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there is agreement on the form of the modification. Regulation and government ownership are to be avoided like the plague if one thinks, as I do, that incentives are crucial.

We have been able to avoid the extensive kind of governmental interference that has occurred in the United Kingdom because we have been able to main. tain a competitive system in the economy. The data collected on concentration show that there has been no tendency in the economy toward increased concentration. The economy does not conform in all markets to the precise definition of perfect competition but it is clear, as we will show later, that markets with only a few markets (oligopolies in economic terminology) are far more competitive than the casual, non-technical observers would believe. We have a competitive economic system that enables governmental interference to be minimized and the system to be decentralized so that it is sensitive to the market. The basic business unit is the corporation and it is important to examine the method of governance since that question is of importance to this committee. Corporate Governance

The ultimate authority in the corporation is the board of directors. Boards vary in size but there are few smaller than ten and few larger than fifteen when the corporation is of any significant size (sales over $100 million). Boards are the final authority in selecting the chief executive officer (CEO) and on the investment of resources of a particular amount. The amount will vary from corporation to corporation. The board is responsible for executive compensation and generally must approve salaries over a given amount. In generai the board is responsible for the overall strategy of the firm and, in the final analysis, for the performance of the organization.

Boards are generally composed of inside and outside board members. The inside members are there because they are crucial to the firm's operations and appointment to the board is a recognition of this fact. As long as there are an adequate number of outside board members, perhaps one-half to three-fourths of the directors, the inside members can play an important role. They can be effective in educating the outside members and they can bring a degree of realism to decisions that may occasionally be missing in a strictly outside board. By the time they are appointed they have independence from the CEO so that there is no problem, generally, in their speaking their mind.

Outside directors are, of course, elected by the stockholders, voting on the basis of share ownership. The president, with the help of the board, is responsible for recruiting new members. The process of recruitment is taken seriously. Generally, discussions on the desired qualities of the new member are held by groups of board members as well as the president and board members. Recruitment is not à question of the president getting his friends on the board. Every president worthy of his job recognizes the difficulty and the enormity of his responsibilities. He wants the best talent available and searches accordingly. The best people are generally already busy and the job must be important or they will not take it. Thus, there are few rubber stamp boards. The persons recruited are generally independent thinkers who have ideas about management and are prepared to argue their positions with the CEO and the rest of the board.

At the same time it should be understood that the board has to be part of the overall management team. The board cannot be in an adversary relationship with the CEO. If the majority of the board is in that frame of mind, they must fire the CEO. The reason is that crucial decisions must be made and the management must make recommendations. If the board has no confidence in the management then recommendations will be rejected. But the board cannot by itself handle the day-to-day running of the firm. With an adversary relationship the decision making of the firm would come to a standstill. The relationship between the board and the CEO should be one in which there can be a free, give-and-take of ideas. A major contribution of a board is the fresh, outside ideas flowing into the company.

There are undoubtedly ways in which boards can function more effectively, just as it is true of any organization. I would like to see more directors get more deeply involved in the details of the firm. The line between policy formation and the everyday management of the organization is more blurred, in my view, than in that of many other directors. I think directors should "meddle" more in the operations of the company, without interfering with the management. I have been doing some of this activity in the area of decision making on the allocation of capital. A paper summarizing the findings has been written with two of my colleagues and is attached. It is useful for this committee because it demonstrates the way in which the board interacts with management on important decisions. Antitrust Policy

Some European observers have called antitrust an American religion. If so, it is a religion based on the concept that a free enterprise, laissez-faire system must rely upon competition to protect the consumer from the businessman. All antitrust legislation is at bottom an attempt to force more competition in the economy. The various laws among other things rule out rivals colluding to set prices, nullify mergers that reduce the number of competitors, and provide for the breaking up of firms into a set of smaller, but larger in number, firms. The assumption is always that competition is increased when there are more firms operating in a market.

Those economists who are the intellectual descendents of Adam Smith have refined the theory of competition into an intellectually and esthetically pleasing model of an economic system. In particular their work has developed the assumptions, in non-quantitative terms, that are necessary if competition is to prevail. Thus an important assumption is that there must be a large number of firms, so large no single firm or group of firms can affect the price. Obviously, it is difficult to know whether five, ten, fifteen, or twenty firms is enough to insure the necessary condition. In fact, it is this ambiguity that has to some extent been responsible for economists and lawyers making a living from antitrust legislation. One of the few attempts to be quantitative in this area was made by Henry Simons, one of the intellectual godfathers of the Chicago School. Simons wrote a brilliant public policy document called, A Positive Program for Laissez-Faire." In it he suggests limiting a firm to 20 percent of the market. Thus, he is implicitly arguing that five firms are enough to produce the results of competition.

The practical implication of all markets being competitive in the economist's sense is that the role of government, to say nothing of the Ralph Naders of the world, is minimized. Competition will drive price to the lowest level compatible with the viability of the firms and the firms will be driven to operate with the greatest efficiency possible. If the product produced by one firm or a group of firms is poor enough to affect the demand, another firm will capture the business by improving the quality. So the consumer is able to live happily ever after with low prices, high efficiency in the use of resources, superb product quality, and little governmental interference.

Unfortunately, the theory as stated does not describe the world. Two developments in particular have rendered the system inoperable. The first relates to the businessman's desire to reduce the amount of uncertainty faced in the kind of competitive model the economist assumes and antitrust legislation attempts to produce. A former colleague and I wrote in a book we published in 1963, “We have argued that the business firm will attempt to avoid uncertainty in its environment by developing information systems that permit the exchange of information on prices, product changes, and so forth. Current concepts of antitrust policy, on the other hand, are directed toward enforcing competition by enforcing uncertainty, by restricting the exchange of information.”

The effects of such a policy are well described by a former lawyer and businessman, “To those who labor in the system, a philosophy which makes the good society depend upon blind competition carried on in ignorance of market facts and in disregard of the profit which, and which alone, can give the business institution permanence—such a philosophy seems irresponsible. Such men find themselves pressed on the one hand by the dogma : Compete yourself out of prof. its. On the other hand, they are pressed to conserve the business, to make it grow, from peace to war, from old styles to new styles, from obsolete technology to advanced technology. The businessman does not understand why his quest for certainty is wrong, why the dogma of competition should be pressed so far as to make a guessing game of the system.”

The second event that upsets the idyllic system of perfect competition is the existence of economies of scale. For some time economists tried to deny the existence of such economies. In the thirties the TNEC produced its famous monograph 13 which alleged that medium size firms rather than large firms had the lowest costs. It was soon recognized that the methodology used was so full of holes that the results were worthless. The next step was to argue that economies of scale were confined to single plants. But it was argued that “It is rare to find vast economies with respect to plant size compared with the size of the market.” Exceptions were soon found to this proposition. As the same writer says, "Recall that Alcoa operated only a single aluminum plant in East St. Louis up to World War II, despite multiple sources of the bauxite input and multiple reduction facilities for the aluminum output. Could this have been due to scale economics of plant relative to market size?"


More recent work stemming from research by myself and other colleagues at Carnegie has developed in much detail the potential economies from vertical integration. In addition this work has vindicated, to a great extent, oligopolistic markets. Oliver Williamson, a former student of mine and now a professor of economics at the University of Pennsylvania writes, “Absent collusion, the presumption that vertical integration is innocent or beneficial is generally appropriate. Vertical merger guidelines which currently advise that acquisition will be challenged where a ten percent firm at one stage of an industry acquires a six percent firm at another stage, are plainly overrestrictive.” Again, "The principal implication of the argument with respect to oligopolistic industries is that oligopoly ought not be equated with a dominant firm condition. It is much more difficult to negotiate a comprehensive collusive agreement, and there are many more problems of effecting a joint-profit maximizing outcome, than are commonly suggested. Theories of 'shared monopoly' ought accordingly to be regarded with skepticism."

Where does this type of analysis leave us ? Specifically the analysis highlights a major conflict between antitrust legislation and efficiency, particularly when transactional economies are taken into account, as they should be. The indict. ment of antitrust policies in relation to efficiency can be made as follows:

(1) The horizontal, multiplant economies tend to be ignored in Section 7 of the Clayton Act cases. If a merger can lead with some probability, to a reduction in competition, it is unlikely that the economies resulting from the merger, even though certain, will be allowed as an argument to allow the merger.

(2) Vertical, multiplant economies whether in Section 7 or Sherman Act cases are not allowed as an argument or more specifically carry little weight. The basic argument of the government is that the market mechanism and shortterm contracts are the way to go. This position is maintained in the face of evidence that vertical integration, joint ventures, or long-term contracts produce greater efficiency.

(3) Multiproduct expansions, Clorox being an example, are disallowed even in the face of evidence of distributional or supply economies.

(4) The problem of developing joint ventures for situations of high risk are not taken into account in antitrust policies.

These examples illustrate some of the aspects of the problem. The society is faced with a confrontation between a reduction in competition and a reduction in the resources expended and is ruling against changes in structure that would allow the economies without making any kind of cost-benefit analysis. Why is the government taking this kind of position? The position of the government and of most economists is given in the following quote from Al Philips, Dean of the School of Public and Urban Policy at the University of Pennsylvania, "Overall, my own assessment is that there are net social benefits from competitive policies. Costs may be apparent to those who see and bear directly some of the disadvantages of these policies. But there is a sense to competitive policy in the dynamic of social history, even if some ostensibly strange results emerge in particular cases. That some kinds of large-scale investments may be discouraged is undeniable. That the resulting social costs exceed the social benefits is an argument less easy to support. Who can point to an antitrust decision or to an unambiguous antitrust doctrine that has produced more evil than good? That is the fundamental question."

This approach is less than satisfying as a justification for the policy, par. ticularly when one looks at the gap between the principle and the practice in particular cases. The difficulty of making a sophisticated economic argument, indeed any economic argument at all before a jury, is tremendous. We are essentially left with a position in which competition as measured by numbers of firms is supported at any cost, that is, the foregone economies of scale.

I am particularly concerned about the role of antitrust legislation and have chosen this topic, because we are at a turning point in our society. It could be argued that during the 85 years of the Sherman Act we have been essentially inward looking. As a result, the pursuance of competitive policies in the internal economy has probably been advantageous. With the advent of OPEC we have been forced to realize our dependence on the rest of the world, for energy and other products. In addition, we have seen in the recent past that those countries in which business and government have a closer relation than in this country have been able to do well in international trade. In other words, I see the U.S. entering an era in which we have to have organizational forms that may be more iexible than we have allowed in the past. In particular, we will probably need more joint actions in which competitors cooperate whether for negoti. ation as in the case of the oil companies, or for investment. Currently, the Department of Justice can give permission for some of their activities through Business Review Clearance. In addition, there are exemptions to antitrust legislation possible in the Defense Production Act and the Energy Act. A Business Review Clearance still leaves the corporation liable to action by private litigants whereas exemption under the two acts does not.

These methods for achieving the type of flexibility I am calling for are fine, but they are too limited. We must in the future that is facing us allow a large number of options for creative management. We need those options for effective solving of the problems that now face us, and that will face us, because these problems are and will be international in scope. We need to put greater value on the economies we now sacrifice in the name of antitrust for the supposed increase of competition.

As we move in this direction, which I would describe as competition on a worldwide basis rather than merely domestic competition, it is important to note that we lose the control aspects of competition. To retain discipline of competition that pushes for lower prices, higher quality-the consumerism aspect of competition—we must rely increasingly on the ability of businessmen to behave like statesmen. In taking this position I find myself increasingly pushed intellectually to a position taken by Edwin Nourse who was the first head of the Council on Economic Advisers. In a book written in 1938, he said, “The greatest promise of realizing the economic progress of which our people are capable is through free action of far-seeing executives . . . . If we expect satisfactory results from the run of business executives, it means, of course, that they must retain their character as true enterpriser and not look upon their business as a device for stock jobbing, or as a means of making a short-run killing on which to retire or a short-run reputation on which to market their services elsewhere. Neither may they seek the comfort of non-competitive understanding with other companies." That description is essentially the one I would use to describe the behavior of a business statesmen.

We live in a period of growing criticism of the corporate form and we live under rules that make it difficult for corporations to act in the public interest because to do so requires action in concert. We need to find a form so that business executives acting together can function as good citizens attempting to solve problems without being subject to antitrust violation. I am convinced that increasingly as the population shows signs of rejecting big government that they will turn to business. I would close by quoting the final paragraph from Nourse's book. Though almost forty years old it is completely relevant for today.

"If the American business man demands the right of freedom of economic enterprise, society in granting it to him may properly ask that he use that freedom aggressively in the public interest. This, to our way of thinking, is the challenge which the industrial system makes to the industrial executive. If he cannot meet it, the system of free enterprise under private capitalism is doomed to a condition of invalidism, low vitality, and unproductiveness which is utterly incompatible with the natural resources, productive equipment, and man power which the nation has at its disposal."

The kinds of restrictions on corporate behavior that are recommended by many of the critics will likely be devastating to the system or relative economic freedom we enjoy. If economic freedom disappears will political freedom be far behind?



(By R. M. Cyert, M. H. DeGroot, and C. A. Holt, Carnegie-Mellon University)

In previous papers we have attempted to demonstrate the usefulness of Bayesian analysis in economic models. Most of the models that have been devel

*This research was supported in part by the National Science Foundation under Grant SOC 74-02071-A01. Magdalena Müller typed the manuscript. The empirical material for this article has been gathered by R. M. Cyert in his capacity as a member of the board of directors of a number of different firms of varying size over the last five years. We have attempted to generalize these observations in the article. 1 The following articles by R. M. Cyert and M, H. DeGroot are relevant :

(a) "Multiperiod decision models with alternating choice as a solution to the duopoly problem. "Quarterly Journal of Economics, Vol. 84, Aug., 1970, pp. 410-29,

(b). "Bayesian analysis and duopoly theory," Journal of Political Economy, Vol. 78, Sept./Oct., 1970, pp. 1168–84.

(c) "An analysis of cooperation and learning in a duopoly context," American Economic Review, Vol. 63, March, 1973, pp. 24–37.

oped relate to decision-making situations in which a firm is dealing with its external environment, particularly with its competitors. This paper moves to analysis of decision making within the firm. More specifically, the paper is concerned with the decisions involving the allocation of resources for capital expenditures by the firm. These decisions determine the total amount of resources that a firm allocates to capital expenditures as well as the amounts it allocates to individual divisions.

Our discussion will focus on the determination of capital expenditures in large, multidivisional firms. Capital expenditures include (i) the replacement of fixed assets, buildings, and equipment; (ii) the acquisition of other firms; (iii) the acquisition of new capital which is directly related to the production process; and (iv) the purchase of some items which are not directly related to the production process but which are large enough to warrant capitalization rather than expensing. For example, the purchase of snow removal equipment or the construction of a new parking lot for employees might fit into the last category. This description is not meant to be complete, but rather to serve as a reference point for our discussion.

The type of firm we have in mind is a large, decentralized organization in which each division is a profit center. The manager responsible for each division is judged by his division's contribution to the firm's total profit. The firm operates in a number of markets, and each division is in a different, though related, industry. The markets are generally oligopolistic, and the firm's market share will be different in each market. These elements characterize most of the firms in the Fortune 500. The structure of the allocation process

The actual allocation process of the firm has generally been ignored by economists in the belief that external market considerations dominate internal decisions, Market considerations are clearly important but so is an understanding of the internal process as we shall attempt to demonstrate.

The approval process for capital allocation requests outside the division is usually a two-step process. For requests greater than the amount which the division manager can approve, but less than the amount required for approval by the board of directors, a capital allocation committee is formed within the firm. This committee includes the major operating officers at the central office, such as the chief financial officer, the president, sometimes legal counsel, some group vice presidents, and others at a similar level. Particular details may vary from firm to firm, but the basic procedure described here is generally followed. The division manager, a central committee, and the board of directors are the three sources of approval, depending upon the size of the capital appropriation request.

Each request to the capital allocation committee must contain an analysis of the proposed investment. Except for those requests that are for the purchase of items in category (iv), each one must meet the firm's criterion for investment. This criterion is usually stated in terms of a minimum rate of return on investment before taxes. A large number of firms in a variety of industries use a return of 25% before taxes as the minimum. The person or division making the request usually must give estimates of future revenue, costs, and profits for a period of years, frequently five. Where such estimates are used, the estimated return on investment for the fifth year must meet the criterion. An investment may be funded if it has strong prospects for the future even though the rate of return might be estimated to be below the minimum in the early years.

In the capital budgeting literature, the firm is often advised to determine the internal rate of return on each possible investment. Then prospective investments are to be ranked on the basis of their internal rates of return. The firm is supposed to approve each investment that has a rate of return greater than its cost of capital. This procedure is a formal, normative one as viewed from outside the firm.

In fact, however, the firm does not and cannot operate this way. Proposals come in from the divisions in a non-systematic pattern. The committee or the board,

2 A notable exception to this statement is Joseph L. Bower, Managing the Resource Allocation Proce88 (Boston: Harvard Graduate School of Business Administration, 1970). This book contains a careful study of the allocation of resources to capital expenditures within a firm.

3 Cf. Joel Dean, Capital Budgeting (New York: Columbia University Press, 1951). See also a more recent book by the same author : Managerial Economics (Englewood Cliffs, N.J.: Prentice Hall, Inc., 1967).

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