William Lazonick

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Corporate Governance

Text of 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 PerformanceRevised June 2000

William LazonickAnd

Mary O'SullivanThe 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: william.lazonick@insead.fr mary.o.Sullivan@insead.fr

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

Corporate Governance, Innovation, and Economic Performance

Contents Summary 2

1.

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

13

2.

The Anglo-American Debates on Corporate Governance 2.1 The Managerial Perspective on Corporate Governance 2.2 "Shareholder Value" as a Principle of Corporate Governance2.2.1 The mechanisms of corporate governance 2.2.2 The productive role of the corporate shareholder 2.2.3 The sources of "residual earnings" in shareholder theory 27 32 35

20 20 24

2.3 The Stakeholder Perspective on Corporate Governance 2.4 Innovation and the Corporate Governance Debates 3. Innovation: Linking Corporate Governance and Economic Performance 3.1 Innovation and Economic Development 3.2 The Economic Theory of Innovative Enterprise

40 46 48 48 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 4.1 Innovative Allocation: Developmental, Organizational, Strategic 4.2 Organizational Control and Innovation 66 70

66

5. 5.1 5.2 5.3 5.4 6.

Organizational Learning and Innovation Individual Learning and Organizational Learning Functional and Hierarchical Integration Within the Firm Horizontal and Vertical Relations Among Firms Within an Industry Learning and Innovation Strategic Management and Corporate Governance 6.1 Strategic Control: Who Makes Decisions to Allocate Corporate Resources and Returns? 6.2 Strategic Control and Organizational Learning: What Types of Innovative Investments Should Strategists Make? 6.3 Strategic Control and Productive Capabilities: How Should Corporate Returns be Distributed? 73 79 91 96

73

101 101 107 115 121 139

References Tables and Figures

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Corporate Governance, Innovation, and Economic Performance

SUMMARY1. 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 t ese enterprises and the h 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 AngloAmerican 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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Corporate Governance, Innovation, and Economic Performance

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 see