Scribd Logo
Upload

Welcome to Scribd!

  • Managerial Resources and Rents

    Uploaded by

    Sujith Gopinathan
    99 views17 pages
    Managerial Resources and Rents

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document
    Managerial Resources and Rents

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    Download as pdf
    99 views17 pages

    Managerial Resources and Rents

    Uploaded by

    Sujith Gopinathan
    Managerial Resources and Rents

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    Download as pdf
    of 17
    Journal of Management 1991, Vol 17,No.1, 155-171 Managerial Resources and Rents Richard P Castanias University of California at Davis Constance E. Helfat Northwestern University This article analyzes the role of top management as a key resource in obtaining sustained, competitive advantage for the firm. The nature of managerial skills is examined and linked to isolating mechanisms and firm rents. The article aims to refocus attention on the importance of ‘managerial expertise as a rent-generating firm resource and implies greater alignment of top management-shareholder interests than in ‘many applications of agency theory to the firm. Introduction This article draws on the resource-based view of the firm to analyze the role of top management in generating firm rents. From the resource-based perspective, rare and difficult to imitate internal firm resources are key to the firm’s acquisition and maintenance of sustainable, competitive advantage. Top management may constitute one such resource. This has implicitly been recognized in the traditional concept of strategy (Andrews, 1987), which emphasizes the key role of the chief executive and general manager in effectively using firms’ resource positions (strengths and weaknesses). Much of the research on the nature of top manage- ment has sought to identify the traits and skills of top managers and to understand the determinants of effective leadership (see, ¢.g., Hampton, Summer, & Weber, 1987; Katz, 1974). In general, this literature has not focused explicitly on the links between top management resources and rent generation. To complement this lit- erature, the analysis presented here characterizes top management resources in a manner that links them more directly to rents. In addition to discussing managerial generation of rents, the article deals with rent collection and the division of firm rents between various claimants. In particular, the analysis examines the relation- ship between top management and diffuse stockholders of a publicly-held firm. Rather than try to encompass the entire topic of rent generation and collection by all possible resources that are within the firm or are in some way related to it, ‘We wish to thank Jay Barney, Philip Bromiley, Kathleen Conner, Diana Day, Cynthia Montgomery, Margaret Peteraf, and two anonymous referees for helpful comments. ‘Address all correspondence to Constance E. Helfat, I L, Kellogg Graduate School of Management, North- western University, Evanston, IL 60208. ‘Copyright 1991 by the Southern Management Association 0149-2063/91/$2.00. 155 Copyright © 2001. All Rights Reserved. 156 RICHARD CASTANIAS AND CONSTANCE E. HELFAT the discussion here focuses more narrowly. This enables the article to provide more detail related to a specific area of inquiry on which subsequent work might build. But even this limited focus—on top management as a rent-generating re- source and the relationship of top management to shareholders—encompasses many issues. In particular, it is difficult to discuss top management and share- holder relations without addressing agency theoretic views regarding top manage- ment, and related topics such as boards of directors, the market for corporate con- trol, etc. The positivist strand of agency theoretic literature (see Eisenhardt, 1989, for a review) sometimes is perceived as focusing primarily on the negative possibilities of shirking and overconsumption of perquisites by top management, particularly at the expense of shareholders. Although agency relationships do not necessarily involve conflict between principals and agents, in their seminal work Jensen and ‘Meckling (1976) helped to set the subsequent research agenda in stating that “If both parties to the relationship are utility maximizers there is good reason to be- lieve that the agent will not always act in the best interests of the principal” (81). As applied to manager-shareholder relations, a good deal of recent research in eco- nomics and finance adopts the view that “Much corporate behavior seems best understood in terms of managers running the show largely as they please” (Shlei- fer & Vishny, 1988: 7). Thus, it appears to many scholars of organizations that in agency theory “the deceitful, shirking economic actors are managers. . .as indi- vidual agents opposite their principals, the owners of the firms” (Donaldson, 1990: 370). Although to some this may seem an overstatement, it does suggest that, the study of ‘willing cooperation’ (Donaldson, 1990) between managers and shareholders may have been overlooked or downplayed somewhat in the agency literature. In what follows, a conceptual model is developed that focuses on the positive contributions of top management to the generation of rents by the firm. Of central importance is the concept of “managerial rents”—those rents that some top ex- ecutives may generate from their superior managerial skills. The analysis suggests that the role that rent-generating managers play within a publicly-held firm having diffuse stockholders inherently provides such managers with an incentive to act efficiently. A corollary to this suggests that greater managerial discretion may not necessarily be harmful to the firm as some interpretations of agency theory might indicate, and may even play an important role in rent generation. As Fama (1980: 289) notes, the “separation of security ownership and control can be explained as an efficient form of organization within the ‘set of contracts’ perspective” employed in agency theoretic analyses of economic behavior in the firm. Fama's explanation relies on the possible loss of a manager's reputation, and its subsequent translation into loss of future pay, to constrain managerial misbe- havior. The managerial rents view presented here also suggests that managers have inherent incentives to perform well, but emphasizes the ability of some managers to earn rents rather than the loss of managerial reputation. The approach in this article, although it relies in part on economic reasoning, is atypical in that it employs a point of view and emphasizes factors more commonly associated with what Hirsch, Friedman, & Koza (1990) term “behavioral” JOURNAL OF MANAGEMENT, VOL. 17, NO. 1, 1991 Copyright © 2001. All Rights Reserved. MANAGERIAL RESOURCES 1s7 models. In particular the primary unit of analysis is that of top managers and their relationship to a particular organization, whereas the analysis of investors and stock prices plays.a secondary role. Hirsch et al, associate this perspective with be- havioral analysis, both in general and with respect to agency theory in particular. ‘The managerial rents framework does not deal with some of the process and im- plementation issues associated with behavioral models, but like such models, the analysis suggests a modification to what often is perceived as a “pro-takeover bias in the finance model” (Hirsch et al., 1990: 95). Insummary, this article examines a particular firm resource in detail—top man- agement—and discusses the relationship between it and another resource—stock market investment—in a rent-generating firm. The article proceeds as follows. Section two provides background from the strategic management literature and the business press for the concept of managerial rents. Section three then analyzes the nature of managerial skills, their associated isolating mechanisms, and mana- gerial rents. In section four, shareholder investment is introduced into the analysis and a conceptual model of the firm is outlined wherein top management is a rent- generating resource. Section five draws some implications for management-share- holder relations and section six discusses issues of corporate governance and cor- porate control. Section seven briefly concludes the paper. The Role of Top Management In organizing and directing all the activities of the firm, top management (the CEO or CEO plus other members of a top management team) makes and imple- ments strategic and operational decisions that may create rents that are not com- peted away by other firms and managers. Managerial discretion may be an impor- tant ingredient in the production of rents. In related work, Hambrick and Finkelstein (1987) have noted that management has greater discretion in pricing, product form, promotion, etc., in differentiated products industries than in com- modity industries and that such discretion may be necessary for the firm to com- pete effectively in such industries.’ More generally, although constrained in part by the organizations and environments in which they function, top managers can have a substantial impact on the organizational structure of the firm, the reward system, new strategic initiatives, and a good deal more, all of which potentially may generate rents for the firm. In related work, Wernerfelt (1989) has argued that “cultural” resources are the most likely to produce above average returns for a firm, Barney (1986) also has suggested that unique organizational skills and abil- ities, involving a combination of firm resources, can be a source of competitive ad- vantage. What is key is that potentially rent-generating cultural resources and or- ganizational skills and abilities do not emerge without effective top management within the firm. In addition, CEO's also have externally-related functions that may generate rents for particular firms or industries. One example might be lobbying efforts (Ungson & Steers, 1984) that may help to produce laws such as tariffs and quotas that limit competition in the product market. ‘As an example, consider the foresight of American Home Products’ management in marketing Advil so suc- cessfully by establishing brand name visibility well in advance of ther competitor (Wl treet Journal. 1989). JOURNAL OF MANAGEMENT, VOL. 17, NO, 1991 Copyright © 2001. All Rights Reserved. 158 RICHARDP CASTANIAS AND CONSTANCE E. HELFAT Asa concrete example of managerial rent generation, consider the current CEO of Merck, P Roy Vagelos. Merck operates in the drug industry, where patents can confer rents, But, in addition, the innovation and selling of patented products are vital to the production of rents, requiring the management and motivation of sci- entists who develop the drugs, the effective negotiation of the government regu- latory process to obtain approval for the sale of drugs, and the development and maintenance of relationships with doctors who prescribe the drugs. ‘Vagelos is known throughout the industry as the R&D manager who changed the industry's search process for new drugs to an academic research-based one. AS CEO, Vagelos has reorganized the company to more closely mimic an academic environment, giving scientists more discretion in new drug development (Business Week, 1987). Vagelos’s stature in the industry and the company's reputation as a well run organization with a first-rate research environment enables Merck to at- tract top scientists in the pharmaceutical industry? The ability to attract and mo- tivate top scientists in turn provides Merck with superior potential to create new drugs that can generate rents, Under Vagelos, Merck also has focused on using its internal organization and links with regulators to help speed up the FDA drug ap- proval process, which has resulted in Merck’s having one of the shortest drug ap- proval waiting periods in the industry. In addition, Merck has developed a sales force that has an excellent reputation and rapport with doctors, who ultimately de- termine a high percentage of final drug sales to consumers? These factors, com- bined with high R&D spending as a percent of sales, appear to have produced a re- turn on equity from 1984-87 well above the industry average (Business Week, 1987). In the Merck example, Vagelos’s skills and other of the firm’s assets, such as its culture, can be thought of as resources that jointly produce rents.‘ On a more ab- stract level, it is possible to conceptualize the rents to these resources as composed of above average returns to Vagelos’s human capital as well as a return to stock- holders’ financial capital and to other factors of production within the firm. In what follows, a more rigorous and more abstract model of managerial rent-gen- erating resources is provided that draws on the work of management scholars as well as on human capital theory, the concept of asset specificity in transactions cost theory (Williamson, 1975, 1985), and Rumelt’s concept of isolating mecha- nisms. This analysis is then imbedded in a simplified model of the firm and its re- sources. The role of stockholder investment financing within the firm is examined and some implications are drawn regarding the division of rents within the firm, managerial incentives, and corporate governance. Managerial Skills, Isolating Mechanisms, and Rents ‘To focus attention on the top mariagement of a publicly-held firm, a simplified model is used that includes four inputs to production for the firm: management, labor, capital (physical), and investor financing. Note that inputs and firm re- *This information is based on conversations with knowledgeable research scientists in the drug industry. The information regarding Merck's reputation for above-average drug approval speed and for superior rap- port with doctors comes from managers currently employed by Merck's competitors in the drug industry. “This is similar to but not the same as Montgomery and Wernerfelts (1989) concept of shared resources. JOURNAL OF MANAGEMENT, VOL. 17, NO.1, 1991 Copyright © 2001. All Rights Reserved. MANAGERIAL RESOURCES 159 sources are not synonymous; although inputs may also be resources (e.g., labor), resources often include other things produced from the usage of inputs such as brand name recognition, technological expertise, etc. The analysis is confined pri- marily to rent-generating top managers and firms. In order to focus attention on top management and on the relationship between top management and diffuse shareholders, the model employs some simplifying assumptions: (a) the corpora- tion has no debt (this allows the analysis to abstract from issues related to stock- holder and debtholder relations); (b) labor and physical capital are supplied in per- fectly competitive markets; and (c) the pay of lower level managers reflects their skills and innate abilities.® The analysis begins with a discussion of rent generation by top management. The nature of the underlying managerial skills is first exam- ined and then linked to managerial rents. Managerial Skills In aneffort to understand the nature of effective management, the traits, skills, functions, roles, and behaviors associated with successful leaders and top man- agers have been st s systems for categorizing managerial capabilities in general and skills in particular. Table 1 provides a cou- ple of representative examples. Katz. (1974) has proposed sifications, dividing managerial skills into the “technical ceptual.”6 According to Katz, at the top management level, conceptual skills (and toa lesser degree, human skills) are the most important. Both the Katz classification of managerial skills and the type of skill categori- zation illustrated by Table 1 do not distinguish between different organizations and environments in which the skills are employed. Companies’ situations differ from one another, however, and certain skills may be more desirable in some situations than in others. For example, for a start-up company, organizing ability and team- building capabilities may be among the necessary skills; in a turnaround situation, strong analytical and diagnostic skills may be particularly important (Gerstein & Reisman, 1983: 36-37). : In addition, firms in different types of businesses or industries may require specialized varieties of the more general types of skills exemplified by those in Ta- ble 1. As Katz notes, the chief executive “not only needs to know the right ques- tions to ask his subordinates; he also needs enough industry background to know how to evaluate the answers” (Katz, 1974: 101-102), Similarly, managerial skills may have a firm-specific dimension as well. The ability to effectively manage an organization may require in-depth understanding of the company’s history, culture, internal strengths and weaknesses, etc. ‘Thus, managerial skills may be characterized partly in terms of their applica “If debtholders are “passive” investors and like diffuse shareholders not involved with operational and stra- tegic decisions, then the analysis is easily extended to include debt as aform of outside financing. Similarly, the ‘other assumptions could be relaxed without changing the basic conclusions reached here. ‘Katz defines these skills as follows: technical skill is one that “implies an understanding of, and proficiency ‘in, specific kind of activity particularly one involving methods, processes, procedures, or techniques. human skill i the executive’ ability to work effectively as a group member and to build cooperative effort within team he leeds. conceptual ability involves the ability to see the enterprise as a whole.” (Katz, 1974: 91,93). JOURNAL OF MANAGEMENT, VOL. 17, NO. 1, 1991 Copyright © 2001. All Rights Reserved. 160 RICHARD P CASTANIAS AND CONSTANCE E, HELFAT Table 1 ‘Managerial Capabilities ‘Skills Characteristic of Successful Leaders Clever degen) Conceptually sled Creative Diplomatic and tcf Fltetin speaking Knowledgeable about group tasks Organized (adminsetiveaiity) Persuasive Socaly sie Source: Yul, 1981, p70 ‘Key Managerial Functions Planing Organizing Supervising Cooednating Controlling Comensaeating Investigating valuing Deeision making Soure: Siener Miner & Gray, 1986: 52 bility to differing situations. At the level of generality of Table I, the types of skills listed are generic, not unique to any particular firm or type of business. As sug- gested by Gerstein and Reisman (1983), some types of generic skills may be rel- atively more important in certain general types of strategic situations (eg, com- pany start-up, turnaround, etc.). In addition, managers may possess skills that apply especially well to particular industries or firms. Thus, the management function can be conceptualized as consisting of a hierarchy of three types of skills: (a) generic skills, defined as those that are transferable across industries, busi- nesses, and firms, (b) type of business or industry-related skills, and (c) firm-spe- cific skills, The management of a diversified firm may also require special mana- gerial skill. Such skill might be viewed as consisting of several different industry- related skills (see Rajagopalan & Prescott, 1988) or alternatively as a type of ge- neric management skill. The three-way classification of managerial skills used here mirrors that of Becker (1964), who employed it to categorize worker skills and human capital more generally in this treatise on human capital theory. ‘The ongoing search to identify and understand the most important top manage- ment skills and characteristics is essentially a search to understand the nature of superior management. This search suggests that there are skill differentials be- tween superior and not so superior managers, both in the types of skills that indi- viduals possess and the degrees of skillfulness. All other things being equal (such as the amount of experience that a manager has), superior managerial skills of any type are likely to result from superior innate abilities (endowments) and/or supe- rior learning processes. Evidence suggests that one set of factors that may underlie managerial abilities are personality characteristics (see, e.g, Hampton, 1987). The latter are, a least to some extent, innate. But learning, particularly by doing, is also JOURNAL OF MANAGEMENT, VOL. 17,NO.1, 1991 Copyright © 2001. All Rights Reserved. ‘MANAGERIAL RESOURCES 161 important. Because managerial skills and know-how in general are intangible, have no clear blueprint, and are difficult to codify, learning by doing becomes im- portant. As Katz (1974) notes, managerial skills develop “through practice and through relating learning to one’s own personal experience and background” (Katz, 1974: 98). Livingston (1971) concurs. Managerial Rents Whether skills are innate or learned, CEOs who possess superior skills may use them to generate rents. In order to more closely link managerial skills to rents, itis, helpful to first briefly review the definition of economic rents. Economic rents to factors of production are of two types: Ricardian (scarcity) rents and quasi-rents. Quasi-rents are defined as the difference between the value of an asset in its first best use and its value in its next best use (see, eg., Klein, Crawford & Alchian, 1978; Monteverde & Teece, 1982). Assets that are specialized to a particular use and therefore lose value in another use produce quasi-rents, Ricardian rents derive from scarcity relative to demand “such that the extra profit (rent) commanded by the factor is insufficient to attract new resources to its use” (Rumelt, 1987: 142). This concept of relative scarcity is tied to the idea of resource superiority. If a re- source produces a product or service superior to that provided by similar re- sources, stich a resource commands a premium (i.e, rent). Almost by definition, superior resources have a limited supply relative to less superior and more widely available resources and therefore yield Ricardian rents. When the efficient use of superior resources produces Ricardian rents, these sometimes are termed “effi- ciency rents.” (See Rumelt, 1987, and Peteraf, 1990, fora more detailed discussion of economic rents to factors of production.) Each of the three types of managerial skills—generic, industry-related, and firm-specific—can be evaluated in terms of their potential to produce either Ri- cardian or quasi-rents. By definition, generic skills do not produce quasi-rents, be- cause they are easily transferable between uses. Industry-related and firm-specific skills, however, may generate quasi-rents. Once a manager has acquired firm-spe- cific (or industry-related) know-how, it is worth less to another firm (or industry). As Williamson (1985) has noted, the top managerial resources of a corporation are likely to be characterized by such asset specificity. All three types of managerial skills may generate Ricardian rents, As an exam- ple of scarcity rents to superior generic skills, a particularly good marketing ex- ecutive is likely to command a high salary in the managerial labor market if he or she has few competitors with comparable marketing expertise. Like scarce generic skills, industry-related skills and expertise also may generate Ricardian rents if they are in short supply (or are superior to the skills of others). In the earlier Merck example, CEO Vagelos’s extensive background as a physician involved in aca- demic basic research and biomedical science provided him with expertise that was highly applicable to the drug industry. Vagelos’s academic background was prob- ably instrumental in Merck’s highly successful method of organizing its R&D unit to simulate an academic environment. And if firm-specific managerial skills pro- duce results superior to those produced by managers in other firms, they too may generate Ricardian rents. Again, in the Merck example, Vagelos’s experience in JOURNAL OF MANAGEMENT, VOL. 17,NO. 1, 1991 Copyright © 2001. All Rights Reserved. 162 RICHARD CASTANIAS AND CONSTANCE E. HELFAT drug development as Merck’s senior vice president for research apparently influ- enced some successful attributes of Merck’s strategy when Vagelos became CEO. These include a combination of Merck’s unusual degree of openness to accepting ideas from outside the company and its emphasis on developing new drugs rather than refining existing ones (Business Week, 1987). ‘Superior top management skills may not only produce Ricardian rents, but such rents also may persist for an extended period of time. Managerial skills inherently have what Rumelt (1984) calls isolating mechanisms, a term he uses “to refer to phenomena that limit the ex post equilibration of rents” (1984: 567). Of the various isolating mechanisms that Rumelt describes, at least three may apply to manage- ment. The first is casual ambiguity, defined as “the inability of economic agents to fully understand the causes of efficiency differences,” which “limits competi- tion by entry or imitation” (Rumelt, 1984: 567). As noted earlier, all managerial skills, whether generic, industry-related, or firm-specific, are intangible, often have no clear blueprint, involve a good deal of learning by doing, etc. Because it is difficult to codify managerial know-how, this know-how is also hard to duplicate perfectly, thus providing an isolating mechanism. A second isolating mechanism applies to assets that are specialized to a particular usage or firm. Almost by def- inition, less specialized assets cannot compete as effectively in the specialized usage. Clearly, firm-specific managerial skills have this property of specialization. ‘And third, uniqueness of resources can be an isolating mechanism, because such resources are not replicable by others. Firm-specific managerial resources may be one such set of unique resources for a firm (Penrose, 1959). Implicit in the foregoing discussion of superior skills and their translation into Ricardian rents is the fact that not all top managers produce such rents, For pur- poses of this analysis it is assumed that managers who do not have superior skills possess only widely available generic skills, Because their skills are widely avail- able, such managers would earn only a competitive rate of pay. This assumption regarding non-rent-generating managers skills is made to simplify the analysis, so as to focus on the main subject of this inquiry—those top managers who can use their superior skills to generate rents. When used productively, superior manage- rial skills produce Ricardian rents. If superior skills have industry-related or firm- specific attributes, then the portion of Ricardian rents derived from such attributes constitute quasi-rents as well. Managerial Incentives When top managers have superior skills, whether and to what extent they ac- tively use their skills to generate rents depends on their incentives to do so. The greater the ability of top managers to collect their earned rents, the greater the in- centive to generate these rents. This suggests it is important both to discuss the in- centives provided by the ability of top management to collect managerial rents and to identify the form that rent collection might take. The ability to collect the two different types of rents to managerial skills—Ri- cardian and quasi-rents—involves two different sorts of incentives. The ability to collect Ricardian rents creates a positive incentive for managers to acquire and use the skills that produce such rents. Quasi-rents, however, are not in and of them- JOURNAL OF MANAGEMENT, VOL. 17,NO. 1, 1991 Copyright © 2001. All Rights Reserved. ‘MANAGERIAL RESOURCES 163 selves above-average returns and therefore may not yield the positive incentives for managers to generate rents that Ricardian rents da. Instead, to the extent that managers can appropriate the quasi-rents associated with their skills, managers have disincentives to misbehave because job loss would result in the loss of firm- specific and perhaps even industry-related quasi-rents. Depending on a manager’s mix of skills and the types of rents these skills generate, the opportunity to collect rents can provide positive incentives for efficiency rent generation as well as dis- incentives to misbehave. To the extent that they are able, top managers may directly collect their earned rents in one or more of the following forms: (a) salary; (b) bonuses, either ex ante (at the initiation of new projects or new strategic and/or organizational moves) or ex post (after the rents have accrued); (c) stock options, other deferred compen- sation, stock ownership, or profit sharing,’ and (4) perquisites. In addition, man- ‘agement may take actions that will allow it to collect rents in the future, such as by investing in future rent-generating projects or by retaining cash or other assets within the firm for the future use by management. Finally, managers may choose to expend less effort and therefore earn fewer rents. The extent to which managers are able to collect their earned rents depends in part on the relationship between top management and stock market investors, which in turn affects management's incentive to generate rents. The following sections first briefly discuss the role of diffuse shareholders in the firm, and then examine the allocation of rents between top management and shareholders. Shareholder Investment and Return ‘To characterize the role of stock market investors in the firm, the following anal- ysis relies on standard finance theory. The analysis deals only with those firms hhaving diffuse investors, the situation to which much of standard capital market theory applies. Although the adoption of the assumptions of capital market theory ‘can pose problems in strategic management research (see Bromiley, 1990), the as- sumption of efficient capital markets is probably a reasonable starting point for this analysis. Furthermore, even using this assumption, the analysis yields a per- spective regarding manager-stockholder relations that differs somewhat from that of more standard treatments in economics and finance. ‘As an input to the production process and as a firm resource, diffuse sharehold- ers provide investment capital and also may bear risk. Fama and Jensen (1983) give this role as the primary reason for the widespread use of the corporate form in large businesses. But the separability of risk-bearing from operational and stra- tegic decision making has two important implications: 1, The skills that lead to efficient risk-bearing may be completely un- related to those having to do with operational and strategic deci- sions; 2. Ifrisk-bearing skills are widely available and if the information that on that is ied tothe overall profits or stock market performance ofthe frm does have different ‘isk attributes than does straight salary compensation. Managers with different risk preferences may choose to receive their ents in differing forms. JOURNAL OF MANAGEMENT, VOL. 17, NO. 1, 1991 Copyright © 2001. All Rights Reserved. 164 RICHARDP CASTANIAS AND CONSTANCE E. HELFAT investors need to use those skills is also widely available (the market for information is “efficient”) then the market for investment funds is likely to be highly competitive. The provision of risk-bearing services does not require financial investors to take an active role in the planning or production processes. Management will offer diffuse shareholders the minimum return required to procure their services in an efficient capital market (e., a competitive rate of return per unitof risk borne). Be- cause they are diffuse, stockholders have little bargaining power and hence little ability to extract top management's earned rents. Although boards of directors are usually thought to represent stockholders’ interests, the ability of the board to ex- tract rents for shareholders above their fair rate of return may be limited. The top management of a corporation often has a large representation on the board and heavily influences its decisions (Mace, 1971)* Nevertheless, although investors require a rate of return that. compensates them, at a minimum, for the investment financing and risk-bearing services that they provide, management does not nec- essarily have to pay stockholders more than this in order to induce them to provide financing for the firm? ‘Top management, unlike diffuse shareholders, may actively generate rents. Here itis important to distinguish between the ownership of assets and the management, of those assets. If is difficult for rents to accrue to assets without the often contin- uous application of managerial skill. Any rents to stockholder asset ownership that can be produced from the application of widely available managerial skills (i.e. non-rent-generating skills) will be capitalized in the stock price, and stockholders then earn a competitive risk-adjusted rate of return on the capitalized value of the stock.'° Superior top managers, however, may generate additional rents by apply- ing their skills to the management of the firm’s assets. (To simplify the analysis, we assume that other inputs are competitively supplied and thus do not earn rents.) One simplified example of this manager-stockholder production of rents might be the case of above average returns that may accrue to some brand name prod- ucts. Suppose stockholders supply the investment capital to fund the development and advertising of the brand name, and top management supplies the strategic and operational skills to develop and effectively use the brand name to produce rents. (For purposes of this example, the contributions of other factors of production in the firm are ignored.) The capitalized value of stockholders’ investment would in- clude, at a minimum, any expected rents to the brand name that would accrue in the absence of superior management. Stockholders would earn a competitive risk- ‘It would not be surprising that arent-generating management with firm-specific skills would want board rep- resentationin order to protect its ability to continue to generate and capture rents (Williamson 1985) In addition, diffuse stockholders have litle leverage in appointing representatives to the board, “The initial founders or stockowners of the firm, however, may earn substantial rents at the first public offer- ing. "in the standard case ofthe non-tent generating firm, in equilibrium the firms’ stock market value equals the ‘present discounted value of the firm's expected future net case flows (ie, discounted future revenues less costs, ‘and payments to factors of production other than shareholders) Ifthe stock price falls below this level, the firm. ‘becomes vulnerable toa takeover attempt. Ths is true forthe rent-generating firm as well, where the value of the firm’s stock market equity also equals the present value of the firm's anticipated net case flows—again net Of all outlays other than those to shareholders, but where these payments also include rents (such as those to ‘management) JOURNAL OF MANAGEMENT, VOL. 17, NO.1, 1991 Copyright © 2001. All Rights Reserved. MANAGERIAL RESOURCES 165 adjusted return on their investment (and also bear the risk that the total returns to the brand name are greater than or less than statistically expected). Top manage- ment could produce additional returns using superior managerial skills. If this process were characterized in very formal terms, top management could be viewed as maximizing its utility (including rents), subject to the constraint that it pay stockholders a competitive risk-adjusted rate of return on their investment. This constraint would be enforced by, among other things, the market for corporate control. For example, should a rent-generating top management attempt to appro- priate more than the returns it generates, management risks a disciplinary take- over or proxy contest. ‘Top Management-Shareholder Relationships The preceding analysis suggests a perspective regarding the relationship be- tween top management and diffuse shareholders that differs somewhat from more common treatments in economics and finance. Specifically, the managerial rents ‘model implies that in rent-generating firms the role of top management inherently provides some incentives for managerial efficiency. Here, the term efficiency de- notes the productive use of the firm’s resources in a manner that also insures share- holders a competitive risk-adjusted rate of return on their investments."* ‘To the extent that managers are able to collect their earned rents, the incentives for managerial efficiency are twofold. First, the ability to collect earned Ricardian rents provides a positive incentive for top managers to generate such rents. By ap- plying their superior skills to the management of the firm’s resources, and in par- ticular by undertaking profitable, rent-generating projects and other initiatives, top managers may earn rents for themselves as well as generate returns sufficient to provide shareholders with a competitive risk-adjusted return. Second, man- agers who do not wish to jeopardize their quasi-rents by risking a takeover have incentives to insure that stockholders receive a fair return. These incentives for managerial efficiency depend in part on management's ability to collect its earned rents. This in turn depends on top management's rela- tionship with diffuse shareholders. Because shareholders are diffuse and provide investment financing in a competitive market, on their own they have little ability toappropriate managers’ earned Ricardian rents. As noted earlier, the ability of the board of directors to extract these rents for shareholders also is likely to be limited. A single outsider (eg., a “Raider”) could attempt to appropriate management's earned rents (perhaps by taking over the firm), but would probably encounter at least some difficulty. If a top manager can transfer his or her superior generic and industry-related skills to other firms, he or she may be able to thwart an outsider by leaving the firm without losing rents. An outsider, however, might attempt to ex- tract firm-specific managerial quasi-rents, because a manager cannot earn these “This definition of managerial efficiency is consistent with that usually employed in financial economics, ‘where the term is synonymous with maximization of shareholder value. The tera be dead vac of fur cash flo tf payments to te cos of podtn ican payments a ‘eats Ina competitive market or investor cepa, mexiniaton farce suc imple tha shreds ‘earn a competitive risk-adjusted rate of return on the value oftheir investment, Stockholder returns in excess of this amount could only come atthe expense of other actors of production. JOURNAL OF MANAGEMENT, VOL. 17, NO. 1, 1991 Copyright © 2001. All Rights Reserved. 166 RICHARD CASTANIAS AND CONSTANCE E. HELFAT rents in another firm. Devices such as golden parachutes can help to protect firm- specific quasi-rents to superior top management skills, by guaranteeing manage- ment a severance payment to compensate for the loss of quasi-rents, Nevertheless, the ability of management to collect its firm-specific quasi-rents may be imper- fect. In such instances, management may opt to yield some of the quasi-rents to shareholders. In return, shareholders rather than management presumably would have financed the development of these skills initially, and their expected value would be capitalized in the price of the stock. In summary, the ability of top managers with superior skills to collect their earned rents provides positive incentives to generate such rents and disincentives to profitat the expense of shareholders, These incentives help to promote goal con- gruence between top managers and shareholders because managerial pursuit of earned rents via investment in profitable projects and strategic initiatives also ben- efits shareholders. Although this model retains the standard agency theoretic as- sumption of self-interested behavior (i.c., utility maximization) by managers and stockowners, here the actors have incentives to cooperate. That is, as suggested earlier, greater managerial discretion is not necessarily harmful to the firm. In contrast, positivist applications of agency theory to management-share- holder relations often (although not always) view management as tending to shirk orotherwise dissipate resources unless either management's rewards are explicitly tied to those of shareholders or management is continually monitored and pun- ished for misbehavior" The managerial rents approach, of course, does not rule out the potential for manager-stockholder conflict. Even managers with superior skills may be tempted to try to appropriate or otherwise reduce stockholder re- turns, either directly in the form of excess pay and perquisites or indirectly by un- dertaking projects that produce rents for managers at the expense of shareholders. If managers do so, however, they risk a disciplinary takeover with the attendant loss of job and quasi-rents.!? More importantly, the managerial rents perspective directs attention to the positive incentives that rent generating managers have to act efficiently, and that help serve as a counterweight to the alternatives of shirking or resource dissipation. Therefore, in instances where top managers can appropri- ate their earned rents, agency problems between managers and shareholders may not be as pervasive as some of the literature might suggest. ‘The basic propositions just outlined hold true regardless of how management collects its rents, so long as such rent collection does not include shareholders’ re- turns as well. But the strength of the positive incentive provided by management's "Note that in equilibrium neither standard agency theoretic models nor the managerial rents model imply that managers ae shirking. The difference lies inthe way this lack of shirking is accomplished. In many agency the- oretic models, monitoring by stockholders (perhaps through boards of directors) and by the market for corporate control is key. Compensation packages tat tie top management pay to stockholder returns may serve to reduce the amount of monitoring required, The managerial rents model, however, incorporates positive incentives in- hherent in the relationship between rent-generating managers and diffuse shareholders that do not necessarily re- ‘uire monitoring by boards of directors or explicit links between executive pay and stock performance. Man- agers of course may voluntarily elect to receive such compensation as a bonding device to reassure shareholders ‘0F a8 a way to share in some of the upside stock market returns. 'SAs in Famas (1980) analysis, the threat of takeover reinforces incentives inberentin the structure of the pub- licly held corporation. The loss of managerial reputation and pay provides the incentive for managerial effi ciency in Fama’s model. JOURNAL OF MANAGEMENT, VOL. 17, NO. 1, 1991 Copyright © 2001. All Rights Reserved. ‘MANAGERIAL RESOURCES 161 ability to collect its earned rents and the extent to which potential manager-share- holder conflicts are mitigated may vary depending on the method of managerial rent collection. Earlier, several methods for managerial rent collection were iden- tified. These included salary, bonus, stock options and other deferred compensa- tion, perquisites, investment in future managerial rent-generating projects, other investments or retention of cash within the firm, and less expenditure of effort. Note that perquisites can be considered as just another form of pay. All of these methods of rent collection provide roughly equal incentives to generate Ricardian rents with the exception of the expenditure of less effort in lieu of rent generation. Italso is true that if managers use their earned rents to invest in less productive en- deavors, overall managerial efficiency will not be as great as it might be. Never- theless, management still has an incentive to generate the rents in the first place. The various methods of rent collection have different levels of risk as well. The riskier types of compensation, however, also tend to have higher returns (eg., stock options). Therefore, on a risk-adjusted basis, the strength of the incentives for rent generation would not necessarily differ by type of compensation. The mix of com- pensation for an individual manager would probably depend in part on his or her tisk preferences. In addition to differences in risk, the various forms of rent col- lection differ in the timing of their receipt. Presumably, all other things equal, these forms would have equivalent expected discounted net present values after adjustment for risk, and here again managerial preferences would partly deter- mine the mix of compensation. In terms of promoting goal congruence between top management and share- holders, the several methods of rent collection have somewhat more pronounced differences from one another. Compensation tied to stockholder returns would most strongly promote goal congruence, and compensation in the form of less ex- penditure of effort would do so the least. Bonuses paid ex post would probably mit- igate potential conflict more than bonuses paid ex ante. The use of managerial rents to invest in projects beneficial to management but not to stockholders would not promote goal congruence to the extent that investment in projects profitable for both management and stockholders would. Nevertheless, such use of mana- gerial rents does not necessarily harm stockholders. Corporate Governance and Corporate Control A primary implication of the managerial rents hypothesis is that the incentives for managerial efficiency in rent-generating firms would be likely to result in lower costs of monitoring and bonding senior management, Because managers with superior skills have incentives to undertake projects profitable for both man- agers and shareholders as well as to insure that stockholders receive their fair re- turns, the need for external monitoring of top management and for the explicit bonding of managers to shareholders is reduced. Monitoring and bonding costs, of course, do not disappear. Indeed, the previous discussion of managerial rent col- lection suggested that bonding of management via some type of deferred compen- sation can enhance goal congruence between top management and diffuse share- holders. What the analysis does suggest, however, is that even in the absence of JOURNAL OF MANAGEMENT, VOL. 17, NO. 1, 1991 Copyright © 2001. All Rights Reserved. 168 RICHARD P CASTANIAS AND CONSTANCE E, HELFAT effective monitoring or explicit bonding, a rent-generating top management still has some strong incentives to act efficiently. These can help to counterbalance the more frequently noted possibilities for managerial misbehavior or subpar perfor- mance. The reduced need for monitoring also has implications for the role of the board of directors and its composition. Donaldson (1990: 376) notes that agency theory perspectives frequently are critical of governance structures where the board of directors is dominated by executives, the chair of the board is also the CEO, or the CEO's compensation or wealth is not explicitly tied to shareholder value. From the ‘managerial rents perspective, however, such arrangements may be less pernicious. A key function of the board is to set broad strategic direction for the company and make major policy decisions. For this, the expertise of the board is of prime im- portance. When executives have superior skills and expertise, their ability to have decisive influence on board decisions may be critical to their ability to generate rents for the firm. The dual role of the CEO as chair of the board can serve to hance his or her ability to influence and carry out rent-generating strategic ini tives and investments. An explicit linkage of CEO compensation and shareholder value is not a prerequisite for managerial efficiency in a firm where superior man- agers can generate rents. This perspective regarding corporate governance coincides with that of stew- ardship theory (Donaldson & Davis, 1989), wherein managers function as good stewards of the firm. In this view, “managers are team players, and the optimal structure is one that authorizes them to act, given that they will act in the best in- terest of owners” (Donaldson, 1990: 377). As in the managerial rents framework, there are “benefits in having a preponderance of executive directors among the board because this adds to the available expertise” (Donaldson, 1990: 377). In addition to issues of corporate governance and related managerial compen- sation arrangements, the managerial rents framework might be applied to the mar- ket for corporate control, particularly hostile takeovers. The most prevalent view in economics and finance regarding hostile takeovers and proxy fights is that they correct for inefficient management. Although there are many variations on this theme, most of them adhere to Marris’s (1963) original idea that takeovers correct for “managerial deviations from profit maximization” (Scherer, 1988: 70) that can result from the separation of ownership and control identified by Berle and Means (1932), The analysis here suggests that all hostile takeover attempts may not nec- essarily be motivated by nor may they necessarily correct for inefficient manage- ment. A top management with superior capabilities has a substantial inherent in- centive to act efficiently by undertaking projects and making decisions that generate earned managerial rents and to insure that stockholders receive a fair re- turn, Thus, because managers in rent-generating firms may well be acting effi- ciently in advance of any takeover attempt, in some instances it may be useful to consider explanations of takeover activity other than the correction for inefficient management. More generally, it may be useful to explore the differences in rent- seeking behavior by firm insiders and outsiders in the market for corporate con- trol. Some hostile takeovers might reflect attempts by outsiders to appropriate JOURNAL OF MANAGEMENT, VOL. 17, NO. 1, 1991 Copyright © 2001. All Rights Reserved. MANAGERIAL RESOURCES 169 ‘managerial quasi-rents if the latter are not adequately protected. Some manage- ‘ment buy-outs might reflect a response to unusual difficulty encountered by rent- generating managers in appropriating their earned rents. Although a more detailed analysis of market for corporate control is beyond the scope of this article, this dis- cussion suggests avenues that could be explored."* Conclusion This article has focused on the role of top management as a rent-generating re- Source within the firm, and has examined the relationship of top management and diffuse shareholders in this context. The analysis suggests some caveats to the fre- quent presumption that the potential for conflict between top management and dif- fuse shareholders is large and pervasive. In particular, the ability of superior top managers to generate and collect their earned rents can help to align management and stockholder interests in a manner that is sometimes overlooked in the usual ap- plications of agency theory to the firm. The ability to collect earned Ricardian rents provides top managers with a positive incentive to use their superior skills in a manner that is profitable for both management and stockholders. The ability to collect quasi-rents provides disincentives for managerial misbehavior that might result in their loss. In short, top managers often may have inherent incentives to ex- pend the effort required to use their superior skills to generate rents. The approach used here implicitly relied on the view that to understand the rea- sons for superior firm performance requires a look at the underlying resources and the relationships between them. The analysis began with a discussion of superior managerial skills and capabilities, their generic, industry-related, and firm-spe- cific attributes, and the translation of these attributes into Ricardian and quasi- rents. Within this context, diffuse shareholders earn a competitive risk-adjusted rate of return, When top management has the ability to collect its earned rents to superior skills, management also has an incentive to acquire and later employ the skills that generate rents. \The managerial rents framework suggests that the separation of ownership and cdfnttol can be an efficient form of organization, particularly in firms where top ‘managers can generate and collect rents from the application of their superior skills to the utilization of other firm resources. This occurs within a framework where managers and stockholders each maximize their own utility, as in a standard agency theoretic model, but where willing cooperation may result. The potential for conflict still exists of course. But there are also strong countervailing incentives for goal congruence between managers and shareholders. This emerges from a model that considers only economic incentives. If other types of human motiva- tion were added to the model (e.g., needs for achievement and responsibility, the intrinsic motivation associated with the satisfaction of a job well done, etc.) the picture probably would become even brighter. Some additional implications of the managerial rents hypothesis have to do With the role and composition of the board of directors and related issues of man- '“Castanias and Helfet (1990) extends the managerial rents hypothesis to deal more specifically with several issues regarding the market for corporate contro JOURNAL OF MANAGEMENT, VOL. 17, NO. 1, 1991 Copyright © 2001. All Rights Reserved. 170 RICHARD P CASTANIAS AND CONSTANCE E. HELFAT agerial compensation. In its role as a key policy-setting body for the firm, the ex- pertise of the board of directors is at least as important as its monitoring function. This point of view is consistent with some propositions of stewardship theory (Donaldson & Davis, 1989). The managerial rents perspective differs from more standard ones in finance largely due to the treatment of managers in the model. Most analyses of manager- shareholder relations do not incorporate skill differentials between top managers, the possibility of efficiency rent generation, and associated isolating mechanisms. Such an approach, however, is in keeping with business policy research that tra- ditionally has been concerned with the observed heterogeneity of firms and their resources. The discussion here of managerial rents has attempted to add to an emerging literature in business policy on the resource-based view of the firm. The analysis focused on only two inputs to the firm, top management and diffuse shareholders, as a step toward building more comprehensive, resource-based an- alytic models of the firm. Much more remains to be done, not only on the topic of ‘managers, but also with regard to other firm resources and stakeholders, their re- lationships with one another, and the creation of sustained, competitive advantage. References Andrews, K.R. 1987. The concept of corporate strategy (3rd ed.) Homewood, IL: Richard D. Irwin. Barney, I B. 1986. Strategic factor markets: Expectations, luck and business strategy. Management Science, 42: 1231-1241. Becker, G. 1964. Human Capitol. New York: Columbia University Press. Berle, A. A., & Means, G.C. 1932. The modern corporation and private property. Chicago: Com- ‘merce Clearing House. Bromiley, P1990. On the use of finance theory in strategic management. In P Shrivastava & R. B. Lamb (eds.) Advances in Strategic Management, 6: 71-98. Greenwich, CT: JAI Press. Business Week. 1987. The miracle company. October 19: 84:90. Castanias,R. P, & Helfat,C.E, 1990, Managerial and windfall rents in the market for corporate con- trol. Forthcoming, Journal of Economic Behavior and Organization Donaldson, L. 1990. The ethereal hand: Organizational economics and management theory. Acad- cemy of Management Review, 15: 369-381 Donaldson, L., & Davis, LH. 1989. CEO Goverance and shareholder returns: Agency theory or stew-

    You might also like