comparative political economy 2 exam paper
TRANSCRIPT
BSc in International Business and Politics
Copenhagen
Comparative Political Economy II
Exam April 2011
Student:
Nenad Krstevski
CPR: 131082-2945 .....................................
Project size: STU 22697
Number of pages: 10
Copenhagen, April 26th, 2011
Nenad Krstevski Comparative Political Economy II CPR: 131082-2945 Spring 2011
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Table of Contents
Introduction ......................................................................................................................................... 2
1. Structuring of the paper .............................................................................................................. 4
2. Theory: Institutional configuration in LME and CME................................................................... 5
3. Varieties of capitalism and innovation ........................................................................................ 6
4. Analysis: Fundamental innovation in Germany and UK .............................................................. 8
5. German corporate governance ................................................................................................... 9
6. Conclusion ................................................................................................................................. 10
Bibliography ....................................................................................................................................... 12
As OECD survey1 shows, fundamental innovation in Germany is still suffering. Even Germany has been
trying through changes in financial market and corporate governance law, to change its abilities for
fundamental innovation, German institutional configuration still does not enable German companies to
carry out fundamental innovation. This paper is trying to examine why the change in financial markets
and corporate governance has not enabled German companies to fundamentally innovate. In addition, I
wish to look at what global German companies can do to overcome this issue.
Introduction
Today, companies don’t face competition only from other national companies. At some point, all
companies in the developed world will face competition from the global market. This means that for a
company to be profitable or even to survive, it must have top of the line capabilities. The company to
have competitive advantage should or own the best product in terms of quality or to develop new
products and technologies. If an economy in the developed world wants to perform well, it’s important
to have those global companies that can create value for the home economy. That’s why we can show
1 OECD, 2005
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that it is beneficial for a global company to be able to produce both new products and high quality. In
the terminology of the Varieties of Capitalism (VOC) approach, high quality and new technology
transforms into fundamental innovation and incremental innovation, respectively2.
New innovation and technology is an important source of economic prosperity and growth, and that’s
accepted by many governments of the developed world. For example, Germany proclaimed the year
2004 as the “year of innovation”3. This shows that governments agree it’s important that they must
enable companies to provide fundamental innovation through country’s institutional configuration.
Due to the institutional configuration that provides them with the possibility to produce fundamental
innovation, UK firms are better at competing in global markets than German firms.4 Although Casper
and Matraves state that that’s only true for the pharmaceutical industry, it is probably true as a general
trend in other industries as well.
Many researches show that a company’s core competencies are closely related to the environment that
it operates in, that is, a company’s behaviour will be influenced by the national institutional
configuration5. This means that depending whether a company operates in a Liberal Market Economy
(LME) or a Coordinated Market Economy (CME) there will be difference in corporate strategies. These
differences between the two, CME and LME, will be analysed in a later section. Because of the scope of
the paper, I will focus on differences of the two corporate governance (ownership structure, access to
finance) regimes and labour market composure.
From research we can see that institutional differences have given companies operating in LME with an
advantage in promoting fundamental innovative environment. Opposite, companies operating in CMEs
have an institutional advantage in generate an environment for incremental innovation6. In terms of
competing in the fast changing markets, that is producing a problem for companies operating in CME. In
the analysis, UK is used as example of LME and Germany as CME. Namely Germany is an interesting case
to study because they have tried to change some of its institutional configuration in order to facilitate
fundamental innovation. In a global economy where fundamental innovation is an important source of
economic growth, a crucial challenge is raised which will be my essay main question:
2 Hall and Soskice, 2001 3 OECD, 2005 4 Casper and Matraves, 2003 5 according to the VOC approach 6 Hall and Soskice, 2001 p. 39
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When the German institutional configuration cannot provide fundamental innovation, what are the
alternatives for Germany to access fundamental innovation?
1. Structuring of the paper
On the beginning i will briefly have a section on the theories that are going to be used for the analysis
and discussion. I will compare UK and Germany in this paper, based on the theory of VOC, which states
that fundamental innovation is much more successful in LME, than in CME. First, I will analyse the
institutional configuration and labour markets7, in a LME and CME. After, I will connect institutional
configurations with what sort of innovation they improve.
Part one of the analysis will emphasis on differences in the institutional configuration of Germany and
UK, which gives UK an advantage in fundamental innovation. In part two of the analysis I will show some
OECD figures in the analysis and describe which are the changes in corporate governance that Germany
has introduced to facilitate more fundamental innovation.
Continuing, I will discuss why the tries to change the German capital market have not helped facilitate
fundamental innovation and which alternatives Germany have to access fundamental innovation. This
paper’s end is with a concluding session which sums up the findings from the discussion.
Clarification: Meaning of fundamental innovation is “shifts in product lines, the development of
entirely new good, or major changes to the production process”8 and on the other side, incremental
innovation is “market by continuous but small-scale improvement to existing product lines and
production processes”9. Fundamental innovation occurs mostly in swiftly changing environment and it’s
typically seen in bio-technology, system-based products and software industry. Incremental innovation
has its strengths in industries for engines, machine factory equipment and tools10. This means that
7 Due to the scope of this paper I have chosen to leave out institutional configuration concerning: training and
education systems, industrial relations and inter-firm relations, and will talk only in terms of access to finance, ownership structure
8 Hall and Soskice, 2001, p. 38-39 9 Hall and Soskice, 2001, p. 39 10 Hall and Soskice, 2001, p. 39
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development of new technology and vast improvements due to institutional configuration as explained
below are more likely to happen in a LME.
2. Theory: Institutional configuration in LME and CME
There are a number of factors that determine whether an economy should be classified as a LME or
a CME. According to the VOC approach, this classification depends on the institutional set up of
corporate governance11, of labour market policies, inter-firm relations and industry relations. Type of
market economy also has great implications for how a single firm will act in terms possibilities and
restraints. In order for a firm to optimize its performance, top management must recognize the
institutional configuration and adapt to it. Notice also that there many advantages and disadvantages in
both types of market economies12.
Access to finance: The way how a company can finance itself has a crucial implication for its strategic
considerations. Any company can either finance itself through public stock markets of through obtaining
a loan from a bank. In a CME finance is usually credit based, i.e. provided by a bank. By obtaining finance
through the bank, companies can make long-term investments. This is in great contrast to a LME where
companies typically are very much focused on giving surplus back to shareholders through dividends13.
Companies in a LME are depended on the stock market to raise capital. Companies in a LME must satisfy
their shareholders when making their strategy, which tend to be very focused on short-term strategies.
Ownership structure: In a company in CME there are two layers of boards. Management board is the
first, and then is the supervisory board. The supervisory board is very significant for a CME. The board
normally consists of various stakeholders in the company, for example employee representatives,
member from the bank, and labour union representatives. This structure is called “governing coalition”,
or is also referred to as an “insider-model” or co-decision model14. With strong contrast to the LME, the
CEO is given monopoly to decision-making. No consensus with stakeholders is needed to implement
11 When using the term corporate governance, I will refer to the company’s access to finance and ownership
structure 12 Hall and Soskice, 2001 p. 15 13 Casper and Whitley, 2003, p. 94 14 Hackethal, Schmidt and Tyrell, 2005 p. 398
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important strategic decisions which are usually made by top management and implement throughout
the company15.
The main difference that exist between companies operating in a CME or a LME, in terms of ownership
structure in relation to strategic decisions is characterised as the stakeholder model vs. shareholder
model, in CME and LME respectively. In the LME, top management is mostly focused on increasing
short-term value for its shareholders and does not have to take the opinions of their shareholders into
account when choosing a strategy.
Opposite, the stakeholder model states that a company must take all of its stakeholders into account
when choosing a strategy. The bank who has provided finance, wants repayment of the loan. Unions and
employee representatives wants job security of the employees on a long-term basis. Most strategies
taken by CME companies are focused on taking low-risks and planned in the long run.
Labour market: LME is strongly characterised with the mentality of “hire-and-fire”, meaning that
companies can easily hire, but also very easily and without costs get rid of employees when once they
are no longer needed.
In CME the picture is much more different, meaning that once a company has hired a worker, it is
relatively expensive to fire him/her, mainly because of the strong labour unions. In a German company
average employment time period is very high, and workers are more willing to learn firm-specific skills,
which is different from LME, where all workers are more depended on being able to sell her labour on
the market and is thus more likely to develop more general skills16.
3. Varieties of capitalism and innovation
The VOC approach guesses that LME is better at facilitating fundamental innovative processes, and CME
will have an advantage in incremental innovative processes. As the VOC explains, this is due to the
institutional configuration (access to finance, ownership structure and labour market regimes), which is
the main focus of this paper.
15 Casper and Matraves, 2003, p. 1869 16 Casper and Matraves, 2003, p.1870
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Access to finance: Stock market equity based finance or credit based through banks? Important factor
of the company’s planning horizon is the way how the company is financed. In LME shareholders wants
the company to perform well in the short run and show profitability every quarter, which is mostly done
by showing shareholders promising signs of new technologies. In pharmaceutical industry, this means a
company investing in R&D for new “Blockbusters”17. This makes the LME company more likely to engage
in fundamental innovation strategies18.
Banks are typically financiers of CME company, which means there is no short-term pressure from
shareholders. The bank wants normally its loan repaid in the long run. Thats why CME companies can
engage in long-term planning, which value incremental planning19.
Ownership structure: Due to ownership structure, big differences exist in how decisions are create in
LME and CME when a company has to decide what strategy to choose. This has major implications for
fundamental innovation. In a LME company, decisions are easily implement throughout the company,
and the top management does not have to worry much about cutting workers who work on research
projects that has failed and it’s relatively cheap to go into developing new technologies. In CME the
company has a management and a supervisory board. The bank, the unions and the employees typically
each have a representative on the supervisory board present, and in terms of fundamental innovation,
unions and employees are not likely to accept a strategy like the one for a LME company. If it is picked
such strategy, many jobs are in danger, in case of research failures. That’s why CME companies push for
more “safe” strategies that build on cumulative knowledge and incremental innovation.
Labour market: By the VOC approach, fundamental innovation in a LME happens because of the very
labour markets that inhibit incremental innovation. Firms that develop new technology and new
products can very easy hire personnel, and get rid of them if the project became un-profitable, i.e. the
cost of failure is lower. Workers are not particular willing to invest in firm-specific skills, because of this
job insecurity that is present. Besides, companies do not wish to invest resources on staff that might
have to be fired very soon. This is also known as the “hire and fire” mentality20.
17 which is a source of quick and great economic rewards, but also a risky one if the R&D
project fails 18 Casper and Matraves, 2003, p. 1869 19 Casper and Matraves, 2003, p. 1869 20 Hall and Soskice, 2001, p. 40
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Opposite, in the CME a very high level of job security of workers is an extremely important reason for
the success of incremental innovation instead of fundamental innovation. Labour unions in Germany are
extremely powerful and influential on the supervisory boards of companies and in the politics. The big
job security encourages employees to invest in firm-specific skills, due to the long-term employment.
This gives support for incremental innovation21. With this kind of a set-up of the labour market,
companies operating in a CME must to some extend consider their workforce as a fixed cost, rather than
a variable cost22. For this reason it is relatively expensive to engage in high risk R&D project that could
have produced fundamental innovation.
4. Analysis: Fundamental innovation in Germany and UK
Why Germany was not able to facilitate fundamental innovation? I will use the article of Casper and
Matraves on why the German pharmaceutical industry was outperformed by the UK pharmaceutical
industry to answer this question. The findings were very expected by the VOC approach. The German
companies were outperformed by the UK pharmaceutical firms, especially in developing completely new
“blockbusters23”. The reason for this result, as Casper and Matraves argue, is based in the institutional
configuration of corporate governance and labour markets. This includes both organizational flexibility
and ownership structure24. By VOC terminology this means that due to centralized decision making
powers of top management the UK firms were able to rapidly adapt to new developments in the
pharmaceutical industry and due to fluid labour markets UK firms could dismiss employees working on
unprofitable research projects. A German company is not able to adopt such a strategy, due to high job
protection, and because of the ownership structure, specifically the co-decision model. Representative
from the union and representative of the employees are not going to adopt a strategy that will cause
many workers to lose their jobs due to unprofitable projects.
Two other arguments have to do with different incentive schemes in the UK and regulations on research
in the pharmaceutical industry in Germany. However, Casper and Matraves found that even when these
regulations and incentive schemes were not present, German companies in the pharmaceutical industry
21 Hall and Soskice, 2001, p. 39 22 Casper and Whitley, 2003, p. 95 23 Blockbuster is a term for a new drug that where sales exceed USD 1 billion in revenue (Casper and
Matraves, 2003) 24 Casper and Matraves, 2003, p. 1877
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would still focus on technologies that are founded on cumulative knowledge instead of creating a new
“blockbuster”, and they25 refer to the institutional configuration of Germany, especially the ownership
structure of the a company.
In short, the main reason why German pharmaceuticals didn’t produce fundamental innovative drugs is,
because of how the German pharmaceuticals react under corporate governance system and labour
market policies in Germany. Not enough flexible corporate governance system and difficulties for a
given manager to implement changes and new ideas that can persuade the supervisory board. On top of
all that, the rigid labour market and too high job security for companies are setting up fundamental
innovative research projects that might not be profitable.
For a conclusion, Casper and Matraves, state that Germany knows and has recognized that it has issues
with its corporate governance structure, and has already started to change its system26. In depth
discussion of the changes in the system of corporate governance in Germany is done below. Already
companies have recognized the lack of fundamental innovation in Germany. As example, the German
originated pharmaceutical company, Aventis, is conducting most of its bio-technical research in USA27
and in cooperation with US universities28.
5. German corporate governance
With this part I want to point out that even Germany has attempted to make changes in its corporate
governance regime, that had not allowed yet to facilitate the growth of fundamental innovation. Casper
and Matraves are stating that, Germany had begun to make changes in its corporate governance regime
because Germany knew that it had problems in starting up and facilitating fundamental innovation29.
Hackethal, Reinhard and Schmidt are stating that “Germany has seen a wave of innovations in corporate
governance and the financial system over the last decade”30. The changes include a new law on insider
trading which is now illegal and some other similar changes like improvements have been made in the
German stock exchange system, providing investors with greater protection, capital gains taxes almost
removed, introduced mandatory take-over bids. All are measures to promote more private investors
25 Casper and Matraves 26 Casper and Matraves, 2003, p. 1878 27 This is done through the take-over of Marion Merrell Dow (Casper and Matraves, 2003, p. 1873) 28 Casper and Matraves, 2003, p. 1873 29 Casper and Matraves, 2003, p. 1878 30 Hackethal, Reinhard and Schmidt, 2005, p. 397
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and investment banks to become involved in the capital market, i.e. introducing more open and liberal
markets. Traditionally, very important as a source of credit and finance in the German industry were
banks, which now are slowly changing. Instead being the lender, banks are becoming more increasingly
the investor. However, the bank’s credit is the most important source of finance31.
They32 argue that even many things in corporate governance have changed, the basic set-up is the same.
Thats why the German model is far from being associated with the shareholder model that is the main
mark of the LME type corporate governance. Even investor protection and more transparency are being
introduced in the German system, still the role of private investors is quite small. The ownership
structure still is not changed very much and banks still have enormous influence on supervisory
boards33. Hackethal, Reinhard and Schmidt also state that almost none changes had been made in the
part of labour markets and industrial relations.
Casper and Matraves state that the changes in the capital market were expected to equip the German
firms with the skills to be more competitive on rapidly changing global markets34. If this statement is
compared with Hackethal, Reinhard and Schmidt statement, that this change did not really occur, the
conclusion is that the shareholder paradigm wasn’t on a primary position for German firms, which
means, according to the VOC approach that German firms still not able to encourage fundamental
innovation, because German corporate governance regime has not changed significantly. Proof got this
is the OECD report, which state that 85 % of all expenditure on R&D is directed towards incremental
innovation35.
6. Conclusion
The departure of VOC approach takes in the reality that UK institutional configuration is good at
producing fundamental innovation. But, it does not take into account what it takes to achieve such
institutional configuration, i.e. what are the pre-requisites that UK had in order to develop it liberal
market economy and it doesn’t give answer how other countries can reform their institutional
configuration so that they also can encourage fundamental innovation.
31 Hackethal, Reinhard and Schmidt, 2005, p. 401 32 Hackethal, Reinhard and Schmidt 33 Hackethal, Reinhard and Schmidt, 2005, p. 404 34 Casper and Matraves, 2003, p.1878 35 OECD, 2005
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When we look at the German case, it looks that the needed prerequisites have not been met when
Germany tried to reform its institutional configuration. If it was better described and understood the
starting point of UK‘s development in to a LME, that could be of a great help and be beneficial for
Germany to know before they start transferring their economy into a LME.
Why hasn’t the change in corporate governance had the effects desired by the German government?
The VOC approach state that the equilibrium market type is a result of the coordination among
players36. Is there a shared political goal among the actors to transform the German market economy
into a LME, is now the question. The question of why players in Germany has not cooperated is vital,
and it raises a question if there is a political desire to change the German institutional configuration.
Summary of findings:
As OECD is showing, Germany is still not able to encourage fundamental innovation and they may
recognize that they cannot create the environment that creates fundamental innovation and therefore
continue to focus on its core capabilities which are incremental innovation and high quality. More,
German companies should enter in alliances with companies from LMEs to receive the needed
fundamental innovation.
OECD has shown that there is very little fundamental innovation in Germany, as of 2005. The German
capital markets and corporate governance were tried to be reformed by the German government. But
when you look closer at the situation faced by companies, these changes has not occurred, in spite of
the government’s effort to change this37.
It is very important to mention that German global companies are competent to use the strengths
associated with both types of market economy. Thats done by locating R&D activities in a LME, and then
to benefit from the fundamental innovation that takes place in such economies. This could very well be
something that Germany should look further into in order to explore political strategies.
36 Hall and Soskice, 2001, p. 13 37 Hackethal, Reinhard and Schmidt, 2005, p. 404
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Bibliography
- Peter A. Hall and David Soskice (2001) ‘An Introduction to Varieties of Capitalism’ in Hall and
Soskice (eds) Varieties of Capitalism, Oxford: Oxford University Press, pp. 1-66.
- OECD (2005), Economic Outlook No. 77, June, Paris
- Hackethal, Andreas; Schmidt, Reinhard H.; Tyrell, Marcel.” Banks and German Corporate
Governance: on the way to a capital market-based system”, Corporate Governance: An
International Review, May2005, Vol. 13 Issue 3, p397-407
- Casper, Steven and Catherine Matraves (2003) ‘Institutional Frameworks and Innovation in the
German and UK Pharmaceutical Industry’, Research Policy 32: 1865-1879
- Casper, Steven and Richard Whitley (2004) ‘Managing Competences in Entrepreneurial
Technology Firms: A Comparative Institutional Analysis of Germany, Sweden, and the UK’,
Research Policy 33: 89-106