1、Corporate Governanceand the Theory of the Firm *Luigi ZingalesWhile some questions surrounding corporate governance have been around since Berle and Means (1932), the term did not exist in the English language until 25 years ago. But in the last two decades, corporate governance issues have become i
2、mportant not only in the academic literature but also in public policy debates. During this period corporate governance has been identified with takeovers, financial restructuring, and institutional investors activism. But what exactly is corporate governance? Why is there a corporate governance “pr
3、oblem?” Why does Adam Smiths invisible hand not automatically provide a solution? What role do takeovers, financial restructuring, and institutional investors play in a corporate governance system? This paper looks at these questions systematically and makes explicit the essential link between corpo
4、rate governance and the theory of the firm. It provides a common framework for analyzing the results obtained in these two fields and identifying questions left unanswered. It is not a survey and so makes no attempt to be comprehensive. (Shleifer and Vishny 1997 provide a comprehensive survey of cor
5、porate governance and the firm.) When Do We Need a Governance System? Governance is synonymous with the exercise of authority, direction, and control. These words seem strange, however, when used in the context of a free-market economy. Why do we need any form of authority? Isnt the market responsib
6、le for allocating all resources efficiently without the intervention of authority? The basic (neoclassi-cal) undergraduate microeconomics courses rarely mention the words authority and control. In fact, neoclassical microeconomics describes well only one set of transactionswhat Williamson (1985) cal
7、ls “standardized” transactions. Consider for example the purchase of a commodity such as wheat. There are many producers of the same quality of wheat and many potential customers. Adam Smiths invisible hand ensures that the good is provided efficiently without the need for any form of authority. But
8、 many daily transactions do not fit this simple model. Consider the purchase of a customized machine. The buyer must contact a manufacturer and agree on the specifications and the final price. Unlike in the case of wheat, the signing of the agreement is not the end of the relationship between the bu
9、yer and the seller. Producing the machine requires some time, during which many things can happen to alter the production cost, as well as the buyers will-ingness to pay for it. More important, before the agreement was signed, the market for manufacturers was competitive. Once production has begun t
10、he buyer and the seller are trapped in a situation of bilateral monopoly. The customized machine probably has a higher value to the buyer than to the market. On the other hand, the contracted manufacturer probably has the lowest cost to finish the machine. The difference between what the two parties
11、 generate together and what they can obtain in the marketplace is a quasi rent, which needs to be divided ex post. In dividing this surplus Adam Smiths invisible hand is of no help, but authority does play a role. In the spirit of Williamson (1985), I define a governance system as the complex set of
12、 constraints that shape the ex post bargaining over the quasi rents generated in the course of a relationship. The initial contract certainly plays a main role in this system. But the contract most likely will be incomplete, in the sense that it will not fully specify the division of surplus in ever
13、y possible contingency. Such specification might be too costly or outright impossible because the contingency was unanticipated. This creates an inter-esting distinction between decisions made ex ante (when the two parties entered a relationship, and irreversible investments were sunk) and those mad
14、e ex post (when the quasi rents are divided). This contract incompleteness also creates room for bargaining. The outcome of the bargaining will be affected by several factors besides the initial contract. The first factor is the party that has ownership of the machine while it is in production. The
15、second is the availability of alternatives. How costly for the buyer is a delay in receipt of the new machine? How costly for the manufacturer is a delay in receipt of the final payment? How much more costly is it to have the job finished by another manufacturer? Finally, the institutional environme
16、nt plays a major role in shaping the bargaining outcome. How effec-tive and rapid is law enforcement? What are the professional norms? How quickly and reliably does information about the manufacturers performance reach potential customers? All these conditions constitute a governance system. As the
17、machine example illustrates, two conditions must be met for a governance system to be needed. First, the relationship must generate some quasi rents. In the absence of quasi rents, the competitive nature of the market will eliminate any scope for bargaining. Second, the quasi rents must not be perfe
18、ctly allocated ex ante. If they are, there is no scope for bargaining either. Corporate GovernanceThe definition of governance presented above is quite general. We can talk about the govern-ance of a transaction, of a club, and of any economic organization. In a narrow sense, corporate governance is
19、 simply the governance of a particular organi-zational forma corporation. Yet the bargaining over the ex post rents, which I defined as the essence of governance, is influencedbut not uniquelyby the legal structure used. A corporation in principle is just an empty legal shell. What makes a corporati
20、on valuable are the claims the legal shell has on an underlying economic entity, the firm. While the legal shell and the economic entity often coincide, this is not always the case. For this reason I define corporate governance as the complex set of constraints that shape the ex post bargaining over
21、 the quasi rents generated by a firm. Many problems that fall into the realm of cor-porate governance can be (and have been) profitably analyzed without necessarily appealing to such a broad def-inition. Nevertheless, all the governance mechanisms discussed in the literature can be reinterpreted in
22、light of this definition. Allocation of ownership, boards of directors, capital structure, labor market competition, managerial incentive schemes, organizational structure, pressure from institutional investors, product market competition, takeoversall can be thought of as institutions that affect t
23、he process through which quasi rents are distrib-uted. The contribution of this definition is simply to highlight the link between the way quasi rents are distributed and the way they are generated. Only by focusing on this link can we answer fundamental questions such as who should control the firm
24、. Of course, this definition of corporate governance raises the age-old question of what a firm is. But this question should be central to corporate governance. Before we can discuss how a firm should be governed, we need to define what it is. This question is also important because it helps us iden
25、tify to what extent, if any, corporate governance is different from the governance of a simple contractual relationship, such as the machine example. There are two main definitions of the firm in the literature. The first, introduced by Alchian and Demsetz (1972), is a nexus of contracts. According
26、to this definition, there is nothing unique about corporate governance, which is simply a more complex version of standard contractual governance. In the second definition, from Grossman and Hart (1986) and Hart and Moore (1990), a firm is a collection of physical assets that are jointly owned. Owne
27、rship matters because it confers the right to make decisions in all the contingencies unspecified by the initial contract. On the one hand, this definition has the merit of differentiating between a simple contractual relationship and a firm. Since the firm is defined by the noncontractual element (
28、the allocation of ownership), corporate governanceas opposed to contractual governanceis defined by the effect of this noncontractual element. Not surprisingly, the corporate governance literature in the past decade has focused on the alloca-tion of ownership; hence this literature is called the pro
29、perty rights view of the firm. On the other hand, this definition has the drawback of making all stakeholders other than the owner of physical assets unimportant to an understanding of the firm. More recently, Rajan and Zingales (1998, 2001) have proposed a broader definition: the firm as a nexus of
30、 specific investments, a combination of mutually specialized assets and people. Unlike the nexus of contracts approach, this definition explicitly recognizes that a firm is a complex structure that cannot be repl-cated instantaneously. And unlike the property rights view, this definition recognizes
31、that all the parties that are mutually specializedworkers, suppliers, cus-tomersbelong to the firm. The definition of a firm as a nexus of specific investments does not necessarily coincide with the legal definition, but it does coincide with the economic essence of a firm: a network of specific inv
32、estments that cannot be replicated by the market. Incomplete Contracts and GovernanceIn an ArrouDebreu economy it is assumed that agents can write all state-contingent contracts without cost. As a result all decisions are made ex ante, and all quasi rents are allocated ex ante. Thus there is no room
33、 for governance. More surprisingly, even relaxing the assumption that every state-contingent contract can be written and admitting that certain future contingencies are not observable (and thus not contractible), there is still no room for governance as long as contracts on all future observable var
34、iables can be written without cost. In the example of the customized machine, let us assume that the manufacturers effort is unobservable to others and therefore not contractible. The neoclassical approach to this problem is to design a mechanism (hence the name mechanism design) that is contingent
35、on all publicly observable variables and that provides the manufacturer with the best possible incentives to exert effort. Myerson (1979) shows that all optimal mechanisms are equivalent to a revelation (direct) mechanism, in which the agent (manufacturer) publicly announces all information and rece
36、ives compensation contingent on the announcement. An impor-tant consequence is that in the mechanism design approach, delegation (giving an agent discretion over certain decisions) is always weakly dominated by a fully centralized mechanism, in which all decisions are made ex ante by the designer. T
37、he mechanism design approach reproduces several distinguishing features of an ArrowDebreu economy. All decisions are made ex ante and only executed ex post; as a result, all conflicts are resolved and all rents are allocated ex ante. This leaves no room for ex post bargaining. All these features are
38、 incompatible not only with my definition of governance, but also with any meaningful definition of governancethat is, related to the sense in which this term has been used. This is best illustrated with two examples. First, a crucial question in corporate governance is in whose interest corporate d
39、irectors should act. In the mechanism design approach, this question cannot even be raised. All possible future conflicts are resolved ex ante, and the initial contract specifies how directors will behave in any observable state of the world. But since this question is raised all the time, it must b
40、e that all possible conflicts are not resolved ex ante. Second, the mechanism design approach avoids renegotiation: the initial contract is designed in such a way that the agents do not want to renegotiate. As a result the designer wants to make renegotiation as inefficient as possible. This reduces
41、 the cost of providing incentives to the agents with no efficiency costs, since renegotiation never occurs in equilibrium (Aghion and others 1997). If this result were taken seriously, the optimal public policy approach would be to preserve any inefficiency in the system in order to avoid destroying
42、 its beneficial incentives ex ante. But in reality the jurisprudential approach is completely different. For example, courts do not support punitive damages viewed as excessive for the issue at stake. Only in a world where some contracts contingent on future observable variables are costly (or impos
43、sible) to write ex ante is there room for governance ex post. Only in such a world are there quasi rents that must be divided ex post and real decisions that must be made. Finally, only in a world of incomplete contracts can we define what a firm is and discuss corporate governance as different from
44、 contractual governance. Not surprisingly, the theory of governance is intimately related to the emergence and evolution of the incomplete contracts paradigm. A milestone in this evolution is the residual rights of control concept introduced by Grossman and Hart (1986). In a world of incomplete cont
45、racts, it is necessary to allocate the right to make ex post decisions in unspecified contingencies. This residual right is both meaningful and valuable. It is meaningful because it confers the discretion to make decisions ex post. It is valuable because this discretion can be used strategically in
46、bargaining over the surplus. Why Does Corporate Governance Matter? By definition corporate governance matters for distribution of rents, but to what extent does it matter for economic efficiency? The conditions that affect the division of quasi rents also affect the total surplus produced, through t
47、hree main channels. These channels distinguish between effects ex ante (when specific investments need to be sunk) and effects ex post (when quasi rents are divided), as though the firm lasted just one period. Of course, in reality ex post considerations of one period mix with ex ante considerations
48、 for the next period. Ex Ante Incentive Effects The process through which surplus is divided ex post affects the ex ante incentives to undertake some actions, which can create or destroy some value, in two main ways. First, rational agents will not spend the optimal resources on value-enhancing acti
49、vities that are not properly rewarded by the governance system. One goal in designing a governance system is to motivate investments that are not properly rewarded in the marketplace. The canonical example of how a change in the governance structure can change the incentives to make a value-enhancing, relationship-specific investment is the Fisher Body case. In the early 1920s the auto body manufacturer Fisher Body refused to locate its plants close to the General Motors plants despite the obvious efficiency improvement such a move would generate. Locating close to Gen
