Download Guidelines for replies to exam in Industrial and Innovation Policy

Guidelines for replies to exam in Corporate Governance,
Summer 2004-06-24/25
Question 1
As concerns the first part of the question, it is natural to refer to Barca, F, Becht, M (ed) (chap.1)
and mention the ‘insider-outsider’ model, where national systems are classified according
ownership. This classification has inspired the dichotomy between Anglo-Saxon systems (outsider
systems), where ownership is usually dispersed among a large number of investors, who rely on
legal protection, and Continental systems (insider systems), where ownership is concentrated to
families and to companies. A good reply also refers to Gurgler, who suggests a classification based
on dispersion-concentration of cash-flow and control rights and to La Porta et.al, who discuss a
legal approach to the classification of governance systems.
The latter approach holds that the protection of outside investors and variations in its enforcement
should be made the major ground for classifying corporate governance systems. It is a favour to
mention the various legal families (common law, French, German and Scandinavian civil law) from
which the legal rules of the countries derive. The very good reply also points to main differences
between common law countries (laws usually made by judges based on precedents) and civil law
countries (laws made by the state). The legal approach considers public regulation a factor of vital
importance to investor protection implying that it stands in contrast to the contractual (transaction
cost) approach, where countries are classified according to enforcement of contractual law. A good
reply mentions that the contractual approach deals with a self-regulated private sector based on
privately negotiated arrangements (see La Porta et al).
The very good reply also refers to Barca & Becht and La Porta et al and points out that international
comparisons have often focused on the financing of firms (distinction between bank-centered
financial systems such as Germany and Japan and market-centered systems such as the UK and
USA).
A good reply to the second part of the question (your opinion about the usefulness of these
classifications) mentions that the outsider-insider model has a rudimentary perspective on
ownership and control. Only quadrant I and IV in Gugler’s model are considered, i.e. ownership
and control are either concentrated or dispersed. It is a favour, therefore, if the answer points out
that Gurgler’s QI-QIV model also is able to predict governance and economic performance for
countries with concentrated voting power, where some degree of liquidity and risk-sharing is
preserved by dispersed ownership (QII). Gurgler’s QI-QIV model is also advantages as it covers
countries with concentrated ownership and dispersed voting power (QIII). A very good reply also
refers to Barca & Becht, where it is mentioned that the empirical basis of the outsider-insider model
is rather weak (few countries and few firms have been included in the studies).
With regard to how useful the legal approach is, the good reply refers to empirical studies showing
that the countries’ legal systems (investor protection) do shape corporate ownership patterns:
countries with poor investor protection exhibit more concentrated control of firms than countries
with good protection (La Porta et. al.). It also mentions that the legal environment predicts
economic performance. For example, that legal rules shape the development of financial markets
(investor protection provides good conditions for financing investments). One advantage the legal
approach has over the contractual model is that the predictions take into account the residual rights
to control. It should be referred to La Porta et. al., who conclude that contractual law alone does not
assure that the free cash-flow is returned to the investors. While the role of the state and public
regulation is ignored in the contractual approach, it is unable to predict governance and economic
performance in countries where regulation is important.
The very good reply also mentions criticism by Barca & Becht and La Porta et. al of the bankcentered vis-à-vis market centered model. For example, it is unable to classify countries such as
Japan, with powerful banks and a highly developed equity market and France in which neither
credit markets nor stock markets are developed.
The reply to the last part of the question (the importance of auditors, analysts and investment
bankers) notes that all classifications systems mentioned do not consider conflicts of interests due to
the intermediaries between the investors and the top-managers. It should be referred to Demski, and
argued that unless the management of all types of “conflicts of interests” (arise “when an
executive, an officeholder or even an organization encounters a situation, where official action or
influence has the potential to benefit private interest”) are included in the classification system, they
cannot predict corporate scandals such as Enron. A very good reply mentions situations, where
intermediaries are the cause of conflicts: auditors also provide
consulting services, professional investors follow the crowd, analysts’ earnings depend on
investment banking. It also points out that theory of these systems should be extended with “theory
of herding”, which could improve the systems’ ability to forecast the spread of poor business
practices.
Question 2
It is natural to start the description of the employment relations by the conditions for ‘no wealth
effects’: 1) Benefits, costs and risk are evaluated as being equal to some cash transfer, 2) These
evaluations do not depend on the wealth hold by individuals and 3) Required payments can be made
without affecting other aspects of a transaction (Milgrom, P, Roberts, J ch. 2). As an example of
employment relations involving wealth effects, a good reply mentions employees earning rents
(condition 2 is violated), (ch. 8 in Milgrom, P, Roberts, J). It is a favor if rents (the employees’
talents are in short supply) are separated from quasi-rents (employees invest in specialized assets).
With regard to rents it should be referred to a model by Shapiro-Stiglitz, where cash penalties for
shirking does not work (condition 1 of ‘no wealth effects’ is violated). A good reply mentions that a
bonus may have favorable properties if it provides high earnings, but an employee looses all rights
to the bonuses when fired (costs of being detected an fired are high).
In turning to quasi-rents, a good reply refers to Vives ch. 6. If employees increase their investments
in specialized (intellectual) assets, then human capital becomes a vital resource in production. As
bonds between shareholder ownership and capital become weak (legal claims to physical assets are
no longer the most important source of power), systems with external shareholders become
insufficient for corporate control. The good reply, therefore, points out that the employment
relations in this case create a need for the owners and managements to protect the integrity of the
firm (prevent the employees from running with critical assets). A bonus system may provide the
‘complementarities’ required to cause persons to voluntarily follow the firm’s command rather than
to go their own way.
A good reply may also refer to employee ownership. It should mention that in those cases, where
the workers only have cash flow rights, rewarding is similar to many bonus systems. It should also
be pointed out that the development of employee ownership with this kind of rewarding has been
explained by difficulties with employment relations violating the no wealth effect (employee lockin, the need of supervision when cash penalty does not work).
The reply to the last part of the question (objections to the transfer of bonus systems to lower-level
employees) could set out from ch. 6 in Milgrom & Roberts. It mentions that bonus for the
management is believed to lead to good behavior as the managers share the risk with the
shareholders. One objection to the use of bonus systems for rewarding lower-level employees could
be that in general they are more risk adverse than the managers. The involvement of employees in
risk-sharing, therefore, may lead to substantial increases in the costs of risk-sharing. It is a favour if
the answer also mentions that rewarding systems should be designed in ways, where the reward is
linked to the variables controlled by the employees involved. At this point, it could be referred to
Hansmann from whom we learn that low-level employees, for the most part, participate in risksharing without having any control rights (bonus systems usually allocate only cash-flow rights to
the employees). With regard to managements the situation is different, because shareholders
contract away some of their controlling rights to the management (risk-sharing and control follow
one and another).
Question 3
A good reply suggests solutions for two groups of non-investing parties: the employees and those
affected by air and water pollution. It starts by referring to Tirole’s contractual approach to
increased social responsibility of the firm. It is a favour if the most important elements of this
stakeholder model are described. Thus, the reply points out that control is undivided, i.e. the
management should be induced to internalise the welfare of all stakeholders (not only the
shareholders but also the employees and those affected by pollution). As no measure of social
wealth can be constructed, to which rewards of the managers could be linked, incentives are linked
to a fixed income and the managers’ concern about multi-task careers. It is an extra plus if the reply
gives a more precise description of this incentive system. For example, that incentives become
implicit: a manager has an interest in giving “correct” signals to those people taking actions that
influence his or her career.
With regard to disadvantages of this solution, a good reply points out that undivided control may
give the controlling part certain advantages leading to biased decision-making. It also mentions that
these difficulties can be reduced by contractual protection of the non-investing parties (limitations
on actions that are expected to pollute the air and the water; exit options for employees, who
become unemployed). Due to these difficulties, the good reply also mentions that employee
interests may be satisfied by solutions based on divided control such as the German system for
codetermination. It should be mentioned (see Hansmann) that this solution gives the employees the
right to participate in decision-making without participating in the earnings. A good reply mentions,
as an advantages of employee-participation in voting, that it increases the value of the firm (Lazear
et. al.). It should be mentioned as a disadvantage that systems with divided control may be
accompanied by high ‘costs of collective decision making’ (Tirole, Hansmann). On the other hand,
a good reply notes that the trade union organises a majority of the workers in the firm and has a
strong bargaining position. Therefore, it may be an ‘egalitarian practice’ reducing the negative cost
effect of heterogeneous preferences. It is an extra plus if the recommendation to the owner notes
that employees invest in their career (they earn quasi-rents) and mentions that an efficient lay off
policy in this case could be to offer stock ownership to the employees.
Also for those non-investing parties affected by pollution, there is an alternative solution to Tirole’s
stakeholder model, which is considered in a good reply. It is referred to Milgrom & Roberts ch. 9,
who suggest a contractual approach, where the firm (the polluter) has property rights to the air and
water. This brings those, who are harmed by pollution, in a position to bargain with the polluters. If
they could agree about a price for the rights to the air and water that is favourable for both parties,
trade with property rights may lead to an efficient amount of pollution. The obvious disadvantage of
this solution is that the transaction costs for the firm would be too large, which brings us to the last
part of the question (limitations of private arrangements, where public regulation is required). The
very good reply, points out that Tirole’s stakeholder model probably is the only feasible private
solution for the firm. Both the solution with worker participation and the solution with property
rights to air and water require public regulation to be efficient.
Lazear et. al. concludes about systems with worker participation (divided control) that the outcome
of bargaining about the allocation of rents between shareholders/management and the employees
usually not maximizes the value of the firm. This suggests that some regulation by governments is
required to safeguard an optimal outcome of these negotiations. With regard to bargaining about
property rights to air and water, Milgrom & Roberts conclude that these rights should be allocated
to the public at large and enforced through public regulation (legal and regulatory systems).