreements are more likely to be found in companies in which an incumbent shareholder (for example, family, private equity) seeks to maintain dominant control. 4.2

Nature of the Industry

Prior studies show that firms’ ownership structures vary across industries (Demsetz and Lehn, 1985; Pedersen and Thomsen, 1997; Villalonga, 2005). For example, family ownership is more prevalent in industries such as food manufacturing and media while government ownership – to take extreme examples – is more frequent in the weapon and aircraft industries. Similarly we would expect that shareholder agreements are not equally distributed across all types of industries. There are two main reasons for this. First, as previously shown, there are ownership conditions (related to ownership concentration and identity of owners) under which the benefits of shareholder agreements exceed the costs, and these conditions may change across industries. Second, shareholder agreements generate costs of ‘lockin’ because they tie up the signing parties for several years without much flexibility. Lock-in is less costly in relatively stable and certain industries than in dynamic industries where short-term changes may be required. Our cases show that all of the firms in our sample operated in mature industries (wine and spirits, electrical equipment, advertising). Findings are reported in Table 11.2. We formally state this proposition as follows: Proposition 5 Shareholder agreements are more likely to be found in companies that operate in relatively stable businesses in which the costs of lock-in for a couple of years are small. This finding departs from previous research on interfirm ownership and strategic alliances which suggests that equity arrangements among firms are more frequent in knowledge intensive industries with high R&D intensity (Allen and Phillips, 2000) such as biotechnologies and electronics.

Contracting around ownership

Table 11.2

269

Shareholder agreements and the nature of industry

Firm

Industry

Pernod Ricard Publicis

Wine and spirits Communication and advertising Leisure and holiday village operator Electrical equipment Electrical distribution

Club Med Legrand Schneider Electric

Industry development Mature Mature Mature Mature Mature

Here, the main role of interfirm shareholdings is to facilitate knowledge flows between firms (Mowery et al., 1996, Gomes-Casseres et al., 2006). In contrast, in our cases, knowledge sharing does not appear to be a dominant motive in transactions between shareholders. 4.3

Nature of the Contract Items

The benefits of shareholder contracts will be particularly high (and exceed the costs) when no other mechanism effectively addresses the issues included in the contract. One of our interviewees told us: We do not use shareholder agreements on a standalone basis but in conjunction with other elements such as charters and commercial law. We see shareholder agreements as one of the tools of a larger toolbox which help protect our interests in the firm. Yet, these contracts are useful because we have a lot of flexibility in the content, and we may address issues that are not explicitly taken into account by charters or by commercial law.

What are these issues? Our cases point to different categories, related to equity rights, control rights and non-control and equity issues. Table 11.3 provides a summary of the issues while the details of the contracts are in Appendix 11.2. Three categories of issues are distinguished: equity rights, control rights, and other (non-equity and control) issues. Equity rights relate to the control of the equity by the signing shareholders. They encompass preemption clauses, tag-along and drag-along rights (respectively the right of joint exit and the obligation of joint exit) and rights of approval (clauses d’agrément) which allow the current shareholders to avoid ‘undesirable’ new shareholders entering the firm. As an illustration, the Publicis (2002) shareholder agreement states that Dentsu will not be able to transfer or sell its equity shares in Publicis until July 2012; after July 2012, Mrs Badinter has a preemptive right to buy Dentsu’s shares.

270

Table 11.3 Firm

The board, management relations and ownership structure

Shareholder agreements and the nature of the contract items Control rights

Board structure Pernod Ricard Publicis Club Med Legrand Schneider

X X X

Voting rights

Equity rights

Non-equity and controlrelated issues

Rights to sell Cash flow Strategic and acquire rights alliances/ shares business deals

X

X

X

X X X

X X X X

X X X

Notes: Board structure refers to the rules attached to the composition of the board of directors and its sub-committees. Shareholders’ agreements encompass the following board-related items: number of board seats granted to the signing shareholders, total number of members on the board, including total number of independent board members; nomination process for board members and chairman; rights to propose nominees and obligation to accept the appointments made by some of the signing parties. Voting rights refer to (1) the rights given to the contract parties relative to the strategic decisions and (2) the total voting rights granted to each of the parties. In the first case, the shareholders’ agreement will specify the type of strategic decisions for which the signing parties agree to vote in concert and those for which they may express an individual opinion. In the second case, it will specify the maximum number of votes given to each of the contract parties. Rights to sell and acquire shares refer to the rules attached to the sale and purchase of equity shares. Shareholders’ agreements specify the minimum holding period of shares, the preemptive rights given to the signing shareholders, and the process that needs to be followed in case of sell-out. They also define the rights and obligations in case of takeover attempts. Includes clauses for joint exit, rights of approval, tag-along and drag-along rights. Cash flow rights refer to the allocation of cash flows between the signing parties, in particular when the firm is sold to a third party or goes public. Strategic alliances refer to agreements between the signing parties about some joint activity, which may range from common distribution channels to joint production and knowledge transfer. Business deals refer to more ad-hoc transactions between the firm and one of the signing investors.

Control rights pertain to the allocation of board seats, the nomination process of the directors and the committees, the allocation of voting rights and the obligation to ‘act in concert’ with respect to strategic decisions. Legrand provides a good illustration. The shareholder contract specifies that the board will comprise 11 members: three representatives of KKR, three representative of Wendel, two independent board members and three top managers. It also stipulates that the strategic committee will be

Contracting around ownership

271

chaired by a KKR representative while the compensation committee will be chaired by a Wendel representative. As for Club Med, the contract explicitly states that all signing shareholders will support the strategy of the current management. Non-equity and control issues relate to business relationships either among the shareholders or between the shareholders and the firm. For example, in the Club Med contract, Fipar, a real estate institutional investor and one of the signing parties, is granted the right to strike a deal with Club Med for its real estate assets. Our findings suggest that the equity and control rights issues included in the shareholder agreements cannot easily be addressed by standard open market transactions like hedging or financial options, partly because they are conditional on what other parties contract do, and partly because of the relatively long time horizon which they cover. Thus the following proposition: Proposition 6 Shareholder agreements are more likely to be found in companies in which shareholders need to address complex and conditional issues characterized by an intermediate level of information asymmetry (which can benefit from third-party arbitration in case of disagreement). Previous research suggests that market mechanisms do not fully address expropriation issues between shareholders (Shleifer and Vishny, 1997; Johnson et al., 2000; Djankov et al., 2008) such as tunneling and selfdealing. Two types of expropriation issues (also called principal–principal issues) need to be distinguished: expropriation of minority shareholders by large shareholders, and expropriation among the large shareholders. La Porta et al. (1999) indicate that legal protection of minority investors is scarce in countries with French civil law origin. Although French law based investor protection has been more favorably regarded in recent research (Djankov et al., 2008), we find it interesting to examine whether French shareholder agreements are substitutes for limitations in legal investor protection, using mechanisms such as the granting of board seats and additional voting power to minority investors. But our cases do not provide evidence of this. The rights of the minority investors signing the contracts tend to be linked to the interests of the dominant owner, with no rebalancing taking place. For example, Kirin, a minority investor, clearly agrees to be on the backseat, leaving the Ricard family with the full decision and control power. However, our cases point to the relevance of shareholder agreements to mitigate expropriation among large shareholders. As an illustration, the shareholder contract between KKR and Wendel (which have equal

272

The board, management relations and ownership structure

stakes in Legrand) stipulates how the two owners will share the control and profits of the firm after the IPO. It forbids one of the parties to pursue an opportunistic behavior at the expense of the other. A revealing quote from our interviewee: When we sign a shareholder agreement, we act as complete paranoiacs. We investigate all possible scenarios under which we could lose control and money because of the other party’s opportunism. We make sure all the scenarios are included in the contract, with clear resolution processes. Never trust another shareholder!

Under these circumstances, shareholder agreements may represent an efficient instrument to moderate potential conflict of interests between large shareholders. Hence, we propose: Proposition 7 Shareholder agreements are more likely to be initiated by large investors seeking to protect their bargaining power than by small shareholders seeking substitute mechanisms for weak legal protection. Prior studies have shown that firms are more likely to adopt antitakeover measures when managers have high discretion and low owner control (Brickley et al., 1988). We found that shareholder agreements are commonly used by large insiders to protect themselves against the entry of ‘undesirable’ shareholders. Schneider Electric and Axa for example have cross-ownership. In the event of a hostile takeover of Schneider, AXA has the right to purchase all AXA shares still owned by Schneider; and conversely for Schneider. As for the Club Med shareholder agreement, it stipulates that, in case of takeover, investors are allowed to sell their shares only if Club Med’s board of directors has given its agreement on the takeover. Another good example of the use of agreement against takeover is Pernod Ricard. The shareholder agreement with Kirin reinforced the family’s equity share by increasing its equity block; yet it did not seem safe enough to secure family control. The following year (2007), a new blockholder, Albert Frère, who is reported to be a ‘40-year-old friend of the family’, entered the firm. Albert Frère had been on Pernod Ricard’s board of directors from 1991 to 1995. In addition, in line with the new finance law ‘Breton’, Pernod Ricard adopted a measure whereby convertible bonds can be given for free to existing shareholders (maximum 50 percent capital) in case of a hostile takeover, consequently increasing the cost of the takeover. Thus: Proposition 8 Shareholder agreements are more likely to be found in companies in which there is a takeover risk (for example, companies with large free cash flows).

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4.4

273

Nature of the Network Ties

A stream of research has examined the ties between directors and top managers and has revealed that the nominations of directors are not random but linked to social and professional networks (Davis et al., 2003; Conyon and Muldoo, 2006; Kirchmaier and Kollo, 2007). In France in particular, there are strong ‘small world’ effects mostly related to top management’s membership of the ‘elite’ schools (Nguyen-Dang, 2006). In such a context, it is likely that the choice of partners for shareholder agreements follows some network rules. Our cases show that this is often so. For example, in the Club Med agreement, all signing shareholders have somewhat tight connections. Accor had close links with the government, both through its founders (notably Mr Pelisson, who also became the mayor of Fontainebleau, a ‘posh’ city on the outskirts of Paris), and through Mr Espalioux, the CEO, who studied at ENA, the top administrative school in France. Accor sold part of its equity in Club Med to a consortium of investors who were related to the French government. Icade is the real estate arm of CDC, a ‘hybrid’ institutional investor strongly connected with the government.6 Fipar Holding is the CDC equivalent for Morocco. Air France Finance is the finance arm of Air France, the former national French airline company, still partly owned by the French government and with a strong connection to Accor (for example, they have a common payment card and share part of their loyalty programs). While ex ante the network ties probably facilitated the signature of the contract, ex post they also increased the enforcement of the contract because of potential social sanctions in case the contract is breached. A close look at the Schneider Electric agreement also reveals many informal relationships among the signing shareholders (Axa, Schneider Electric, BNPParibas, and AGF for the 2002 agreement), in particular, board ties. Over the period 2000–07, the board of AXA (one of France’s top insurance companies) included Michel Pebereau (CEO of Bank BNP-Paribas, one of France’s top banks) and Henri Lachman (CEO and subsequently chairman of Schneider Electric) as members. Until 2002, Claude Bebear (CEO of AXA) was a director on the board of Schneider Electric. Directors and managers have mutual board ties which possibly give them more scope for ‘gentlemen’s agreements’ not to interfere in the strategic decisions of socially connected parties for fear of retaliation. The Schneider Electric agreement seems to reflect a social arrangement between managers of top French corporations, banks and insurance companies. From these various cases, we propose the following: Proposition 9 Shareholder agreements are more likely to be found in companies whose leading officers and directors have social ties, such as

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belonging to the ‘elite’ network (where formal contacts can be backed up by social sanctions). In the case of Kirin–Ricard and Dentsu–Publicis it is relatively clear that the foreign firms did not have the same strong social ties. But recent research has indicated that alliances may be a means to achieve social ties and legitimacy (Koka and Prescott, 2002; Dacin et al., 2007). Since minor ownership shares have been used to express a commitment to future business relations among Japanese firms (in the so-called keiretsu system), the contractual relations with the French firms could be seen as an international extension of a traditional Japanese practice. In addition, a closer look at the Dentsu–Publicis deal reveals the existence of significant informal ties – although not at the CEO level – between the two companies. Secondary sources indicate that the founder of Publicis (Marcel BleusteinBlanchet) and the founder of Dentsu (Hideo Yoshida) knew each other from the 1960s. The CEO of Publicis, Maurice Levy, made a revealing comment when announcing the arrangement with Dentsu: ‘Friendly ties were established in the sixties between Marcel Bleustein-Blanchet, our founder, and Mr Hideo Yoshida. I am glad that this partnership offers us new opportunities to build on this tradition.’

5.

IMPACT OF SHAREHOLDER AGREEMENTS

Shareholder agreements bias the formal ownership structure by introducing idiosyncratic arrangements between selected shareholders. This phenomenon of ‘contracting around ownership’ may constitute an impediment to the efficiency of the markets because it introduces some complexity in the allocation of control and cash flows among shareholders. Yet, the conflicting perspectives of the finance and strategic management streams of literature suggest that we still have no clear view on the effects of shareholder agreements. On the one hand, the finance literature indicates that protections against takeovers such as poison pills (included in company charters) destroy value (Gompers et al., 2003). Takeovers and particularly hostile takeovers are demonstrated to be an important source of value creation for target firm shareholders (for example, Schwert, 2000). Accordingly, we would expect a similar negative effect to apply to shareholder agreements, given that they restrict hostile takeovers and deter entry of new shareholders. On the other hand, concentrated control is believed to create value under some circumstances (Thomsen and Pedersen, 2000) and the

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Table 11.4

275

Impact of shareholder agreements

Firm

+/−1 month +/−2 months Announcement date of the Change in Change in Change in Change in shareholder company the CAC 40 company the CAC 40 agreement stock price index (%) stock price index (%) (%) (%)

Pernod Ricard Publicis Club Med Legrand

27 March 2006 24 May 2002 21 June 2006 27 April 2006

Schneider 15 March 2002 Electric (renewal) Schneider 19 May 2006 Electric

+4.9

+1.9

+3.9

+2.4

−9 −12.7 4.8

−7.7 +0.7 −1.1

−15 −1.2

−3.2

−2.8

−22 −16.6 N.A. (IPO occurring on 7 April 2006) −2.6

−11.6

−6.8

−10.9

−6.4

−2.9

Notes: Variations of the firm’s stock price +/−1 month or +/−2 months around the announcement date of the agreement. The CAC 40 index reflects the stock price variation of the 40 largest companies in France. The source for the stock price data is Datastream.

strategic management literature suggests that equity arrangements between shareholders may be positive for the firm. They can promote strategic alliances – complementary or additive – between firms (Allen and Phillips, 2000), ultimately creating firm value. In addition, long-term shareholders, such as banks, corporations and government, may be in a better position to expand the firm’s resource base and access critical resources for the firm (for example, bank loans, lobbying of governmental bodies, R&D funding) (Pfeffer and Salancik, 1978). Accordingly, we would expect some positive reaction of the markets over shareholder agreements. Our cases suggest that the impact of shareholder agreements is highly contingent upon their content. Findings are reported in Table 11.4. Market reactions to the announcement of the Club Med and Schneider Electric (2006) deals were clearly negative, while they appear to be positive for the Pernod Ricard and Legrand agreements. As explained in the previous section, the Club Med and Schneider Electric contracts function as defense mechanisms against takeovers (see also details of contracts in Appendix 11.2). The first one points to the

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creation of a coalition that replaces the ‘reference’ owner and protects Club Med against takeovers. The later one (2006 version) is largely focused on protection against takeovers, with mutual preemption rights between Axa and Schneider in case of hostile bids. In comparison, Pernod Ricard and Publicis’ agreements combine both strategic and financial components. Kirin seems to have traded its investor power for some potential business agreement with Pernod Ricard, thus expanding out of its traditional (slow growth) Japanese beer business. Dentsu went for a global alliance with Publicis following the sell-out of Bcom 3. It thus gave up its role as an external shareholder for a larger financial and strategic agreement. As officially announced by Dentsu: Dentsu Inc. has reached today a basic agreement to form a strategic global alliance with a new company created through the merger of Bcom3, a U.S. based communications group and Publicis Groupe . . . In addition, Dentsu and Publicis will discuss working together on specific projects on a global basis. (Dentsu’s website)

We may argue that the Publicis agreement was not positively greeted because the positive perspective of a strategic alliance was probably already included in the announcement of the deal between Publicis, Dentsu and Bcom 3. Finally, the Legrand agreement seems to follow a different logic. KKR and Wendel were the company’s two main shareholders at the time of the IPO (initial public offering). The renewed commitment in the firm and the willingness to ‘bind their fate’ over a somewhat longer period of time can be a reassuring signal for the markets, which may be especially important in IPOs. Private equity funds are known to be focused on value maximization and to exert strong monitoring over the firm management. Thus their agreement communicates to the financial markets that agency issues related to adverse selection will be minimal. In addition, long-term investors and particularly those with a strong financial objective in mind bring additional value through some continuity in strategies. Overall, our cases indicate that the markets are ‘smart’ enough to distinguish between various types of contracts and to value those that promise a positive long-term effect on the firm. Thus, we propose the following: Proposition 10 Shareholder agreements are more likely to be negatively perceived when they are primarily defense mechanisms against takeovers. Proposition 11 Shareholder agreements are more likely to be positively perceived when they offer additional strategic benefits.

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Proposition 12 Shareholder agreements are more likely to be positively perceived when they signal an increased commitment to value creation objectives. We propose that these hypotheses are empirically testable in event studies which distinguish between alternative types of shareholder agreements based on industry and firm characteristics. For example, companies characterized by substantial free cash flow, low debt and low valuation ratios and companies in newly deregulated industries with restructuring potential are more likely to be takeover targets. In such firms we expect news of shareholder agreements to be associated with negative abnormal returns. In contrast we expect that shareholder agreements with a business case – which extend the technological or sales capacity of the companies involved – will tend to generate positive abnormal returns. Moreover, shareholder agreements among owners with clear value-maximizing objectives – such as private equity funds – are also more likely to be associated with positive abnormal returns.

6.

DISCUSSION AND CONCLUSION

This chapter explores the determinants and consequences of shareholder agreements among large listed firms in France. Shareholder agreements are contractual instruments that organize the relationships between shareholders ‘backstage’, that is, behind the formal ownership structure. Because of their confidentiality, they are often hard to study. Yet, without access to these ‘backstage’ agreements, it is difficult to understand what is going on in the firm. The formal ownership structure may provide an inadequate picture of the allocation of power between shareholders and between shareholders and managers. Using a sample of shareholder agreements among listed firms in France, we look at the cost/benefit trade-off of these contracts versus other governance instruments such as increased ownership and market discipline. We define the costs of shareholder agreements as the transaction costs (negotiating, renegotiating and enforcing the contracts) and the costs of lock-in. The benefits of shareholder agreements vary according to the issues faced by the shareholders. We propose that shareholder contracts are particularly effective instruments for firms with specific ownership patterns (intermediate concentration of ownership, long time horizons and non-financial goals) and in certain (mature) industries. In addition, we conjecture that shareholder agreements are more likely to be considered when there are expropriation risks between large shareholders

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(principal–principal issues) and takeover risks. Finally, we propose that shareholder agreements will be more effective and frequent among members of the same ‘elite’ network, as the enforcement of the contract can be backed by social sanctions. With respect to the economic performance, we propose that the value of shareholder agreements is highly contingent upon the content of the contract. Agreements emphasizing protection against hostile takeovers will tend to destroy value. In contrast, agreements including both strategic and financial components and those signaling long-term commitment by valuemaximizing owners will tend to increase shareholder value. We conjecture that shareholder agreements are likely to create value when stability of ownership is required to give the firm a secure strategic direction. Despite remarkable changes in stock ownership – the average holding period for common stock has fallen significantly over the past decade – we have seen very little research on the importance of the stability of ownership to the continuity of strategy and financial results. We would argue that stability of ownership may under certain circumstances provide the right background for firms to progress, and that shareholder contracts can be an instrument in this regard. Moreover, we find reasons to believe that firms can occasionally benefit from having the shareholders assign ownership (control) rights to a competent owner who can then exercise authority to the benefit of the shareholders as a group. Shareholder contracts provide a flexible framework for this, because they have limited duration and need to be renewed at regular intervals. We regard this chapter as a first step towards improving our understanding of the relatively unexplored domain of shareholder agreements in listed firms. Obviously, there are limitations to this study that need to be made explicit. First, we chose to focus on a very limited number of ‘different’ cases. Expanding our sample would improve the generalizability of the findings. Second, because of the availability of the agreements, we focus on the French institutional context. Research looking at cross-country comparisons of ownership structures and corporate governance practices underlines the importance of the institutional context and more particularly of company law (La Porta et al., 1999; Gedajlovick and Shapiro, 1998; Pedersen and Thomsen, 1997). Thus, we should test our propositions in other contexts, for example in both countries with similar French civil law origin and in countries with common law origin. The protection of minority investors, which is held paramount in common law countries, may limit the scope for agreements between blockholders. For example, Roe (1991) demonstrates how US law has historically blocked cooperation between minority investors because of a fear of insider trading and cornering the

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279

market. Countries with other legal traditions – like France – may be more amenable to contracts between shareholders. Nevertheless, we think this chapter contributes to the current debate on ownership from both the financial contracting literature and the governance literature perspectives. The emerging theory of financial contracting has understandably been preoccupied with fundamental issues like differences in generic types of debt and equity and what these imply for firm behavior and performance. But the fact is that the real-world financial contracts are often more complicated because they combine generic liability types with specific contractual provisions which influence the allocation of decision, control and cash flow rights. This chapter demonstrates that shareholder contracts tailor-make the relationships between shareholders. Thus we highlight the need for a systematic analysis of these contracts for fear that an important dimension of the financial structure should be missed. In addition, we provide indications of the conditions under which shareholder agreements are more likely to be efficiently used. The governance stream of literature has been relatively silent on shareholder agreements. In particular, cross-country studies have often overlooked this dimension when studying ownership structures in French civil law origin countries (for example, Gedajlovic and Shapiro, 1998; La Porta et al., 1999; Faccio and Lang, 2002). This chapter points to the importance of an in-depth understanding of less visible contextual variables such as shareholder agreements when studying governance systems as well as individual firms. As it turns out, theories emphasizing relational capitalism seem quite right; some of the relationships can be documented by studying interfirm contracts. We see several possible avenues for future research. First, one could test the propositions on a larger sample of firms within France (circa 300 detailed contracts available). Another analysis would be to measure the relative influence of the formal and real controls on firm outcomes. Thirdly, it would be interesting to test the propositions in other institutional contexts. As explained earlier, we expect shareholder agreements to be particularly frequent in countries characterized by intermediate degrees of ownership concentration such as France, Germany and Belgium, but less common in countries like the USA and the UK (firms with low ownership concentration) or Italy (firms with high ownership concentration). Finally, these findings have implications for corporate governance guidelines. On the premise that all materially relevant information (that is, with the potential to influence stock prices) should be disclosed quickly in a well-functioning stock market, shareholder agreements should be made public information, since they can influence corporate strategy and stock

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prices. In this respect, we believe that the French approach (a public register) is a good solution.

NOTES 1. This chapter originated as a paper prepared for the Workshop on ‘The Economics of the Modern Firm’, Jönköping, Sweden , 21–22 September 2007. It has benefited from comments by Benito Arunada and an anonymous referee. 2. In 2005. Source: AMF. Note that some companies have been delisted while others have gone public over the period 1997–2007. 3. These two disclosure requirements tie in with a third requirement on ownership thresholds (‘declaration de franchissement de seuils et declarations d’intentions’ – article I-233-7 of commercial law) which asks shareholders to notify the market authority when their shares in a firm go above the 5, 10 and 15 percent voting or equity thresholds. 4. The contract between the Badinter family and Dentsu states that Dentsu will commit to nominate ‘all management team members proposed by E. Badinter’ as well as ‘all supervisory board members who have been chosen by E. Badinter’. In addition, it will ‘vote in favor of E. Badinter’s decisions in the cases of change of Publicis’ charters, M&A, distribution of dividends, capital offerings and share repurchase’. 5. ‘Dentsu Inc. announced today that it has reached an agreement to form a strategic global alliance with a new company created through the merger of Bcom3 Group, Inc., a U.S. based communications group and Publicis Groupe S.A., a major European communication group headquarted in France’ (published in Dentsu’s website – Investors’ relations – 7 March 2002. Emphasis added). Yukata Narita, Dentsu’s president, further commented: ‘We aim to provide the very best marketing communication services covering every domain in the world market by integrating the power of the three corporations. By doing so, we believe we can win the confidence of clients and establish the very best global network’ (emphasis added). 6. CDC invests funds collected through the ‘Livret A’ (typical non-risk placement for French households) and acts as a long-term owner in a large number of French firms. The CDC director is nominated by the French president.

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APPENDIX 11.1 Table A11.1

285

SHAREHOLDER AGREEMENTS IN FRENCH LISTED FIRMS

Number of shareholder agreements

Year

Number of (new) shareholder agreements1

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

16 26 34 56 37 66 45 Not available 16 58 25

Note: 1 Including changes in shareholder contracts (avenants) and changes in equity shares held by shareholders included in shareholder agreement. Excluding breach and end of contracts (résiliation, declaration de fin de concert, fin de clauses, caducité d’une convention) as mentionned in the ‘comment’ section of the database. Source:

amf-france.org

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APPENDIX 11.2

DETAILED CONTENT OF SHAREHOLDER AGREEMENTS

Table A11.2 Firm Pernod Ricard

Agreement

Agreement on the voting patterns/voting rights ● Both investors agree to vote in concert ● In case of disagreement between parties, Kirin commits to vote in favor of all resolutions proposed by the board of directors of Pernod Ricard and to equally vote against resolutions that were not accepted by the board on issues related to: ● Nomination and compensation of directors ● Modification of the firm’s charters ● M&A ● Extraordinary dividends ● Measures against takeovers Agreement on the sale and purchase of shares ● Kirin commits not to sell its shares before the end of the agreement (31 Dec. 2007) ● After Dec. 2007, Pernod Ricard has a preemptive right to buy Kirin’s shares at the following price: the average between (1) the average weighted stock price over the 30-day period before Kirin announced its willingness to sell out and (2) the average weighted stock price over the 30-day period before Kirin effectively sells its shares. Publicis Agreement on the board structure ● Dentsu will be granted 2 seats on the supervisory board (as long as it owns at least 10% of the equity); in case the total number of directors increases, Dentsu will be granted additional seats in proportion to its voting rights. ● Dentsu commits to nominate or maintain all supervisory board members who have been chosen by E. Badinter ● Dentsu commits to nominate E. Badinter or any representative (proposed by her) as the chairman of the supervisory board ● Dentsy commits to nominate all management team members proposed by E. Badinter ● A strategic committee (named ‘special committee’ will be formed. Members will be nominated by E. Badinter and Dentsu (with E. Badinter having the discretion to nominate the majority of members) Agreement on the voting patterns/voting rights ● Dentsu will not be able to own more than 15% of voting rights (33.5% for E. Badinter) ● Dentsu commits to vote in favor of E. Badinter’s decisions in the following cases:

Contracting around ownership

Table A11.2 Firm

287

(continued)

Agreement

Change of Publicis’ charters M&A ● Distribution of dividends ● Capital offerings ● Share repurchases ● Dentsu may freely vote (after consultation with E. Badinter) on the related topics ● Transfer of assets ● Granting of subscription rights ● ‘Reserved’ capital offerings ● Transaction involving E. Badinter, Dentsu or a subsidiary of Publicis ● Dentsu commits to vote in favor of the certified accounts, after Dentsu’s comments have been taken into account by the financial auditors Agreement on the sale and purchase of shares ● In case of seasoned offers (that is, share issues by companies who have already listed shares), Dentsu will be granted an antidilution right. Yet it will not be able to participate in the offer through preferred subscription rights ● Dentsu will not be able to transfer or sell its equity shares in Publicis until July 2012 ● After July 2012, E. Badinter has a preemptive right to buy Dentsu’s shares ● Dentsu commits not to make any special arrangements with Publicis’ management without prior notice of E. Badinter. Conversely for E. Badinter Club Med Agreement on the board structure ● Fipar is granted the right to propose the nomination of one director (as long as it owns 4% equity) ● All investors commit to vote in favor of this nominee, and ‘fire’ the directors that would be requested by Fipar ● Accor will keep one representative on the board of directors Agreement on the voting patterns/voting rights ● All investors confirm to support current management’s strategy Agreement on the sale and purchase of shares ● Investors agree not to sell any of their shares without informing the other investors for a period of 2 years ● Investors agree not to increase their ownership level (on an individual or collective basis) until either the agreement or the date when the group of investors will own less than 20% of Club Med’s equity or voting rights ● ●

288

The board, management relations and ownership structure

Table A11.2 Firm

Agreement After two years, investors have the preemptive right on the purchase of shares sold by other investors ● The parties may unanimously decide to lift the ban on additional share purchases so as to increase their shares in Club Med’s equity ● Agreement on takeovers: in case of takeover, investors are allowed to sell their shares only if Club Med’s board of directors has given its agreement on the takeover. If one of the parties wishes to make a competitive offer, it may terminate the agreement Non-equity and control issues ● Icade (real estate arm of institutional investor CDC) has joined the agreement under the specific condition that it will conclude a contract with Club Med related to real estate issues Agreement on the board structure ● The board will include 11 members ● Until the initial period (2 years and 3 months after the IPO date), the parties agree that the board will be composed of: ● 3 representatives of each signing party ● 2 independent board members ● 3 top managers ● After the initial period, Wendel and KKR commit that the board will be constituted by a majority of board members nominated by both parties ● In addition, Wendel and KKR will be granted seats in proportion to their respective voting rights ● The governance structure will include ● A strategic committee, chaired by a KKR representative ● A compensation committee, chaired by a Wendel representative ● An audit committee, chaired by an independent board member Agreement on voting patterns/voting rights ● Wendel and KKR forbid to vote in favor of granting dual rights to shareholders holding Legrand’s shares for more than two years ● The chairman of the board will be granted significant discretion with respect to the daily management of the firm, except on decisions relative to ● Share offer and buy back ● Subscription of new debt or early pay back ● Acquisition of equity shares in other firms, acquisition of other businesses and JV for deals above €50m ●

Legrand

(continued)

Contracting around ownership

Table A11.2 Firm

289

(continued)

Agreement Sell-out of businesses asset or participation above €50m Agreement or modification of Legrand’s 3-year strategic plan and annual budget ● Firing or nominating auditors ● Any projects that would entail the full or partial transfer of Legrand’s assets ● Any deal that would result in equity increase of equity reduction, including convertible debt or preferred shares ● The cancelling out of double voting rights or any decision that would modify the voting rights attached to Legrand’s shares ● Any modification of the governance rules, such as the composition of the board ● The introduction of Legrand’s shares in a stock market other than Euronext ● A voluntary liquidation of the firm or any decision that would generate a collective procedure against Legrand ● Any modification of Legrand’s charters that would favor one of the parties ● Any transaction or treaty if amounts at stake exceed €50m ● The parties commit that Lumina White (Lumina Participation) will vote in accordance with KKR and Wendel. In case of disagreement between the parties, Lumina White will conform to instructions given its owners in relation to their respective shares Agreement on the sale and purchase of shares ● Wendel and KKR both commit not to sell their equity shares before the end of the ‘restrictive’ period (the minimum between (1) 18 months after the expiration of the lock-up period for syndicate loans and (2) date when the parties have jointly agreed they could sell a portion of their stocks) ● Some transactions will however be allowed: ● Cessions in favor of entities which are fully owned by either Wender or KKR (sociétés apparentées) ● Cessions that do not exceed €10m, in so far as the other party has been informed at least the day before the transaction ● Cessions of shares in favor of a board member of Legrand, to the extent that it does not exceed what is written in the charters ● After the restriction period, the sell-out of Legrand’s shares will be unrestrained as long as it is consistent with ● The right of preemptive offer ● The ban on block sell-out and joint sell-out (‘tag along’) applicables to blocks ● Cessions that are forbidden by the investors’ agreement contract ● ●

290

The board, management relations and ownership structure

Table A11.2 Firm

(continued)

Agreement The stipulations of ‘offering rights agreement’ and ‘tag along agreement’ Preemptive right: each party commits to inform the other party when it wishes to sell its shares. The remaining party has the right to make a preemptive offer (at a price which equals or is superior to the one offered by the selling party) Block sell-out: when one of the parties wishes to sell out its shares in ‘blocks’, it is required to inform the other party through a letter. The recipient has 5 days to also inform the seller that it equally wishes to sell its shares. The seller commits to inform the other parties in advance of the conditions of the block sell-out Under the ‘tag along agreement’, if the informed party does not wish to sell its shares, the seller will be authorized to sell all of its shares. If the second party also wants to sell its shares, a specific rule of ‘share allocation’ will be enforced. Each party will be authorized to sell only a specific portion of their shares. Each party has agreed not to sell its blocks of shares to an industrial firm above a value of €100m The above conditions do not hold for: ● Cessions of shares authorized along prior conditions ● Cessions sold within a seasoned offer led by a banking syndicate (following a guarantee contract) ● Swaps by one of the parties between Legrand securities and Legrand stocks or other financial instruments ● Cessions in the context of a takeover ● All cessions ruled by the ‘tag along agreement’ (agreement relative to the joint cession of Legrand’s shares after the IPO) Agreement on takeovers by one of the parties ● Each party commits to get the written consent of the other party before its proceeds to a takeover offer. The informed party has three days to give its answer. Beyond this period, agreement is assumed. In case of disagreement, the ‘takeover’ party is expected to incur all costs related to the offer ● If after the takeover offer, one of the parties becomes a majority owner and the other one a minority owner, a new investors’ agreement will be concluded. In any case, this new agreement will give the minority investor a veto right on all strategic decisions on Legrand as long the minority investor holds 20% of the voting rights ● In addition, a joint ‘exit right’ will be implemented if the majority owner wants to sell its block equity ● ●

●

●

● ●

●

Contracting around ownership

Table A11.2 Firm

291

(continued)

Agreement

Schneider 2002. Agreement on the sale and purchase of shares ● Second modification (avenant) of the investors’ agreement Electric contract signed in 1993 between AXA, BNP-Paribas & AGF. Updates the respective equity shares included in the agreement, i.e. 3%, 1.4% and 0.4% of capital 2006. Agreement on the sale and purchase of shares ● AXA commits to keep at least 2.5m equity shares in Schneider ● Schneider commits to keep at least 8.8m equity shares in AXA ● In case of a hostile takeover of Schneider, AXA has the right to purchase all AXA shares still owned by Schneider; conversely for Schneider

12.

Board governance of family firms and business groups with a unique regional dataset Lluís Bru and Rafel Crespí

1.

INTRODUCTION

This study is a detailed description with methodological contribution to the measurement of a set of family business groups in the Balearics region in Spain that belong to either the Balearic Family Business Association (ABEF) or the nationwide association, the Spanish Family Business Institute (IEF). Before we discuss the object of our study, we will examine the main aspects that characterize the family business as an economic organization. Next, we will display their economic activity and relevance in the region’s economy. Subsequently, we will take a closer look at the economic behaviour and organization of the 556 companies that belong to the 50 family business groups. In our description we will examine these companies on two levels. First, each individual company will be contemplated as a separate economic entity. Second, we will offer a specific description of each family business group. For this, we have used the data we have on the family companies and their boards of directors as the essential basic information for our study. The main methodological innovation of our study is that the Spanish ‘two-surnames’ system allows us to analyse in detail the family ties among administrators at both the firm and the business group level.

2.

OUR DEFINITION OF THE FAMILY BUSINESS

What is understood by the term ‘family business’? We might define the family business as a company that fulfils two basic requirements: persistent belonging to individuals within a single family circle, and being governed by one or more of the members of that family. 292

Board governance of family firms and business groups

293

When applying this definition to specific companies, to avoid ambiguity it is important to be more precise about what we exactly mean by a family company. Three factors are taken into consideration in our attempt to define a family business.1 First, the ownership of the company by a family is essential for such company to be defined as a family business. Typically we use the term ‘family firm’ when the majority of the capital, with the corresponding voting rights, is owned by individuals from a single family circle, in such a manner that we can be sure that the family do govern the fate and future of the company. Whilst the control of the company can occasionally be attained with a minority of shares, it is most common to see most of the share capital in the hands of the family. To possess the majority of the voting rights means having the power to take all sorts of strategic and operative decisions within the company. Of course, the greater the percentage of ownership, the stronger the family’s influence on the fate of the company. The second defining feature of the family business is that the management of the company is controlled by the family members, who are also the primary decision makers. However, when analysing any firm, we know it is important to distinguish between the management of the company and its control. In the family company, when it is said that one or more members of the family take part in the management, this could mean that such members undertake the control and management activities simultaneously – this is frequently the case in first-generation companies and small businesses – or it may imply that they only undertake the control of the company, while the business is managed by professional managers who do not belong to the family. This latter case is more typical of companies in which the ownership is distributed among many members of the third and subsequent generations of a family and is also commonly seen in the case of large companies. Although the management activities of the family company are frequently conceived of as remaining in the hands of the family members, it is no less true that, if the family actively controls the company, this would be enough of a determining factor in the company’s decision-making process, and thus in the path that the company will follow. The third defining characteristic of the family company is the family’s continuous involvement over time, through successive generations of the same family. It makes no sense to speak of a family business if the company does not continue to be a long time under the control of the family circle.2 This aspect greatly limits the scope of enterprises that we refer to when we speak of a family company and defines certain aspects of business organization as distinguishing features of the family business.

294

The board, management relations and ownership structure

Thus, the transmission of the ownership, the requirements established to enable family members to become a part of the company, the leadership in the successive generations and the necessary attraction of professionals who are not family members are relevant issues in any study of the family business.

3.

DATA SOURCES AND METHODOLOGY

The quantitative information used in this study comes from the Spanish section of the Amadeus database, created by Bureau Van Djick, which basically compiles data that Spanish companies are required to record with the Companies Registry. Because this database is computerized, its contents can be processed, as we will see below. The large number of companies included in the database (virtually all of the Spanish companies) has enabled us to cover information on large, medium and small companies throughout Spain over several years. In fact, the number of Spanish companies included in the last database update was 830,000, and for the autonomous region of the Balearic Islands this figure was 26,747. There are essentially four types of information in the database that are relevant to our study: (i) the financial statements, (ii) information on the activities that the companies are engaged in, (iii) the list of administrators of the companies and the positions they hold, and finally (iv) the ownership listings, including both company shareholders and companies partially owned by other companies. The financial statements, including the balance sheets and operating statements, give us information on the size of the companies analysed and offer us an approach to the structure of their share capital. Certain proportions of business debt and earnings can also be compared among companies. The information on the business line of activity of each company is primarily based on that company’s assigned NACE (economic business activity) code. This classification makes it possible to assign each company a highly specific economic activity code, up to four digits, gradually adding in three-, two- and one-digit codes, to progressively specify the economic activity, while at the same time enabling companies with similar economic activities to be grouped together. The list of company administrators is essential to our purpose, as it allows us to measure the extent to which family businesses entrust the seats on their boards of directors (and therefore the firms’ governance and management powers) to family members. Here we can make use of the information that the Spanish ‘two-surnames’ incorporate. This surname

Board governance of family firms and business groups

295

system is very suitable for genealogical purposes, because it has two features that help to establish kinships. First, married women usually do not change their name; and secondly, every newborn has two surnames or family names (apellidos in Spanish): the first is the father’s first surname, and the second is the mother’s first surname.3 Having the names and surnames of the administrators makes it possible to process family ties on the computer, using first two surnames (enabling us to infer whether or not two administrators are siblings) and then one surname, which allows us to trace the generational family ties among administrators of different generations (parents and children, grandparents and grandchildren, uncles/aunts and nieces/nephews, and so on) as well as among those of the same generation (cousins). By way of example, consider the very simple board of directors of Barcelo Corporacion Empresarial SA, a firm pertaining to the Barcelo family included in our sample: Board of directors of Barcelo Corporacion Empresarial SA Barcelo Vadell, Simon Pedro Barcelo Tous, Guillermo Barcelo Vadell, Francisca Gonzalez Rodríguez, Raul The names of the board’s members are stated in the following order: father’s surname, mother’s surname, and finally Christian name (possibly two, as in Simon Pedro). The coincidence of two surnames in exactly the same order (Barcelo first, then Vadell) allows us to infer that Simon Pedro and Francisca are siblings; whereas the fact that there is only one surname that coincides between them and Guillermo Barcelo Tous allows us to infer that they either pertain to a different generation or are cousins (the order also allows us to discard some family ties; for instance, Guillermo cannot be Francisca’s son, since Barcelo would then appear in second place). Finally, the fourth member of the board is not identified as a member of the family, since there is no coincidence whatsoever of surnames. Finally, the lists of company shareholders show the proportions of share capital held by the individual shareholders of the firms, establishing who the last shareholder is. This information is not available for all of the companies included in the database. Another relevant type of information is the structure of the companies that control other subsidiary companies, with information on the percentage of their interest in their affiliates. This information is particularly useful to ascertain business groups and shed light on the relations between the companies and the ties between their administrators.

296

The board, management relations and ownership structure

Based on the personal information of the members of the ABEF and the Balearic families that belong to the IEF, we have used the Amadeus database to outline the different business groups in the Balearics. Our starting point was the notion that a company belongs to the family group whenever it is controlled by the family. To establish the business groups, we applied the following steps: (i) initially the family group included the companies in which the corporate partner who was a member of the above-mentioned associations figured as a company board member with significant ownership of the companies; (ii) subsequently, the group came to include companies in which its direct family members also figured as board members; (iii) this extended to the companies that were partially owned by the above companies, with the condition that such ownership consisted of at least one-fourth of the share capital; (iv) once firms were identified, we checked with representatives of the family firms associations the identification of firms within family business groups, correcting case by case any possible error which stemmed from the automated processes described in steps (i) to (iii). Finally, different controls were applied to the data to ensure that the companies analysed were indeed engaged in an actual economic activity. We eliminated from our sample any companies in the process of liquidation, those with no existing income and asset volume data for 2004 financial year, which was the last year fully published in the database, as well as the companies in which either of these two measures did not reach €60 000. Following the application of these selection criteria, the resulting number of sample companies was 556. Below we will describe the group of companies analysed. Prior to a detailed description of the family businesses, the object of our study, we offer some aggregate figures on these companies that show the significant amount of economic activity that they generate, and thus the importance of studying them. Subsequently, we explore these companies in some detail by applying two different procedures: first, we will analyse the companies individually; next, we group the companies according to the family that controls them, which gives us a group of companies for each of the 50 families of the Balearic Islands that form part of the ABEF or IEF. 3.1

The Relevance of Associated Family Companies in the Region

To address the relative importance of the member companies of the family business association in the Balearics, we can compare the figures of their economic activity with the economic activity volume generated in the autonomous region at large, namely the regional gross domestic product (GDP), or we can consider the number of workers employed by these

Board governance of family firms and business groups

Table 12.1

297

Aggregate values of the main magnitudes of the sample family companies Total value in thousands of €

Total assets Revenue Employees (number) Added value Equity Earnings before taxes Corporation tax

14 200 000 10 600 000 70 269 2 867 307 6 599 452 486 969 139 261

companies compared with the number of active workers in the Balearic Islands.4 In Table 12.1 we see that the 556 companies in our sample had a total asset volume of more than 14 200 million euros in 2004. If we add up the income volume generated by each of the 556 sample companies, our total is 10 060 million euros. By way of reference, for the year 2004 the value of the gross domestic product for the Balearic Islands was approximately 20 900 million euros. Obviously these figures are not comparable in the sense that the asset is a stock measure and the GDP a flow measure. To attain a figure that can be compared with the regional GDP we must refer to the added value generated by the companies in our sample. For this item, the value was 2867 million euros. As to the employee volume, the aggregate figure for 372 of the 556 companies that we have information on comes to more than 70 000 workers. Once again and to attain a point of reference, according to the statistics of the INE (Spanish Institute of Statistics), the employment volume for the year 2004 in the Balearic Islands was 455 000.5 Table 12.1 describes some aggregated data of interest on our sample of family businesses, including the value of their equity, which comes to nearly 6600 million euros; the earnings before taxes, which are approximately 486 million euros; and the total corporation tax, which comes to 139.26 million euros. Another aspect worth bearing in mind is the organization and control of the companies. All in all, the 556 companies have structured their governing bodies with a total of 2244 board members, and an average of 4.04 members, where 77.6 per cent of them are men, in 4.5 per cent of the cases another company figures as a board member in the official register, and nearly 18 per cent of board members are women. This first approach to associated family companies in the Balearic Islands gives us an idea – albeit

298

The board, management relations and ownership structure

a rather imprecise one – of their relative importance, and thus reveals their most salient magnitudes. A more in-depth study will enable us to characterize them according to what we might refer to as the typical or average company.

4.

COMPANIES UNDER THE CONTROL OF ASSOCIATED FAMILIES

4.1

The Representative Company

Characterizing the typical business based on our sample of 556 companies is by no means easy, given their vastly diverse sizes and the different sectors of activity that they belong to. Nevertheless, we see that the average company has assets of around 25.5 million euros, a revenue volume of 19.6 million euros and equity of approximately 5.19 million euros for the year 2004, as shown in Table 12.2. However these average values represent a great deal of dispersion among the 556 companies in the sample. The standard deviations are more than five times higher than the average values, which points to the bias introduced by several extreme observations, due to their very high values, for any of the financial magnitudes that we are contemplating. Hence, the median of the 556 sample companies can better characterize the typical company. We can now see that the observation of the company holding the central position in our sample is smaller than what the average of the observations could lead us to believe: it has an asset value of 2.6 million euros and a revenue volume of 1.27 million euros, it generates an added value of 543 million euros, and its equity is approximately 1 million euros. Panel B of Table 12.2 informs us about the boards of directors of these firms. The representative company has an average of four board members, one of which is a woman and the rest of which are men, with the exception of several seats assigned to legal entities (companies). The average business age of the 556 sample companies is 17.5 years. This is not excessively far from the median, which is 14 years. Panel C of Table 12.2 displays data on the average number of employees, which represents a great deal of dispersion, making the interpretation of this item quite difficult. Nevertheless, by examining the average data we can see that a third of the income from operations is allocated to staff salaries, and that the average return for shareholders is 10.4 per cent. This value goes down to 2.4 per cent when placed in relation to the return on assets. Finally, we can give information on the solvency ratio, which takes

Board governance of family firms and business groups

Table 12.2

299

Descriptive statistics of average values of the main magnitudes of the sample family companies (2004) Values in thousands of €

Panel A Total assets Revenue Added value Equity Earnings before taxes Corporation tax

average 25 519 19 683 5 194 11 870 889 255

median 2 683 1 278 543 1 001 23 4

standard deviation 142 167 100 152 30 035 69 350 5 414 1 456

Panel B Size of board of directors Men on board of directors Women on board of directors Companies on the board of directors

4.04 3.13 0.721 0.182

4 3 0 0

2.8 2.28 1.06 0.647

Panel C Employees (number) Company age (years) Staff costs/income from operations (%) Solvency ratio (%) Return on shareholders’ investments (%) Return on assets (%)

189 17.5 33.2

27 14.0 22.3

1 033 12.9 53.2

43.7 10.4

42.2 5.2

40.2 84.5

2.4

1.3

18.8

in the proportion of the company’s assets in relation to its net worth. In this case, the average value is 43.7 per cent, which is very similar to the median for the same item. This review of the financial magnitudes and administrative bodies enables us to make an initial approach. However, the high variability on the observed magnitudes suggests that a more detailed study is in order, distinguishing the characteristics of the companies according to their size or their sector of activity, as we shall see in the sections below. 4.2

Differences According to Size

In this section we have established the parameters for company comparisons by grouping them according to their size. To do so, we have divided

300

The board, management relations and ownership structure

the sample into three groups, corresponding to what we shall refer to as small, medium and large enterprises, according to their asset volume. Each tertile of the 556 sample companies is made up of 185 companies.6 This procedure aims to show more homogeneity than the analysis in the above section, amid the companies of each tertile, and in turn enables us to see any differences that may emerge among the companies that belong to different size groups. The values of Panel A in Table 12.3 illustrate the significant differences between small, medium and large enterprises. Thus, the average small company has an asset volume of 484 000 euros and a revenue volume of 711 000 euros, generates an added value of 238 000 euros, and its average earnings before taxes are 7000 euros. As a group, the 185 small companies only generate 126.6 million euros, for a total asset volume of 89.5 million euros. Their overall earnings before taxes are around 1.27 million euros. At the opposite end of the spectrum, large companies together account for more than 90 per cent of the revenue volume, number of employees and asset volume for the sum total of all the companies in our sample. On average, the large companies have 33.8 million euros in equity, and the earnings before taxes of the average company within this group come to nearly 2.5 million euros. The typical medium company generates a revenue volume of 2.7 million euros, with assets of 3.14 million euros, and equity for a value of 1.46 million euros. As a group, these 186 medium companies account for approximately 500 million euros in assets and revenue, with aggregate earnings before taxes of 24.67 million euros. Beyond the descriptive figures mentioned above it is interesting to observe the behaviour of the magnitudes associated with the corporate governing bodies according to their size. In Panel B in Table 12.3 we can see that, for the same number of companies in each size group, the total number of board members is 901 for large enterprises, 543 for small enterprises, and 803 for medium companies. Indeed, it is plain to see that the average size of the board of directors goes up as the company grows larger in size. The average values are 2.94 board members for the small companies, 4.34 for the medium companies, and 4.84 for the large companies. This comes as no surprise, if we consider that larger companies may require a greater participation in their government. For example, the corporate governance report for Spanish listed companies, Corporate Governance Report of the Companies with Values Listed in Stock Exchanges for the 2004 year, published by the regulator of the Spanish Stock Exchange, the Comision Nacional del Mercado de Valores (CNMV), reveals that the number of board members also rises with the size of the companies listed on the Spanish Stock Exchange, although the average number of members

301

Note:

543 444 76 23

2.40

0.41

0.12

0.22

0.74

3.38

4.34

3 140 2 726 28 836 1 460 135 53

average

medium

41

136

625

803

580 901 493 350 3 772 153 870 270 012 24 647 9 746

total

0.20

1.02

3.62

4.84

72 678 55 101 440 14 431 33 821 2 492 694

average

large total

37

189

673

901

13 500 000 10 000 000 65 047 2 669 824 6 290 648 461 049 128 330

Data correspond to the 2004 year, with 185 companies for the small and large tertiles and 186 for the medium company tertile.

Size of board of directors Men on board of directors Women on board of directors Companies on the board of directors

89 587 126 629 1 450 43 613 38 792 1 273 1 185

total

2.94

484 711 16 238 210 7 7

Total assets Revenue Employees (number) Added value Equity Earnings before taxes Corporation tax

Panel B (number of persons)

average

small

Average and total values of the main magnitudes of the sample family companies for three size levels, based on assets

Panel A (thousands €)

Table 12.3

302

Table 12.4

The board, management relations and ownership structure

Average values of the proportions of the main magnitudes of the sample family companies for three size levels, based on assets

Age (years) Staff cost/income from operations (%) Solvency ratio (%) Return on shareholders’ investments (%) Return on assets (%)

small

medium

large

13.9 38.2

19.9 31.2

18.6 31.4

43.6 22.1

46.0 −1.4

41.4 10.7

0.6

3.9

2.7

Note: Data correspond to the 2004 year, with 185 companies for the small and large company tertiles and 186 companies for the medium company tertile.

is not directly comparable with the companies in our sample, as the average number of board members for the listed companies is 9.7. While there are differences in the number of board members according to the size of the family companies, differences can also be seen in their composition. The proportion of women on the boards of directors of the small companies is 14 per cent, becoming 16.9 per cent in the medium companies and reaching 21 per cent in the large companies. Finally, the size-based classification enables us to observe some proportions regarding the cost, profitability and structure of the family businesses. Table 12.4 shows no significant difference in the average age of the medium and large enterprises, standing at approximately 19 years for both groups. However, the average age of the small companies is markedly lower: 13.9 years. Moreover, it seems that the small companies tend to be more labour intensive, as they allocate a larger proportion of their revenue to staff salaries (38.2 per cent, in relation to the 31 per cent allocated by medium and large companies). The solvency ratio oscillates between 41 per cent and 46 per cent, with no apparent pattern related to the average size of the companies. The profitability ratios display the greatest differences in the average values according to company size. The returns for shareholders are higher for small companies than for large ones, whilst, on the other hand, the return on assets is greater for the large and medium companies. The medium companies, in this comparison, present the lowest shareholders’ returns of the three groups and the highest total returns on assets.7 In any case, we must proceed with caution when considering these average values, for two reasons. The first is the heterogeneity of the companies included in each

Board governance of family firms and business groups

303

group, as these average values are not weighted, meaning that they place the same relative importance on the smallest company within the tertile as they do on the largest. The second reason lies in the database, which conveys the information provided by the companies to the Trade Registry. A significant number of the very small companies present unaudited accounts, as the regulations in force do not require them to be audited. 4.3

Sector of Activity Diversity

Indeed, the vast disparities in the sizes of the companies allow us to observe differences in some of their behaviour variables such as profitability and the composition of their boards of directors. All the same, there are operational aspects of the companies that could potentially affect their profitability, and which are tied to their specific business activity. In this section we present different magnitudes, assessing the companies together according to their sector of activity at the NACE one-digit level. Table 12.5 illustrates the main measurement magnitudes of the companies by sector of activity, and shows the distribution of the sample companies among the eight major sectors into which the sample has been divided. Most of the economic activity, according to the aggregate values of asset and revenue volume, resides in three sectors of activity: hotel and catering, transport and communications, and real estate and business services. These three sectors embrace the majority of the companies associated with tourism, which is characteristic of the Balearic economy. Along these lines, Table 12.5 suggests that the distribution of economic activity for family firms follows a similar pattern to that of the Balearic GDP. Moreover, the distribution of the companies in the sample, which was calculated with different variables such as the number of companies in the sample, asset value and revenue level, is similar to the relative weight of each of the sectors in the Balearic economy, as shown in Table 12.5. The distribution of the number of companies in the sample is to a large degree in line with the data on the regional GDP composition, with the exception of the grouping of other activities, which takes in such diverse activities as education, healthcare and veterinary activities, social services, personal services and financial intermediation. The figures of the companies in hotel and catering and in real estate and business services are representative of the considerable weight of the tourist industry in the Balearic Islands, as it includes lodging in hotel establishments and other forms of rentals, and also what is known as the complementary supply. By asset volume, the average size of the hotel companies is significantly greater than those of agriculture, industry, construction and trade, despite the fact that its number is equal to the sum of those that form these other

304

Table 12.5

The board, management relations and ownership structure

Relative relevance of the economic activity sectors in the 556 sample companies

Agriculture, livestock, fishing and power Industry Construction Trade and repairs Hotel and catering Transport and communications Real estate and business services Other activities

Companies in sample (%)

Contribution of the sector to regional GDP (%)

Companies’ sample assets (%)

Companies’ sample revenues (%)

1.26

3.64

0.12

0.05

6.29 6.29 9.53 21.76 12.59

5.75 10.43 9.93 25.22 8.96

1.59 1.75 2.70 43.74 8.03

2.41 1.90 7.45 22.53 41.55

35.61

18.16

40.98

23.59

6.65

17.92

1.09

0.52

Note: Comparison of relative weights of the magnitudes of asset size and revenue volume, as well as the number of sample companies, with industry distribution reported by the National Institute of Statistics (INE) in the regional accounts. The industry groupings are based on the NACE 1-digit level.

sectors. The high average revenue volume of the companies in transport and communications is due to the fact that this sector includes the Balearic Islands’ major travel agencies,8 which are well-established nationally and internationally and have relatively very high revenues and assets. To assess profitability, labour expenses and financial structure, Table 12.6 displays the corresponding proportions after weighting these values according to the size of the companies, which in turn was calculated according to the asset volume of each company. This prevents us from attributing to a small company the same weight that we attribute to the large sample companies in the same sector. Particularly worthy of note in the column on staff expenses over income from operations is the high intensity of labour in the primary sector and the ‘other activities’ group, which is essentially made up of personal services. As to the solvency ratios, the low values for the construction companies are salient, which is now typical of this sector and of the transport and communications sector, given the high debt rates in relation to their equity. As regards the returns on assets, the values oscillate within margins that display little dispersion among the sectors. The return on stockholders’ equity, however, exhibits greater dispersion, although

Board governance of family firms and business groups

Table 12.6

305

Proportions of profit, financial structure and expenses by activity sector Return No. of Return on companies shareholders’ on assets (%) investments (%)

Agriculture, livestock, fishing and power Industry Construction Trade and repairs Hotel and catering Transport and communications Real estate and business services Other activities Total

Solvency ratio (%)

Staff cost / income from operations (%)

7

25.6

4.0

51.6

43.1

35 35 53 121 70

2.4 26.3 16.7 7.0 39.5

3.6 5.0 8.5 3.6 4.2

38.6 23.5 46.0 45.0 18.3

24.3 15.7 8.5 33.9 10.9

198

8.0

2.7

60.3

38.5

37 556

−5.6 10.5

3.0 3.4

54.2 48.8

71.5 32.6

Note: The proportions were weighted according to the size of each company, bearing in mind each company’s total assets.

it must be viewed with caution, as some of the companies do not present audited financial statements, as we have mentioned, and the absence of certain observations could distort the average values of the sample.

5.

BUSINESS GROUPS UNDER THE CONTROL OF ASSOCIATED FAMILIES

Although we have explored the family companies in the section above, we have to consider the fact that each family can control more than one company. Naturally a family will not take a certain business decision for each company separately, but rather will consider the group of companies under its control as a whole. This calls for a description of business groups under the control of each family in the sample. The key to making this possible resides in the ability to ‘build’ the group of companies to be assigned to each of the families, so as to assess the decisions of the associated corporate families in the Balearic Islands.9 The first issue that we can address by studying the family groups is

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the concentration or dispersion of sizes among the different family groups, and, within them, the differences we observe among the companies within each group. By individually studying the companies in the above section, we have seen vast differences in size, sector and even governing body composition. By attaching these companies to their respective family groups, the questions regarding heterogeneity continue to be of application among companies of a single-family group. We also explore the families’ corporate diversification strategy, distinguishing the degree of sector diversification, according to whether diversification revolves around a main business activity (related diversification) or whether sector diversification is more intense, meaning that it is not necessarily linked to any initial core business. Finally, we delve more deeply into the administrative and management bodies of the business groups and the degree of involvement of the controlling family. 5.1

Family Group Heterogeneity

Among the family groups studied, the typical one has an average of 11 companies, with a total asset value of 283 million euros and an average revenue nearing 213 million euros, and provides employment to a total of 1464 employees. These averages represent a great deal of dispersion, however. Another way of characterizing the ‘usual’ family group would be to consider the median of the values mentioned above: 7 companies per family group, with a total revenue volume of around 29 million euros, and total assets of nearly 42 million euros. These are family group companies with an age of around 18 years and are run and controlled by the second or third generation of the family. To address the structure of the companies that form the family groups, we can present two opposite structures. On one hand, there are groups made up of several companies (on average seven), all of which are equally important as regards the volume of activity or the asset volume. On the other hand, there may be business groups that are formed by many companies but there is one of them that generates nearly all of their aggregate activity, while the other companies are virtually insignificant. What is the most common structure among the family groups in our sample? What we see is that they tend more towards the second situation than the first, although with significant differences. Indeed, Table 12.7 shows that the largest company of each of the 50 family groups of our study generates 53 per cent of the total asset volume and 44 per cent of the total revenue of the group.10 The degree to which the activity is concentrated in a reduced number of companies can also be seen in the fact that the three largest companies in each group represent three

Board governance of family firms and business groups

Table 12.7

Distribution of the importance of the largest and succeeding companies in each group in the study sample

Importance of the company in the group largest second third fourth fifth

307

Proportion of total activity (%) Assets

Accumulated

Revenue

Accumulated

53.0 17.7 6.6 4.6 2.9

53.0 70.7 77.3 81.9 84.9

44.1 19.0 13.0 3.8 2.0

44.1 63.1 76.1 79.9 81.9

quarters of the family group activity, both in terms of asset volume and in terms of revenues. For 36 of the 50 family groups that have formed five or more companies, the total activity of those five largest companies accounts for nearly 85 per cent of the group total, while the fifth most important company represents only 3.6 per cent of the group’s activity. As regards their legal format, 270 of the 556 are limited companies, 282 are public limited companies and 4 are other types of organizations. Among the largest companies in the 50 family groups, 34 are public limited companies and 16 are limited companies. Thus, we can confirm that the business structure of the associated family companies in the Balearics is complex, though it is built upon a small number of companies. In many cases, hidden beneath the number of companies that sustain the family business structure there is a diversification strategy. Indeed diversification into activities that may or may not be similar to the core activities of the family business is important from the perspective of the diversification of risks. In the next section we apply the appropriate method to explore their diversification strategies. 5.2

Measurement of Family Group Diversification

When we speak of business diversification we refer to the entry of a company, business group or shareholder into a number of different economic activities. Alternatively, a non-diversification strategy means focusing on a single activity or line of business. Moreover, it is common in the business and the economics literature to distinguish between related and unrelated diversification. Related diversification implies involvement in several different lines of activity that share a group of corporate resources and the same organizational abilities or skills. The sharing of technology, sales forces or distribution activities might be considered an example of related diversification. When these

308

The board, management relations and ownership structure

technological, commercial or skill-related connections do not exist among different business units, diversification is understood as being unrelated.11 Undoubtedly, any abstract classification ranging between the extremes of ‘non-diversification’ and ‘maximum unrelated diversification’ enables the practice of many different levels or degrees of diversification. The actual positioning of each company or business group on this scale between the extremes can be empirically measured thanks to the existence of universally accepted sectorial classification standards. We will use below the European sectorial classification (NACE) system implemented by Eurostat, which uses four-digit codes to classify the different types of activities. There are also three-digit groupings, and two-digit divisions, which can be broken down into one-digit divisions for large-scale sectorial grouping. Moreover the database we use assigns each company a main activity code and another secondary activity code, which allows us to measure the distance between the sectorial activities, bringing us closer to the concepts of related and unrelated diversification. In the case of family groups, the relevant unit with which to study the level of diversification is the family group, not the individual company.12 A first simple way to measure the family business groups’ sectorial diversification consists of simply counting the number of different activity codes within a group. For the three- or four-digit NACE codes, a high number of different codes will mean a high degree of related diversification. A high number of different NACE onedigit codes, on the other hand, would be indicative of the group’s unrelated diversification. Obviously, if all of the activity revolves around a single NACE code, regardless of the number of companies that make up the group, this tells us that the family group has chosen to focus its economic activity on very few activities. In other words, it has decided not to diversify. Table 12.8 illustrates how the median number of activities of the family business groups is amid three different codes, if measured within the NACE one-digit code for large sectors. When we further specify the breakdown of the codes, the averages for two- and three-digit codes are 3 and 4 respectively. The company groups with an average of 6 companies are devoted to 4 different activities if calculated with the NACE 3-digit code, or to 3, if the NACE calculation is within the one-digit sphere. For the values of the average number of activities of the 50 family business groups taken together, the number of different sectors increases with the level of precision (number of digits considered) from 2.76 for a one-digit NACE to 4.9 for a three-digit NACE. In other words, the 11.2 companies of the average are devoted to only 2.76 different NACE one-digit activities, whilst the number of different activities of these companies with greater sectorial precision is 4.9. However, these levels of diversification provide little information, as it is difficult to establish points of comparison. Nor

Board governance of family firms and business groups

Table 12.8

309

Family groups and sectorial diversification according to number of different NACE codes and group size Number of different NACE codes

Panel A: median values Family group size Small Medium Large Overall

1 digit

2 digits

3 digits

Number of companies per group

2 3 3 3

2 3 6 3

3 4 6 4

3 6 16 6.5

2.00 2.59 3.65 2.76

2.31 3.12 5.82 3.78

2.69 3.76 8.12 4.90

3.25 6.88 22.76 11.12

Panel B: average values Small Medium Large Overall

can such points of comparison be established with non-family-business groups, as it becomes difficult to define where these other groups begin and end. Moreover, there are no references for other studies on family business groups in other geographic regions, thus making the assessment of these levels of sectorial dispersion more difficult. All the same, Table 12.8 displays some interesting results: if we divide our sample of 50 family business groups into three sub-groups according to their size, we will see how the small groups form an average of around 3.25 companies per group, the medium family groups have 6.8 companies and the large groups show an average of 22.7. The overall median value of these large family groups is 16 companies per group. In other words, we see that the greater organizational complexity of large family groups by virtue of their numerous companies is actually based on businesses within the same activity sector. At the other extreme, for the smaller family groups each branch of activity appears to be proportionally closer to a different company, particularly for the three-digit sectorial classification. This first approach to the diversification strategies of the family business groups leads us to the conclusion that large groups tend to diversify more in absolute terms, which is probably explained by the fact that their larger size entails a large number of companies, in relation to the medium and small family business groups. We can also conclude that when entering new economic activity sectors, which may or may not be interrelated, the large family groups do so with a larger number of companies, whereas the small family groups tend more towards the structure of companies that are each associated with a different activity, if they opt for several companies.

310

The board, management relations and ownership structure

A descriptive study based on calculating the number of different activities that a family business group has become involved in is highly simplistic. Such approach assumes that each and every one of the activities bears the same weight within the business group, thus skewing the results towards potentially fictitious diversification rates. Hence, we next proceed to a more sophisticated analysis that takes into account the relative importance of each of the companies within the group. The literature on business diversification often makes use of the entropy measure to offer a weighted assessment of the degree of sectorial diversification, enabling the distinction between related and unrelated diversification. Our entropy measure uses a weighted average of the activities within the business group at a NACE three-digit level in relation to diversification at a one-digit level.13 This is a typical continuum measurement that assigns higher values to high diversification levels and lower values to low diversification levels. By way of example, consider two business groups with construction, hotel and food activities. Group A has 90 per cent of its activity in hotels, 5 per cent in construction and another 5 per cent in food. Group B has one-third of its activity in each of the aforementioned sectors. If we only take into account the different NACE numbers in each case, there are 3 in both groups, leading to the misleading conclusion that Group A is just as diversified as Group B. The entropy index instead gives us a value of 0.39 for Group A, whereas for Group B the index is 1.09. The entropy index is thus a more precise depiction of the concept of business diversification. As occurs with the NACE number diversification measure, the simple observation of the entropy index values offers little information on the intensity of diversification. Once again, because we have no non-family business groups as a control group, our study must be limited to the differences in behaviour according to the size of the different family business groups. Panel A of Table 12.9, which shows the entropy index diversification median values for each of the three family group sizes, does not differ considerably from Panel B, which displays the average of each of these groupings. We must point out that related diversification is more important than unrelated diversification for any family group size. In fact, in Panel B, the average of the entropy coefficient for all of the business groups together is 0.93 while the unrelated diversification is 0.56. Hence related diversification accounts for 62 per cent of the total diversification, and unrelated diversification explains the remaining 38 per cent. These values show how diversification particularly revolves around the group’s core business areas, though with some dispersion in areas that are not directly related to such central business activities. This behaviour is more pronounced in the small family groups, which

Board governance of family firms and business groups

Table 12.9

311

Family groups and entropy coefficient for related and unrelated diversification according to the size of the business group

Panel A: median values Family group size Small Medium Large Overall

Diversification Related

Unrelated

Total

0.71 0.79 0.90 0.81

0.55 0.60 0.68 0.6

1.38 1.51 1.75 1.48

0.84 0.90 1.03 0.93

0.44 0.59 0.64 0.56

1.28 1.50 1.67 1.49

Panel B: average values Small Medium Large Overall

often hinge two-thirds of their diversification on a main activity. Even though the entropy measure plots the relative importance of an economic activity sector within the family group, the diversification value is greater in large groups than in small groups, for both related and unrelated diversification. As a result, we see that the larger family groups diversify more than smaller groups, even when the measure of diversification weights the relative importance of each activity. This effect of diversification is based more on related diversification for the small groups than for the larger groups. The concept of entropy takes in the organizations’ natural tendency to become more complex through time. In our case, diversification comes to take on this tendency in connection with the growth and age of the organizations, and particularly for family businesses in which successive generations are admitted into the company. In the case that this assertion is true, the level of diversification will grow with the overall age of the companies that make up the family business group. In fact, as can be seen in Figure 12.1, the business groups that amass greater experience, with more consolidated and more numerous companies, adopt higher levels of diversification. For well-established family groups with several generations of experience, the evolution through time that accompanies the years of business experience leads to the decision to diversify to a greater extent than the diversification generally undertaken by younger family groups. This study of diversification gives us a reference of the behavioural business patterns of the family groups to diversify risks by investing in

312

The board, management relations and ownership structure Small groups

Accumulated number of years of companies of the group

1000

Medium groups

Large groups

Total diversification values Adjustment

500

0 0.5

Figure 12.1

1

1.5

2

2.5 0.5

1

1.5

2

2.5 0.5

1

1.5

2

2.5

Level of sectorial diversification (entropy) and accumulated age of the companies within the family group

different sectors of activity. It is not only the reduction of financial risks that explains the tendency to diversify. Economic efficiency reasons, such as the attainment of economies of scope, capitalizing on specific skills or aptitudes within the company, or the mere need to allocate the funds generated by the business activity can explain this tendency to diversify. On the other hand, diversification also brings along potential expenses, given the need to incorporate new skills into unrelated activities, difficulties in implementing systems of control when the activities are diverse and even inefficiencies in the allocation of resources outside the discipline of the capital markets. The advantages and disadvantages of business diversification are processed by the controlling shareholders, which by definition in the case of family groups are the family members. All the same, diversification can require the incorporation of new skills or simply of new financial partners, which can lead to the possible dilution of family control. These aspects are further explored in the next section. 5.3

Business Group Directors and the Family

The control of the companies within a family group can be organized into many different possible models between two extremes: at one end of the spectrum, the governing bodies can revolve around a small number of people who amass offices as board members in each of the companies;

Board governance of family firms and business groups

313

and, at the other end, the administrative bodies can be entrusted to a large number of individuals that barely repeat from one company to another. If we form a hypothetical board of directors of the business group, by adding up the members of the boards of directors within the family groups, we can shed some light on these matters. The representative family group of our sample, made up of 11 companies and 4 board members per company, could be described, at the lowermost limit, as a family group entrusted to a number of people that equals the size of the largest board in the group.14 On the other hand, the maximum possible number of board members could be applied, in which case it would be made up of 44 different people. Table 12.10 illustrates the average and median values for the 50 family groups in our sample. Panel A shows how the median number of companies per family group is 6 and the number of board member posts to be covered is 23. On average, the family groups entrust these 23 board positions to 10 different individuals. Panels C and D of Table 12.10 contain the proportions of each type of relative in relation to the size of the board. The median (Panel C) for the dispersion of individuals is 43 per cent, and the average for such items is 41 per cent, as can be seen in the same column in Panel D. As we have seen in the previous section, there are significant differences in the median values for the business groups according to their size per asset volume. Thus, the small groups with 3 companies use 4 different individuals to cover the 7 positions. Abounding in this sub-sample of smaller family groups are companies with sole administrators. This circumstance makes the proportions to which they become open to different individuals higher than in larger size business groups. For the large groups, as illustrated in Panel B, the number of different individuals is higher, simply due to the larger size of their boards of directors. However, the proportion of different individuals is the lowest of the three business group sizes, with a proportion of 38 per cent, as shown in Panel D. As a result, we can conclude that the associated family groups in the Balearics rely on a common nucleus of 6 people for every 10 board positions to be covered. This proportion is smaller in the small family groups than in the larger ones, which in absolute terms place their posts in the hands of a larger number of different individuals. These measures of diversity or dispersion of individuals do not necessarily comply with the dictates of the family centre of control. Thus, for companies that have outside members or bring in experts in certain lines of business for technological reasons, the dispersion rates can vary considerably. Yet, from the perspective of family groups, the salient question is how many of the individuals that form part of the boards of directors actually share family ties. The data available in the public registries, which in this

314

The board, management relations and ownership structure

Table 12.10

Opening of family groups to non-family board members, for different degrees of kinship, according to the size of the business group

Panel A: median values Family group size Small Medium Large Overall

Dispersion of board members (number) Number of Board companies members per group 3 6 16 6

7 22 59 23

Panel B: average values Small Medium Large Overall

Different individuals 4 9 34 10

Different ‘siblings’

Different ‘cousins’

3.5 7 29 8

2.75 4.5 19 6

Dispersion of board members (number) 3.25 6.88 22.76 11.12

10.69 24.18 93.59 44.44

7.13 11.12 35.29 18.06

4.81 8.65 30.29 14.78

3.88 6.59 19.53 10.12

Panel C: median proportions

Dispersion of board members (proportion)

Small Medium Large Overall

0.57 0.41 0.58 0.43

Panel D: average proportions

Dispersion of board members (proportion)

Small Medium Large Overall

0.67 0.46 0.38 0.41

0.50 0.32 0.49 0.35

0.45 0.36 0.32 0.33

0.39 0.20 0.32 0.26

0.36 0.27 0.21 0.23

case come from the Trade Registry (information recorded in the SABI database we use), give us the identities of the members of the different boards of directors. One way to examine family control and take advantage of the name and two-surname structure in force in Spain is to look at the number of family ties among board members. Thus, the individuals who share both first and second surnames will be listed as siblings, and those who share only one surname will be listed as ‘cousins’. The sibling kinship listings will seldom lead to an error when considering family ties,

Board governance of family firms and business groups

315

with the exception of situations that stem from second marriages or other special cases. Undoubtedly however, our cousin listing covers many family relations beyond those known as cousins in daily language, as it includes, in addition to actual cousins, parent–child and grandparent–grandchild relations, and uncle/aunt–niece/nephew relations. The concurrence of surnames on a board of directors of a family group is a reasonable indication of the degree of kinship among its members, and its consideration thus enables us to quantitatively evaluate the extent to which families keep the control of the business groups in the hands of family members or the degree to which they are open to the inclusion of non-family members on their boards of directors. Among the measures of dispersion of board members, Table 12.10 also offers the median and average values for the number of ‘different siblings’ in the Balearic family groups. For a typical business group, taking the median values (Panel A), with 6 companies and 23 board members, the administrative bodies are made up of 10 different individuals. Eight of them have different pairs of surnames, suggesting that 2 of the 10 are siblings. Moreover, 6 of the 10 members show no surname concurrence with any of the other members, leading us to believe that there are 2 individuals of the remaining 8 who have a family relationship that we have generically listed as ‘cousins’. These median measures of dispersion for the family group are not proportionally very different from the values presented by the average, which can be seen in Panel D of Table 12.10. In fact, every 10 seats on the boards of directors are covered by a little more than 4 individuals (average 41 per cent proportion). More than 3 of those individuals are not siblings (average 33 per cent proportion), and nearly 2 of them have no family relationship that can be inferred from the surname (average 23 per cent proportion). Panel D of Table 12.10 also shows us the existing differences between the small family groups and the larger ones, as regards the proportion of board members that share family ties. The small family groups incorporate greater proportions of individuals without sibling or ‘cousin’ family ties onto their boards of directors. These proportions of outsiders to the family are considerably lower in the large family groups, despite the fact that the latter tend to incorporate a larger number of non-family members on their boards, by virtue of the larger numbers of board seats. 5.4

Sector Diversification and Family Control

There is one last aspect that allows us to find relations between two of the points that we have discussed thus far: on one hand, diversification as a

316

The board, management relations and ownership structure

relevant aspect of the family group policy, and on the other, the degree to which the boards of directors are open to include board members from outside the family. Here, the relevant question is whether the family groups that opt for greater sectorial diversification do so through tighter family control over the governing bodies or whether they rather tend to be more open to the inclusion of outsiders on their boards of directors. There are numerous theory-based arguments in favour of and against family control of diversified companies. Family expansion in new business areas may require the incorporation of new members, whether financial (who contribute monetary resources) or technological (who bring in new know-how or organizational skills in order to carry out new activities). For a given size of the family that controls the business group, embarking on new business ventures can depend on the family members’ management skills or knowledge of the new sector. If these requirements are fulfilled, one could expect greater degrees of diversification to be accompanied by a larger number of members from outside the family, and the proportion of family members on the boards of the companies within the group would be lower than on those of the groups that do not diversify. On the other hand, the expansion into new business areas can also mean the potential loss of family control over the activities of the group of companies. The incorporation of new executive directors or managers of new business areas may require greater board supervision and control, which will be exercised by appointing family members as board members. In these situations, the mechanisms of trust are what justify a strong family presence to prevent the loss of control over the important decisions made in the group’s companies. If this effect is prevalent, we might anticipate that the higher the degree of diversification, the higher the rates of family members on the boards of directors in the family business groups. Table 12.11 shows the average values and proportions of the groups’ openness to non-family members on the boards of directors, and divides the business groups according to their overall diversification level (measured by means of the entropy index). The results of Panel A are clear: greater diversification goes with a larger number of different individuals as well as a larger number of sibling board members. The cousin-relation trend follows a similar pattern: the greater the sectorial diversification, the larger the number of individuals with no surname concurrence. This trend is explained by the size of the business group: greater sectorial diversification also occurs with a higher number of group companies. This necessary opening of the company to incorporate new talent or new partners into the diversified activities is explained by how they complement the family administrators.

Board governance of family firms and business groups

Table 12.11

Opening of family groups to non-family board members, for different degrees of kinship, according to the degree of sectorial diversification

Panel A: average values Sectoral diversification Low Medium High Overall

Low Medium High Overall

Dispersion of board members (number)

Number of companies per group

Board members

Different individuals

Different ‘siblings’

Different ‘cousins’

3.25 6.88 22.76 11.12

10.69 24.18 93.59 43.46

7.13 11.12 35.29 18.06

4.81 8.65 30.29 14.78

3.88 6.59 19.53 10.12

Panel B: average proportions Sectoral diversification

317

Dispersion of board members (proportion) Different individuals

Different ‘siblings’

Different ‘cousins’

0.67 0.46 0.38 0.42

0.45 0.36 0.32 0.34

0.36 0.27 0.21 0.23

Panel B of Table 12.11, nevertheless, shows that as the business groups diversify more, they become less open to non-family members. Indeed, the proportion of non-sibling board members in relation to the total number of board members for the group is 45 per cent for the family groups with more limited sectorial diversification, whereas for more diversified groups the rate is only 34 per cent. A similar result is seen when the type of family relation taken into consideration is limited to one surname. In such cases, the less diversified groups display a 36 per cent proportion of ‘non-cousin’ individuals, whereas the more diversified groups only have a 21 per cent dispersion rate, suggesting that the remaining 79 per cent of the members share a surname. This study can lead to the conclusion that the more diversified business groups incorporate a larger number of new talents into their boards of directors, and that such new individuals do not necessarily share any family relations with already-existing members. Nevertheless, the control effect is also prevalent, as the proportion of non-family members brought into the group is increasingly lower in relation to the members that share some sort of family tie.

318

6.

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CONCLUSIONS

This chapter presents a general description of the business groups of families that belong to the ABEF and IEF associations in the Balearic Islands. The first thing to be verified, their economic relevance in the general level of economic activity of the Balearic Islands, has become evident when we evaluate their weight through aggregate measures such as total regional employment and GDP. We have presented a description of the organizational structure of the companies that belong to the associated families, which are analysed individually. Organizational aspects such as the size of the boards of directors and the most relevant economic information from their annual accounts reveal large disparities in activity sectors and company size. The relatively high presence of women in the governing bodies of the companies (by Spanish standards) is also worthy of note. The 566 sample companies are not intended to be a representative sample of the economic activity of the Balearics. However the distribution of their activities in the different sectors, and particularly those directly or indirectly associated with tourism, are not significantly different from the information of the aggregate official statistics. We also have analysed the characteristics of the business groups that have been formed around the 50 member families studied. Once again, the diversity of the sizes has allowed us to undertake a homogeneous comparison after grouping them according to their asset volume. These groups of companies are formed around one or two central companies, which generate nearly 70 per cent of their activity, despite the fact that the average number of companies per group is eleven. The largest family business groups present higher degrees of sectorial diversification, although it is the smallest groups that base a larger proportion of their diversification on activities that are not related to their main core business activity. The study of the governing bodies of the family groups reinforces the idea of family control in the sense that these groups rely on a small group of people to serve as board members in their companies, and the types of family relations among them are diverse. This phenomenon is more pronounced in the largest family groups: by having larger boards of directors, the number of different people that they rely on is also larger. However, these larger groups also show a larger proportion of board members that share family ties than the smallest family groups do. The trust effect inherent in the inclusion of officers that share family ties is predominant over the entry of non-family member officers for the companies with the highest rates of sectorial diversification, demonstrating that

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diversification strategies are possible while keeping the family structure of the business groups intact. Future studies could enhance the description of these family groups by following two basic approaches. The first would be to gradually incorporate new sources of data that would allow us to describe in greater detail the elements discussed here and explore new aspects of the organization of the family groups. For example, it would be interesting to look into the requirements for the degree of participation of women on the boards of directors of these companies. Could such participation be contingent on the founding generation’s continued control of the business group or on successive generations being incorporated into it? We have taken an aggregate approach to family relations, using public information. A detailed study of the specific posts held by the family members and outsiders might clarify the concept of family control, while enabling us to ascertain the true role of the women in this mechanism of control. Secondly, here we have offered a static description of these family business groups. It would be interesting to follow their evolution through time, which would allow us to examine the determining factors of the groups’ business organization decisions in greater detail, their diversification strategies, their organizational structure and even their profitability.

NOTES 1.

2. 3.

4.

See Shanker and Astrachan (1996) and Sharma (2003) for a discussion and different definitions of family firms, based on the degree of family involvement in the firm. Another literature develops a typology of family firms along the potential combinations of three axes: the ownership of the firm, the family structure and the characteristic of the company (see Gersick et al., 1997; Neubauer and Lank, 1998). Indeed, it has been argued that one main non-pecuniary benefit for family members to own and control a firm is the satisfaction of transferring the firm to the descendants (see Casson, 1999). The law has recently been modified in Spain, so that the order of surnames can be changed: first the mother’s surname, and then the father’s surname. This change can be done by mutual agreement of both parents, or by the choice of the concerned individual when he/she reaches the age of majority (18 years). Until now this modification has had almost no practical impact on the structure of surnames in Spain. In any case, the reader will have to bear in mind that the data on the companies studied do not exclusively refer to the economic activity or employment generated in the Balearic Islands. Indeed, when a hotel chain of an ABEF member, for example, has establishments in Mexico, and its earnings are calculated within a Spanish company that is included in the database that we have used, such economic activity is under the control of the member families of the ABEF and is therefore taken into account in our study of the economic activity of the family businesses under control of ABEF-member families, although it is not an economic activity in the Balearic Islands. Similarly, our study calculates the activity of the Banca March, where it is a well-known fact that this institution has a large number of offices outside of the Balearics that generate employment

320

5.

6. 7. 8. 9. 10. 11.

12. 13. 14.

The board, management relations and ownership structure and economic activity outside of the Islands. By our definition, this is a new economic activity under the control of a Balearic family business. Let us recall again that we must proceed with caution when drawing these comparisons, as the sample includes companies under the control of the families of family business associations in the Balearic Islands, regardless of where their activity is carried out, and in some cases a significant part of such activity is undertaken outside of the Islands. Actually, the middle tertile is made up of 186 companies. The univariant study presented does not allow us to reach any conclusions or explanations for the non-monotonic behaviour of a variable, although we could make some speculations on this significant fact. These also include those of the group Globalia. Section 3 above explains the procedure we follow to assign the companies to Balearic ABEF- and IEF-member families. If, rather than measuring the importance in relation to the total activity volume, the average relative importance of the largest company is measured and expressed in the percentage of each family group, such percentage goes up to 56 per cent. There is a large literature that tries to evaluate the possible benefits of diversification for firms; see Campa and Kedia (2002), Grant et al. (1988), Hadlock et al. (2001) and Villalonga (2004). For the particular case of family firms, see Anderson and Leeb (2003). Anyway, let us mention that, for the family firm, Anderson and Reeb (2003) find that family firms diversify less than non-family firms. The use of the entropy index for measuring diversification is based on work by Jacquemin and Berry (1979). For further details, see Appendix 12.1, which displays the breakdown of the entropy index. For a group of 11 companies with 4 board members each, the minimum number of people to whom the administration would be entrusted in this case would be 4.

REFERENCES Anderson, R.C. and D.M. Reeb (2003), ‘Founding-family ownership, corporate diversification, and firm leverage’, The Journal of Law and Economics, 46, 653–84. Campa, J.M. and S. Kedia (2002), ‘Explaining the diversification discount’, The Journal of Finance, 57 (4), 173–62. Casson, M. (1999), ‘The economics of the family firm’, Scandinavian Economic History Review, 47, 10–23. Gersick, K.E., J.A. Davis, M. Hampton and I. Lansberg (1997), Generation to Generation: Life Cycles of the Family Business, Boston: Harvard Business School Press. Grant, R.M., A.P. Jammine and H. Thomas (1988), ‘Diversity, diversification, and profitability among British manufacturing companies’, Academy of Management Journal, 31, 771–801. Hadlock, C., M. Ryngaert and S. Thomas (2001), ‘Corporate structure and equity offerings: are there benefits to diversification?’, Journal of Business, 74 (4) 613–35. Jacquemin, A.P. and C.H. Berry (1979), ‘Entropy measure of diversification and corporate growth’, Journal of Industrial Economics, 27, 359–69. Neubauer, F. and A.G. Lank (1998), The Family Business: Its Governance for Sustainability, London: Macmillan. Shanker, M.C. and J.H. Astrachan (1996), ‘Myths and realities: family businesses’

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contribution to the US economy: a framework for assessing family business statistics’, Family Business Review, 9 (2), 107–23. Sharma, P. (2003), ‘Stakeholder mapping technique: toward the development of a family firm typology’, mimeo, Laurier Business & Economics. Villalonga, B. (2004), ‘Diversification discount or premium? New evidence from the business information tracking series’, Journal of Finance, 59 (2), 475–502.

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APPENDIX 12.1

THE ENTROPY INDEX

This index is used as a measurement of diversity. In our case, it allows us to assess the extent to which a family group diversifies its activity in different economic sectors. If Pij is the proportion of the assets of a given business group in activity i (NACE 3-digit code) in industry j (NACE one-digit code), the entropy index for the total diversification of this business group is calculated as follows: m

n

Total diversification 5 DT 5 a a [ Pij 3 ln (1/Pij) ] for Pij 2 0 j51 i51

Jacquemin and Berry (1979) propose the following breakdown of the total diversification into related and unrelated diversification: m n Pij Pij Related diversification 5 DR 5 a Pj a c a b 3 lna b d Pj Pj j51 i51 m Pij Non-related diversification 5 DNR 5 a Pj 3 lna b P j51

j

It must be noted that these two measurements and the measurement of total diversification are consistent in the sense that the measurement of the entropy of the total diversification is the sum of the related and unrelated diversification, DT 5 DR 1 DNR. Reference Jacquemin, A.P. and C.H. Berry (1979), ‘Entropy measure of diversification and corporate growth’, Journal of Industrial Economics, 27, 359–69.

13.

Better firm performance with employees on the board? R. Øystein Strøm*

1.

INTRODUCTION

This chapter deals with the impact of co-determination1 upon firm performance. Two conflicting views on the benefits of co-determination exist. One says that co-determination increases firm performance, either because employee directors supply outside directors with information they would otherwise not have access to (Freeman and Reed, 1983; Blair, 1995), or because co-determination is a safeguard against dismissal, inducing employees to invest in firm-specific human capital (Zingales, 2000; Becht et al., 2003). The other view is that owners’ and employees’ interests are not aligned, and therefore allowing employees into the boardroom means that conflicting goals are pursued. When decision makers with different objectives share in the board’s decisions, its focus may become unclear (Tirole, 2001), its decision time longer (Mueller, 2003), and its decision quality inferior.2 The prediction is that firm performance will be lower than it could otherwise be. Even though co-determination is important in many European countries,3 few firm-level studies have been made of its firm performance impact. This chapter is an attempt to bring more academic research to the still under-researched (Goergen, 2007) comparison of firm performance in shareholder determined companies and co-determined companies. Earlier studies give mixed results, showing a negative impact in German firms (Fitzroy and Kraft, 1993; Schmid and Seger, 1998; and Gorton and Schmid, 2000, 2004), Canadian (Falaye et al., 2006), and Norwegian (Bøhren and Strøm, 2008), but a positive impact in a later German study (Fauver and Fuerst, 2006). Compared with former literature, the simultaneous equation estimation of the relationship between firm performance and explanatory variables is the distinctive feature of this chapter. The need for simultaneous modelling arises from the fact that the presence of employee directors may induce shareholders to adjust other governance mechanisms, notably board 323

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composition and leverage, in order to neutralize the co-determination effects (Buchanan and Tullock, 1962). Employee directors may have a direct impact upon firm performance, but also an indirect effect. This also means that board composition is at least partly determined by employee directors. Thus, the chapter necessarily also relates to the board endogeneity issue (Hermalin and Weisbach, 2003). And since the data cover several periods, it is possible to test the reverse causation hypothesis that firm performance determines board composition (Hermalin and Weisbach, 1998). The simultaneous equation setup allows not only the discovery of endogeneity in governance mechanisms, but also a quantification of its importance compared with direct effects. I am unaware of former literature containing a measure of the endogeneity effects. The chapter’s results come from a panel data set of non-financial firms spanning the 14 years from 1989 to 2002, containing financial information, data on ownership, and board composition data. Employee representation was mandated by law in 1972 in Norway, and regulations have remained almost unchanged since (Aarbakke et al., 1999). The data on employee directors seem to be superior to those pulled from German and Canadian institutional frameworks. While the employee director in a German board may be elected from the national labour union, and the Canadian evidence is from firms where employees have considerable shareholdings, in Norway the employee director must be employed in the company. Furthermore, because the mandatory employee director rules only apply to certain firms, some firms have employee directors, others have none. Thus, the study avoids the Dow (2003, p. 87) objection that empirical investigations on the effects of employee directors suffer from a lack of control group. Thus, unlike previous studies, the Norwegian institutional framework allows comparison between similar firms with and without employee directors. This setting allows for sharper estimates of the co-determination effects. The chapter has relevance for the emerging regulation literature on boards (Hermalin, 2005). Because the sample includes both the co-determined (by regulation) and the shareholder determined kind, I can study the effects of governance regulation by comparing the two sub-samples. Compared with the related Bøhren and Strøm (2008) study, I introduce a number of new features. I construct a board structure index that captures many standard board characteristics in the same manner as Bertrand and Mullainathan (2001), I add financial leverage and average wage as new explanatory variables, I perform a system estimation rather than a single-equation estimation, and I make separate regressions for various sub-samples, for instance employee director firms only. These steps should yield better estimations of the employee director impact than the partial regressions in Bøhren and Strøm (2008), and should also subject the

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co-determination hypothesis to more severe robustness tests. Furthermore, I confirm their results when using individual board characteristics instead of the board index. In order to fully utilize the information in the panel data, I use the fixed effects model (Woolridge, 2002), employing a three-stage least squares (3SLS) methodology in system estimations. With the fixed effects method, I am able to remove firm heterogeneity, as did Palia (2001). Therefore, few (if any) control variables are needed. Using Tobin’s Q as the measure of firm performance, the results confirm the employee directors’ negative relationship to firm performance in earlier studies, but also show a positive indirect effect on the board index and leverage. This reflects endogeneity, but the economic significance of the indirect effects turn out to be much smaller than the direct. The reverse causation hypothesis also finds confirmation, since lagged firm performance is significant regarding both the board index and leverage. But again, the indirect effects of the lagged firm performance are low compared with the direct. I find clear differences in the various board characteristics’ impact upon firm performance in sub-samples of co-determined and shareholderdetermined firms. This means that regulations have costs, both in relation to firm performance and in the remaking of boards. The results stand up to a number of robustness tests, including alternative performance measures (stock return and accounting return on assets), and also to dividends replacing leverage. The chapter proceeds as follows. In the next section, a brief review of the literature is given. Then, in Section 3 testable implications are spelled out. Section 4 contains data sources and institutional background, while Section 5 discusses estimation methodology. Then Section 6 shows results, in Section 7 robustness checks are undertaken, and Section 8 concludes.

2.

LITERATURE REVIEW

Few empirical studies of co-determination have been undertaken. Evidence in Fitzroy and Kraft (1993), Schmid and Seger (1998), and Gorton and Schmid (2000, 2004) shows that co-determination has a negative economic effect upon firms in Germany, where employees have the right to equal representation in the Aufsichtsrat with shareholders. Recently, Fauver and Fuerst (2006) find a positive relationship to performance in a 2003 sample of German companies in information intensive industries. In the regressions with all industries, however, the relationship is not significant. The German data often contain two kinds of employee directors, some elected from among the employees in the company and others, national

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union representatives. In contrast, the Norwegian system is such that only persons employed in the company may be elected. Thus only a company and not a national union representative may sit on a Norwegian board. Presumably, company employed persons are more authentic stakeholders than their national union representatives. Using Canadian data, Falaye et al. (2006) find that firms giving employees a greater voice in corporate governance spend less on new capital, take fewer risks, grow more slowly, create fewer new jobs, deviate more from value maximization, show greater cash flow problems, and exhibit lower labour and total factor productivity. This chapter is set in a different institutional environment. The Canadian employee directors are elected in their capacity as owners of company shares. The influence of these directors on firm performance thus picks up two effects, one as a supplier of labour services, the other as owner. None of these studies use panel data or simultaneous data estimations. Using Norwegian data, Bøhren and Strøm (2008) show that the employee director variable has a negative impact upon Tobin’s Q. They also find evidence of interdependencies among board characteristics. However, they do not explore the indirect effects of co-determination, nor do they carry their analyses into sub-samples of co-determined and shareholder determined firms. In this chapter, the analysis is extended to include effects upon average wage, leverage is a new governance variable, and the board index is defined; I employ simultaneous equations modelling, and perform regressions in sharply defined sub-samples. The robustness tests are also more extensive, as I use return on assets and stock return as new dependent variables, and also vary the definition of the board index.

3.

THEORY AND HYPOTHESES

3.1

Stakeholder or Interest Group?

Board decisions include the formulation and control of strategy, larger investments and disinvestments, and the determination of the company’s organization. Employee directors’ influence upon these decisions may have long-time impact upon firm performance. Therefore, an analysis over a long period of time is needed to detect the effects. The impact upon firm performance could be positive, non-significant, or negative. One possibility is that the firm performance and employee link is positive. Blair and Stout (1999) view stakeholders as members in a team production. Since stakeholders make firm-specific investments, it is in their interest to co-operate. The firm-specific human capital investments make

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the employees residual claimants to much the same extent as shareholders (Zingales, 2000; Becht et al., 2003). The upshot is that employees should be represented on the board, and that this co-determination will lead to improved firm performance. The conclusion rests on the argument that the stakeholders’, including the shareholders’, interests are aligned. How could this be manifested in the board? Employee directors could have a dual informational role in bringing inside information to the board (Blair, 1995, p. 16) but also relating board information to the employees (Freeman and Lazear, 1995). Since employees are in the middle of the day-to-day running of the company, they may bring valuable operational knowledge to the board. The information may expand on or contrast with information from the CEO. Thus, the information set available to the outside directors is enlarged. This comes close to viewing the employee director in the same role as the insider in the Raheja (2005) theory, although in this model the insider is willing to furnish the outside directors with information only if this furthers his own career interests. Secondly, the role as messengers of board information to the employees at large could be of particular value in the case of personnel reductions or plant closures, when the board may want to instil an understanding for the need for drastic measures among employees. The dual informational role of employee directors should lead to better firm performance (Fauver and Fuerst, 2006). Another possibility is that co-determination has no significance for firm performance. This may come about through co-optation (Pfeffer, 1981, pp. 166–73). In the board employee directors are exposed to fiduciary duties and conformity pressures to accept the shareholder value logic. Also, since the employee director is made co-responsible for decisions with adverse outcomes for employees, the decisions carry higher legitimacy among employees. If co-optation is the case, interests are again aligned, but this time because employee directors have taken on the views of shareholders. The effect upon firm performance should be non-significant. The third possibility is that the co-determination impact upon firm performance is negative. It may be hard to accept the premise that stakeholder interests are aligned. If this were so, co-determination would be an efficient economic organizational mode, and firms would adopt this mode voluntarily (Jensen and Meckling, 1979; Hansmann, 1996). But while shareholders seek to maximize residual income, employees want to maximize pay and the protection of firm-specific human capital,4 that is, a part of the residual income. The inconsistency of these two objectives makes the board decision process longer and more difficult (Mueller, 2003). The firm’s objectives may become unfocused, and the CEO may develop capabilities as a compromise maker rather than a shaper of the firm under a

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clear objective (Tirole, 2001, 2002). The implied consensual decision model in co-determination means that the firm pursues stability and predictability instead of bold new moves (Siebert, 2005). If employee directors are successful, they should influence the average wage positively. The unfocused decision structure should result in weaker firm performance. I call this the interest conflict model for reference, and hypotheses stemming from the model are set forth in the next section. When objectives diverge, shareholders and employees may game against each other so as to further their own interests. Employees may furnish information strategically to further their own interests (Pistor, 1999; Hopt, 1998), and they may use moral arguments in parallel. Information strategizing could take the form of economizing on the supply of internal information to the board. For instance, employee directors may not inform of low productivity units in the organization. Another form could be information leakage from the board.5 Employee directors will hardly inform their fellow workers only on matters that owners and management find in their interests to inform about. Stakeholder theorists seem to assume only beneficial information dissemination through employee directors. Furthermore, moral arguments against, for instance, plant closures or high management pay may be put forward, too. The shareholder elected directors may have trouble withstanding such arguments, since they may experience large personal costs and small personal gains from making decisions that affect employees adversely (Baker et al., 1988). Taking the issue to the public attention could make the decision even harder for the shareholder elected directors. Thus, even though the employees are in a minority position in the board, they may influence board decisions to their advantage. Their access to board information seems to be vital in this respect. But the presence of employee directors may have indirect effects upon the use of other governance mechanisms as well. Shareholders may adjust governance mechanisms in order to neutralize the co-determination impact. This is analogous to the situation Buchanan and Tullock (1962) point out, that when an exogenous regulation is imposed upon a (political) committee, it will try to compensate for the regulatory effect by placing a heavier weight on the unregulated. These previously unexplored indirect effects make a simultaneous equations approach necessary. In the remainder of this section governance mechanisms and hypotheses about interactions are explained. 3.2

Simultaneity and Endogeneity

In a simultaneous equations system some variables are endogenous, others exogenous. In the present setup, the exogenous variables are the fraction of employee directors, the lagged firm performance, the firm size, and firm

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risk. Since employee directors are imposed from outside the firm, they must constitute an exogenous variable. These variables determine firm performance and average wage, but also the intervening governance variables, the board characteristics and leverage. Thus, the intervening governance variables and the average wage are at least partly determined by the employee directors and lagged firm performance. The simultaneous setup gives the researcher the opportunity to recognize the governance variables’ endogeneity, but at the same time also to measure the magnitude of the effect relative to their direct effects upon firm performance. Specifically, the co-determination hypothesis says that the mechanism of employee directors has a negative relationship to firm performance, but a positive one to average wage, the board characteristics, and leverage. The reverse causation hypothesis says that lagged firm performance is associated with governance variables and average wage, but that signs are uncertain. The remainder of this section concerns explanations of variables and their relationships. In this chapter, shareholders may adjust the board characteristics and the leverage. In order to achieve a reliable measure, and in the interest of economy, I build an index by including board characteristics that have proven to be important in board studies. The board index BI is:6 BI 5 DH 1 BN 2 BS 2 G

(1)

DH is directors’ holdings, BN is the board network, BS is board size, and G is gender. The board index construction follows the Bertrand and Mullainathan (2001) procedure, as each index variable in equation (1) is standardized to have average zero and standard deviation 1 before summation. The sum is then standardized. This gives a continuous variable, in contrast to the Gompers et al. (2003) type of index. Their governance index is based upon a subjective allocation of categorical points for reasons that restrict shareholder rights, and then summed over all characteristics. Since all variables in equation (1) are continuous, the resulting index is continuous as well, and this is an advantage in estimations. Another advantage is that the index is likely to be more stable in sub-samples than the individual variables. The interpretation is that the higher the board index, the better is the board structure. It should be positive towards firm performance and negative towards average wage. If it is complementary to leverage, a positive sign will appear. The choice of variables in the index reflects important board characteristics that are decision variables for shareholders. Directors’ ownership represents the need for the board to be aligned with shareholders, the network variable the need for the board to be informed, the board size

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and gender diversity the need for the board to be decisive. The signs in are common findings in the literature. The ownership literature (Morck et al., 1988; McConnell and Servaes, 1990) confirms the positive sign on directors’ ownership share, and so do studies taking other board characteristics into account, for example, Bøhren and Strøm (2008).7 The network variable is little used in studies of boards, but Bøhren and Strøm (2008) find a positive sign.8 It comprises direct and indirect connections to other listed non-financial firms stemming from directors’ multiple board seats. A variety of studies, such as Yermack (1996) and Eisenberg et al. (1998), document that performance decreases with increasing board size. The relationship between gender and firm performance may be more controversial, as Shrader et al. (1997), Smith et al. (2006), and Bøhren and Strøm (2008) report a negative relationship, whereas Carter et al. (2003) find the opposite. I perform robustness tests with other definitions, described in Section 4, to test the choice of index. Next, I include leverage. A higher leverage will decrease the firm’s free cash flow, and will, therefore, limit the potential for agency costs (Easterbrook, 1984; Jensen, 1986). Perotti and Spier (1993) model how the lower free cash flow may be used as a bargaining tool against employees, implying better firm performance and lower average wage. Both effects should point to higher firm performance from higher leverage. However, the complexity of leverage leads to an indeterminate prediction. On the one hand, given the presence of employee directors, owners may fear higher debt may bring even higher decision costs. If, as Easterbrook (1984) supposes, higher leverage brings the lender into closer oversight of the firm, the firm may end up with three decision makers with potentially divergent interests. Furthermore, if the leverage is also used to signal investment prospects (Myers, 1977), a high leverage used to discipline employees can be taken to signal weak investment opportunities in the firm. Another aspect is that, as Tirole (2006, pp. 51–3) points out, higher leverage may cause costs related to illiquidity and bankruptcy. This complexity of leverage means that the sign is uncertain. It could be the case that shareholders in co-determined firms adjust the leverage in an effort to neutralize employee directors to a greater extent than they do in shareholder determined firms. In a simultaneous equations setup, Brick et al. (2005) find a negative relationship. Thus, I expect employee directors to be associated with better board composition and higher leverage. If these are successful from the shareholder point of view, a positive indirect effect may compensate for the negative direct employee director effect upon firm performance. In the stakeholder theory, the employee director should be a welcome addition to the board, and thus carry a positive sign to firm performance, while the indirect effects should not appear.

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In addition to the endogeneity induced by employee directors, the reverse causation hypothesis says governance mechanisms may be at least partly determined by past performance (Hermalin and Weisbach, 1998, 2003). The signs on the board index and the leverage may be difficult to set out. In the Hermalin and Weisbach (1998) bargaining model the CEO bargains over pay and monitoring intensity. Good past firm performance gives the CEO a better bargaining position, which he will use to reduce monitoring. This means that the association between past firm performance and governance mechanisms should be negative. However, it may well be that governance mechanisms are improved after a good performance, for instance, since the firm learns good practices. Since shareholders may adjust either board composition or leverage, or both, leverage and board composition may be either complements or substitutes (Agrawal and Knoeber, 1996). Thus, the sign is ambiguous. I study the direct and indirect effects of employee directors in a simultaneous setup. Since the lagged firm performance is included, the system is dynamic. Taken together, and with constants suppressed, this results in the system of equations

(2)

where FP is firm performance, and FPt21 indicates one period lag; W stands for the average wage, BI is the board index, DE is the leverage (debt to equity), ED is employee director, FS is firm size, FR is firm risk, and uit is the error term. The main hypotheses are summarized below the coefficients. Thus, the co-determination hypothesis is set out for the ED variable.

4.

DATA AND INSTITUTIONAL BACKGROUND

The sample comprises all non-financial firms listed on the Oslo Stock Exchange (OSE) at year-end at least once during the period 1989 to 2002.9

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Board data are collected from the handbook Kierulfs Håndbok for the first years, and from the national electronic register at Brønnøysund from 1995. The register provides information on name, date of birth, and director status (chairman, vice-chairman, ordinary member, and employee director). The CEO’s name and date of birth are recorded as well. The CEO or director name gives gender information. Data on board and CEO ownership, as well as outside ownership concentration, are pulled from the public securities register, while share price and accounting data come from OSE’s data provider (Oslo Børs Informasjon). The ownership structure data cover every equity holding by every investor in each sample firm. By international standards, the size and quality of the data are considerable. The data for this chapter span the period from 1989 to 2002. During this period, the law regulating the governance of the companies is from 1972, with amendments in 1987 (‘Aksjeloven’), and a new law in 1997 (‘Allmennaksjeloven’). The regulations for representation have been unchanged since 1987. In this respect, there is no before-and-after situation, as with the Cadbury Committee (1992) report in the UK, in the sample period. As a general rule, firms with more than 200 employees must have at least two employee directors, or at least one-third of the board.10 In the size bracket 31 to 200 employees, the firm must have labour board seats if a majority of the employees vote in favour, first with one representative in the 31 to 50 bracket, then two in the 51 to 200. The employee director must be employed in the company. A number of important Norwegian industries are exempted from these rules, that is, the employees have no rights of representation in these industries. These include newspapers, news agencies, shipping, oil and gas extraction and financial firms. The characteristics of employee board representation mean that some firms have employee directors, others do not, and also that co-determined firms have different fractions of employee directors. Thus, an implication of the regulations is that comparisons of two sets of differently governed but otherwise similar firms can be made, and that further analyses can be carried out in subsamples of, say, co-determined firms with more than 200 employees. This data property answers the Dow (2003, p. 87) objection that the study of co-determined firms lacks a proper control group. I define the employee director variable as the fraction of employee directors, unlike most former studies, which only use employee directors as a dummy variable. This institutional framework offers advantages over the German and Canadian studies referred to in Section 2, since the Norwegian employee directors represent an authentic stakeholder group. The German regulations are such that one-third of the employee representatives on German boards need to be labour union officials (Siebert, 2005). Presumably, the

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union officials are supposed to look after the interests of workers in general, not only those in the firm. No such minimum is required in Norway, and the employee directors need to be employed in the firm. The Canadian co-determination comes about when workers are also shareholders in the company. This might cause a conflict of interests, when the optimal policy from the shareholder point of view is detrimental to the optimal policy for workers. In Norway, employee directors are elected in their capacity as workers in the firm, not through their shareholdings. The initiative for employee representation came from a joint committee of the Labour Party and the major employee union (LO) in the early 1960s. However, concurrent with this initiative, LO and the employer association (NAF) ran a ‘co-operative project’ together with researchers to study co-determination in selected companies. This was in the consensus and cooperation spirit that arose from common war-time experience. The question was not only about co-determination, but also about new production methods. Later, the need for co-determination in order to improve productivity was the guiding principle of the official document NOU (1985:1), whose recommendations were unanimous, as opposed to the original 1971 report. The insider information argument was behind the codification of employee board representation in Norway. Thus, it seems as if the lawmakers were familiar with stakeholder theory. Bråthen (1982, p. 14) interprets the law on co-determination to imply that profit maximization is no longer the single objective of the company. Employees’ interests now become one of several objectives the firm has to consider. Thus, a harmony of interests model is behind the regulations on co-determination in Norway. Next, I report some descriptive statistics on employee directors. Table 13.1 shows the number of employee directors in firms according to employment size. The table shows the percentage of firm-year observations of employee directors in various employment sizes. It turns out that in firms where employees may demand representation, few do so. In the 101–200 employees category, 61.5 per cent do not have employee directors. Furthermore, in the highest category, where representation is compulsory if the industry is not exempted, employees have no board seats in about one-third of the companies. Among the firms that do have employee directors, the legal minimum, two representatives, is found in the majority of cases. Very few have four employee board seats. Thus, the Jensen and Meckling (1979) conjecture that co-determination requires law backing seems to be supported in our Norwegian data. Next, Table 13.2 shows the distribution of employee directors according to industry, and also the percentage of firms with no employees on the board in each year. Exempted industries such as Energy and Transport (including shipping) have no employee directors to a higher degree than average. The

334

Table 13.1

The board, management relations and ownership structure

The percentage of firms with zero or more employee directors by employment size

Employees

0–30 31–50 51–100 101–200 200+ Total N

Employee directors 0

1

2

3

4

98.4 95.8 73.5 61.5 33.5 49.5 749

0.5 2.1 5.3 4.5 8.1 6.3 96

0.5 2.1 18.6 24.4 30.0 24.0 363

0.5 0.0 2.7 9.6 27.1 19.3 292

0.0 0.0 0.0 0.0 1.3 0.9 13

N 190 48 113 156 1006 1513

Note: The table shows the percentage of firms having employee directors, according to employment categories. N is the number of firms in the employee directors or the number of employees category. The number of employees category reflects the regulations on co-determination (Aarbakke et al., 1999). With more than 200 employees co-determination is compulsory. In the 31 to 200 bracket co-determination is realized if an employee majority demands it, with a larger proportion of representation with a larger workforce. In all categories, including the above 200 employees, firms in some industries are exempted from the rules.

low representation in Hotels, restaurants and entertainment is perhaps due to high labour turnover. The two industries Health care equipment and supplies and Software and supplies also have a lower than average representation. These are industries where the human capital element should be above average, and co-determination of extra value, according to stakeholder theory. Yet, obviously, employees do not demand board seats to a great extent. The time trend is that firms with no employee directors increase in relative importance. Thus, nothing in the overall descriptive statistics shows that co-determination is a preferred organizational mode. Firms seem to avoid it if they can, and keep it to a minimum if they cannot. Variable definitions are shown in Table 13.3, which also presents the main characteristics of variables in the analysis in the two main subsamples of co-determined and shareholder determined firms. The table shows that a large number of variables are distributed differently in the two sub-samples. The firm performance variables Tobin’s Q and stock return are not significantly different, while the ROA in co-determined firms is significantly higher than in shareholder determined firms. Apart from directors’ holdings, all other variables are significantly different at the 5.0 per cent level or better. Obviously, the two types of firms are different. The table shows that the fraction of employee directors is 0.301, or slightly below the minimum requirement for the 2001 employee size group.

335

77.7 17.8 34.5 49.4 77.1 0.0 24.0 90.9 24.3 46.2 50.0 36.4 75.0 55.2 88.5 71.4 40.2 15.8 57.4

0 1.1 8.5 2.8 8.9 5.8 4.3 18.0 0.0 8.1 6.2 0.0 0.0 0.0 3.4 3.1 5.8 14.5 5.3 5.7

1 8.2 39.5 35.3 25.3 5.6 69.6 48.0 9.1 35.1 24.6 50.0 36.4 5.0 24.1 8.5 15.3 23.2 31.6 20.0

2 12.7 34.1 27.0 16.5 11.6 26.1 10.0 0.0 21.6 23.1 0.0 27.3 20.0 13.8 0.0 6.9 20.7 47.4 16.3

3

Employee directors

0.3 0.0 0.4 0.0 0.0 0.0 0.0 0.0 10.8 0.0 0.0 0.0 0.0 3.4 0.0 0.5 1.2 0.0 0.7

4 16.0 5.8 11.4 3.6 18.8 1.0 2.3 2.5 3.4 2.9 0.4 3.5 0.9 1.3 5.9 8.6 10.9 0.9 100.0

% of total 354 129 252 79 414 23 50 55 74 65 8 77 20 29 130 189 241 19 2208

N 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

95 99 93 95 91 103 186 192 215 217 213 209 202 199

2209

57.4

N

50.5 49.5 48.4 45.3 48.4 52.4 61.3 60.9 62.8 59.0 57.3 58.4 60.9 61.8

% no empdir

Note: The table shows the distribution of employee directors across industries. The Global Industry Classification Standard (GICS) is used. The whole or parts of the industry may be exempted, for instance the Energy (hydro power and petroleum) sector. Transport contains the important shipping segment. Media is exempted as well, but in some firms co-determination comes about through union negotiations. ‘Empdir’ is short-hand for employee directors.

Energy Materials Capital goods Commercial services Transport Autos and components Consumer articles, clothes Hotels, rest., entertainment Media Retailing Food/staples Retailing Beverages Health care equip./supplies Pharmaceuticals biotech. Real estate Software/supplies Hardware/equipment Telecom. Total

Industry

Table 13.2 The percentage of firms with zero or more employee directors by industry and the percentage with zero by year

336

1.461 16.109 3.272 558.442 0.065 0.180 4.834 0.024 0.192 2.387 0.197 0.000 0.000 5.427 0.828 0.918

Mean 1.105 −1.700 6.220 340.878 0.000 0.198 5.000 0.000 0.233 1.165 0.000 0.000 0.000 5.462 0.724 0.646

Median 1.156 121.515 18.840 1516.360 0.189 0.115 1.330 0.078 1.877 5.955 0.747 0.000 0.000 0.788 0.749 1.200

Std

Shareholder determined

867 774 838 677 966 1264 1267 1267 965 857 960 1267 1267 905 888 885

N 1.501 17.666 6.531 355.909 0.063 0.191 5.341 0.045 −0.271 1.903 0.261 2.282 0.301 6.071 0.707 0.738

Mean 1.162 2.520 8.210 316.306 0.000 0.208 5.000 0.000 −0.078 1.044 0.085 2.000 0.300 6.021 0.690 0.584

Median 1.064 78.204 13.883 222.129 0.187 0.075 1.271 0.101 1.956 3.216 0.564 0.707 0.082 0.725 0.535 0.597

Std

Co-determined

Definitions of various board measures and their main statistical properties

Tobin’s Q Stock return ROA Average wage Directors’ holdings Network Size1 Gender1 Board index Leverage Div. payout rate Empdir Empdirfrac Firm size Systematic risk Volatility

Table 13.3

773 724 771 762 825 942 942 942 825 761 822 942 942 801 794 788

N

0.459 0.770 0.000 0.000 0.828 0.015 0.000 0.000 0.000 0.046 0.042 0.000 0.000 0.000 0.000 0.000

F sign

337

Notes: Tobin’s Q is market value divided by book value of assets; Stock return is the raw stock return corrected for dividend and stock split; ROA is accounting profits on book value of assets; Average wage is the logarithm of total wages divided by the number of employees; Directors’ holdings is the percentage of directors’ ownership; Network is a summary measure of the board’s direct and indirect relations to other firms through multiple directorships (see endnote 8); Size1 is the board size of shareholder elected directors; Gender1 is the fraction of women of the shareholder elected directors; Board index is a summary measure of the above board variables; Leverage is the book value of debt on book value of equity; Dividend payout rate is dividends on net income; Empdir is the number of employee directors divided by the number of directors; Empdirfrac is the fraction of employee directors in the total board; Firm size is the natural logarithm of accounting income; Systematic risk is the company’s exposure to market changes (equity beta); Volatility is the firm’s total risk measured as its yearly standard deviation. The ‘F sign’ shows the significance of the test of the null hypothesis that the two group means are equal, estimated from an analysis of variance (ANOVA). Low values indicate rejection of the null hypothesis. The F value is found by dividing the Between Groups Mean Square by the Error Mean Square (Johnson and Wichern, 1988, p. 235).

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Like the findings in Table 13.2, this is evidence that the firms attempt to minimize the employee director importance. The two firm groups differ in background variables, notably firm size. The co-determined firms are larger on average. This warrants paying particular attention to the largest firm size groups in regressions, in order to control for firm size biases.

5.

ESTIMATION AND METHOD

I estimate the relationships in equation (2) with simultaneous equations regressions on the full samples as well as sub-samples. The equations spell out behavioural relationships between variables. Since the equilibrium model of governance is not known, reduced form estimation is not possible (Greene, 2003, section 15.2). The equations are behavioural, but not structural in the sense of belonging to an equilibrium model. The fixed effects method (Woolridge, 2002) is common to all regressions. Fixed effects estimation amounts to removing the individual heterogeneity of firms contained in the fixed effect ci.11 Remember the error term in the system equation (2) is uit, which contains the fixed effect ci and a idiosyncratic effect vit, which varies over time and companies; i refers to the firm number, and t is the time period. When demeaning the variables, the fixed effect element disappears. So does the constant term. I use the three-stage least squares (3SLS) methodology in estimations. The 3SLS is an instrumental variables estimation method where the instruments are the predicted values of the dependent variable in a regression on all the explanatory variables in the system (Greene, 2003, p. 398). The predicted values are found from GLS regressions, and iterations are taken until convergence is achieved. Meaningful overall measures, such as R2 in OLS regressions, are not available. Instead, I include a Wald test (Greene, 2003, p. 107) to study whether all coefficients in a given equation are zero. The danger in simultaneous equation estimation lies in the model specification (Greene, 2003). If, for instance, a misspecification has occurred in the first equation, the mistake may contaminate all other equations as well. To investigate if this propagation of misspecification is a serious problem, I perform several robustness tests. I perform estimations in the full sample and for sub-samples. First, the model in equation (2) is estimated on the full sample with Tobin’s Q as firm performance, and then on sub-samples of co-determined and shareholder determined firms. The sub-sample tests will reveal whether results from the overall sample really apply to co-determined firms alone, or whether the employee director effect is merely due to difference in sampling. I further

Better firm performance with employees on the board?

339

partition the sample to include only firms with more than 200 employees, when co-determination is compulsory. This will remove firm size effects. In robustness tests, I perform an estimation with all index variables included individually (the right hand side of equation (1) on p. 329), as well as an estimation of a wider definition of the board index,12 this time including non-significant effects in Bøhren and Strøm (2008) as well. Further robustness tests include replacing Tobin’s Q with ROA and stock return as a dependent variable, and replacing leverage with the dividend payout rate. Also, I remove the lagged firm performance in order to investigate whether parameter estimates remain stable. The last robustness test is a test of the Fauver and Fuerst (2006) information hypothesis, which I interpret to mean that in information intensive industries firm performance is improved with co-determination. This regression should show whether their positive employee director result is also the case in Norway. The explanatory variables are assumed to be simultaneous with firm performance. Since board members are predominantly elected in the late spring, the new board should also have had some time to make a noticeable impact upon firm performance, measured at year-end. This assumption is reasonable, given some market efficiency.

6.

ECONOMETRIC EVIDENCE

Do employee directors improve firm performance, and are governance mechanisms at least partly endogenously determined? This section reports simultaneous regression results of the model in equation (2). I estimate for the whole sample, and then turn to sub-samples of co-determined and shareholder determined companies, and for firms with more than 200 employees. All regressions are done with standardized values. This means that comparisons of economic importance can be read off from coefficient values. I start with estimations of the model in equation (2) for the entire sample. Table 13.4 shows the estimation results. The Wald tests show that no equation supports the null hypothesis that all coefficients are zero. Comparing the two sections of the table, signs and coefficient values are very much the same. Thus, I restrict comments to the case of systematic risk in the upper section. The co-determination hypothesis says that the employee director variable is negative to firm performance, and positive to the board index and leverage. Table 13.4 confirms this except for the leverage, where only the sign is as predicted. Furthermore, the co-determination hypothesis implies a positive impact on average wage. Here too, only the sign is confirmed.

340

Table 13.4

The board, management relations and ownership structure

Is co-determination associated with negative firm performance and positive governance mechanisms? Full sample (N51135) estimations using systematic and firm specific risk

Independent Variable

Dependent variable Tobin’s Q

Average wage

Leverage

0.065* −0.038

−0.094** 0.204** −0.191**

Tobin’s Q lagged Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value

0.106** −0.035 0.122** −0.041** −0.119**

−0.030 0.145** 0.072

−0.171** 0.314**

−0.141** 0.004 79.516 0.000

−0.027 0.030 39.396 0.000

−0.060 0.010 82.612 0.000

0.129** −0.035 87.617 0.000

Tobin’s Q lagged Average wage Board index Leverage Employee directors Firm size Volatility Wald c2 test p-value

0.105** −0.031 0.119** −0.034 −0.123**

0.032

0.062* −0.036

−0.082** 0.181** −0.182**

−0.136** −0.045** 85.137 0.000

0.028

Board index

-0.029 0.131** 0.066 −0.019 0.028 36.095 0.000

−0.167** 0.311** −0.066 −0.003 79.369 0.000

0.044

0.042 0.145** 0.116** 103.055 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) with systematic risk (upper part) and firm-specific risk (lower part). The dependent variable is Tobin’s Q, which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test (Greene, 2003, p. 107) is here a test of the null hypothesis that the coefficients in the given equation are all zero. A low value indicates null hypothesis rejection. If R is the q 3 K matrix of q restrictions and K coefficients, g the K vector of coefficients, and r the vector of the q restrictions, the Wald c2 (q) statistic is c2 (q) 5 (r 2 Rg) r [ RSXRr ] 21 (r 2 Rg) , where SX is the estimated covariance matrix of coefficients. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level. Significant results at the 5% (10%) level are marked with ** (*).

Better firm performance with employees on the board?

341

This weaker result may be due to pay being determined by external market conditions. Thus, the direct and indirect effects of co-determination are partly confirmed. Consequently, employee directors carry a negative association with firm performance, and shareholders tend to take compensatory actions to alleviate the influence of employee directors. The board index is at least partly endogenously determined. Are the board index and the leverage positively related to firm performance and negatively to average wage? For the board index, this is confirmed for firm performance, but the only sign is as expected for average wage. Thus, a better composed board will improve firm performance. On the other hand, leverage is against the free cash flow hypothesis expectations in both firm performance and average wage. A higher leverage indicates a lower firm performance and higher average wage. In conclusion, the governance hypothesis is not fully confirmed. The negative association between leverage and firm performance confirms findings in empirical studies (Barclay et al., 1995; Rajan and Zingales, 1995; Brick et al., 2005). I offer two alternative explanations to the free cash flow hypothesis: the fear of higher decision costs in a situation with three decision makers, that is, shareholders, employees, and banks; and the negative signalling effect of a high leverage (Myers, 1977). Also note the complementarity between the board index and leverage (Agrawal and Knoeber, 1996). The sign is negative and significant. Thus, the two governance mechanisms are substitutes rather than complements. The Hermalin and Weisbach (1998) reverse causation hypothesis is only partly confirmed, as the board index is positive and leverage is negative. Lower leverage should bring lower monitoring intensity. The results are significant, indicating that good performance leads to a better board index and to an easier debt burden. In all, endogeneity is confirmed, as both the board index and the leverage are at least partly determined from the presence of employee directors and from past performance. Are shareholders able to neutralize the employee director by adjustments in the board index and the leverage, taking the employee director relationship to average wage into consideration as well? Since the variables are standardized to have average zero and standard deviation 1.0 in regressions, coefficients can be compared. They show that the direct effect is stronger than the indirect effect on the board index. For the negative direct employee director effect is now 0.119, while the indirect effect upon the board index is positive and 0.314. Since the board index is now 0.122 to firm performance, the positive, indirect impact of employee directors through the board index is only 0.038 (5 0.122 3 0.314), or 31.1 per cent of the direct board index effect. The shareholders are able to compensate 31.9 per cent of the negative direct effect of employee directors through adjustments to board

342

The board, management relations and ownership structure

characteristics. Furthermore, the employee director also impacts positively upon average wage, which is negatively related to firm performance. Even though the average wage is not significant in the overall sample, it is for codetermined firms, as I shortly report. The same applies to leverage. Likewise, the economic significance of the indirect effects from the lagged firm performance is very low, being 0.01 for both the board index and the leverage. Thus, the economic magnitude of the indirect effects from employee directors or past firm performance upon firm performance is small compared to the direct effect of the board index and the leverage. Endogeneity matters, but not very much. The volatility measure in the lower section of Table 13.4 gives two interesting relationships in the board index and the leverage equations. It turns out that only leverage has the expected positive and significant sign. The Raheja (2005) theory of board composition implies that the board index is positively related to firm risk. For volatility the opposite sign obtains. Next, the model is studied in sub-samples. If regulation plays a role, a less than optimal board composition is likely to follow. Therefore, we should observe stronger and more significant coefficients in the co-determined firms than in the shareholder determined. Table 13.5 is a report on the two sub-samples of firms. Note that the Wald test shows rejection of the null hypothesis that all variables have zero significance. Furthermore, a Chow dummy variable test rejects the hypothesis that the coefficients of the sub-samples are equal to those in the overall sample. Thus, there is a difference between co-determined and shareholder determined firms. In the co-determination sub-sample the employee director effects are even more pronounced than in the overall sample. The negative employee director impact upon firm performance is about 45 per cent higher than in the overall sample and the indirect effect on the board index increases even more. Now, the employee director variable is significant in relation to leverage and to average wage. Thus, the co-determination hypothesis is even more strongly confirmed in the sub-sample of only co-determined firms than in the overall sample. The board index and the free cash flow hypotheses come out more in line with expectations in the co-determined firms too. Now a significant result for the board index towards average wage appears. Leverage turns out to be negative and significant towards average wage, while positive in the overall sample. In shareholder determined firms, significant results are fewer and of different sign. Leverage is positively correlated with average wage, in contrast to the co-determined firms. In both sub-samples the board index and leverage are negatively related. Thus, the substitution result from the overall sample is confirmed in the

Better firm performance with employees on the board?

Table 13.5

Independent Variable

343

Is firm performance (Tobin’s Q) differently related to governance mechanisms in co-determined and in shareholder determined firms? Dependent Variable Tobin’s Q

Co-determined firms N5639 Tobin’s Q lagged 0.303** Average wage −0.089 Board index 0.118** Leverage −0.103** Employee −0.173** directors Firm size 0.077 Systematic risk 0.034 112.123 Wald c2 test p-value 0.000 Shareholder determined firms N5496 Tobin’s Q lagged −0.072** Average wage −0.023 Board index 0.121** Leverage −0.018 Firm size −0.296** Systematic risk −0.048 57.543 Wald c2 test p-value 0.000 Chow dummy c2 (7): variable test

Average Wage

Board Index

Leverage

0.011

0.059 −0.520**

−0.069* −0.156** −0.274**

−0.175** −0.080** 0.186** −0.001 −0.010 83.056 0.000 0.030 0.035 0.208** −0.077 0.060 30.281 0.000 62.160

−0.414** 0.484** −0.210** 0.027 212.330 0.000 0.041 0.032 −0.109** −0.021 −0.006 9.986 0.076 p-value

0.140** −0.083 −0.035 89.279 0.000 −0.101 0.272** −0.158** 0.237** −0.028 45.030 0.000 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) with co-determined firms in the upper part and shareholder determined firms in the lower part. The dependent variable is Tobin’s Q , which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except one where a 7.7% level is required. The Chow (Greene, 2003, Ch. 7) dummy variable test is an exclusion test for the null hypothesis that variables formed by a co-determination dummy variable interacted with each of the explanatory variables are all zero. Low value indicates hypothesis rejection. The test result shows that the hypothesis that the two sub-samples have equal coefficients must be rejected. Significant results at the 5% (10%) level are marked with ** (*).

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The board, management relations and ownership structure

sub-samples. We also see that the past firm performance endogeneity hypothesis gains less support in the sub-samples than in the overall sample. In fact, only the negative leverage result in the co-determined sub-sample is significant. Another difference exists for firm size. Firm size is negative and significant in the firm performance equation in shareholder determined firms, while positive in co-determined ones. Also, in the leverage equation the signs are reversed, and significant in shareholder determined firms only. The latter confirms ‘stylized facts’ about the positive relationship between firm size and leverage (Harris and Raviv, 1991). An interpretation of the difference in sub-samples is that in shareholder determined firms the board composition is closer to the optimal, and therefore exogenous characteristics such as firm size play a larger role. The large differences between samples confirm the Buchanan and Tullock (1962) theory. Are the results arrived at so far driven by a firm size effect? Table 13.6 shows regressions for all firms with more than 200 employees in the upper part, while the lower part is limited to the largest co-determined firms. The 2001 employee sample shows results very similar to those in the entire sample in Table 13.4 in the upper part, and for the co-determined firms in Table 13.5 in the lower part. Thus, the former results are not due to some firm size effect. In fact, even among firms where co-determination is compulsory, the main co-determination hypothesis is confirmed. Looking back, the co-determination and governance hypotheses are confirmed. Tests in sub-samples do not overturn these conclusions; on the contrary, they add to their strength. For instance, while the employee director effect is negative for leverage in the overall sample, it is positive in the codetermined sub-sample, as the hypothesis predicts. Thus, having representatives of one stakeholder group, the employees, in addition to shareholders on the board does not improve firm performance, as a stakeholder (Freeman and Reed, 1983; and Blair, 1995) or a new economy position (Zingales, 2000; Becht et al., 2003) implies. Instead, the results point to conflict of interests among the stakeholders. Furthermore, evidence of substitution between the board index and leverage is present in all regressions. I also find evidence of endogeneity (or reverse causation) from past firm performance, but with opposite signs to those predicted in Hermalin and Weisbach (1998). However, the indirect effects of employee directors and past firm performance upon firm performance through the board index and leverage are small compared with the direct effects from the board index and leverage. Endogeneity counts, but has low economic significance. The negative relation between employee directors and firm performance is in agreement with Fitzroy and Kraft (1993), Schmid and Seger (1998), Gorton and Schmid (2000, 2004), Falaye et al. (2006), and Bøhren and

Better firm performance with employees on the board?

Table 13.6

Independent Variable

345

Are the employee director direct and indirect (endogenous) effects upheld in all firms with more than 200 employees and in co-determined firms with more than 200 employees? Dependent Variable Tobin’s Q

200+ employee firms, N5814 Tobin’s Q lagged 0.168** Average wage −0.012 Board index 0.094** Leverage −0.065** Employee directors −0.107** Firm size −0.083 Systematic risk 0.013 73.709 Wald c2 test p-value 0.000 200+ employees co-determined, N5565 Tobin’s Q lagged 0.358** Average wage −0.111* Board index 0.047 Leverage −0.126** Employee directors −0.148** Firm size 0.008 Systematic risk 0.017 110.682 Wald c2 test p-value 0.000

Average Wage

Board index

Leverage ratio

0.008

0.139** −0.101*

−0.090* 0.075 −0.145**

−0.041* 0.041 0.049 0.103* 0.045 13.037 0.042 0.025 −0.148** −0.180** 0.093** 0.031 −0.027 73.992 0.000

−0.197** 0.420** −0.093 0.025 85.068 0.000 0.091* −0.478** −0.413** 0.522** −0.248** 0.008 190.267 0.000

−0.006 0.172** -0.101** 46.726 0.000 −0.060 −0.359** −0.256** 0.099** −0.028 −0.041 99.414 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) with all firms larger than 200 employees in the upper part and all co-determined firms larger than 200 employees in the lower part. The dependent variable is Tobin’s Q , which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except one, where a 4.3% level is required. Significant results at the 5% (10%) level are marked with ** (*).

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The board, management relations and ownership structure

Strøm (2008), but at odds with Fauver and Fuerst (2006). None of these studies contain simultaneous equations models, and only the Bøhren and Strøm (2008) paper investigates the endogeneity of board mechanisms. I will return to the Fauver and Fuerst (2006) and Bøhren and Strøm (2008) articles in the following robustness section.

7.

ROBUSTNESS CHECKS

I perform robustness checks on the definitions of the board index, firm performance, and leverage. In addition, I check for the absence of serial dependence of the firm performance, that is, whether lagged firm performance is zero. Finally, I check the Fauver and Fuerst (2006) results in two sub-samples of information industries and other industries. With simultaneous equations, changes in one place are likely to propagate throughout the system. Thus, different coefficient values and significance from the original formulation are quite likely to appear. Fortunately, the results largely confirm those in Section 6. Do the co-determination results survive when the individual board mechanisms are used in place of the board index? Table 13.7 shows simultaneous regressions results when all four board characteristics making up the board index enter the regressions individually. Former results for codetermination largely apply. The employee director variable is negative to Tobin’s Q, and positive to average wage and leverage. For the board characteristics, only the relation to board size is significant. On the other hand, the hypotheses on governance variables are upheld for all board characteristics but the gender variable. It turns out to be non-significant in the Tobin’s Q relation. The other variables are as expected, and their coefficients are close to those Bøhren and Strøm (2008) find in partial GMM estimations. These authors also discuss endogeneity. Even though the estimations are not directly comparable, none of the significant results in Table 13.7 conflict with the endogeneity results in Bøhren and Strøm (2008). The second endogeneity effect from lagged firm performance is significant in the leverage but not in any of the board variables. However, the signs on the individual board variables conform to the positive sign of the board index in earlier tables. Besides these main points, Table 13.7 contains many new details, which it is beyond this chapter to explore. For instance, the substitution effect between the board index and leverage in former tables now turns out to concern network, while leverage is a complement to board size and gender. Thus, overall the results are well in line with former findings, except for the lagged firm performance relationship to governance variables. In Table (13.8) I have modified the board index to include all board

347

0.106** −0.039 0.051* 0.091** −0.062** −0.025 −0.041** -0.114** −0.144** 0.001 86.300 0.000

Tobin’s Q lagged Average wage Directors’ holdings Network Board size Gender Leverage Employee directors Firm size Systematic risk Wald c2 test p-value −0.057* 0.061** 0.052 0.124** 0.140** 0.102** −0.043 0.022 65.395 0.000

0.026

Average wage

0.019 0.136** 0.026 −0.023 0.074 0.082 −0.104** 45.170 0.000

−0.022 −0.049*

Directors’ holdings

0.175** −0.177** −0.131** 0.043 0.044 0.093** 57.520 0.000

0.071 0.127** 0.046

Network

0.129** 0.124** −0.565** 0.258 0.034 301.551 0.000

−0.030 0.043 0.131** 0.070**

Board size

0.045** −0.005 0.006 −0.041 58.640 0.000

−0.027 0.097** 0.024 −0.067** 0.122**

Gender

0.108* 0.089 −0.032 98.443 0.000

−0.091** 0.199** −0.038 −0.090** 0.212** 0.082**

Leverage

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when the individual variables making up the board index replace the board index. The board index consists of directors’ holdings, network, board size, and gender. The definition of directors’ holdings is the fraction of ownership for the board as a whole; network is information centrality (Wasserman and Faust, 1994), see note 9; the board size is the number of shareholder elected directors; and gender is defined as the number of shareholder elected women over board size. The dependent variable is Tobin’s Q , which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All non-financial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level. Significant results at the 5% (10%) level are marked with ** (*).

Tobin’s Q

The employee director direct and indirect (endogenous) effects upon firm performance when the individual board variables are used instead of the board index (N5 1135)

Variable

Table 13.7

348

Table 13.8

The board, management relations and ownership structure

Does a wide definition of the board index change the relationship between firm performance, employee directors and governance mechanisms? (N51135)

Independent Variable

Tobin’s Q lagged Average wage Board index 2 Leverage Employee directors Firm size Systematic risk Wald c2 test p-value

Dependent Variable Tobin’s Q 0.114 ^** −0.031 0.091 ^** −0.048 ^** −0.094 ^** −0.129 ^** 0.005 65.962 0.000

Average Wage 0.027 −0.102 ^** 0.143 ^** 0.077 ^* −0.048 0.030 54.197 0.000

Board Index 2

Leverage

0.009 −0.136 ^**

−0.109** 0.204** −0.083**

−0.077 ^** 0.152 ^** −0.218 ^** 0.005 42.933 0.000

−0.004 0.126* −0.037 56.620 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when all individual variables enter the board index, and not just directors’ holdings, network, board size, and gender. The added variables are outside owner concentration, independence, CEO director, exported and imported directors, and board age dispersion. Outside owner concentration is the sum of squared equity fractions across all the firm’s outside owners; independence is the board tenure of the non-employee directors minus the tenure of the CEO; CEO director equals 1 if the CEO is a member of his company’s board and zero otherwise; exported CEO is the number of outside directorships held by the firm’s CEO; imported CEO is the proportion of CEOs from other companies on the board; board age dispersion is the standard deviation of board age. The dependent variable is Tobin’s Q, which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level. Significant results at the 5% (10%) level are marked with ** (*).

variables used in Bøhren and Strøm (2008) as specified in note 12 to check whether the board index is sensitive to the selection of board characteristics. The overall Wald tests are strong and the significance of the coefficients are almost similar to what earlier full sample results in Table 13.4 show. We note that the impact of the employee director variable is less in the new board index, and is now significant in its positive relationship to average wage. Thus, the co-determination hypothesis is supported with

Better firm performance with employees on the board?

349

this new board index, although with lower coefficient values. The endogeneity effect of a lagged firm performance loses significance in the board index relation. The same happens when individual board characteristics replace the board index, and the effect also disappears in the shareholder determined sub-sample. Thus, a preliminary conclusion is that the reverse causation in the board index relation seems to be sensitive to the specification of the index and in sub-samples. The conclusion from the discussion of the two previous tables is that the results are upheld; in particular, the co-determination hypothesis is confirmed. Now I turn to variations on firm performance, using the stock return and ROA instead of Tobin’s Q. The stock return and ROA may be seen as two extremes in performance measurement, the one only market based, the other only accounting based. Bhagat and Jefferis (2002) argue in favour of accounting measures, noting that market measures may contain an anticipation bias, since accounting numbers may be manipulated during a given year. Since our data span 14 years, this accounting manipulation should be a minor concern. These two measures of firm performance should together provide an adequate framework for robustness tests. The results for the full sample are given in Table 13.9. Since the results in the sub-samples largely parallel those found for the full sample, the subsample results are not reported. The results in Table 13.9 largely replicate those already found for Tobin’s Q in Table 13.4. The co-determination and the governance hypotheses show the same confirmations. As before, leverage is negative in the firm performance equation. Again, the board index and leverage are substitutes. Endogeneity (or reverse causation) is evident in both firm performance specifications, although at different variables. For the stock return the lagged stock return is significant in firm performance and leverage, as before. One would expect this to happen with accounting numbers due to earnings management or conservative accounting practices (Watts, 2003), which would induce serial correlation. However, lagged performance is significant for only the board index for the accounting measure ROA. Overall, Table 13.9 supports earlier findings. The upshot is that alternative performance measures do not upset conclusions reached with Tobin’s Q. Therefore, further robustness tests may well proceed with Tobin’s Q as the dependent variable. Next, Table 13.10 shows results when the dividend payout rate replaces leverage, and Tobin’s Q is the firm performance in the upper part, while in the lower part the lagged firm performance is removed. Dividend payout rate is gauged as the annual dividend as a fraction of the earnings before interest, taxes, depreciation, and accruals (EBITDA). During the period of study, share buybacks were illegal in Norway.

350

Table 13.9

The board, management relations and ownership structure

The employee director direct and indirect (endogenous) effects when the stock return and the return on assets (ROA) define firm performance

Independent Variable

Stock return, N51019 Stock return lagged Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value ROA N51135 ROA lagged Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value

Dependent Variable Tobin’s Q

Average Wage

Board Index 2

Leverage

−0.242** −0.056 0.132** −0.232** −0.165** −0.112 −0.138** 123.539 0.000

−0.046**

−0.008 −0.057*

−0.072** 0.077** −0.223**

−0.008 −0.129** 0.066** −0.170** −0.125** 0.033 −0.024 68.694 0.000

−0.055* 0.056** 0.052 0.012 −0.003 15.975 0.014 −0.043 −0.022 0.077** 0.062 −0.010 0.014 15.739 0.015

−0.169** 0.302** −0.026 −0.010 78.542 0.000 0.063** −0.028 −0.183** 0.322** −0.051 0.025 86.037 0.000

0.039 0.117* −0.043 61.258 0.000 −0.011 0.106** −0.195** 0.060 0.103 −0.048 57.564 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when the stock return replaces Tobin’s Q in the upper part and the return on assets replaces Tobin’s Q in the lower part. The dependent variable is the stock return, defined as the raw stock return adjusted for dividend and stock splits; alternatively, as the return on assets, gauged as the accounting profits on book value of assets. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except for the average wage, where at least a 1.6% level is needed. Significant results at the 5% (10%) level are marked with ** (*).

Better firm performance with employees on the board?

Table 13.10

351

The relationships between firm performance, employee directors and governance mechanisms when dividend payout rate replaces leverage ratio and when lagged firm performance is removed

Independent Variable

Dependent Variable Tobin’s Q

Average Wage

Board Index 2

0.014

0.088** −0.075**

Dividend payout rate, N51150 Tobin’s Q lagged 0.106** Average wage −0.046* Board index 0.125** Dividend payout rate 0.005 Employee directors −0.117** Firm size −0.178** Systematic risk 0.002 79.275 Wald c2 test p-value 0.000

−0.059** −0.011 0.082* 0.004 0.028 8.236 0.221

−0.012 0.317** −0.106* 0.020 48.154 0.000

Tobin’s Q

Average Wage

Board Index

−0.062** 0.131** −0.058** −0.117** −0.151** 0.027 71.943 0.000

−0.014 0.152** 0.058 0.021 0.015 45.253 0.000

No lag N51333 Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value

−0.018 −0.161** 0.306** −0.066 0.017 85.976 0.000

Dividend Payout 0.035 −0.025 −0.021 0.092 0.022 −0.066 4.785 0.572 Leverage

0.201** −0.169** 0.029 0.100** −0.031 84.992 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when the dividend payout rate replaces leverage in the upper part and the lagged firm performance is removed in the lower part. The dependent variable is Tobin’s Q, which we measure as the market value of the firm over its book value. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. I use fixed effects estimation in 3SLS framework with standardized variables. The sample comprises all non-financial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except for the average wage and the dividend payout relations in the upper part, where I cannot reject the hypothesis. Significant results at the 5% (10%) level are marked with ** (*).

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The board, management relations and ownership structure

The striking results are first that the dividend payout rate is nowhere significant as an independent variable, and second, as a dependent variable no variable in the system is related in a significant way. In fact the Wald test cannot reject the hypothesis that all coefficients in the dividend payout rate equation are zero. An exclusion test (not reported) for the dividend payout rate cannot confirm that the variable coefficient is different from zero. Thus, the dividend payout rate is an inferior substitute for leverage. Moreover, the results for the other variables are not affected, even though changes in one part of a simultaneous system may bring about new values in other parts. Therefore, the results in Table 13.10 increase the confidence in the original model. The lower part of Table 13.10 shows results when the lagged firm performance is left out. The reason for the removal is that lagged firm performance induces bias (Hsiao, 2003, pp. 71–2), since the errors are no longer independent of the regressors. The smaller the bias, the larger is the number of periods in the panel and the closer to zero is the auto-correlation coefficient on lagged firm performance. Furthermore, if the explanatory variables apart from the lagged firm performance have very persistent elements, the bias will not disappear. This persistence can be a concern in governance studies. For instance, the firm’s board size is likely to be fairly stable. To test for the seriousness of this bias, I include static system regressions, that is, with no lagged performance. Comparing the results from the no lagged firm performance regression with the original estimates in Table 13.4, we see that practically all signs are maintained, and also that coefficient values are quite similar. The co-determination hypothesis is confirmed. For average wage on firm performance, the variable is significant in the static specification but not in the dynamic. But overall the results from the dynamic estimations are upheld. Apparently, the low auto-correlation coefficient, the rather long time period and the small persistence in the explanatory variables warrant the use of the dynamic specification in Table 13.4. I also run a regression (not reported) with all explanatory variables lagged one period for the entire sample. This regression shows far fewer significant results, and, although the signs are the same as before, this specification is far inferior to the main regression in Table 13.4. Again, this points to a contemporaneity in governance mechanisms. Finally, I run a test for the Fauver and Fuerst (2006) information hypothesis in the sub-samples. The authors assume information significance to trade, transportation, and manufacturing industries. Using the same GICS industry classification as in Table 13.2, I allocate Capital goods, Transport, Consumer articles, Retailing, Food and staples retailing, Health care equipment and supplies, and Telecommunications to the information intensive industries, while the rest are in other industries. Co-determined firms are

Better firm performance with employees on the board?

353

distributed in the two sub-samples almost as in the total population, with 61.1 per cent without employee directors in the Other industries category against 57.4 in the full sample. A test for the Fauver and Fuerst (2006) information hypothesis is that the employee director variable is positive in the information intensive industries. Table 13.11 shows the results. The main interest is in the employee director, that is, the co-determination hypothesis. Both sub-samples show a negative and significant coefficient on the employee director variable. The Chow test shows that the two subsamples are different, but the main Fauver and Fuerst (2006) hypothesis is not supported. Overall, the results for the robustness tests do not invalidate the results found in Table 13.4.

8.

CONCLUSION

In this chapter I pose the question whether board representation of one group of non-owner, the employees, improves firm performance. I conclude it does not. The conclusion runs counter to claims from stakeholder theorists (Freeman and Reed, 1983; Blair, 1995) and some financial economists (Zingales, 2000; Becht et al., 2003) that co-determination improves firm performance. Instead the results support most former findings in the empirical literature (Fitzroy and Kraft, 1993; Schmid and Seger, 1998; Gorton and Schmid, 2000, 2004; Falaye et al., 2006; Bøhren and Strøm, 2008) that employee board representation reduces firm performance. The Norwegian regulations on co-determination provide the institutional framework. Co-determination is required by law for firms with more than 200 employees, and is an option if an employee majority demands so in firms having between 30 and 200 employees. A number of industries are exempted, and in all industries employees exercise their option. Thus, testing can take place using sub-samples, for instance in co-determined and shareholder determined sub-samples. For the whole sample, nearly 60 per cent do not have employee directors. The percentage has been rising during our period from 1989 to 2002. For firms with more than 200 employees, twothirds have employee directors. The resultant data set is of a panel nature. I estimate a system of simultaneous equations where employee directors, firm size (sales), firm systematic risk, and one period lagged Tobin’s Q are the exogenous variables, and Tobin’s Q, average wage, board index, and leverage are the endogenous. The board index is constructed from important board characteristics, that is, directors’ holdings, the board’s network, board size and the female fraction. The free cash flow hypothesis (Easterbrook, 1984; Jensen, 1986) warrants the use of leverage.

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The board, management relations and ownership structure

Table 13.11

Firm performance, employee directors and governance mechanisms in sub-samples of information intensive industries and other industries

Independent Variable

Information industries N5533 Firm performance lag Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value Other industries N5601 Firm performance lag Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value Chow dummy variable test

Dependent Variable Tobin’s Q

Average Wage

Board Index

Leverage

0.277** −0.041 0.015 −0.024 −0.081** 0.007 0.003 60.354 0.000

0.210**

0.127 −0.150**

−0.240** 0.440** −0.040

0.069* −0.050 0.153** −0.081** −0.117* −0.215** 0.062 41.646 0.000 c2 (7):

−0.093** 0.217** 0.182** 0.167* 0.055 88.323 0.000 -0.040 −0.131^ ** 0.044 −0.033 −0.129^ * 0.013 14.737 0.022 28.362

−0.032 0.197** −0.060 0.062 17.790 0.007 −0.036 −0.113** −0.033 0.157** −0.145** −0.165** 35.541 0.000 p-value

−0.044 0.141 0.009 61.376 0.000 −0.088** 0.047 −0.040 −0.016 0.131* −0.133** 15.583 0.016 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when the full sample is sub-divided into informationally intensive industries in the upper part and other industries in the lower. Using the same GICS industry classification as in Table 13.2, informationally intensive industries are Capital goods, Transport, Consumer articles, Retailing, Food and staples retailing, Health care equipment and supplies, and Telecommunications, while the rest are in other industries. The dependent variable is Tobin’s Q, which we measure as the market value of the firm over its book value. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. I use fixed effects estimation in 3SLS framework with standardized variables. The sample comprises all non-financial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except for a 2.3% level in the average wage relation in the Other industries estimation. The Chow dummy variable test is explained in Table 13.5. The test result indicates that coefficient values are different in the two sub-samples. Significant results at the 5% (10%) level are marked with ** (*).

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The setup allows the testing of direct and indirect employee director effects upon firm performance. The indirect effects constitute a test of endogeneity (Hermalin and Weisbach, 2003). The lagged firm performance gives a test of the reverse causation hypothesis (Hermalin and Weisbach, 1998) that past firm performance determines current governance. Furthermore, it allows testing of complementarity between the two governance variables board index and leverage (Agrawal and Knoeber, 1996). Regressions are performed on the whole sample, the sub-samples of codetermined and shareholder determined firms, and then the sub-samples of firms with more than 200 employees. I use a fixed effects model implemented in a three-stage least squares (3SLS) estimation. In all regressions, the estimated coefficient for employee directors is significantly negative. Moreover, the economic importance becomes larger as regressions proceed from the overall sample to the sub-sample of codetermined firms, and then to co-determined firms with 200 employees or more. The result is at odds with Fauver and Fuerst (2006), who find a positive relationship when a dummy employee director variable is interacted with information intensive industries. In sub-samples of information intensive and other industries I confirm the negative employee director correlation to Tobin’s Q. Overall, the results support agency theory and reject stakeholder theory. The indirect effects are also present. Employee directors are positively associated with average wage, the board index, and, in co-determined samples, leverage. For the board index, this means that shareholders improve board composition so as to neutralize the negative employee director effect, as Buchanan and Tullock (1962) predict. However, this neutralizing effect falls far short of the negative direct employee director effect. The lagged firm performance is significantly positively related to the board index and negatively to leverage. This result runs counter to the Hermalin and Weisbach (1998) reverse causation theory that earlier firm performance determines board composition. Thus, the results show endogeneity effects, but the economic significance falls far below the importance of the direct effect. The negative direct effect of employee directors is only partially compensated for by a better board. Endogeneity matters, but not very much. Furthermore, leverage turns out to be negatively related to firm performance, contrary to the free cash flow hypothesis (Easterbrook, 1984; and Jensen, 1986). The negative association with firm performance confirms findings in empirical studies (Barclay et al., 1995; Rajan and Zingales, 1995; Brick et al., 2005). Jensen and Meckling (1979) argue that co-determination can only survive if supported by law. The long-term data set employed here supports this view. Evidently, owners have good economic reasons for not

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The board, management relations and ownership structure

choosing the co-determination form of organization if they can. This also implies that there are costs to maintaining co-determination required by law. First, I document the negative impact of employee representation upon firm performance. Second, shareholders try to work around the regulations by strengthening aspects of board characteristics that are left unregulated. Thus, co-determination, supported by law, has costs. Therefore, these results are relevant for the emerging literature on board regulation (Hermalin, 2005).

NOTES *

1. 2.

3. 4. 5. 6.

7.

8.

Acknowledgements: I have benefited from comments made by Øyvind Bøhren, Ole Gjølberg, Roswitha King, Gudbrand Lien, participants at the 7th workshop on Corporate Governance and Investment, Jönköping, 2006, and at the 2nd International Business Economics Workshop, Majorca, 13–14 September 2007. Pål Rydland and Bernt Arne Ødegaard have guided me to data. Co-determination is defined as employee board representation (Jensen and Meckling, 1979; Furubotn, 1988). Tirole (2002, p. 118) argues that these ‘[c]onflicts of interest among the board generate endless haggling, vote-trading and log-rolling. They also focus managerial attention on the delicate search for compromises that are acceptable to everyone; managers thereby lose a clear sense of mission and become political virtuosos.’ In a similar vein, Hansmann (1996, p. 44) states that ‘because the participants [that is, stakeholders] are likely to have radically diverging interests, making everybody an owner threatens to increase the costs of collective decision making enormously.’ According to the EIRO (1998) full employee representation is found in Austria, the Nordic countries, and Germany, while the Netherlands and France have systems closer to a consultative function for employee representatives. In a recent booklet, the long-time employee director Svein Stugu (2006) says that the main objective is to prevent plant closures. Mergers, takeovers, and outsourcing must also be prevented. Stugu (2006, p. 63) says that opposition to plant closures was organized in co-operation with representatives of the local community, but that this could only be done effectively if labour representatives had access to internal information. The variables are defined as follows. Directors’ holdings is defined as the fraction of equity owned by the board of directors; board network is the information centrality, constructed from network theory (Wasserman and Faust, 1994), see note 8 below; board size is the number of shareholder elected directors; gender is the proportion of shareholder elected female directors. I keep only a linear specification in the board ownership relation, despite evidence in Morck et al. (1988) and McConnell and Servaes (1990) pointing towards a concave relationship. The Bøhren and Strøm (2008) study finds no significance in the squared term, maybe due to the inclusion of other board characteristics. Network theory uses concepts such as nodes and lines. In our setting, a node is a firm, and a line between two firms represents a joint director in the two firms. We define geodesic gjk as the shortest path between two nodes j and k, and G as the total number of nodes. The node i is designated as ni. Using Wasserman and Faust (1994, pp. 192–7), our information centrality measure is constructed in the following way. Form the G 3 G matrix A with diagonal elements aii equal to 1 plus the sum of values for all lines incident to ni and off-diagonal elements aij, such that aij 5 0 if nodes ni and nj are not adjacent, and aij 5 1 2 xij if nodes ni and nj are adjacent. xij is the value of the link from firm ni

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to nj, that is, 0 or 1. The inverse of A, which is C 5 A21, has elements { cij } , where we G G define T 5 g i51cii and R 5 g j51cij. The information centrality index for firm ni is: Ci (ni) 5

9.

10. 11. 12.

1 cii 1 (T 2 2R) /G

The index measures the information content in the paths that originate and end at a specific firm. The OSE had an aggregate market capitalization of 68 billion USD equivalents by yearend 2002, ranking the OSE 16 among the 22 European stock exchanges for which comparable data are available. During the sample period from 1989 to 2002, the number of firms listed increased from 129 to 203, market capitalization grew by 8 per cent per annum, and market liquidity, measured as transaction value over market value, increased from 52 per cent in 1989 to 72 per cent in 2002 (sources: www.ose.no and www.fibv.com). The main sources are Bråthen (1982) and Aarbakke et al. (1999) and a government report (NOU 1985:1). In order to maintain readability, specific references have been dropped in tables and text. For every individual firm, an overall average is constructed. Then, from each company observation the overall individual average is subtracted. In addition to the variables in (2), I include outside owner concentration, independence, CEO director, exported and imported directors, and board age dispersion. Outside owner concentration is the sum of squared equity fractions across all the firm’s outside owners; independence is the board tenure of the non-employee directors minus the tenure of the CEO; CEO director equals 1 if the CEO is a member of his company’s board and zero otherwise; exported CEO is the number of outside directorships held by the firm’s CEO; imported CEO is the proportion of CEOs from other companies on the board; board age dispersion is the standard deviation of board age.

REFERENCES Aarbakke, M., J. Skåre, G. Knudsen, T. Ofstad and A. Aarbakke (1999), Aksjeloven og Allmennaksjeloven (Company Law), Oslo: Tano Aschehoug. Agrawal, A. and C.R. Knoeber (1996), ‘Firm performance and mechanisms to control agency problems between managers and shareholders’, Journal of Financial and Quantitative Analysis, 31 (3), 377–97. Baker, G.P., M.C. Jensen and K.J. Murphy (1988), ‘Compensation and incentives: Practices vs. theory’, Journal of Finance, 43 (3), 593–616. Barclay, M.J., C.W. Smith and R.L. Watts (1995), ‘The determinants of corporate leverage and dividend policies’, Journal of Applied Corporate Finance, 7 (4), 4–19. Becht, M., P. Bolton and A. Röell (2003), ‘Corporate governance and control’, in G. Constantinides, M. Harris and R. Stulz (eds), Handbook of the Economics of Finance, Volume 1A, Amsterdam: North-Holland, pp. 1–109. Bertrand, M. and S. Mullainathan (2001), ‘Are CEOs rewarded for luck? The ones without principals are’, Quarterly Journal of Economics, 116 (3), 901–32. Bhagat, S. and R.H. Jefferis (2002), The Econometrics of Corporate Governance Studies, Cambridge, MA: The MIT Press. Blair, M.M. (1995), Ownership and Control: Rethinking Corporate Governance for the Twenty-first Century, Washington DC: The Brookings Institution. Blair, M.M. and L.A. Stout (1999), ‘A team production theory of corporate law’, Virginia Law Review, 85 (2), 247–328.

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Bøhren, Ø. and R.Ø. Strøm (2008), ‘Aligned, informed, and decisive: characteristics of value-creating boards’, in R.Ø. Strøm, Three Essays on Corporate Boards, Dr. Oecon. thesis, BI Norwegian School of Management, Oslo, Norway, pp. 21–60. Bråthen, T. (1982), Bedriftsforsamlingen i aksjeselskaper (The Supervisory Board in Shareholder Owned Companies), Oslo: Tanum Nordli. Brick, I.E., D. Palia and C.-J. Wang (2005), ‘Simultaneous estimation of CEO compensation, leverage, and board characteristics on firm value’. Buchanan, J.M. and G. Tullock (1962), The Calculus of Consent: Logical Foundations of Constitutional Democracy, Ann Arbor: The University of Michigan Press. Cadbury Committee (1992), Report of the Committee on the Financial Aspects of Corporate Governance, London: Gee and Co. Ltd. Carter, D.A., B.J. Simkins and W.G. Simpson (2003), ‘Corporate governance, board diversity and firm value’, Financial Review, 38, 33–53. Dow, G.K. (2003), Governing the Firm: Workers’ Control in Theory and Practice, Cambridge, UK: Cambridge University Press. Easterbrook, F.H. (1984), ‘Two agency-cost explanations of dividends’, American Economic Review, 74 (4), 650–59. Eisenberg, T., S. Sundgren and M.T. Wells (1998), ‘Larger board size and decreasing firm value in small firms’, Journal of Financial Economics 48, 35–54. European Industrial Relations Observatory On-line (EIRO) (1998), ‘Board-level employee representation in Europe’, September. Falaye, O., V. Mehrotra and R.Morck (2006), ‘When labor has a voice in corporate governance’, Journal of Financial and Quantitative Analysis, 41 (3), 489–510. Fauver, L. and M.E. Fuerst (2006), ‘Does good corporate governance include employee representation? Evidence from German corporate boards’, Journal of Financial Economics, 82 (3), 673–710. FitzRoy, F.R. and K. Kraft (1993), ‘Economic effects of codetermination’, Scandinavian Journal of Economics, 95 (3), 365–75. Freeman, R.B. and E.P. Lazear (1995), ‘An economic analysis of works councils’, in J. Rogers and W. Streeck (eds), Works Councils: Consultation, Representation, and Cooperation in Industrial Relations, Chicago: The University of Chicago Press, pp. 27–50. Freeman, R. E. and D. L. Reed (1983), ‘Stockholders and stakeholders: a new perspective on corporate governance’, California Management Review, 25, 88–106. Furubotn, E.G. (1988), ‘Codetermination and the modern theory of the firm: a property-rights analysis, Journal of Business, 61 (2), 165–81. Goergen, M. (2007), ‘What do we know about different systems of corporate governance?’, ECGI Finance Working Paper No. 163/2007. Gompers, P., J. Ishii and A. Metrick (2003), ‘Corporate governance and equity prices’, Quarterly Journal of Economics, 118 (1), 107–55. Gorton, G. and F.A. Schmid (2000), ‘Universal banking and the performance of German firms’, Journal of Political Economy, 58 (1–2), 29–80. Gorton, G. and F.A. Schmid (2004), ‘Capital, labor, and the firm: a study of German codetermination’, Journal of the European Economic Association, 2 (5), 863–905. Greene, W.H. (2003), Econometric Analysis, 5th edn, New York: Prentice Hall. Hansmann, H. (1996), The Ownership of Enterprise, Cambridge, MA: Harvard University Press. Harris, M. and A. Raviv (1991), ‘The theory of capital structure’, Journal of Finance 46 (1), 297–355.

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Hermalin, B.E. (2005), ‘Trends in corporate governance’, Journal of Finance, 60 (5), 2351–84. Hermalin, B.E. and M.S. Weisbach (1998), ‘Endogenously chosen boards of directors and their monitoring of the CEO’, American Economic Review, 88 (1), 96–118. Hermalin, B.E. and M.S. Weisbach (2003), ‘Boards of directors as an endogenously determined institution: a survey of the economic literature’, Economic Policy Review, 9 (1), 7–26. Hopt, K.J. (1998), ‘The German two-tier board: experience, theories, reform’, in K.J. Hopt, H. Kanda, M.J. Roe, E. Wymeersch, and S. Prigge (eds), Comparative Corporate Governance: The State of the Art and Emerging Research, Oxford: Oxford University Press, pp. 227–58. Hsiao, C. (2003), Analysis of Panel Data, 2nd edn, Cambridge: Cambridge University Press. Jensen, M.C. (1986), ‘Agency cost of free cash flow, corporate finance and takeovers’, American Economic Review, 76, 323–39. Jensen, M.C. and W. Meckling (1979), ‘Rights and production functions: an application to labor-managed firms and codetermination’, Journal of Business, 52 (4), 469–506. Johnson, R.A. and D.W. Wichern (1988), Applied Multivariate Statistical Analysis, 2nd edn, Englewood Cliffs, NJ: Prentice-Hall. McConnell, J. and H. Servaes (1990), ‘Additional evidence on equity ownership and corporate value’, Journal of Financial Economics 27, 595–612. Morck, R., A. Shleifer and R. Vishny (1988), ‘Management ownership and market valuation: an empirical analysis’, Journal of Financial Economics, 20, 293–315. Mueller, D.C. (2003), Public Choice III, Cambridge, UK: Cambridge University Press. Myers, S.C. (1977), ‘Determinants of corporate borrowing’, Journal of Financial Economics, 5, 147–75. NOU (1985), Videreutviklingen av bedriftsdemokratiet (Further development of codetermination), Oslo: Statens forvaltningstjeneste. Palia, D. (2001), ‘The endogeneity of managerial compensation in firm valuation: a solution’, Review of Financial Studies, 14 (3), 735–64. Perotti, E. and K.E. Spier (1993), ‘Capital structure as a bargaining tool: the role of leverage in contract renegotiation’, American Economic Review, 83 (5), 1131–41. Pfeffer, J. (1981), Power in Organizations, Cambridge, MA: Ballinger Publishing Company. Pistor, K. (1999), ‘Codetermination: a socio-political model with governance externalities’, in M.M. Blair and M.J. Roe (eds), Employees and Corporate Governance, Washington, DC: Brookings Institution Press, pp. 163–93. Raheja, C.G. (2005), ‘Determinants of board size and composition: a theory of corporate boards’, Journal of Financial and Quantitative Analysis, 40 (2), 283–306. Rajan, R.G. and L. Zingales (1995), ‘What do we know about capital structure? Some evidence from international data’, Journal of Finance, 50 (5), 1421–60. Schmid, F.A. and F. Seger (1998), ‘Arbeitnehmermitbestimmung, Allokation von Entscheidungsrechten und Shareholder Value’ (Codetermination, decision right allocation, and shareholder value), Zeitschrift für Betriebswirtschaft, 68 (5), 453–73. Shrader, C.B., V.B. Blackburn and P. Iles (1997), ‘Women in management and

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firm financial performance: an exploratory study’, Journal of Managerial Issues, 9 (3), 355–72. Siebert, H. (2005), The German Economy: Beyond the Social Market, Oxford: Oxford University Press. Smith, N., V. Smith and M. Verner (2006), ‘Do women in top management affect firm performance? A panel study of 2300 Danish firms’, International Journal of Productivity and Performance Management, 55 (7), 569–93. Stugu, S. (2006), Orkla: Bedriftskultur og bedriftsdemokrati 1991–2004 (Orkla: Company culture and democracy 1991–2004), Oslo: DeFacto. Tirole, J. (2001), ‘Corporate governance’, Econometrica, 69 (1), 1–36. Tirole, J. (2002), Financial Crises, Liquidity, and the International Monetary System, Princeton: Princeton University Press. Tirole, J. (2006), The Theory of Corporate Finance, Princeton: Princeton University Press. Wasserman, S. and K. Faust (1994), Social Network Analysis: Methods and Applications, Cambridge, UK: Cambridge University Press. Watts, R.L. (2003), ‘Conservatism in accounting: Part I: Explanations and implications’, Accounting Horizons, 17 (3), 207–21. Woolridge, J.M. (2002), Econometric Analysis of Cross Section and Panel Data, Cambridge, MA: The MIT Press. Yermack, D. (1996), ‘Higher market valuation of companies with a small board of directors’, Journal of Financial Economics, 40, 185–212. Zingales, L. (2000), ‘In search of new foundations’, Journal of Finance, 55 (4), 1623–53.

14.

The determinants of German corporate governance ratings Wolfgang Drobetz, Klaus Gugler and Simone Hirschvogl

1.

INTRODUCTION

In recent years many countries have introduced ‘corporate governance codes’. These codes represent unmistakable improvements in minority shareholder right protection as well as transparency, and they generally entail a movement towards Anglo-Saxon institutions. Many of the rules in these codes are only recommendations, however, and there is much scepticism that best-practice recommendations and/or principles-based approaches are effective substitutes for more rule-based approaches, such as the US Sarbanes-Oxley Act. This is all the more the case since there is the widespread perception that markets do not function well in punishing deviant behaviour of managers, particularly in Continental Europe, where regulators tend to rely heavily on principles-based approaches in their attempts to reform corporate governance. There are many reasons to believe that markets are less of a constraint on managerial discretion in Continental Europe than in the US or the UK, in particular. For example, ownership and voting right concentration is tremendous, liquidity of shares is low, and there is frequently a separation between cash flow and voting rights.1 In general, therefore, the ‘exit option’ is less of a threat to firms’ management, and the ‘voice’ of institutional investors, in particular, ought to be strengthened. The existing literature on codes is scant at best, and if it exists it is on the effects of corporate governance codes on performance.2 Most recently, Drobetz et al. (2004) construct a corporate governance rating for 91 German firms and find that the rating of a firm positively affects market value and the returns to shareholders. Their empirical analysis reveals that for the median firm a one standard deviation change in the governance rating results in about a 24 per cent increase in the value of Tobin’s Q.

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This evidence notwithstanding, there are problems with the link between corporate governance code ratings and firm performance. First, there is the well-known endogeneity problem already mentioned above: if only ‘good’ firms adopt the code (for example, because the costs are low, since they fulfil the code anyway), one must expect a positive code–performance relationship.3 Second, a high rating on the code only indirectly affects performance: a high rating must correlate with the true ‘spirit’ of good governance, which only then can affect performance.4 In fact, very little is known about the underlying mechanism that relates corporate governance practices and firm performance (for example, see Shleifer and Wolfenzon, 2002). A more cautious approach of analysing corporate governance codes is adopted in this chapter. We take one step back and do not try to assess the impact of code fulfilment on the performance of companies (which is, of course, ultimately the most interesting question). Instead, we use the corporate governance rating constructed by Drobetz et al. (2004) for publicly listed German firms and analyse the determinants of this rating. This approach has the advantage that we do not run into the same endogeneity problems with the determinants of code fulfilment that we would encounter by trying to assess the effects on firm performance. For example, one cannot sensibly argue that a high or low governance rating affects the voting rights of the largest shareholder or the size/composition of the supervisory board. It must be the case that the decision making process is determined or at least monitored by the largest shareholder and/or the board, and their decisions naturally affect compliance with the code. The decision to improve corporate governance practices and attitudes should be made in awareness of its consequences and obligations (for example, see Demsetz and Lehn, 1985). However, we only have a cross-section of data at hand, which may also limit our analysis. Our results show that there is a non-linear relationship between ownership concentration and the corporate governance rating. Moreover, firms with larger boards have lower ratings, but firms that apply US-GAAP or IAS rules or use an option-based remuneration plan have higher ratings. The remainder of this chapter is structured as follows. Section 2 develops our hypotheses, which are subject to empirical testing. Because our corporate governance rating mainly refers to the rules and recommendations of the German Corporate Governance Code, we give a brief and general comparative analysis of the governance codes in place throughout the European Union in Section 3. Section 4 describes the data, Section 5 presents our empirical results, and Section 6 concludes.

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2.

363

HYPOTHESES

Germany is the prototype of an insider system of finance and control, and thus our hypotheses as to the determinants of ratings must reflect its institutional background. The most striking fact of even large, listed firms in Germany is that ownership and voting right concentration is tremendous. While the median largest ultimate voting block in US or UK listed firms is well below 10 per cent, it is above 50 per cent in Germany, Italy and Austria (see Becht and Röell, 1999). Therefore, presumably the owner of this block has ultimate control over the company and can decide which stance to adopt with regard to the code of good corporate governance. Accordingly, we hypothesize that the voting power of the largest shareholder affects the code rating. We also develop the notion that the size of the board of directors, a firm’s accounting principles, and its method of executive remuneration impact the code ratings. 2.1

Ownership Concentration

In the literature two main effects of large shareholders have been disentangled (for example, see Claessens et al., 2002; Gugler et al., 2003a). First, with increasing cash flow rights of the largest shareholder, there is a positive incentive effect. A good code rating – provided it is awarded by the capital market – increases the value of the firm and, hence, the value of the ownership stake of the largest shareholder. S/he should therefore have an incentive to comply with the code. However, there is a second, negative entrenchment effect. The larger the voting rights of the largest shareholder, the more entrenched s/he is and the more s/he can influence the decision making process. A high code rating achieved by making it easier for small shareholders to cast their votes in general assemblies, increasing transparency by disclosing information on individual compensation of management and the supervisory board, or agreeing to strict incompatibility regulation, to give a few examples, is not necessarily in the largest shareholder’s interest. We summarize the discussion as follows: Hypothesis 1 Ownership concentration is non-linearly related to the corporate governance rating. At low to intermediate holdings of the largest shareholder the entrenchment effect outweighs the incentive effect and we expect a negative relation between ownership concentration and the corporate governance rating. At high levels of ownership concentration the incentive effect outweighs the entrenchment effect and, hence, we expect a positive relation between ownership concentration and the corporate governance rating.

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Board Size

Our second determinant of code compliance is the size of the supervisory board. The decision making process in the supervisory board is likely to be affected by its size for at least two reasons. First, coordination problems are larger on a large board than on a small board. Jensen (1993) and Lipton and Lorsch (1992) suggest that large boards can be less effective than small boards, presuming that the emphasis on politeness and courtesy in boardrooms is at the expense of truth and frankness. Specifically, when boards become too big, agency problems (such as director free-riding) increase and the board becomes more symbolic and neglects its monitoring and control duties. Moreover, large boards may reflect an inadequate perception of the true executive function, particularly in firms with public involvement. Supporting this rather ad hoc proposition, Yermack (1996) was the first to report empirical evidence for a negative relationship between board size and firm valuation (see also Eisenberg et al., 1998; Beiner et al., 2004). Second, on a large board it is likely that more conflicting groups of stakeholders, such as representatives of large shareholders, employees, and creditors, are represented than on smaller boards. Third, many companies do have a (and if so, at most one) representative of small shareholders. However, the larger the board the less weight this representative has at a ballot. All of these arguments lead us to: Hypothesis 2 Larger boards tend to be reluctant to adopt ‘good’ corporate governance practices and, hence, board size is negatively related to the corporate governance rating. 2.3

Accounting Principles

There are several papers that find significant effects of accounting practices on the performance of companies as well as on the distribution of profits among stakeholders, such as dividends or interest payments on debt (see, for example, La Porta et al., 1997, 1998, 2000; Gugler et al., 2003b, 2004). In Germany there are three possibilities as to how firms are allowed to account: US-GAAP (US Generally Accepted Accounting Principles), IAS (International Accounting Standards) and HGB (‘Handelsgesetzbuch’). US-GAAP and IAS contain much stricter rules on accounting practices than HGB, which is the national law standard for accounting, particularly with respect to transparency and details of information. Due to its conservative approach (for example, historical cost accounting), HGB accounting appears to favour debtholders and large shareholders versus minority shareholders.

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Accounting according to international standards and compliance with the code can be viewed as complements for a number of reasons. First, many of the requirements of code compliance are antedated by the decision to account according to international principles. Thus the marginal costs of code compliance are smaller for these firms than for firms using HGB. Second, firms that account with US-GAAP or IAS may want to signal their good investment opportunities, and code compliance is one way to achieve this goal. Finally, although we explicitly account for firm size (total assets) in the determinants regressions below, part of the co-variation in accounting principles and code rating may be attributable to firm size (for example, due to measurement errors of true firm size), which is a main determinant of international accounting. Accordingly, we formulate: Hypothesis 3 Firms accounting according to US-GAAP or IAS have higher corporate governance ratings than firms accounting according to HGB. 2.4

Executive Remuneration

Our final variable affecting code rating is whether or not the firm has adopted an option-based remuneration plan. Diamond and Verrechia (1982) and Holmström and Tirole (1993) developed models that are based on the interaction of capital markets and contingent compensation. Giving managers an equity stake in the firm is a solution to ensure that managers pursue the interests of shareholders without necessarily increasing managerial entrenchment. Provided that a high governance rating is awarded by the capital market, management of firms using option-based remuneration has an incentive to comply with the code. Therefore, we formulate: Hypothesis 4 Firms that use an option-based remuneration plan have higher corporate governance ratings than other firms.

3.

CODES OF GOOD CORPORATE GOVERNANCE

3.1

European Corporate Governance Codes

Recently, all EU member states have adopted at least one governance code document.5 It is generally acknowledged that the legal framework for corporate governance is most effective if it aims at ensuring: (i) fair and equitable treatment of all shareholders, (ii) managerial and supervisory body accountability, (iii) transparency as to corporate performance, ownership structure and governance, and (iv) corporate responsibility. While the codes originate

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from countries with very diverse cultures, financing traditions, ownership structures, and legal origins, they are remarkably similar in their general notion of ‘best practice’ corporate governance rules. In fact, codes appear to serve as a converging force in corporate governance practices. Nevertheless, two observations are noteworthy. First, the coverage of the codes differs substantially due to differences in legal origins and frameworks. While some codes address general principles and practices of corporate governance, other nations establish these in company laws and securities regulation. Second, while some codes strongly emphasize the supervisory body holding managers accountable to a broad base of relatively dispersed shareholders (for example, in the UK), other codes focus on the protection of minority shareholders to ensure equal treatment to a dominant shareholder (for example, in Germany). The codes have three stated objectives: (i) stakeholder and/or shareholder interests, (ii) the work of supervisory and managerial bodies, and (iii) disclosure requirements. The majority of codes recognize that corporate success, shareholder profit, employee security and well-being, and the interests of other stakeholders are strongly interrelated. They generally call for shareholders to be treated equitably, disproportional voting rights to be avoided or at least fully disclosed to all shareholders, and removal of barriers to shareholder participation in general meetings, whether in person or by proxy.6 Despite structural differences between two-tier and unitary board systems, they all stress that supervisory responsibilities are distinct from management responsibilities. Many suggest practices designed to enhance the distinction between the roles of the supervisory and managerial bodies, including supervisory body independence, separation of the chairman and CEO roles, and reliance on board committees (such as the nominating committee).7 Finally, all codes contain various disclosure requirements. An issue that has received specific public attention is the greater voluntary transparency as to executive and director compensation.8 In addition, the codes also support the increasing public interest in disclosure as regards director independence (in both one-tier board and two-tier board systems), share ownership, and, in many instances, issues of broader social concerns. With regards to code enforcement, the prescriptions supplement and complement the mandatory prescriptions provided by company and securities laws and listing rules. However, they are non-imperative and lack mandatory compliance authority. The vast majority of codes merely require companies to provide greater voluntary disclosure of governance practices, including disclosure about the extent of compliance with a particular code recommendation. Listed companies are required to disclose whether they comply with the specified code and explain any deviations

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(‘comply or explain’). Even though compliance with code provisions is wholly voluntary, reputational market forces can result in significant compliance pressures. Finally, codes are increasingly used by investors and market analysts, rating agencies, shareholder monitoring groups and commentators to benchmark supervisory and management bodies. 3.2

The German Corporate Governance Code

After a few private interest groups began establishing best practices of corporate governance in the late 1990s, in June 2000 the German federal government appointed a commission with the goal to formulate proposals for modernizing German corporate law. This report prepared the ground for the development of a national code for improving the management and control functions of publicly quoted companies. The results were elaborated into the code of conduct by a second, follow-up commission. The German Corporate Governance Code was finally published on 26 February 2002, and the Transparency and Disclosure Act (TransPuG), which took effect on 26 July 2002, obliges publicly quoted companies to apply the code recommendations. The code is an example of self-commitment by the corporate sector and requires disclosure on the ‘comply or explain’ rule described in Section 3.1. The stated goal of the code is to ‘promote the trust of international and national investors, customers, employees and the general public in the management and supervision of listed German stock corporations’.9 This is in contrast to the Anglo-Saxon view of corporate governance, where there is little room for the general public. Nevertheless, the code constitutes a regime shift in the German corporate governance system by taking a surprisingly pragmatic view on the ‘fundamental’ differences in stakeholder and shareholder interests, an issue that has been fiercely debated in particular in the German literature (for example, see Albach, 2003).

4.

DATA DESCRIPTION

4.1

A German Corporate Governance Rating

The corporate governance rating applied in this chapter is from Drobetz et al. (2003, 2004). They construct a broad, multifactor corporate governance rating, which is based on responses to a survey sent out to a broad sample of German publicly listed firms. To qualify for inclusion in the corporate governance rating, each practice and attitude (i) had to refer to a governance element that is not (yet) legally required and (ii) needed to be considered as

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international market practice from an investor’s perspective. Most proxies included in the rating represent recommendations and suggestions of the German Corporate Governance Code. Note that while the former work according to the comply-or-explain principle, the latter are wholly voluntary. A few other governance proxies originate from the DVFA German Corporate Governance Scorecard,10 from CalPERS German Market Principles, and from the Deminor Corporate Governance Checklist. In total, the rating contains 30 governance proxies divided into five categories: (1) corporate governance commitment, (2) shareholder rights, (3) transparency, (4) management and supervisory board matters, and (5) auditing. A representative question from each category is listed below: ● ●

●

● ●

Are there firm-specific corporate governance guidelines set out in writing? Are there measures in place to facilitate the personal exercising of shareholder voting rights (for example, via internet) and to assist the shareholders in the use of proxies? Are the fixed and variable remuneration elements as well as share ownership (including existing option rights) of members of the management and supervisory board published separately and in individualized form in the notes to the financial statements? Are there supervisory board committees to deal with complex matters (such as audit, compensation, strategy)? Are there firm-specific rules to ensure that the auditor does not perform other services for the firm (such as consulting work)?

A questionnaire with all 30 governance proxies was sent out to all firms in the four principal market segments of the German stock exchange: DAX 30 (blue-chip stocks), MDAX (mid-cap stocks), NEMAX 50 (index of growth firms), and SDAX (small-cap stocks), comprising a total of 253 firms. Data collection was completed at the end of March 2002. Overall, the survey had a response ratio of 36 per cent, which results in a sample of 91 German firms. The construction principles of the aggregate governance rating are kept simple. Twenty-five basis points are added for each acceptance level of the respective proxy in a five-scale answering range. For each firm the aggregate rating is an unweighted sum of the basis points across all proxies, ranging from 0 (minimum) to 30 (maximum).11 Hence, the dependent variables in our empirical analysis are: OVERALL (aggregate corporate governance rating), CG_UNT (governance commitment), CG_AKT (shareholder rights), CG_TRA (transparency), CG_ENT (management and supervisory board matters), and CG_ABS (auditing).

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12

Number of firms

10 8 6 4 2 0 0

2

4

6

8

10 12 14 16 18 20 22 Corporate governance rating

24

26

28

30

Note: This figure shows the distribution of the survey-based corporate governance rating (CGR) for 91 German public firms from Drobetz et al. (2004). The survey was sent out in February 2002, and the data collection was completed by the end of March 2002. The rating represents an unweighted sum of the basis points (on a five-scale answering range) for all governance proxies in five broad categories: (1) corporate governance commitment, (2) shareholder rights, (3) transparency, (4) management and supervisory board matters, and (5) auditing. The corporate governance rating ranges from 0 (minimum) to 30 (maximum). The ratings in the figure are rounded to the nearest integer.

Figure 14.1

Distribution of the German corporate governance rating

The histogram in Figure 14.1 shows that the rating over the 91 firms in our sample is slightly skewed to the right. More than 40 per cent of the firms have a rating between 20 and 23. Nevertheless, governance proxies display a sufficiently wide distribution to mitigate a possible sample selection bias in the survey. Panel A in Table 14.1 presents summary statistics of the dependent variables. Due to data limitations for the independent variables, the sample in our empirical analysis is reduced to 80 firms. The average rating is 19.51, with firm ratings ranging from 9.75 to 27.25. The sub-indices with the highest ratings are CG_ENT (management and supervisory matters) and CG_TRA (transparency), which can be explained by the fact that these areas are strongly accompanied by laws and regulation. 4.2

Explanatory Variables

The data for ownership structure/voting rights are based on the CD-ROM ‘Wer gehört zu Wem?’ (‘Who owns whom?’, 30 April 2002) or taken

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Table 14.1 Variables

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Summary statistics Mean

Median

Minimum Maximum

Panel A: Aggregate rating and components OVERALL 19.51 19.75 9.75 CG_UNT 2.27 2.00 0.00 CG_AKT 3.07 3.00 0.00 CG_TRA 4.55 4.75 2.00 CG_ENT 5.98 6.25 1.25 CG_ABS 3.63 3.75 1.00 Panel B: Aggregate rating by ownership concentration VR1