William Lazonick

Corporate Governance, Innovation, and Economic Performance in the EU (CGEP)

A research project funded by the Targeted Socio-Economic Research (TSER) Programme of the European Commission (DGXII) under the Fourth Framework Programme, European Commission (Contract no.: SOE1-CT98-1114; Project no: 053), coordinated by William Lazonick and Mary O'Sullivan at the European Institute of Business Administration (INSEAD).

Perspectives on

Corporate Governance, Innovation,

and Economic Performance

Revised June 2000

William Lazonick

And

Mary O'Sullivan

The European Institute of Business Administration (INSEAD)

Boulevard de Constance 77305 Fontainebleau Cedex

France

Tel: + 33 1 60 72 41 82 + 33 1 60 72 44 41

Fax: +33 1 60 74 55 56 Email: [email protected]

[email protected] We gratefully acknowledge comments on this report from many CGEP participants, especially Martin Fransman, Andrea Prencipe, and Ulrich Jürgens, as well as the assistance of Marie Carpenter and Michèle Plu in preparing this report. Andreea Balan and Brock Wolf provided research assistance.

Corporate Governance, Innovation, and Economic Performance

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Contents

Summary 2 1. Corporate Governance and Economic Performance 13

1.1 A Critical Policy Issue 13 1.2 The Definition of "Corporate Governance" 13 1.3 The Current Debates on Corporate Governance 16 1.4 Innovative Enterprise and Corporate Governance 17

2. The Anglo-American Debates on Corporate Governance 20

2.1 The Managerial Perspective on Corporate Governance 20 2.2 "Shareholder Value" as a Principle of Corporate Governance 24

2.2.1 The mechanisms of corporate governance 27 2.2.2 The productive role of the corporate shareholder 32 2.2.3 The sources of "residual earnings" in shareholder theory 35

2.3 The Stakeholder Perspective on Corporate Governance 40 2.4 Innovation and the Corporate Governance Debates 46

3. Innovation: Linking Corporate Governance and Economic Performance 48

3.1 Innovation and Economic Development 48 3.2 The Economic Theory of Innovative Enterprise 51

3.2.1 The neoclassical theory of the firm 51 3.2.2 From transaction cost theory to a theory of innovative enterprise 54 3.2.3 The dynamics of innovative enterprise 60

4. The Organization of the Innovation Process 66

4.1 Innovative Allocation: Developmental, Organizational, Strategic 66 4.2 Organizational Control and Innovation 70

5. Organizational Learning and Innovation 73

5.1 Individual Learning and Organizational Learning 73 5.2 Functional and Hierarchical Integration Within the Firm 79 5.3 Horizontal and Vertical Relations Among Firms Within an Industry 91 5.4 Learning and Innovation 96

6. Strategic Management and Corporate Governance 101

6.1 Strategic Control: Who Makes Decisions to Allocate Corporate Resources and Returns? 101

6.2 Strategic Control and Organizational Learning: What Types of Innovative Investments Should Strategists Make? 107 6.3 Strategic Control and Productive Capabilities: How Should Corporate Returns be Distributed? 115

References 121 Tables and Figures 139


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SUMMARY 1. Corporate Governance and Economic Performance The question of how corporations should be governed to enhance corporate and economic performance has been widely discussed in the last two decades in the United States and Britain. In recent years, corporate governance has increased its profile in the EU to become a major, and critical, policy issue throughout the member states. Of course, many of the issues being discussed under the rubric of corporate governance today, such as company law, takeover codes, worker participation, and shareholder rights and responsibilities have been debated for some time, in some cases for more than a century. Yet new pressures have emerged in the last two decades that have raised the profile of these issues within the EU. Contemporary debates about corporate governance in the US and Britain largely stem from the recognition of the centrality of major enterprises for allocating resources in the economy. Publicly-listed corporate enterprises, the shares of which are generally widely held, play a critical role in shaping economic outcomes through the decisions that they make about investments, employment, trade, and income distribution. The process through which corporate revenues are allocated has profound effects on the performance of the economy as a whole. In countries such as Germany and Italy where family-owned firms are important economic players and the publicly-listed corporation is not the predominant legal form of the large-scale business enterprise, an understanding of corporate governance remains crucial for analyzing the relation between resource allocation in and by these enterprises and the performance of the national economies in which they operate. Corporate governance is concerned with the institutions that influence how business corporations allocate resources and returns. Specifically, a system of corporate governance shapes who makes investment decisions in corporations, what types of investments they make, and how returns from investments are distributed. • Who controls the corporate allocation of resources? Put differently, what are the

incentives and abilities with respect to the allocation of resources and returns of the types of people who exercise strategic decision-making power in corporations?

• What types of investments in productive resources do they make? In particular what types of productive capabilities, embodied especially in human resources, do these strategic decision-makers seek to put in place?

• How do they distribute the returns that are generated from these investments? Specifically, to what extent do they reinvest in productive capabilities and to what extent do they distribute returns to various types of "stakeholders" such as shareholders, different groups of employees, suppliers, distributors, governments, and communities?

Our definition of corporate governance is broader than that which dominates the Anglo-American debates on governance, where the main focus has been on the institutions that mediate a separation of ownership and control in the corporation. In part that focus stems from the concern in these debates with the widely-held corporation, a concern that is much less appropriate in European governance debates. But it also reflects the dominance in the Anglo-American debates of one particular perspective on corporate governance: the shareholder perspective. Proponents of the theory argue that the separation of ownership and control poses a major problem for the performance of corporations. To consider alternative perspectives on corporate governance, it is necessary to invoke a much more fundamental definition of corporate governance. In directly addressing the corporate governance questions of who should control the allocation of corporate resources, what types of investments should they make, and how the returns on these investments should be distributed, a theory of innovative enterprise calls for a research agenda and an assessment of policy alternatives that are being ignored in the current corporate governance debates. The innovation process requires financial commitment, organizational, integration, and strategic control. Financial commitment


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requires the allocation of money to sustain the process that develops and utilizes productive resources until the products generated by that process can generate financial returns. Organizational integration is a set of relations that creates incentives for participants in the hierarchical and functional division of labour to apply their skills and efforts to engage in collective and cumulative learning. Strategic control enables strategic decision makers to link financial commitment and organizational integration in the innovation process. Individuals, through learning, acquire knowledge and skill. Organizational, as distinct from individual, learning occurs when people with different hierarchical responsibilities and functional specialties interact in the pursuit of common goals. When integrated into an organization, and sustained by committed finance, such functional and hierarchical capabilities and responsibilities represent skill bases that can engage in organizational learning. Different industrial activities, characterized by different technologies, require different skill bases to generate innovation, and within a particular activity, the breadth and depth of these innovative skill bases change as the very accumulation of organizational learning transforms the realities of, and the possibilities for, the development and utilization of productive resources. Hence the allocation of enterprise resources to the development and utilization of skill bases is integral to an enterprise's strategy. The past two decades or so have witnessed the appearance of a voluminous literature, by both academics and practitioners, on the transformation of the organizational conditions for innovative enterprise. From the literature on organizational learning, we seek to understand • the process that transforms individual learning into organizational learning; • the interactions among individuals with different functional capabilities and hierarchical

responsibilities in the organizational-learning process; • the interactions among firms (as distinct units of financial control) with different functional

capabilities and hierarchical responsibilities in the organizational-learning process; • the relation between the learning that takes place within a business organization and the

innovative capability of that organization. From the literature on strategic management, we seek to understand • the relation between investment strategy and organizational learning in the innovation

process; • the sources and loci of strategic control within the business organization for making these

interventions (corresponding to the “who” in our key questions on corporate governance); • the types of resource allocations to the innovation process that strategists make

(corresponding to the “what” in our key questions on corporate governance); • the ways in which strategists allocate returns from the innovation process to ensure the

continuity of the process (corresponding to the “how” in our key questions on corporate governance).

2. The Anglo-American Debates on Corporate Governance In the current debates, we can identify three major perspectives on corporate governance: managerial, shareholder, and stakeholder. • The managerial perspective: The dominant perspective on corporate governance of the post-World War II decades, “managerialism” reflected the prominence of the large-scale corporate enterprise in the allocation of resources and returns in many of the most successful national economies. While these economies were doing well, there was no concerted effort to challenge the legitimacy of managerial control of the nation’s leading corporations. In the postwar decades the leading corporations tended to retain both the money that they earned and the people whom they employed. Retentions in the forms of earnings and capital consumption allowances provided the financial foundations for corporate growth, while the building of managerial organizations to develop and utilize productive resources enabled investments in plant, equipment, and personnel to succeed. Corporate managers largely controlled the


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allocation of these resources without interference in strategic decisions from shareholders or workers. The managerial perspective often uses words such as “capabilities”, “knowledge”, “skills”, “learning”, “factor creation”, and “innovation” as sources of “sustained competitive advantage” for the enterprise. But the enduring and fundamental problem with the managerial perspective, which has made it vulnerable to critiques from shareholder advocates, is that it is not underpinned by a theory of innovation that can show how and under what conditions managerial resource allocation can yield competitive success. The proponents of managerial control are unable, therefore, to provide a systematic explanation of the conditions under which managers will make investments that promote innovation and generate returns and those under which such investments will not be made. From the managerial perspective, what determines whether or not an enterprise invests in innovation is the “mindset” of the strategic manager, but what determines the mindset of the manager is rarely addressed. Lacking such an analysis, the managerial perspective provides little basis on which to understand how the incentives and abilities of those who exercise corporate control enhance or impede the process through which resources are allocated to generate returns in the corporate economy. • The shareholder perspective: Having emerged in the 1970s and 1980s in the US and Britain as an attack on the perceived failures of “managerial capitalism”, this perspective has become dominant both in theory and practice in the corporate governance debates of the 1990s. The basic argument underlying the shareholder perspective on corporate governance is that as equity investors shareholders are the only participants in the business corporation whose returns to their productive contributions are "residual". All other groups besides shareholders, such as workers, external suppliers, and creditors, who provide resources to the firm do so on the basis of contracts that specify the relation between their contributions to the productive process and the returns that they receive for those contributions. The returns to shareholders, then, depend upon what, if any, revenues are left over after all other contractual claims have been paid. As “residual claimants”, shareholders bear the risk of the corporation’s making a profit or loss. They thus have an interest in allocating corporate resources to their “best alternative uses” to make the residual as large as possible. Since all other “stakeholders” in the corporation will receive the returns for which they have contracted, the “maximization of shareholder value” will result in superior economic performance not only for the particular corporation but also for the economy as a whole. Advocates of shareholder theory therefore contend that shareholders are the “principals” in whose interests the corporation should be run even though they rely on others for the actual running of the corporation. To contribute to the optimal allocation of resources in the economy, managers should seek to maximize shareholder value, either by making corporate investments in projects that can yield at least the same risk-adjusted rate of return that shareholders could receive elsewhere in the economy, or by distributing revenues to shareholders who can then reallocate these resources themselves in search of the highest available returns. It is regarded as economically efficacious for shareholders to bear the risk of the corporation’s generating a residual. As a class, they are deemed to be better equipped to bear risk than managers and workers because they are not tied to the firms in which they hold shares. Consequently, shareholders can diversify their investment portfolios to take advantage of the risk-minimization possibilities of grouping or consolidating different types of risk. The central preoccupation of financial economists who work on corporate governance has been the analysis of mechanisms that increase the control of financial markets over corporate resource allocation and that, as a result, limit the discretion of corporate managers to act other than in the interests of shareholders. One way to resolve the problem is through a reintegration of share ownership and managerial control. Such integration of ownership and management has the disadvantage, however, of eliminating a social division of labour that proponents of the shareholder perspective view as central to the operation of a market


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economy; namely, the division of labour between a financier who diversifies his portfolio across many different investment opportunities and a producer who possesses specialized decision-making skills. To deal with the agency problem in a way that permits this division of labour between the financier and producer to be maintained, shareholders can either use the carrot or the stick. The carrot is to grant stock options to managers so that they will align their own incentives with that of shareholders, even though their stakes in the company as shareholders will typically be too small to result in the actual integration of ownership and management. The stick is to use “the market for corporate control” -- that is, the takeover of effective control of a company by a group of shareholders – to change the behaviour of opportunistic managers by threatening their removal, or, if such discipline fails to do the job, by replacing them with new managers who will align their interests with shareholders. During the 1980s and 1990s in the United States, the widespread use of these mechanisms to align the interests of corporate managers with those of public shareholders helped to transform the rhetoric of shareholder value into a dominant ideology of corporate governance. This period has also witnessed the longest stock market boom in history, with the yields on corporate stock recovering significantly from their depressed state in the 1970s. The critical issues for the debate on corporate governance are whether the claims of the shareholder perspective that maximizing shareholder value results in the highest common good are justified in theory and in practice. The claims of proponents of shareholder value can be called into question on three different levels. Firstly, notwithstanding the fervour with which the efficacy of the governance mechanisms proposed by shareholder advocates is propounded, unambiguous empirical evidence to support these assertions has not been forthcoming. Secondly, the two key assumptions that shareholder theory makes about the role of corporate shareholders – that they supply capital for productive investment and that they bear risk to a degree that entitles them to corporate residuals – can be challenged on the grounds that they ignore some basic facts concerning the twentieth-century operation of a corporate economy, including that of the United States. Finally, and most fundamental of all, the concept of economic efficiency on which the shareholder theory is premised precludes an understanding, not to mention an analysis, of the dynamic process through which productive resources are developed and utilized to generate higher quality, lower cost products, or what is often called innovation. • The stakeholder perspective: With its roots in older arguments for “industrial democracy” going back to the 1920s, this perspective has been elaborated once again as the institutions of “managerial capitalism” have faltered and as the shareholder perspective has been promoted as the most “efficient” solution to the problem of corporate governance. As shareholders have flexed their muscles to demand greater control over the allocation of corporate resources, there have been various attempts to develop an intellectual response by arguing that there are other "stakeholders", besides shareholders, who have a claim to corporate residual returns.

Stakeholder theories of governance often have a strong political component. One important strand of the literature on worker control of enterprises, for example, justifies its position on humanistic grounds, arguing that employee involvement in enterprise governance is a necessary precondition for individual and social development. Another strand contends that traditional hierarchical relationships between employers and employees are inherently undemocratic and unjust, and must be countered by worker involvement in the governance of enterprises. In the contemporary debates on corporate governance, the stakeholder perspective continues to be exposited more often as a political position than as an economic theory of governance. It is rare in this literature to find an analysis of how the allocation of returns to different stakeholders affects economic performance. An important exception is Margaret Blair, Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century. Blair accepts that shareholders have “residual claimant” status because she believes that they invest in the productive assets of the enterprise and bear some of the risk of its success. But she argues that the physical assets in which shareholders allegedly invest


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are not the only assets that create value in the corporation; a critical dimension of the economic process that generates wealth is that individuals invest in their own "human capital". Because employees with firm-specific skills have a "stake" that is at risk in the company, Blair argues that they should be accorded “residual claimant” status alongside shareholders. Blair's analysis of firm-specific skills owes much to Gary Becker's theory of investments in on-the-job training. Becker, and Blair in turn, maintain the neoclassical assumptions that resource allocation is individual. Investments in, and returns from, productive resources are assumed to attach to individuals, even when these factors of production are combined in firms. Yet the introduction of the concept of firm specificity represents a break with the neoclassical concept of resource allocation, rendering a theory so focused on exchange relations less hostile to productive investment.

Becker’s work on training has had a profound influence on labour economists. In particular, the concept of firm-specific human capital is widely employed in analyses of labour market behaviour by those supportive and critical of Becker’s conclusions. But, to an extraordinary degree, given its centrality to their work, labour economists have failed to open the black box of firm-specificity to analyze where it comes from and, relatedly, why it makes sense to assume that it might be an important phenomenon in the economy. Our review of the extensive literature on the concept of firm-specificity reveals that most scholars take as their starting point some version of Becker’s definition of firm-specific human capital, and proceed to build models of labour market behaviour without going beyond Becker in providing a theory of who allocates resources to this type of productive investment, what kinds of investments they make, or how the returns to these investments are distributed

Blair recognizes the need for an analysis of what she calls “wealth creation” in order to make the case for a corporate governance process that allocates returns to “firm-specific” human assets. For her, as for Becker, the role of economic governance is to get factor returns “right” so that the individual actors are induced to make the “firm-specific” investments that the enterprise requires. But she provides no theory of the process that enables such human capital to contribute to the generation of higher quality, lower cost products. She merely asserts that investment in "firm-specific" assets can generate "residuals". Her willingness to accept the neoclassical assumption that resource allocation is the result of investments by optimizing individuals, and that the firm is, as a result, nothing more than a combination of physical and human assets that for some reason -- labeled "firm-specificity" -- happen to be gathered together, precludes an understanding of the economic foundations of strategic control by one group of people over the learning opportunities of others and the governance institutions that shape the abilities and incentives of strategic decision makers in corporate enterprises. Without such a theory of wealth creation, it is impossible to determine the “right” returns to factors of production. If one wishes to base a theory of corporate governance on investments in “firm-specific human capital”, then one needs a theory of the “who, what, and how” such investments. 3. Innovation: Linking Corporate Governance and Economic Performance To transform productive resources into useful and affordable products, modern economies rely on business enterprises that must ultimately generate sufficient revenues from the sale of these products to survive. In a competitive environment, survival over the long run requires that the enterprise be innovative. Innovation entails the transformation of productive inputs into saleable outputs to generate products that are "higher quality" -- more desirable to users -- and "lower cost" -- more affordable to users -- than those goods and services previously attainable at prevailing factor prices. The task for a theory of innovative enterprise is to explain how a particular enterprise can emerge as dominant in its industry. Unlike the optimizing firm of neoclassical theory, the innovative enterprise does not take as given the fixed costs of participating in an industry. Rather, the level of fixed costs that it incurs reflects its innovative strategy. This “fixed-cost” strategy is not dictated by indivisible technology or the “entrepreneur” as a fixed factor, but by the innovative enterprise’s assessment of the quality and quantity of productive resources in


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which it must invest to develop products that are higher quality and lower cost than those that it had previously been capable of producing and that (in its estimation) its competitors will be able to produce, given their investment strategies. This internal development of productive resources creates the potential for an innovative enterprise to gain a sustained competitive advantage over its competitors and emerge as dominant in its industry. Such development, when successful, becomes embodied in products, processes, and people with superior productive capabilities than those that had previously existed. But even the generation of superior productive capabilities will not result in competitive advantage if the high fixed costs of the innovative strategy place the enterprise at a cost disadvantage relative to less innovative competitors. For a given level of factor prices, these higher fixed costs derive from the size and duration of the innovative investment strategy. Innovative strategies tend to entail higher fixed costs than those incurred by the optimizing firm because the innovation process tends to require the simultaneous development of productive resources across a broader and deeper range of integrated activities than those undertaken by the optimizing firm. But in addition to, and generally independent of, the size of the innovative investment strategy at a point in time, high fixed costs will be incurred because of the duration of time required to develop productive resources until they result in products that are sufficiently high quality and low cost to generate returns. If the size of investments in physical capital tends to increase the fixed costs of an innovative strategy, so too does the duration of the investment in an organization of people who can engage in the collective and cumulative – or organizational – learning. Such learning is the central characteristic of the innovation process. The high fixed costs of an innovative strategy create the need for the enterprise to attain a high level of utilization of the productive resources that it has developed. As in neoclassical theory, the innovative enterprise may experience increasing costs because of the problem of maintaining the productivity of variable inputs as it employs larger quantities in the production process. But rather than taking increasing costs as a given constraint, the innovative enterprise will attempt to transform its access to high-quality productive resources at high levels of output by investing in the development of that productive resource, the utilization of which as a variable input has become a source of increasing costs. Having thus added to its fixed costs, the innovative enterprise is then under more pressure to expand its market share to transform high fixed costs into low unit costs. The ability of the innovative enterprise to achieve decreasing costs even as it produces larger volumes of output relative to the size of the industry’s market means that the neoclassical “optimizing” rule of marginal cost equals marginal revenue is irrelevant to its output and pricing decisions. Constraining its level of output at a point in time is typically the presence in the industry of a small number of other innovative enterprises that compete among themselves for market share. The innovative enterprise can seek to increase its market share by offering buyers lower prices. But constraining such price reductions is the need of the innovative enterprise to generate sufficient surplus revenues to reward its employees at levels above and beyond those that their labour services would fetch on the open labour market while investing in new technology, including the skills of workers, and building an organization to develop and utilize the new technology. Such investments can enable the enterprise to maintain or extend its competitive advantage in a given market or transfer some of its productive capabilities to produce output for another market that can make use of these capabilities. Insofar as the enterprise undertakes an innovative strategy in this diversification process, it will have to complement its existing capabilities with investment in, and development of, new capabilities, thus adding to the fixed costs that it must utilize to achieve low unit costs. The developmental impact of the innovative enterprise, therefore, manifests itself in a larger volume of output that it can, if is so chooses, make available to users at lower prices than the optimizing firm. The fear of the “monopolistic” firm among neoclassical economists is that it will choose to raise prices and restrict output. But the innovative enterprise has an interest in lowering prices as part of a strategy to increase the extent of the market available to it, which in turn lowers unit costs further as the enterprise reaps economies of scale. Indeed, the innovative enterprise has the potential of not only outperforming the optimizing firm in terms


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of product quantity and price but also generating sufficient surplus revenues to pay higher wages to employees and higher returns to other stakeholders such as suppliers and stockholders. The innovation process, that is, can overcome the “constrained-optimization” trade-offs between consumption and production in the allocation of resources and between capital and labour in the allocation of returns. 4. The Organization of the Innovation Process The innovative enterprise gains sustained competitive advantage by transforming the technological and market conditions that it faces. It transforms these industrial conditions by mobilizing the skills and efforts of large numbers of people to participate in the innovation process over a sustained period of time. Specifically, the innovative enterprise allocates resources and returns to building "innovative skill bases": the productive capabilities that result when people with different functional capabilities and hierarchical responsibilities work cumulatively and collectively to engage in organizational learning. This organizational learning is not simply the sum of individual learning by enterprise participants. Rather this organizational learning is the result of the ongoing cumulative and collective interactions among participants in the enterprise's functional and hierarchical divisions of labour. If the innovation process can be characterized as cumulative and collective, it can also be characterized as uncertain. It is subject to technological uncertainty: the organizational learning that is the essence of innovation may not result in processes and products that are superior to those already available. It is also subject to market uncertainty: unforeseeable changes in product demand, factor prices, or the capabilities and strategies of competitors may thwart the generation of higher quality, lower cost products by an enterprise, even when it has succeeded in developing superior processes and products than those that were previously available. On the basis of the extensive body of theoretical and empirical research on the economics of innovation, the underlying resource allocation process can be characterized as one that is 1) developmental -- resources must be committed to irreversible investments with uncertain returns; 2) organizational -- returns are generated through the integration of human and physical resources; and 3) strategic -- resources are allocated to overcome market and technological conditions that other firms take as given. That the resource allocation process that shapes innovation is developmental, organizational, and strategic places requirements on the governance of corporations if they are to be innovative. Recent debates on corporate governance have largely ignored these requirements because the leading theories of corporate governance do not systematically integrate an analysis of the economics of innovation. That the resource allocation process that generates innovation is developmental, organizational, and strategic implies that, at any point in time, a system of corporate governance supports innovation by generating three conditions – financial commitment, organizational integration, and strategic control – that, respectively, provide the institutional support for 1) the commitment of resources to irreversible investments with uncertain returns; 2) the integration of human and physical resources into an organizational process to develop and utilize technology; and 3) the vesting of control over strategic decision-making within corporations with those who have the incentives and abilities to allocate resources to innovative investments. In combination, financial commitment, organizational integration, and strategic control support organizational control in contrast to market control over the critical inputs to the innovation process: knowledge and money. Financial commitment permits not only the strategic allocation of resources to organizational learning, but also the appropriation of product market revenues by the innovative enterprise. How these revenues are allocated, and in particular the extent to which the returns from successful innovative investments are strategically channeled into future innovative activities, is critical for sustaining a strategy of continuous innovation. Only through continued investment can the depreciation or obsolescence of existing productive resources – skills, knowledge and physical assets – be counterbalanced by the development of new skills and


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knowledge and physical resources in order to sustain the competitive advantage of the learning collectivity. Organizational integration creates incentives for participants in a complex division of labour to commit their skills and efforts to the pursuit of the goals of enterprises rather than selling their ‘human capital’ on the open market. To some extent the collective and cumulative character of the learning process constrains individuals to commit their skills to the investing organization. In addition, however, the prospects of sharing in the gains of the innovative enterprise can lead even mobile participants to forego the lure of the market and remain committed to the pursuit of organizational goals. An innovative enterprise must vest strategic control over the allocation of corporate resources and returns with decision makers who are integrated with the learning process that generates innovation. When strategists are members of the learning collectivity, they can become privy to some of the knowledge that the collectivity generates, and can use it as a basis for organizing the work that members of the collectivity undertake. The integration of strategy and learning enables strategic decisions to shape the direction and structure of learning and the knowledge continually generated through learning to inform strategy. It enhances not only the abilities of strategists to develop innovative investment strategies but also their incentives to do so because they see their own goals as being furthered through investment in a learning process that is both collective and cumulative Without governance institutions that support financial commitment, organizational integration and strategic control -- that is, without the organizational control over knowledge and money that these conditions support -- business enterprises cannot generate innovation through strategic investment in collective learning processes. That organizational control is supported by a system of corporate governance does not imply, however, that innovation will in fact occur. Firstly, at any point in time, the organizational and financial requirements of innovative investment strategies, and the learning processes that they shape, vary across industrial activities. Such differences in the content of innovation across industrial activities mean that certain types of organizational control that promote innovation in one activity may fail to support, and even constrain, innovative capability in other activities that depend on different types of learning processes. Secondly, the relationship between a system of corporate governance and innovation is complicated by the change inherent in the innovation process. To the extent that the competitive environment evolves to generate more powerful strategies and learning processes, social conditions that supported the generation of higher quality and/or lower cost products in an earlier era in a particular industrial activity may prove unsuitable as a basis for further innovation in that activity. Finally, the institutions of governance are themselves subject to change. Institutional change may be a response to social pressures that are not related to the dynamics of the innovation process. Institutional transformation may also occur in response to competitive challenges from enterprises embedded in different systems of corporate governance. 5. Organizational Learning and Innovation An organization is made up of individuals, all of whom, through formal training and informal interactions learn how to do their jobs within a specialized division of labour. The functional division of labour means that different people within an organization have specialized knowledge about different phenomena. The hierarchical division of labour means that some people coordinate the work of others. Individual learning may be simple and repetitive, or it may be complex and creative. The individual may focus on a narrowly defined task in a narrowly defined job over the course of his or her working life. Or the individual may engage in a variety of tasks in a variety of jobs at different hierarchical levels or functional specializations within the organization. Individuals may spend their entire working lives working for one organization. Or they may be mobile across organizations. A key question for understanding the organizational conditions for innovation is how the individual learning of large numbers of participants engaged in the hierarchical and functional divisions of labour within an enterprise contributes to the process of organizational learning both within that enterprise and across enterprises that are seeking to transform the same technological and market conditions.


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Surveying the literature on organizational learning, we argue that learning is a necessary condition for innovation and that learning that results in innovation is “organizational” because it is cumulative and collective. It is cumulative because what has already been learned forms a foundation for what can be learned. It is collective because large numbers of people in the functional and hierarchical divisions of labour must interact in the learning process. But cumulative and collective learning does not always result in innovation. The very organizational structures that enabled organizational learning to generate innovation in the past may obstruct the cumulative and collective learning that is required to renew the innovation process. The cumulative and collective character of the learning that generates innovation can pose barriers to further innovation when such innovation requires a new cumulation path and a new collective process. Understanding the process that allocates corporate resources is of central importance to an analysis of both the transformation of individual learning into organizational learning and the reorganization of the innovation process when old learning blocks new learning. A theory of the process of strategic management is fundamental to answering the questions that we have posed concerning the "who, what, and how" of corporate resource allocation. 6. Strategic Management and Corporate Governance Within the strategic management literature, there are two broadly different perspectives on the loci of strategic control -- a "top-down" model that we depict as the "position" perspective and an "organizational" model that we depict as the process perspective. In general, the position perspective views the substance of corporate strategy as managerial choices to engage in, and trade-offs among, relatively well-defined business activities, with competitive advantage deriving from the superior utilization of a corporation's resources. In contrast, the process perspective views the substance of corporate strategy as an evolving process that entails learning about technologies and markets as well as about the organization itself and the environment in which it operates, with competitive advantage deriving from the superior, often unforeseen, development of a corporation's resources. One's conception of who should exercise strategic control will be bound up with one’s theory of what strategic decision makers have to do to be successful. The position perspective argues that resource allocation relies basically on optimization rules in choosing the range of different activities in which the corporation should invest. From this perspective, strategic decision makers need to be rational calculators who are positioned to see the big picture in order to optimize from a corporate point of view. Hence the assumptions that it is top corporate managers who should exercise strategic control and that strategic decision making does not rely on an organizational process. In contrast, the process perspective contends that resource allocation relies on social phenomena such as learning, culture, and power. From this perspective, the process of strategic decision making needs to be embedded within the organization, where participants in the process can understand how the existing capabilities of the enterprise can be developed and utilized to generate innovation. The main virtue of the process perspective is its emphasis on the link between strategy and learning. To make use of this insight to understand the sources of innovation and sustained competitive advantage, however, requires an analytical framework to determine who exercises strategic control within the organization's functional and hierarchical division of labour in ways that combine the access to the financial commitment required to sustain an innovation process and an understanding of the organizational learning that is critical to generating innovative outcomes. Yet the process perspective largely ignores the relation between strategic control and financial control. Nor has it developed a conceptual framework for analyzing who within the functional and hierarchical division of labour is included and who is excluded from the process of organizational learning, and how such organizational


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integration and segmentation varies across industrial activities, across institutional environments, and over time. In recent years, the strategic management literature has been dominated by "resource-based" theories of the firm that represent elaborations of the "positions" perspective. Resource-based theories seek to explain why enterprises can maintain monopoly positions in markets rather than how they became dominant through the organization of the innovation process. As a theoretical framework within the strategic management literature that goes beyond the resource-based view and seeks to analyze “what organizations do”, the most ambitious approach to date is the "dynamic capabilities" perspective that seeks to combine the analysis of asset positions, organizational processes, and evolutionary paths. But this perspective has had nothing specific to say about the locus of strategic control that ensures that the enterprise seeks to grow using the collective processes and along the cumulative paths that are the foundations of its distinctive competitive success. Nor has it provided guidance for understanding how an enterprise can and should respond strategically when it is confronted by new competitors, supported by different institutional environments, whose dynamic capabilities render the enterprise’s processes and paths, and hence asset positions, obsolete. The dynamic capabilities perspective focuses on the core substance of the innovation process -- the "what" of our three corporate governance questions -- but it does not have a theory of the "who" and the "how". From our perspective, therefore, it lacks a theory of innovative enterprise. The organizational processes that are central to the development and utilization of productive resources in the economy are dependent on the strategic allocation of corporate returns as well as the strategic allocation of corporate resources. The allocation of corporate returns, including as it does a division of corporate revenues into retentions and salaries on the one side and distributions to shareholders and debtholders on the other side, influences both the financial commitment that the corporation can make to the enterprise as a productive organization and the organizational integration of corporate employees that mobilizes the skills and efforts of these employees to the pursuit of organizational goals. By linking financial commitment and organizational integration, those who exercise strategic control over the allocation of corporate returns can have a preponderant influence over the development and utilization of the enterprise's productive resources. It is important to recognize that the allocation of corporate returns is not just about whether or not a company should retain surplus revenues for reinvestment in plant and equipment or distribute them to shareholders. It is also about how those who exercise strategic control over surplus revenues invest in the skills of employees and reward their efforts. Given the historical importance in the advanced economies of 1) retentions as a source of corporate investment funds, and 2) corporate careers as incentives to employees to identify with corporate goals, an understanding of the relation between the allocation of corporate returns and the innovation process should surely be of prime interest to the study of strategic management. Indeed, the current Anglo-Saxon corporate governance debates are all about the allocation of corporate returns; the critical shortcoming of these debates is their failure to address the relation between the allocation of resources and the innovation process. Hence if the strategic management literature that focuses on the allocation of corporate resources is to have anything to say about the impacts of corporate governance on an enterprise's competitive capabilities, it must analyse the strategic allocation of corporate returns as well.


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1. Corporate Governance and Economic Performance 1.1 A Critical Policy Issue The question of how corporations should be governed to enhance corporate and economic performance has been widely discussed in the last two decades in the United States and Britain. Until recently, the subject of corporate governance has attracted much less attention on the European Continent, in Asia, and in other parts of the world. By the late 1990s, however, corporate governance had become a major, and highly contentious, issue in all of the advanced economies and, increasingly, in developing countries as well. International organizations have devoted increasing attention to corporate governance as a topic of global concern. In May 1999, for example, the OECD published its “Principles of Corporate Governance”, which it noted "are the first inter-governmental attempt to develop a set of international standards for corporate governance" (OECD 1999). In June 1999 the OECD and the World Bank signed a memorandum of understanding that created a Global Corporate Governance Forum for the discussion and coordination of global standards of corporate governance. Other multilateral agencies, including the International Monetary Fund (IMF), the Asian Development Bank, and the Asia-Pacific Economic Cooperation organization, as well as American and British institutional investors, are actively pursuing agendas to bring about reform of corporate governance systems around the world. In recent years, corporate governance has increased its profile in the EU to become a major, and critical, policy issue throughout the member states. Of course, many of the issues being discussed under the rubric of corporate governance today, such as company law, takeover codes, worker participation, and shareholder rights and responsibilities have been debated for some time, in some cases for more than a century. Yet new pressures have emerged in the last two decades that have raised the profile of these issues within the EU and have lent a certain urgency to the debates that surround them. The surface manifestations of these pressures are numerous; they include growing merger and acquisition activity within and across borders, the rising importance of foreign institutional investors as shareholders in European companies, and the recent wave of privatizations of state-owned companies. At first glance what seems to be needed are institutional responses to these trends. What, for example, is the appropriate institutional framework for mergers and acquisitions within and across the member states? Yet there are broader issues at stake in addressing such questions that need to be considered if the sum of regulatory responses are to amount to a cohesive whole that makes sense for companies and the economies in which they are embedded. In a nutshell these issues turn on the relationship between systems of corporate governance and economic performance in the EU. 1.2 The Definition of "Corporate Governance" Before we can even begin to understand that relationship, we need to define “corporate governance” because its meaning and the ends toward which it is exercised are matters of considerable debate and disagreement. Contemporary debates on corporate governance are heavily influenced by discussions of the role of the corporations in the economies of the United States and Britain in the 1980s and 1990s. The predominant focus of these debates has been the publicly listed corporation in which share ownership is widely diffused.


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An indirect measure of the importance of these types of enterprise in various economies is the ratio of stock market capitalization to GDP. As Figure 1 shows, the importance of public corporations rapidly increased in most European countries in the 1990s. Nevertheless, as Table 1 illustrates, they are still far less important in most of the major continental European economies than in the US and Britain. Overall the average stock market capitalization in the EU falls far below the levels registered in the US. At the end of 1998, the 15 Member States of the EU had a domestic stock market capitalization of 84 per cent of GDP compared with 186 per cent in the US. Excluding the UK, the average stock market capitalization as a proportion of GDP for EU member states was 67 per cent. On the basis of these figures, there is perhaps a temptation to assume that corporate governance is currently a topic of relatively lesser concern in most of the EU since it affects fewer enterprises in the economy. Yet such a conclusion would be to put the definitional cart before the analytical horse, and in doing so to obscure the basic reason why the discussion of corporate governance is of such importance to understanding economic performance. Contemporary debates about corporate governance in the US and Britain largely stemmed from the recognition of the centrality of major enterprises for allocating resources in the economy. In these economies, publicly-listed corporate enterprises, the shares of which are generally widely held, play a critical role in shaping economic outcomes through the decisions that they make about investments, employment, trade, and income distribution. As a result, the process through which corporate revenues are allocated has profound effects on the performance of the economy as a whole. In countries such as Germany and Italy, moreover, where family-owned firms are important economic players and the publicly-listed corporation is not the only or even the predominant legal form of the large-scale business enterprise, an understanding of corporate governance remains crucial for analyzing the relation between resource allocation in and by these enterprises and the performance of the national economies in which they operate. When we speak about corporate governance, broadly construed to include the governance of all large-scale business enterprises, what do we mean? Corporations are important to the operation and performance of these economies because they exercise substantial control over the allocation of the economy's resources. Specifically, business corporations control the allocation of people to engage in productive activities and the allocation of money to finance these activities by investing in physical and human capital. Hence business corporations exercise considerable control over the allocation of resources in the economy in the forms of both labour and capital – the two generic factors of production. Moreover, as ongoing entities that must generate returns on these investments to survive, successful business corporations can exercise considerable control over the allocation of returns from productive activities as well the allocation of resources to productive activities from which returns can potentially be generated. Corporate governance is concerned with the institutions that influence how business corporations allocate resources and returns. Specifically, a system of corporate governance shapes who makes investment decisions in corporations, what types of investments they make, and how returns from investments are distributed (O’Sullivan 2000b). Our definition of "corporate governance" as the social process that determines the corporate allocation of resources and returns reflects a recognition that the large-scale business enterprise plays an important allocative role in the economy and that modes and outcomes of corporate governance will vary across social environments. Given this definition that links corporate governance to the economy's system of


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allocation of resources and returns, a perspective on corporate governance and economic performance should be prepared to pose the following three types of “who, what, and how” questions1:

• Who controls the corporate allocation of resources? Put differently, what are the

incentives and abilities with respect to the allocation of resources and returns of the types of people who exercise strategic decision-making power in corporations?

• What types of investments in productive resources do they make? In particular what types of productive capabilities, embodied especially in human resources, do these strategic decision-makers seek to put in place?

• How do they distribute the returns that are generated from these investments? Specifically, to what extent do they reinvest in productive capabilities and to what extent do they distribute returns to various types of "stakeholders" such as shareholders, different groups of employees, suppliers, distributors, governments, and communities?

Our definition of corporate governance is broader than that which dominates the Anglo-American debates on governance, where the main focus has been on the institutions that mediate a separation of ownership and control in the corporation. In part that focus stems from the concern in these debates with the widely-held corporation, a concern that we have claimed is much less appropriate in European debates on governance. But it also reflects the dominance in the Anglo-American debates of one particular perspective on corporate governance: the shareholder perspective. Shareholder theory, as we shall explain in detail below, is fundamentally concerned with the same general question of the relationship between governance institutions and corporate performance that we have defined above, that is of the institutional determinants of the who, what and how of corporate resource allocation. Proponents of the theory argue, however, that the separation of ownership and control poses a major problem for the performance of corporations because of certain arguments that they make about the relationship between shareholder behaviour and corporate resource allocation. The tendency to equate the problem of corporate governance with the separation of ownership and control is therefore to conflate definition with theory to a degree that makes it impossible to consider competing theoretical perspectives. To consider alternative perspectives on corporate governance, it is necessary to invoke a much more fundamental definition of corporate governance. We are interested in these perspectives as arguments about how to govern corporations to improve the performance of the economy as a whole rather than as arguments for increasing the returns flowing to any particular group, be they managers, workers, or shareholders. In other words, we look to these perspectives for theoretically logical and empirically supportable arguments about economic performance in an economy in which these corporations play a major role in the allocation of resources and returns. We are not interested in these perspectives insofar as they simply argue that, on normative (social, ethical, or moral) grounds, managers, shareholders or stakeholders should be rewarded in the economy.

1 These questions are in fact the same fundamental questions that most economists pose in

considering the operation and performance of the economy, with the differences that most economists begin with the belief that the allocation of resources and returns by “markets” rather than “organizations” (be they states or enterprises) will generally be the preferred mode of allocation in the economy.


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Nevertheless, normative arguments concerning who gains and who loses under a particular system of corporate governance have an important role to play in motivating and stimulating the corporate governance debates, and in helping to arrive at policy solutions that promote economic growth that is both equitable and stable. Moreover, normative arguments will have an influence on how we define and measure superior economic performance. For example, it may be more likely that shareholder proponents will be satisfied with the rate of economic growth as an adequate measure of macroeconomic performance, while stakeholder proponents of value will pay more attention to measures of economic equality and stability. We therefore want to assess alternative theories of corporate governance not only on their own terms but also in terms of alternative measures of economic performance. 1.3 The Current Debates on Corporate Governance Contemporary debates on corporate governance, as we have already observed, are heavily influenced by arguments developed in discussions of the role of business corporations in the economies of the United States and Britain in the 1980s and 1990s. We shall begin, therefore, by reviewing the alternative perspectives advanced in these debates. They have been dominated by 1) a shareholder theory of governance – one that argues that shareholders are the principals for whom the corporation should be run. The main challenges to shareholder theory have come thus far from 2) stakeholder theorists who contend that the corporation should be run for the benefit of other interest groups besides shareholders; and 3) management scholars who argue that managers need some autonomy from financial interests to commit resources to “long-term” investments. We shall outline the main arguments of the shareholder perspective, and explore the limits of its practical application and in particular its failure to address the issue of the sources of economic development and hence the sources of the surpluses -- or, in the language of the shareholder perspective, the "residual earnings" -- to which shareholder theory contends that shareholders can lay claim. As Joseph Schumpeter (1934) demonstrated long ago, a theory of economic development requires a theory of innovation. The fundamental argument of our project is that without a theory of innovation in the process of economic development, the link between corporate governance and economic performance cannot be made. We shall then show how the stakeholder perspective has sought to counter the powerful arguments of the shareholder perspective, in large part by reinterpreting the theory of shareholder value so that it applies to workers as well. The stakeholder perspective can also be criticized, however, for its failure to embed its arguments in a developmental theory of the economy in which the innovation process plays a central role. The managerial perspective on governance is the only approach that takes as its central concern the relationship of a system of governance to the innovative capacity of the corporate economy. However, although it calls for governance mechanisms that promote investments in innovation -- for example, by the provision of "patient capital" -- the managerial perspective provides little in the way of a systematic analysis of the process through which resources are developed and utilized to generate higher quality, lower cost products. In the limit, it defaults to the view that managers know best about the process of innovation. As corporate governance has commanded increased attention on the European Continent, the issues have been framed in terms that are largely derivative of the Anglo-American debates. Recently, there has been a growing recognition that Anglo-American theories of corporate governance, especially the shareholder theory,


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may not be appropriate to a continental European context (see, for example, Becht and Röell 1999, 1049, who argue that the high concentration of shareholder voting power in Europe implies that “the relationship between large controlling shareholders and weak minority shareholders is at least as important to understand as the more commonly studied interface between management and dispersed shareholders"). Nevertheless, there has been a tendency to stick with the basic definition of, and theoretical approach to, corporate governance that dominates the American and British discussions of the subject. For example, in a recent article entitled “A European Perspective on Corporate Governance”, Karel Lannoo of the Centre for European Policy Studies provides the following introduction to his analysis of corporate control:

Corporate governance in this article is defined as the organization of the relationship between the owners and the managers in the control of a corporation. This implies that the problem emerges where both groups are not the same, which is mainly the case in larger corporations. A good corporate governance system will be able to tackle the conflicts of interest between managers and owners of a corporation and resolve them. Other stakeholders, such as the workforce, government agencies, banks, suppliers and customers, or the public at large, have an interest in corporate control, but the way in which this is worked out differs widely across countries. Ultimately, it is the shareholder-manager relationship which is the most essential in corporate governance and which best lends itself to international comparison (Lannoo 1999, 272).

As Lannoo’s statement reveals, even among commentators who recognize the important differences between continental European systems of corporate governance and their Anglo-American counterparts, there is a striking inclination to analyze corporate governance solely from the point of view of the shareholder theory of governance (see, for example, the work of the influential European Corporate Governance Network, a research initiative designed to generate comparative empirical research on European corporate governance systems (www.ecgn.ulb.ac.be/ecgn)). The same theoretical shortcomings are therefore found in European discussions of the subject of corporate governance as are found in their Anglo-American counterparts, namely the failure to root arguments about corporate governance in a theoretical analysis of the firm as an innovative enterprise. 1.4 Innovative Enterprise and Corporate Governance Specifically, we shall seek to demonstrate that, in directly addressing the corporate governance questions of who should control the allocation of corporate resources, what types of investments should they make, and how the returns on these investments should be distributed, a theory of innovative enterprise calls for a research agenda and an assessment of policy alternatives that are being ignored in the current corporate governance debates. How, then, can we begin to conceptualize the relation between a theory of innovative enterprise and a theory of corporate governance? The conceptual foundation for linking innovative enterprise and corporate governance is a characterization of the innovation process in terms of its implications for the "who, what, and how" of corporate resource allocation. The innovation process requires financial commitment, organizational, integration, and strategic control (see Figure 2). Financial commitment requires the allocation of money to sustain the process that develops and utilizes productive resources until the products generated by that process can generate financial returns. Organizational integration


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is a set of relations that creates incentives for participants in the hierarchical and functional division of labour to apply their skills and efforts to engage in collective and cumulative learning. Central participants in this social division of labour are the enterprise's strategic decision makers, whose own abilities and incentives in the allocation of the enterprise's resources and returns depend on how and to what extent they are themselves integrated with the processes of organizational learning that can generate innovation. Strategic control enables strategic decision makers to link financial commitment and organizational integration in the innovation process. Who the "insiders" are who can make this critical strategic link is a basic question that a theory of the relation between corporate governance and economic performance must be able to answer. But a theory of the relation between corporate governance and economic performance cannot end with the "answer" to the question of who should exercise strategic control. For, unless the theory also addresses what types of investments those with insider control make and how the returns are distributed, it cannot assess whether those who exercise strategic control are using it to develop and utilize productive resources to generate higher quality, lower cost products. Individuals, through learning, acquire knowledge and skill. Organizational, as distinct from individual, learning occurs when people with different hierarchical responsibilities and functional specialties interact in the pursuit of common goals. When integrated into an organization, and sustained by committed finance, such functional and hierarchical capabilities and responsibilities represent skill bases that can engage in organizational learning. Different industrial activities, characterized by different technologies, require different skill bases to generate innovation, and within a particular activity, the breadth and depth of these innovative skill bases change as the very accumulation of organizational learning transforms the realities of, and the possibilities for, the development and utilization of productive resources. Hence the allocation of enterprise resources to the development and utilization of skill bases is integral to an enterprise's strategy. Accumulated skill bases influence the enterprise's choice of activities in which to engage, and the allocation of resources to build on these skill bases reflects strategic decisions concerning the particular types of capabilities that, in the presence of particular industrial conditions, the innovative enterprise has to develop itself rather than buy "ready-made" on the market. An enterprise that seeks to develop its own capabilities to produce an input when the market can supply the enterprise with an adequate quality and quantity of that input may well find itself incurring high fixed costs to develop productive resources that place it at a competitive disadvantage rather than at a competitive advantage (Lazonick 1991, ch. 3). In effect, the "innovative" enterprise may make the strategic error of striving to be innovative in activities in which it can rely on inputs purchased ready-made on the market, and in which, therefore, in-house investments in innovation are not required. That is, the innovative enterprise must make critical strategic decisions that distinguish those technological and market conditions that constrain the innovation process, and hence must be transformed, from those technological and market conditions that it can take as given precisely because the quantity and quality of productive inputs that the market will supply pose no effective constraints on its innovative strategy. Given an innovative strategy, what is the organizational form that generates the requisite organizational learning and in which the requisite organizational incentives are embedded? The need to use organizational incentives to integrate innovative skill bases should make analysts wary of speaking about the innovative "firm" as an entity that acts as if it were an individual decision maker -- that is, as an entity in


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which the people who deem themselves to be members of the enterprise all have an inherent interest in working toward common (enterprise) goals. The modern business corporation -- employing not just of hundreds or thousands of people, but commonly tens of thousands and in some cases even hundreds of thousands of people -- is a complex social organization. The individuals who occupy positions in the functional and hierarchical divisions of labour within such an organization may well decide to work within, to use the terminology of transaction-cost economics, the constraints of "bounded rationality" while they “opportunistically” pursue their own particular goals rather then the goals of the enterprise as a whole (see Williamson 1985, and the discussion below). Indeed, when speaking, as we have done, of “the innovative enterprise,” there is a need to identify the location within the functional and hierarchical division of labour of those within the enterprise who make strategic decisions concerning the allocation of resources and returns. Is strategy an individual process or an organizational process? Does control over the allocation of resources and returns reside at the “top” of an enterprise hierarchy, or is strategic control embedded within the organizational structure? Since the essence of innovative strategy is the allocation of resources and returns to skill bases that can engage in organizational learning, what are the relations within the enterprise between “strategic decision makers” and “organizational learners”? And, given the enterprise strategy, how broad are the functional skill bases and how deep are the hierarchical skill bases that must be integrated in order to engage in organizational learning (see Figure 3)? By the same token, as indicated in Figure 4, there is no reason to believe that the relevant organization that develops and utilizes productive resources is confined within the boundaries of a single firm -- that is, within the organizational structure of a unit of financial control. In historical and comparative perspective, the theory of innovative enterprise posits that the organizational conditions required for the development and utilization of innovative skill bases can help to explain many of the changes that we observe in the evolution of enterprise structure -- for example, the "growth of the firm" as analyzed by Edith Penrose (1959) -- and industry structure -- for example, the “industrial district” as analyzed by Alfred Marshall (1890, 1919). Figure 4 provides a schematic picture of the myriad organizational possibilities in the co-evolution of enterprise and industry structure. The past two decades or so have witnessed the appearance of a voluminous literature, by both academics and practitioners, on the transformation of the organizational conditions for innovative enterprise. In Parts 5 and 6, we shall consider this literature as it provides insights and information on two main fields of inquiry: organizational learning and strategic management. Our objective is not a comprehensive review of the literature but to use it selectively to broaden and deepen our own theoretical perspective on corporate governance, innovation, and economic performance. The resultant theoretical perspective can then both guide our own empirical research and enable us to build on the work of others whose foci and findings are relevant to understanding innovation as the link between corporate governance and economic performance. From the literature on organizational learning, we shall seek to understand • the process that transforms individual learning into organizational learning; • the interactions among individuals with different functional capabilities and

hierarchical responsibilities in the organizational-learning process;


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• the interactions among firms (as distinct units of financial control) with different functional capabilities and hierarchical responsibilities in the organizational-learning process;

• the relation between the learning that takes place within a business organization and the innovative capability of that organization.

From the literature on strategic management, we shall seek to understand • the relation between investment strategy and organizational learning in the

innovation process; • the sources and loci of strategic control within the business organization for

making these interventions (corresponding to the “who” in our key questions on corporate governance);

• the types of resource allocations to the innovation process that strategists make (corresponding to the “what” in our key questions on corporate governance);

• the ways in which strategists allocate returns from the innovation process to ensure the continuity of the process (corresponding to the “how” in our key questions on corporate governance).

3. The Anglo-American Debates on Corporate Governance In the current debates, we can identify three major perspectives on corporate governance. • The managerial perspective: The dominant perspective on corporate governance

of the post-World War II decades, “managerialism” reflected the prominence of the large-scale corporate enterprise in the allocation of resources and returns in many of the most successful national economies.

• The shareholder perspective: Having emerged in the 1970s and 1980s in the US

and Britain as an attack on the perceived failures of “managerial capitalism”, this perspective has become dominant both in theory and practice in the corporate governance debates of the 1990s.

• The stakeholder perspective: With its roots in older arguments for “industrial

democracy” going back to the 1920s, this perspective has been elaborated once again as the institutions of “managerial capitalism” have faltered and as the shareholder perspective has been promoted as the most “efficient” solution to the problem of corporate governance.

3.1 The managerial perspective on corporate governance During the 1990s the debate on corporate governance, both within academic and policy circles, has focused on whether corporations should be run in the interests of shareholders or, alternatively, in the interests of a broader array of “stakeholders”. Until the late 1990s, this debate was primarily an Anglo-American affair, and as the debate began to be exported to continental Europe and Japan the shareholder perspective held a dominant and seemingly impregnable position. Yet even in the United States, where the principle of maximizing shareholder value has been put forth most vigorously, the argument is of relatively recent origin, with the theory and practice of maximizing shareholder value only coming into its own in the 1980s and 1990s.


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Indeed, until the 1980s in the United States it was widely accepted that managers exercised control over the allocation of corporate resources and returns. In the postwar decades, social scientists and legal scholars put forth a number of variants of a managerial perspective on corporate governance that sought to identify the motivations and abilities of managers that would yield superior economic outcomes. Common to most of these arguments was a view of corporate managers as trustees or stewards of corporate assets for society. As Howell John Harris (1982, 97) described it:

In managerial ideology, businessmen are held to be accountable to a variety of pressures and "constituencies" -- the state, the public interest, the consumer, the local community, the business community, employees, et al., variously ranked. But it is up to the management of any particular firm to decide what its obligations are, how to meet them, and when they have been met. Management is the "trustee" or "steward" of the various groups with an interest in the firm; it devotes itself to "service" to them, and gains legitimacy thereby. Management claims that it is in the best position to reconcile and satisfy the numerous and conflicting demands made of it, and that its performance in doing so is adequate. There is no need for unions, the state, or others to impose specific, enforceable obligations upon it.

The view of corporate management as trustees for society was by no means confined to the self-descriptions of corporate managers. “Managerialism” was found among journalists, writers and many leading scholars of the corporation in the postwar period. The broad acceptance of the managerial ideology of trusteeship seemed to be rooted in the technocratic consensus that prevailed in elite circles of US society after the war, and in the faith in professionalism that it spawned. In a view that resonated with the ideas of influential students of the corporation, the editors of Fortune declared in 1951 that "[t]he manager is becoming a professional in the sense that like all professional men he has a responsibility to society as a whole" (Fortune 1951; see also Drucker 1949, 35, 99, 102, 340, 342; Kaysen 1959; Sutton et al. 1956, 57-8, 65, 86-7, 155, 163, 165, 359; Fortune 1956). Proponents of the "managerialist" thesis of the corporation seemed content to let professionalism do the job of ensuring that the broader objectives that corporate managers espoused would be achieved. These social responsibilities were certainly not enshrined in corporate law. Although the burst of US federal regulation in the 1930s, as well as later regulatory initiatives such as industrial safety and accident laws, created new legal requirements of which corporate managers had to take account in their allocation of corporate resources, the law did not attempt to interfere with the internal governance of the corporation in a way that would directly challenge managerial control. And, with the development of the "business judgement rule", the courts became more and more reluctant to challenge corporate management on decisions that were deemed to be part of the normal process of running a business (Kaufman et al. 1995, 51). But although the de facto legal treatment of the corporation ensured that corporate control remained firmly in the hands of managers, the acquiescence of corporation law and the courts to unilateral managerial control remained implicit. As Willard Hurst noted, with the exception of laws authorizing the use of corporate funds for philanthropic purposes, "the law added no definition of standards or rules to spell out for what purposes or by what means management might properly make decisions other than in the interests of shareholders" (Hurst 1970, 107). The lack of formal legal recognition of the widely-accepted legal and economic obsolescence of the shareholder-designate concept of corporate management


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stemmed in part from the powerful emotional attachment in the United States to the idea that the shareholder "owned" the corporation. Thus, notwithstanding the evidence that the development of the corporate economy had split the "atom" of property, as Adolf Berle and Gardiner Means (1932, 354) had put it, "the law's response to these facts," in the judgement of Bayless Manning, the Dean of Stanford Law School:

has been partially to ignore them, partially to try to exorcise them by mislabeling, and partially to decree that the clock of history shall run backward. Finding the shareholder a passing investor, we have insisted that he is an owner and a member of an electorate. Finding managements to be hirers of capital, we have tried to bury this disquieting fact by calling them hired of the shareholder-owners. Finding 'control' to have slid away from 'ownership,' we have sought to put the control back with the ownership where it 'belongs' (Manning 1965, 107).

But the failure to recognize at law the reality of corporate control stemmed not only from an emotional commitment to the ideology of private property. It also reflected the vagueness of the most widely-accepted alternative, the view of the manager as trustee for society, for justifying that control. Edward Mason effectively highlighted its nebulosity in 1958 in an attack on what he called "The Apologetics of Managerialism". Mason contended that "the institutional stability and opportunity for growth of an economic system are heavily dependent on the existence of a philosophy or ideology justifying the system in a manner generally acceptable to the leaders of thought in the community". The power of classical economics, he argued, was that it had provided not only an analytical framework that could be used to explain economic behaviour, "but also a defense -- and a carefully reasoned defense -- of the proposition that the economic behavior promoted and constrained by the institutions of a free-enterprise system is, in the main, in the public interest" (Mason 1958, 118). Mason recognised that, towards the end of the nineteenth century, "the growth of large firms and other institutional changes began to call into question the assumptions on which the system was built" to the extent that "the attempted resuscitation by the National Association of Manufacturers, in 1946, of the ‘philosophy of natural liberty’ is inevitably a somewhat moth-eaten patchwork" (Mason 1958, 199). The problem was, from his point of view, that the managerial literature, though it undermined the intellectual presuppositions of classical economics, did not provide "an equally satisfying apologetic for big business" because it failed to provide answers to some critical questions:

Assume an economy composed of a few hundred large corporations, each enjoying substantial market power and all directed by managements with a "conscience". Each management wants to do the best it can for society consistent, of course, with doing the best it can for labor, customers, suppliers, and owners. How do prices get determined in such an economy? How are factors remunerated, and what relation is there between remuneration and performance? What is the mechanism, if any, that assures effective resource use, and how can corporate managements "do right by" labor, suppliers, customers, and owners while simultaneously serving the public interests? The "philosophy of natural liberty" had a reasoned answer to these questions, but I can find no reasoned answer in the managerial literature (Mason 1958, 120).

Essentially Mason challenged proponents of managerialism to develop a persuasive theory of the relationship between the governance of corporations and economic performance. To answer his questions would have required an economic analysis of


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the process through which corporate organizations allocated resources and returns as well as the manner in which social institutions shaped that process. The postwar bias among US economists toward neoclassical theory, however, at best diverted them from the task and, at worst, persuaded them to treat corporate activities as reducible to market forces. While the US economy was doing well, there was no concerted effort to challenge the legitimacy of managerial control of the nation’s leading corporations. In the postwar decades the leading corporations in the US tended to retain both the money that they earned and the people whom they employed. Retentions in the forms of earnings and capital consumption allowances provided the financial foundations for corporate growth, while the building of managerial organizations to develop and utilize productive resources enabled investments in plant, equipment, and personnel to succeed (O’Sullivan 2000a, chs. 3 and 4). Corporate managers largely controlled the allocation of these resources without interference in strategic decisions from shareholders or workers. In the 1960s and 1970s, however, the principle of “retain and reinvest” common to US corporations at the time began running into problems for two reasons, one having to do with the growth of the corporation and the other having to do with the rise of new competitors. Through internal growth and mergers and acquisitions, corporations grew too big with too many divisions in too many different types of businesses. The central offices of these corporations were too far from the actual processes that developed and utilized productive resources to make informed investment decisions about how corporate resources and returns should be allocated to enable strategies based on retain and reinvest to succeed. The massive expansion of corporations that had occurred during the 1960s resulted in poor performance in the 1970s, an outcome that was exacerbated by an unstable macroeconomic environment and by the rise of new international competition, especially from Japan (Lazonick and O’Sullivan 1997c; O’Sullivan 2000a, ch. 4). The overextension of US corporate enterprises helped to foster the strategic segmentation of top managers from their organizations. At the same time, the innovative capabilities of international competitors made it harder to sustain the employment of corporate labour forces, unless the productive capabilities of many if not most of these employees could be radically transformed. Under these conditions, US corporate managers faced a strategic crossroads: they could find new ways to generate productivity gains on the basis of retain and reinvest, or they could capitulate to the new competitive environment through corporate downsizing. It was in this context that the shareholder perspective emerged to challenge managerial control over corporate resources and returns in the United States. When it came, however, an uprising of small shareholders did not fuel the shareholder attack. Rather, it was powered by the growing importance of institutional investors in the US economy, a phenomenon that was in turn the result of a veritable revolution in the financial sector of the economy driven by the accumulation of financial assets by older Americans and the search for higher returns on these assets. Within the new financial environment that stressed higher financial returns on corporate securities, many top corporate managers aligned their own interests with those of financial interests more generally, with an explosion in CEO pay as one very visible result. In the process, the shareholder perspective increasingly replaced the managerial perspective as the dominant corporate-governance ideology in the United States, even though top managers maintained and even enhanced their control over the allocation of resources and returns in established US corporations.


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Perhaps because of the continued centrality of managerial control in practice, the managerial perspective still has its proponents in the United States. In the contemporary debates on corporate governance it has been put forward by a number of business school academics, most notably Michael Porter (Porter 1992; see also Thurow 1988; Chandler 1990; Jacobs 1991). The proponents of managerial control recognize that the competitive success of the corporate enterprise depends on investments in innovation that entail specialized in-house knowledge, and that require time, and hence financial commitment, to achieve their developmental potential. Thus they argue that, to allocate corporate resources, managers need discretion, which they are only assured if they have access to “patient capital” that will enable them to see their investments in productive resources through to competitive success. The managerial perspective often uses words such as “capabilities”, “knowledge”, “skills”, “learning”, “factor creation”, and “innovation” as sources of “sustained competitive advantage” for the enterprise. But the enduring and fundamental problem with the managerial perspective, which has made it vulnerable to critiques from shareholder advocates, is that it is not underpinned by a theory of innovation that can show how and under what conditions managerial resource allocation can yield competitive success. The proponents of managerial control are unable, therefore, to provide a systematic explanation of the conditions under which managers will make investments that promote innovation and generate returns and those under which such investments will not be made. From the managerial perspective, what determines whether or not an enterprise invests in innovation is the “mindset” of the strategic manager, but what determines the mindset of the manager is rarely addressed. Lacking such an analysis, the managerial perspective provides little basis on which to understand how the incentives and abilities of those who exercise corporate control enhance or impede the process through which resources are allocated to generate returns in the corporate economy. Thus they provide no response to allegations from shareholder proponents that corporate managers have grown, to use the words of Michael Jensen, “fat and lazy” (quoted in Farrell 1995). 3.2 "Shareholder value" as a principle of corporate governance The basic argument underlying the shareholder perspective on corporate governance is that as equity investors shareholders are the only participants in the business corporation whose returns to their productive contributions are "residual". All other groups besides shareholders, such as workers, external suppliers, and creditors, who provide resources to the firm do so on the basis of contracts that specify the relation between their contributions to the productive process and the returns that they receive for those contributions. It is assumed that market forces determine the resources provided and the returns received by these other groups, and that the possessors of these resources will use the market to allocate the resources that they control to their best alternative uses. The returns to shareholders, then, depend upon what, if any, revenues are left over after all other contractual claims have been paid. As “residual claimants”, shareholders bear the risk of the corporation’s making a profit or loss. They thus have an interest in allocating corporate resources to their “best alternative uses” to make the residual as large as possible. Since all other “stakeholders” in the corporation will receive the returns for which they have contracted, the “maximization of shareholder value” will result in superior economic performance not only for the particular corporation but also for the economy as a whole. Advocates of shareholder theory therefore contend that shareholders are the


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“principals” in whose interests the corporation should be run even though they rely on others for the actual running of the corporation. To contribute to the optimal allocation of resources in the economy, managers should seek to maximize shareholder value, either by making corporate investments in projects that can yield at least the same risk-adjusted rate of return that shareholders could receive elsewhere in the economy, or by distributing revenues to shareholders who can then reallocate these resources themselves in search of the highest available returns (Shleifer and Vishny 1989; Jensen 1989). It is regarded as economically efficacious for shareholders to bear the risk of the corporation’s generating a residual. As a class, they are deemed to be better equipped to bear risk than managers and workers because they are not tied to the firms in which they hold shares. Consequently, shareholders can diversify their investment portfolios to take advantage of the risk-minimization possibilities of grouping or consolidating different types of risk. As Fama and Jensen put it: "the least restricted residual claims in common use are the common stocks of large corporations. Stockholders are not required to have any other role in the organization; their residual claims are alienable without restriction; and, because of these provisions, the residual claims allow unrestricted risk sharing among stockholders" (Fama and Jensen 1983, 303). The financial theory of risk-bearing thus hinges on "a separation of decision management and residual risk bearing" in the corporation. That separation permits optimal risk allocation in the corporate economy; indeed, that the corporate form facilitates this allocation is financial economists' key explanation for the growth and persistence of the corporate enterprise with diffuse shareholding. The risk allocation advantage comes, however, at a cost in terms of incentives within the corporation: "[s]eparation and specialization of decision management and residual risk bearing leads to agency problems between decision agents and residual claimants. This is the problem of the separation of ownership and control that has long troubled students of the corporation" (Fama and Jensen 1983, 312). The governance challenge of the modern corporation, as financial economists conceptualize it, is that those who bear the residual risk -- the shareholders or "principals" -- have no assurance that the corporate managers or "agents" who make decisions that affect shareholder wealth will act in shareholder interests. The costs that result from the exercise of managers' discretion to act other than in the best interests of their principals, as well as the expenses of monitoring and disciplining them to prevent the exercise of that discretion, are described as "agency costs". For financial economists, therefore, the central problem in corporate governance is an “agency problem” that must somehow be resolved if the economy is to achieve an optimal allocation of its productive resources. In the long run, given the assumptions underlying the shareholder perspective, the governance problem may well be corrected through the forces of competition. In particular, corporations that do not seek to maximize shareholder value, it is argued, will be unable to attract risk capital to fund their investment projects, whereas those corporations that do seek to maximize shareholder value will receive investment finance. Meanwhile, however, in the shorter term, managers of corporations that are generating substantial residual revenues may use their control over the allocation of these corporate revenues to pursue their own goals (ranging from lining their own pockets with corporate cash to building their egos by favouring the growth of “their” enterprises). The result will be a misallocation of resources in not only the enterprise but also the economy as a whole unless there are effective mechanisms by which shareholders can discipline managerial behaviour.


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The central preoccupation of financial economists who work on corporate governance has been the analysis of mechanisms that increase the control of financial markets over corporate resource allocation and that, as a result, limit the discretion of corporate managers to act other than in the interests of shareholders. One way to resolve the problem is through a reintegration of share ownership and managerial control. A “big owner,” for example, a financial institution or a very wealthy individual, can amass sufficient shares to exercise managerial control. Or managers themselves can become the major shareholders, for example through a leveraged buyout that substitutes corporate debt for corporate equity. In either case, it is assumed, that the owner-managers will have an interest in maximizing shareholder value. Such integration of ownership and management has the disadvantage, however, of eliminating a social division of labour that proponents of the shareholder perspective view as central to the operation of a market economy; namely, the division of labour between a financier who diversifies his portfolio across many different investment opportunities and a producer who possesses specialized decision-making skills. To deal with the agency problem in a way that permits this division of labour between the financier and producer to be maintained, shareholders can either use the carrot or the stick. The carrot is to grant stock options to managers so that they will align their own incentives with that of shareholders, even though their stakes in the company as shareholders will typically be too small to result in the actual integration of ownership and management (Murphy 1985; Baker, Jensen, and Murphy 1988; Jensen and Murphy 1990). The stick is to use “the market for corporate control” -- that is, the takeover of effective control of a company by a group of shareholders – to change the behaviour of opportunistic managers by threatening their removal, or, if such discipline fails to do the job, by replacing them with new managers who will align their interests with shareholders (Jensen and Ruback 1983; Jensen 1986; Scharfstein 1988; Jensen 1988; Grossman and Hart 1988). During the 1980s and 1990s in the United States, the widespread use of these mechanisms to align the interests of corporate managers with those of public shareholders helped to transform the rhetoric of shareholder value into a dominant ideology of corporate governance. This period has also witnessed the longest stock market boom in history, with the yields on corporate stock recovering significantly from their depressed state in the 1970s (see Table 1). The critical issues for the debate on corporate governance are whether the claims of the shareholder perspective that maximizing shareholder value results in the highest common good are justified in theory and in practice. The claims of proponents of shareholder value can be called into question on three different levels. Firstly, notwithstanding the fervour with which the efficacy of the governance mechanisms proposed by shareholder advocates is propounded, unambiguous empirical evidence to support these assertions has not been forthcoming. Secondly, the two key assumptions that shareholder theory makes about the role of corporate shareholders – that they supply capital for productive investment and that they bear risk to a degree that entitles them to corporate residuals – can be challenged on the grounds that they ignore some basic facts concerning the twentieth-century operation of a corporate economy, including that of the United States. Finally, and most fundamental of all, the concept of economic efficiency on which the shareholder theory is premised precludes an understanding, not to mention an analysis, of the dynamic process through which productive resources are developed and utilized to generate higher quality, lower cost products, or what is often called innovation.


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3.2.1 The mechanisms of governance There is a striking dearth of unambiguous empirical evidence to support the claims by proponents of shareholder theory of the effectiveness of the governance mechanisms that they propose for improving economic performance. The empirical studies that financial economists have undertaken to bolster their arguments for enhanced shareholder control over corporate resource allocation generally rely on stock market valuations of corporate equities as proxies for corporate performance. With regard to the market for corporate control, for example, most of this research consists of “event studies” in which the “abnormal” changes in stock prices of bidder and target companies around the time of the public announcement of these transactions are used as a proxy for their economic effects; abnormal returns represent the difference between actual and expected stock returns as calculated using an asset pricing model such as CAPM (Capital Asset Pricing Model). Yet, even if we accept the questionable assumption that corporate performance can be adequately proxied by abnormal returns to shareholders, the empirical findings based on the event-study methodology fall short of providing clear-cut support for the alleged benefits of the market for corporate control for disciplining corporate resource allocation. Advocates of the economic merits of the market for corporate control rely heavily on one empirical finding that is unambiguous: that shareholders in target firms earn sizeable positive returns around takeover announcements. In merger and acquisition transactions during the period from 1976 to 1990, the shareholders of target companies received an average premium over market value of 41 per cent (Jensen 1993). Estimates of the total abnormal returns from the announcement of a bid through to its conclusion vary from 15.5 per cent to 33.9 per cent (Dodd 1980; Asquith 1983; see also Asquith et al. 1983; Malatesta 1983; Dodd and Ruback 1977). In contrast to the gains of target company shareholders, however, the wealth of acquiring company shareholders showed little change or even decreased around the time of the transaction (Bhagat, Shleifer, and Vishny 1990). Since the bidder firms were, on average, much larger than the targets, the enormous premia paid to target firms did not always imply a positive change in the wealth of the target and acquirer shareholders combined. Moreover, the abnormal positive returns to target shareholders are not robust over the longer term. Most event studies focus only on the weeks surrounding the takeover bid but if we extend the period of analysis the returns to bidder shareholders become negative. Michael Jensen and Richard Ruback reviewed six studies that calculated these returns one year after the takeover was concluded. These studies found abnormal negative returns, averaging –6.56 per cent, with the exception of one study which showed a slightly positive abnormal return of 0.6 per cent. As Jensen and Ruback concluded: "[t]hese post-outcome negative abnormal returns are unsettling because they are inconsistent with market efficiency and suggest that changes in stock price during takeovers overestimate the future efficiency gains from mergers" (Jensen and Ruback 1983, 21). Magenheim and Mueller (1989) and Agrawal et al. (1992) claim that abnormal returns to bidders were negative over a three-year period (-16 per cent) and a five-year period (-10 per cent) respectively. The unimpressive returns to acquirer shareholders, as well as concerns about the time consistency of shareholder returns on takeovers, cast doubt on the contention by proponents of shareholder theory that the market for corporate control is a mechanism for disciplining corporate management. To question the reliance on changes in shareholder wealth as proxies for corporate performance is to raise even


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more concerns about the empirical basis of the shareholder theory of corporate governance. With regard to the market for corporate control, for example, studies based on accounting data suggest that the returns to target shareholders overestimate the economic gains that occur through disciplinary action. To the extent that takeovers act as antidotes to managerial deficiencies in the allocation of corporate resources, one would expect the returns to target shareholders to be abnormally low prior to the bid and to improve once the bid is completed. Some studies have found that targets of hostile bids do exhibit abnormally poor performance (Ravenscraft and Scherer 1987; Morck et al. 1988) but others find no significant difference in the pre-bid performance of the targets of hostile and friendly transactions (Franks and Mayer 1996). Nor is there persuasive evidence from empirical analyses of post-acquisition performance that the market for corporate control enhances corporate performance. Ravenscraft and Scherer (1987) found that profitability declined after acquisitions. Herman and Lowenstein (1988) concluded that during the 1980s there was a noticeable decrease in the post-acquisition return relative to the pre-acquisition period. With a few exceptions, most empirical studies of post-acquisition performance have failed to provide strong evidence of the disciplinary role of takeovers and some have even suggested that the market for corporate control reduces economic performance. Although the merits of the market for corporate control for promoting economic efficiency have been widely touted by proponents of shareholder theory, the balance of empirical evidence can hardly be interpreted as unequivocal support for their claims. Nor is the ambiguity of evidence confined to empirical analyses of the effects of the market for corporate control. It is also found with respect to other mechanisms of corporate governance advocated by proponents of shareholder value (for a review of the evidence on institutional investor activism, for example, see Black 1998). Scepticism about the claims of financial economists is therefore warranted even on the basis of evidence assembled according to their own preferred empirical methodology of event studies. Clearly, if one challenges the central assumption behind that methodology -- that shareholder wealth is an adequate proxy for corporate performance -- the empirical evidence is even less persuasive. And there are good reasons to raise questions about the wisdom of interpreting stock valuations as indicators of improvements in corporate performance. One direct challenge to that assumption has come from financial economists who have attempted to analyze the source of the enormous abnormal gains to target-company shareholders in the market for corporate control. They have suggested that these gains are evidence not of efficiency improvements but of transfers of value away from other claimants on enterprises’ cash flows. One argument that has been made is that shareholders gain at the expense of lower wages and pensions for employees and fewer employment opportunities. A frequently invoked example of this phenomenon is Carl Icahn’s takeover of TWA in 1985 when the post-takeover reduction of $200 million in total wages was larger than the entire takeover premium (Shleifer and Summers 1988). Based on their analysis of a sample of 62 hostile takeover bids launched between 1984 and 1986, Bhagat, Shleifer, and Vishny (1990) concluded that layoffs after takeovers are common and can explain 10-20 per cent of the premium. Other studies have suggested that decreased tax liabilities of target firms can in part account for takeover premia; in these cases there is a transfer of value from the government to the shareholders (Kaplan 1989; Bhagat, Shleifer, and Vishny 1990). It has, however, proven difficult to account for most of the shareholder gains on takeover activity in terms of transfers from other stakeholders.


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The quest for the sources of shareholder gains only makes sense, however, to those who believe that they can be accounted for predominantly in terms of changes in the real economy, be those changes associated with the creation or the redistribution of value. Conventional financial economists have traditionally attempted to rule out the alternative hypothesis of the possibility of significant dislocations between financial market valuations and corporate performance by invoking the assumption that financial markets are informationally efficient. That assumption, the efficient markets hypothesis (EMH), holds that a capital market is efficient if, as Burton Malkiel (1987, 120) put it, “it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some information set, Φ , if security prices would be unaffected by revealing that information.”2 When financial economists use the concept of market efficiency in the sense of the EMH, therefore, what they are referring to is the capacity of a market to impound information. Despite the centrality of the EMH to financial economics, the hypothesis cannot, in fact, be empirically tested in isolation from assumptions about the way in which economic actors price securities. One cannot assess whether a financial market “fully and correctly reflects all relevant information in determining security prices” without knowing what “correctly” and “relevant” mean. In other words, one must rely on some assumptions about the “appropriate” or “rational” way to price securities. As a result, as Fama (1970, 384) put it, “[m]arket efficiency per se is not testable. It must be tested jointly with some model of equilibrium, an asset pricing model." Basically the problem is “that we can only test whether information is properly reflected in prices in the context of a pricing model that defines the meaning of ‘properly’. As a result, when we find anomalous evidence on the behavior of returns, the way it should be split between market efficiency or a bad model of market equilibrium is ambiguous” (Fama 1991, 1576). “Anomalous” evidence on the behaviour of returns is in fact rife. All of the leading models of asset pricing on which financial economists rely posit some relationship between risk and return. When these theories have been empirically tested, however, the risk-bearing explanation has proven problematic. The total real return -- capital gain plus dividends -- on American equities exceeded that on short-term US treasury bills by an average of 6.1 percentage points per annum between 1926 and 1992 (Siegel 1994). The difference between the return on stocks and "risk-free" assets like t-bills is often called the "equity risk premium" because it is thought to reflect equity holders' compensation for additional risk associated with stocks. The equity premium has been declared a "puzzle" because the measured risk of equity returns is not high enough to justify premia of the order of six percent without resorting to unreasonable assumptions about risk aversion among portfolio investors (Mehra and Prescott 1985; Kocherlakota 1996; Siegel and Thaler 1997). When mean reversion -- a characteristic of the real returns on stocks but not of fixed income assets -- is considered, the puzzle deepens. Although the annual standard deviation of real t-bill rates of returns is approximately 6.14 per cent compared with 18.15 per cent for real equity returns, the standard deviation of annual rates of return on t-bills over 20 year periods is 2.86 per cent which is greater than the comparable figure of 2.76 per cent for stocks. As Siegel and Thaler (1997, 195) observe in their recent review of the equity premium literature:

2 A distinction is often drawn between three different types of informational efficiency. Markets

are said to be weak-form efficient when security prices reflect all information available in past prices. Semi-strong-form efficiency implies that security prices reflect all publicly available information. Finally, the strong form of the EMH means that security prices reflect all information available, be it publicly or privately held.


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This analysis suggests that the equity premium is even a bigger puzzle than has previously been thought. It is not that the risk of equities is not great enough to explain their high rate of return; rather, for long-term investors, fixed income securities have been riskier in real terms. By this reasoning, the equity premium should be negative!

Financial economists have encountered similar puzzles and anomalies in their attempts to use their risk calculus to account for differential returns among stocks. Expected returns are estimated using an asset-pricing model. The CAPM, for example, is based on the proposition that asset prices are determined by risk that cannot be reduced by holding a diversified portfolio of stocks. In other words the model estimates the expected returns on securities as a positive linear function of risk as measured by their market ß (the slope in the regression of a security's return on the return from the market portfolio) (Sharpe 1964; Lintner 1965a, 1965b). There is, however, little empirical support for the CAPM. Market betas have been found to have little explanatory power in analyses of cross-sections of realised average returns on US common stocks (Banz 1981; Reinganum 1981; Breeden, Gibbons, and Litzenberger 1989; Fama and French 1992). The response to this "anomaly" by some financial economists has been to search for other factors that have more power in these regressions. The list of identified variables is now extensive, and includes size, book-to-market equity, earnings/price, cash flow/price, and previous sales growth (see, for example, Fama and French 1996). Mining the data for correlations has generated these factors. As a result, the “multifactor” models of asset pricing based upon the relationships that have emerged from this analysis have been criticized, even within financial economics, as essentially atheoretical, because none of the identified factors are linked to economic explanations of asset pricing. The relationship between risk and return that financial economists commonly assume does have a theoretical foundation but its lack of empirical support means that financial economists rely on it as an article of faith rather than a proven fact. As Richard Roll (1994, 7), a leading financial economist, put it recently:

Perhaps the most important unresolved problem in finance, because it influences so many other problems, is the relation between risk and return. Almost everyone agrees that there should be some relation, but its precise quantification has proven to be a conundrum that has haunted us for years, embarrassed us in print, and caused business practitioners to look askance at our scientific squabbling and question our relevance. Without a risk/return model that allows one to quantify the required rate of return for an investment project, how can it be valued?

The limitations of asset pricing research means that the EMH cannot be properly tested. What then is the basis for the widespread reliance of financial economists on the EMH? The methodological difficulties of performing empirical tests of the EMH mean, as Brenda Spotton and Robin Rowley (1998, 671) put it, that

the commitment to EMH often stems from a prior conviction that efficiency is clearly desirable and must emerge from some evolutionary process which removes inefficient market participants, rather than from a clear evidential basis. Data, from this perspective, merely confirms the obvious presence (apart from some irritating, hopefully ephemeral, anomalies) and convenience of market efficiency.


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Malkiel (1987, 122) has argued that “the empirical evidence in favour of EMH is extremely strong. Probably no other hypothesis in either economics or finance has been more extensively tested.” Yet the empirical basis for such claims by financial economists is indirect evidence that is consistent with the EMH. The leading examples of empirical analysis of this type are studies that suggest that stock prices follow a random walk and those that suggest that the stock market responds quickly to announcements that convey new information about fundamentals. All of these analyses suffer from serious methodological limitations but perhaps their most important deficiency is that their findings are also consistent with theories of the behaviour of stock markets that compete with the EMH, most notably with a variety of theories that contend that stock markets are subject to fads (see, for example, Summers 1986; Davidson 1978; Glickman 1994; Raines and Leathers 1996). Moreover, more and more evidence has accumulated of what look like “anomalies” from the perspective of the EMH. Of particular importance has been empirical research on market volatility that suggests that price changes occur even in the absence of new information. Robert Shiller’s (1981) analysis of the relationship between dividends and stock prices is the classic paper on the subject. It is generally assumed in financial economics that stock prices represent an estimate of the present value of future dividends. Shiller pointed out, however, that variations in the present value of actual dividends paid out over the century are too small to explain volatility in stock valuations. In his more recent work, Shiller (1990) contends that stock markets are, as a general rule, influenced by fads and fashions and invoked evidence on popular models used by investors to analyse the US 1987 stock market crash. Indeed, given the apparent absence of any major news that might justify it, the crash raised serious questions in the minds of a number of leading economists about the validity of their assumption of a rational connection between stock valuations and the economic fundamentals. In a paper entitled “What Moves Stock Prices?” David Cutler, James Poterba, and Lawrence Summers (1989), for example, highlighted “the difficulty of explaining as much as half of the variance in aggregate stock prices on the basis of publicly available news bearing on fundamental values”. Various other lines of empirical research have also fostered critiques of the EMH. For example, considerable evidence for recent decades suggests that information on the size of firms, their price-earnings ratios, and their market-to-book ratios, predict future returns, facts that are inconsistent with the hypothesis that stock prices reflect all publicly available information. A number of financial theorists who describe themselves as behavioural financial economists have argued that to understand the anomalies that have already been uncovered, and stock market behaviour more generally, there is a need to overhaul the theoretical foundations of financial economics. Whereas conventional finance theorists assume that only “rational” behaviour affects equity prices,3 behavioural finance theorists argue that how people actually behave makes a different to stock prices. Specifically, behavioural finance is based on the observation (from cognitive psychology and decision theory) that in some circumstances humans make systematic “errors” in judgement and that these behavioural biases affect equity prices. Behavioural theorists have focused on various different types of non-rational behaviour. They have argued, for example, that under certain circumstances individuals may be prone to non-wealth maximizing behaviour such as excessive

3 Even if some, indeed most, traders are irrational, rational traders will ultimately drive the

irrational traders out of the market by trading to drive stock prices back to fundamental values.


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trading of stocks due to overconfidence. Individuals may also make cognitive errors usually due to their reliance on heuristics, rules adopted by economic actors to simplify their decision-making processes, which may lead to biases in certain situations. Notwithstanding its relatively recent vintage, behavioural finance has already generated a considerable body of empirical evidence to support its various claims with respect to the manner in which behavioural biases influence stock prices (for reviews of the behavioural finance literature, see Thaler 1993; Heisler 1994; see also Daniel, Hirshleifer, and Subrahmanyam 1998). There has been, however, far from a general acceptance within financial economics of the implications for the credibility of the EMH of the empirical findings on anomalies or, more generally, the theoretical and empirical research in behavioural finance. Orthodox financial economists have tended to respond in a defensive way. Although in his 1991 update of his original article on the EMH, Fama recognized that “the task is thornier than it was 20 years ago”, he remains firmly committed to the hypothesis on the rather dubious grounds that:

… the alternative hypothesis is vague, market inefficiency. This is unacceptable. Like all models, market efficiency (the hypothesis that prices fully reflect available information) is a faulty description of price formation. Following the standard scientific rule, however, market efficiency can only be replaced by a better specific model of price formation, itself potentially rejectable by empirical tests (Fama 1998, 284).

Fama is by no means alone among financial economists in this view that the only possible alternative hypothesis to "market efficiency" must be "market inefficiency". Indeed, there seems to be quite a consensus around the merits of, to paraphrase Keynes, being precisely wrong rather than vaguely right as revealed by the following sympathetic explanation of the resistance to behavioural finance among most financial economists:

A general criticism often raised by economists against psychological theories is that, in a given economic setting, the universe of conceivable irrational behavior patterns is essentially unrestricted. Thus, it is sometimes claimed that allowing for irrationality opens a Pandora’s box of ad hoc stories which will have little out-of-sample predictive power (Daniel, Hirshleifer, and Subrahmanyam 1998, 1840-1).

That the proponents of the shareholder theory of corporate governance include among their party some of the most orthodox of all financial economists in part explains their unwillingness to countenance the critiques of the EMH. Michael Jensen once famously stated, for example, that he believed "that there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis" (Jensen 1978, 95). But their reticence is also explicable by the devastating consequences that any concession on their part would have for their arguments about corporate governance. The importance of the EMH to financial economics, and especially to the shareholder theory of corporate governance, can hardly be overstated. In the words of Terry Marsh and Robert Merton (1986), “[t]o reject the Efficient Market Hypothesis for the whole stock market… implies broadly that production decisions based on stock prices will lead to inefficient capital allocations”.


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3.2.2 The productive role of the corporate shareholder Questions about the empirical bases for the claims made about the efficacy of the governance mechanisms by proponents of shareholder theory certainly cast doubt on the validity of their overall argument. There are, moreover, more direct routes to scepticism of these claims. In theory, the shareholder perspective makes two key assumptions about the role of corporate shareholders, one having to do with the allocation of resources in the economy and the other with the allocation of returns. Shareholder theory assumes that, for the allocation of resources, productive investments in the economy depend on financial investments by corporate shareholders. The theory also assumes that, for the allocation of returns, it is only shareholders among participants in the corporate enterprise who have residual claimant status, and hence incur non-contractual risk in participating in the economy. Both of these assumptions can be challenged on empirical grounds. The assumption concerning the allocation of resources that underpins the shareholder perspective is that the stock market allocates capital to productive investments. Yet data on the sources of corporate funds flatly contradicts this assumption. Retained earnings -- undistributed profits and capital consumption allowances -- have always provided, and continue to provide, the financial resources that are the foundations of investments in productive capabilities that made innovation and economic development possible (Lazonick and O’Sullivan 1997a and 1997b).4 Even, or perhaps especially in the so-called equity based system of the United States, corporate retentions and corporate debt, not equity issues, have been the main sources of funds for business investment throughout the twentieth century (Ciccolo and Baum 1985; Corbett and Jenkinson 1996). Indeed, during most years since the mid-1980s the net contribution of stock issues to corporate funds has been negative, primarily because of the increased importance of corporate stock-repurchase programs. That is, contrary to conventional wisdom, corporate financial resources have on balance been a source of funds for the booming stock market rather than vice versa. Even when equity has been issued, it has not necessarily played a role in funding investment in new productive assets. New corporate equity issues have often been used, not to finance investment, but to transfer financial claims over existing assets or to restructure corporate balance sheets. The ownership transfer may be an initial public offering (IPO), in which case share ownership is transferred from the original owner-entrepreneurs and their venture-capital partners to public stockholders. High levels of IPO activity, therefore, do not necessarily indicate that households and institutional investors are funding a wave of innovative investment. Rather, in absorbing IPOs, these entrepreneurs are paying the entrepreneurs who built the businesses for a claim on the enterprise’s future earnings, based on investments in productive capabilities that have already been made. Whether any of the money realized from an IPO ends up committed to new innovative investment strategies, either in the issuing company or some other new venture, is at the discretion of those who control corporate resource allocation in the newly public enterprise and the original owner-entrepreneurs whose shares have been liquidated in part or full. It is not inherent in the IPO itself. The ownership transfer may also occur for the purpose of one company acquiring another company. Typically, the acquiring company issues new stock of its

4 The contribution of internal funds to net sources of finance of non-financial enterprises

during the period 1970-1989 has recently been estimated as 80.6% for Germany, 69.3% for Japan, 97.3% for the UK, and 91.3% for the USA (Corbett and Jenkinson 1996).


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corporation to exchange for the existing stock of the acquired company, the stock of which is then retired. In the aftermath of the acquisition, the acquiring company may make substantial investments in the acquired company, but once again the equity issue does not provide the source of such investment financing. Funds raised through equity issues may also be used to restructure the corporate balance sheet but here again the new equity issue does not necessarily lead to an increase in direct investment. The assumption that an active stock market necessarily allocates capital to productive investments confuses the roles of direct investment and portfolio investment in the operation of a modern economy. When a person invests her own money in productive resources -- plant, equipment, and personnel – to start a new venture, she engages in direct investment. The expectation is that this investment will generate returns when the productive resources have been transformed into products that buyers want at prices that they can afford. The realization of such returns is uncertain. The technological transformation of the invested resources into outputs of sufficiently high quality and low cost to be competitive on product markets may not succeed – what Chris Freeman (1982, 148-50) calls “technological uncertainty”. Moreover, even if the technological transformation does succeed in terms of the market conditions that prevailed with the investment in productive resources was made, by the time of the completion of the technological transformation those market conditions may have changed – what Freeman calls “market uncertainty”. For the direct investment in productive resources to succeed in generating returns – that is, for the initial conditions of technological and market uncertainty to be overcome and for the new venture to be transformed into a going concern – the technological and market conditions that will determine success or failure have to be managed, which is what a direct investor in a new venture must do. That is, there is an integration of asset ownership and managerial control. At some point, however, the direct investor, having successfully managed the development and utilization of the productive resources in which she has invested, may want to realize the (now enhanced) monetary value of her invested capital. To do so, she can either find a private buyer for these productive assets – that is, she can sell the business enterprise to someone else who is willing and able to take over as a direct investor who integrates ownership and control. Alternatively, she can list the company on a stock market, and sell shares in the company to portfolio investors. In contrast to a direct investor who manages the investment in productive investment that she owns, a portfolio investor is willing to hold shares in the company precisely because his expectation of reaping returns of these shares does not require that he manage the underlying productive assets. Once the shares are listed on a stock market, if the portfolio investor is not satisfied with the returns that he is getting by holding the shares, he can readily find a buyer to whom to sell the shares. That is, in allocating their financial resources to tradable, and hence liquid, shares (especially ones that limit the liability of the shareholder to the purchase price of the share), portfolio investors do not have to participate in the management of the company whose shares they own. Indeed, it is the liquidity of publicly traded shares that makes them an attractive investment for portfolio investors. They can own shares, but they do not have to manage them. In contrast to the portfolio investors’ interest in financial liquidity, direct investors must be prepared to supply the corporation with financial commitment (Lazonick and O’Sullivan 1996) – a willingness to eschew the mobility of their financial resources in search of returns elsewhere in the economy for the sake


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of sustaining the development and utilization of productive resources in the particular business enterprise until such time that these resources can generate products of sufficiently high quality and low cost to be sold on the market. If the assumption that the stock market plays a central role in the allocation of resources to productive investment lacks empirical support, so too does the assumption that shareholders are the only participants in the corporation whose returns are not contractually determined and who hence have an interest in generating “residual” – or more accurately, surplus -- earnings. Even when financial economists have attempted to evaluate their own theories with reference to empirical evidence, as we have already observed, the risk-bearing explanation has proven problematic. Moreover, the assumption that all other participants possess contracts that specify the relation between resources supplied and returns received derives more from the ideology of the market economy than from a study of the organizational process through which the people who participate in the corporation develop and utilize the resources that they supply to the corporation’s productive processes. Corporate employees may have the expectation that the corporation will allocate some of its future returns not only to reinvestment in plant and equipment, but also to keep them productively employed and well remunerated. In keeping these people employed, those who allocate resources and returns in the corporation may expect a dynamic interaction between productive contributions of long-term employees and the long-term rewards that these employees can expect to receive; that is, the ways in which the corporation allocates resources and returns may be key to mobilizing the skills and efforts of its employees to generate the productivity that in fact makes long-term employment viable. It is this process that creates incentives for employees to contribute their skills and efforts toward the pursuit of corporate goals that we call organizational integration (Lazonick and O’Sullivan 1996). The expectation of sharing in a future stream of surpluses may give a variety of “stakeholders” the incentive to devote their skills and efforts to developing and utilizing the resources of the enterprise, including their own labour services. These expectations are generally not contractual. Stakeholder thus bear the risk that, for reasons external and/or internal to the enterprise, such surpluses will not be generated – or that even if they are generated there will be shifts in the power of different participants in the corporation that allow them to lay claim to a larger share of the “residual” than was previously expected. If workers and other stakeholders besides shareholders bear non-contractual risk, one could argue, as Margaret Blair (1995) has, that they should be included in a process that influences the corporate allocation of resources and returns. 2.2.3 The sources of the “residual earnings” in shareholder theory The obvious question raised by the shortcomings of shareholder theory in explaining the productive contribution of corporate shareholders is why the returns to corporate shareholders are so high and have been so for such an extended period of time. There are ongoing attempts within financial economics to deal with some of the empirical anomalies highlighted above. Yet it is difficult to see how such a theory could ever explain the high returns to shareholders that have been sustained for almost a century. More than half of the real returns on equities were realised by shareholders in the form of dividends,5 paid out by corporations during a period in which wages continually increased and output prices fell. Any explanation of these 5 For the period 1921-95 U.S. stocks earned a real compound return of 8.22% of which 4.84% can be attributed to dividend payments (Goetzmann and Jorion 1997, 23).


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returns would therefore seem to require an understanding of how the pie was being expanded in the real economy. Innovation -- the process through which productive resources are developed and utilized to generate higher quality and/or lower cost products -- is central to the dynamic through which successful enterprises and economies improve their performance relative to each other as well as over time. As it provides a foundation on which wealth can be accumulated by more and more people, innovation can mitigate conflicts among different interest groups over the allocation of resources and returns: an increase in the living standards of one interest group does not have to come at the expense of another. A relevant theory of resource allocation must, therefore, incorporate an understanding of the central characteristics of the innovation process. In studying the economics of the process through which resources are developed and utilized, the enterprise is the central unit of analysis. Indeed, historical research on innovation in all of the advanced industrial nations has highlighted the importance, as loci of innovation, of corporate enterprises that compete for markets to survive. An economy’s capacity to develop is thus importantly related to the process through which corporate revenues are allocated. However, the concept of resource allocation on which the shareholder theory of corporate governance is based precludes any understanding of the dynamic process of innovation through which productive resources are developed and utilized to generate higher quality, lower cost products. The basic foundation for the treatment of resource allocation in financial economics is Irving Fisher's theory of interest, articulated in its most complete form in his 1930 book, The Theory of Interest. In Fisher's (1930, 61-2) own words:

The theory of interest bears a close resemblance to the theory of prices, of which, in fact, it is a special aspect. The rate of interest expresses a price in the exchange between present and future goods. Just as, in the ordinary theory of prices, the ratio of exchange of any two articles is based, in part, on a psychological or subjective element -- their comparative marginal desirability -- so, in the theory of interest, the rate of interest, or the premium on the exchange between present and future goods, is based, in part, on a subjective element, a derivative of marginal desirability; namely, the marginal preference for present over future goods. This preference has been called time preference, or human impatience. The chief other part is an objective element, investment opportunity.

For Fisher it was the interaction of these two conditions, human impatience and investment opportunity that determined the rate of interest. In developing Fisher's theory of the market determination of interest rates, economists in the 1950s and 1960s extended it to include an equilibrium analysis of risk. Many economists, including Fisher himself, had long attributed differences in the returns on securities to the differential risk of their income streams. In extending the Fisherian model, the objective was to develop an explanation of these differences by analyzing how the market "priced" risk. Drawing on the Arrow-Debreu theory of general equilibrium, and the concept of expected utility on which it is based, as well as a host of additional heroic assumptions about preferences and probabilities, it was argued that a linear relationship -- the "market line" -- should be observed between the return on a financial asset and its risk, as measured by its


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contribution to the total risk of the return on an efficient market portfolio. From this perspective, the expected return on a risky security was considered to be a combination of a risk-free rate of interest and a risk margin linked to the covariance between the security's returns and the return on the market portfolio (Debreu 1959; Markowitz 1959; Arrow 1964; Hirshleifer 1965; Sharpe 1964; Lintner 1965a, 1965b; Mossin 1966). Accordingly, in the words of Jan Mossin (1966, 774), one of the key contributors to the extension of the Fisherian model, "we may think of the rate of return of any asset as separated into two parts: the pure rate of interest representing the 'price for waiting,' and a remainder, a risk margin, representing the 'price of risk'." It is this logic that is at the heart of modern finance theory and, as a result, the shareholder theory of governance; shareholders' returns are compensation for both waiting and risk-bearing. "Waiting" was a key element in Fisher's explanation of interest as a return to capital; in responding to socialists who think of "interest as extortion" (Fisher 1930, 51) he claimed that

…capitalists are not… robbers of labor, but are labor-brokers who buy work at one time and sell its products at another. Their profit or gain on the transaction, if risk be disregarded, is interest, a compensation for waiting during the time elapsing between the payment to labour and the income received by the capitalist from the sale of the product of labor. (Fisher 1930, 52)

For Fisher, that the act of waiting brought forth a return to capital was inherent in the technique or the "objective facts" of production. In The Theory of Interest, he repeatedly emphasized the importance of productivity in the determination of interest to correct a widespread interpretation of his theory, as one in which impatience was considered as the sole determinant of the rate of interest. In a review of Fisher’s earlier work in the American Economic Review, for example, one critic had contended that

[t]he most striking fact about this method of presenting his factors is that he [Fisher] dissociates his discussion completely from any account of the production of wealth. From a perusal of his Rate of Interest and all but the very last chapters of his Elementary Principles (chapters which come after his discussion of the interest problem), the reader might easily get the impression that becoming rich is a purely psychological process. It seems to be assumed that income streams, like mountain brooks, gush spontaneously from nature's hillsides and that the determination of the rate of interest depends entirely upon the mental reactions of those who are so fortunate as to receive them…The whole productive process, without which men would have no income streams to manipulate, is ignored, or, as the author would probably say, taken for granted (Seager 1912, 835-7).

Fisher (1913, 610) railed against this criticism on the grounds that he was not only cognizant of the fact that the "technique of production" entered into the determination of the rate of interest but that it was a central element in his analysis. He took pains to distinguish himself from economists who "still seem to cling to the idea that there can be no objective determinant of the rate of interest. If subjective impatience, or time preference, is a true principle, they conclude that because of that fact all productivity principles must be false" (Fisher 1930, 181-2). Fisher argued that in ignoring the influence of the technique of production on the interest rate their proposed solutions were indeterminate. He considered that the rate of interest was determined by an interaction between time preference and investment opportunity.


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When asked to which school of interest theory he belonged -- "subjective or objective, time preference or productivity" -- Fisher (1930, 182) thus replied: "To both". In fact, he claimed that "[s]o far as I have anything new to offer, in substance or manner of presentation, it is chiefly on the objective side." Fisher’s conceptualization of the determination of interest owed much to that of Eugen Böhm-Bawerk. Indeed, he dedicated his Theory of Interest to the Austrian economist (and to John Rae) “who laid the foundations upon which I have endeavored to build”. Böhm-Bawerk preceded Fisher in arguing that it was the interaction between time preference and the productivity of investment that gave rise to interest. The former he took to be a general characteristic of the average man. To explain the latter, he introduced the concept of the "roundabout process of production". Böhm-Bawerk argued that a given quantity of goods yielded a larger physical product when those goods passed through more stages of production; that is, when they were used first to make intermediate products and then to produce consumer goods. The generation of higher productivity was, from his perspective, inextricably tied to the extension of the time during which an investment was tied up in the production process.6 Notwithstanding the problems with Böhm-Bawerk’s theory, especially his roundaboutness theory of production, a watered-down version of it – a concept of interest as the result of the interaction of time preference with the productivity of investment -- became the most widely-accepted theory of interest among neoclassical economists, with Fisher as its most influential exponent. Although Fisher took issue with certain elements of Böhm-Bawerk's theory, Schumpeter (1951, 232) nevertheless observed that "whatever may be said about Böhm-Bawerk's technique, there was no real difference between him and Fisher in fundamentals" (see also Blaug 1997, 509; Mandler 1999, 173).7 What is certainly true is that Fisher provided no alternative theory of production to replace that of Böhm-Bawerk. Indeed, he regarded such a theory as unnecessary for his purposes: "it does not seem to me that the theory of interest is called upon to launch itself upon a lengthy discussion of the productive process, division of labor, utilization of land, capital, and scientific management. The problem is confined to discover how production is related to the rate of interest" (Fisher 1930, 473). But lacking a theory of production, that might expose the principles of the process through which productive resources are developed and utilized, Fisher did not add anything to Böhm-Bawerk’s controversial analysis of the relationship between production and interest. Consequently, his work did not provide an adequate explanation of the return to capital.8

6 For an introduction to the writings of Böhm-Bawerk, see "Eugen von Böhm-Bawerk," in

Schumpeter (1951, 143-90). 7 In a discussion of Fisher (1930) Joseph Schumpeter noted that most of it was "splendid

wheat… with very little chaff in between". However, he went on to say that "[t]he criticism of Böhm-Bawerk's teaching on the 'technical superiority of present goods' in § 6 of chapter XX must, I fear, be classed with the chaff. By that time it should have been clear that, whatever may be said about Böhm-Bawerk's technique, there was no real difference between him and Fisher in fundamentals": see "Irving Fisher's Econometrics," in Schumpeter (1951, 232).

8 It is surely for this reason, and notwithstanding his distaste for "naïve productivity theories" that consider interest to express the physical productivity of land, or nature, or of man, that Fisher ended up relying to a great extent on examples of natural production to illustrate his theory.


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One economist who did attempt to go beyond the limitations of Böhm-Bawerk’s theory of interest, as well as other economists’ attempts to explain interest within a theoretical framework in which technological and market conditions were taken as given, was Joseph Schumpeter. The central foundation of his theory of interest was an analysis of innovation, the process through which resources are developed as well as utilized, and its implications for resource allocation (Schumpeter 1996). The mainstream of the economics profession, and especially Fisher’s followers in financial economics did not, however, follow Schumpeter’s lead. At best, they disregarded the productive sphere as anything more than an extension of neoclassical price theory. At worst, they attempted to further colonize production by asserting that investment decisions in the productive sphere should be made according to the dictates of financial markets (Fama and Miller 1972, 108-43). In both cases their analytical frameworks were based on a concept of economic activity as the allocation of scarce resources to alternative uses where the productive capability of these resource and the alternative uses to which they can be allocated are given. By imposing this static concept of resource allocation on their analysis of interest and capital, they have thus lost even the limited appreciation in Böhm-Bawerk’s work, and to a lesser extent in Fisher’s analysis, of the developmental nature of the resource allocation process. Modern financial economists are, as a result, truly guilty of that of which Fisher was accused: of providing "an explanation of distribution as completely divorced from the explanation of production, as though incomes 'just growed' (Seager 1912, 837)". They analyze why it is that portfolio investors would demand a return on the securities that they hold without ever posing the question of why such a return might be forthcoming in the economy. Without a theory of why investment can be expected to generate a return to capital in the form of interest, they give the impression "that the determination of the rate of interest depends entirely upon the mental reactions of those who are so fortunate as to receive them" (Seager 1912, 835-7). And they compound Fisher's problem by adding another stream of capital income to interest -- a risk premium -- without ever explaining why a return to risk-bearing might be forthcoming in the real economy. There are, of course risks inherent in the process of production, but to say that the process is one that is risky does not imply that bearing risk is the key activity involved in generating a return.

How returns to investment are generated within the economy cannot be understood without analyzing the process through the economy develops and utilizes productive resources. Financial economists make no attempt to deal with innovation and its implications for resource allocation. Instead, following Fisher, they take investment opportunities as given. Then, as proponents of shareholder theory, they try to justify why shareholders are entitled to lay claim to the rewards that these investments generate. The subordination of the process of innovation, and of production more generally, is not exclusive to financial economics. The general tendency in neoclassical economics has been to favour the sanctity of exchange over production. Analysis of the characteristics of the process of production was cordoned off into the field of industrial organization, which was, as Philip Mirowski (1989, 328) put it, "by general consensus an elephant's graveyard of little theoretical consequence." The history of the neoclassical treatment of production is summarized well by Luigi Pasinetti (1977, 26) when he says:

In dealing with production, whenever anything came to light that was not quite consistent with the model of pure exchange, the typical reaction has


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been to modify the production side of the picture, i.e., to introduce into the theory of production all the assumptions that are necessary to restore its consistency with the preconceived model of pure exchange.

Whatever the virtues of the neoclassical characterization of resource allocation as the foundation for an analysis of exchange (and its merits have been contested even for this purpose by, for example, Friedrich von Hayek and his successors, the Austrian economists), the characterization is extremely confining for those who are interested in the economics of production, primarily because it is inimical to any concept of productive investment. The analytical limitations of neoclassical economics for dealing with production and investment are especially problematic for students of the corporate allocation of resources. Given its overwhelming concern with developing a theory of value, and thus with the analysis of the economics of market equilibrium, neoclassical theory has failed to develop a dynamic theory of the firm that could provide the microfoundations for a rigourous and relevant theory of corporate governance. Since it has lacks a theory of how a business enterprise might generate returns that are not market determined as well as a theory of how a business enterprise might distribute these returns, neoclassical theory provides no direct guidance on the production or distribution of the persistent profits of dominant enterprises with which the contemporary discussion of corporate governance is centrally concerned. Rather than confronting the challenge of providing plausible explanations of how corporate residuals are generated, proponents of shareholder theory have concentrated their energies on analyzing institutional mechanisms that would allow the corporate economy to mimic as closely as possible the perfect market ideal of neoclassical economics. Of course, precisely because the neoclassical framework is so badly suited to their field of inquiry, proponents of shareholder governance have had to improvise substantially within the neoclassical framework to develop their theory of corporate governance. They have focused, in particular, on developing "explanations" for the claims of shareholders to the residual, despite their lack of plausible explanations of how these residuals are generated. They have not questioned whether the mobility of resources is an appropriate benchmark for the corporate economy, notwithstanding the fact that since the 1920s, if not before, the very existence of the corporation as a central and enduring entity in the advanced economies has prompted a number of economists to question the relevance of neoclassical theory to an understanding of the most successful economies of the twentieth century (Veblen 1923; Berle and Means 1932; Schumpeter 1975; Galbraith 1967). Instead, the proponents of shareholder theory remain uncritically wedded to the tenets of neoclassical theory and, in particular, have failed to go beyond the confines of the neoclassical analysis of resource allocation in which individual preferences and technological opportunities are taken as given.

2.3 The stakeholder perspective on corporate governance Notwithstanding the fundamental problems with the theoretical framework that financial economists bring to the analysis of corporate governance, shareholder theory remains dominant in the governance debates. Yet, as shareholders have flexed their muscles to demand greater control over the allocation of corporate resources, there have been various attempts to develop an intellectual response by arguing that there are other "stakeholders", besides shareholders, who have a claim to corporate residual returns. Stakeholder theories of corporate governance, like their managerial and shareholder counterparts, have important historical


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antecedents. For example, for more than a century, scholars and practitioners have been writing about the importance of employee involvement in enterprise governance.

Stakeholder theories of governance often have a strong political component. One important strand of the literature on worker control of enterprises, for example, justifies its position on humanistic grounds, arguing that employee involvement in enterprise governance is a necessary precondition for individual and social development. Another strand contends that traditional hierarchical relationships between employers and employees are inherently undemocratic and unjust, and must be countered by worker involvement in the governance of enterprises (for a review of the extensive literature on organizational participation, see Heller, Pusic, Strauss, and Wilpert 1998).

In the contemporary debates on corporate governance, the stakeholder perspective continues to be exposited more often as a political position than as an economic theory of governance. Indeed, many of its proponents rely on sweeping and unsubstantiated assumptions about the foundations of economic success. For example, in their recent edited volume of essays on “stakeholder capitalism”, Gavin Kelly, Dominic Kelly, and Andrew Gamble identify the key challenge for proponents of stakeholder governance as reconciling in practice the competing claims of economic efficiency and social justice; they take it as given that “[i]ndividuals well endowed with economic and social capabilities will be more productive; companies which draw on the experience of all of their stakeholders will be more efficient; while social cohesion within a nation is increasingly seen as a requirement for international competitiveness” (Kelly, Kelly, and Gamble 1997, 244).

It is rare in this literature to find someone who has gone beyond such (rather hopeful) statements to analyse how the allocation of returns to different stakeholders affects economic performance. An important exception is the recent work by Margaret Blair (1995). We focus on her arguments in our analysis of stakeholder theories of governance because she has attempted to embed them in a framework of economic analysis. To do so is not to devalue the importance of the politics of corporate governance but to emphasize the importance of a cogent economic theory of governance as a foundation for an understanding of its politics.

In her book, Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century, Blair emphasizes the need for an analysis of corporate governance that is based on “a broader range of assumptions [than in the shareholder theory] about how wealth is created, captured, and distributed in a business enterprise” (Blair 1995, 15). She does not challenge the claims of the shareholder perspective that shareholders are “principals”; she accepts that shareholders have “residual claimant” status because she believes that they invest in the productive assets of the enterprise and bear some of the risk of its success. But she argues that the physical assets in which shareholders allegedly invest are not the only assets that create value in the corporation. A critical dimension of the economic process that generates wealth, Blair argues, is that individuals invest in their own "human capital". To some extent the assets that are developed through these investments are "firm-specific" and, as a result, those who make these investments bear some of the risk of the corporation doing well or poorly.

… in most corporations, some of the residual risk is borne by long-tenured employees, who, over the years, build up firm-specific skills that are an important part of the firm's valuable assets, but which the employees cannot market elsewhere, precisely because they are specific to the firm. These


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employees have contributed capital to the firm, and that capital is at risk to the extent that the employees' productivity and the wages they could command at other firms are significantly lower than what they earn in that specific firm. (Blair 1995, 15)

Because employees with firm-specific skills have a "stake" that is at risk in the company, Blair argues that they should be accorded “residual claimant” status alongside shareholders (Blair 1995, 238). In other words, in allocating corporate returns, the governance of corporations should recognize the central importance of individuals' investments in human assets to the success of the enterprise and the prosperity of the economy. Blair's analysis of firm-specific skills owes much to Gary Becker's theory of investments in on-the-job training. Becker contended that many workers increase their productivity by learning new skills and perfecting old ones on the job, that on-the-job training is costly, and that the nature of training -- and, in particular, its relationship with the activities of the firm that undertakes it -- has an important influence on the process through which resources are allocated to training (Becker 1975). Specifically, he argued that the costs of "general training" -- training useful in many firms besides those providing it -- and the profit from its return will be borne, not by the firms providing it, but, by the trainees themselves. In contrast, Becker contended that it is plausible, at least as a first approximation, that the costs of "specific training" -- training that increases productivity more in the firms providing it -- and the returns that it generates will be borne by employers because "no rational employee would pay for training that did not benefit him" (Becker 1975, 28). The analysis of specific training is complicated, however, by the potential for a "hold-up problem" between employer and employee. Becker reasoned that:

[i]f a firm had paid for the specific training of a worker who quit to take another job, its capital expenditure would be partly wasted, for no further return could be collected. Likewise, a worker fired after he had paid for specific training would be unable to collect any further return and would also suffer a capital loss. (Becker 1975, 29)

To overcome this problem, Becker considered that the costs of, and returns to, specific training would be shared between employer and employee, the balance being largely determined by the likelihood of labour turnover. Based on his analysis of workers' incentives to quit and firms' incentives to layoff, Becker concluded that "rational firms pay generally trained employees the same wage and specifically trained employees a higher wage than they could get elsewhere" because "[f]irms are concerned about the turnover of employees with specific training, and a premium is offered to reduce their turnover because firms pay part of their training costs" (Becker 1975, 31). To the extent that employees pay a share of the costs of specific training, he argued, the wage effects would be similar to those for general training: employees would pay for this training by receiving wages below their current (opportunity) productivity during the training period and higher wages at later ages when the return was collected (Becker 1975, 31-2).

In Becker’s human capital theory, as in neoclassical theory more generally, optimal resource allocation takes place through the market. Specifically, he argues that the appropriate incentives for investments in training, whether it is general or specific, will be provided through wage adjustments in competitive labour markets. Thus, from Becker's standpoint, market control represents the ideal system of economic governance even when firm-specific investments are taken into consideration.


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In contrast to Becker, Blair claims that when investments are firm-specific “competitive markets are of little use in determining how to allocate the rents and risk associated with those investments” (Blair 1995, 267). She argues that there is a need to supplement the market with institutions that govern how corporations allocate their returns to provide incentives for individuals to commit resources to investments in firm-specific assets:

if stakeholders are defined to mean all those participants who have substantial firm-specific investments at risk, then this idea is actually a reasonable and appropriate basis for thinking about corporate governance reforms. Far from abandoning the idea that firms should be run for all the stakeholders, contractual arrangements and governance systems should be devised to assign control rights, rewards, and responsibilities to the appropriate stakeholders – the parties that contribute specialized inputs (Blair 1995, 274).

Blair displays considerable caution in prescribing corporate governance reform – indeed she claims that, at least in the United States, “there is no need for radical changes in the law or the tax code, or in the structure of existing regulatory institutions (Blair 1995, 324)” – since she believes that “because U.S. corporation law, contract law, and securities law readily accommodate most experiments in new organizational forms, many new governance structures are emerging on their own” (Blair 1995, 277). Nevertheless, she does suggest some specific reforms of the extant US system of corporate governance to correct “institutional biases in the allocation of risk and control that may discourage investments in human capital” (Blair 1995, 277). Her recommendations include the introduction of mechanisms to encourage boards to act as representatives of all the important stakeholders in the firm, the development of new measures of investment and wealth creation that include investments and returns to human capital, the promotion of employee ownership, and the encouragement of more mobile employee benefits (Blair 1995, 323-39).

Becker, and Blair in turn, maintain the neoclassical assumptions that resource allocation is individual. Investments in, and returns from, productive resources are assumed to attach to individuals, even when these factors of production are combined in firms. Yet the introduction of the concept of firm specificity is an attempt to break to some extent with the neoclassical concept of resource allocation and, in particular, to make a theory so focused on exchange relations less hostile to production and productive investment. By assuming that training can be firm-specific -- that is, that it can increase productivity by more in the firm providing the training than in other firms -- Becker implicitly recognized that firms in the same industry can differ in terms of the investments that they make and the productive resources that they control. However, Becker did not provide any explanation of the sources of these differences nor, as a result, any analysis of the source of returns to firm-specific skills. Becker argues that investments in training will be undertaken when investors, be they firms or employees, expect them to generate a return. But he treats the characteristics of different training options -- the degree to which they are general or specific -- as factors exogenous to the economic process with which he is concerned (for a critique, see Eckaus 1963). The returns to all participants (productive factors) in the enterprise – in such forms as wages, rent, and interest – remain strictly determined, as they are in the pure neoclassical model, by technological and market forces that are external to the operation of the enterprise and human control more generally. All economic agents are assumed to optimize their objectives subject to market and


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technological constraints that shape the specificity of investments and the returns that they generate.

Becker’s work on training has had a profound influence on labour economists. In particular, the concept of firm-specific human capital is widely employed in analyses of labour market behaviour by those supportive and critical of Becker’s conclusions. Yet, to an extraordinary degree, given its centrality to their work, labour economists have failed to open the black box of firm-specificity to analyze where it comes from and, relatedly, why it makes sense to assume that it might be an important phenomenon in the economy. Our review of the extensive literature in labour economics that relies on the concept of firm-specificity revealed that most scholars took as their starting point some version of Becker’s definition of firm-specific human capital, and proceeded to build their models of labour market behaviour without going beyond Becker in providing a theory of who allocates resources to this type of productive investment, what kinds of investments they make, or how the returns to these investments are distributed (see, for example, Becker and Lindsay 1994; Chang and Wang 1995; Coyte 1984; Hashimoto 1975, 1980, 1981; Jovanovic 1979; Jung and Magrabi 1991; Kahn and Lang 1992; Kwok 1995; Laing 1994; Lam and Liu 1990; Levy and Haber 1986; MacDonald 1982; Parsons 1972; Scoones and Bernhardt 1998; Weisberg 1996; Willis 1985; White 1980; Zábojník 1998). David Donaldson and B. Curtis Eaton, for example, merely state that “[c]ertain skills or knowledge which an employee may acquire while working for a particular firm are of no value to other firms, even though such skills contribute to the productivity of the employee in that particular firm” (Donaldson and Eaton 1976, 463). The most detailed “analysis” of the concept that we could find was in a paper by Candice Prendergast (1993, 523) who made the following statement:

Workers routinely carry out activities that increase their productivity with their current employer for which they are not directly compensated. For example, a worker may be asked to develop relationships with clients or shop floor staff, or he may develop a better understanding of how his firm operates. Firm-specific human capital of this type is difficult to quantify so that it is likely to be difficult to directly compensate the worker for its acquisition

. Blair, at least, recognizes the need for an analysis of what she calls “wealth creation” (Blair 1995, 232-4, 240ff, 327-8) in order to make the case for a corporate governance process that allocates returns to “firm-specific” human assets. For her, as for Becker, the role of economic governance is to get factor returns “right” so that the individual actors are induced to make the “firm-specific” investments that the enterprise requires. But she provides no theory of the process that enables such human capital to contribute to the generation of higher quality and/or lower cost products. She merely asserts that investment in "firm-specific" assets can generate "residuals" without specifying under what conditions (market, technological, or organizational) such increased returns are generated. Without such a theory of wealth creation, it is impossible to determine the “right” returns to factors of production. If one wishes to base a theory of corporate governance on investments in “firm-specific human capital”, then one needs a theory of the “who, what, and how” such investments.

There are economists who have argued that the characteristic of firm-specificity is an outcome of organizational learning processes through which resources are developed and utilized in the economy (see, for example, Penrose 1995; Best 1990; Lazonick 1991). Yet, given the change inherent in the process of innovation, the organizational requirements of innovative investment strategies differ over time as learning within and outside the enterprise develops. Thus the firm-specific skills that


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result from continued innovation are constantly evolving. Firm-specific skills that were at one time part of a process that enhanced economic performance may fail to do so in another era, and may even retard it.

To focus on firm-specific skills as the critical dimension of the process of wealth creation is to ignore the dynamics of the innovation process. Linked to a theory of governance, such a perspective may well encourage the entrenchment of the claims of economic actors who have participated in and benefited from wealth creation in the past, even when the integration of their skills is no longer a viable basis on which the enterprise or the economy can generate the returns to meet these claims. That is, the stakeholder theory risks becoming a de facto theory of corporate welfare. Besides the theoretical shortcomings of Blair’s stakeholder theory for dealing with the process of wealth creation there is also a lack of clear-cut empirical evidence to back up Blair’s central assumption that employees make significant, value-creating investments in their own human capital. To support this claim, Blair points to evidence from the US labour market that shows "that employees accumulate valuable firm-specific skills if they stay with the same employer for an extended period" (Blair 1995, 263).

Firstly, wages typically rise with job tenure by more than they would be expected to rise solely as a result of the employee's increased general experience. These higher wages are generally taken as evidence that the employee becomes more productive as he accumulates firm-specific human capital. Second, job turnover rates (both layoffs and quits) typically fall with job tenure. This is also construed as evidence that employees accumulate firm-specific human capital that makes them more valuable to the firm and the jobs more valuable to the workers…The third piece of evidence is the fact that the costs of being laid off are typically larger for workers with more tenure. If workers had only generic skills that they could easily take with them to the next job, labor markets would not be expected to exhibit any of these three features. (Blair 1995, 263-5)

Blair (1995, 255) goes on to argue that

… because employees are promised a share in the rents, most economists believe that employees also share in the costs of firm-specific training, perhaps by accepting wages that are below what they might earn elsewhere during the early months and years that they work for a given employer and perhaps only by sacrificing the opportunity to learn special skills and share in the rents in some other enterprise.

That higher returns can be attributed to firm-specific capital is, to use Blair's term, “construed” from the fact that high returns seem to be positively correlated with employment tenure. That employees make the investments that allegedly generate these returns requires an even greater leap of faith; we must rely on the belief that because employees were rewarded, they must have made the investments that generated these rewards. In fact, the evidence is just as consistent with the view that firms made these investments: Becker's model predicted that rational employers would pay workers a premium over the market wage precisely to reduce their turnover. He also argued that firms would be reluctant to lay off workers with specific skills unless there was a permanent decline in demand, which would be consistent with workers with long-tenure incurring high costs of layoff.


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Blair's argument seems particularly implausible as applied to US blue-collar workers. The notion that they reaped supernormal returns on the basis of investments that they made in their own firm-specific human capital confronts much of what we know about the jobs that these workers did in the companies in which they were employed. Labour historians have provided extensive documentation of the process, that evolved over more than a century, through which the US blue-collar workforce was systematically excluded from any meaningful role in the productive process in all of the leading sectors of American industry (Montgomery 1987; Brody 1993; see also, Gordon, Edwards, and Reich 1982; Lazonick 1990). Increasingly, as the century unfolded, and certainly in the post-war period, blue-collar workers were denied the opportunities to participate in organizational learning processes through which they could develop firm-specific skills; that privilege was reserved for the managerial class (Chandler 1977; Lazonick 1990). The managers of US corporate enterprises proved themselves vehemently hostile to initiatives taken by some union leaders after World War II to allow workers to participate in the allocation of corporate resources. Once these attempts were rebuffed, American unions did not, in general, challenge the principle of management's "right" to control the development and utilization of productive capabilities (Harris 1982). In practice, however, the quid pro quo for union cooperation was that seniority be a prime criterion for promotion along well-defined job structures, thus giving older workers best access to a succession of jobs paying gradually higher hourly wage rates (Lazonick 1990, chs. 8-9; O’Sullivan 2000a, ch., 3). It seems more plausible, in light of US business history, that it was this labour-management accord, rather than shop-floor workers’ firm-specific skills, that provided the institutional basis on which the dominant industrial corporations were compelled to share the gains of post-World War II prosperity.

The stakeholder theory of governance put forward by Blair provides no theoretical basis for dealing with this reality. In particular, her willingness to accept the neoclassical assumption that resource allocation is the result of investments by optimizing individuals, and that the firm is, as a result, nothing more than a combination of physical and human assets that for some reason -- labeled "firm-specificity" -- happen to be gathered together, precludes an understanding of the economic foundations of strategic control by one group of people over the learning opportunities of others and the governance institutions that shape the abilities and incentives of strategic decision makers in corporate enterprises. 2.4 Innovation and the Corporate Governance Debates The shareholder, managerial, and stakeholder perspectives all provide different answers to the “who, what, and how” of corporate governance. In doing so, all three perspectives raise the issue of how an economy not only allocates resources and returns at a point in time but also develops and utilizes resources over time. Yet, what continues to be missing from the corporate governance debates is a theory of economic development that can help to explain why resources that are allocated today may yield more or less returns to be shared tomorrow. Central to such a theory of economic development is a theory of innovation: the transformation of productive resources into saleable products that are higher quality and/or lower cost than those that had previously been available.

A theory of innovation is most clearly absent in the shareholder perspective, with its foundation in the neoclassical theory of resource allocation, which takes existing investment opportunities as given. In assuming that these investment opportunities are risky, the shareholder perspective recognizes that the returns to resources that


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are allocated occur over time rather than instantaneously. But, as the allocator of resources to such risky investments, the role of the shareholder is to diversify his financial portfolio over large numbers of such investments rather than devote his time and effort to the development and utilization of the productive resources committed to a particular investment, as a direct investor must do. Even then, however, the shareholder perspective assumes that in general investments in productive resources will generate a residual to which the shareholder as risk-bearer can lay claim without asking how risk-bearing per se can generate returns and hence why the average return to risk-bearing may be more or less. In our view, the explanation of the residual – or surplus – as a general phenomenon requires a theory of innovation.

The managerial perspective comes closer than the shareholder perspective to locating the potential sources of innovation by recognizing that the role of managers is to allocate resources to, and returns from, a value-generating process. Porter (1985), for example, emphasizes that managers have to oversee the “value chain” that transforms purchased inputs into salable outputs. Yet Porter’s conceptual framework does not contain a theory of what makes the value chain more or less productive, except perhaps to argue that, as strategic decision makers who allocate resources and returns, there are “good” managers and “bad” managers. But what determines whether managers are “good” or “bad”? Specifically, what determines whether or not managers oversee an innovation process that develops and utilizes resources to generate higher quality, lower cost products? To go beyond an answer that focuses on the “mindset’ of the manager, what are the organizational and institutional conditions that enable some managers in certain corporations and epochs to be “good” while condemning others to be “bad”?

Moreover, who are the managers who exercise control over the allocation of resources and returns? Are they the top managers or are they members of a managerial organization? And what is the relation of these managers to the executive, supervisory, consultative, and regulatory institutions of corporate governance that supports or proscribes their decisions and actions (see Lazonick and O'Sullivan 1998). Once one recognizes that control over the corporate allocation of resources and returns may be exercised by an organization that exists within an institutional environment rather than by an individual whose "mindset" is disembodied from society, one must ask what makes an organization, and a set of institutions, good or bad at generating innovation.

In probing the relation between the allocation of resources by and the allocation of returns to many different types of people who participate in the corporate enterprise, the stakeholder perspective on corporate governance lends itself much more than the managerial perspective to an organizational conception of the corporate allocation process. Hence it opens the door to a theory of corporate innovation that is not confined to exploring the mindsets of top managers but delves into the allocation of resources and returns as an organizational phenomenon. As we have seen, the stakeholder perspective, in its recent re-emergence as a counter to the shareholder perspective, contends that other stakeholders besides shareholders should have rights to participate in the allocation of resources and returns. But what is the relation between the allocation of resources by and the allocation of return to particular types of stakeholders that renders the exercise of such rights sustainable?

It is also clear that to focus on the allocation of “labour,” as the stakeholder perspective does, rather than the allocation of “capital,” as the shareholder perspective does, renders the distinction between portfolio investment and direct investment untenable. Unlike “capital”, “labour” cannot diversify its portfolio in search


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of a return. Even if over her career the worker moves from job to job and from firm to firm, she must be a “direct investor “ – she must work in a particular job at any point in time -- in order to generate a higher return on her labour. Thus, as we have seen in the arguments put forth by Blair, the stakeholder perspective confronts the need for a theory of value creation. Indeed, a key question raised by the stakeholder perspective is whether corporate governance is about the ability of different types of stakeholders to augment their returns by reslicing a given economic pie or about how the interaction among different types of stakeholders supports the generation of bigger pies that can potentially yield bigger slices for all. 4. Innovation: Linking Corporate Governance and Economic Performance 3.1 Innovation and Economic Development What, then, determines the growth of an enterprise and of an economy in which these enterprises allocate resources and returns? How does an enterprise, and by extension, a society share among its members the costs of generating economic growth and the benefits that are derived from it? These fundamental questions of growth and distribution are as old as the discipline of economics. But modern economics has not been very successful in providing cogent answers. The main problem is that the conventional theory of the market economy lacks a theory of economic development. This intellectual deficiency is neither inevitable nor accidental. During the nineteenth century, the elaboration of a theory of economic development was the central project of what came to be called “classical” economics. But during the twentieth century, the economics discipline has displayed an ever-growing commitment to the individualistic ideology and ahistorical methodology of what has become known as "neoclassical" economics. Given these ideological and methodological orientations, adherents to the neoclassical perspective have neglected to build a theory of economic development that can comprehend the historical experiences of economic growth and income distribution in the world’s most advanced national economies (Lazonick 1991). Indeed, the neoclassical research agenda by its very definition -- the study of the allocation of scarce resources among competing uses -- places the process of economic development beyond its analytical scope. This definition of “the nature and significance of economic science” has meant that conventional economic analysis assumes that, in the determination of economic performance, technological and market conditions can be taken as exogenous.9 The neoclassical economist takes the “scarcity” of resources -- technology -- and the “competing” uses to which they can be allocated -- markets -- as given constraints in the resource-allocation process. Economic actors are assumed to operate subject to these exogenously determined constraints as they seek to optimize their objectives. In contrast, a theory of economic development takes as given neither the quantity nor the quality of productive resources available, nor the uses to which these resources can be applied. Economic development occurs through the transformation of prevailing technological and market conditions so that higher quality, lower cost goods and services become available to enhance the standards of living of the

9 The quote is from the title of the influential methodological treatise of Robbins (1932), in

which the economics discipline was thus circumscribed. For a critique, see Lazonick (1991, 62-70).


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society’s population as a whole. The augmentation of the wealth of the nation requires change in the outcomes that the neoclassical economist would deem to be “optimal” under “existing” technological and market conditions – that is, conditions that are assumed to operate in the economy as “given” constraints on resource allocation. To analyze the process of change, a theory of economic development must identify: • the main types of economic actors engaged in the development and utilization of

productive resources; • the technological and market conditions that constrain their activities at a point in

time; • their incentives and abilities to transform these conditions over time; • the extent to which technological and market conditions that previously

constrained economic activity are in fact transformed; and • the economic outcomes of this transformation process, when and where it

occurs. The quest for a theory of economic development raises a number of key questions for empirical analysis with methodological implications for how this research is to be performed: • What technological and market conditions stand in the way of economic

development at any point in time? The very notion that conditions that constrained economic activity at one point in time can be transformed to generate economic development means that the study of the economy must be historical.10

• Is it entrepreneurial individuals, business enterprises, or governmental agencies that carry out such historical transformations? The answer to this question determines the agents of change that are the foci of research, and ultimately permits us to analyze of how different social units interact in the process of economic development.

• What are the results of the transformation of technological and market conditions that constitute economic development? From a social point of view, the evaluation of the achievements of the economy must address such issues as what makes goods and services “higher quality” and “lower cost” and the welfare implications of the distribution of the costs and benefits of generating these products among the relevant population. That is, the economic analysis must be grounded in a developmental perspective on the assessment of economic performance.

The historical study of the evolution of modern economies suggests that business organizations are the central social units of analysis for understanding the process of change that results in economic development. To transform productive resources into useful and affordable products, modern economies rely on business organizations that must ultimately generate sufficient revenues from the sale of these products to survive. In a competitive environment, survival over the long run requires that the enterprise be innovative. Innovation entails the transformation of productive inputs into saleable outputs to generate products that are "higher quality" -- more desirable to users -- and "lower cost" -- more affordable to users -- than the previously attainable quality/cost of those goods and services at prevailing factor prices.

10 Such was the great analytical insight of Schumpeter (1934, 1942). See Lazonick (1994).


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A theory of economic development, therefore, requires a theory of innovative enterprise. Innovative enterprise refers to the business organizations that undertake this transformation process. By its very nature, given competitive conditions, innovative enterprise requires the transformation of prevailing technological and/or market -- that is, "industrial" -- conditions, for it is only by the transformation of these industrial conditions that higher quality, lower cost products can be generated. Moreover, when competitive conditions change – when new competitors emerge with the capability of developing even higher quality and/or lower cost products, then an enterprise that had been innovative in the past will have to transform the technological and/or market conditions it faces to remain an innovator. But how does an enterprise transform industrial conditions? Specifically, what are the social foundations of economic development that underlie the incentives and abilities of enterprises to transform the technological and market conditions that they face? To address this question, we use a conceptual framework that analyzes the role of organizational conditions characteristic of an enterprise (which may entail large numbers of related units of financial control, as in enterprise group an industrial district) in mediating between institutional conditions and industrial conditions. At a point in time, the industrial conditions that that an enterprise faces are technological, market, and competitive. The enterprise faces these industrial conditions with certain organizational conditions that define the enterprise as an organization and that are strategic, cognitive, and behavioural. The enterprise operates within a particular institutional environment that is defined by employment, financial, and regulatory conditions (see Figure 5). Technological conditions are the readily available human skills as well as physical equipment and materials that can transform a combination of specific inputs into specific outputs of known quality, and, given market conditions, known cost. Market conditions are the factor prices of labour, land, capital, and products and the size of the readily available market. Competitive conditions, reflecting as they do the cost structures and pricing strategies of rivals, affect existing technological and market conditions. But the inclusion of competitive conditions as a separate category of industrial conditions entails the recognition that different enterprises that compete for the same product markets may not all face the same technological and market conditions. When competitive conditions change, the technological and market conditions that an enterprise faces will change as well. To remain competitive, an enterprise may have to transform the technological and market conditions it faces, which may require a change in its organizational conditions, beginning with its strategic conditions (see Figure 5). We define innovation as any transformation in an enterprise’s technological and/or market conditions that, at prevailing unit factor costs, generates products that are higher quality and/or lower cost than those that previously prevailed in the industry. Cognitive conditions represent what the people who make up the enterprise’s organization know. At a point in time, this knowledge may or may not be embodied in technological and market conditions, that is, in the enterprise’s readily available access to technology and markets. Behavioural conditions are what motivates the people within the enterprise’s organization, and hence affects the types of goals that they will pursue and the types of incentives to which they will respond. Strategic conditions represent the location within an enterprise’s organization of people with strategic decision-making power and the ability and incentives of these people to transform the technological and market conditions that the enterprise faces (see Figure 5). Such transformations of industrial conditions may require the transformation of the enterprise’s cognitive and/or behavioural conditions, which in turn depend on the control that strategic decision makers exercise over both the


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required money to finance the processes of industrial and organizational transformation (financial commitment) and the people who have to be able and willing to participate in the transformation of industrial and organizational conditions (organizational integration). Strategic control, therefore, represents the linking of financial commitment and organizational integration. A major corporate enterprise may be an institution unto itself, but in general the institutional conditions within which an enterprise operates reflects a broader social environment, characterized by national institutions. The national institutions that create the institutional conditions of financial commitment, organizational integration, and strategic control are, respectively, financial institutions, employment institutions, and regulatory institutions. Taken in combination these national institutions constitute a national system of corporate governance; the institutional conditions created by these national institutions can have a significant influence on how corporations that operate within the national institutional environment allocate corporate resources and returns (Lazonick and O’Sullivan 1996). In the course of its business activities in a particular institutional environment, the transformation of institutional conditions may be outside the control of even the most powerful business enterprises. If so, in pursuing its objectives, the business enterprise must treat these institutional conditions as "given constraints." Yet these institutional conditions will influence how an innovative enterprise transforms the industrial and organizational conditions that are potentially under its control. Moreover, even within particular institutional environments, institutional conditions do change over time, and, in longer run historical perspective, it may well be the case that the collective and cumulative impact of the organizational transformations of innovative enterprises will be a prime determinant of the forms that these institutional changes take. 3.2 The Economic Theory of Innovative Enterprise 3.2.1 The neoclassical theory of the firm A theory of innovative enterprise must, of course, dispense with the neoclassical assumption that all enterprises have equal access to the same technologies and markets; it is the transformation of the technological and market conditions that it faces that can enable an enterprise to differentiate itself from other competing enterprises in its ability to generate higher quality, lower cost products. Nor is the analysis aided by positing, as is typically the case among economists, that the innovative enterprise gained competitive advantage because of "market imperfections". Such an adherence to an "ideal" benchmark of "perfect competition" leads one to view any organizational or institutional condition that supports innovation as a "market imperfection". Yet the innovative enterprise takes some of these "imperfect" conditions as social foundations for generating higher quality, lower cost products. Had the market been "perfect", the conventional economist's "optimum" may have prevailed, but innovation would not have occurred. Indeed, we can demonstrate the importance of understanding the transformation of technological and market conditions for generating innovation – and in the process lay out the basic economics of the innovative enterprise -- by contrasting the theory of innovative enterprise with the neoclassical theory of the optimizing enterprise that dominates the economics textbooks. Most economists who adhere to the ideological and methodological precepts of neoclassical economics would be quick to point out that the modern “neoclassical” theory of the firm now includes the analysis of such


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phenomena as transaction costs, agency costs, incomplete contracts, and asymmetric information. We would contend, however, that these phenomena enter into the analysis as manifestations of “imperfect markets,” with the textbook theory of the optimizing enterprise that operates in a perfectly competitive environment providing the conceptual foundation for their elaborations of more realistic theories of the firm. As a result, the imperfect market theories of the firm take the perfectly competitive firm as the ideal against which the "imperfectly competitive" firm should be compared. Furthermore, in the absence of an attempt to develop a theory of the innovative enterprise, these theories remain within the neoclassical realm of discourse by adopting the constrained-optimization methodology; the objective is to determine optimal outcomes subject to market imperfections such as transaction costs, agency costs, incomplete contracts, and asymmetric information. Moreover, as we elaborate in some detail below, even those economists who have departed from the neoclassical ideological and methodological precepts in elaborating evolutionary theories of the firm have not sufficiently grounded their analyses in a critical evaluation of the conventional theory of the firm. Yet, as we shall show, such a critical evaluation provides key insights into the economics of the technological and market transformations that constitute the theoretical foundation of a theory of innovative enterprise. The familiar textbook theory of the firm based on the U-shaped average cost curve, and the marginal cost curve that is mathematically derived from it, assumes that firms incur fixed costs in engaging in the production of good and services. Fixed costs are defined as those costs of productive inputs that are incurred even when the firm produces no goods and services, whereas variable costs vary directly with the amount of goods and services produced. Indeed, these fixed costs define the firm as a distinct economic entity, for without fixed costs there would be no reason why households, as suppliers of both labour and capital, would not simply enter into agreements with other households to combine units of labour and capital to produce units of output. It is typically assumed that fixed costs reflect indivisible technology, such as plant and equipment. Some versions of the theory also treat “the entrepreneur” as a fixed factor of production, with the cost of the entrepreneur being his actual or (as the firm’s owner) imputed salary. The firm must then spread out these fixed costs over multiple units of output in order to reduce average (that is, unit) costs. As the firm spreads out its fixed costs over more units of output, average fixed costs fall, as do average total costs so long as the decrease in average fixed costs more than offsets any increase in average variable costs. The theory assumes that the firm complements its fixed inputs with variable inputs of labour and materials, more or less of which are purchased on the market as the firm expands or contracts its level of output. As the firm produces larger volumes of output, however, it experiences increasing average variable costs, either because of “overmanning” and/or “control loss”. In the first case, as more workers are employed with the fixed resources, they overman the fixed production facilities, leading each worker to be less productive. In the second case, as the number of employees increases the entrepreneur as manager loses control over the quality and quantity of labour services that the employed workers provide. In either case, productivity per unit of labour input falls even though the firm continues to purchase these inputs on the market at the same market-determined wage, and hence unit labour (i.e., variable) costs rise. As the firm increases its volume of output, this increase in average variable costs offsets the decrease in average fixed costs derived from spreading out the fixed factors over more units of output. When the resultant increases in average variable costs outweigh the decreases in average fixed costs, total average costs


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begin to increase, thus tracing the U-shaped relation between the volume of output and average cost that is central to the textbook theory of the firm. The derivation of the U-shaped cost curve has played a critical role in enabling economists to view the essence of firm behaviour as optimization subject to given technological and market constraints. The fixed-cost assumption provides an explanation of why an entity called “the firm” exists in a market economy,11 and why the firm requires "management" to achieve decreasing unit costs, even as it accepts existing technological and market conditions as given constraints. The increasing cost assumption makes it theoretically possible for the firm not only to exist but also to reach its optimal size while remaining so small relative to the size of the industry as a whole that it can be considered to be engaged in “perfect competition” – that is, the individual firm will be able to produce and sell at its optimal level with no discernible impact on the market price of the product. By embedding the theory of the optimizing firm in a theory of “perfect competition”, the neoclassical economist can contend that the best possible economic performance of an industry can be achieved when the organization of the industry is characterized by large numbers of optimizing firms, each with a small market share and identical cost structures. This “best-of-all-possible-economic worlds” is one, where all firms take the technological and market conditions in the industry as given constraints. “Good managers” in the best-of-all possible worlds are those who optimize subject to these constraints (see Figure 6). Within the constrained-optimization framework, the alternative to the theory of perfect competition is, of course, the theory of monopoly. In both theories, the firm optimizes subject to technological and market constraints. But in the monopoly case, the firm reaches such a large size relative to total industry demand before increasing average variable costs drive up average total costs that one can no longer assume that the market price of the product will be unaffected by the level of output at which the firm optimizes. It can then be demonstrated, within the constrained-optimization framework, that if an optimizing firm in perfect competition is compared to an optimizing firm that is a monopoly, the presence of monopoly results in inferior industry performance. Compared with perfectly competitive conditions, monopoly results in higher product prices and lower volumes of output. Elaborated within the Marshallian tradition of partial equilibrium in the 1920s and 1930s (see Lazonick 1991, ch. 5), this conventional perspective on industrial organization still remains implanted within the economics textbooks, and for most of the twentieth century provided the theoretical basis for arguing the purported economic superiority for the allocation of productive resources in the economy of having more rather than less competitors in an industry. The comparison of constrained optimization under conditions of perfect competition and monopoly contains, however, a fundamental flaw (see Figure 7). The problem is 11 Ronald Coase (1937) argued that “transaction costs” (that is, the cost of using the market)

explain why firms exist in a market economy. But the fixed cost assumption of the textbook theory, already propounded at the time Coase wrote (see for example Viner 1931-2; Robinson 1933), provides a more fundamental rationale for the existence of the firm. One could perhaps argue that if it were not for “transaction costs”, a number of firms could share the investments that create fixed costs. But to make such an argument would constitute an attempt to save the transaction-cost approach as an explanation for the existence of the firm more than an effort to generate a theory that captures a basic characteristic of the firm in a market economy. At best, transaction costs might be used to analyze, as indeed was Coase’s actual argument, the range of activities in which a firm engages rather than the existence of the firm per se.


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not with the logic of constrained optimization per se but with the logic of comparing the competitive model with the monopoly model within the constrained-optimization framework. If technological and market conditions make perfect competition a possibility, how can one firm (or even a small number of firms) come to dominate an industry? One would have to assume that the monopolist somehow differentiated itself from other competitors in the industry. But, the constrained-optimization comparison that yields the monopoly model argues that both the monopolist firm and perfectly competitive firms optimize subject to the same cost structures that derive from given technological and factor-market constraints. Indeed, except for the assumption that in one case the firm can make its profit-maximizing output decision as if it can sell all of its output at a constant price and that in the other case the firm is so large that it can only sell more output at a lower price, there is absolutely nothing in terms of the structure or operation of the firm that distinguishes the perfect competitor from the monopolist! So why would monopoly ever emerge under such conditions? Of course, economists have argued that some industries, as exemplified by electric utilities, are characterized by natural monopoly. Relative to the size of the market to be served, the fixed costs of setting up an enterprise in an industry are so high that it is uneconomical to have more than one firm in the industry. But, if that is the case, then the comparison with the “optimal” levels of product price and product output under competitive conditions is irrelevant. If one opts for the "natural monopoly" explanation for the concentrated structure of an industry, one cannot then logically invoke the "perfectly competitive" comparison to demonstrate the inefficiency of monopoly. Recognizing the irrelevance of the competitive alternative, governments have long regulated natural monopolies by (in principle at least) setting output prices that can balance the demands of consumers for reliable and affordable services with the financial requirements of utility companies for developing and utilizing productive resources. 3.2.2 From transaction cost theory to a theory of innovative enterprise Over the past three decades, a direct and sustained direct critique of the neoclassical monopoly model has been mounted by transaction cost theorists, the most prominent among whom has been Oliver Williamson (1975, 1985, 1996). The basic argument of transaction cost theory is that, from the point of view of achieving the optimal allocation of resources in the economy, antitrust policy is unwarranted because the vertically integrated and horizontally concentrated enterprises that one finds in the modern economy themselves represent optimal responses to conditions relating to "given" constraints. These given constraints reflect cognitive capabilities -- what Williamson calls "bounded rationality" -- and human behaviour -- what he labels "opportunism" -- both of which are in turn impossible to change, representing in Williamson's words "human nature as we know it". In addition, these given constraints reflect technological conditions -- what Williamson calls "asset specificity" that are assumed to be prohibitively costly to change. In terms of understanding the possibilities and problems in the growth of the firm, the main contribution of transaction-cost theory is the introduction of relevant cognitive and behavioural assumptions into the theory of the firm. But Williamson follows the post-Marshallian methodology that remains central to conventional economic analysis more generally of analyzing the operation and performance of the enterprise within the constrained-optimization framework. In Williamson’s case, it is the cognitive constraint of bounded rationality, the behavioural constraint of opportunism, and the technological constraint of asset specificity that combine to limit the way in which an economy can allocate resources, and which, as a result, yield "hierarchies"


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rather than "markets" as the economically optimal way of organizing certain activities within the economy. In confronting the "monopoly model" that, as we have seen, emerged out of the post-Marshallian theory of the optimizing firm, Williamson enriches the theory of the optimizing firm by adding a set of assumptions concerning the cognitive, behavioural, and technological constraints that the enterprise faces. He makes no attempt, however, to comprehend whether and how the enterprise might transform these cognitive, behavioural, and technological conditions in ways that can contribute to the process of economic development. Yet, as we shall show, if one accepts that the business enterprise can through its investment strategies and organization structures, transform the conditions of bounded rationality, the transaction-cost model can contribute to a theory of innovative enterprise that furthers our understanding of the historical evolution of the modern industrial corporation. Transaction-cost theories have their origins in a paper, “The Nature of the Firm”, published by Ronald Coase in 1937. Influenced by the post-Marshallian debates, Coase’s aim was to construct a theory of the firm that would be both realistic and tractable. By realistic, Coase meant a theory that could account for the fact that, within the economy, resources are allocated internally within firms rather than by the price mechanism. By tractable, Coase meant that “the nature of the firm” could be analyzed using the Marshallian tool of “substitution at the margin” (Coase 1937, 344, 350). Hence, Coase assumed that “the nature of firm” could be understood as an optimizing firm, and that constrained optimization provided an adequate methodology for analyzing the conditions under which firms rather than markets allocate resources in the economy. Coase argued that the firm differs from the price mechanism because within the firm the allocation of resources occurs through “conscious power”. As Coase put it: “If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so.” “But,” Coase asked, "in view of the fact that it is usually argued that coordination will be done by the price mechanism, why is such organization necessary? . . . Our task is to discover why a firm emerges at all in a specialized exchange economy” (Coase 1937, 336-8). Coase answered this question by pointing out that there are costs of using the market – that is, transaction costs. Participants in the economy have to discover what relative prices are, they incur costs of negotiating and enforcing contracts for each separate market transaction, they face uncertainty in relying on market relations when planning is required, and they may be able to avoid taxes on market transactions by organizing these transactions within a firm. The firm arises and then augments its coordinating functions when the cost of organizing these functions internally is less than the cost of using the market (for a critique of Coase, see Lazonick 1991, 168-70). Influenced by Coase’s contribution (which was largely neglected until its inclusion in Stigler and Boulding’s influential collection of readings on price theory in 1952), there is now a vast literature on transaction-cost economics, dominated by the theoretical work of Oliver Williamson. In writings dating back to the 1960s, Williamson has sought to elaborate a theory of the firm that is applicable to understanding the organization and performance of the modern corporation. In the manner of Coase, Williamson has sought to explain why, in a “market economy,” hierarchies rather than markets might organize economic activity. Moreover, like Coase, he has conceived of “hierarchies” as optimizing firms (see Lazonick 1991, ch. 6).


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Unlike Coase, however, Williamson locates “transactions”, and hence “transaction costs”, not only in market exchange but also within the firm. Therefore, to assess the relative performance of markets and hierarchies in allocating resources, one must compare the transaction costs of the two different modes of economic organization. Williamson attributes “transaction costs” to a behavioural condition that, following Kenneth Arrow, he calls “opportunism” and a cognitive condition that, following Herbert Simon, he calls “bounded rationality” (Williamson 1985). It is Williamson’s inclusion of behavioural and cognitive conditions as central to the theory of the firm that marks his contribution as an important advance over prior theories of the optimizing firm that treated technological and market conditions as if they were devoid of organizational implications. Williamson defines “opportunism” as a condition of “self-interest seeking with guile.” “Opportunism,” says Williamson, “refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse” (Williamson 1985, 47). In organizing transactions, markets and hierarchies possess different capabilities for “attenuating opportunism”, and hence for minimizing transaction costs. Market transactions provide a protection against opportunism because the market provides options for one party not to transact with another. In contrast, hierarchical transactions expose one party to the opportunism of another. Yet such opportunism only becomes a problem in the presence of bounded rationality. In entering into transactions, economic actors have incomplete access to information and a limited ability to absorb that information to which they do have access. They make decisions that they intend to be rational – by which Williamson means to minimize costs – but they have a limited cognitive competence to do so. Bounded rationality is this condition of being “intendedly rational but only limitedly so” (Williamson 1985, 45). With unbounded rationality, economic actors would not be reliant on others for information. Indeed, absent limits to their cognitive competence, decision-makers would know the opportunistic propensities of other actors and could simply avoid entering into transactions with those known to be prone to “self-interest seeking with guile.” The critical phenomenon that links the condition of bounded rationality with the condition of opportunism is uncertainty that is both cognitive and behavioural. The possibility of unforeseen “disturbances” in the economic environment creates the need for “adaptive, sequential decision making”, and markets and hierarchies “differ in their capacities to respond effectively to disturbances.” But for the condition of bounded rationality, the changing environment would not create cognitive uncertainty and pose problems of adaptation, because “it would be feasible to develop a detailed strategy for crossing all possible bridges in advance” (Williamson 1985, 56-7). The occurrence of these unforeseen disturbances creates opportunities for one party to a transaction to take advantage of the other. In the presence of parties to transactions who are looking for the opportunity to seek their own self-interest in deceitful, dishonest or guileful ways, cognitive uncertainty is transformed into behavioral uncertainty – that is “uncertainty of a strategic kind . . . attributable to opportunism.” As Williamson goes on to argue: “Behavioral uncertainty would not pose contractual problems if transactions were known to be free from exogenous disturbances, since then there would be no occasion to adapt and unilateral efforts to alter contracts could and presumably would be voided by the courts or other third party appeal” (Williamson 1985, 58-9).


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So what does the interaction of bounded rationality and opportunism tell us about the choice between markets and hierarchies, and hence about the activities in which a firm will engage? Given the behavioural condition of opportunism and the cognitive condition of bounded rationality, individuals who want to minimize transaction costs should choose to organize their transactions through markets rather than hierarchies. Markets permit those entering into a contract to attenuate opportunism by switching to other parties, and to operate within the constraint of bounded rationality by engaging in adaptive, sequential decision making. Why then do firms exist and grow in a modern economy? The critical condition that, according to Williamson, favours hierarchies over markets is “asset specificity”. Williamson introduced asset specificity as a deus ex machina into his argument when it became apparent that the assumptions of opportunism and bounded rationality provided an explanation for why markets would organize transactions (compare Williamson 1975 and 1985). The problem that Williamson wanted to explain, however, was why, given the possibility of organizing transactions by markets, hierarchies – that is, business organizations – exist. As Williamson himself puts it: “The absence of asset specificity [would] vitiate much of transaction cost economics” (Williamson 1985, 56). Asset specificity is inherent in “transaction-specific durable assets”, both human and physical, that cannot be deployed to alternative uses – that is, to other transactions -- without incurring a financial loss. Williamson distinguishes between physical asset specificity and human asset specificity. Physical asset specificity can exist because of what he calls “site specificity” – the physical immobility of invested resources that have been located in a particular place to be near a particular supplier or buyer – or because of “dedicated assets” – the special-purpose nature of capital goods (even if they can be easily moved), especially when the investments have been made to service a limited extent of the market (in the extreme, a particular buyer). Human asset specificity can exist because of the need for “learning by doing” or “team configurations" in the development of human resources (Williamson 1985, 34, 55-6, 95-6, 104). Generally, what imbues assets involved in any specific transaction, therefore, with “specificity” is the participation of particular parties, as investors, workers, suppliers, or buyers, in the transaction. “Faceless contracting,” characteristic of market transactions, is, according to Williamson, “supplanted by contracting in which the pairwise identity of the parties matters” (Williamson 1985, 52, 60, 72-3). As a result, transaction-specific assets cannot be reallocated to another use without a loss. Therefore, to generate revenues from these assets, the party that has invested in them requires continuity in his or her ability to utilize them. In effect, asset-specificity is a form of Marshallian fixed costs that requires that the asset be utilized for a high “frequency” of transactions if these fixed costs are to be transformed into low unit costs (Williamson 1985, 52, 60, 72-3). But, in Williamson’s framework, the governance of these transactions in the presence of asset specificity is critical to minimizing costs because, with bounded rationality, the participation of particular parties in transactions creates the possibility for opportunistic behaviour. Bounded rationality means that the economic actor cannot foresee future “disturbances”, while opportunism means that other parties to the transactions will deliberately take advantage of these disturbances to promote their own self-interests. Non-market transaction relations exist, therefore, because of asset specificity, and, in the presence of bounded rationality and opportunism, the optimal governance of these relations must seek to minimize transaction costs. According to Williamson:


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“Transactions, which differ in their attributes, are assigned to governance structures, which differ in their organizational costs and competencies, so as to effect a discriminating (mainly transaction cost economizing) match” (Williamson 1985, 387-8). Specifically, he hypothesizes that “market contracting gives way to bilateral contracting, which in turn is supplanted by unified contracting (internal organization) as asset specificity progressively deepens” (Williamson 1985, 60, 79, 151, 204). But, when confronted with asset specificity, opportunism, bounded rationality, why does internal organization outperform market contracting? According to Williamson (1985, 60, 72-3), the economic virtues of internal organization lie in its relative ability to “work things out”:

Whenever assets are specific in nontrivial degree, increasing the degree of uncertainty makes it more imperative that the parties devise a machinery to “work things out” – since contractual gaps will be larger and the occasions for sequential adaptations will increase in number and importance as the degree of uncertainty increases.

These internal governance structures that “work things out” add to the fixed costs of internal organization, and thus require that these costs be spread over larger numbers of transactions (that presumably result in more units of revenue-generating output) to obtain lower unit governance costs (Williamson 1985, 60, 72-3). As the frequency of transactions organized by a particular governance structure increases, economies of “scale” and “scope” appear. But these economies are not the result of spreading out the costs of indivisible technology and/or the fixed entrepreneurial factor as the post-Marshallian economists assumed. Rather, in the face of opportunism and bounded rationality Williamson contends that these economies of scale and scope are the result of economizing on the combined costs of asset-specific investments and the governance structures to “work things out”. The main virtue of Williamson’s transaction-cost theory of the firm is that, in contrast to the conventional theory of the firm, he focuses on relationships among people who have specified cognitive and behavioural characteristics. The main problem with his theory is that he employs constrained-optimization methodology to analyze the organizational and performance implications of bounded rationality, opportunism, and asset specificity. That is, Williamson takes these cognitive, behavioural, and technological conditions as given, and asks how those who control corporate resources optimize subject to these conditions as constraints. Hence Williamson’s perspective contains no theory of innovative strategy -- that is, a strategy for confronting and transforming these constraining conditions (see Lazonick 1991, chs. 6-7). Indeed, Williamson specifically denies the importance of strategic corporate behaviour in the evolution of the U.S. economy in the twentieth century (to which his transaction-cost analysis purportedly applies) -- and in any case views corporate strategy as inherently predatory behaviour.12 12 To quote Williamson: “Suffice it to observe here that strategic behavior has relevance in

dominant firm or tightly oligopolistic industries. Since most of the organizational change reported [here] occurred in nondominant firm industries, appeal to strategic considerations is obviously of limited assistance in explaining the reorganization of American industry over the past 150 years” (Williamson 1985, 128). This despite numerous references by Williamson’s to Alfred Chandler’s The Visible Hand (1977). For Williamson, strategic behavior represents predatory attempts by corporations that already have dominant market power to bankrupt existing rivals and create barriers to entry against potential competitors. (Williamson 1985, 373 376-80). In his words, “Strategic behavior has reference to efforts by dominant firms to take up and maintain advance or preemptive positions and/or to respond punitively to rivals” (Williamson 1985, 128, 373).


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Despite his invocation of “asset specificity” as a central theoretical concept, Williamson’s analysis does not address the issue of how productive resources are developed within an enterprise. As Williamson (1985, 143) recognizes explicitly:

The introduction of innovation plainly complicates the earlier-described assignment of transactions to markets and hierarchies based entirely on an examination of their asset specificity qualities. Indeed, the study of economic organization in a regime of rapid innovation poses much more difficult issues than those addressed here.

So they do. By portraying corporate strategy as solely predatory behaviour and the organization of transactions by “hierarchies” as a second-best solution to their organization by markets, Williamson’s transaction-cost theory explains the modern corporate enterprise as a response to what economists call “market failure”. The cause of this market failure is “asset specificity” – a technological condition that is given to the firm. Also given to the firm in Williamson’s transaction-cost theory are bounded rationality and opportunism. Opportunism is inherent in “human nature as we know it” (Williamson 1985, 80), while bounded rationality is given by the limited capacity of individuals to absorb information. From the Williamsonian perspective, markets create “high-powered” incentives for participants in the economy because the returns that participants can reap from the application of their efforts are not constrained by the need to share these returns with any other participants on a continuing basis (Williamson 1985, 132). The modern business corporation, in contrast, offers only “low-powered incentives”, as exemplified by the payment of salaries that segment remuneration from productive effort (Williamson 1985, 144-5). In the presence of asset specificity, and given the inherent limits on cognitive competence and the inherent human pursuit of self-interest with guile, for the Williamsonian firm “to work things out” means to optimize subject to these technological, cognitive, and behavioural constraints. In sharp contrast, for a theory of the innovative enterprise, “to work things out” is about how, through an investment strategy and an organizational structure, the enterprise transforms these technological, market, cognitive, and behavioural conditions so that they support the generation of higher quality, lower cost products. From this perspective, the modern corporation can be viewed as a manifestation of “organizational success" rather than as a response to “market failure”. Asset specificity" results from an enterprise investment strategy to develop and utilize productive resources. The challenge for the innovative enterprise is then to transform these investments in physical and human resources into higher quality, lower cost products than had previously been available. In our view, the critical determinant of the success of the innovative strategy is “organizational integration”: a set of social relations that provides participants in a complex division of labour with the incentives to cooperate in contributing their skills and efforts toward the achievement of common goals (Lazonick and O’Sullivan 1996, 1997c). From the perspective of the innovative enterprise, the essence of organizational integration is that, by making possible organizational learning, it transforms "bounded rationality" and "opportunism" so that the cognitive and behavioural characteristics of participants in the enterprise contribute to the innovation process. Organizational integration can transform “individual rationality” into “collective rationality” and thus unbounds the cognitive abilities available to the enterprise. Organizational integration can transform opportunism, and indeed transform “human nature as [Oliver Williamson] know[s] it”, by both generating and sharing the gains of the innovation process in ways that create “high-powered”


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incentives – employment security, career opportunities, collective purpose -- for the people on whom the enterprise relies to develop and utilize productive resources. The essence of the modern corporation as an innovative enterprise is that, through its investment strategy, it relies on “asset specificity” as a developmental source of competitive advantage, and that, through its organizational structure, it unbounds “rationality” and reduces “opportunism” -- or even transforms opportunists into cooperative members of a learning organization (see Figure 8). To analyze the modern corporation as a manifestation of organizational success rather than a response to market failure requires a methodology that integrates theory and history. Moreover, it is only when one has developed a viable explanation of the social foundations for organizational success in the modern corporation that one can begin to analyze how, within an existing business organization, success turns to failure. Organizational integration dissolves into organizational segmentation as participants in the enterprise, and particularly, one might argue, those at the top, become prisoners of bounded rationality, act opportunistically, and seek to use accumulated assets as if they were general sources of revenues rather than the historical accumulations of organizational learning that provide the indispensable foundations for sustained competitive advantage. 3.2.3 The dynamics of innovative enterprise Within economics, the seminal theoretical work for addressing these issues is Edith Penrose, The Theory of the Growth of the Firm (1959). Penrose argued that the modern corporate enterprise has to be viewed as an organization that administers a collection of human and physical resources. By far the most critical are human resources because they render services that can enable the firm to make unique contributions as a generator of higher quality, lower cost products. People contribute these unique labour services to the firm, not merely as individuals, but as members of teams who engage in learning about how to make best use of the firm’s productive resources – including their own. At any point in time, this learning endows the firm with experience that gives it productive opportunities that are unavailable to other firms, even in the same industry, that have not accumulated the same experience. The Penrosian firm is an innovative enterprise. As Michael Best has put it, “Penrose’s theory of the growth of the firm is based upon two assumptions: everything cannot happen at once, and a person cannot do everything alone” (Best 1990, 125, and, more generally, ch. 4; see also Best and Garnsey 1999; O’Sullivan 2000a, ch. 1). For Penrose (1995, chs. 5-7), the accumulation of developmental experience enables the firm to overcome the “managerial limit” that in the theory of the optimizing firm causes the onset of increasing costs and constrains the growth of the firm. This developmental experience enables the firm to transfer its existing productive resources to new productive opportunities and even to shape the market for its products to generate new market opportunities.13

13 In the Foreword to the 1995 edition of The Theory of the Growth of the Firm (p. xii),

Penrose states that “the growing experience of management, its knowledge of the other resources of the firm and the potential for using them in different ways, create incentives for further expansion as the firm searches for ways of using the services of its own resources more profitably. The firm’s existing human resources provide both an inducement to expand and a limit to the rate of expansion. Even growth by acquisition and merger does not escape the constraints imposed by the necessity of using inputs from existing managerial resources to maintain the coherence of the organization.”


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Each move into a new product market enables the firm to utilize unused productive services but also requires investments in the creation of new productive services that are the basis for the continuing growth of the firm. These unused productive services can enable a firm to grow not only through diversification of its products but also through the acquisition and absorption of other firms that have developed complementary productive services. Key to the determination of which productive opportunities the firm pursues, and in the case of merger and acquisitions, which firm absorbs which, is the possession of what Penrose calls “entrepreneurial services” on the part of the growing firm (Penrose 1995, 182-9). But, in a growing enterprise, entrepreneurial services will not yield success if the productive resources under the firm’s control are not administered in an integrated way. Hence the critical importance to the growth of the firm of “managerial services” that engage in “administrative integration” (Penrose 1995, 189-94). Through this process of the growth of the firm, innovative capability becomes embedded in its very operations (Penrose 1995, 189-94). What enables the firm to grow over time is this continual ability of the enterprise to utilize its unique pool of resources to generate new products, developed in the past, while building on this existing pool of resources to generate new unique capabilities. “The proposition,” says Penrose, “that enterprising firms have a continuous incentive to expand and that there is no limit to their absolute size (other than that imposed by our conception of the nature of an industrial firm) stands in sharp contrast to the notion of an ‘optimum’ size of firm” (Penrose 1995, 88). How then can one characterize the economies that result when the “enterprising firm” is able to utilize the productive resources that it has developed? Penrose makes a distinction between “economies of size” and “economies of growth”, arguing that “growth is a process; size is a state”. “Economies of size,” Penrose (1995, 89) argues,

are present when a larger firm, because of its size alone, can not only produce and sell goods and services more efficiently than smaller firms but also can introduce larger quantities of new products more efficiently. In discussion of the economies of size, so-called ‘technological economies’, derived from producing large amounts of given products in large plants, are commonly distinguished from ‘managerial’ and ‘financial’ economies, derived from improved managerial division of labour and from reductions in unit costs made possible when purchases, sales, and financial transactions can be made on a large scale.

After a discussion of these different types of “economies of size” and their interaction, Penrose makes it clear that, once one recognizes that firms can differ in their managerial capabilities, it is futile to attempt to specify the “optimum” size of the firm, without reference to these particular capabilities. “Only for firms incapable of adapting their managerial structure to the requirements of larger operations,” she argues, “can one postulate an optimum size” (Penrose, 1995, 98). In other words, a unique “optimum” only applies to those firms that, because of inferior managerial capabilities, must take as constraints the technological and market conditions that other enterprises, with superior managerial capabilities, are able to transform. For such an enterprise with superior managerial capabilities, and hence the potential to continue to grow, “the economies of growth” that it can reap depend on a unique process that evolves over time. Hence the outcome of this process – an eventual “optimal” state that derives from the process of growth -- cannot be known before the productive resources that can generate this growth have been developed and utilized. As Penrose (1995, 99) puts it:


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Economies of growth are internal economies available to an individual firm which make expansion profitable in particular directions. They are derived from the unique collection of productive services available to it, and create for that firm a differential advantage over other firms in putting on the market new products or increased quantities of old products. At any time, the availability of such economies is the result of the process [discussed earlier in the book] by which unused productive services are continually created within the firm.

Penrose adds that economies of growth “may or may not be also economies of size” because “under given circumstances, a particular firm may be able to put additional output on the market at a lower average cost than any other firm, whether larger or smaller”. “For one of the significant characteristics of the economies of growth,” she goes on to explain, “is that they depend on a particular collection of productive resources possessed by the particular firm, and the exploitation of the opportunities provided by these resources may be quite unrelated to the size of the firm”. (Penrose 1995, 99-100) The main methodological strength of Penrose’s work is her explicit recognition of the theoretical difference between the innovative enterprise and the optimizing firm. The basis for this distinction is her understanding that a firm is a unique social entity that can engage in learning that is both collective and cumulative (O'Sullivan 1996, ch. 1). She also emphasized the dynamic relation between the development of productive resources and their utilization, and hence between the achievement of high quality and low cost. She understood, therefore, that innovative strategies could place the enterprise at a competitive disadvantage if the productive resources that the enterprise develops are not sufficiently utilized. Compared with the neoclassical theory of the firm, the main theoretical strength of Penrose’s work is that she placed organizational learning at the center of the analysis. She equated the “firm” with its managerial organization, and organizational learning with managerial learning.14 Penrose's perspective on the enterprise as managerial organization represents an important advance on economic theories of the firm in which social organization plays no role. Typically, in such theories, the “firm” is assumed to be either a solitary actor -- the individual “entrepreneur” -- or a unified entity with no attention paid to the motivations of the different participants in the enterprise and the types of incentives to which they respond. Moreover, Penrose’s emphasis on managerial organization as defining the boundaries of organizational learning in the modern corporation reflected a reality of the U.S. industrial enterprises that she studied in the mid-twentieth century. In comparative and historical perspective, however, the main weakness of the Penrosian "theory of the growth of the firm" for building a theory of innovative enterprise is its implicit assumption that organizational learning means managerial learning (see Lazonick forthcoming). Such a perspective has difficulty explaining, for example, why most Japanese and many European enterprises in the post-World War II decades extended organizational learning to shop-floor workers and independent suppliers, and how this development and utilization of broader and deeper skill bases

14 As Penrose puts it in the Foreword to the 1995 edition of her book: “I elected to deal with

what was called the ‘managerial firm’ – a firm run by a management assumed to be committed to the long-run interest of the firm, the function of shareholders being simply to ensure the supply of equity capital. Dividends need only be sufficient to induce investment in the firm’s shares.” (Penrose 1995, xii).


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affected international competitive advantage and national economic performance (Lazonick and O’Sullivan 1996; 1998). Even at the managerial level, Penrose's theory of the growth of the firm lacks a theory of the organizational -- strategic, functional, and hierarchical -- integration of administrative, technical, and professional personnel into the managerial structure of the modern corporation. As a result her perspective is ill-equipped to comprehend the erosion of cohesive managerial organization in major U.S. industrial corporations that occurred in the 1980s and 1990s. The characteristic feature of this managerial "downsizing" is that the services of once-valued “human assets” are thrown on the market rather than being mobilized for the further growth of the firm, or even for the strategic creation of “spin-off” firms. Penrose assumes throughout her book that the modern industrial corporation will always try to utilize the unused productive resources at its disposal. But she also understands that to make use of these available productive resources to enter new markets means investing in new, complementary, productive resources, including reinvestment in the productive capabilities of current personnel. But, as the experience of many U.S. corporations over the past few decades has shown, internal growth may reach a point where diseconomies of growth outweigh economies, either because of a separation of strategic decision making from organizational learning or the emergence of new competitors with superior organizational capabilities (O’Sullivan 2000a, ch. 5). Penrose equates the profit motive and the growth motive in determining the investment strategy of the firm (Penrose 1995, 26-30). But this equation only holds if those who control the allocation of corporate resources cannot or will not seek higher returns for the “firm” – now defined as those who remain in the enterprise’s employment, including themselves -- by shedding “unused productive resources” – that is, those “human assets” whose services are no longer valued. As Penrose recognizes in the Foreword to the 1995 edition of her book, writing in the late 1950s, one had yet to witness the advent in the United States of the conglomeration movement of the 1960s, the subsequent divestments of the 1970s, the rise of the market for corporate control under the slogan of “creating shareholder value” in the 1980s, and the consolidation of the practice of running companies to “maximize shareholder value” in the 1990s (Lazonick and O’Sullivan 2000). It may be that many of these practices have reflected a tendency for U.S. industrial corporations to favour competitive strategies that are “optimizing”, or more realistically “adaptive”, (Lazonick 1991, ch. 3) as opposed to those that are innovative. Rather than confront new industrial, organizational, and institutional conditions by engaging in strategies to transform them, those who control corporate resources see it as in their interests to view these conditions as constraints, and consequently are content to “optimize” subject to them. What is optimal for those who control corporate resources may not be optimal for other people associated with the corporation or for the economy as a whole – thus raising the question of the relation between corporate strategy and the development of the economy, a central issue that a theory of innovative enterprise must address. In The Theory of the Growth of the Firm, Penrose sought to deal with this issue in the last two chapters of her book on “large and small firms” and “industrial concentration” -- traditional foci of industrial-organization economists working within the constrained-optimization approach. In doing so, Penrose shifted her analytical focus from “the growth of the firm” to the “size of the firm”. But once one recognizes that the “firm” is not a unified entity that bears costs and receives benefits as if it were an individual, the concern with “big versus small” loses much of its analytical meaning for assessing the relation between corporate resource allocation and the development of the economy. Moreover, from the perspective of the enterprise itself, the issue is


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not whether a firm should "choose" to be bigger or smaller, but rather the organizational dynamics that permit it to develop and utilize resources, and hence to grow from being smaller or larger relative to the markets it serves. One way of addressing Penrose's problem of the growth of the firm is to ask how a small number of innovative enterprises transformed technology and markets were able to differentiate themselves from the optimizing, or what Lazonick (1991, ch. 3) calls “adaptive”, firms in the industry to gain sustained competitive advantage (see Figure 6). It is with the economic performance of such an innovative enterprise that the optimizing firm of neoclassical theory should be compared. To do so, the theory of innovative enterprise must have an analysis of the determinants of total fixed costs, and the relation between average fixed costs and average variable costs during the innovation process. The task for a theory of innovative enterprise is to explain how, by changing its cost structure, a particular enterprise can emerge as dominant in its industry. Unlike the optimizing firm, the innovative enterprise does not take as given the fixed costs of participating in an industry. Rather, given prevailing factor prices, the level of fixed costs that it incurs reflects its innovative strategy. This “fixed-cost” strategy is not dictated by indivisible technology or the “entrepreneur” as a fixed factor, but by the innovative enterprise’s assessment of the quality and quantity of productive resources in which it must invest to develop products that are higher quality and lower cost than those that it had previously been capable of producing and that (in its estimation) its competitors will be able to produce, given their investment strategies. It is this development of productive resources internal to the enterprise that creates the potential for an enterprise that pursues an innovative strategy to gain a sustained competitive advantage over its competitors and emerge as dominant in its industry. Such development, when successful, becomes embodied in products, processes, and people with superior productive capabilities than those that had previously existed. But even the generation of superior productive capabilities will not result in competitive advantage if the high fixed costs of the innovative strategy place the innovative enterprise at a cost disadvantage relative to less innovative competitors. An innovative strategy that enables the enterprise to generate superior productive capabilities may place that enterprise at a cost disadvantage because innovative strategies tend to entail higher fixed costs than the fixed costs incurred by rivals that optimize subject to given constraints. For a given level of factor prices, these higher fixed costs derive from the size and duration of the innovative investment strategy. Innovative strategies tend to entail higher fixed costs than those incurred by the optimizing firm because the innovation process tends to require the simultaneous development of productive resources across a broader and deeper range of integrated activities than those undertaken by the optimizing firm. Hence, at a point in time, the innovative enterprise must generally make a broader range of investments in fixed plant and equipment and a deeper range of investments in administrative organization than would have to be undertaken by the optimizing firm. But in addition to, and generally independent of, the size of the innovative investment strategy at a point in time, high fixed costs will be incurred because of the duration of time required to develop productive resources until they result in products that are sufficiently high quality and low cost to generate returns. If the size of investments in physical capital tends to increase the fixed costs of an innovative strategy, so too does the duration of the investment in an organization of people who can engage in the collective and cumulative – or organizational – learning. Such learning is the central characteristic of the innovation process.


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The high fixed costs of an innovative strategy create the need for the enterprise to attain a high level of utilization of the productive resources that it has developed. As in the neoclassical theory of the optimizing firm, given the productive capabilities that it has developed, the innovative enterprise may experience increasing costs because of the problem of maintaining the productivity of variable inputs as it employs larger quantities of these inputs in the production process. But rather than, as in the case of the optimizing firm, taking increasing costs as a given constraint, the innovative enterprise will attempt to transform its access to high-quality productive resources at high levels of output. To do so, it invests in the development of that productive resource, the utilization of which as a variable input has become a source of increasing costs. The development of the productive resource adds to the fixed costs of the innovative strategy, whereas previously this productive resource was utilized as a variable factor that could be purchased at the going factor price incrementally on the market as extra units of the input were needed to expand output. Having added to its fixed costs in order to overcome the constraint on enterprise expansion posed by increasing variable costs, the innovative enterprise is then under even more pressure to expand its share of the market in order to transform high fixed costs into low unit costs. As, through the development and utilization of productive resources, the enterprise succeeds in this transformation, it in effect “unbends” the U-shaped cost curve that the optimizing firm takes as given (see Figure 915). By shaping the cost curve in this way, the innovative enterprise creates the possibilities for gaining competitive advantage over its rivals. Hence the innovative enterprise is not constrained by market demand to produce at the profit-maximizing output where marginal cost equals marginal revenue because, over the long run, it is not subject to increasing costs. The innovative enterprise may be subject to increasing costs in the short run, but, by continually confronting and transforming those technological and market conditions that result in increasing costs, the innovative enterprise can generate high-quality products, the unit costs of which decline as it reaps larger and larger market shares. The innovative enterprise thus not only has differentiated itself from its competitors but also has gained a sustained competitive advantage that is reinforced as it expands its level of output. In contrast to the neoclassical monopoly model that posits that an optimizing monopolist will choose to produce at a smaller volume of output and at higher prices than the aggregate of optimizing competitive firms in a particular industry, the innovative enterprise becomes dominant by transforming the industry cost structure and producing at a larger volume of output that it can sell at lower prices than the optimizing firms in the industry. By confronting and transforming technological conditions rather than accepting them as constraints on its activities, the innovative enterprise, that is, can outperform the “optimizing” firm in terms of both output and cost. The ability of the innovative enterprise to achieve decreasing costs even as it produces larger volumes of output relative to the size of the industry’s market means that the neoclassical “optimizing” rule of marginal cost equals marginal revenue is irrelevant to its output and pricing decisions. Constraining its level of output at a point in time is typically the presence in the industry of a small number of other innovative enterprises that compete among themselves for market share. Given the cost structure that it has put in place, the innovative enterprise can seek to increase 15 For a fuller theoretical elaboration of this process of sustained innovative transformation,

see Lazonick (1991, ch. 3), and Lazonick (1993).


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its market share by offering buyers lower prices. But constraining such price reductions at a point in time is the need of the innovative enterprise to generate sufficient surplus revenues to reward its employees at levels above and beyond those that their labour services would fetch on the open labour market while investing in new technology, including the skills of workers, and building an organization to develop and utilize the new technology. Such investments can enable the enterprise to maintain or extend its competitive advantage in a given market or transfer some of its productive capabilities to produce output for another market that can make use of these capabilities. Insofar as the enterprise undertakes an innovative strategy in this diversification process, it will have to complement its existing capabilities with investment in, and development of, new capabilities, thus adding to the fixed costs that it must utilize to achieve low unit costs. The developmental impact of the innovative enterprise, therefore, manifests itself in a larger volume of output that it can, if is so chooses, make available to users at lower prices than the optimizing firm. The fear of the “monopolistic” firm among neoclassical economists is that it will choose to raise prices and restrict output. But the innovative enterprise has an interest in lowering prices as part of a strategy to increase the extent of the market available to it, which in turn lowers unit costs further as the enterprise reaps economies of scale. Indeed, the innovative enterprise has the potential of not only outperforming the optimizing firm in terms of product quantity and price but also generating sufficient surplus revenues to pay higher wages to employees and higher returns to other stakeholders such as suppliers and stockholders. The innovation process, that is, can overcome the “constrained-optimization” trade-offs between consumption and production in the allocation of resources and between capital and labour in the allocation of returns. 4. The Organization of the Innovation Process 4.1 Innovative Allocation: Developmental, Organizational, Strategic The innovative enterprise gains sustained competitive advantage by transforming the technological and market conditions that it faces. The means by which it transforms these industrial conditions are organizational: the innovative enterprise mobilizes the skills and efforts of large numbers of people to participate in the innovation process over a sustained period of time. Specifically, the innovative enterprise allocates resources and returns to building "innovative skill bases": the productive capabilities that result when people with different functional capabilities and hierarchical responsibilities work cumulatively and collectively to engage in organizational learning. This organizational learning is not simply the sum of individual learning by participants in the enterprise's organizational structure. Rather this organizational learning is the result of the ongoing cumulative and collective interactions among participants in the enterprise's functional and hierarchical divisions of labour. If the innovation process can be characterized as cumulative and collective, it can also be characterized as uncertain. It is subject to technological uncertainty: the organizational learning that is the essence of innovation may not result in processes and products that are superior to those already available. It is also subject to market uncertainty: unforeseeable changes in product demand, factor prices, or the capabilities and strategies of competitors may thwart the generation of higher quality, lower cost products by an enterprise, even when it has succeeded in developing superior processes and products than those that were previously available.


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On the basis of the extensive body of theoretical and empirical research on the economics of innovation, the underlying resource allocation process can be characterized as one that is 1) developmental -- resources must be committed to irreversible investments with uncertain returns; 2) organizational -- returns are generated through the integration of human and physical resources; and 3) strategic -- resources are allocated to overcome market and technological conditions that other firms take as given. The stylized characterization of innovative resource allocation as developmental, organizational, and strategic on which we rely in the following discussion may be challenged on the basis of future theoretical and empirical research. Yet to the extent that it represents a summary of our current understanding of the innovation process, it is worthwhile considering its implications for a theory of corporate governance (the following material is drawn from O'Sullivan 2000b). That innovative resource allocation is a developmental process means that it involves irreversible commitments of resources for uncertain returns. By definition, underlying the innovation process is a learning process; if we already knew how to generate higher quality, lower cost products then the act of doing so would not require innovation. To commit resources to innovation means foregoing their exchange while the learning process is underway. What one learns changes how one conceives of the problem to be addressed, the possibilities for its solution, and the appropriate direction for further learning. The withdrawal of some of the learners or physical resources from the learning process before it is complete may endanger the success of the entire undertaking. The scale of innovative investment thus depends not only on the size of the investment in productive resources and the abilities and incentives of learners, but also on the duration of the investment necessary to sustain that process over the period during which learning occurs (Freeman 1974; Kline and Rosenberg 1986, 298-300; Teece 1986; Lazonick and O'Sullivan 1996; Freeman and Soete 1997, chs. 10 and 11). The returns to these developmental investments are highly uncertain and the investments that will result in the development of higher quality and/or lower cost products cannot be known in advance (Schumpeter 1996, 85). Given macro-economic conditions, an enterprise that attempts to innovate confronts two types of uncertainty: technological uncertainty and market uncertainty. Technological uncertainty exists because business enterprises that undertake innovative strategies have to develop the productive capabilities of the resources in which they have invested before these resources can generate returns. The learning process may not be successful. Market uncertainty exists because even when a business enterprise is successful in generating a product that is higher quality and/ or lower cost than it had previously been capable of producing, it may not gain competitive advantage and generate returns because a competitor, pursuing an alternative approach to innovation, is even more successful at doing so. The uncertainty inherent in the innovation process unfolds over time. Kline and Rosenberg describe the innovation process as follows:

When one does innovation… [o]ne starts with problem A. It looks initially as if solving problem A will get the job done. But when one finds a solution for A, it is only to discover that problem B lies hidden behind A. Moreover, behind B lies C, and so on. In many innovation projects, one must solve an unknown number of problems each only a step toward the final workable design -- each only a shoulder that blocks the view of further ascent. The true summit, the end of the task, when the device meets all the specified criteria, is seldom visible long in advance. (Kline and Rosenberg 1986, 297-8)


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From this perspective, the future state of the world cannot be defined until it is discovered through the process of innovation (Rosenberg 1994, 53-4). Thus, a failure to generate returns at any point in time may be a manifestation not of a failed innovative strategy, but of the need to commit even more resources to an ongoing learning process. A central finding of the literature on innovation is that the learning that generates higher quality and/or lower cost products occurs through a process that is organizational. The way work is organized -- how it is divided and integrated -- within an economy shapes the extent to which, and the manner in which, knowledge is generated. Learning is influenced by what a person does -- his experience -- as well as the creativity with which that experience is shaped through the specification of the problems that he attempts to solve. How work is divided influences the scope that individuals have to learn because it shapes what they do and the autonomy they have in doing it. How work is integrated shapes the way in which people interact in the performance of their work and the working relationships that they establish with each other. The organization of work thus shapes the opportunities for the transmission and transformation of knowledge in a process of collective learning (Maurice, Sellier, and Silvestre 1986; Lane 1989; Clark and Fujimoto 1991; Jorde and Teece 1990; Best 1990; Lazonick 1991; Lundvall 1992; Funk 1992; Susman 1992; Penrose 1995; Nonaka and Takeuchi 1995; Edquist 1997). What distinguishes collective learning from individual learning are the ways in which learning by individuals in the collective process is affected by the concomitant learning of others and integrated as new, collective, knowledge. The vitality of a collective learning process is critically dependent on the creativity and experience of the individuals who participate in it. But through their integration into a process of collective learning, individual learners have possibilities for learning that are not available to outsiders to that process. Relations among people open up new opportunities for learning beyond the individual’s direct experience of work and personal creativity. These social relations permit the transmission of the knowledge of individual learners -- their creativity and experience -- but also its transformation through the conveyor’s interaction with the learning of another. Knowledge is thus shared and transformed through collective learning.

When collective learning is based on and embedded in the social relations among its participants, it is neither reducible to the knowledge of the individuals or insiders that generated it nor easily replicable by other collectivities. Through their participation in a collective process of learning the insiders acquire knowledge that is specific to the social process that generates it. As Edith Penrose described collective learning in the managerial structure in her book The Theory of the Growth of the Firm:

Much of the experience of businessmen is frequently so closely associated with a particular set of external circumstances that a large part of a man’s most valuable services may be available only under these circumstances. A man whose past productive activity has been spent within a particular firm, for example, can, because of his intimate knowledge of the resources, structure, history, operations, and personnel of the firm render services to that firm which he could give to no other firm without acquiring additional experience. (Penrose 1995, 54)

Therefore, to the extent that an enterprise successfully innovates -- generates new knowledge through learning that allows it to deliver products to customers at prices that they are willing to pay -- it can build and sustain a competitive advantage. Rivals


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cannot secure the same level of productivity from resources as can the advantaged organization unless they replicate or surpass the capabilities that it has developed. Nor can rivals, without equivalent productivity, afford to reward these resources to the same extent (Penrose 1995; Lazonick and O'Sullivan, 1996; Teece, Pisano, and Shuen 1997, 524-6).

To the extent that they successfully learn to innovate, business organizations can thus develop integrated structures of abilities and incentives for their participants that cannot be replicated through the market coordination of economic activity. If a competing organization commits resources to replicating the advantages that the incumbent has already accumulated -- a time-consuming and expensive process -- it will not secure privileged access to specific organizational knowledge. To innovate, the competitor must shape a process of organizational learning that renders obsolete, as a basis for competition, the incumbent’s cumulative history of collective learning. One can certainly find examples of innovative strategies that engender radical shifts in product and/or process technologies and render outmoded the previous learning trajectory in that industry. These shifts are, however, rare and are seldom attributable to the efforts of a single enterprise.12

That the process of resource allocation is organizational means that there is substantial ambiguity in the relationship between innovative investments and returns. Firstly, given the collective nature of the innovation process, it is not possible to closely link individual contributions to a joint outcome (Alchian and Demsetz 1972; Teece, Pisano, and Shuen 1997). Secondly, the cumulative dimension implies ambiguity in the relationship between investments and returns over time. If a return is generated in period 10 it will not be clear to what degree it is because of contributions made by participants in period 10, period 9, or even period 1. Strategic decisions are a creative response to existing conditions. There are no objective guidelines for making these decisions, or for resolving disputes, about the allocation of resources to the learning process. To strategically shape the organization of work in an innovative way requires the visualization of a range of potentialities that were previously hidden and that are now believed to be accessible. Thus, innovative strategy is, in its essence, interpretative and therefore subjective, rather than "rational" and objective. In The Theory of Economic Development, Schumpeter described it in the following terms:

As military action must be taken in a given strategic position even if all the data potentially procurable are not available, so also in economic life action must be taken without working out all the details of what is to be done. Here the success of everything depends upon intuition, the capacity of seeing things in a way which afterwards proves to be true, even though it cannot be established at the moment, and of grasping the essential fact, discarding the unessential, even though one can give no account of the principles by which this is done. Thorough preparatory work, and special logical analysis, may under certain circumstances be sources of failure. (Schumpeter 1996, 85-6)

Innovative strategy involves more than one decision based on an interpretation of a particular set of conditions at a given point in time. It depends on a process of decision making that occurs as the uncertainty inherent in the innovation process unfolds over time. It is, as a consequence, experiential as well as interpretative. The basis for strategic decision making shifts as learning occurs through the process of innovating. The fruits of learning may, for example, render unattainable the solution that the learning process is designed to achieve and necessitate a restructuring and redirection of the learning process. By contrast, learning may make possible,


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through the discovery of new means, the attainment of ends that were previously considered impossible. Innovative resource allocation is strategic and, therefore, interpretative and experiential, so decision makers must have control of resources if they are to commit them to a developmental process in accordance with their evaluation of the problems and possibilities of alternative learning strategies. They also require control to keep resources committed to the innovative strategy until the learning process has generated the higher quality, lower cost products that enable the investment strategy to reap returns. Thus, inherent in the process of innovation, in the need to commit resources to undertake it and the uncertainty of returns from innovative investments, is a need for control of resources by the decision makers who shape the innovative process (Schumpeter 1996; Lazonick and O'Sullivan 1996). That the resource allocation process that shapes innovation is developmental, organizational, and strategic places requirements on the governance of corporations if they are to be innovative. Recent debates on corporate governance have largely ignored these requirements because the leading theories of corporate governance do not systematically integrate an analysis of the economics of innovation. Instead, as we have argued, they cling to a concept of resource allocation that is at variance with what we know about the allocation of resources in innovative enterprises. 4.2 Organizational Control and Innovation That the resource allocation process that generates innovation is developmental, organizational, and strategic implies that, at any point in time, a system of corporate governance supports innovation by generating three conditions – financial commitment, organizational integration, and strategic control – that, respectively, provide the institutional support for 1) the commitment of resources to irreversible investments with uncertain returns; 2) the integration of human and physical resources into an organizational process to develop and utilize technology; and 3) the vesting of control over strategic decision-making within corporations with those who have the incentives and abilities to allocate resources to innovative investments. In combination, financial commitment, organizational integration, and strategic control support organizational control in contrast to market control over the critical inputs to the innovation process: knowledge and money. One condition, financial commitment, is that institutions support the ongoing access of a business organization to the financial resources required to undertake and sustain the development and utilization of productive resources until such time that these resources can generate returns that provide the financial liquidity that allows the enterprise to survive. Financial commitment permits not only the strategic allocation of resources to organizational learning, but also the appropriation of product market revenues by the innovative enterprise. How these revenues are allocated, and in particular the extent to which the returns from successful innovative investments are strategically channeled into future innovative activities, is critical for sustaining a strategy of continuous innovation. Only through continued investment can the depreciation or obsolescence of existing productive resources – skills, knowledge and physical assets – be counterbalanced by the development of new skills and knowledge and physical resources in order to sustain the competitive advantage of the learning collectivity. Another condition, organizational integration, is that institutions support the incentives of participants in a complex division of labour to commit their skills and


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efforts to the pursuit of the goals of enterprises rather than selling their ‘human capital’ on the open market. To some extent the collective and cumulative character of the learning process constrains individuals to commit their skills to the investing organization. In addition, however, the prospects of sharing in the gains of successful innovation by the investing organization can lead even mobile participants to forego the lure of the market and remain committed to the pursuit of organizational goals. The final condition, strategic control, is that institutions vest control over the allocation of corporate resources and returns with decision makers who are integrated with the learning process that generates innovation. The integration of strategy and learning ensures that those who exercise control over the allocation of resources and returns have the abilities and incentives to make innovative investments. Strategists must be aware of what the learning process is generating if, in shaping or reshaping it, they are to take account of the opportunities for, and threats to, innovative success that learning reveals. When the basis for the generation and transmission of learning is an organizational process, strategic decision makers need to be integrated into the network of relations that underlies it; they must be insiders to the learning process to allow strategy and learning to interact in the process of innovation. When strategists are members of the learning collectivity, they can become privy to some of the knowledge that the collectivity generates, and can use it as a basis for organizing the work that members of the collectivity undertake. The integration of strategy and learning facilitates a developmental interaction of strategy and learning in which strategic decisions actively shape the direction and structure of learning and the knowledge continually generated through learning informs strategy.

The integration of strategic decision makers with the organizational learning process enhances not only the abilities of strategists to develop innovative investment strategies but also their incentives to do so because they see their own goals as being furthered through investment in a learning process that is both collective and cumulative. When strategists are insiders to the learning process that sustains innovation, the value of their learning is specific to the collectivity that generates it. The innovative success of that collectivity therefore enhances the strategists’ own success.

Organizational integration, financial commitment and strategic control represent social conditions that vary across nations. Reflected in the operation of a nation’s employment, financial, and regulatory institutions, these social conditions constitute norms according to which a nation’s business enterprises seek to make strategic decisions concerning the allocation of resources to the productive transformation in their enterprises and the allocation of returns from it. In previous work, we documented the emergence and evolution of different types of organizational control in the U.S., Germany, and Japan in considerable institutional detail and contrasted the experiences of these corporate economies with that of the British corporate economy where market control has had the upper hand for most of the twentieth century (Lazonick and O’Sullivan 1996; O’Sullivan 1996; Lazonick and O’Sullivan 1997a and 1997b). Without governance institutions that support organizational integration, financial commitment and strategic control, or more precisely, without the organizational control over knowledge and money that these conditions support, business enterprises cannot generate innovation through strategic investment in collective learning processes. That organizational control is supported by a system of corporate governance does not imply, however, that innovation will in fact occur.


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Firstly, at any point in time, the organizational and financial requirements of innovative investment strategies, and the learning processes that they shape, vary across industrial activities. For example, in industries, such as pharmaceuticals, in which value-added comes mainly from research, design, and marketing, investments in narrow and concentrated skill bases of scientists, engineers, and patent lawyers form the basis of successful corporate performance. In other industries, such as automobiles, value-added is dependent to a greater extent on manufacturing processes and, at least since the Japanese competitive challenge, the leading auto companies have had to make investments that integrate shop-floor workers in organizational learning processes to maintain their competitive positions. Such differences in the content of innovation across industrial activities mean that certain types of organizational control that promote innovation in one activity may fail to support, and even constrain, innovative capability in other activities that depend on different types of learning processes. Thus, one would expect to see, as the empirical evidence suggests, substantial variations in innovative capability across industries when we hold institutional conditions constant.

Secondly, the relationship between a system of corporate governance and innovation is complicated by the change inherent in the innovation process. Innovation is defined relative to the competitive environment in which it occurs. Whether certain products are considered higher quality and lower cost, and hence innovative, depends on the quality and cost of competitive offerings. To the extent that the competitive environment evolves to generate more powerful strategies and learning processes, social conditions that supported the generation of higher quality and/or lower cost products in an earlier era in a particular industrial activity may prove unsuitable as a basis for further innovation in that activity. Particularly when competitive challenges come from foreign enterprises that develop and utilize productive resources with the support of different social institutions, existing governance institutions may act as a barrier to competitive responses by supporting claims to resources by stakeholders whose contributions to the economy no longer generate returns.

Since the organizational and financial requirements of innovation vary across industrial activities, as well as with the emergence of new competitive challenges over time, we should not expect that governance institutions that supported innovation in one activity and era will be an appropriate basis for the generation of higher quality, lower cost products in another activity and era. Particular types of organizational integration, financial commitment, and strategic control may, once instituted, either promote or constrain innovative business enterprise depending on the industrial activity and the competitive environment.

Finally, the institutions of governance are themselves subject to change. Institutional change may be a response to social pressures that are not related to the dynamics of the innovation process. Institutional transformation may also occur in response to competitive challenges from enterprises embedded in different systems of corporate governance. It may be politically initiated or prompted by a concerted corporate response to these challenges. Once corporate enterprises conform to existing types of organizational integration, financial commitment, and strategic control, it will be very difficult for them to overcome these conditions to the extent that they become a constraint on innovation. But when competitive challenges are sufficiently threatening that they call into question the very survival of an enterprise, and/or when a particular enterprise has a unique organizational history that gives their strategists incentives and abilities that distinguish them from decision makers in other firms, those who control corporate enterprises may be willing to exert the substantial effort


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required to reshape institutionalized practices. There is, of course, no assurance that insiders, who have benefited from an existing system of organizational control, will be motivated to reshape governance institutions in ways that revitalize the innovation process. To the contrary, they may well have incentives to promote change that protects their interests but that are inimical to meeting the new competitive challenges. 5. Organizational Learning and Innovation 5.1 Individual Learning and Organizational Learning An organization is made up of individuals, all of whom, through formal training and informal interactions, learn how to do their jobs within a specialized division of labour. The functional division of labour means that different people within an organization have specialized knowledge about different phenomena. The hierarchical division of labour means that some people coordinate the work of others. Individual learning may be simple and repetitive, or it may be complex and creative. The individual may focus on a narrowly defined task in a narrowly defined job over the course of his or her working life. Or the individual may engage in a variety of tasks in a variety of jobs at different hierarchical levels or functional specializations within an organization. Individuals may spend their entire working lives working for one organization. Or they may be mobile across organizations. A key question for understanding the organizational conditions for innovation is how the individual learning of large numbers of participants engaged in the hierarchical and functional divisions of labour within an enterprise contributes to the process of organizational learning both within that enterprise and across enterprises that are seeking to transform the same technological and market conditions. The functional and hierarchical divisions of labour that one observes in any given organization at any point in time may be the result of many other factors besides an organizational strategy to generate organizational learning. National institutions related to employment and finance affect the organization of work within enterprises, resulting in distinct differences in the prevailing divisions of labour within enterprises in any particular industry across the advanced economies (see Figures 10-13 based on 1996; see also Jürgens et al. 1993; Lazonick and O’Sullivan 1997a, 1997b, 1997c; Freyssenet et al. 1998; Jürgens 2000). Moreover, within a given regional or national industry, enterprise divisions of labour that were put in place in the past to implement an innovative strategy may at a later date reflect the capabilities and interests of incumbents rather than an organizational structure that promotes organizational learning in the present. Attempts by the enterprise to pursue an innovative strategy that requires the transformation of these organizational conditions may be undermined by factions within the enterprise’s prevailing division of labour who have neither the ability nor incentive to cooperate in this transformation. As we shall discuss below, within a business organization such groups may engage in “factional” learning that blocks or hinders organizational learning. The problem of transforming individual learning into organizational learning is thus a problem of creating structures that encourage collective learning. In addition, like individual learning, organizational learning is a cumulative process, but with the difference that the individuals who learn within an organization can come and go. As Bo Hedberg (1981, 6) has argued:

although organizational learning occurs through individuals, it would be a mistake to conclude that organizational learning is nothing but the cumulative


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result of their members’ learning. Organizations do not have brains, but they have cognitive systems and memories. As individuals develop their personalities, personal habits, and beliefs over time, organizations develop world views and ideologies. Members come and go, and leadership changes, but organizations’ memories preserve certain behaviors, mental maps, norms, and values.

To argue by analogy is not, however, to provide a perspective on how the transformation from individual learning to organizational learning occurs, or whether the organizational “memories, mental maps, norms, and values” are promoting behaviour that results in organizational learning. In our view, the analysis of the transformation of individual learning into organizational learning must be rooted in an analysis of the organizational integration of the learning by individuals within an enterprise’s functional and hierarchical division of labour. As we have seen, organizational integration entails social relations that create incentives for large numbers of people to apply their skills and efforts to the pursuit of common goals. In the case of the innovative enterprise, those common goals must include the development and utilization of productive resources to generate higher quality, lower cost products. A central concept in the organizational learning literature is “tacit knowledge” -- knowledge that is only acquired through personal experience in a particular context and that is difficult to codify or make explicit. The seminal work on “tacit knowledge” was done by Michael Polanyi (1962; 1983). According to Polanyi (1983, 6), tacit knowledge is “the outcome of an active shaping of experience performed in the pursuit of knowledge.” It is the tacit dimension of individual learning that makes both knowledge itself unique to each person: it entails not only knowing what, but also knowing how. As a result, according to Polanyi (1962, 4), as individuals, “we know more than we can tell”. The tacit dimension, therefore, could pose a problem for the sharing of knowledge, be it in an enterprise or a society. As indicated by the title of his book, however, Polanyi was interested, in the acquisition of “personal knowledge”, particularly by scientists working as independent individuals to create knowledge. For Polanyi (1962, 29), the tacit dimension of personal knowledge was the creative component in the individual learning process:

The things that we know in this tacit way include the identification of critical problems, hunches about their solutions, skill in performing certain activities and mental processes, the use of tools, as well as more primitive knowledge of external objects perceived by our senses….[I]nto every act of knowing there enters a passionate contribution of the person knowing what is being known, and…this coefficient is no mere imperfection but a vital component of that knowledge.

If Polanyi himself did not use tacit knowledge for understanding organizational learning or even how individuals within organizations learn, Richard Nelson and Sidney Winter (1982) transformed Polanyi’s notion of tacit knowledge into the foundation for “an evolutionary theory of economic change”. For Nelson and Winter, tacit knowledge as embodied in organizational “routines” is a rationale for the existence and persistence of the firm as an entity, endowed with “organizational capabilities” that could be central to the process of economic change. Drawing on Herbert Simon’s notion of bounded rationality, Nelson and Winter (1982, 73) argue that an organizational capability cannot be captured in “blueprints”, or explicit knowledge, but is tacitly understood by participants in the organization as decision-making routines that become habits or rules of thumb. These routines, which become embedded in the organizational memory, provide “a smooth sequence of


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coordinated behavior that is ordinarily effective relative to its objectives, given the context in which it normally occurs” (Nelson and Winter 1982, 73). As Nelson (1996, 111) has put it in a more recent essay entitled, “Why Do Firms Differ, and How Does It Matter”:

Winter and I have proposed that well-working firms can be understood in terms of a hierarchy of practiced organizational routines, which defined lower-order organizational skills, and how these are coordinated, and higher-order decision procedures for choosing what is to be done at lower levels. The notion of a hierarchy of organizational routines is the key building block under our concept of core organizational capabilities. At any time the practiced routines that are built into an organization define a set of things that the organization is capable of doing confidently. If the lower-order routines are not there for doing various tasks, or if they are but there is no practiced higher-order routine for invoking them in the particular combination needed to accomplish a particular job, then the capability to do that job lies outside the organization’s extant core capabilities.

From a perspective that seeks to make the concept of “organizational capabilities” central to a theory of why certain firms persist as viable economic entities over a sustained period of time, there are many problems with this formulation. Firstly, it is not clear why and to what extent the practice of “routines” entails learning. Secondly, it is not clear how routines are integrated so that they reflect capabilities rather than disabilities of the organization. Thirdly, it is not clear how organizations change their routines when they are no longer economically viable. Indeed, the focus on routines in general is problematic for a theory of why organizations exist, let alone why organizations learn. Nelson and Winter take as given in their analysis the existence of the firm as an organization, making no attempt to explain how firms come into being or why they persist over long periods of time. If the activities that firms undertake can be routinized in the way that Nelson and Winter describe, it is not clear why an economy needs organizational capabilities to coordinate the development and utilization of productive resources. The coordination and combination of routinized activities – be they “lower-order” or “higher-order” – would seem to be a task for which markets are ideally suited (see O’Sullivan 1996, 42-5). One can, of course, impute organizational content to Nelson’s formulation of “well-working firms” being characterized by a “hierarchy of practiced organizational routines” by assuming that “higher-order routines” are those practiced by managers and “lower-order routines” are those practiced by workers. But other than the notion of a higher-order routine “invoking” a lower-order routine (when such routines exist) “in the particular combination needed to accomplish the job”, there is no indication of how individual capabilities are transformed into organizational capabilities. The fundamental problem is that, to understand how the specialization and integration of knowledge and skill can generate organizational learning, the Nelson-Winter model lacks any analysis that goes beyond the distinction between higher-order and lower-order routines. Our contention is that a systematic analysis of the organizational integration of the learning process must be at the core of an “organizational capabilities” perspective on economic change.16 Over the past two decades a number of “systems thinkers” have directly addressed the question of how individual learning can be transformed into organizational learning (see Flood 1999). The most well known work is that of Peter Senge, The Fifth Discipline (1990, see also Senge et al. 1994; Flood 1990, ch. 2), emanating 16 For an extended, but in the end unsatisfying, discussion of routines, see ** 199*. [ICC]


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from the MIT Center for Organizational Learning (Fulmer 1995; for the experiences of two top managers who were involved with Senge’s work at MIT, see Stata 1996; De Geus 1996, 1997). Senge’s approach to systems thinking adds a human dimension to the work on information-feedback (cybernetic) systems developed by his mentor, Jay Forrester (1961). Influenced as well by the work of Chris Argyris and Donald Schön (1978) on “double-loop learning” (see below), Senge’s approach entails five “disciplines” in the transformation of individual learning into a system of learning that enables an organization to be innovative – or as Senge puts it, “generative”. 1) personal mastery: Individual learning creates the potential for people who are

highly competent in their functional specializations to contribute to the organizational learning process.

2) mental models: Individuals conceptualize the work that they are doing and how they are going to do it, thus developing “personal visions” of their roles in the organization.

3) shared vision: The integration and in many cases, transformation of the mental models of individuals generate a common sense of purpose.

4) team learning: Discussion and dialogue align the ways in which individuals with a shared vision think and work.

5) systems thinking: An organizational language evolves that helps individuals deal with dynamic complexity within organizations by integrating their mental models and permitting shared vision and team learning.

Within Senge’s framework, “routines” are the enemy of the transformation of personal mastery into systems thinking. When mental models become routinized, individuals do not question why or how they are doing their work, thus creating barriers to organizational learning. As Argyris (1999, 54) has put it: “tacit knowledge is the primary basis for effective management and the basis for its deterioration.” Indeed, Argyris (1985; 1999, ch. 2) labels mental models that ultimately block the discussion and dialogue required for team learning “defensive routines”, and recognizes that such defensive routines can be “organizational” – or what might be called “factional” – as well as individual. Senge contrasts “adaptive learning” that relied on existing mental models with “generative learning”, which will require that the organization confront routinized mental models to achieve a “shared vision”. It is the organizational process that transforms the mental models of highly capable people into a shared vision that constitutes the critical feedback mechanism that permits team learning in Senge’s system. Ultimately "shared vision" ensures that "personal mastery" becomes integral to systems thinking. In the process, “systems thinking” itself is a result of “generative learning”. The feedback process that transforms mental models, and even the content of personal mastery, also transforms team learning and systems thinking. As Flood (1999, 24) has succinctly summarized the dynamics of this organizational process that shaped systems thinking at the MIT Center for Organizational Learning:

The core idea on which methods for shared vision are constructed is intensive dialogue between people involved and those affected by the dialogue. The process is developmental. This is the antithesis of visioning exclusively from the top of a management hierarchy. The Fifth Discipline Fieldbook [Senge et al. 1994] suggests how to move visioning from the top of the management hierarchy to widespread intensive dialogue – from “telling” to “co-creating”. Telling is where those at the top know what the vision should be and the organization is going to have to follow it. People do what they are told either because they think that those at the top believe that they


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know what the vision should be, or they simply believe that they have no other choice. There is little generative learning. Co-creating, on the other hand, is a widespread and collaborative process where a shared vision is built in a mood of generative learning.

Drawing on his work with Schön, Argyris (1999, 67-68) argues that “double-loop learning” – analogous to Senge’s “generative learning” – occurs when organizational learning entails a change in basic assumptions or “governing variables”. These governing variables “can be inferred, by observing the actions of individuals acting as agents for the organization, to drive and guide their actions.” “Single-loop learning” occurs when individuals in an organization identify a mismatch between intentions and outcomes, and take steps to correct it, but without changing the “governing values of the organization." In Argyris’s (1999, 69) words:

Single-loop learning is appropriate for the routine, repetitive issue – it helps get the everyday job done. Double-loop learning is more relevant for the complex, non-programmable issues – it assures that there will be another day in the future of the organization….Double-loop actions – the master programs – control the long-range effectiveness, and, hence, the ultimate destiny of the system.

Argyris (1999, 69-71) describes the problems that he and Schön confronted when they sought “to help individuals [in organizations] unfreeze the old in order to produce double-loop learning.” First, individuals may not be willing to change their “governing variables” because it would mean placing trust in, and making themselves vulnerable to, others in the organization whom they mistrust. Second individuals may be unaware of their own lack of skills; indeed, the state of being unaware “may actually be tacitly designed, largely automatic, and, hence, a highly skilled action”. Third, this lack of awareness may be “primarily related to some form of suppression, especially of feelings" that can only be overcome if individuals “alter reasoning processes”. And fourth, individuals may practice theories that are inconsistent with the values that they espouse, thus making it difficult for them to detect a “mismatch” when it occurs. In effect, they may find ways of rationalizing “errors” as normal outcomes that enable them to avoid questioning how their “routines” relate to organizational goals that they believe themselves to hold. There is a recognition, therefore, in some (but, as we shall see, by no means all) of the organizational learning literature that the transformation of individual learning into organizational learning is a dynamic and dialectical process, where individuals must continually be confronted with the limitations of their own particular capabilities, and, perhaps of more importance, their beliefs. In a word, the learning company is treated as a “social” organization. Yet, in reviewing this literature, what we find to be generally missing is a specification of the functional and hierarchical divisions of labour that exist within a company at a point in time, and the ways in which these interactions must be changed to yield innovation in a particular industrial activity, characterized by particular technological and market conditions. In other words, the insights of the organizational learning literature have rarely been brought to bear on how the transformation in the social organization of the learning process has enabled enterprises, or groups of enterprises, to generate innovation through the transformation of specific technological and market conditions. One result of this neglect is a tendency to think of the “learning organization” as residing at the top of the organizational hierarchy. Given that much of this literature has emanated from the United States in the 1980s and 1990s, it may well be that the focus on top management reflects the reality of a bias of US corporations toward


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investing in what we call “narrow and concentrated” skill bases of highly educated personnel in a limited range of functions rather than in broad and deep skill bases that have characterized investments in organizational learning in, for example, Japan (see the discussion below). The tendency of such an elitist view of organizational learning, even if it does reflect the reality of certain social environments, is to view the rest of the corporate labour force -- if they figure in the analysis at all -- as commodities that can be hired and fired as the derived demand for their services warrants. Among systems theorists, such a view of “the deployment of labor” was explicit in the work of Jay Forrester (1961, 239-245), but is implied in contemporary, human-oriented systems theories such as that of Senge by virtue of the omission of an analysis of the role of “labor” in the learning organization. As Geert Hofstede (1978: 453) put it: “As far back as 1953, Jonas (1953,11) signaled the tendency among cyberneticians to apply two kinds of doctrine – one to the people in their models, who are taken as robots, and another one to themselves….People usually dislike being taken as robot, and they will resist an organization built on such a double doctrine.” The danger is, of course, that, in practice, the elitist orientation will lead both academic analysts and business executives to assume, a priori, that companies cannot generate learning by investing in broader and deeper skill bases than those in which they are currently investing. Yet there may be many employees with long-term attachments and commitments to the business organization whose skills and efforts could contribute to an innovation process if resources were allocated to enhance their capabilities through inclusion in the organizational learning process and if returns were allocated to give them incentives to contribute to organizational goals. A failure, moreover, to include certain groups of employees in the learning process may, as the statement by Hofstede implies, place these employees in opposition to organizational goals, thus reinforcing top management’s bias toward treating these employees as outsiders to the organizational learning process. In certain companies in certain social environments, such “strategic biases” may exist. But given changes in technology and markets, and given the ability of the corporation to reorient its investment strategies toward activities that demand different types of skill bases, one should not accept that such biases reflect organizational realities that can not, or need not, be changed. As Charles Perrow (1967) put it over three decades ago, the comparative analysis of organizations must be based on the study of the technologies that organizations use and hence the work that they do. For understanding the social organization of the innovative enterprise, comparative analyses are needed because the organizational learning process that results in innovation is collective, cumulative, and uncertain. Hence, at any point in time, when investment decisions are being taken, there are no optimal solutions to the allocation of resources and returns to the innovation process. It is for this reason that, as we shall see, the orientation toward understanding successful corporate strategy that is closest to our perspective is one that emphasizes that it must be an emergent process that is embedded in the organization in which the learning process occurs (see Mintzberg et al. 1998). Most of the literature on organizational learning comes from organizational behaviour. As such, it rarely focuses on the transformation of industrial – technological and market – conditions to generate innovation. Fortunately there is a small but growing literature that comes mainly from technology and operations management that looks at the functional and (to a lesser extent) the hierarchical positions of those who interact in the development and utilization of productive resources in particular industries and in particular times and places. Some of this work is comparative, the most extensive of which has been done on enterprises


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within the automobile and electronics industries of the United States and Japan. Moreover there is a growing body of empirical research on the role of collective and cumulative learning across enterprises that are either horizontally or vertically related in the generation of innovation. In the two subsections that follow, we shall summarize some of this research with the objective of elaborating a theoretical perspective on the organizational dynamics of the innovation process. Given this analysis, we shall then turn to a body of empirical literature that recognizes the possibility that, depending upon who learns and toward what ends, learning and innovation may be in conflict with one another. 5.2 Functional and Hierarchical Integration Within the Firm At any point in time, the technological possibilities and organizational requirements of the innovation process vary markedly across industries in terms of the breadth and depth of the skill base in which the innovating enterprise must invest. In both Europe and the United States, it was the Japanese manufacturing challenge of the 1970s and 1980s that stimulated research into the role of organizational integration in the learning processes that result in industrial innovation. Especially during the 1980s there was a burgeoning English-language literature on Japanese manufacturing methods, much of it written by industrial engineers with considerable experience as employees of, or consultants to, manufacturing companies in Japan and the West. In addition, there has been a growing body of academic research on the subject, although it has tended to focus more on functional integration than on hierarchical integration, and much more on the US-Japanese comparison that on the Europe-Japanese or Europe-US comparison (but see Jürgens et al. 1993; Fujimoto et al. 1997; Freyssenet et al. 1998; Jürgens 2000). The main industrial focus has been on automobiles, consumer electronics, machine tools, and semiconductors – that is, the industries that have been central in the Japanese challenge to the West. A fundamental source of Japanese manufacturing success in competition with both the United States and the economies of Western Europe in these industries was a dynamic interaction between functional integration and hierarchical integration in the development and utilization of productive resources. The most well-known book on organizational learning in Japanese enterprises is Ikujiro Nonaka and Hirotaka Takeuchi's The Knowledge-Creating Company: How Japanese Companies Create the Dynamics of Innovation, published in 1995. Explicitly basing their arguments on the experiences of Japanese companies that became global leaders through innovation over the last few decades, Nonaka and Takeuchi recognize that tacit knowledge is personal knowledge that must be transformed into organizational knowledge to create value. They contend:

The explanation of how Japanese companies create new knowledge boils down to the conversion of tacit knowledge to explicit knowledge. Having an insight or a hunch that is highly personal is of little value to the company unless the individual can convert it into explicit knowledge, thus allowing it to be shared with others in the company. Japanese companies are especially good at realizing this exchange between tacit and explicit knowledge during the product development phase (Nonaka and Takeuchi 1995: 11).

In critiquing the "organizational learning" literature, Nonaka and Takeuchi (1995: 45) articulate the distinctive features of their own approach to knowledge creation.


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First, as seen in Senge (1990), organizational learning theories basically lack “the view that knowledge development constitutes learning”.17 Most of them are trapped in a behavioral concept of “stimulus-response”. Second, most of them still use the metaphor of individual learning (Weick 1991; Dodgson 1993). In the accumulation of over 20 years of studies, they have not developed a comprehensive view of what constitutes “organizational learning.” Third, there is widespread agreement that organizational learning is an adaptive change process that is influenced by past experience, focused on developing or modifying routines, and supported by organizational memory. As a result the theories fail to conceive an idea of knowledge creation. The fourth limitation is related to the concept of “double-loop learning” or “unlearning” (Hedberg 1981) as well as to a strong orientation toward organizational development…[I]t assumes that someone inside or outside an organization “objectively” knows the right time and method for putting double-loop learning into practice.

But, they continue, "from the vantage point of organizational knowledge creation, double-loop learning is not a special difficult task but a daily activity for the organization…[T]he capacity for double-loop learning is built into the knowledge-creating organization without the unrealistic assumption of the existence of a 'right answer'." The characterization of the innovation process as collective, cumulative, and uncertain means that there is no “right answer” to “organizational knowledge creation”. Hence the innovation process is dependent on the unfolding history of the organization that seeks to generate higher quality, lower cost products. How then to characterize the organization that creates knowledge? Nonaka and Takeuchi (1995, 48) are also critical of the "resource-based approach" to corporate strategy because it says little about how companies create capabilities and it assigns too much importance to the CEO or the top management team (we shall take up this theme later in this paper). Nonaka and Takeuchi (1995, 48-9) argue that in the well-known Harvard Business Review article by C. K. Prahalad and Gary Hamel (1990) on "the core competence of the corporation", the authors "assign the key role of identifying, developing, and managing competencies or capabilities to top management; the responsibilities of middle managers and front-line workers are not made clear in their approach." The theory of organizational knowledge creation that Nonaka and Takeuchi (1995, ch. 3) put forward focuses on the conversion of tacit knowledge, possessed by individuals, into explicit knowledge, possessed by knowledge-creating collectivities that can be groups within enterprises, enterprises themselves, or groups of enterprises. They stress that the conversion of tacit to explicit knowledge is a social process among individuals, while individuals build on a body of explicit knowledge in developing tacit knowledge. Thus, they argue that, within a collectivity, there is a dynamic interaction of the two types of knowledge that generates four different stages of knowledge conversion -- socialization, externalization, combination, and internalization -- that can build on one another in a cumulative manner. The interaction of different people with tacit knowledge socializes people to work together, sharing "mental models" and "technical skills" -- that is, “shared experience" more generally -- that remain within the realm of the tacit. It would seem that in the Nonaka and Takeuchi framework such socialization generates the "routines" that are central to the Nelson and Winter 17 The quote is from Weick (1991, 122).


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notion of organizational capability. But Nonaka and Takeuchi recognize that the sharing of tacit knowledge is a social process that is just the first stage in the knowledge-creation process that develops productive resources. The next stage, which Nonaka and Takeuchi (1995, 66) argue "holds the key to knowledge creation", is the conversion of tacit knowledge to explicit knowledge, a process that they label "externalization." This stage holds the key because it creates new knowledge that, having been made explicit, becomes independent of the particular actors on whose tacit knowledge the new explicit knowledge built. If, however, externalization were to be the last phase of the knowledge-creation process, the knowledge thus created would diffuse quickly in the economy, rendering the knowledge creating company an ephemeral phenomenon. The next two stages re-imbed this explicit knowledge in the enterprise, first through the combination of explicit knowledge into a system of knowledge, and then, more importantly, through the conversion of the explicit knowledge into tacit knowledge, so that individuals internalize the new system of knowledge through learning-by-doing. This organizational learning in turn generates more sophisticated and organizationally developed tacit knowledge than had existed at the outset. In a new round of what Nonaka and Takeuchi (1995, 71) call "the knowledge spiral", this more sophisticated tacit knowledge can be converted into more sophisticated explicit knowledge. Nonaka and Takeuchi (1995, ch. 5, especially 151-4) argue that the process entails a "middle-up-down" management process, and explicitly argue that a critical component of the "knowledge spiral" may occur through the hierarchical interaction of "knowledge practitioners", including front-line employees, and "knowledge engineers". But, in keeping with much of the recent literature on organization integration and innovation, their focus is on product development rather than process development, and as a result they neglect issues that concern the integration of production workers into the organizational learning process (see also the essays in Clark and Wheelwright 1995). In comparative perspective, however, a fundamental difference between the organizational learning process in Japan and the United States has been the inclusion of shop-floor workers in Japan and their exclusion in the United States. It is not by accident that the Nonaka-Takeuchi analysis, as insightful as it is on new product development and functional integration, ignores the ways in which Japanese manufacturers developed world-class processes in the post-World War II decades as a prelude to their advances in new product development in the 1970s, 1980s, and 1990s. In a comprehensive account of Japan’s manufacturing challenge, Kiyoshi Suzaki (1987), a former engineer at Toshiba who then turned to consulting in the United States, contrasts the operational and organizational characteristics of a “conventional” (traditional American) company and a “progressive” (innovative Japanese) company in the use of men, materials, and machines in the production process (see Table 2). In what follows, we draw on the comparative literature on organization integration in US and Japanese manufacturing, focusing on a) utilization of machines, b) utilization of materials, c) product quality, and d) factory automation. The purpose of this summary is to demonstrate the importance of a perspective on organizational learning that can analyze the roles of functional and hierarchical integration in the innovation process.

• Utilization of Machines

In the decade after the war, the Japanese pioneered in cellular manufacturing – the placement of a series of vertically-related machines in a U-shape so that a worker, or team of workers, can operate different kinds of machines to produce a completed


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unit of output. Used particularly for the production of components, cellular manufacturing requires that workers perform a variety of tasks, and hence that they be multi-skilled. The Japanese system differed from the linear production system used in the United States in which shop-floor workers specialized in particular tasks, passing the semi-finished unit from one specialized worker to the next. Historically, this fragmented division of labour resulted from the successful strategy of American managers in the late nineteenth century to develop and utilize mechanized technologies that could overcome their dependence on craft contractors who had previously controlled the organization of work. To better supervise the “semi-skilled” workers who operated the new mechanized technologies, American managers then sought to confine adversarial shop-floor workers to narrow tasks. After the rise of industrial unionism in the 1930s, shop-floor workers used these narrow job definitions as a foundation for wage-setting, thus institutionalizing this form of job control in collective bargaining arrangements. The prevalence of adversarial bargaining and job control only served to increase the resolve of most U.S. corporate managers to keep skill and initiative off the shop floor in the decades after World War II. Meanwhile, developing and utilizing the capabilities of the multi-skilled shop-floor worker in a myriad of ways, Japanese companies created new standards of quality and cost. This continuous improvement, which the Japanese called kaizen (Imai 1986), enabled Japanese companies to outcompete the Americans, even in their own home markets, even as Japanese wages rose and the yen strengthened in the 1980s and 1990s. With the need to use mass-production equipment to produce a variety of products in the 1950s, Japanese companies placed considerable emphasis on reducing setup times. Long setups meant excessive downtime, which meant lost output. Once set in motion, the search for improvements often continued over years and even decades. By the 1980s the extent of the market that Japanese manufacturers had captured meant that small-batch production was no longer the necessity it had been 30 years earlier. But the ability of these companies to do what the Japanese call “single-digit” (under ten minutes) setups enabled them to use the same production facilities to produce a wide variety of customized products. Single-digit setups had become a powerful source of competitive advantage. The reduction of setup times involved the redesign of fixtures, the standardization of components, and the reorganization of work. Shop-floor workers had to be willing and able to perform as much of the setup operations as possible for the next product batch while machines were producing the current product batch. The reorganization of work needed to reduce setups represented another productive activity that could take advantage of the incentive and ability of Japanese shop-floor workers to engage in a variety of tasks. The broader knowledge of the production process that these workers possessed was in turn used to find new ways to reduce setup times. In the United States, in contrast, the problem of reducing setup times was neglected in part because of long runs and in part because of the unwillingness of American management to invest in shop-floor skills. In Japan a dynamic learning process was set in motion in which the learning of shop-floor workers was critical. In the United States, hierarchical segmentation meant that, when the production of long runs of identical output was no longer a viable competitive strategy, corporations had not developed the skill bases required for reducing setup times.


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If shop-floor skills can prevent downtime through quick setups, they can do so as well through machine maintenance. Keeping machines trouble free requires the involvement of shop-floor workers in continuous inspection and daily maintenance as well as engineers to solve chronic problems and to train the shop-floor operatives (see Jürgens et al. 1993, ch. 5). As Suzaki (1987, 123) put it,

zero machine troubles can be achieved more effectively by involving operators in maintaining normal machine operating conditions, detecting abnormal machine conditions as early as possible, and developing countermeasures to regain normal machine conditions. This requires development of a close working relationship among operators, maintenance crews, and other support people as well as skill development and training to increase the abilities of those involved.

In American mass production, shop-floor workers have not only lacked the skills to maintain machines. They have also been denied the right to maintain machines by managers who feared that, far from reducing downtime by keeping machines trouble free, such shop-floor intervention would be used to slow the pace of work. Indeed one role of first-line supervisors employed on American mass-production lines has typically been to ensure that production workers do not interfere with machine operations on the assumption that such intervention will make the machines more trouble prone. Cellular manufacturing, quick setups, and machine maintenance all contribute to higher levels of machine utilization and lower unit costs. But ultimately unit costs are dependent on how quickly products can be transformed from purchased inputs into salable outputs. That is, unit costs depend on cycle time. As Jeffrey Funk (1992, 197) described it on the basis of his experience working at Mitsubishi Electric Corporation for a year: “The reductions in cycle time were achieved through numerous engineer and operator activities.”

The engineers were primarily responsible for making system-wide improvements concerned with identifying and resolving production bottlenecks, and with developing “product families” of different types of chips that undergo the same processes, thus reducing setup times and eliminating mistakes. The operators were primarily responsible for identifying possibilities for localized improvements on the wafer and assembly lines. Each operator was in a working group that met once or twice a month, through which they made numerous suggestions for improvements, a high proportion of which were acted upon by engineers. Operators responsible for wafer furnaces contributed, for example, to improvements in the delivery, queuing, and loading systems, all of which reduced cycle time. At Mitsubishi Electric between 1985 and 1989, cycle time for semiconductor chips was reduced from 72 days to 33 days, even as the number of chip styles more than doubled to 700 and the number of package types assembled increased from 20 to 70.

A comparison of the Mitsubishi wafer department with a US factory using similar equipment found that the Japanese factory produced four times the number of wafers per direct worker, employed fewer support workers per direct worker, had a higher ratio of output to input in the wafer process, and had a cycle time that was one-fourth of that achieved by the US factory. “These improvements,” according to Funk (1992, 198-204),


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lead to shorter cycle time, higher yields, less wafer breakage, and higher production of wafers per direct worker. The multifunctional workers enable Mitsubishi to have fewer support staff. Since the direct workers perform many of the activities typically performed by support staff in a U.S. factory, the direct workers can determine which activities are most important and how to improve the efficiency of these activities.

• Utilization of Materials

Perhaps the most famous Japanese management practice to emerge out of the “high growth era” was the just-in-time inventory system (JIT). By delivering components to be assembled as they are needed, the carrying costs and storage costs of work-in-progress can be dramatically reduced. But JIT only works if the parts that are delivered just in time are of consistently high quality. JIT only yields lower unit costs when component suppliers, be they in-house or external subcontractors, have the incentive and ability to deliver such high-quality parts. It was to ensure the timely delivery of such high-quality components, for example, that in 1949 and 1950 the first step taken by Taichi Ohno in developing JIT at Toyota was to reorganize the machine shop into manufacturing cells that required multi-skilled operatives (Wada 1995, 22). In the Japanese assembly process, JIT demands high levels of initiative and skill from production workers. Using the kanban system, it is up to assembly workers to send empty containers with the order cards – or kanban – to the upstream component supplier to generate a flow of parts. The assembly worker, therefore, exercises considerable minute-to-minute control over the flow of work – a delegation of authority that American factory managers deemed to be out of the question in the post-World War II decades on the assumption that shop-floor workers would use such control to slow the speed of the line. To prevent a purported shortage of components from “creating” a bottleneck in the production process, American managers kept large buffers of in-process inventory along the line. The Japanese assembly worker also has the right to stop the line when, because of part defects, machine breakdowns, or human incapacity, the flow of work cannot be maintained without sacrificing product quality. When a problem is discovered and a worker stops the line, a light goes on to indicate its location and others in the plant join the worker who stopped the line in finding a solution to the problem as quickly as possible. To participate in this process, therefore, shop-floor workers must develop the skills to identify problems that warrant a line stoppage, and they must contribute to fixing the problem. Without hierarchical integration, JIT and kanban cannot work (Urabe 1988).

• Product quality

The willingness of Japanese companies to develop the skills of shop-floor workers led to a very different mode of implementing quality control in Japan than in the United States. Statistical quality control (SQC), as already mentioned, originated in the United States. In American manufacturing, however, SQC remained solely a function of management, with quality-control specialists inspecting finished products after they came off the line. Defective products had to be scrapped or reworked, often at considerable expense. Defects that could not be detected because they were built into the product would ultimately reveal themselves to customers in the form of unreliable performance, again at considerable expense to the manufacturing company, especially when higher quality competitors came on the market.


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For American companies, from the 1970s the higher quality competitors were typically the Japanese. In Japan, the integration of shop-floor workers into the process of organizational learning meant that product quality could be monitored while work was in progress in the production process, and thus that defects could be detected and corrected before they became built into the finished product. The result was less scrap, less rework, and more revenues from satisfied customers. In the 1950s American managers could justify the exclusion of shop-floor workers from participation in quality control on the grounds that the SQC methods in use were too complicated for the blue-collar worker. Only more highly educated employees were deemed capable of applying these tools. Given the quality of education received by young Americans destined to be “semi-skilled” factory operatives, the managers of US companies had a point. With mass education being controlled and funded by local school districts, most future blue-collar workers received schooling of a quality that was consistent with the minimal intellectual requirements of repetitive and monotonous factory jobs. This correspondence between schooling and prospective skill requirements in hierarchically segmented workplaces helps to explain why to this day the United States ranks among the lowest of the advanced economies in terms of the quality of mass education and among the highest in terms of the quality of higher education. In Japan, even in the 1950s, blue-collar workers with manufacturing companies were high-school graduates. But as part of a national system of education of uniformly high standards, they received much the same quality education as those who would go on to university. Even then, the involvement of Japanese shop-floor workers in SQC was accomplished by making the methods more easily accessible to, and usable by, blue-collar workers. As Kaoru Ishikawa (1985, 18), the pioneer in the implementation of SQC in Japan, put it: “We overeducated people by giving them sophisticated methods where, at that stage, simple methods would have sufficed”. The reliance of Japanese companies on the skill and initiative of shop-floor workers for superior machine utilization and reductions in materials costs made these employees ideal monitors of product quality. Relying on this skill base, SQC became integral to the Japanese practice of building quality into the product rather than, as in the United States, using SQC to inspect completed products that had defects built in. In the 1960s the involvement of shop-floor workers in improving machine utilization, materials costs, and product quality became institutionalized in quality control (QC) circles. (Ishikawa 1985; Nonaka 1995). QC circles became extremely effective in generating continuous improvements in the quality and cost of Japanese manufactured products. In participating in the continuous improvement of these production systems, shop-floor workers did not solve problems in isolation from the rest of the organization but as part of a broader and deeper process of organizational learning that integrated the work of engineers and operatives. The foreman as team leader served as the conduit of information up and down the hierarchical structure. In reporting the work of this QC circle, the magazine, Quality Control for the Foreman, stated:

The supervisor may understand the design of the machine and how to run it, but is probably unaware of its detailed tendencies or weaknesses. The people who know best about the condition of the machine are the workers, and quality circles provide an opportunity to get important information from them (quoted in Nonaka 1995, 154).


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In solving problems in machine utilization, QC circles found that the solutions invariably entailed improvements in product quality as well. As Izumi Nonaka (1995, 151) has put it in his account of the history of quality control at Toyota and Nissan:

Toyota production methods, such as just-in-time, kanban, and jidoka (automation) are well known, but it should be stressed that, in relation to quality control, if 100 per cent of the parts reaching a given process are not defect free, Toyota methods will not work smoothly. In other words, quality is the foundation of Toyota production methods. From about 1963, just-in-time and jidoka were adopted in all Toyota factories, and a close relationship between these methods and quality was immediately established.

The QC circle movement focused Japanese workers on the goal of achieving “zero defects” – detecting and eliminating defects as the product was being built rather than permit defects to be built into the product. In recounting why an incipient zero defect (ZD) movement (initiated by the U.S. Department of Defense for its contractors) failed in the United States in the mid-1960s, Ishikawa put the blame squarely on the failure of American companies to integrate shop-floor workers into the process, as was being done in Japan. “The ZD movement became a mere movement of will,” Ishikawa (1985, 151-152) observed, “a movement without tools... It decreed that good products would follow if operation standards were closely followed.” In the Japanese quality control movement, however, it was recognized that “operation standards are never perfect.”

What operations standards lack, experience covers. In our QC circles we insist that the circle examine all operation standards, observe how they work, and amend them. The circle follows the new standards, examines them again, and repeats the process of amendment, observance, etc. As this process is repeated there will be an improvement in technology itself.

Not so, however, in the United States, where management practice “has been strongly influenced by the so-called Taylor method.” In the United States, according to Ishikawa (1985, 151-152),

engineers create work standards and specifications. Workers merely follow. The trouble with this approach is that the workers are regarded as machines. Their humanity is ignored. [Yet] all responsibilities for mistakes and defects were borne by the workers... No wonder the [ZD] movement went astray. During the 1980s, in the face of intense and growing competition from the

Japanese, many companies throughout the United States sought to introduce Japanese-style “quality programs” into their workplaces. In their comprehensive survey of available case studies of these “experiments in workplace innovation,” Eileen Appelbaum and Rose Batt (1994, 10) found that “U.S. companies have largely implemented innovations on a piecemeal basis and that most experiments do not add up to a coherent alternative to [traditional U.S.] mass production." They contended that

quality circles and other parallel structures [of work reorganization] were a ‘fad’ in the early 1980s and have since been discredited in most U.S. applications as either not sustainable or providing limited results... The overwhelming majority of cases show that firms have introduced modest changes in work organization, human resource practices, or industrial relations – parallel structures such as quality circles involving only a few employees, a training program, or a new compensation system. We consider


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these to be marginal changes because they do not change the work system or power structure in a fundamental way (Appelbaum and Batt 1994, 10; see also Kochan et al. 1984; Lawler et al. 1989; Cole 1989).

The fundamental problem, we would argue, was lack of resolve by those who governed these corporations to effect the organizational integration of “hourly” shop-floor workers and “salaried” managerial employees. What is more, it appears that hierarchical segmentation in U.S. industrial enterprises fostered functional segmentation. Distant from the realities of problem-solving in the actual production process, US technical specialists sought to solve problems by using the tools of their own particular disciplines, putting up barriers to communicating even with other specialists within the managerial organization, and throwing partially solved problems “over the wall” into the domains of other functional specialists (for cross-national studies of functional integration and segmentation, see Clark and Fujimoto 1991; Funk 1992; Okimoto and Nishi 1994; Westney 1994). In Japan, by contrast, the hierarchical integration of technical specialists in a learning process with production workers created lines of communication and incentives to solve problems in concert with other specialists. Relative to their competitors in the United States, the result of functional integration for Japanese manufacturers has been not only superior product quality but also more rapid new product development. The different ways in which quality control systems were implemented in Japan and the United States is a case in point. In Japan, QC was embedded in the whole structure of organizational learning. In Japan quality control is, as Izumi Nonaka (1995) has put it, “the responsibility of all employees, including top and middle management as well as lower-level workers, from planning and design, to production, marketing, and sales... [in] contrast with the American reliance on specialist quality control inspectors.” Ishikawa (1985, 23) has emphasized the functional segmentation of American QC inspectors:

In the United States and Western Europe, great emphasis is placed on professionalism and specialization. Matters relating to QC therefore become the exclusive preserve of QC specialists. When questions are raised concerning QC, people belonging to other divisions will not answer, they will simply refer the questions to those who handle QC. In Western countries, when a QC specialist enters a company, he is immediately put in the QC division. Eventually he becomes head of a subsection, a section, then of the QC division. This system is effective in nurturing a specialist, but from the point of view of the entire business organization, is more likely to produce a person of very limited vision. For better or for worse, in Japan little emphasis is placed on professionalism. When an engineer enters a company, he is rotated among different divisions, such as design, manufacturing, and QC. At times, some engineers are even placed in the marketing division.

• Factory Automation

In the late 1970s, American manufacturers continued to attribute the mounting Japanese challenge to low wages and the persistent productivity problem at home to worker alienation. By the 1980s and 1990s, however, the innovative reality of the Japanese challenge became difficult to ignore, as the Japanese increased their shares of US markets across a range of key industries, even as Japanese wage rates rapidly rose and the yen steadily strengthened.


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Even then, there appeared to be a way out for US manufacturers that did not require imitation of the Japanese by building broader and deeper skill bases. Since the 1950s American management had envisioned “the Factory of the Future” - a completely automated production facility that would do away with the need to employ production workers altogether (Noble 1984, ch. 4). Yet, notwithstanding massive investments by US corporations and the US government in factory automation, attempts by American companies to create the “factory of the future” failed (Noble 1984; Thomas 1994). In sharp contrast, building on their investments in broad and deep skill bases, and decades of continuous improvement of production processes, Japanese companies succeeded in factory automation. In 1995, the number of robots per 10,000 workers was only 21 in the UK, 33 in the United States, 69 in Germany, and 338, in Japan (Tidd, Bessant, and Pavitt 1997, 192; see also Jürgens et al. 1993, ch. 6). In part this vast difference can be explained by the concentration of Japanese industry in sectors in which robotics have been most heavily utilized and by the propensity of the Japanese to use simpler robots, although given the fact that the Japanese have led in the development of robotics more generally, it is difficult to distinguish between cause and effect. The Japanese also developed and utilized flexible manufacturing systems (FMS) -- computer-controlled configurations of semi-independent work stations connected by automated material handling systems -- in advance of, and on a scale that surpassed, other nations (Jaikumar 1989). Japan’s success in machine tools and factory automation reflected their leadership in the integration of mechanical and electronics technologies, or what since the mid-1970s the Japanese have called “mechatronics” (Hunt 1988; Kodama 1995, 193). For example, in his case study of the introduction of FMS at Hitachi Seiki, Ramchandran Jaikumar (1989, 126) found that the first two attempts, undertaken between 1972 and 1980, had failed because of insufficient coordination across functions. In 1980, therefore, the company set up the Engineering Administration Department that “brought together a variety of different functions from machine design, software engineering, and tool design.” The new structure of organizational learning, which built on the lessons of the previous failures, led to success. The development teams on the two failed attempts had, according to Jaikumar (1989, 126),

integrated the different components of their systems through machinery design rather than through general systems engineering concepts. They had viewed flexible manufacturing systems as technical problems to be solved with technical expertise. The difficulty of evaluating trade-offs whenever conflicts arose over design specifications or procedures convinced Hitachi Seiki that it was problems of coordination among people that was stymieing systems development. The company realized that what was needed was to view FMS as a manufacturing problem to be solved with both manufacturing and technical expertise. Consequently the third phase of FMS development at Hitachi Seiki was a radical departure from the previous two.

In his comparisons of Japanese and US FMS in the first half of the 1980s, Jaikumar found that, even though the FMS installations in both countries contained similar machines doing similar kinds of work, the Japanese developed the systems in half the time, produced over nine times as many parts per system in average annual volumes that were about one-seventh of American practice, with much greater automation, and utilization rates. ”Differences in results,” said Jaikumar (1989, 129), “derive mainly from the extent of the installed base of machinery, the technical


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literacy of the work force, and the competence of management. In each of these areas, Japan is far ahead of the United States.” More specifically, he described how the Japanese developed the reliability of FMS to achieve untended (automated) operations and system uptime levels of over 90 percent, in the process transforming not only shop-floor technology but also the job of a “shop-floor operator”.

The entire project team remains with the system long after installation, continually making changes. Learning occurs throughout and is translated into on-going process mastery and productivity enhancement.…Operators on the shop floor, highly skilled engineers with multifunctional responsibilities, make continual programming changes and are responsible for writing new programs for both parts and systems as a whole. Like designers, they work best in small teams. Most important, Japanese managers see FMS technology for what it is -- flexible -- and create operating objectives and protocols that capitalize on this special capability. Not bound by outdated mass-production assumptions, they view the challenge of flexible manufacturing as automating a job shop, not simply making a transfer line flexible. The difference in results is enormous (Jaikumar 1989, 130).

Central to factory automation have been teams of highly educated and highly trained engineers who had mastered their technical specialties but who were also able and willing to integrate across electronic, mechanical, and chemical specialties. As stated earlier, that the Japanese could even consider entry into complex manufacturing industries such as automobiles and consumer electronics after World War II was because of the learning that their scientists and engineers had accumulated in the decades before as well as during the war. But the Japanese history of the hierarchical integration of traditional blue-collar workers into the development and utilization of manufacturing technology laid the basis for functional integration as technology became more and more complex. The accumulated learning of Japan’s scientists and engineers after the war was in and of itself no match for that which the American’s possessed. Yet, during the postwar decades Japanese scientists and engineers developed and utilized their collective capabilities in manufacturing as part of an organizational learning process that integrated the capabilities of shop-floor workers in making continuous improvements to the manufacturing process. In the 1980s and 1990s this history of hierarchical integration played a significant role in fostering the functional integration that has been key to Japan’s success relative to the United States in factory automation. The importance of taking organizational learning to the shop floor also applies in the semiconductor industry, the most complex and automated of manufacturing processes. As Daniel Okimoto and Yoshio Nishi (1994, 193) argue in their excellent comparative study of Japanese and U.S. semiconductor manufacturing:

Perhaps the most striking feature of Japanese R&D in the semiconductor industry is the extraordinary degree of communication and ‘body contact’ that takes place at the various juncture and intersection points in the R&D processes – from basic research to advanced development, from advanced development to new product design, from new product design to new process technology, from new process technology to factory-site manufacturing, from manufacturing to marketing, and from marketing to servicing. Owing to pragmatic organizational innovations, Japanese


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semiconductor manufacturers have excelled – where many American and European manufacturers have faltered – at the seemingly simple but extremely difficult task of making smooth ‘hand-offs’ at each juncture along the long-interconnected R&D pipeline.

The key links in this pipeline in Japanese semiconductor R&D are between divisional labs and factory engineering labs. Engineers from these labs, according to Okimoto and Nishi (1994, 195), “continually meet and interact in seeking to iron out problems that inevitably arise in mass-manufacturing new products.” Okimoto and Nishi (1994, 195) continue, stressing the importance of the integration of R&D with manufacturing:

The largest concentration [of engineers] is usually found at the FELs [factory engineering laboratories], located at factory sites where the messy problems of mass production have to be worked out. The majority of Japanese engineers have at least some exposure to manufacturing engineering as part of their job rotation and career training. Not only is there no stigma attached to manufacturing assignments; the ladder of promotion leading up to higher reaches of executive management – and beyond (including amakudari, or post-career executive entry into new companies) – pass through jobs that involve hands-on manufacturing experience. It is almost a requirement for upward career and post-career mobility. In the United States, by contrast, manufacturing engineers carry the stigma of being second-class citizens. To the manufacturing engineers falls the “grubby” work of production – for which they receive lower pay and lower prestige compared with the “glamorous” design jobs. In how many US semiconductor companies can it be said that the majority of engineers are engaged in manufacturing? Few, if any. And, looking at the large number of merchant semiconductor houses in Silicon Valley, we see that only a minority even possess manufacturing facilities, much less factory engineering laboratories.

Organizational integration also appears to be important for explaining international trade in semiconductors. In 1995 Japanese exports of integrated circuits accounted for 6.2 percent of all Japanese exports to the United States (up from 1.4 percent in 1987), and hence represented one-quarter of 1995 electrical machinery exports (Lazonick 1998). This bilateral trade in integrated circuits reflects US specialization in microprocessors and Japanese specialization in dynamic random access memories (DRAMs) - an international division of labour built on investments in different skill bases in the two nations (see Jelinek and Schoonhoven 1990; Burgelmann 1994; Okimoto and Nishi 1994). Describing the “lagged parallel model” of new product development, pioneered at Toshiba and subsequently diffused to other Japanese enterprises as well as US-based Texas Instruments, Okimoto and Nishi (1994, 197-8) have pointed out that

the lagged parallel project model is effective for work on only certain types of technology. It works for DRAMS, SRAM [sic], and other commodity chips, which share highly predictable linear trajectories of technological advancement. The model is not particularly well suited for products based on nonlinear, highly volatile technological trajectories, where the parameters of research for the next and successive product generations cannot be understood ahead of time. Thus it is not accidental that Japanese companies have dominated in commodity chips but have lagged behind U.S. companies


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in logic chips, microprocessors, and software for applications and operating systems. The latter may require a different, perhaps less structured, organizational approach.

It would appear more generally that, by focusing the skills and efforts of engineers on continuous improvements in quality and cost in the production process, hierarchical integration provided a foundation for functional integration in Japanese manufacturing. If, in the first half of the 1980s, most Western analyses of the sources of Japanese competitive advantage focused on the integration of the shop-floor worker into the organizational learning process, over the last decade or so the emphasis has shifted to the role of “cross-functional management”, “company-wide quality control,” or “concurrent engineering” in generating higher quality, lower cost products. Much of the discussion of functional integration has been focused on its role in “new product development” in international comparative perspective (Clark and Fujimoto 1991; Nonaka and Takeuchi 1995; Aldridge and Swamidass 1996). But we would argue from the US-Japanese comparison that the key to understanding the influence of functional integration on innovation and international competitive advantage is the integration of product and process development, and the skill-base strategy that such integration entails. Such an understanding of organizational integration requires an analysis of functional integration in relation to the legacy of hierarchical integration or segmentation. This perspective on organizational integration is of considerable consequence for Europe. In the automobile industry coming into the 1980s, for example, German companies tended to exhibit greater hierarchical integration than US companies but less functional integration than Japanese companies, while British companies were afflicted by both hierarchical and functional segmentation at a time when the dynamic interaction of hierarchical and functional integration was becoming increasingly important for process and product innovation (Jürgens et al. 1993; Lazonick and O’Sullivan 1996; Freyssenet et al. 1998; Jürgens 2000). 5.3 Horizontal and Vertical Relations Among Firms Within an Industry Horizontal concentration and vertical integration are common terms in the economics literature on industrial organization. Taking the neoclassical “monopoly model” as its point of departure, the mainstream economics literature on horizontal concentration and vertical integration has generally avoided an analysis of the innovation process. The neoclassical perspective views horizontal concentration among firms that produce the same product as an attempt to restrict output and raise prices. This perspective does not contemplate the possibility that horizontal concentration could be the result of the development and utilization of productive resources by an innovative enterprise. As we shall see, horizontal concentration that results from innovation is typically achieved by increasing output and lowering prices, as the innovative enterprise captures larger market share. Similarly, when it is technologically possible for vertically-specialized firms to undertake vertically-related processes, the neoclassical perspective views vertical integration as a strategy by a downstream firm (i.e., one closer to the final market) to exercise monopolistic control over an upstream factor of production. As a result of this monopolistic control, the theory contends, nonintegrated competitors face restricted supplies of and higher prices for that factor compared with the factor market conditions that would prevail under perfectly competitive conditions. As in the case of horizontal concentration, the neoclassical perspective does not explain why, given the neoclassical assumption that all firms in an industry optimize subject to the


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same technological and market constraints, some firms in an industry come to exercise “monopolistic” control and foist inferior market conditions on other firms in the industry. Transaction-cost theorists have critiqued the monopoly model of conventional industrial organization theory by analyzing horizontal and vertical integration as a response to the cost of using the market rather than as a strategy to achieve monopolistic power. The transaction-cost argument is that, given the costs of using the market, the degree of horizontal concentration and vertical integration that we observe in an industry are the most efficient arrangements possible. Yet, as we shall outline in the section on theories of business enterprise, in making these arguments against the neoclassical monopoly model, transaction-cost theorists have completely ignored an analysis of the innovation process, portraying horizontal and vertical integration as optimal responses to “market failure” rather than as innovative strategies that can yield what we would term “organizational success”. We are not arguing that the traditional monopoly model and the transaction-cost model that has sought to replace it are inherently wrong. Rather we are arguing that these models do not, and on the basis of the constrained-optimization methodology that they employ cannot, analyze the roles of horizontal and vertical relations among enterprises in the development and utilization of productive resources that enable some enterprises to generate higher quality, lower cost products than other enterprises that compete in the same industry. From an innovation perspective, one must ask what types of horizontal and vertical relations among enterprises within a particular industry promote collective and cumulative learning that can generate higher quality, lower cost products. In carrying out this analysis, one must also ask how the organizational integration of the activities across firms that participate in a specialized division of labour relates to the organizational integration of activities within these firms to generate organizational learning. That such an industrial-organization perspective on the innovation process is needed has been explicitly recognized by economists working within the national systems of innovation (NIS) framework (Lundvall 1992; Nelson 1993; Mowery and Nelson 1999). In their book, The Associational Economy: Firms, Regions and Innovation, Philip Cooke and Kevin Morgan (1998, 202) recognize that the Nelson (1993) project that compared national innovation systems lacks a clear theoretical framework -- a problem that remains in the recent volume edited by Mowery and Nelson (1999) that contains cross-national industry analyses. But they also criticize the Lundvall (1992) project for lacking empirical research, while praising the volume for being “very strong on developing the new and extremely useful theory of interactive learning as the basis for analysing the NIS phenomenon.” In his introduction to the volume, Lundvall makes it clear that innovation is both a cumulative and collective process. The Lundvall approach ignores the problem of hierarchical integration in the innovation process but pays some attention to functional integration (see Gjerding 1992). But the prime focus of this perspective is on the interactive learning among firms in an industry, rather than on the dynamic of an innovation process characterized by an interaction between cumulative and collective learning within enterprises and cumulative and collective learning across enterprises. To focus exclusively on interactive learning across enterprises makes sense when the firms in question are all very small and draw on the common resources developed in an industrial district for improvements in processes and products. In such cases, which characterize what have come to be called – somewhat inappropriately -- “Marshallian industrial districts”, the learning that occurs within constituent enterprises can be construed as individual learning, or perhaps “familial’


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learning. Yet, if enterprise-level learning were the only source of learning in modern industrial districts, these districts would not have been able to become world leaders in their industries. Rather, as exemplified by the industrial districts in the Third Italy producing such goods as furniture, textiles, and tiles, it is collective learning through marketing boards and research associations, as well as the collective provision of enterprise finance, that have been critical to the international success of these enterprises (Brusco 1982; Best 1990; Pyke 1994; Locke 1995; Cooke and Morgan 1998, ch. 5). Michael Porter (1990, ch. 210-225) has argued that the main source of competitive advantage in the Italian industrial districts is “domestic rivalry” among small firms in the same industry that are in close geographic proximity to one another. This domestic rivalry allegedly spurs individual firms to innovate in processes and products and to maintain proprietary control over the knowledge that they generate in the process. The evidence on the sources of innovation in the Italian industrial districts, however – including the evidence that Porter himself presents for the case of the Sassuolo tile district – reveals that it is cooperation among firms in the district, particularly through the organizations of collective research, marketing, and finance that is the source of their sustainable competitive advantage (Brusco 1982; Best 1990; Lazonick 1993b). It is in the social organization of the learning process in the modern industrial districts that they differ markedly from those that characterized the original “Marshallian” industrial districts that provided a foundation for British leadership in the international economy in the late nineteenth and early twentieth centuries (Marshall 1890, Book IV, ch. 4; 1919, 140-70; 597-603; Elbaum and Lazonick 1986). Lacking institutions for the collective organization of research, marketing, and finance, these British industrial districts entered into long-term competitive decline from the 1920s (Elbaum and Lazonick 1986). In historical perspective, the main lesson that can be drawn from the modern industrial district is that the complexity of developing technology and accessing markets means that the constituent firms in a district are individually too small to generate innovation but require instead collective organizations to develop and utilize productive resources. Indeed, in the face of technological and market complexity, even major corporate enterprises that control internally substantial processes of organizational learning find that they must enter into strategic alliances with industry competitors in order to develop productive resources sufficiently and quickly enough to enable them to capture new markets. In strategic alliances, as within companies, the social conditions for such innovative transformation are, on the one hand, organizational integration that mobilizes the specialized capabilities of different groups of people into an organizational learning process and, on the other hand, financial commitment that can sustain the innovation process until it generates returns. Organizational integration and financial commitment can occur across as well as within companies. But the company or firm remains a unit of financial control on which individuals who engage in organizational learning depend for employment and which can make a unilateral decision not to sustain the innovation process. Strategic alliances tend to occur across companies that have dominant positions in the same markets. As a vice president for science and technology at Johnson & Johnson put it: “Technology has become so sophisticated, broad, and expensive that even the largest companies can’t afford to do it all themselves” (quoted in Leonard-Barton 1995, 135). Strategic alliances involve functional integration of different organizational capabilities but they do not involve hierarchical integration. In contrast to a subcontracting relationship, in which the "systems integrator" employs the


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"component supplier", and hence exercises financial control, the very nature of a strategic alliance means that the companies share financial responsibility and hence financial control. Viewed from outside the strategic alliance, the collaboration is seen as horizontal rather than vertical. From the point of view of the process that generates innovation, a strategic alliance should be viewed as the building of a cross-company organization for the common purpose of transforming technological and market conditions. For example, Benjamin Gomes-Casseres (1996: 82-3) argues that “both technology transfer and shared innovation…are discouraged by competition between partners in downstream markets.”

This issue highlights an obstacle to collaboration in precompetitive R&D….When firms engaged in the research are likely to compete with each other using the very fruits of this research, they will not invest in shared learning. In contrast, when the postresearch competition is moderated, either by the companies themselves or by market and regulatory conditions, then firms are more likely to share costs and capabilities in joint research.

In analyzing sources of the success or failure of a number of strategic alliances, Yves Doz (1996, 56) focuses on "how learning processes in alliances mediate between initial conditions and outcomes." He summarizes the relation between initial conditions and learning processes in successful strategic alliances as follows:

Initial conditions (set in terms of task definition, partners; organizational routines, interface structure and partners' expectations) facilitate or hamper partner learning along five dimensions: environment, task, process, skills, and goals. Learning, in turn, allows the partners to reevaluate their partnership on the basis of perceived efficiency, equity, and adaptability. Reevaluation then leads to readjustment to initial conditions and, hopefully, to a new cycle of learning and reevaluation. Partners in more successful alliances engage in a series of iterative and interactive learning cycles over time, typically characterized by greater and greater trust and adaptive flexibility, as well as the willingness to make larger and larger, as well as increasingly specific and irreversible, commitments (Doz 1996, 74).

For example, in his analysis of the successful alliance between GE and SNECMA, begun in 1973 and still in operation today, to build the CFM56 turbo engine, he stresses the strategic, cognitive, and behavioural conditions that made collective and cumulative learning possible (Doz 1996, 69). Strategically, the companies entered the alliance with the common goal of building a mid-sized engine (it was adopted by Airbus), and they saw the alliance as a way of challenging the civilian turbo engine industry leader, Pratt & Whitney. Moreover, they were not direct competitors in the military engine business. Each side maintained its financial autonomy in the process of developing the CFM56, GE through its military contracts with the US Defense Department and SNECMA as a French government-owned enterprise. Initially, a considerable overlap in the "experience and skill base" of the two companies meant that teams from each company could develop the engine through a well-defined and well-understood division of labour that did not require the cross-team integration of activities. But the two companies did coordinate the establishment of organizational routines in their respective operations that mirrored each other, apparently through "a small but intensely 'connected' program management joint venture…located in the USA on GE's premises, but headed by a French executive, and staffed with managers and specialized personnel delegated from both parents." Thus, there was a organizational foundation to deepen the integration of the actual development


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process at a late stage: "once the engine was in test, and in service, more interdependent work became necessary to optimize its performance, but by then the partners had learned to trust each other and to work together" (Doz 1996, 69). In analyzing the organizational learning process per se, Doz (1996, 74) makes the distinction between "cognitive learning" -- "understanding how cooperation should take place" -- and "behavioural learning" -- "making the alliance work", and indeed argues that alliances that promote cognitive learning may actually lead to failures in behavioural learning, as participants become more aware of the difficulties of making the alliance work. "Such discrepancies between cognitive and behavioural learning," he argues, "lead to reevaluation which lowers expectations and typically heightens suspicions between partners." In general, his "process" approach to alliance development recognizes that, depending on whether or not the interaction of cognitive and behavioural conditions fosters what we have called collective and cumulative learning, the strategic alliance may or may not be successful in transforming technological and market conditions that generate innovation. If innovative strategic alliances rely on functional integration, innovative supplier relations rely on hierarchical integration. Such a vertical relation exists when one company controls the design of a complex product system, and hence is the systems integrator, while another company is a component supplier to this system. The organizational integration of the component supplier into the organizational learning process of the systems integrator typically entails functional integration as well; the component supplier may provide distinct functional capabilities to the organizational learning process. But the relationship occurs within a well-defined hierarchical structure. Viewed from outside the supplier relation, such organizational integration may be seen as a form of vertical integration across distinct units of financial control. During the 1980s the Japanese mass producers, especially in the automobile industry, became well known for their ability to generate organizational learning through their supplier relations (see Liker et al. 1995; Sako 1998). The work of Mari Sako (1998) suggests in the case of Japanese automobile suppliers, different supplier relations across core companies operating in the same national environment may reflect differences in the internal organization of the learning processes in those companies. Once a product system is in place, a systems integrator can seek to advance the development of the components of the system by subcontracting more complex development tasks to component suppliers. The result is modularization, a process that particularly characterized the development of the microcomputer industry in the 1980s (Langlois 1992; more generally, see Sanchez and Mahoney 1996; Baldwin and Clark 1997; Prencipe 1997; Brusoni and Prencipe 1999; Sako and Murray 1999). Critical to the development of modularization in the microcomputer industry was the strategy of IBM to outsource the development of key components: the microprocessor to Intel and the operating system to Microsoft. Indeed, IBM dominance of the mainframe industry on the basis of its Systsem/360 computer, launched in 1964, was in part based on its decision to adopt a modular design that would allow independent companies to develop peripherals and software that could be used on IBM computers (Baldwin and Clark 1997, 85). IBM's dominance of the mainframe computer industry and its quick entry into the minicomputer industry in 1980 meant that the IBM-Intel-Microsoft specifications created the architecture of the minicomputer as a system (see Campbell-Kelly and Aspray 1996). The locus of strategic control over the development of a modular system depends on which company controls the "hidden information" in the system; that information which is not made available to component suppliers (Baldwin and Clark 1997). In


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the case of the minicomputer, IBM's decision to outsource the microprocessor and the operating system meant that loci of strategic control over the development of hardware and the development of software shifted to Intel and Microsoft, which then became systems integrators in their own right. As a result, new entrants such as Compaq and Dell were able to compete head-on with IBM as assemblers and marketers -- but not systems integrators -- of personal computers. What is important from the perspective of inter-company relations and organizational learning is that modularization can promote the decentralization of the innovation process to units of financial control that can integrate strategy and learning in the development of complex but separable parts of a larger technological system. The emergence of modularity as a major phenomenon in a number of industries that entail complex technologies and markets may lead one to ignore the importance of the system integrator in developing a "dominant design" (Utterback and Abernathy 1975; Abernathy and Utterback 1978) that enables the decentralization of component design to modular producers. It is the system integrators that determine the allocation of knowledge between "hidden information" that is proprietary and "visible information" that is widely available to other companies. As Baldwin and Clark (1997, 91-2) argue:

For…organizational processes [that entail modular design] to succeed…the output of the various decentralized teams (including the designers at partner companies) must be tightly integrated. As with a product, the key to integration in the organization is the visible information. This is where leadership is critical. Despite what many observers of leadership are now saying, the heads of these companies must do more than provide a vision or goals for the decentralized development teams. They must also delineate and communicate a detailed operating framework within which each of the teams must work.

5.4 Learning and Innovation We have argued that learning is a necessary condition for innovation. We have also argued that learning that results in innovation is “organizational” because it is cumulative and collective. It is cumulative because what has already been learned forms a foundation for what can be learned. It is collective because large numbers of people in the functional and hierarchical divisions of labour must interact in the learning process. But cumulative and collective learning does not always result in innovation. Indeed, the very organizational structures that enabled organizational learning to generate innovation in the past may obstruct the cumulative and collective learning that is required to renew the innovation process. In a widely cited 1981 survey on organizational learning in the Handbook of Organizational Design entitled: “How organizations learn and unlearn”, Bo Hedberg (1981:4) spoke of “learning that enslaves and learning that liberates”. A similar distinction appears in the work of Chris Argyris and Donald Schön as “single loop” versus "double loop" learning. Single loop learning embeds routines in the organization that can block organizational learning, whereas double loop learning provides feedback to participants in the learning process that can change, to quote Hedberg (1981:8) “norms, values, and world views.” The problem posed by single loop learning is not just, or even primarily, a matter of opportunistic behaviour by factions with vested interests in the old way of doing


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things. Unless the organization provides people with "double loop" feedback, they will continue to practice their "single loop" routines because it is through these routines that they exercise their skills. In an article entitled “Skilled incompetence,” Argyris (1996, 85-6, 91) has argued:

One of the most powerful ways people deal with potential embarrassment is to create 'organizational defensive routines'….People leave the organization and new ones arrive, yet the defensive routines remain intact.

Similarly, Peter Senge (1996, 289) distinguishes between adaptive and generative learning, which he views as analogous to Argyris and Schön’s distinction between single loop and double loop learning. For Senge, adaptive learning is about coping, while generative learning is about creating. According to Senge, adaptive learning is not inherently in conflict with generative learning; he argues, for example, that during the 1980s the Japanese quality movement may have made a transition from adaptive to generative learning. But under what conditions might adaptive learning block generative -- or, as we would refer to it, "innovative" -- learning? As we have already discussed, the organizational learning process can be characterized as cumulative and collective. The role of an innovative enterprise is to put in place an organizational structure that permits cumulative and collective learning to occur. Yet the cumulative and collective character of the learning that generates innovation can pose barriers to further innovation when such innovation requires a new cumulation path and a new collective process. That old learning blocks new learning has been recognized as a general phenomenon in the literature, now well-known among economists, on "path dependency" (David 1985; Arthur 1989). Given the "network externalities" on which the development of a particular technological trajectory depends, enterprises and even whole economies become "locked in" to particular set of technological standards, even when the original rationale for these standards disappears. In the case of the QWERTY typewriter keyboard, made famous by Paul David (1985), millions of individual learners became adept at using a configuration of the alphabet that was originally intended to reduce the probability of type hammers interfering with one another on mechanical typewriters. With the elimination of the type hammer technology on, first, electric typewriters equipped with ball fonts, and, then, electronic computer technology, the QWERTY keyboard system remained in place because the manufacturers of these products had neither the incentive nor the ability to retrain the countless number of typists to use a straightforward ABCDEF keyboard. That the adoption of the QWERTY keyboard configuration on the mechanical typewriter generated a lock-in effect is a compelling argument.18 It may also be the case that, had a conversion to an ABCDEF keyboard configuration occurred early on in the history of the development of word-processing technology, society as a whole may have enjoyed significant productivity gains in the training of typists. There

18 Based on his experience with a first-generation Sharp electronic organizer, placed on the

market in 1989, one of the authors of this paper can attest to the accuracy of this interpretation of the problem of changing the QWERTY keyboard configuration. Presumably to differentiate the new product from a personal computer, SHARP produced this first-generation organizer with an ABCDE keyboard, which Lazonick (not even a touch typist) found difficult to use. It was presumably because users were habituated to a QWERTY keyboard that, with its second-generation organizer, Sharp switched to the classic QWERTY configuration.


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would have been a limited cumulative element to these gains as millions of individuals would have found it somewhat easier to learn to type utilizing a configuration of phonetic symbols that they had already learned for the purpose of reading and writing. But, since the invention of the typewriter over a century ago, the learning process that generates typing skills has been highly individual, while the market for word-processing technologies -- be they mechanical, electro-mechanical, or electronic -- has been highly fragmented across the hundreds of millions of people who have, to a lesser or greater degree, developed these skills. The persistence of the QWERTY path dependency, that is, may well be attributable to the fact that this particular technology did not entail significant cumulative or collective learning. In contrast, it does not appear that, in the transitions from mechanical to electro-mechanical to electronic word-processing technologies, the QWERTY path dependency has posed any barriers whatsoever to organizational learning. A company such as IBM has successfully made these transitions while taking the QWERTY keyboard as a given. Nor is there any reason to believe that IBM would have been any more or less successful in making these technological transitions had the ABCDEF keyboard, rather than the QWERTY keyboard, been in place. In other words, the QWERTY path dependency may well have survived over a century of technological change in the products on which keyboards are used primarily because the skills involved in typing could be effectively segmented from the organizational learning involved in producing innovations in the machines that typists use. And the fact that no business organizations have come along to break the QWERTY path dependency in the training of typists is because of the limits to cumulative and collective learning in this particular activity. The implication is that if one wants to look at the problem of the relation between learning and innovation that is raised by the literature on path dependency, one must take some care in identifying the critical sources and locations of organizational learning that have enabled major corporations to become dominant in the first place and that, in a changed competitive environment, block the innovation process. Fortunately, there is now a significant empirical literature, much of it deriving from the insights of William Abernathy (1978) into "the productivity dilemma" that focuses on the dynamic possibilities and problems of organizational learning within the business enterprise. Based largely on an analysis of the history of the Ford Motor Company into the 1970s, Abernathy argued that a company would be able to generate productivity gains on the basis of its existing technological base, but in doing so may fail to invest in new technology that provides the basis for innovation. In effect, by focusing on "learning" on the basis of given technological and market conditions, established companies fail to innovate. Abernathy's work stressed "the limits of the learning curve" (Abernathy and Wayne 1975), but did not address the issue of whether the "productivity dilemma" arose because of a lack of capability or a lack of incentive of established enterprises to transform the technological and market conditions that they faced. In a famous 1980 article with Robert Hayes, a fellow professor at Harvard Business School, Abernathy argued that the problem of the competitive decline of US industry in the 1970s could be traced to the increased dominance within top management circles of financial types rather than production types (Hayes and Abernathy 1980). But even if one were to accept this central assertion (the empirical evidence that Hayes and Abernathy provided was in fact quite weak), one still had to ask whether the problem was cognitive or behavioural -- that is, whether financial-oriented top managers did not know how to innovate or whether they just did not want to innovate. Nevertheless, Abernathy's approach stimulated a generation of research in technology and operations management on what Kim Clark, Robert Hayes, and


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Christopher Lorenz called "the productivity-technology dilemma" (Clark, Hayes, and Lorenz 1985; see also Tushman and Anderson 1986; Henderson and Clark 1990; Utterback 1994; Clark and Wheelwright 1995; Christensen 1997). The main question that the literature has asked is how established companies react to a competitive threat from the appearance of a "technological discontinuity" (Tushman and Anderson 1986), an "architectural innovation" (Henderson and Clark 1990), a "disruptive innovation" (Utterback 1994), or a "disruptive technology" (Christensen 1997). In general, the incumbent firms have been seen as unable to invest in new technology because the organizational capabilities they had developed to establish a dominant technological and market position may be unsuited to organizing the transformations in technologies and markets that the new competition requires. For example, James Utterback (1994, xxvii) has argued:

One reason for the lethargy of well-established competitors in a product market in the face of potentially disruptive innovation is that they face increasing constraints from the growing web of relationships binding product and process change together. At the start of production of a new product, general-purpose equipment, available components, and highly skilled people may suffice to enter the market. As both product and market increase in sophistication more specialization is generally required in equipment, components, and skills. Thus change in one element, the product, requires changes throughout the whole system of materials, equipment, methods, and suppliers. This may make changing much more onerous and costly for the established firm than for the new entrant.”

The most thorough and sophisticated treatment of the productivity dilemma is that of Clayton Christensen (1997), in a book that explores the innovative strategies of dominant companies in a number of industries, including disk drives, computers, excavators, and steel. Although Christensen calls the challenge to established companies "disruptive technology" (as distinct from "sustaining technology"), the problem that he identifies is not technology at all but the interaction of technology and markets in the growth of the firm. Christensen argues that established companies are very good at generating innovations -- higher quality, lower cost products -- for a known customer base. But they are not very good at innovating for an unknown customer base, even when those customers want the products that the established company is quite capable of producing. Yet the unknown customer of today may become the known customer of tomorrow. By failing to develop the products that these new types of customers want at prices that they can afford, the established company can lose out. As Christensen (1997, 4) sums up the argument based on his study of the disk drive industry:

Simply put, when the best firms succeeded, they did so because they listened responsively to their customers and invested aggressively in the technology, products, and manufacturing capabilities that satisfied their customers' next-generation needs. But paradoxically, when the best firms subsequently failed, it was for the same reasons -- they listened responsively to their customers and invested aggressively in the technology, products, and manufacturing capabilities that satisfied their customers' next-generation needs. This is the innovator's dilemma. Blindly following the maxim that good managers should keep close to their customers can be a fatal mistake.

The problem is that there are some entrepreneurs (many of whom will have worked for dominant companies in an industry before setting up on their own) who will set up new ventures to try to develop products for the "unknown customers" that the established companies choose to ignore. Christensen argues that these new


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ventures often begin with well-known technology; the source of their innovation is the development of a new customer base -- that is, a new market. As it transforms the market conditions that it faces, the company generates revenues that fund further investment and, like established companies, upgrades the products that it can provide to its known customer base. When successful, a new venture may develop the capabilities to compete for the more sophisticated and extensive markets of established companies, while the established companies will have failed to develop its technological capabilities to serve the markets developed by the increasingly powerful new ventures. Christensen's framework, which he applies convincingly to the industries that he studies, helps to explain why established companies may fail to capture new markets, even when they would appear to have the requisite technological capabilities available to them. The main point of his argument is that, in the face of "disruptive technology" (that is, new market opportunities), the failure of an established company to capture the new markets need not, and indeed generally cannot, be explained by "bad" management. Managers of established companies, he argues, remain innovative and serve their existing customers well. But, in doing so, they are unable or unwilling to pursue strategies that can enable their companies to develop a new customer base. As Christensen puts it in summing up his findings on the disk drive industry:

When demand for an innovation was assured, as was the case with sustaining technologies, the industry's established leaders were capable of placing huge, long, and risky bets to develop whatever technology was required. When demand was not assured, as was the case in disruptive technologies, the established firms could not even make the technologically straightforward bets required to commercialize such innovations. That is why 65 percent of the companies entering the disk drive industry attempted to do so in an established, rather than emerging market. Discovering markets for emerging technologies inherently involves failure, and most individual decision makers find it very difficult to risk backing a project that might fail because the market is not there (Christensen 1997, 160).

Why? In some cases, such as IBM's move into the microcomputers, Christensen recognizes that established companies do move into an emerging market, but they do so by separating off the strategy and organization that develops the new venture from the strategy and organization of the going concern. He argues that in most cases, however, established companies are unwilling and unable to perceive the potential of the new markets for because of the way in which resources are allocated in such organizations. Christensen (1997, 82-3) contrasts two descriptive models of corporate resource allocation based on very different conceptions -- one top down and one bottom up -- of how strategic management takes place within established corporations. It is worth quoting Christensen's depiction of these two models at length because he succinctly highlights the importance of one's perspective on the process that allocates corporate resources and returns for understanding the relation between strategic management and innovation.

The first model describes resource allocation as a rational, top-down decision-making process in which senior managers weigh alternative proposals for investment in innovation and put money into those projects that they find to be consistent with firm strategy and to offer the highest return on investment. Proposals that don't clear these hurdles are killed.


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The second model of resource allocation, first articulated by Joseph Bower (1970), characterizes resource allocation decisions much differently. Bower notes that most proposals to innovate are generated from deep within the organization, not from the top. As these ideas bubble up from the bottom, the organization's middle managers play a critical but invisible role in screening these projects. These managers can't package and throw their weight behind every idea that passes by; they need to decide which are their best, which are their most likely to succeed, and which are most likely to be approved, given the corporate financial, competitive, and strategic climate. In most organizations, managers' careers receive a big boost when they play a key sponsorship role in very successful projects -- and their careers can be permanently derailed if they have the bad judgment or misfortune to back projects that fail. Middle managers aren't penalized for all failures, of course. Projects that fail because the technologists couldn't deliver, for example, are often not (necessarily) regarded as failures at all, because a lot is learned from the effort and because technology development is generally regarded as an unpredictable, probabilistic, endeavor. But projects that fail because the market wasn't there have far more serious implications for managers' careers. These tend to be much more expensive and public failures. They generally occur after the company has made full investments in product design, manufacturing, engineering, marketing, and distribution. Hence, middle managers -- acting in both their own and the company's interest -- tend to back those projects for which market demand seems most assured. As such, while senior managers may think they're making the resource allocation decisions, many of the really critical resource allocation decisions have actually been made long before senior management gets involved. Middle managers have made their decisions about which projects they'll back and carry to senior management -- and which they will allow to languish.

Understanding the process that allocates corporate resources is of central importance to our project on corporate governance, innovation, and economic performance. A theory of the process of strategic management is fundamental to answering the questions that we have posed concerning the "who, what, and how" of corporate resource allocation. In the next section of this paper, therefore, we look at how, by asking and answering these three questions, the literature on strategic management can inform the CGEP perspective. 7. Strategic Management and Corporate Governance 7.1 Strategic Control: Who Makes Decisions to Allocate Corporate Resources

and Returns? The two models of resource allocation that Christensen describes -- the one top down and the other organizational -- reflect two broadly different perspectives on the loci of strategic control within the strategic management literature. For our purposes, we can depict the "top-down" model as the "position" perspective, of which the most well-known proponent is Michael Porter (1980, 1985, 1987, 1996), while we can depict the "organizational" model as the "process" perspective, of which the most well-known proponent is Henry Mintzberg (1983, 1987, 1989, 1994).19 In general,

19 Mintzberg, Ahlstrand, and Lampel (1998) divide "the wilds of strategic management" into

ten schools of thought, which they label as the "design", "planning", "positioning", "entrepreneurial", "cognitive", "learning", "power", "cultural", "environmental", and


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the position perspective views the substance of corporate strategy as managerial choices to engage in, and trade-offs among, relatively well-defined business activities, with competitive advantage deriving from the superior utilization of a corporation's resources. In contrast, the process perspective views the substance of corporate strategy as an evolving process that entails learning about technologies and markets as well as about the organization itself and the environment in which it operates, with competitive advantage deriving from the superior, often unforeseen, development of a corporation's resources. One's conception of who should exercise strategic control will be bound up with one’s theory of what strategic decision makers have to do to be successful. The position perspective entails an application of a theory of the firm in which resource allocation relies basically on optimization rules in choosing the range of different activities in which the corporation should invest. From this perspective, strategic decision makers need to be rational calculators who are positioned to see the big picture in order to optimize from a corporate point of view. Hence the assumptions that it is top corporate managers who should exercise strategic control and that strategic decision making does not rely on an organizational process. In contrast, the process perspective entails an application of a theory of the firm in which resource allocation relies on social phenomena such as learning, culture, and power. From this perspective, the process of strategic decision making needs to be embedded within the organization, where participants in the process can understand how the existing capabilities of the enterprise can be developed and utilized to generate innovation. Top corporate managers participate in this process by articulating what Mintzberg (1987, 70) has called an “umbrella strategy”, or what C. K. Prahalad and Gary Hamel (1990, 89-91) have called a “strategic architecture”, but the formulation of strategy involves an organizational learning process. Mintzberg (1994, 357-61) captures the distinction between these two perspectives in his discussion of different views of the definition and role of "strategic control" in determining the relation between "the realization of intended strategy" and "the success of realized strategy". From the position perspective – or what Mintzberg (1994, 357) calls the "traditional view" -- strategic control has to do with "keeping organizations on their strategic tracks: to ensure the realization of intended strategies, their implementation as expected, with resources appropriately allocated." But, Mintzberg (1994, 357) argues, "there has to be more to strategic control than this." In his view, from the traditional perspective, "the concept of strategy has always been misconstrued, forcing strategic control to bypass one critical aspect -- the possibility of emergent strategy….In other words, strategic control must assess behavior as well as performance." For the position perspective, the challenge of strategic control is "rationality", or what we would call "optimizing": ensuring the optimal relation between strategic plan and competitive outcome, while for the process perspective, the challenge is "learning" that permits successful strategy to emerge in an evolutionary process (Mintzberg 1994, 360). Mintzberg does not deny that "optimizing" can or should play a role in strategic control, but only that, in a creative organization, such optimization of the process plays a subsidiary role. Using the vocabulary from our perspective on the innovation

"configurational" schools. For our main purpose, which is to highlight the distinction between strategy as a top management decision and strategy as an evolving organizational process, we can divide these ten schools into two, the "position" school (which broadly includes the first five schools listed above) and the "process" school (which broadly includes the second five schools).


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process, strategic control entails both the development and the utilization of productive resources. The development of productive resources requires learning, which is the sine qua non of the innovation process. The enterprise can then strive to optimize the utilization of productive resources that the enterprise has developed. But, as we have seen in the case of the neoclassical theory of the firm, if optimization becomes the essence of an enterprise’s strategy, that enterprise will cease to have an innovative strategy. To ignore the development of productive resources as a central challenge for strategic control is to ignore the cumulative and collective learning that is the essence of the innovation process. And it is the uncertainty of this learning process, and the need to confront that uncertainty by drawing on the organization’s knowledge-creation process, that makes it plausible that innovative strategy itself must be an organizational learning process rather than simply an optimal choice among a menu of alternative business activities. A reading of Porter reveals that, in advocating the position perspective on strategic management, he does indeed ignore the development of productive resources, focusing only on how top management can construct a strategy to realize the optimal utilization of productive resources. The starting point for Porter is, in effect, a Schumpeterian notion of “new combinations” (Schumpeter 1934), but without the Penrosian notion of the organizational process that develops the capabilities of these “new combinations”. The economic problem that Porter poses is that when one corporate entity coordinates new combinations of what he calls “activities”, it incurs additional costs compared with those that would be incurred if the activities had been performed by different corporate entities. The challenge for corporate managers is to ensure the utilization of resources across these activities so that the added costs of coordination are more than offset. It is the corporation’s success in meeting this challenge that is the source of its sustained competitive advantage. As Porter (1996, 64) has put it in an article entitled "What is Strategy?":

Competitive strategy is about being different. It means deliberately choosing a different set of activities to deliver a unique mix of value….[T]he essence of strategy is in the activities -- choosing to perform activities differently or to perform different activities than rivals.

Porter (1996, 70) goes on to argue:

Strategy is making trade-offs in competing. The essence of strategy is choosing what not to do. Without trade-offs, there would be no need for choice and thus no need for strategy.

It is these choices of "activities" and how to perform them -- choosing a trade off, for example, between quality and cost -- that enables a firm to have a unique position that can give it sustained competitive advantage over its rivals. Porter assumes that "top managers" are in the best position to makes these choices and trade offs because they have an overview of, and responsibility for, the performance of the company as a whole. Porter does not ignore the existence of a strategic process altogether. In a 1987 article, "Competitive Advantage to Corporate Strategy" (the empirical substance of which was a critique of the failure of major US corporations in joint ventures, startups, and acquisitions from 1950 to 1986), he recognized that within a diversified corporation, it is business units that implement corporate strategies, and hence that the interaction between top corporate managers and top divisional managers is inherent in the strategic decision making process.


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Porter (1987, 43) argued that "a diversified company has two levels of strategy: business unit (or competitive) strategy and corporate (or companywide) strategy."

Successful corporate strategy must grow out of and reinforce competitive strategy….A business unit must explain its decisions to top management, spend time complying with planning and other corporate systems, live with parent company guidelines and personnel policies, and forgo the opportunity to motivate employees with direct equity ownership (Porter 1987, 46) .

Porter's concern was not, however, with how this process of strategic decision making could generate competitive advantage. To the contrary, his concern was with the "costs and constraints" that the relation between the corporation and its business units entailed. Given these costs and constraints of corporate diversification, and given that public shareholders (for whom Porter assumes that corporations ultimately add value) could easily and inexpensively diversify their own portfolios across different types of businesses governed as distinct corporate entities, a corporate diversification strategy only has an economic rationale if "it truly adds value…to business units by providing tangible benefits that offset the inherent costs of lost independence, and to shareholders by diversifying in a way that they could not replicate" (Porter 1987, 46). What is the value-creating role of the diversified corporation that can offset "the inherent costs of lost independence" and that diversifies in way that portfolio investors cannot? Porter (1987, 53-7) emphasizes the transfer of skills and the sharing of activities across business units. Given his focus on "skills" and "sharing" one might expect that Porter would invoke some notion of inter-business organizational learning that develops new productive capabilities. And, indeed, at first sight, Porter's (1987, 57) statement concerning the need to integrate the activities of business units would appear to bear out such an interpretation:

Following the shared-activities model requires an organizational context in which business unit collaboration is encouraged and reinforced. Highly autonomous business units are inimical to such collaboration. The company must put in place a variety of what I call horizontal mechanisms -- a strong sense of corporate identity, a clear corporate mission statement that emphasizes the importance of integrating the business unit strategies, an incentive system that rewards more than just business unit results, cross-business-unit task forces, and others methods of integrating.

But it is clear that what Porter means by transfer of skill and sharing of activities has much less to do with the integration of activities to develop new productive capabilities and much more to do with the more complete utilization of the capabilities that already reside in some business units by employing these capabilities across business units. For example, Porter (1987, 56) states: "Sharing can lower costs if it achieves economies of scale, boosts the efficiency of utilization, or helps a company move more rapidly down the learning curve." Note that even the last-stated benefit of sharing -- "moving more rapidly down the learning curve" -- does not, as the concept is normally used, entail a strategy of organizational integration to develop productive resources; the "learning curve" is generally assumed to be an attribute of cumulated experience that is independent of investment strategy and organizational structure (see Dutton et al. 1984). As Porter (1987, 57) puts it: "Because they do not rely on superior insight or other questionable assumptions about the company's capabilities, sharing activities and transferring skills offer the best avenue for value creation."


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Indeed, in his 1996 article, "What is Strategy?", he relegates the types of productive activities in which people learn to develop capabilities to the realm of "operational effectiveness", which, as the very first section heading of the paper warns, "is not strategy" (Porter 1996, 61). He contends that "[d]ifferences in operational effectiveness were at the heart of the Japanese challenge to Western companies in the 1980s", but that managers who are "preoccupied with improving operational effectiveness…[through] continuous improvement, empowerment, change management, and the so-called learning organization" will find that "staying ahead of rivals gets harder and harder every day" because of "the rapid diffusion of best practices" (Porter 1996, 62). Porter goes on to argue that "the Japanese companies have rarely developed distinct positions of the kind discussed in this article."

To do so, they will have to overcome strong cultural barriers. Japan is notoriously consensus oriented, and companies have a strong tendency to mediate differences among individuals rather than accentuate them. Strategy, on the other hand, requires hard choices. The Japanese also have a deeply ingrained service tradition that predisposes them to go to great lengths to satisfy any need a customer expresses. Companies that compete in that way end up blurring their distinctive positioning becoming all things to all customers (Porter 1996, 63).20

For Porter, "strategy" is deciding which product markets to serve, whereas "operational effectiveness" is about how to generate the products in the "value chain" to serve those markets, once the strategy has been set. Moreover, he argues, it is "strategy", not "operational effectiveness" that is the source of sustained competitive advantage. "[F]ew companies,” he contends, ”have competed successfully on the basis of operational effectiveness over an extended period of time" because of the "rapid diffusion of best practices", which in turn is possible because, as he goes on to argue "operational effectiveness is about achieving excellence in individual activities, or functions", and hence is not integral to the organization of the enterprise (Porter 1996, 63, 70). In sharp contrast, "strategy is about combining activities", and it is the "strategic fit" achieved by this combination of strategic choices that "creates competitive advantage and superior profitability" (Porter 1996, 70). How does "strategic fit" generate such outcomes? Porter's (1996, 70-5) answer to this question tells us what, beyond making choices, strategic managers do, and hence who, in terms of their capabilities and positions in the corporation, successful strategic managers should be. He contends that the strategic fit of corporate activities depends on consistency, reinforcement, and optimization of effort. "Consistency," he argues, "ensures that the competitive advantages of activities cumulate and do not erode or cancel themselves out. It makes the strategy easier to communicate to customers, employees, and shareholders, and improves implementation through single-mindedness in the corporation." Translation: consistency makes it easier for top managers to convince everyone else that they know what they are doing. Reinforcement in the strategic choice of activities spreads the costs of functions such as marketing over more market segments. That is, reinforcement enables companies to reap economies of scope. Optimization of effort occurs when coordination and information exchange across activities eliminate redundancy and minimize wasted effort. In addition, by making certain choices of

20 Somewhat ironically, a footnote to this statement states that "this discussion of Japan is

drawn from the author's research with Hirotaka Takeuchi,", whose 1995 book with Nonaka, The Knowledge-Creating Company, extolled the virtues of "middle-up-down" management and "the knowledge spiral" in new product development.


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activities in which to engage, a company can eliminate the need to perform other activities; Porter (1996, 73) gives the example of product design choices that eliminate the need for after-sales service. The result of such strategic choices, Porter contends is that the corporation engages in a system of "activities", and that it is the "fit" inherent in this system that is the source of sustainable competitive advantage.

General management is more than the stewardship of individual functions. Its core is strategy: defining and communicating the company's unique position, making trade-offs, and forging fit among activities. The leader must provide the discipline to decide which industry changes and customer needs the company will respond to, while avoiding organizational distractions and maintaining the company's distinctiveness. Managers at lower level lack the perspective and the confidence to maintain a strategy. There will be constant pressures to compromise, relax trade-offs and emulate rivals. One of the leader's jobs is to teach others in the organization about strategy -- and to say no (Porter 1996, 77).

Three of Porter's fellow professors at Harvard Business School responded to “What is Strategy?” in a comment published the Harvard Business Review by arguing that "[t]here are two important elements missing in [Porter's] concept of strategy…people (both customers and employees) and organization" (Heskett, Sasser, and Schlesinger 1997, 158). Porter (1997, 162) responded:

[I]f strategy is stretched to include employees and organizational arrangements, it becomes virtually everything a company does or consists of. Not only does this complicate matters, but it obscures the chain of causality that runs from competitive environment to position to activities to employee skills and organization.

After quoting this response, Mintzberg, Ahlstrand and Lampel (1998, 119) opined:

But what is wrong with seeing strategy as ‘everything a company does or consists of’? This is simply strategy as perspective (rather than position). And why must there be any such chain of causality at all, let alone having to run in one direction?

There is no doubt that Porter's perspective on corporate strategy precludes analysis of the relation, let alone the dynamic interaction, between enterprise strategy and organizational learning. But it is not useful to argue that strategy is everything a company does. Strategic control may be embedded within the organization and strategy formulation may be an emergent process. But if a company's productive capabilities are to be developed and utilized, strategic decisions must be made and resources must be allocated. In our view, the main virtue of the process perspective is its emphasis on the link between strategy and learning. To make use of this insight to understand the sources of innovation and sustained competitive advantage, however, requires an analytical framework to determine who exercises strategic control within the organization's functional and hierarchical division of labour in ways that combine the access to the financial commitment required to sustain an innovation process and an understanding of the organizational learning that is critical to generating innovative outcomes. In Porter's version of the position perspective, "financial commitment" is not an issue because it is assumed that those who exercise financial control and


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strategic control are the same people.21 In the process perspective, such an assumption of the unity of strategic and financial control clearly cannot be made, especially given the argument that strategy is an emergent process; the perspective recognizes that financial commitment must be made in the presence of inherent uncertainty. Yet the process perspective largely ignores the relation between strategic control and financial control.22 Nor has it developed a conceptual framework for analyzing who within the functional and hierarchical division of labour is included and who is excluded from the process of organizational learning, and how such organizational integration and segmentation varies across industrial activities, across institutional environments, and over time. If the integration of strategy and learning is central to the innovation process, one must ask not only who controls the strategic allocation of corporate resources, but also what investments in productive resources they make, and how they distribute the returns on these investments in ways that generate innovation. 7.2 Strategic Control and Organizational Learning: What Types of Innovative

Investments Should Strategists Make? As Porter propounds it, the position perspective on strategy orients itself toward asking the demand-side question of what markets the firm should serve23 (see also Porter 1980 and 1985, as well as his emphasis on "sophisticated demand" in Porter 1990). Once the firm's strategy has answered this question, people must be employed and physical assets purchased to achieve "operational effectiveness". In effect, in the manner of Alfred Chandler (1962, 1977, 1990), structure follows strategy.24 For the firm, the competitive challenge is not to develop productive resources that result in higher quality products and processes under its control but rather to ensure a high rate of resource utilization once the strategy is in place. During the 1980s, a supply-side version of the position perspective -- the "resource-based view of the firm" -- emerged in the strategic management literature (see Wernerfelt 1984; Rumelt 1984; Barney 1986). The resource-based perspective took as its theoretical starting point the theory of the market economy in which the market allocation of resources should result in all firms in an industry optimizing subject to the same cost structures, and hence experiencing the same performance outcomes. Yet, for anyone concerned with “competitive strategy” and “competitive advantage”, it was clear that what had to be explained were the facts that in the real world firms that competed in the same industry had control over different resource bases and experienced different performance outcomes, whether measured in terms of growth

21 For an analysis from the position perspective that recognizes that strategic control and

financial control may be exercised in different hierarchical locations in a multi-business corporation, see Goold and Campbell 1987; and Goold, Campbell, and Alexander 1994.

22 But see Simons 1995, which is treated approvingly in Mintzberg et al. 1998, 62-3, in the few pages in their book-length survey of the strategy literature that they devote to the relation between strategic control and financial control.

23 Indeed, all the specific examples of companies with successful strategies mentioned in Porter's (1996) article are service providers -- airlines, commercial printing companies, banks, retailers – for whom innovation entails the transformation of market conditions rather than technology suppliers for whom the main source of competitive advantage is transforming technological conditions.

24 For a critique of the Chandlerian for focusing on the utilization of productive resources while neglecting the development of productive resources, see Lazonick (2000). For the importance, nevertheless, of Chandler’s historical research on the evolution of the US industrial corporation to the construction of a theory of innovative enterprise, see Lazonick (1991).


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or profitability. Whereas the transaction cost perspective of Coase and Williamson asked why firms exist in a world of market transactions, the resource-based perspective asked why firms differ in a world of markets. What scholars of strategic management needed to explain was how, in a market economy, different firms acquired unique resource bases, how they maintained control over these resource bases over time, and how these unique resource bases might contribute to superior economic performance – that is, sustained competitive advantage. The early proponents of the resource-based theory such as Birger Wernerfelt (1984), Richard Rumelt (1984), and Jay Barney (1986) sought to answer these questions within the neoclassical paradigm of an economy in which markets, rather than enterprises, allocate resources. Lacking a developmental theory of the economy in which the strategic allocation of resources and returns by business enterprises provided the motive force, resource-based theorists delineated the “firm-specific“ characteristics of the unique and presumably valuable resource bases held by firms that would keep other firms from imitating these resource positions or competing them away by means of market resource reallocations. In effect, resource-based theorists asked how, in a market economy, firm-specific resource bases could function as barriers to entry to other firms that had not had the luck or foresight to establish these resource-base positions. In taking this approach, resource-based theory followed in the footsteps of Michael Porter’s 1980 book, Competitive Strategy in which he had turned mainstream industrial organization, based on the neoclassical monopoly model, on its head. Working in economics departments, industrial organization economists such as Joe Bain (1968) and Richard Caves (1977) had asked how monopolistic barriers to entry could be brought down to improve the allocation of resources in the economy as a whole. In contrast, working within a business school, Porter (1980) had constructed his “five forces” analysis to ask how a company could secure competitive advantage by building up barriers to entry against existing rivals, deterring new entrants from competing in the industry, avoiding competition with substitutes, and increasing its bargaining power vis-à-vis buyers and suppliers. By asking how a firm’s resources enhanced its ability to exert market power, Wernerfelt (1984) saw a resource-based theory of the firm as an extension of Porter’s analysis. Through “first-mover advantages” in acquiring “attractive resources”, a firm could create “resource-position barriers” to entry. Influenced by the work of game theorists such as Michael Spence (1979), Wernerfelt (1984, 173-4) supposed that attractive resources acquired by first movers could be machine capacity that deterred entry by others for fear of creating excess capacity in an industry, production experience that gives first movers “experience curve” advantages, customer loyalty that is difficult to replicate, and technological leads that by yielding higher returns attract better personnel to the first mover. As Wernerfelt (1984, 173, his emphasis) stressed: “What a firm wants is to create a situation where its own resource position directly or indirectly makes it more difficult for others to catch up.” Wernerfelt did not have anything to say about why or how a firm could be a first mover, and he also recognized the possibility that there may be what Richard Foster (1986) was later to call “the attacker’s advantage”. So too, neither Rumelt (1984) nor Barney (1986) provided an analysis of why one firm might be a first mover or why a first-mover advantage necessarily became translated into a competitive advantage. Rumelt (1984, 557-8) defined “strategy” as a “the concept…that a firm’s competitive position is defined by a bundle of unique resources and relationships and that the task of general management is to adjust and renew these resources and relationships as time, competition, and change


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erode their value.” He emphasized that “a firm’s strategy may be explained in terms of unexpected events that created (or will create) potential rents together with the isolating mechanisms that (will) act to preserve them….Firms that are lucky or insightful enough to make early commitments to what turn out to be defensible positions can be stunningly successful” (Rumelt 1984, 568, emphasis in original). In a later contribution, Barney (1991, 104) posited: “To be a first mover by implementing a strategy before any competing firms, a particular firm must have insights about the opportunities associated with implementing a strategy that are not possessed by other firms in the industry, or by potentially entering firms.” But how do “insights” (or luck) get translated into a “resource-based” competitive advantage? The resource-based argument can easily reduce to the tautology that if a firm somehow comes to possess resources that are both valuable, i.e., yield sustained competitive advantage, and difficult for other firms to acquire through the market or replicate than one can account for differences in the performance among firms in terms of the resources that they possess. What made the resource-based perspective interesting, and indeed essential, for these scholars of strategic management was a fundamental belief in what Lazonick (1991) has called “the myth of the market economy”: the belief that the US economy of the 1970s and 1980s (for example) was an economy characterized primarily by the market allocation of resources rather than the corporate allocation of resources. And in such a “market economy”, there should not be any differences among firms competing in the same industry -- indeed that there should not even be any barriers to firms in shifting from one industry to another in response to changing technological and market conditions. From this ideological perspective, business “strategy” was basically seen as building “barrier-to-entry” positions to market competition, and not as an organizational process in which the corporate allocation of resources and returns developed and utilized productive resources. Within this market-oriented resource-based perspective, Ingemar Dierickx and Karel Cool (1989), in a short article that was a critique of Barney’s (1986) notion of “strategic factor markets”, helped to move the positions perspective a step toward a process perspective. Dierickx and Cool recognized that 1) “strategic assets” have to be non-tradable if the firm is to capture the competitive advantages attributable to these assets, and 2) the way in which a firm could achieve such a result was through the accumulation of a “firm-specific” stock of capabilities inherent in such assets over an extended period of time. Asking the question, “Can a scholar buy his or her reputation for quality work in a strategic factor market?”, Dierickx and Cool (1989, 1505) drew “the managerial implication…that firms should focus their analysis mainly on their ‘unique’ skills and resources rather than on their competitive environment.” Dierickx and Cool couch their arguments in terms of imperfections in factor markets rather than, as we would put it, the dynamics of organizational success. Hence for them the line of causation is from an imperfection in the factor market to an internal process of what they call “the accumulation of asset stocks" – that is from a market position to an organizational process. “Being nontradeable,” they argue, ”the firm-specific component [of the asset stock] is accumulated internally” (Dierickx and Cool 1989, 1506). Yet, based on their discussion of the asset-stock accumulation process, they conclude that “[t]he common element in all these cases is that the strategic asset is the cumulative result of adhering to a set of consistent policies over a period of time.” One might, therefore, conclude the line of causation runs the other way: from an organizational process that allocates resources and returns to the accumulation of “firm-specific” assets to the creation of a market position that is superior to those enterprises who have not undertaken such an organizational process. If such is the case, the focus of the study of strategic management should


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be on the processes whereby corporations allocate resources and returns rather than on how firms exploit market imperfections to create unique resource positions in an economy characterized by the market allocation of resources and returns. Indeed, the need for such a process orientation toward strategic management is indicated by comments by Birger Wernerfelt published in 1997 that in his original 1984 contribution to the resource-based perspective, he had “assumed that resources were leveraged inside the firm and took as given that firms had heterogeneous resource endowments” (Wernerfelt 1997, xvii, his emphasis).” Wernerfelt recognized that in the ensuing years, the resource-based perspective had been enhanced by work on such phenomena as “competencies”, “the evolutionary perspective”, “commitments”, and “dynamic capabilities” (Wernerfelt 1997, xvii). Nevertheless, he observed, “many resources remain mystical”.

We have made progress in discussing them in terms of their effects, but we do not really know what they are. I feel that we need to move towards a more specific understanding of the nature of different resources, rather than of their effects. We have some understanding of reputational resources, including brand names, as well as irreversible investments in physical assets. However, many resources are only known indirectly. A good example of this is ‘group resources’. What is it exactly that makes one group of people better at doing something than another? I suspect that this class of resources contains most of the critical ones. However, at the moment its contents are in a black box, and unless we open it, we will not be able to say much about it (Wernerfelt 1997, xvii-xviii).

Yet, as we have seen, almost 40 years previously, Edith Penrose had published The Theory of the Growth of the Firm, a book that surely looked “inside the black box” at the operation of “group resources.” Indeed, in his 1984 article, Wernerfelt (1984, 171) stated that “[t]he idea of looking at firms as a broader set of resources goes back to the seminal work of Penrose (1959)” So fond have resource-based theorists been of claiming Penrose’s book as part (or even all) of their intellectual tradition that in a comparison of “process oriented” evolutionary theory with “equilibrium-oriented” resource-based theory, Nicolai Foss, Christian Knudsen, and Cynthia Montgomery (1995, 10) included Penrose (along with the “strategic management tradition” and “Chicago industrial economics”) within the “intellectual heritage” of resource-based theory, as exemplified by what we have called the “position perspective” contributions of Wernerfelt, Barney, Rumelt, and Dierickx and Cool. Yet, Penrose’s contribution to the theory of the firm as a social organization (see above Section 3.2.3, as well as Best 1990, ch. 4 and O’Sullivan 2000a, ch. 1) confronts the ideological and methodological orientation of the position perspective in resource-based theory. The problem for Foss, Knudsen, and Montgomery may be that they could not possibly have included Penrose as an intellectual predecessor of evolutionary theory, given that they include (along with Joseph Schumpeter), Armen Alchian within that intellectual tradition. In 1952, as a prelude to her work that resulted in The Theory of the Growth of the Firm, Penrose (1952) published a devastating critique of Alchian for his use of the biological analogy in economics to analyze phenomena, such as the nature of the firm, that clearly had to be analyzed as social processes. The problem is that Penrose’s contributions do not fit with either evolutionary theory (the path perspective) or resource-based theory (the position perspective); in terms of the “dynamic capabilities trilogy” of positions, paths, and processes (see below) her work belongs to the process perspective. Recognition of this fact might help to explain why such a seminal contribution as The Theory of the Growth of the Firm was for so long ignored by mainstream economists


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(who still have not embraced her work). Given their fundamental belief in the “myth of the market economy”, it has been difficult for mainstream economists to come to grips with a perspective that supports the idea that the corporate allocation of resources represents a central mode of resource allocation in the modern “market economy.”25 In practice, what appears to have provided the impetus for the transition from the position to the process perspective of a firm’s resources, and an intellectual reconsideration of the myth of the market economy, was the obvious success of the Japanese in developing and utilizing productive resources in an economy in which, with its institutions of lifetime employment and cross-shareholding, the market allocation of resources was clearly not the driving force. It was difficult for anyone who looked at how Japanese companies had risen to dominance in the 1970s and 1980s to avoid the conclusion that it was “processes”, not “positions”, that had been critical to their success. An important, and oft-cited, early work was Richard Pascale’s 1984 article, “Perspectives on Strategy: The Real Story Behind Honda’s Success.” Using the case of the successful entry of Honda Motor Company into the US motorcycle market from the late 1950s, Pascale (1984, 48-50) critiqued the “position” perspective that the Boston Consulting Group (BCG) had propounded for explaining why the British motorcycle producers had lost out to Honda. The BCG Report, presented to the British government in 1975, quickly became condensed into case studies at US business schools to show how a company could win out by taking a low-cost position and exploiting economies of scale. Pascale (1984, 51) quoted the statement from Richard Rumelt’s UCLA teaching note on the case that “[t]he fundamental contribution of BCG is not the experience curve per se [for which it had become famous in the 1970s] but the ever-present assumption that differences in cost (or efficiency) are the fundamental components of strategy.” Detailing the actual chain of events, decisions, and actions that resulted in Honda’s rise to a dominant position in the US motorcycle market, Pascale countered Rumelt’s statement with what he called an “organizational process perspective.”

[E]xtensive reading of strategy cases at business schools, consultants’ reports, strategic planning documents as well as the coverage of the popular press, reveals a widespread tendency to overlook the process through which organizations, experiment, adapt, and learn. We tend to impute coherence and purposive rationality to events when the opposite may be closer to the truth. How an organization deals with miscalculation, mistakes, and serendipitous events outside its field of vision is often crucial to success over time. It is this realm that requires better understanding and further research if we are to enhance our ability to guide an organization’s destiny (Pascale 1984, 57).

Referring to the general evidence on the loss of market share by major US industrial corporations from the early 1960s to the early 1980s, Pascale (1984, 63-71) argued that an understanding of these changes in market position required a richer framework for analyzing innovation, responsiveness, and operational efficiency. Besides the traditional notions of strategy, structure, and systems, the framework

25 How else can one explain that, Fritz Machlup, Penrose’s mentor at the Johns Hopkins

University, failed to mention Penrose’s work not only in his 1962 book, The Production and Distribution of Knowledge in the United States but also in his Presidential Address to the American Economic Association, entitled, "Theories of the Firm: Marginalist, Behavioral, Managerial" (Machlup 1962; 1967).


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had to integrate concepts of what managers do (“style”), how companies create committed employees (“staff”), and “the overarching value system that ties the purposes of the corporation to the customer, society, and higher order human values (“shared values”). Perhaps the most important single contribution to the strategic management literature that shifted the resource-based view from a position perspective to a process perspective was C. K. Prahalad and Gary Hamel's 1990 Harvard Business Review article on “the core competence of the corporation”. Drawing primarily on the experiences of Japanese companies such as Canon, Honda and Sony, Prahalad and Hamel (1990, 82) argued that “[c]ore competencies are the collective learning in the organization, especially how to coordinate diverse production skills and integrate multiple streams of technologies.”

If core competence is about harmonizing streams of technology, it is also about the organization of work and the delivery of value….Core competence is communication, involvement, and a deep commitment to working across boundaries. It involves many levels of people and all functions. World-class research in, for example, lasers or ceramics can take place in corporate laboratories without having an impact on any of the businesses of the company. The skills that together constitute core competence must coalesce around individuals whose efforts are not so narrowly focused that they cannot recognize the opportunities for blending their functional expertise with those of others in new and interesting ways.26

In a 1992 article entitled “Knowledge of the Firm, Combinative Capabilities, and the Replication of Technology,” Bruce Kogut and Udo Zander explicitly articulated the need by those concerned with strategic management to examine the resource base of the firm as an organization that could create core competencies in a corporate economy rather than as a “barrier to entry” in a market economy. “In our view,” they argued, “the central competitive dimension of what firms know how to do is create and transfer knowledge efficiently within an organizational setting.”

“[O]rganizations are social communities in which individual and social expertise is transformed into economically useful products and services by the application of a set of higher-order organizing principles. Firms exist because they provide a social community of voluntaristic action structured by organizing principles that are not reducible to individuals….In contrast to a perspective based on the failure to align incentives in a market as an explanation for the firm,…firms are a repository of capabilities, as determined by the social knowledge embedded in enduring individual relationships structured as organizing principles….After nearly two decades of research in organizational and market failure, it is time to investigate what organizations do (Kogut and Zander 1992, 407).

As an intellectual framework within the strategic management literature that seeks to analyze “what organizations do”, the most ambitious approach to date has been the dynamic capabilities perspective (Teece et al. 1997; see also Teece and Pisano

26 Little of this perspective, it should be noted, can be found in a theoretical article entitled “A

Resource-Based Theory of the Firm” that Prahalad co-authored with Kathleen Connor in which “[f]irm organization is distinguished from market contracting based on the existence of authority in the former (i.e., employer over employee), as compared to parties acting autonomously in the latter” (Connor and Prahalad 1996, 480).


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1994).27 Explicitly seeking to integrate work on asset positions, organizational processes, and evolutionary paths, the dynamic capabilities perspective links the position and process perspectives as elements of an evolutionary theory of the firm. The dynamic capabilities perspective follows the resource-based perspective understanding of asset positions “such as the firm’s difficult-to-trade knowledge assets and complementary assets” (Teece et al. 1997, 509). For its understanding of organizational processes, it draws on the empirical research on technology integration that has emanated from the Harvard Business School (for example, Hayes, Wheelwright and Clark 1988; Henderson and Clark 1990; Clark and Fujimoto 1991; Iansiti and Clark 1994; Leonard-Barton 1995). For its understanding of technological paths, it draws on evolutionary theory of the firm à la Nelson and Winter (1982; see also Dosi 1982; Nelson 1991; Dosi, Winter, and Teece, 1992; Winter 1995). In contrast to a “position” perspective that views “strategizing” as “engaging in business conduct that keeps competitors off balance, raises rival’s costs, and excludes new entrants” and that conceives of “rents” as “flow[ing] from privileged product market positions”, Teece at al. (1997, 509-10) argue that

the [dynamic capabilities] framework suggests that private wealth creation in regimes of rapid technological change depends in large measure on honing internal technological, organizational, and managerial processes inside the firm. In short, identifying new opportunities and organizing efficiently and effectively to embrace them are generally more fundamental to private wealth creation than is strategizing [against existing and potential rivals].

They see the distinctiveness of firms as opposed to markets as residing in the capabilities in “organizing and getting things done” in ways that “cannot be accomplished merely by using the price system to coordinate activity. The very essence of capabilities/competences is that they cannot be readily assembled through markets” (Teece at al. 1997, 517). Of the three elements of their framework – positions, processes, and paths – it is organizational processes that define their approach:

We define dynamic capabilities as the firm’s ability to integrate, build, and reconfigure internal and external competences to address rapidly changing environments. Dynamic capabilities thus reflect an organization’s ability to achieve new and innovative forms of competitive advantage, given path dependencies and market positions (Teece at al. 1997, 516, our emphasis).

Or, as they state, later in the paper: “The essence of a firm’s competence and dynamic capabilities is presented here as being resident in the firm’s organizational processes, that are in turn shaped by the firm’s assets (positions) and its evolutionary path” (Teece at al. 1997, 524).

27 For an excellent collection of readings on the historical antecedents of the resource-based

and dynamic capabilities perspective as well as the seminal contributions to the two perspectives themselves, see Foss (1997). For the papers from a 1993 conference that sought to synthesize the resource-based and evolutionary theories of the firm, see Montgomery (1995). For a review of the transition from the resource-based view toward a dynamic capabilities perspective, see Conner (1991). See also Foss and Knudsen (1996), and Heene and Sanchez (1997). For a textbook the employs the dynamic capabilities (positions, processes, paths) framework, see Tidd, Besant, and Pavitt (1997).


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“Organizational processes,” they argue, “often display high levels of coherence, and when they do, replication may be difficult because it requires systemic changes throughout the organization and also among interorganizational linkages, which may be hard to effectuate” (Teece at al. 1997, 519). Teece at al. (1997, 520) liken “coherence” to Nelson and Winter’s notion of “routines”, with the caveat that “the routines concept is a little too amorphous to properly capture the congruence among processes and between processes and incentives that we have in mind.” They stress the importance of learning processes that are “intrinsically social and collective” and argue that the “concept of dynamic capabilities as a coordinative management process opens the door to the potential for interorganizational learning” (Teece at al. 1997, 520). Whereas organizational processes transform the capabilities of the firm over time, asset positions determine the firm’s “competitive advantage at any point in time” (Teece et al. 1997, 521). Teece et al (1997, 521-2) describe asset positions under the separate headings of “technological”, “complementary”, “financial”, “reputational”, “structural”, “institutional”, “market structure”, and “organizational” – that is, they include under the label "asset positions" virtually any descriptive dimension of the firm as an organizational entity at any point in time. And while organizational processes can transform these characteristics of the firm, and hence its competitive capabilities over time, its evolutionary path – its particular history – constrains the types of industrial activities in which a firm can be competitive. Teece et al. (1997, 523-4) stress that, while the firm’s technological paths are constrained by its history, or “path dependency”, it nevertheless has the capacity to take advantage of technological opportunities created by “new scientific breakthroughs”. The technological opportunities created by these breakthroughs, moreover, “may not be completely exogenous to an industry, not only because some firms have the capacity to engage in or at least support basic research, but also because technological opportunities are often fed by innovative activity itself” (Teece at al. 1997, 523). Nevertheless, they argue, the firm’s “evolutionary path, despite managerial hubris that might suggest otherwise, is often rather narrow” (Teece at al. 1997, 524). Strategic change is generally incremental, as new capabilities have to build cumulatively on the capabilities previously put in place. From the dynamic capabilities perspective, “strategy”, Teece at al. (1997, 529) state, “involves choosing among and committing to long-term paths or trajectories of competence development.” Teece at al. say nothing specific about the locus of strategic control that ensures that the enterprise seeks to grow using the collective processes and along the cumulative paths that are the foundations of its distinctive competitive success. That is, although their “process” perspective provides much more insight into the governance question of what types on investments strategists should make, they have nothing to say about who within the organization's hierarchical and functional division of labour should make strategic decisions to maintain the integration of strategy and learning and thereby sustain the innovation process. Nor, as we shall see in the next and last section of the paper, do they have anything to say about how returns should be allocated to sustain the innovative process. As a result, the dynamic capabilities approach has thus far provided no insights into the conditions under which strategic control might become segmented from the organizational learning process that are central to the development of an enterprise’s core competencies, or how, under such circumstances, the structure of strategic control can be transformed to effect the reintegration of strategy and learning.


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Nor has the dynamic capabilities approach as of yet provided guidance for understanding how an enterprise can and should respond strategically when it is confronted by new competitors, supported by different institutional environments, whose dynamic capabilities render the enterprise’s processes and paths, and hence asset positions, obsolete. Teece at al (1997, 529) note that, for example, “American companies tend to favor ‘strategic leaps’ while, in contrast, Japanese and German companies tend to favor incremental, and rapid, improvements.” But they speculate that these “observed differences in strategic approaches” have to do with the dominance of position rather than process approaches to strategic thinking in the United States. It is much more plausible, however, that ideas, whether put forth by business academics or managers themselves, reflect rather than determine how corporations are governed. That Teece, Pisano, and Shuen might agree with this proposition is indicated in the last sentences of their paper, where they call for further theoretical and empirical work to help “understand how firms get to be good, how they sometimes stay that way, why and how they improve, and why they sometimes decline.”

Researchers in the field of strategy need to join forces with researchers in the fields of innovation, manufacturing, and organizational behavior and business history if they are to unlock the riddles that lie behind corporate as well as national competitive advantage. There could hardly be a more ambitious research agenda in the social sciences today (Teece at al. 1997, 530).

6.3 Strategic Control and Productive Capabilities: How Should Corporate

Returns be Distributed? The organizational processes that are central to the development and utilization of productive resources in the economy are dependent on the strategic allocation of corporate returns as well as the strategic allocation of corporate resources. The allocation of corporate returns, including as it does a division of corporate revenues into retentions and salaries on the one side and distributions to shareholders and debtholders on the other side, influences both the financial commitment that the corporation can make to the enterprise as a productive organization and the organizational integration of corporate employees that mobilizes the skills and efforts of these employees to the pursuit of organizational goals. By linking financial commitment and organizational integration, those who exercise strategic control over the allocation of corporate returns can have a preponderant influence over the development and utilization of the enterprise's productive resources. It is important to recognize that the allocation of corporate returns is not just about whether or not a company should retain surplus revenues for reinvestment in plant and equipment or distribute them to shareholders. It is also about how those who exercise strategic control over surplus revenues invest in the skills of employees and reward their efforts. For example, in Competitive Advantage on the Shop Floor, Lazonick (1990, 333-52) develops a model of "shop-floor value creation" in which managerial decisions to allocate a portion of the surplus under their control (after paying the cost of capital) to wage increases affects the levels of effort that workers supply. Effort levels in turn affect the rate of utilization of the technology in which the company has invested, and hence the total amount of value created that (given the cost of capital) can be shared between managers and workers. On a given technology, increases in the amount of value created require increases in the amount of effort workers supply. But investments in what Lazonick calls "effort-saving technological change" can, depending on the relation between the cost of the


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technological change and its effort-saving impact, make it possible for workers to receive higher wages, supply less effort, and still increase the amount of value created. Indeed, depending on the extent of wage increases and effort reductions that accompany the technological change, the size of the "managerial surplus" may increase as well. One implication of this model is that, under certain conditions, workers may have an interest in the allocation of the surplus not only to wage increases but also to effort-saving technology that can reduce the trade-off between effort and earnings. Such a conclusion, however, must assume that current workers expect that, with the introduction of new technologies, they will retain their employment with the company. Such expectations of long-term employment will be greater when investments in new technologies entail the enhancement rather than the displacement of workers' skills. Such expectations will also be enhanced when there is "organizational control" over the allocation of corporate returns that limits returns to shareholders than when there is "market control" over these returns that places pressures on corporate managers to distribute surplus revenues (Lazonick and O'Sullivan 1996). Given the historical importance in the advanced economies of 1) retentions as a source of corporate investment funds, and 2) corporate careers as incentives to employees to identify with corporate goals,28 an understanding of the relation between the allocation of corporate returns and the innovation process should surely be of prime interest to the study of strategic management. Indeed, as we have seen, the current Anglo-Saxon corporate governance debates are all about the allocation of corporate returns; the critical shortcoming of these debates, as we have shown, is to be found in their failure to address the relation between the allocation of resources and the innovation process. Hence if the strategic management literature that focuses on the allocation of corporate resources is to have anything to say about the impacts of corporate governance on an enterprise's competitive capabilities, it should have something to say about the strategic allocation of corporate returns as well. On this issue, however, neither the resource-based perspective nor the dynamic capabilities perspective has virtually anything to say. The resource-based perspective on strategic management habitually refers to the returns on unique resources as “rents”, a term that derives from the perspective's underlying adherence to the theory of the market economy. As used in economics, rent is a return to a factor of production the supply of which is fixed -- for example, land in a particular location. Its supply cannot be increased through the process of production. Yet what enables the innovation process to contribute to economic development is the transformation of the production process to overcome conditions of scarcity imposed by the resource base. A surplus generated by the innovation process is the result of the ability of the enterprise to produce a larger quantity or a higher quality of output with a given quantity and quality of inputs. This surplus is not a "rent", and it is a fundamental error of economic analysis to call it such. It has long been recognized by students of economic development (including economic anthropologists) that the process of economic development generates economic surpluses, not rents, in which different groups of participants in the development process can potentially share. It is these surpluses, not rents, that are the basis for the achievement of higher standards of living through economic development. The use of the term “rents” in resource-based theory, as in other economic theories that rely on the theory of the market economy, reflects the perspective's lack of a theory

28 For syntheses of the comparative-historical evidence on corporate finance, see Lazonick

and O'Sullivan (1997a and 1997b), and on corporate employment, see Lazonick and O'Sullivan (1997c).


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of innovation and economic development. Such a “rent-generating” perspective cannot possibly be used to analyze the relation between the allocation of corporate returns and the process of innovation. Moreover, if one insists upon using the concept of rents as the explanation for "residual" returns to unique resource bases, one has to account for a lack of quasi-rents (a century-old concept, much used in Marshallian economics) that, in a market economy, would erode the competitive advantage of the firm that employed unique resource bases. The existence of quasi-rents means that market competition for the unique resources enables the scarcity-value of these resources to be appropriated by the owners of the resources who can trade them on the market, and not by the firm that employs these resources. Hence Dierickx and Cool's (1989) insight that, within the framework of resource-based theory, one has to assume that a unique resource is “nontradeable” for it to be a source of competitive advantage. But, then, as we have already pointed out, the critical question for understanding the allocation of corporate returns among participants in the enterprise is whether a condition of “nontradeability” represents simply a barrier to exit for a particular factor of production – in which case it is difficult to see why the unique resource generates any residual, whatever one labels it – or whether it represents (as we have claimed Dierickx and Cool implicitly argue) the outcome of an organizational process that integrates the resource into the cumulative and collective structure of an innovative enterprise. In this case, the surpluses that accrue to the enterprise after all factors of production are paid their market rates of return derive from the fact that, as an organization, the enterprise has developed the unique resources that can generate higher quality, lower cost products -- and in doing so has made these resources less scarce than they had previously been. Unlike resource-based theory, the dynamic capabilities perspective on strategic management clearly addresses itself to the organizational processes that generate organizational learning and innovation. Yet, like the resource-based perspective more generally, the dynamic capabilities perspective, as it has been put forth thus far, has had nothing to say about the strategic allocation of returns. As a result, it lacks a perspective on how strategic control can link financial commitment and organizational integration to generate innovation. More than that, it has nothing to say about how and whether changes in the national institutions of corporate governance support or proscribe strategies to develop and utilize "dynamic capabilities". The dynamic capabilities perspective focuses on the core substance of the innovation process -- the "what" of our three corporate governance questions concerning the corporate allocation of resources and returns. But it does not have a theory of the "who" and "how", and therefore does not have a theory of innovative enterprise. If both the resource-based perspective and the dynamic capabilities perspective fail to analyze the relation between the allocation of corporate returns and the innovation process, such an analysis receives little attention in the strategic management literature more generally. For example, in their recent review of the strategy literature, the only reference that Mintzberg at al. (1998, 76) make to the subject of the allocation of corporate returns is the quite plausible argument that "not only is capital budgeting not strategy formation, it most decidedly impedes strategy formation" (see also Baldwin and Clark 1994). Or, for another example, of 33 Harvard Business Review articles reproduced in a 1991 volume entitled Strategy: Seeking and Securing Competitive Advantage (Montgomery and Porter 1991), only two articles concern the allocation of corporate returns. Nevertheless, the two particular articles included -- Gordon Donaldson’s “Financial Goals and Strategic Consequences” and Michael Jensen’s “The Eclipse of the Public Corporation” -- are


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of considerable interest to the debates on corporate resource allocation. The authors of both the articles were Harvard Business School finance professors in the 1980s who assumed that top managers should exercise strategic control. Yet they put forth diametrically opposite views, reflecting the managerial perspective in the one case and the shareholder perspective in the other, on how US industrial corporations should allocate corporate returns. Originally published in 1985, just as the shareholder value movement was taking hold in the United States, Donaldson's “Financial Goals and Strategic Consequences” propounded the traditional view among US corporate managers and business academics concerning the relation between the allocation of corporate returns and long-term corporate growth. Donaldson (1985, 62) contended:

Academics and CEOs have nurtured the belief that shareholder wealth and return on investment are a company’s ultimate priorities at all times. But that belief is not supported by my observations….A preoccupation with one constituency or one goal distorts the reality of the diverse communities to be accommodated.

Donaldson (1985, 59) argued that a well-managed company -- one that is determined to have stable growth -- requires a balanced financial goals system. These goals reflect the corporation's desire

to grow aggressively in promising market segments; stay number one in product quality, markets, and technology; attract and hold superior management and technical personnel; diversify; provide a stable revenue stream, a superior return on investment, steady dividends, a superior price-earnings ratio; maintain a conservative debt policy.

“Contrary to popular belief," Donaldson (1985, 58) argued, "companies do not put maximum profit before all else."

In practice, no absolute or external financial priorities exist; they change as the economic and competitive environments change. Mature companies assign priorities to multiple financial goals based on the relative power of the economic constituencies represented by these individual goals – whether capital or product markets or the market for human resources….Managing a company’s financial goals system is an unending process in which competing and conflicting priorities must be balanced. At any point, the system is potentially unstable because of the changing corporate environment and shifts in power and influence among constituencies.

Donaldson (1985, 59) observed that most corporate managers preferred self-sufficiency from capital markets: "To fuel growth, they rely primarily on internally generated funds coupled with conservative debt limits linked to the equity base. Reliable funds, even in large, mature, and successful corporations, are finite." And, later in the article he reiterated this point: “Whatever the merits from society’s perspective, corporate financial management has as its implicit, if not explicit, objective decreased dependence on capital market uncertainty and interference" (Donaldson 1985, 63). In a concluding section of the article, with the subheading "What is Financial Reality?", Donaldson (1985, 65) appears to be speaking to the new financial pressures on US corporations in the 1980s, stating that “[a] company’s goals do not exist in a vacuum."


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Inevitably they confront the reality of the existing corporate environment and established strategy. A serious inconsistency with that reality threatens the stability of the system. In such cases, either management persistently rationalizes and ignores discrepancies between goals and performance or, worse, warps actions and results to meet expectations.”

He went on to argue that short-term financial goals are largely given to the corporation by its past strategic decisions including its debt structure, contractual commitments, and organization structure. But long-term financial goals depend on the nature of the corporation's competitive strategy, and hence are under the control of corporate decision makers. Corporate managers should define long-term goals in ways that ignore exigencies of short-term goals. Such long-term financial goals "transcend current competitive conditions." Unless corporate managers specify precise plans and a timetable for strategic redirection, the long-term financial goal will, Donaldson (1985, 65) argued,

have little impact in the organization's behavior. The long-term goal may be a cause for concern by those responsible for current performance, but the immediacy of short-term goals will drive long-term goals out every time.

Indeed, during the 1980s, many proponents of what we have called the managerial perspective on corporate governance bemoaned the triumph of short-termism over long-termism in the allocation of corporate returns. Yet, as we have seen, in the United States over the course of the 1980s, the managerial perspective suffered a resounding defeat at the hands of the shareholder perspective, as one by one, and then as a herd, top corporate managers took firm strategic control over the allocation of corporate returns and adopted the new ideology of maximizing shareholder value (Lazonick and O'Sullivan 2000). But the fundamental reason for this change in corporate behaviour was not that financial markets forced top managers to become more short-term in their investment behaviour as was widely believed in the mid-1980s when Donaldson wrote his paper. Rather the change in managerial behaviour reflected the implementation of "shareholder value" as a new ideology of corporate governance in the United States in ways that transformed the “who, what, and how” of the corporate allocation of resources and returns, Jensen’s "The Eclipse of the Public Corporation" (originally published in 1989) exemplified, and promoted, the new ideology of corporate governance. Perhaps the foremost academic proponent of the shareholder perspective, Jensen made the argument for the economic efficiency of "disgorging the free cash flow" from US publicly traded corporations that refused to "maximize shareholder value." Jensen (1989, 66) defined "free cash flow" as that "cash flow in excess of that required to fund all investment projects with positive net present values when discounted at the relevant cost of capital." From the perspective of a theory of innovative enterprise, however, there are a number of problems with this definition as a decision rule for the allocation of corporate returns -- problems that highlight the importance of understanding the relation between the "who, what and how" of corporate governance and the innovative enterprise, and the need for microlevel and macrolevel research on corporate governance, innovation, and economic performance. Firstly, the decision rule contains a bias against innovative investment projects that entail investments in skill bases that can engage in cumulative and collective learning -- or what we have called "innovative skill bases". Despite all of the attention devoted to the importance of "firm-specific human capital" as a source of


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value creation, human assets are still not accounted for in corporate capital budgeting. Moreover, even if one were to try to account for it, there has been, as we have seen, very little work done on what "firm-specific human capital" actually is and on how it creates value. To even begin such a project, there is a need for a theory of cumulative and collective learning based on functional and hierarchical integration. Recognition of the centrality of investments in innovative skill bases to the creation of value would result in a much lower assessment of the size of the enterprise's free cash flow than when, as is conventionally the case, "investment projects" entail only tangible plant and equipment. Secondly, given the inherent uncertainty of the innovative process, conventional capital budgeting procedures have no way of assessing the flows of returns from innovative investment projects. In our view, such uncertainty is best confronted under a corporate governance regime that encourages the integration of strategy and learning. As we have argued, it was the separation of strategy and learning in overgrown US corporations in the post-World War II decades that rendered these companies vulnerable to the rise of new competition in the 1970s and 1980s, thus creating a plausible basis for proponents of shareholder value, such as Jensen, to argue that a disgorging of the corporate cash flow would enhance the efficiency of the economy. But, as we have also argued (Lazonick and O'Sullivan 2000), a main effect of the implementation of shareholder value as a principle of corporate governance in the 1980s was to concentrate strategic control in the hands of corporate CEOs, thus exacerbating strategic segmentation in US corporations. Moreover even if, in the presence of uncertainty, strategic decision makers were to choose a notional cost of capital and an estimated stream of future cash flows as a basis for constructing a guideline "hurdle rate" for new investment projects, the relevant cost of capital is not necessarily independent of the prevailing corporate governance regime. In the United States, for example, the rise of shareholder value as a principle of corporate governance in the 1980s and 1990s was accompanied by a structural increase in actual yields on corporate securities (see Table 3). Insofar as such higher realized yields enter into the calculations of the "relevant cost of capital", the size of the "free cash flow", as Jensen defines it, will also increase.

Finally, even after adjusting for such problems of actually measuring the "free cash flow", a major corporate governance issue still remains: how should the free cash flow be distributed to generate superior economic performance? As we have stressed, among economists, Jensen included, the current corporate governance debates are not about who is entitled to corporate returns, but rather about how the distribution of corporate returns to one group or another can yield the greatest net benefits to the economy as a whole. As we discussed earlier in this paper, a shareholder theorist such as Jensen makes the argument that the distribution of residual returns to shareholders will result in the greatest net benefits to the economy because shareholders will reallocate these resources to investments in the best available alternative investment opportunities. In contrast, a stakeholder theorist such as Margaret Blair argues that, because of the need for workers to have an incentive to invest in firm-specific human capital, they should receive a portion of residual returns. One cannot resolve these issues about the relation between the allocation of corporate returns and economic performance without a theory of the innovation process -- a theory that thus far has been lacking in the mainstream corporate governance debates (O'Sullivan 2000b). Research on organizational learning and strategic management has much to contribute to our understanding of the innovation process. But, ultimately, to say anything about economic performance -- be it in


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terms of economic growth, income distribution, and/or financial stability -- at either the microlevel of the enterprise or the macrolevel of the economy, this research must be linked explicitly to a theory of innovative enterprise, which in turn must be imbedded in a theory of an innovative economy. Progress in understanding the innovation process and its implications for economic performance requires that economists free themselves from the grip of "the myth of the market economy" that has so long defined their professional identity, and get "inside the black box" of business organization to fashion a theory of innovative enterprise (Lazonick 1991 and 2000). But it also requires that business academics (many of them trained as economists) free themselves from the grip of dominant business ideologies -- get "outside the black box" so to speak to see business organizations in the light of the economies and societies to which they are central -- so that they can consider how organizational learning and strategic management might be the effects and causes of processes that can generate innovation. Once one has developed a perspective on how, through the corporate allocation of resources and returns, value is created, one can begin to consider how alternative regimes for the distribution of value might affect economic performance. Why not distribute some corporate returns directly to entrepreneurs (or groups of entrepreneurs) who, having gained experience in the corporation, could use the funds to launch innovative new ventures characterized by an integration of strategy and learning? Why not to employees in the form of higher wages, or to consumers in the form of lower product prices, thus enabling these groups to increase their consumption or their saving or both? Why not, to communities and governments to invest in institutional and physical infrastructures that can support an innovative economy and include more people in it? At a minimum, it should be clear that corporate governance is not about aligning the incentives of shareholders and managers. Corporate governance is about the relation between resource allocation and economic performance on a national, regional, and even global scale.


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139

Total Capitalization of Shares of Domestic Companies

Country $ bn1 % GDP2

The Netherlands 603.18 160 Greece 80.13 67 Belgium 245.66 98 Germany 1,093.96 51 Finland 154.83 124 Ireland 66.59 80 Italy 569.73 49 Portugal 62.95 59 Luxembourg 38.18 219 France 991.48 69 Spain 402.16 73 Sweden 278.71 123 Austria 35.78 17 EU less UK 4,768.51 67 UK 2,372.74 175 EU incl. UK 7,141.25 84 Switzerland 689.20 260 Norway 46.27 32 Japan 2,495.76 66 US3 15,323.29 186

1 FIBV 2 Source of GDP figures: OECD figures at current prices and exchange rates 3 Comprising Amex, Chicago, NASDAQ and NYSE Stock Exchanges

Table 1 Stock Market Capitalization Shares of Domestic Companies, Dec. 31, 1998


140

0%50%

100%150%

200%

250%

300%

The N

etherla

nds Greece

Belgium

Denmark

Germany

Finlan

dIrel

and Italy

Portug

al

Luxem

bourg

France Spa

inSw

eden

Austria

EU les

s UK UK

EU inc

l. UK

Switze

rland

Norway

Japan US

1990

1994

1998

M a r k e t C a p i t a l i z a t i o n a s a p e r c e n t a g e o f G D P

F i g u r e 1

Linking Enterprises and Nations:

Financial Commitment:allocation of money to sustain the process that develops &utilizes productive resources until it can generate returns

Institutional Conditions for Innovation*

Organizational Integration:relations that create incentives for large numbers of peopleto apply their skills & efforts to organizational learning

*Sources: William Lazonick and Mary O’Sullivan, “Organization, Finance, and InternationalCompetition,” Industrial and Corporate Change, 5, 1, 1996; Mary O’Sullivan, “The InnovativeEnterprise and Corporate Governance,” Cambridge Journal of Economics, 24, 4, 2000.

Strategic Control:strategic power to combine financial commitment andorganizational integration so that money and people engagein innovation

Figure 2


141

Operat ions and Organizat ion inUS and Japanese Manufactur ing

A m e r i c a n J a p a n e s eOperat ional characterist ic

Lot s ize Large Smal lSetup t ime Long Shor tMachine trouble High L o wInventory Large Smal lFloor space Large Smal lTransportat ion Long Shor tLead t ime Long Shor tDefect Rate High L o w

Organizational characterist ic

Structure Rigid FlexibleOrientat ion Local opt imizat ion Tota l opt imizat ionCommunicat ion Long chain of command O p e nAgreement Contract-based Institution -basedUnion focus Job-based Company-basedSkill base Narrow B r o a dEducation/training Low qual i ty High qualityTraining Insignif icant Signif icantSupplier relations Short- term/many compet i tors Long-term/selected few

Source: Adapted f rom Kiyoshi Suzaki , The New Manufactur ing Chal lenge , Free Press, 1987, 233.

Table 2

O r g a n i z a t i o n a l C o n d i t i o n s :I n t e g r a t i o n , L e a r n i n g , a n d I n n o v a t i o n

Hie

rarc

hica

l In

tegr

atio

n?

I n t e g r a t i o n ?

T o pE x e c u t i v e s

Techn ica l Spec ia l i s t s T e c h n i c a l S p e c i a l i s t s

Middle M a n a g e r s

P r o d u c t i o nW o r k e r s

Ski l l ed“Semi” Ski l l edU n s k i l l e d

Off iceW o r k e r s

Ski l led“ S e m i ” S k i l l e dUnski l l ed

S t r a t e g y a n d L e a r n i n gW h o a l l o c a t e s r e s o u r c e s ?A r e t h e y i n t e g r a t e dw i t h l e a r n i n g p r o c e s s e s ?

I n n o v a t i v e S k i l l B a s e sH o w b r o a d a n d d e e p a r e

t h e s k i l l b a s e s t h a t t h el e a r n i n g p r o c e s s r e q u i r e s ?

F u n c t i o n a l

R e s e a r c h a g e n d a : h o w d o i n n o v a t i v e s k i l l b a s e s v a r y i n b r e a d t h a n d d e p t h a c r o s sn a t i o n s , i n d u s t r i e s , e n t e r p r i s e s w i t h i n i n d u s t r i e s a n d n a t i o n s , a n d o v e r t i m e ?

B r o a d s k i l l b a s e :f u n c t i o n a lin tegrat ion

D e e p s k i l l b a s e :h ierarch ica l in tegrat ion

Figure 3


142

Organizational Conditions:Evolution of Company and Industry Structures

VerticalEnterprise Group

Horizontal

Industrial District

Joint VentureStrategic Alliance

Proprietary Firm

CorporateEnterprise

New Venture

Going Concern

Evolution of Industry Structure

Evo

lutio

n of

Com

pany

Str

uctu

re Unit of Financial Control

DivisionsConglomerate

Spinoffs

Inter-Company Relation

Mergers andAcquisitions

Strategy, Organization, and Structural Change•How do organizational conditions and industrial conditions interact in theevolution of company and industry structure?•How do company structure and industry structure interact in determining theevolution of organizational conditions?

Buyouts

Figure 4

Subcontractor

I n d u s t r i a l , O r g a n i z a t i o n a l , a n d I n s t i t u t i o n a l C o n d i t i o n s i n t h e I n n o v a t i o n P r o c e s s

F i n a n c i a l F i n a nc i a l C o m m i t m e n tE m p l o y m e n t O r g a n i z a t i o n a l I n t e g r a t i o nR e g u l a t o r y S t r a t e g i c C o n t r o l

I n d u s t r i a l C o n d i t i o n s O r g a n i z a t i o n a l C o n d i t i o n s

T e c h n o l o g i c a lM a r k e t

C o g n i t i v e

B e h a v i o r a l

e n a b l e a n d p r o s c r i b e

I n s t i t u t i o n a l C o n d i t i o n s

S t r a t e g i ct r a n s f o r m

C o m p e t i t i v e c h a l l e n g e

F i g u r e 5

S o c i a l C o n d i t i o n s o fI n n o v a t i v e E n t e r p r i s e

s h a p e

c o n s t r a i n

r e f o r m

e m b e d


143

T r a n s f o r m i n g t h e C o n v e n t i o n a l T h e o r y o f t h e F i r m

q c

p c

p m i n c

q m a x c

i n n o v a t i v e e n t e r p r i s e ( I E )

p e r f e c t c o m p e t i t o r s( P C s )

a v e r a g ec o s t

m a r g i n a lc o s t

m a r g i n a la n d a v e r a g er e v e n u e

• T e c h n o l o g i c a l a n d m a r k e t c o n d i t i o n s g i v e n b y c o s t a n d r e v e n u e f u n c t i o n s . • T h e “ g o o d m a n a g e r ” o p t i m i z e s s u b j e c t t o t e c h n o l o g i c a l a n d m a r k e t c o n s t r a i n t s .

• T h e i n n o v a t i v e e n t e r p r i s e t r a n s f o r m s t h e t e c h n o l o g i c a l a n d m a r k e t c o n d i t i o n s i t f a c e s t o g e n e r a t e h i g h e r q u a l i t y , l o w e r c o s t p r o d u c t s .• T h e r e i s n o “ o p t i m a l ” o u t p u t . T h e r e i s n o “ o p t i m a l ” p r i c e .

p = p r i c e ; q = o u t p u t ; m = m o n o p o l i s t ; c = p e r f e c t l y c o m p e t i t o rp m i n = m i n i m u m b r e a k e v e n p r i c e ; q m a x = m a x i m u m b r e a k e v e n o u t p u t

F i g u r e 6

Compet i t i on and Monopo ly Compared

Monopo ly means lower ou tpu t andhigher pr ices = infer ior per formance.But how d id the monopo l is t ga in a dominant market pos i t ion?

qq m c

p

pm

c

p m i n c

q m a x c

By t ransforming h igh f ixed costs into low uni t costs , IE can achieve lower costs and h igher output than PCs that opt imize subject to constraints. The low -cost, high -output IE becomes a “monopol is t” !

1

2

3 THE LOGICAL FLAW: I t i s inva l id to assume that the cost structures of “compet i t ive” f i rms would be the same as those of enter -pr ises that are dominant in an industry .

innovat ive enterpr ise ( IE )

Per fec tcompet i tors( P C s)

averagecost

marginalcost

marginalrevenue

averagerevenue

p = pr ice; q = output m = monopol is t ; c = per fec t ly compet i torpmin = min imum breakeven p r iceqmax = max imum breakeven output

Figure 7


144

I n n o v a t i v e E n t e r p r i s e o r O p t i m i z i n g F i r m ?T h e T r a n s f o r m a t i o n o f T r a n s a c t i o n - c o s t T h e o r y

I n n o v a t i v e E n t e r p r i s e D e v e l o p s & U t i l i z e s P r o d u c t i v e R e s o u r c e s

T r a n s a c t i o n - C o s t T h e o r y

T h e o r y o fI n n o v a t i v e E n t e r p r i s e

G i v e n C o n s t r a i n t s

A s s e t S p e c i f i c i t y( I n d u s t r i a l )

B o u n d e d R a t i o n a l i t y( C o g n i t i v e )

O p p o r t u n i s m( B e h a v i o r a l )

I n n o v a t i v e T r a n s f o r m a t i o n s

E n t e r p r i s e I n v e s t m e n t S t r a t e g y D e v e l o p s “ S p e c i f i c A s s e t s ”

O r g a n i z a t i o n a l L e a r n i n g C o l l e c t i v i z e s “ R a t i o n a l i t y ”

O r g a n i z a t i o n a l I n c e n t i v e s O v e r c o m e “ O p p o r t u n i s m ”

F i g u r e 8

Industr ia l Transformat ion:Technology , Markets and Innovat ive Enterpr ise

innovat ive enterpr i se ( IE)

opt imiz ingf irms (OFs)

pr ice ,cost

output output

innovat ive enterpr i se :p h a s e o n e

innovat ive enterprise:p h a s e t w o

By internal iz ing var iable factor creat ing increas ing cos ts , IE incurs even h igher f ixed costs but the investment enables i t to “unbend” the U -shaped cos t curve .

expecteddecreas ing costs

actua lincreas ing costs

Through h igh f i xed-cost s trategy , IE expects to outcompete OFs . But , in per iod one , IE’ s s trategy only resul ts in h igh uni t costs , and IE remains a t a compet i t ive d i sadvantage .

Figure 9


145

Social Conditions of Innovative Enterpriseand Competitive Performance

in the “Old Economy”Cross-national comparisons, circa 1980

Financial Commitment

Organizational Integration

CompetitivePerformance

Market Control

Managerial Control

Organizational Control: Formal

Organizational Control:Informal

FSHS

HI/FS (managerial)HS (shop floor)

HIFS

HIFI

Low quality,high cost

Low quality, low cost

High quality,high cost

High quality,low cost

FI = functional integration; FS = functional segmentationHI = hierarchical integration; HS = hierarchical segmentation

Source: William Lazonick and Mary O’Sullivan, “Organization, Finance, and International Competition,” Industrial and Corporate Change, 5, 1, 1996.

Germany

Japan

Britain

USA

Figure 10

Strategic ControlStructural

Segmentation

Evolving Segmentation

FormalIntegration

InformalIntegration

Executives

Specialists

Executives

Specialists

Regular Male OperativesXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX

Mostly Females and Temporary Employees

UnitedStates

Japan

XXXXXXXXXXXXXXXXXXXXXXXXXXXX

Hourly Operatives

XXX =HierarchicalSegmentation

Organizations and Institutions United States and Japan, Circa 1980

=HierarchicalIntegration= HierarchicalInteraction

=FunctionalSegmentation

??

Figure 11

? ?


146

Executives

Specialists

Executives

Specialists

Craft Workersand Assistants

XXXXXXXXXX

UnitedStates

Hourly Operatives

XXX =HierarchicalSegmentation

Britain

Organizations and Institutions United States and Britain, Circa 1980

XXXXXXXXXXXXXXXXXXXXXXXXXXXX

=HierarchicalIntegration


Figure12

Specialists

Regular Male Operatives

Germany

JapanXXX =Hierarchical

Segmentation

Organizations and Institutions Germany and Japan, Circa 1980

Craft Workers

Executives

Executives

X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X

Most females and temporary employees

Specialists

=HierarchicalIntegration= HierarchicalInteraction


Figure13


147

U.S. Corporate Stock and Bond Yields1950-1998

Percent, annual averages

Real stock yieldStock price yield

Dividend yield

Change in CPI

Real bond yield

1950-9 1960-9 1970-9 1980-9 1990-8

17.7 8.3 -1.7 14.311.714.8 7.5 1.4 12.9 14.8

3.2 4.14.9 4.3 2.6

2.1 2.4 7.1 5.6 3.1

1.3 2.7 4.91.2 5.8

Sources: US Congress, Economic Report of the President, 1992, US Government Printing Office, 1992: 366, 378, 397; US Congress, Economic Report of the President, 1999, US Government Printing Office, 1998: 399. 412, 436

Table 3

Documents

William Lazonick