Relationships in the Wild: How Institutions Affect the Governance of Firms

Gani Aldashev (Universite Libre de Bruxelles, ECARES)
Heikki Rantakari (University of Rochester, Simon Business School)
Giorgio Zanarone (University of Lausanne, HEC Lausanne)

Abstract

We study how institutional constraints on the executive affect the governance of firms. In our model, each firm can be privately or state owned, and can elicit effort from a manager and an upstream agent through a mix of formal and relational contracts. We show that in contrast to the conventional wisdom, private ownership and high-powered incentives are not always an optimal governance bundle. Under weak constraints on he executive, state-owned firms can sustain stronger incentives and higher output than private ones. As institutions begin to strengthen, firms are optimally privatized and yet are trapped into weaker incentives and lower output than the state-owned firms they replaced. Only under strong enough institutions we see ”Toyotas,” highly productive firms governed by private ownership and high-powered incentives, optimally emerge in equilibrium. Our model can explain the mixed success of privatizations, and the slow diffusion of best management practices, in developing countries, suggesting that (radical) institutional reforms may be a pre-condition for managerial innovations.

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