University of Southern California Dissertations and Theses

The corporate economy and growth of corporations in Taiwan

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The corporate economy and growth of corporations in Taiwan

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Content THE CORPORATE ECONOMY AND GROWTH
OF CORPORATIONS IN TAIWAN
Copyright 2004
by
Hui-Ru Ellen Chen
A Dissertation Presented to the
FACULTY OF THE GRADUATE SCHOOL
UNIVERTIY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements for the Degree
DOCTOR OF PHILOSOPHY
(POLITICAL ECONOMY AND PUBLIC POLICY)
December 2004
Hui-Ru Ellen Chen
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UMI Number: 3155391
Copyright 2004 by
Chen, Hui-Ru Ellen
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Acknowledgements
I would like to thank all University of Southern California professors who
taught me before and sat on my dissertation committee. Professor Harrison Cheng of
the Department of Economics was the chair of my dissertation committee. Professor
Saori Katada of the Department of International Relations was the second member
and Professor Kalaba of the Department of Electrical Engineering served as the
outside member. Professor James Chu of the Department of Economics at the
National Taiwan University assisted with valuable guidance and suggestions for
research. Dr. Farideh Motamedi provided her moral support. My friend, Professor
Zagros Madjd-Sadjadi of the Department of Economics at The University of the
West Indies, Mona read through drafts of two chapters and provided useful
comments. The list of those to whom I am indebted is much longer than this brief
listing allowed.
I also want to thank my family, my friends, and especially my parents for
their unconditioned support and true belief in me even when I doubted my own
ability to finish this seemly endless project. This dissertation means to me the
accomplishments of complexity, time consuming and emotional tribute. Indeed, I
was very grateful at this moment.
Hui-Ru Ellen Chen
August 2004
University of Southern California
Los Angeles, California
ii
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CONTENTS
ACKNOWLEDGEMENTS ii
LIST OF ILLUSTRATIONS AND TABLES v
LIST OF ABBREVIATIONS vii
ABSTRACT ix
CHAPTER 1 Introduction: 1
Problem Formation, Research Topic and Methodology
CHAPTER 2 Literature Review: 10
Modernization, Dependency Theories and 11
Dependent Development
Neoclassical Resurgence and the Challenge from 17
Developmental State of East Asian
Review on Evolution of Corporations 24
Review on the Firm’s Growth Theories 33
CHAPTER 3 The Dependent Development of Taiwan 42
The Initial Condition after 1949 in Taiwan 45
The Root and Development of an 53
Outward-oriented Economy
Evidence on Trade Balance and Industrial 62
Production Index Analysis
CHAPTER 4 Corporate economy under dependent development 74
The Characteristic of Taiwan’s Corporate Economy 74
The Changing Corporate Economy in Taiwan: How 83
Does Government Engineer Corporate Economy
Differing Corporate Structure from other East 95
Asian Models
CHPATER 5 The Nature of Modem Corporation
The Evolving Modem Corporation
Definition of Modem Corporation
The Alternative Definition of Corporation
108
108
111
123
ill
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CHPATER 6 The Impact of Control Type and the Growth of Corporation 132
Separation of Ownership and Management in Managerial 134
Corporation
Incentive Problems and Theories of the Firms 136
Control type, Growth Hypothesis and External Constraints 140
Data and Test Result on Corporations of USA (1) 146
Data and Test Result on Corporations of Taiwan (II) 152
CHPATER 7 Financial Factors and the Growth of Corporations: 157
Cross-sectional examination in 1997 and 2003
Financial Data and Prior Statistical Analysis 159
Principal Component Analysis 163
Data and Definition of Variables 167
Empirical Result of PC A 170
Regression Analysis of Financial Factors 180
CHAPTER 8 Conclusions 185
BIBLOGRAPHY 195
iv
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List of Illustrations and Tables
Table 1: Comparative Growth Experence 48
Table 2: Size and Extent of Labor Surplus 49
Table 3: Comparative Adult Literacy Rate and School Enrollment Ratios 49
Table 4: Growth in Agricultural Productivity 49
Table 5: Improvement on Taiwanese Education 51
Figure 1: GNP % 60
Figure 2: Import and Export to GNP Ratios 61
Figure 3: Trade Balance 64
Figure 4: IP Index 69
Table 6: Small and Medium-Sized Enterprises 75
Table 7: Financial Sources of Taiwanese Companies 82
Table 8: Growth of Sales in Industrial Park 93
Figure 5: Ownership Structure 101
Table 9: Leverage for East Asian Countries and US, 1988-1996 102
Table 10: Capital Investment for East Asian Countries and US, 1988-1996 103
Table 11: Discriminant Analysis (US) 149
Table 12: Discriminant Analysis (Taiwan) 154
Graph 1: Plot of Eigenvalues (1997) 171
Graph 2: Plot of Eigenvalues (2003) 172
Table 13: Principal Component Analysis (1997) 173
Table 14: Principal Component Analysis (2003) 173
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Table 15: Factor Loadings (1997) 174
Table 16: Factor Loadings (2003) 175
Table 17: Regression Summary for Dependent Variable on Growth Rate (1997) 181
Table 18: Regression Summary for Dependent Variable on Growth Rate (2003) 181
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List of Abbreviations
AP Account Payable
EA East Asian
EBIT Earning Before Income Tax
EOI Export-Oriented Industrialization
EPZs Export Processing Zones
ERSO Electronics Research and Service Organization
HSIP Hsinchu Science Industrial Park
ISI Import-Substituting Industrialization
ITRI Industrial Technology Research Institute
KMT Kuo Min Tang
KAIST Korean Advanced Institute of Science and Technology
MDA Multiple Discriminant Analysis
MM1 Modigliani-Miller Theorem 1
NICs Newly Industrializing Countries
NTS New Taiwan Dollar
01 Operating Income
PCA Principal Component Analysis
PCs Principal Components
PRC People’s Republic of China
ROC Republic of China
vii
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ROA Return of Asset
ROE Return of Equity
SMSE Small-Medium Sized Enterprise
SOE State-Owned Enterprise
TFP Total Factor Productivity
TSE Taiwan Stock Exchange
TSEC Taiwan Stock Exchange Committee
TSMC Taiwan Semiconductor Manufacturing Corporation
VLSI Very Large-Scale Integrated Circuit
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ABSTRACT
First, this dissertation explores how the corporate economy in Taiwan was
shaped by its political economy. Under the export-oriented economy, this research
identifies main characteristics of corporate economy in Taiwan to form the basis for
supporting the growth process: 1) predominance of small- to medium-sized
enterprises, 2) small firms aiming at outward economy since the colonial period, 3)
the importance of state enterprise 4) political paranoia and financial conservativeness
, and 5) the low macro leverage and low debt of corporations. What contrasts Taiwan
from most other Asian economies was financial conservativeness (low macro
leverage and low-debt of corporations). This might limit economic growth in some
way, but also helped it to weather the financial storm in 1997.
The dissertation goes on to explore how Taiwan made it through the export
expansion in the late 1960s, industrial depending in the 1970s, and technological
upgrading in the 1980s. Guided by state autonomy, Taiwan was able to maximize
the flow of foreign investment and technology into its economic development, not
being exploited as dependency theorists claimed. “Learning by doing“ linked
outward economic development with gradual phases of industrialization as well as
from internally generated changes to increase the technological self-sufficiency. The
growth model of corporations is different than that of other Asian countries in terms
of size, ownership concentration, and financing structures. Compared to other Asian
countries, the size of corporations in Taiwan was smaller, the ownership structure
was more widely held, and the leverage and investment were relatively lower.
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Does a management-controlled corporation grow faster than owner-
controlled corporations, even if the agency problem exists? I examine the empirical
validity of the growth hypothesis, taking into account of growth constrains via the
use of discriminant analysis. Within management-controlled corporations in US, the
growth constraints are weakly binding; I find the management-controlled
corporations indeed grow faster than owner-controlled corporations in the case of
USA. But, in the case of Taiwan, almost of corporations are owner-controlled and
the growth constraints are strongly binding; in Taiwan, owner-controlled
corporations grow faster than management-controlled corporations.
Via the Principal Component Analysis, five financial factors for driving the
common variation in differentiating company performance are identified as (1)
return on investment (2) capital turnover ratio (3) size of corporation (4) long-tern
solvency (5) short-term liquidity. The analysis of variation in 1997 and 2003 reveals
that the five financial ratio groups posses a high degree of cross-sectional stability;
financial stability is often acknowledged as a contributing part to a healthy financial
system in a country. Using those five PCs as independent variables to properly
interpret repressors in a regression equation, I find that firm growth is not random in
nature. There is a positive significant relationship between corporate growth rate and
the return on investment for years of 1997 and 2003; after the financial crisis, “the
size of corporation” plays an important role as well, which means that bigger
companies have more successful rate in financing company’s growth.
x
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Chapter 1 Introduction:
Problem Formation, Research Topic and Methodology
Problem Formation
“Economic Development” became an important issue because a lot of
newly emergent countries came to the world stage after WWII and the gap in
economic performance between developing and developed countries was a long
standing debate. In the post-war era, developing countries have been characterized
by developmental states1 , which try to promote national economic growth.
Governments try to create suitable environments for enhancing the competitiveness
of national productivity and pursing economic growth; but the implementations and
outcomes of “growth and development” have differed and varied according to the
volatile nature of political economy at any given country. The rapid growth of the
East Asian newly industrializing countries (NICs), including Hong Kong, Korea,
Singapore, and Taiwan has drawn a lot of attention; researchers analyzed the East
Asian developmental experiences and wished to draw lessons that might be learned
of relevance for other developing countries.
There are two broad categories of developmental state in the context of East
Asia (EA): “state socialist” such as China, North Korea and Vietnam, and “state
capitalist” including Korea, Taiwan and Japan. No matter what kind of political
regime is used, including Westminster-style democracy, semi-democracy,
1 “The developmental state”, by definition, “is a state which sets out to promote national development by means
o f institutionalized patterns o f policy intervention guided by some kind o f plan or strategic conception, and plays a central
role in that p rocess” (White, p.5,1992)
1
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authoritarian state, or communist state, they let authoritarian rules continue while
maintaining some degree of economic liberalism; the goal for developmental states
to pursuit national economic growth is on a continuum base along with their initial
conditions. The East Asian Economies proved the possibility of breaking
economic inequity to pursuit economic growth and also indicated a positive
developmental linkage between state intervention and economic growth, which
were counterexamples to dependency theory claimed in the early development of
several Latin American states.
The emergence and growth of developmental states in East Asia resurged
the arguments about the inadequacies of dependency theory and the robust critiques
of neo-classical orthodoxy. Since the late 1980s, the growth of East Asian
Economy has become the subject of intense research and culminated in the works
of Amsden (1989), Wade (1990,1992), Haggard (1988,1990) in the 1990s. On the
other hand, Johnson (1982) and Calder (1982) were the pioneers to critique the
neo-classical orthodoxy on East Asia. To set the stage, we discussed briefly those
arguments in the following section, and more thoughtful reviews regarding
Modernization theories (neoclassical orthodoxy), Dependency theories (dirigisme
doctrine), and theories of East Asian Growth will be examined in the following
Chapter of Literature Review.
After WWII, the orthodox prescription for development policies was
systematized in the writing of neoclassical economists, who emphasized on the
external forces in initiating development (U.S. Aid or Direct foreign investment by
2
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multinational corporations), reliance on market forces, both domestically and
internationally and political setting of Westminster-style democracy (, assuming the
economic development could foster the democratization in an increasingly middle-
class society.) Despite tremendous efforts from U.S. and UN Development
Agency, the gap in economic performance between the developing and developed
countries was continuously worsening and dichotomized. Some modernization
theorists such as Black (1966, p i3) or Rostow (1971, p25) started to departure from
orthodoxy and claim the need for strong developmental states to implement
government planning.
Originated from Latin American scholars, Dependency theory provided
theoretical foundations for the “dirigisme” doctrine and claimed the incomplete
development in the Third world was resulting from that rich nations at the core
exploited the poor nations at the periphery. “Free trade” was used as an agent of
oppression perpetuating the dependence of underdeveloped countries. Following
dirigisme, Latin American countries intended to reserve national markets for local
goods and adopted inward import-substitution policies with extensive state
interventions in financial and labors markets; the result was that generally poor
economic performance of Latin America region, compared to the success of East
Asia. Many political economists commented state-led outward economic growth in
East Asian was a “challenge to dependency theory”. (Amsden, 1979)
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Research Topic
The causes of “Asian Miracle” have become one of the most discussed
subjects empirically and theoretically in the field of “growth theory, developmental
economics, state theory, international political economy, industrial organization
and comparative sociology (Amsden, 1989; Wade, 1992; Henderson, 1993 Lucas,
1993; Krugman, 1994; Evans, 1995). Much of the literature on the NICs deals with
political and economic conflicts, development policy, state autonomy, alternative
paths to industrialization, and how those elements were associated with their
growth. The particular interest in this research is in bringing together the architects
and analysts for the developmental experience in Taiwan and also examining how
organizational behaviors of Corporations reacted to the pursuit of growth. The
economic “miracles” of the EA region have been examined from various
perspectives, but not too much research has been done within the perspective of
corporate economy. The author intended to understand how governments and
corporations in this open, high-growth economy of Taiwan could have successfully
broken the unfavorable economic initial condition, adapted to the changing
economic environment of world economy, and paved its own way toward the
“growth and development”.
Taiwan has been part of the “East Asian miracle”, enjoyed sustained
economic growth, and seems relatively immune to the 1997 Asian Financial Crisis.
“Expansion of trade” for development is often regarded as the engines of Taiwan’s
4
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economic growth; but the growth of trade expansion needed to be channeled
through the growth of corporations. East Asian corporations were considered an
important contributing part of the East Asian miracle and was generally viewed
upon as very competitive. “How have the developmental states in East Asia
pursued the goals of economic development?” Understanding the growth of
corporation is a key element to realize the progressive growth of national economy;
after all, markets are made of thousands of individual firms for transactions. What
modern corporation really is a locus of collective action in which a number of
individuals with varied interests are brought together in pursuit of economic
interest along with the invisible hand of market. On the one hand, the corporation
has its own life, form and decision-making; on the other hand, the corporation is
also embedded in a system of market processes and political institutional setting.
By studying Taiwan, I hope to provide additional perspectives in understanding
how the country growths out of its original political economy on macroeconomic
side and how the company growths out of its specific ownership and financial
patterns on microeconomic side.
The main purpose of this study was to produce a comprehensive and
detailed analysis of the performance of corporate economy in the developmental
state of Taiwan and how the growth of companies was related to the ownership
structures and financial patterns. I approached this investigation by mainly
focusing on, 1) if Taiwan is providing a successful example for dependent
development and a counterexample for dependency theorist; and if so, 2) how the
5
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form and development of its corporate economy was shaped under its political
economy? and 3) how the engine of growth is channeled through the growth of
corporations in terms of its ownership and financial pattern? I not only look at
theoretical thinking, but also question the empirical validity of the growth theory -
what is the evidence that different forms of ownership result in different
performance by firms (empirically tested in Chapter 6), and also seeks to identify
which financial factors are important for driving the common variation in
enhancing Taiwan’s company performance (empirically tested Chapter 7).
The corporate economy in Taiwan is the product of its unique historical
political economy. The evolution of corporations and the corporate economy was
introduced by the Japanese colonial government at around the turn of twentieth
century, developed by Nationalist authoritarian regime since 1950s, then followed
with the economic liberalization at around 1980s, which transformed the
Nationalist authoritarian regime to develop the democracy of Taiwan. In order to
understand in real world how corporations react in the pursuit of profits, how
businessmen behave and by what processes they reach decisions, the different
interests between the owner and managers within a corporation, a political
economic perspective should be added on as the analysis methodology while we
interpret the results of empirical testing.
6
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Methodology
As for Methodology, the success and failure of Asian Economy have
become the most discussed subjects empirically and theoretically in the fields of
“growth theory, developmental economics, state theory, international political
economy, industrial organization and comparative sociology. (Amsden, 1989;
Wade, 1992; Henderson, 1993 Lucas, 1993; Krugman, 1994; Evans, 1995). This
thesis uses various approaches such as comparative, marginalist, institutionalist and
empirical methods covered in the interdisciplinary fields to address different
fundaments aspects of corporate economy in Taiwan. Neither single economic nor
single policy equations can fully explain the success of economic performance; to
search the answers for economic growth, we need multi-dimensional approaches to
find the dimensions that play a key role in determining the economic dynamics.
The general marginalist theory of the firm remains dominant in academic
research; however, corporations can no longer be viewed as purely economic
agents trying to maximize their utility as the dominant economic theorists claim.
Rather, it becomes necessary to regard the corporation as a locus of collective
action, and both political and economic power will provide for the input of
constituencies of the behavior of corporation. The Institutional Economy views
“institutions” as endogenous “variables” and three basic types of institutions are
“markets, firms, and states”. In this research, the units of analysis are the
“corporation” itself on the microeconomic level and the whole “corporate
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economy” on the macroeconomic level. I explore the growth of Taiwan’s economy
by looking at how the institutions evolved historically and what was the form and
development of corporate economy to support the growth of Taiwan’s economy.
This research also conducted two empirical studies based on firm-level data of
publicly traded companies at Taiwan Stock Exchange to understand the corporate
behavior in the pursuit of growth. The first empirical study replicates Berle and
Means on the separation of ownership from control and its effect of firm’s growth.
Via the statistical technique of discriminant analysis, I examine the empirical
validity of the growth hypothesis, by taking into account of the growth constrains.
The second empirical paper use the statistical techniques of principal component
analysis, by examining the financial data of cross-sectional companies in 1997 and
2003, to search for the determinations of corproate’s growth rate, the impact of
certain financial pattern and identify the variations at different time periods before
and after the Asian Financial Crisis in 1997.
Organization of the Study
The dissertation is organized as follows. Chapter one describes research
topic, problem formation, methodology and points out the research angle that is
focused by author to explore the growth of developmental state in Taiwan from the
perspective of corporate economy. Chapter two presents the theoretical
background and literature reviews for providing basic knowledge in understanding
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the framework to be developed in this research. Chapter three provides the
relevance of political economy for understanding the form and development of
corporate economy, the evolution of dependent development and export expansion
and argues in favor the positive linkage between trade and growth. Chapter four
explains how the corporate economy was shaped by its political economy and
identifies main characteristics of corporate economy in Taiwan to form the basis for
supporting the rapid growth process. Chapter five defines the form and content of
Modem Corporation on which I run empirical studies later on to capture the
corporate behavior in pursing the growth. Chapter six is the empirical study to
realize the relationship between control type and the growth of corporations;
Chapter seven is another empirical study in order to understand the relationship
between financial factors and the growth of corporations. Chapter eight is the
concluding remarks, which summarize the findings of this research and details the
growth model of Taiwan’s corporations.
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Chapter 2 Literature Review
This dissertation addresses the question of how Taiwan’s economy grew out
of its initial political economy and emphasizes on the role of the corporate
economy in economic growth. Research on the East Asian growth experience has
been focused on the role of the state, social classes, economic policies, but not too
much has been analyzed from the perspective of the corporate economy, especially
in the case of developmental state of Taiwan. The growth of the country needs to
be channeled through the growth of corporations and understanding the growth of
corporations serves as a key element to realize the progressive growth of national
economies. The corporation has its own will to growth based on its internal
structures related to financial and ownership structure, but the growth of
corporation is also shaped and influenced by the country’s political economy,
natural resources and its relative position in the world economy. Searching for key
elements of growth, this research intends to identify main characteristics of
corporate economy to form the basis for supporting the growth at national level and
also exam the effects of ownership and financial structures related to the growth of
corporation at the firm level. The following literature review investigated different
theories related to the growth of national economic and the growth of corporations
on both macroeconomic and microeconomic levels.
Due to the interdisciplinary nature of our study, the general literature review
should provide background and knowledge in understanding the framework to be
developed in this research and the specific literature review referred to each
10
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hypothesis-testing will be containing in each chapter as provided below. As
pointed out in my Introduction (see Ch. 1), the emergence and growth of
Developmental states in East Asia has drawn a lot of attention and the debate
between the neoclassical and dependency perspectives has resurfaced. Following
the previous discussion in chapter one, this review section starts with 1) literature
review on Modernization theories (neoclassical orthodoxy), Dependency theories
(dirigisme doctrine), and Dependent development, followed by reviewing 2)
Neoclassical Resurgence and East Asian Growth, then, 3) literature review on the
evolution of Modern Corporations, and 4) literature review on the Firm’s Growth
Theories.
Modernization, Dependency Theories,
and Dependent Development
After WWII, Modernization theorists have optimism about the economic
future of the Third World, and are influenced by orthodox developemnt thinking of
neoclassical theory. Rostova’s stage theory, for example, suggests that
underdeveloped countries will grow by pursuing a linear path similar to the
Western Capitalist Nations’ experience through successive sages of development
toward modernization. Modernization theorists emphasize the benefits of external
economic polices based on the interplay of market forces that developed out of
liberally though and the positivist tradition. Such theorists (Apter3 , 1965; Levy4,
2 Rostow Walt, Politics and the Stages of Growth. New York: Cambridge University Pres, 1971.
3 Apter David, the politics of Modernization, Chicago: University of Chicago Press, 1965.
11
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1966) believe that the international linkages the states, corporations, markets, and
development resources such as capital and technology have positive long-term
effects on economic growth. In general terms, Modernization theorists believe that
different economic performance will evenly converge; however, the answer for
dependency theorists is a resounding “No”.
Dependency theories originated with the dependency writers of Latin
America in the late 1960s. The 1960s showed that the import-substituting
industrialization (ISI) policy of Latin American did not produce the results
originally hoped for and lead to significant inefficiencies, a discouragement of
exports, increased unemployment and a worsening of the term of trade and income
distribution. Instead of looking at growth of GNP per capita, Latin American
scholars were concerned more with political authoritarianism, socioeconomic
inequalities, poverty, appropriate forms of economic growth, and external
constraints on national autonomy.
Dependency ideas were influenced by Marxism, Imperialism (Evans5 , 1979,
p. 14-3 5) and were a reaction against orthodox development thinking of neoclassical
and modernization theories. Dependency theorists critiqued the classical principle
of trade theory - comparative advantage was a damaging myth that covered up and
justified the exploitative nature of international capitalist economic relations.
Whereas neoclassical economic developments emphasize increases in productivity,
4 Levy, Marion, Modernization and the Structure of Societies, Princeton: Princeton University Press,
1966.
5 Evans Peter, Dependent Development: The Alliance of Multinational, State, and Local Capital in
Brazil, Princeton: Princeton University Press, 1979.
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efficient resource allocation and increases in aggregate national product,
dependency theories are concerned more about equitable distribution among
classes, regions, and sectors. On the other hand, dependency theorists critiqued
modernization theories on a number of grounds. Modernization theorists tend to
treat national units as autonomous while dependency theorists stress the
international context of national development: the social and economic
development of developing countries are conditioned by external forces - the
domination of peripheral countries by powerful center nations. Modernization tried
to identify the universal functions for all societies and political system, the patterns
of action of traditional society which ere the cause of underdevelopment and
designed the stages of development toward “Modernization” based on the ideal
example of Western European countries. In contrast, dependency theorists argue
that fundamental differences existed between the developmental experience of
Europe and the less-developed countries and this means that the success of such
development stages cannot be replicated.
Dependency theory encompasses a large body of literature that incorporates
many different concepts and methods. In general, the Dependency school can be
classified into three major approaches and labeled as: “underdeveloped
development”, “distorted development” and “dependent development”. The first
approach was begun by Andre Gunder Frank and has been continued by scholars
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such as Theotonio dos Santos and Rui Mauro Marini. (Palma6, 1978, p.899) They
rejected the possibility of capitalist development in Latin America, built their
“development of underdevelopment” model in which the extraction of surplus led
directly to economic stagnation, and claimed the capitalist of core countries leads to
the underdevelopment of undeveloped countries. Frank criticized the
socioeconomic problem of “Dual Economy” between traditional and modem
sectors of the periphery and concluded that peripheral industrialization through ISI
would note break the cycle of surplus extraction and underdevelopment except
through the socialist revolution.
The second approach was founded by Celso Furtado and Osvaldo Sunkel
(Palma7 , 1978, p.906-909, Packenham8 , p. 16-19) and criticized the first approach
as being not deep enough and only attacking the assumptions and not the real
problem of developmental issues. Therefore, Furtado and Sunkel attempted to
reformulate the prior analysis of “unequal exchange” between center and periphery
and focused on the external or internal “obstacles” and “distortions” of periphery,
particularly market constrictions. Furtado observed that the mutually reinforcing
relationship between mass consumption and investment, which provided the basis
for sustained economy growth in the advanced capitalist countries, did not exist in
the periphery. He saw the foreign multinational corporations and local domestic
6 Palma, Gabriel, “Dependency: A formal theory of underdevelopment or a Methodology for the
analysis of concrete situation of underdevelopment”, “World Development, Vol6, p.881-924)
7 Palma, Gabriel, “Dependency: A formal theory of underdevelopment or a Methodology for the
analysis of concrete situation of underdevelopment”, “ World Development. Vol 6, p.881-924)
8 Robert, Packenham, The Dependency Movement, Harvard University Press: Cambridge,
Massachusetts, 1992.
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“oligarchy” using coercive power to dominate the market and exploit the mass
consumer. He concluded those consumption patterns and the rigid social structures
erected under colonialism condition the success of ISI strategies and constitute the
central mechanism of dependence. Like Furtado, Sunkel saw the countries of Latin
America as highly dependent on their foreign economic relations; the ISI strategy
had not reduced but actually increased foreign dependence of technology and
capital since imported luxury consumption goods has been replaced by more
necessary imported intermediate goods and also increased the dependence on
primary exports to foreign market. He advocated expansion and diversification of
traditional exports and greater local control of the multinational firms to facilitate
the development of local technology and generate local-owned surpluses of
resources for investment.
These two Dependency theory approaches remain useful for an
understanding of classic dependency situation and provide helpful insights for the
developmental difficulties faced by Third World. However, the successful cases of
Asian NICs show clearly the need for reformulation to account for the economic
dynamism of the NICs. This research will focus on this new wave, namely
“dependent development” school and give particular interest in examining the
theories into non-Latin American cases such as the developmental state of Taiwan
and non-Latin American author such as Peter Evans9. This third approach, founded
by Fernando Henrique Cardoso and Enzo Faletto, accepted the possibility of
9 Evans Peter, Dependent Development: The Alliance of Multinational. State, and Local Capital in
Brazil. Princeton: Princeton University Press, 1979.
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capitalist development by concentrating its analysis on ‘concrete situations of
dependency”. This “dependent development” school recognizes a more complex
and contingent relationship between dependency and economic growth. First,
Latin American economies as an integral part of the world capitalist system, the
analysis requires primarily an understanding of the characteristic of the world
capitalist system. In the words of Cardoso: “The very existence of an economic
“periphery” cannot be understood without reference to the economic drive of
advanced capitalist economies which were responsible for the formation of a
capitalist periphery and for the integration of traditional noncapitalists economies
into the world market.” (Cardoso and Faletto1 0 , 1979, p.xvii)
Second, the path of dependent development becomes possible, as the
benefits of foreign capital have increasingly been converged into the benefits of
manufacturing industry in the periphery. An understanding of the particular
historical structure of the developing nation under considerations is necessary in
order to understand the way in which the interaction of domestic and foreign
groups, classes and organizations influence economic development. This approach
studies of how general (external) and specific (internal) determinants interact with
one another in the context of a specific historical structure within a country extends
dependency analysis by forcing consideration of the internal determinants of
development in each economy. Analysis of diverse situations of dependency
permits specification of the sociopolitical context of dependency, which itself
1 0 Fernando Henrique Cardoso and Enzo Faletto, Dependency and development in Latin America.
Berkeley: University of California Press, 1979.
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determines the possibility, nature, and rate of growth. This research analyzed the
diverse situations of dependency in Taiwan throughout different time periods,
which permits specification of the sociopolitical context of dependency, and how
the success of dependent development was associated with an open-trade policy
evolving with world economic system.
Neoclassical Resurgence and the Challenge
from Developmental State of East Asian
As past the golden age of dependency and its dirigisme doctrine in the
1960s, the experiences of East Asian growth showed the possibly to grew out of
underdeveloped periphery through trade openness, aid and foreign capital, which
embraces the neoclassical resurgence and challenges the tenets of dependency
theory. The neoclassical resurgence started in the 1970s by the works of Little1 1
(1979, 1982), and Bhagwati1 2 (1978), later reinforced by what Williamson1 3 (1990)
has called the “Washington Consensus”, “...which described the shared ideas of
the US Treasury and the Washington-based, Bretton Woods institutions of the IMF
and World Bank on appropriate universal economic policies. Thus free markets,
1 1 Little I.M.D., “An Economic Reconnaissance” in W. Galenson (ed.), Economic Growth and
Structural Change in Taiwan: the Post-War Experience of the Republic of China. Ithaca, Cornell
University Press, 1979. Economic Development: Theory. Policy and International Relations. New
York, Basic Books, 1982.
1 2 Bhagwati Jagdish, Anatomy and Consequence of Exchange Control Regimes. Cambridge, Mass:
Ballinger for the National Bureau of Economic Research, 1978.
1 3 Williamson, J. “What Washington Means by Policy Reform” in J. Williamson (Ed.), Latin
American Adjustments: How much has happened?. Washington DC, Institute for International
Economics.
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free trade, free capital mobility, and limited government represented the virtues
pertinent to both poor and rich nations in delivering economic prosperity.”
(Iyanatul, 2000, p7) The first generation of neoclassical critique of Dirigisme
generally acknowledged that the Hong Kong, Singapore, Korea, and Taiwan had a
brief engagement with ISI, and then switched to export-oriented industrialization
(EOI) through policy reforms, regarding this change as triumph of EOI over ISI, as
well as, a triumph of “free trade” over “market protection”.
Examining the case of NICs, the positive developmental consequences of
linkage to foreign capital and technology would seem to support the neoclassical
interpretations; and the growth rates achieved through export expansion were
evidently superior to those achieved though ISI. However the neoclassical
interpretation of East Asia growth also faced some critiques and, some researchers
even argued that the “developmental state” of East Asia was a reinvention of
dirigisme to overcome the burden of dependence on rich nations (Iyanatul1 4 , 2000,
p.2-3). The theories of development economy have come under increasing
challenge recently and the study of political economy of East Asia was at critical
juncture.
One of the best-known studies to question the tenets of dependency theories
was written in Pathways from the Periphery by Stephan Haggard. According to
him, neoclassical criticized the inward-oriented policy of ISI based on three
strands: “the first stressed the benefits of participation in the international division
1 4 Iyanatul Islam and Anis Chowdhury, The political economy of East Asia. Oxford University
Press, 2000.
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of labor, the second the costs and distortions of ISI, and the third the performance
of countries pursuing market-conforming policies”(Haggard, p. 10, 1990). The
new neo-classical political economics have already proved mathematically that
“control of import licensing” and “rationing of foreign exchange” encourage rent-
seeking problem (Bhagwati1 5 , 1978). Heavily protected IS industries were
oligopolistic in nature and caused inefficiency, high mark-up and low-quality
output. On the other hand, trade and openness indeed coped with technological
adoption, learning and entrepreneurial maturation in the East Asian countries.
Being “latercomer” (Amsden, 1989) of industrializing process has the advantage of
adopting available technology without putting resources to develop, as we
described in the dependent development of Taiwan (Ch4, p.17-22), who
successfully increased the “dependency” of transitional corporations as a source for
technological upgrading and sophisticated machinery. Furthermore, many
problems of developing countries may not come from the international systematic
factor or structural rigidities but rather from the misguided government
intervention. What was the role of government autonomy in making good polices
leads to new theoretical territory for hypothesis of “developmental state” in East
Asia.
The states in East Asia are generally recognized as strong states that enjoy
relative autonomy from pressure groups, where no single dominant class is able to
set against other classes. Indeed, most of East Asian countries enjoy high
1 5 Bhagwati Jagdish, Anatomy and Consequence of Exchange Control Regimes. Cambridge, Mass:
Ballinger for the National Bureau of Economic Research, 1978.
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economic growth rates are authoritarian regimes; they let the authoritarian rulings
continued as long as the regime maintain economic liberalism from which, if not
equally, at least, all the social classes are most likely to benefit from the economic
gain. In the neo-classical orthodoxy, the governmental intervention in the economy
is seen as being inevitably inefficient and distorting; in the Dependency theory, the
states of peripheral country are subject to the power of international coalition
dominated by core countries and simply cannot be an agent of development for
their own countries. The new attention devoted to the role of state as an engine of
growth in developing countries challenged both perspectives of neo-classical
orthodoxy and Dependency theory, which led to the new theoretical work of
developmental state model to explain economic growth in East Asia, associated
with pervasive government intervention.
In 1982, Chalmers Johnson1 6 was the first one to advocate the extensive
state intervention in economic growth and explained why it worked effectively. He
observed that the Ministry of International Trade and Industry (MITI) served as the
modal economic planning bureaucracy in Japan, ’’ which constructed a Weberian
ideal type of an interventionists state that was neither socialist (described as a
“irrational” state in which both ownership and management remained in the hands
of the state, such as in the former USSR nor free-market (no plan and where private
control coincided with private ownership), but something different: the plan-
rational capitalist developmental state, conjoining private ownership with state
1 6 Charmers Johnson, MITI and the Japanese Miracle: the growth of Industrial Policy. 1925-1975.
Stanford: Stanford University Press, 1982.
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guidance.” (Woo-Cumings1 7 , 1999, p.2-3) Johnson focused on documenting the
“Nationalism1 8 ” bom of wartime period in Japan, Taiwan and South Korea for
understanding the rise of the developmental state in East Asia. In the eyes of
Johnson, Japan economic nationalism was trying to correct status inconsistency
with US or European countries; and South Korea and Taiwan was trying to get
even with their respective communist enemies.
In the 1990s, it was no longer possible to ignore the relationship between
economic growth and state interventions; Amsden (1989), Wade (1988) and
Haggard (1988, 1990) all exam the developmental state hypothesis by looking at
actual economic development in East Asia. Amsden1 9 (1989, 1991) illustrated
South Korea’s model of “late industrialization”, where policy-makers were able to
manipulate the structure of relative prices through the allocation of subsidized
credit to targeted firms and industries. Haggard2 0 (1988) used South Korea and
Taiwan as examples, and argued that the state-guided developmental policies could
be used to promote economic growth consistent with international comparative
advantage, on the condition that the strong states needed to be able to control and
suppress interest groups from both dominant and subordinant classes. Similar to
1 7 Woo-Cumings, The Developmental state. Ithaca and London, Cornell University Press, 1999.
1 8 Charmers Johnson, Peasant Nationalism and Communist Power. Stanford: Stanford University
Press, 1962. Revolution and the Social System. Stanford: Stanford University Press, 1964. Japan,
Who Governs? The Rise of the Developmental State. New York: W. W. Norton, 1995.
19
Alice Amsden. Asia’s nest giant: South Korean and late industrialization. New York, Oxford
University Press, 1989. “Diffusion of Development: the late industrializing model and greater
Asia”, American Economic Review. Papers and Proceedings, 81(2): 282-6, 1991.
20
Haggard Steven, “The Politics of Industrialization in the Republic of Korea and Taiwan”, in H.
Hughes (ed.), Achieving Industrialization in East Asia. Cambridge, Cambridge University Press,
1988.
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Haggard, Wade2 1 (1988) argued why the task of “governing the market” was
successful because of institutional prerequisites embedded in the East Asian state.
Those theoretical demonstrations focused on the institutional features of political
authoritarianism, bureaucratic competence, and insulation from fractious social
groups.
Other scholars explained the success of state-led development by looking at
the relationship between government, business or the key component of policy
effectiveness. Weiss (1996) captured the existence of “policy networks” linking
government and industry to formulate effective strategy. Rodrik2 2 (1996) believes
land reform in Taiwan and Korea has created an “initial equity” which allowed
both governments to emphasize growth more than equity. Fei2 3 argued the
dominant Confucian culture has its special values to society in which affect
regime’s ability of stimulating economic growth. Some economists tried to
incorporate the economic concept to explain the growth model of developmental
East Asian states. Applying the concept of “transaction costs”, Lee and
Naya2 4(1988) viewed the state as an “efficient quasi-intemal organization”, which
represents analogy to the M-form in the Modern Corporation (full definition of M-
form will be given in chapter 5). State acts as transaction-costs-minimizer and
2 1 Wade R, “the Role of Government in Overcoming Market Failure: Taiwan, Republic o f Korea
and Japan”, in H. Hughes (ed.), Achieving Industrialization in East Asia. Cambridge, Cambridge
University Press, 1988.
2 2 Rodrik Dani, “Understanding the Economics of Policy Reform”, Journal of Economic Literature.
34 (march): 1-41, 1996.
2 3 Fei John, “Economic development and Traditional Chinese Cultural Values”, Journal o f Chinese
Studies. 3:1, 1986.
2 4 Lee and Naya, “Trade in East Asian development with comparative reference to southeast Asian
experience”, Economic Development and Cultural Change. 38 (3): 123-52.
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monitors the performance of multi-division of business groups through the internal
capital market in the sense that funds are allocated to competing divisions on the
basis of high yield use. Mancur Olson uses the theory of collective action to
analyze how different social groups may benefit from cooperative sacrifice. If a
lower chance for organizing social groups to influence policy, (which is the case in
East Asian authoritarian regime), a lower chance for distributional coalitions will
result, meaning, it represents a higher chance for state to execute its ability.
However, the financial crisis in East Asia in 1997 has shaken the very
foundation of developmental state hypothesis; scholars now face new intellectual
challenge to develop a paradigm that allows us to understand the crisis and its
ramifications for the future of the region. Even before the financial crisis, a well-
known economist Krugman (1994) used conventional neo-classical growth theory
and selective evidence to argue that the growth of East Asian was primarily input-
driven rather than productivity-driven; due to the diminishing return to investment,
the growth of East Asia won’t sustain as the ratio of capital to labor rises, and the
catch-up of rapid growth will only exist for a period of time. How relevant is the
institutional framework derived form the East Asian countries to explain the
economic growth? All the developmental state theories indicate that internal
organizational characteristics of the state would influence policy choice and the
effectiveness of implementation. This research believes that the role of growth-
promoting institutional factors do not exist on only within the internal
2 5 Mancur Olson. The Rise and decline of Nations. New Haven: Yale University Press, 1982.
2 6 Krugman Paul, “The Myth of Asia’s Miracle”, Foreign Affairs, vol.73 (6), p.62-78, 1994.
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organizational characteristics of the state, but also coexist within the internal
organizational characteristics of the corporations. Nowadays, the economic growth
of nations should be channeled through the growth of corporations, especially in
the form of Modem Corporations, such as Korean Chaebol and Japanese K, in
order to compete effectively in the world economy. The national political economy
set up the country’s initial economic stmcture, and the corporations have their own
will to react and purist the growth out of its initial economic conditions. So far, we
have discussed the growth and economic development on national level, and in the
following sections, I will go into the details in the evolution, development and
growth of corporations, on the microeconomic level and will run empirical testing
on its corporate behaviors related to ownership and financial structures on this
country-specific case in order to explore the internal organizational characteristics
of the corporations.
Review on Evolution of Corporations
When the modem corporation just appeared, some corporation beaters saw
the corporation as the new leviathan, showing no regard for anything and only
greedy for money and power. On the other side of debate, corporation devotees
viewed this profit-oriented organization as the most creative power ever imagined
for the coordination of human economic activity. Nowadays, we realized the
corporation has become an established part of our daily life even in the most
maximal socialist state. Perhaps the best way to understand the development of
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the modern Business Corporation is by placing it in a broader intellectual and
historical context of economic thought. I intend to explore the evolving corporation
by examining theories of the corporation in Classical Economics and Institutional
thought.
Corporations in Classical Economics. Smith, looking at the economic
organization of industry in his day, observed that specialization and division of
labor increases the productivity of labor. Even though Smith saw the extended
development and efficiency of these new economic institutional arrangements to
exploit fully the economies of scale; his sympathy went wholly to the laborer who
“clothe everybody and himself goes in rags.” Once Smith believed that
managerially controlled business corporations would “ very seldom succeed
without an exclusive privilege.” He was not so incisive for the long-run
performance of corporations as they thrive in today. Adam Smith contributed
several important concepts and gave a brilliant overview of the functions of
corporations. First, he recognized the existence of corporations or stock Joint
Corporation as they were commonly called at the 18th century. Second, Adam
Smith clearly separated the functions of capitalists from those of the managers.
The capitalists were entitled to make “profits”, while directors or managers were
compensated by the “wages” of management as payment for “the labor of
inspection and direction”. Third, Smith did surprisingly notice conflicts between
the owner of corporation and those salaried managers; these are what we call the
principal-agent problem today.
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John Stuart Mill was one of the pioneer proponents to advocate the limited
liability of Corporations. According to him, “ Production on a large scale is
greatly promoted by the practice of forming a large capital by the combination of
many small contributions; or, in other words, by the formation of joint stock
companies. The advantages of the joint stock principles are numerous and
97
important.” (Principles , p. 137) First, Mill thought that limited liability would
encourage the investments of savings by the middle and working classes, because
“many undertakings require an amount of capital beyond the means of the richest
individual or private partnership... by the exigencies of a society in an advancing
state.” (Principles, p. 137) In advancing state, total productivity depends on capital
formation to buy more expensive machinery to increase goods for consumption; it
was necessary to raise capital through the small contributions of many investors.
Second, by foaming joint-stock companies, one of consequences was to avoid the
possible large variance of investment outcomes under an unlimited liability regime.
Third, in terms of risk bearing, Mill argued the rich would be more likely to invest
money in business venture involving the middle and working classes as if it would
reduce the risk of being the chief targets of creditor’s attention in the event of a
business failure compared to the sole ownership in business failure foreclosed by
limited liability. Both rich and middle classes would like to invest and this would
lead to a net increase in the aggregate level of economic activity.
2 7 Principles o f Political Economy. John Stuart Mill,
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Although, we noticed Mill had some doubts about the efficiency of the joint
stock Corporation - if the hired servants would operate the corporation to
maximize profits. Despite the observation of the principal-agent problem, Mill was
not as pessimistic as Smith about the success of corporation. On the contrary,
turning to Karl Marx, he conceived the most negative dislike for the private
property and predicted the ultimate destruction of capitalism due to its inherent
contradictions in the system; clearly, he held an answer “no” to the corporate form
of economy. Nowadays, even in the most maximal socialist state, the corporate
economy has become an important economic activity pursing the national
economic growth.
Corporations in Institutionalism. The development of the modern
corporation is seen as evidence of power in the economic system but
institutionalists, unlike Marxists, do not reject the capitalist system because of power
asymmetries between capital and labor. Instead, they see power as part of an
evolutionary process by which capitalism has changed from the individual
proprietorship system used in classical economics to one in which power is wielded
by corporations and individual workers come together to form a "countervailing
power" within unions.
Thorstein Veblen, the founder of institutional economics was the first
economic theorist to take seriously the difference in capitalist enterprises structures in
the modem economy. As Veblen correctly pointed out, modem corporations differ
significantly from the idealized firm in economics. Management does not own the
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firms and their interests may differ from those of the owner-shareholders. The
individuals controlling the manufacturing (the “engineers”) may not have the same
interests as those of the management. The difference of interests means that the
corporation acts differently than if a single individual ran the firm. The result is a
"war" within various corporations in which management and engineers battle it out.
The actual owners of the firm are increasingly isolated as the battle shifts between
engineers desiring to “maximize production” and management using the political
system to “support their growing imperialist adventures emanating from the
worldwide quest for markets and profits.” (Elliott28 , p.94,1978)
Veblen also pointed out consumption was not characterized by individual self-
interest; instead it was a combination of habit, custom, and fad. He called the excesses
of the rich “conspicuous consumption” because such purchases often were valued
because they had a high price tag and not because of any intrinsic value. Thus
individual preferences are modified but culture and corporate preferences are
modified by the nature of the interactions between members within the firm. Those
individuals or businesses who could change the culture or could affect the interactions
within a firm hold "power" for Veblen. Corporations, to Veblen, were not interested
in competition but the stifling of it. They wanted a monopoly and would do anything
to achieve it.
28
Elliott, John E. (1978). "Institutionalism as an Approach to Political Economy", Journal of
Economic Issues. XII (March): p.91-113.
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Commons saw economic power as a threat to society and believed that
government could tame it. (Klein2 9, 1987, p. 1359) He also saw the legal system as
the force that channeled the "process, of repetitive conflict and conflict resolution,
0
[that is] the driving force of social evolution." (Mayhew , p. 979, 1987) The legal
system shapes the "working rules" of the society and they govern all of the three basic
types of transactions in a society: bargaining transactions (involving voluntary
transfers between legal equals), managerial transactions (involving commands given
by superior to legal inferiors), and rationing transactions (involving the distribution of
resources by an authority). These transactions, along with the working rules which
govern them, form the definition of an "institution" for Commons. (Colander3 1 , p.
398,1989)
Commons identified power as emanating within the institution, which he
called “Collective Action in Control of Individual Action," (Commons quoted in
Mirowski3 2 , 1987, p. 1026). As such he saw two basic institutions vying for power in
the system: political and economic. The political side "what he called emerging
'reasonable capitalism' or 'collective democracy,' characterized by an 'equilibrium of
2 9 Klein, Philip A., "Power and Economic Performance: The Institutionalist View", Journal of
Economic Issues. XXI September, p.1341-1373, 1987.
3 0 Mayhew, Anne, "The Beginnings of Institutionalism". Journal of Economic Issues, vol. XXI
September, p.971-993, 1987.
3 1 Colander, Landreth, History of Economic Theory. Second Edition. Boston: Houghton Mifflin
Company, p.392-404,1989.
3 2 Mirowski, Philip, "The Philosophical Bases of Institutionalist Economics", Journal of Economic
Issues. September, p.1001-1038, 1987.
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economic power' among conflicting interests and classes" versus the economic
"banker capitalism." (Elliott3 3 , p. 105, 1978)
Commons saw corporations as controlling both the economic and political
systems and exerting an increasing influence on the American way of life, at least
until the Great Depression. Only with the New Deal was the balance of power
changed. He also noted there were differences between capitalism in America and
Europe in the areas of stock ownership, corporate culture, and available resources.
These differences pointed to different outcomes for each in the battle between labor
and capital in both political and economic domains. (Elliott, p. 106,1978)
One of Means's most important works was Berle and Means's The Modem
Corporation and Private Property. He argued that orthodox economics failed to
recognize there had been two major institutional changes since the time of the
classical economists. Corporations were now the major force, replacing the small
individual proprietorship, while "flexible market prices" which adjusted under a
competitive market mechanism had been displaced by "administrated pricing"
according to the bargaining power and the size of the large-scale corporation. He saw
the corporation as one instrument in a new form of capitalism, namely "collective
capitalism". (Tool and Samuels3 4 , p.147, 1989). The corporation provided the owner
33
Elliott, John E. (1978). "Institutionalism as an Approach to Political Economy", Journal of
Economic Issues. XII (March): p.91-113.
34
Tool, Marc R. and Warren J. Samuels, The Economy as a System of Power, second edition. New
Brunswick, New Jersey, 1989.
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with a managerial structure enabling him to supervise the workers and production
process in order to reduce transaction costs.
Means distinguished between management, ownership and control.
Ownership is defined as those "owning the shares of the corporation" (stockholders)
while "management of the corporation consisted primarily of the senior and junior
officers and the board of directors" and control was the "power to direct the
corporation's activities and determine the distribution of corporate profits." (Lee,
1990, p. 680) It is management which exercises control, according to Means, not the
owners. As control and ownership are divided, there can be differences in the
incentives for managers and those of shareholders. Managers are interested in
building up a vast corporate empire while shareholders are interested in profits. This
can lead to a clash between these two desires and an imbalance between savings (the
purchase of securities by shareholders) and investment (the purchase of capital goods
by companies). (Lee3 5, 1990, p. 682)
Starting with Berle and Means’ The Modern Corporation and Private
Property (1932), there are many publications discussing the emergence,
development, and role of the modern business enterprise. The power of large
corporations and the emergence of the professional manager contribute to the
advantages of internalizing contractual transactions and the effects on economic
growth. However, problems introduced by the rise of the managerial corporations
35
Lee, Frederic S. (1990). "The Modem Corporation and Gardiner Means's Critique of Neoclassical
Economics", Journal of Economic Issues, XXIV (September): 673-691.
31
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are also recognized within the principal-agent constraint for its monitoring and
shrinking. In these new enterprises, a managerial hierarchy was created to
supervise the production process in order to integrate mass production with mass
distribution.
The Berle and Means observation has since been widely interpreted as
principal-agent problem; and this assertion of “separation of ownership” was
generally thought to imply the control type hypothesis that the management-
controlled corporations perform differently from the owner-controlled
corporations. One major contribution of this research (see chapter 6) is that this
paper criticized the testability of the control type hypothesis and intended to
examine the empirical validity of the growth hypothesis. By taking account into
the external constrains for companies to grow in Taiwan, the control hypothesis can
j / r
be narrowed into what we call the growth hypothesis s if that a management-
controlled corporations actually grows faster than an owned-controlled
corporations. The growth hypothesis is a proposition that is related to the incentive
of managements and could be tested via the use of statistical technique of
discriminant analysis.
3 6 The specific literature reviews referred to each hypothesis-testing will be contained in each
chapter.
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Review on the Firm’s3 7 Growth Theories
The central theories of economics remain the neoclassical theory; but the
firms are usually viewed as the “black box” in the neoclassical economics and
treated simply as production functions. It was until the evolution of Modem
Corporations was noticed by many others non-mainstream economists , economic
•3Q
historians and other social scientists that the newly emerging theories of the firm
started looking at “why there is a firm in the theory of price and what defines the
firm in the theory”. The basic actors in this research are the firms. But what factors
cause the different growth rates of firms? There appears to be no general
agreement on firm growth theory; therefore, it may be useful to review what theory
does exist on firm growth in order to guide the analysis which follows and to point
the way to a more complete and appropriate theory. The review is organized as
follows by looking at firm in three different perspectives: the neoclassical view, the
stochastic model of firm growth, and the new institutional economics view.
Traditional neoclassical economics says that workers are added until the
value of the marginal product of the last worker is equal to the wage paid to that
worker. The “firm “ is effectively defined as a cost curve and a demand curve; the
“equilibrium of the firm” is the “equilibrium output” governed by rules of prices
371 use the term of “firms”, instead o f corporation, because the New Institutional Economics prefer
using this term. Throughout this paper, I might explain different ways of looking at firms or
corporations; however I did not intend to make strict distinguish between “firm” and “corporation”.
3 8 The Institutionalist School described in section 3.2 was generally regarded as as important
forerunner to New Institutional Economics.
3 9 For example, North Douglass, Structure and Change in Economic History. New York: W.W.
Norton, 1983.
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determination and resources allocation. The question what limits the growth of a
firm is the same question what limits the increase of output produced by the firm
with respect to the cost and revenue amount of it will produce with respect to the
cost and revenue curves that are used to represent the firm. This implies that firm
growth will occur as a reaction to changes in the wage rate, the price of the product
or the innovative technology; the optimum size of the firm is the lowest point on
the average cost curve for its given product. If we ask why firms grow in
developing countries, this theory suggests that one’s attention must focus on the
factors that have an impact on supply and demand for the products produced by the
firms.
The stochastic models extended this static model by making it more
dynamic to consider the evolution of firm growth over time and also introduced
firm-specific costs into the models. These models are based on “Gibraf s Law”4 0,
which is a postulate that the firm’s growth rate is a random growth process.
“Gibraf s law of proportionate effect4 1 ” states that the probability of a given
proportionate change in size during a specified period is the same for all firms in a
given industry; the smallest firms has the same change of growing or shrinking as
4 0 Gibrat R., Les ineealites economiques. Librairie du Recueil Sirey, Paris, 1932. J. Steindl,
Random processes and the growth of firms: a study of the Pareto law. Griffin, London, 1965.
4 1 Gibrat formulated the law of proportionate effect for growth rate to explain the empirically
observed distribution of firms. That law of proportionate effect states that the expected increment of
a firm’s size in each period is proportional to the current size o f the firm. ( Yoshi Fujiwara, Corrado
Di Guilmi, 2003, p.3, submitted, http://arxiv.org/abs/ cond-mat/03100611.
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the industry’s largest firms. Following this framework, Simon and Bonini4 2 (1958)
assume that Gibraf s law holds for firms above the minimum efficient size level;
Lucas4 3 (1967), in his model of capital adjustment, claims that the time series for
firm’s employment, capital, and output obey Gibrat’s Law. While many studies do
find that Gibraf s law holds, most of these studies are based on samples of the
largest firms in the economy; some other empirical studies do also find a negative
relation between firm growth and firm size. Recent studies are trying to provide a
theoretical explanation for this negative relation in the stochastic model of firm
growth.
The stochastic model was superseded in the theoretical literature of
emphasizing the “learning” ability on firm growth and changes in market structure.
Jovanovic’s (1982) “learning model” claimed that efficient firms (that is, firms
with able managers) grow over time. Jovanovic’s4 4 model predicts that the annual
growth rate of a firm will depend on the accuracy of the manager’s predictions
regarding his ability, as well as the price of the product. As a successful firm
matures, its manager’s estimate becomes increasingly accurate; this reduces the
probability that next period’s output will be widely different from this year’s.
Therefore, firm growth decreases with firm age when firm size is held constant.
Bigger firms are more efficient and have less room for further increases; firm
4 2 Simon and Bonini, “The size distribution of business firms,” American Economic Review, vol.48,
p607-601, 1958.
4 3 Lucas Robert, “Adjustment costs and the theory of supply”, Journal of Political Economy. 1967.
Lucas Robert, “On the size distribution of business firms”, Bell Journal of Economics, vol.9, p.508-
523.
4 4 Jovanovic, “Selection and evolution of Industry”, Econometrica. vol.50, p649-70, 1982.
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growth decreases with firm size. In another words, the Gibrat’s law may not hold,
recent evidences4 5 showed that smaller firms grow more than proportionally with
respect to large one. Many studies test firm-level data of developed countries, yet
not too much attention has been attracted to a developing-country environment
where the medium-small scale enterprises grow and change over time becomes
glaring.
Another strand of the literature to look at “firms” is in the analysis of “New
Institutional Economics” (NIE). “Transaction costs”, “property rights” and
“contractual relations” are three basic elements in the literature of the New
Institutional Economics. In 1937 Coase4 6 argued in his classic paper entitled “The
Nature of the Firm” that firms emerge and exist as a least-cost means of economic
coordination. Why would a worker voluntarily submit to direction by an
entrepreneur or an agent instead of selling his own output directly to the market?
In order to discover an answer, Coase looked at the costs of operating the market,
notably the costs of discovering prices. A central agent, which employs and directs
worker activity, avoids the costs of the numerous negotiations and measurements
which would otherwise be required in determining prices fro multiple transactions.
Entrepreneurs begin to use firm coordination when a comparison of the costs and
benefits between alternative forms of coordination (market or firm) indicates
positive benefits to coordination within rather than without. When do firms stop
4 5 For a survey, Geroski P. “what do we know about entry?” International Journal of Industrial
Organization. 13(4), p421-440, 1995.
4 6 Coase Ronald, “the nature of the firm’, Economica. vol4, p.386-405, 1937.
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growing in size? Because there are increasing costs of organization, firms face a
limit to growth when, at the margin, the net saving derived from internal
organization falls below the net benefits of organizing tasks through the free
market.
This general approach of “transaction and information cost economics” has
been stimulated by the influential work of Oliver Williamson4 7 (1975, 1985). As
Oliver Williamson argued that market failure is common due to the pervasive
presence of transaction cost; the institutions emerges a means of transaction cost-
minimizing arrangements which may evolve with change in the nature and sources
of transaction costs and the means for minimizing them. Oliver Williamson has
identified three different forms of economic organization: market, hybrid, and
hierarchy4 8 49; each of these uses different coordination and control mechanisms
and, accordingly, has different abilities to adapt to disturbances. Due to the
bounded rationality and opportunistic behavior, Williamson uses this insight go
show how the design of corporate governance could mitigate both market failure
and organization failure, which leads to the theory of the multidivisional (M-form)
firm. Applying this general approach, the research will exam in details (see
Chapter 5) the nature of Modern Corporations in terms of its legal identity, M-
form, corporate governance and control dilemma.
4 7 Williamson Oliver, Markets and Hierarchies: Analysis and Antitrust Implications. New York:
Free Press, 1975. The Economics Institutions of Capitalism. New York: Free Press, 1985.
4 8 Williamson Oliver, The Economic Institutions of Capitalism. New York, Macmillan, 1987.
4 9 Coase Ronald, “the Problem of Social Cost”, Journal of Law and Economics, vol.3, p.l-p.44,
1961.
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The “property rights” approach is anther theme in the NIE, which are based
on the pioneering work of Alchian (19615 0 ), Coase (19615 1 ) and Demsetz (19675 2 ).
This approach argued that the existence of property rights help reduce conflicts and
facilitate cooperation, which would lead to reducing transaction costs and more
efficient economic outcome. However, as argued by Farrell (19875 3 ), this
proposition is valid only when all the relevant information is public knowledge. If
the asymmetries of information are present between the parties to a contract, then
the efficient outcomes are no longer guaranteed. In examining the case of
developing countries, why some developmental states are more successful in
implementing the economic policy and having more efficient outcomes than
others? As this research argued that no matter under what kind of institutional
arrangements, the rules for residual claimant and default responsibility should be
clearly defined and enforced to have a more efficient economic outcome, which is
showed in the case of Taiwan development state that seems relatively immune from
the Financial Crisis in 1997 by taking low-risk in corproate’s behavior. (See
Chapter 4)
From other perspective, the firm is defined as a “ nexus of contracts,” first
used by Jensen and Meckling (1976). The choice of organizational arrangements is
actually the choice of contractual organizational arrangements. Economic agents
5 0 Alchian, Some Economics of Property. Santa Monica: Rand Corporation, 1961.
5 1 Coase Ronald, “the problem of social cost”, Journal of Law and Economics, vol.3, p.l-p.44, 1961.
5 2 Demsetz H, “Towards a Theory of Property Rights”, American Economics Review, vol.57 No2,
p.347-359, 1967.
3 Farrell Joseph, “Information and the Coase Theorem”, Economics Working Papers 8747,
University of California at Berkeley.
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seek new contractual forms to lower the cost of exchange; the competition among
contractual arrangements leads to the equilibrium outcome of contracts.
Transactions are governed by contract so if the contractual basis changes, the
nature and costs of the transactions will change as well. How to transfer property
rights defined in the contract depends on the legal system defined by the state. This
approach has been extended to the analysis on the role of state by redefining the
legal system to influence the resource allocation and economic growth. A general
“agency problem” in contractual arrangement is generally recognized; Jensen and
Meckling (1976) and Williamson (1975, 1985) have applied the agency concept to
managerial behavior and the ownership structure of firm. The concepts of NIE are
extended in the following chapters and this research is used to empirically test the
corporate control dilemma due to the principal-agent problem.
Stiglitz5 4 (1974), as well as Jensen and Meckling (19765 5 ), stated changes
in financial structures affect the performance of a firm; this contrasts sharply with
the Modigliani-Miller theorem on the irrelevance of corporate financial structure
for total value of the firm. Modigliani-Miller5 6 (1963) argued under certain
assumptions, the “firm’s ratio of debt to equity” (leverage level) is irrelevant and
that performance of companies remains unaffected by financial restructuring. In a
world of perfect markets and without taxes and transaction costs, Modigliani and
5 4 Stiglitz Joseph, On the irrelevance of corporate financial Policy”, American Economic Review.
vol.64, p.851-66, 1974.
5 5 Jensen and Meckling, “theory of the firm: managerial behavior, agency cost, and ownership
structure”. Journal of Financial Economics. vol3. p.305-60, 1976.
5 6 Miller and Modigliani, “Corporate income taxes and the cost of Capital”, American Economic
Review, vol.53, June 1963, p.433-43; “The cost of capital, Corporation Finance and the theory of
investment”, American Economic Review, vol.48, June 1958, P.261-97.
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Miller showed in MM1 theory that the value of a firm is independent of its debt-
equity mix; in other words, the capital structure is irrelevant. But, if corporate
income is taxed and interest payments are tax deductible, then, leverage has a tax
advantage and companies would tend to go for debt financing. In reality, variation
in the debt-equity mix depends upon the macroeconomics environment as well as
government controls and intervention in the domestic capital structure.
Institutional arrangements of capital structure will influence the determinants of
financing cost and the “capital structure puzzle” is even more complicated in
developing countries, where markets do not always work efficiently and firms may
not be able to get excess to financial resources as needed. One contribution of this
research is that, searching for the determinations of firm’s corproate’s growth rate,
this research did not assume a priori model, instead, the statistical technique of
principal component analysis is used to detect which common financial factors are
informative for differentiating company’s performance. (See chapter 7)
New Institutional Economics is still at an exploratory stage and there are no
clear-cut definitions and terminology. The mathematical models are not as well
developed as in microeconomic theory, however there is a stronger emphasis on
empirical testing. Here we do not attempt to synthesize the theory as a whole, but
give a short overview of different ways to look at “firms” and attempt to apply it
with the help of statistical techniques to analyzing the determinants of firm growth.
This is a country-specific study, applying theses theories and statistical techniques
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to analyze the actual development of the national corporate economy and corporate
behavior in terms of ownership structure and financial patterns in pursing growth.
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Ch3. The Dependent Development of Taiwan
When government tries to promote national economic development, the
engine of growth needs to be channeled through the growth and development of the
corporate economy. The relevance of political economy for understanding the form
and development of corporations is essential, especially in the context of the
developmental state searching for the engine of growth. The parallel existence and
mutual interaction of state and market are the nature of political economy: The
modern corporation is different in its relation to the state in the western society
from the context of the Asian Economy, so studying the role of the corporate
economy and its relative importance to the political economic development in
Taiwan provides unique social experiments and gives valuable lessons for the
developmental experience. World War II and its political aftermath provided many
shocks and influences to the Chinese political economy; this analysis begins with
the initial conditions of the post-war era.
Not only did World War II in the Pacific Theatre end with Japan’s surrender
in 1945 but also the eight-year long Sino-Japanese war finished. The victory in
1945 terminated ultimately Japanese ambition to conquer China and Southeast
Asia, however the political conflicts between nationalists and communists lead to
an unfinished civil war and China became a divided country. In 1949, the Chinese
Communist Party grabbed power in China and the People’s Republic of China
(PRC) was founded; the KMT was defeated and fled to Taiwan where the Chinese
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proto-capitalist state of the Republic of China (ROC) was continued. The
competition between the “developmental socialist state” of PRC and
“developmental capitalist state” of ROC has been continuously going on and both
sides have claimed superiority and sovereignty over the other side for most of the
postwar period.
The ROC on Taiwan fought a losing battle against the PRC to retain its seat
in the United Nations. Since U.S. de-recognition of Taiwan in 1975, Taiwan’s
diplomatic relations have been isolated from the international stage; under the
pressure of the Beijing government, Taiwan has been excluded from most
international organization including the United Nations, IMF, and the World Bank
and has only been allowed to join the WTO as “Chinese Taipei.” But,
economically, Taiwan has ranked among the top 20 trading countries in the world
for the past two decades. For example, in 1995, its exports and imports amounted
to 117.billion US dollars and 103.6 US billion dollars, the country’s foreign
exchange amounted to 84.8 billion US dollars, the second highest in the world
when measured in per capita terms. In 2001, its exports and imports amounted to
122.9 billion US dollars and 107.3 US billion dollars; the country’s foreign
exchange amounted to 106.71 billion US dollars, the world’s fourth largest, next to
Japan, China and Hong Kong.5 7 If dependency theorists regarded Latin American
as countries of the periphery and claimed impossibility of “development of
underdevelopment”; Taiwan is no doubt a country growing out of periphery and
5 7 Sources: Monthly Bulletin of statistics of the Republic of China published by the Directorate-
General of Budget, Accounting and Statistics, Executive Yuan, the Republic of China.
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highly dependent on their foreign economic relations with center countries
throughout the nation’s developing stages. Without international diplomatic
recognition, this developmental state can survive and achieve economic
development in this particular international context “without” or “try to minimize”
the cost of having the powerful developed nations expropriate its surplus. Taiwan
successfully challenges tow hypothesis of dependency theory: foreign economic
penetration leads to slow economic growth and tends to lead to a high inequality of
income distribution.
Two main questions are addressed in the following two chapters: first, how
does Taiwan achieve its economic development, in going from underdeveloped to
developing status under its special political economic environment? Second, how
does the economic growth in Taiwan is channeled through the development of its
corporate economy? We start with the first question by taking into account the
time factor, the analysis is organized in the followings: 1) The initial condition after
1949 in Taiwan, 2) the outward economic development of Taiwan was rooted
under colonialism 3) the changing economic policy from import substitution in
1950s to export orientation since 1960s under KMT, 4) examining the evidence on
trade balance and industrial production, and 5) concluding the positive
developmental linkage between outward economic and dependent development.
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The initial condition after 1949 in Taiwan
Taiwan did not fulfill the conditions for catching up to the Western
modernization happening in the 19th century. In the book of Economic
Development of Taiwan. 1860-1970. Ho (1978) described Taiwan as a
sophisticated but inert and traditional agricultural society before it was handed over
to the Japanese in 1894 due to the defeat of Imperial China. However, the social
and economic infrastructure began to change under Japanese rule prior to the
regaining of Chinese control by the KMT in the 1940s. What was the initial
economic condition of Taiwan after the post-war era? During the KMT’s last years
on the mainland, the military and the budget for the government and bureaucratic
expenses were financed by the printing of money; national finances fell into
disaster and prices reached the level of being hyperinflationary. In the period of
1946-1949, the Taiwanese people faced difficult transitional political and economic
changes and had difficulty to reestablish properly functioning markets. First, the
withdrawal of Japanese technicians, administrators, and professionals caused the
loss of the bulk of human capital resources in the industrial and public sectors.
Second, after 1945, the mainland authorities operated Taiwan through a military
governor; at that time China was afflicted by the disorganization produced by the
civil war; it is no doubt that during the 1946-49, Taiwan was mismanaged by the
central Chinese government. Third, the economy of Taiwan was also influenced in
a negative way through the increasing interaction with Mainland China, combined
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with the severe inflationary fiscal and monetary crisis on the mainland, and faced
severe problems of war reconstruction, the squelching of productive economic
activity, a severing of traditional market ties and difficulty in reestablishing
properly the functioning market. (Haggard 1990, p.85-86)
In 1950 GDP per capita in Taiwan stood only at the level of 10 %5 8 of the
GDP per capita in the USA and had to support a suddenly increasing population,
military force and bureaucrats who retreated from the mainland with the KMT.
After currency reform in June of 1949, when the new Taiwan dollar was introduced
and to exchange the old Taiwan dollar at rate of 1: 40,000 to cut the inflationary
expansion, the wholesale price index of Taiwan still increased at the level of 170%,
66%, and 23%, separately in 1950,1951 and 19525 9 . It was not until the outbreak
of the Korean War in June 1950 that U.S. Aid was resumed6 0, which financed about
38.3% percent of Taiwan’s imports of goods and services, or about 10% of GNP in
19506 1 and helped Taiwan to cut its inflation rate. From 1953 to 1960, the average
inflation rate was able to remain at a more moderate level of 8.8 percent.6 2 In his
A ?
book “Economic Development o f Taiwan, 1860-1970 Samuel Ho concluded that
Taiwan did not stand a chance to survive the transitional period in the 1950s
5 8 Marcel Timmer, “Catch up patterns in Newly Industrializing Countries, an International
Comparison of Manufacturing Productivity in Taiwan 1961-1993”, Research Memorandum GD-40,
1998, p.l.
5 9 Council for U.S. Aid, Taiwan Statistical Data Book. (Taipei, 1961) Table, 10-1.
6 0 With the ending of the civil war on the mainland, the nationalist government was no longer
receiving the foreign aid from US. It was resumed after the outbreak of Korean War.
6 1 The hundred years of Taiwan’s experience. Li Chung-Shen 1998, p.91 and p.l 19.
6 2 The hundred years of Taiwan’s experience. Li Chung-Shen, 1998, pl4.
6 3 Samuel Ho, Economic Development of Taiwan. 1860-1970. (New Haven: Yale University Press,
1978)
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without American financial aid, which helps showcase the importance of foreign
aid and foreign investment to capital formation for LDCs such as Taiwan in the
initial developmental stage.
The rate of growth in the 1940s was almost zero, and the rate of growth in
the 1950s pushed by the export expansion was slightly increased to 4.0%6 4 , in
terms of New Taiwan Dollars and adjusted to the inflation rate. However, the
effect of economic growth was offset by the increase in population growth. In
1953, Taiwan had a total population of approximately eight million, and almost 15
percent of them migrants form mainland. Due to 1) the suddenly increasing
population, 2) the devaluation of NT dollar and 3) the balance-of-payments
problem (export-import balance was negative), all caused the slow growth of GDP,
if divided by per capita and converted to in terms of U.S. dollar -a per capita
income of less than 100 dollars. As W.W. Rostow mentioned in his book praising
modernization theory, The stages of economic growth: A Non-Communist
Manifesto, the LDCs were lacking the capital available for domestic investment
and one of the key elements for economic take-off was seeking external capital for
economic growth. The U.S. Aid provided external capital flow for developmental
purposes at the initial stage; and later on in the 1960s, the external capital flow
needed for economic growth was channeled through the investment of
multinational corporations. In brief, the economies of years between 1945-52 were
difficult and progress went slowly in the 1950s in terms of market saturation,
6 4 T.H. Lee, Agriculture & Economic development in Taiwan, v o l.l. (Taichung, 1983) pp.382-3.
Table 6.
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slowed growth and sluggish investment. It wasn’t until the early 1960s that
Taiwan’s economic growth started to take off and the government adopted a series
of intensive “market-friendly” reform policies.
From Table 1, we have a general idea about where the East Asian countries
stood in 1960s compared to other LDCs when their economies were just entering
into the take-off stage and the progress they have made in the world economy by
the end of 1990s.
Table 1: Comparative Growth Experience
Country Per capita GDP,
1960(1985
dollars)
Per capita GDP,
1989(1985
dollars)
Per capita GDP
growth, 1960-89
South Korea 883 6202 6.82
Taiwan 1359 8207 6.17
Ghana 873 815 -0.54
Brazil 1745 4138 3.58
Mexico 2798 5163 2.36
Argentina 3294 3608 0.63
Source: Penn World Tables 5.5
Tables 2 and 3 indicate the relatively ample human resources providing
labor needed in agriculture and the strength of Taiwan’s government to improve the
quality of human resources to compensate for relative scarceness of natural
resource. Adult literacy and school enrollment rates significantly increased from
the 1950s to the 1970s while the growth in agricultural output, shown in Table 4,
increased as a consequence of greater efficiency rather than increased labor inputs.
(Alice Amsden, 1979, p354)
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Table 2: Size and Extent of labor surplus:
initial conditions (approximately 1950)
Size Labor Surplus
Mexico 25,826 1.0
Taiwan 7,981 4.0
Philippines 19,910 2.2
Size: population (in thousands)
Labor surplus: Rural population/arable land ratios (in persons per hectare)
Source: United Nations, Statistical Yearbook: UNESCO, Statistical
Yearbook
Table 3: Comparative Adult literacy rate and School enrollment ratios
Adult literacy rate (%)___________ School enrollment ratios (%)6 5
First and second level
‘50 ‘60 ‘50 ‘60 ‘70
Mexico 56.8 64.5 37 43 53
Taiwan 51.1 73.0 47 57 74
Philippines 60.0 74.9__________________89 70 70
Sources: United Nations, Demographic Yearbook: United Nations,
Statistical Yearbook: UNESCO, Statistical Yearbook
Table 4: Growth in agricultural productivity
Annual growth rate in Agricultural Productivity. 1949-1970s
Increase in Productivity per
Worker Working day Hectare of arable land
1946-51 6.8 3.6 9.2
1951-60 4.4 3.0 4.6
1960-70 3.9____________13____________________ 19
Source: From Table 2, Alice Amsden, 1979
6 5 These are the ratios of total enrollment at the two levels to the estimated population in the age
group corresponding to the actual duration of schooling in each country
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Taiwan’s initial condition in the 1950s fits with dependency theory that
relatively ample supply of labor allowed for low-cost laborers, working in the
primary agricultural sector and producing goods according to the external demand
of core richer countries. Under Japanese rule, Taiwanese had little access to higher
education, “In 1939, while more than 500,000 children attended primary school,
only 4,117 Taiwanese were studying in higher institutions.’’(Clough, 1996) This
inhibited upgrading of labor skills and prohibited free movement of labor between
different societal sectors. An elaborate network of agricultural associations to
facilitate police surveillance and control over the local population governed much
of rural Taiwan. The Japanese government or rich landlord might provide peasants
with education for the cooperative purchase of fertilizers, warehousing, or other
services, but sectoral inequity and societal structures based on landlordism and
imperialism remained intact.
Not until the Nationalists fled to Taiwan in the later period did a sizable
number of Taiwanese people have access to higher education, disrupting traditional
class relations and forming the basis of a new middle class. Education was made
more accessible financially and geographically to all; Table 5 indicated a
significant responding to new educational opportunities; as educational opportunity
is more equal for all, differences in social status and economic power were more
attributed to individual success at fulfilling educational prerequisites for highly
valued jobs. Among the minority of mainlanders fleeting to Taiwan, the proportion
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of educated, skilled, experienced manpower was exceptionally large for a
developing country with a low per capita GNP.
Table 5: Improvement on Taiwanese Education
Schools Students
Primary Education
1952-53 1,251 1,003,304
1993-94 2,501 2,104,713
Secondary Education
1952-53 214 139,388
1993-94 1,102 2,048,707
Higher Education
1952-53 8 10,037
1993-94 125 575,391
Sources: Taiwan Statistical Data Book, 1994.
As the Peasant Revolution has been an important force in undermining the
KMT’s power on Mainland China; the authoritarian government in Taiwan
launched extensive land reforms6 6 of 1949-1953 and the power of rural elites was
broken at an early stage; the KMT was furthermore unconstrained by ties with rural
elites and made smallholder agriculture viable; this “Land to the Tiller program”
was regarded as the most dramatic example of state autonomy. There was no rural
counterweight to the government’s interest in implanting economic policy; land
reform has been considered as one important factor for providing state with ample
autonomy from class interference due to the destruction of the great landlord class
and the absence of a comprador class with strong ties to metropolitan capital. Land
Reform followed by agricultural policy development with increasing educational
6 6 Gates Hill, “Dependency and the Part-Time Proletariat in Taiwan,” Modem China, vol.5, No.3
Symposium on Taiwan: Society and Economy, Jul., 1979, p.381-407.
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opportunity created egalitarian basis for income distribution, emergence of new
middle class and the future booming growth of private sector.
Taiwan is a labor surplus developmental state due to poor natural
resources and rich human resources. The initial conditions Taiwan faced included
difficult transitional political and economic changes from rule by the Japanese to
the Chinese Mainlander, slow GNP growth, an inflationary fiscal and monetary
crisis, weak capital formation and the need to improve human resources. As
dependency theorists claimed, exploitation of labor did happen; Taiwanese workers
worked long hours, did unskilled assembly for low wages at the bottom of the heap
in the world scale, but they worked their way out to be prepare in transition
• • • f \ l • •
between peripheral and semiperipheral status . Without deepening dependency on
world trade, it is questionable if Taiwan could survive in the absence of a sizable
domestic market or simply being stuck with its initial conditions of poor natural
resource, rich human reservoir, and insufficient capital.
Transforming surplus of labor forces into efficient productive manpower
achieved a privileged place in early development strategies for this labor surplus
development state. Social groups involving rural labor and protection-seeking
domestic business traditionally opposed to economic development were overcome
by certain degrees of institutional insulation and the state’s ability to implement
policy.
6 7 Daniel Chirot, Social change in the twentieth century (New York: Harcourt Brace Jovanovich,
1977), p.218-20.
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The root and development of an outward-oriented Economy
1) The outward economic development was rooted in colonialism. It is
generally agreed Taiwan’s economic growth since the 1960s is credited to its
outward economic development; however, export orientation during the colonial
periods is not often emphasized. Taiwan was a colony of Japan for over fifty years
and Japanese imperialism had a great impact on the Taiwanese economic
infrastructure, its export orientation and development of light-industrialization, and
Japan’s economic development strategies have served as models for the Taiwanese
people and the KMT policy makers.
As a colony of Japan, Taiwan became a dependent economy and an
important part of the agricultural sector of the Japanese economy. Taiwan’s
subsistence agriculture was improved to be more productive in order to provide for
the Japanese and export to Japan. Taiwan had only a few traditional agricultural
products such as sugar and rice that could be exported due to limited natural
resources, but its subtropical climate allowed all year-round multi-cropping. The
colonial government extracted agricultural surplus and this outward orientation
helped build the foundation of the Taiwanese rural economy.
For higher production and export of raw materials, as well as for easier
Japanese control, the Japanese built the transportation and communication
infrastructure to permit easy access to Taiwan’s countryside, improving health and
sanitary standards and building an irrigation and drainage system to increase
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productivity. Taiwan improved rural infrastructures, commercialized agricultural
food processing and facilitated the development of light industry. By the end of the
colonial period, a few essential features were present to prepare for the future
potential takeoff. (Ho, 1978; Haggard, 1990)
T.H. Lee6 8 calculated that throughout the colonial period, one-fifth of total
output of agricultural production was transferred out as net capital outflow to the
rest of the economy through mechanisms such as agricultural taxes or individual
savings. A large part of the outflow was exports to Japan, generating a surplus
extracted from the periphery to the core-state.
Being peripherally dependent, Taiwan was an agricultural appendage to the
Japanese economy during the colonial period; the agricultural sector was
modernized and the expanded production in agriculture created the more
modernized social and economic infrastructure, along with new institutions such as
research institutes, a banking system and peasant associations. The literacy rate
improved from 1 % in 1905 to 27 % in 19406 9 under the Japanese who limited
access to higher education. This combination made Taiwan was one of the most
literate populations in the underdeveloped world, but denied it the trained
70
manpower which industrialization required; later on the literacy rate was
improved to 51% in the 1950s, strengthening human capital and labor productivity
6 8 Teng-Hui Lee. Intersectoral Capital Flows in the Economic Development of Taiwan. 1895-1960
(Ithaca: Cornell University Press, 1971)
6 9 Source: Statistics for Higher Education, published by Ministry of Education, Taiwan, Republic of
China.
7 0 Today the literacy rate is 93.00%, http://www.phrasebase.com/countries.
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for further development. Taiwan’s infrastructure was designed to support
agriculture; the industrial transformation of Taiwan did not progress much under
Japanese rule.
A short time before WWII erupted; Japan reshaped its policy, attempting to
transform Taiwan into an industrial adjunct for war preparation in Southwest
Pacific, which demanded a development of military bases located nearby. “The
raw materials were processed in Taiwan, adding to the industrial base; the
beginning of the local manufacture of some goods which had previously been
imported from Japan; the construction of a hydroelectric power installation in 1934
gave rise to the beginnings of metallurgical and chemical sector, both of which rely
heavily on low-cost power.. .While the last -minute efforts to construct transport
and harbor facilities suited to military and industrial needs proved highly beneficial
in postwar year.” (Alice Amsden, 1979, p.347-348) The economic structure
implanted by Japanese included agriculture, industry, and social overhead, such as
law and order.
Taiwan was a Japanese colony and its economy developed to serve
economic and military needs of Japan; the Japanese colonial administration treated
the Taiwanese as second-class citizens and Taiwanese life was strictly regulated.
Being peripherally dependent, many Taiwanese had mixed feelings about the
Japanese administration given the internal contradictions of colonialism. The best
description is by Pen Ming-min (1972, p59-60), a professor of law and a leader in
the Taiwan Independence movement:
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“Under the Japanese, (the Formosans) enjoyed the benefits of a rule of law.
The police were strict, often harsh, and the Japanese colonial administration treated
Formosans as second-class citizens. However, under Japanese reorganization and
direction our island economy had made spectacular gains, and our living standard
rose steadily until among Asian countries. We were second only to Japan in
agricultural and industrial technology, in communication, in public health and in
provisions for the general public welfare... Our grandparents had witnessed this
transformation from a backward, ill-governed, disorganized island nominally
dependent on eh Chinese. They did not like Japanese, but they appreciated the
economic and social benefits for fifty years of peach which they enjoyed while the
Chinese on the Mainland proper endured fifty years of revolution, war-lordism and
civil war.”
When the KMT fled to Taiwan after 1949, the Taiwanese faced a difficult
time in transitional political and economic changes; the infrastructure implanted by
the Japanese facilitated economic development. Economic development of Taiwan
under Japanese rule went as far as it could; indeed, the growth of outward
economic development of Taiwan was rooted in colonialism. Industrialization
might proceed at a slow pace, but Taiwan prepared for future economic catch-up
and industrialization.7 1
2) The economic policy changed from import substitution in the 1950s to an
emphasis on export orientation since the 1960s under Kuomintang (KMT) policy.
The debate about adopting trade liberalization or protectionism has a long history
in the developmental economy. Taiwan’s economy was credited with export-led
growth, however, in the 1950s when the Chinese nationalist had just fled to
Taiwan, who also had just broken away from Japanese imperialism, the political
elite did not favor free trade policy; au contraire it was full of protectionism
7 1 P3, July 1998, Marcel Timmer, “Catch up patterns in Newly industrializing countries. An
International Comparison of Manufacturing Productivity in Taiwan.”
56
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thinking. The KMT was afraid to repeat the same economic mistakes of Mainland
China, which included the “squelching of productive economic activity,
inflationary fiscal and monetary policies and inattention to the countryside.” (P.76,
Stephan Haggard, 1992) The economic environment favored protectionism and an
import substitution policy, accompanied with high tariffs and strict quantitative
import controls, an overvalued exchange rate and multiple-exchange rate system,
lower-than-equilibrium domestic interest rates, and strong government intervention.
By the mid-1950s, the economy was facing problems caused by import
substitution. Taiwan faced market saturation and slow growth, GNP growth rates
dropped each year, consumption per capita did not increase, and investment was
sluggish.
Due to limitations of being a small island nation with a highly protected
domestic market and low purchasing power, Taiwan could not generate sufficient
demand for industry to produce import substitutes that enjoyed the economies of
scale and efficiency of production; although the rural economy did expand at that
time (Park and Johnston, 1995). Qualitative and quantitative restrictions on imports
prevented the economy from benefiting from specialization based on comparative
advantage. Under inward-looking policies, the process toward industrialization was
limited and economic growth was slow.
What was there to export, given the fact Taiwan has few natural resources
and high population density? Based on the Hecksher-Olin model and on
comparative advantage, products exported should rely on labor-intensive
57
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production, not on the traditional agricultural products, which were a vested
comparative advantage inherited from its colonial period. In the late 1950s,
scholars and policy markers debated if devaluation would worsen the economy’s
terms of trade and cause imported inflation or if products made in Taiwan could
compete with foreign goods. Chinese economists T.S. Tsiang7 2 and T.C. Liu tried
to persuade the government that increasing export promotion would earn more
foreign exchange while devaluation would not cause inflation if it was coupled
with trade liberalization. Even as imports expanded with exports after trade
liberalization as long as trade continued to balance, there was no need to worry
about the unmatched expansion in aggregate demand resulted from the devaluation.
As these debates carried on, by the mid-1950s, the economy faced typical
problems caused by import substitution. The need for export expansion was
clarified and policy reform began in 1958, including the simplification of the
foreign exchange system, devaluation of the domestic currency, and reduction of
restrictions on imports. It took a decade for Taiwan to transform form the inward-
looking (the phase of import substitution) in the 1950s to the outward-looking
policies (the phase of export promotion) in the 1960s. The most orthodox
economic views were that export orientation led Taiwan’s economy to specialize in
its comparative advantages, therefore increased the productivity, income, savings
and investment. The first stage of export promotion replaced labor-intensive
7 2 T. S. Tsiang, “Taiwan’s economic miracle: Lessons in Economic Development,” in Arnold
Harberger, ed., World Economic Growth. (San Francisco: Institute fore Contemporary Studies,
1984)
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agricultural products with labor-intensive manufacturing products. The secondary
phase of export expansion caused a shift from labor-intensive to more knowledge
and capital-intensive manufacturing. According to the definitions of Marcel
Timmer7 4 , “Taiwan’s post war industrial development can be divided up into four
gradually evolving phases, namely from primary import substitution using
domestic raw materials (phase 1), to primary export substitution using unskilled
labor and imported materials (phase 2), followed by a more knowledge and capital
intensive secondary import substitution (phase 3), and finally secondary export
substitution (phase 4).”
nc
Figure 1 shows economic growth performance since the early 1960s.
Notice that economic growth has fluctuated around a high mean in 1970s, was
severely hit by the two oil shocks in 1974-75 and 1979-82, but growth quickly
recovered and Taiwan entered into the second phase of export expansion after those
oil shocks. Taiwan started to lose its comparative advantage in labor-intensive
exports when wages of labor increased and the labor surplus reservoir was reduced.
Taiwan’s population growth reduced from an average of 3.6 % in the 1950s to 1.7
% in the early 1980s; with the growth of real per capita, wages of labor had become
relatively high compared to other developing countries. Taiwan gradually moved
7 4 P4. July 1998. Marcel Timmer, “Catch up patterns in Newly industrializing countries. An
International Comparison of Manufacturing Productivity in Taiwan.
7 5 Source: yearly data published by National Statistics of Taiwan, (www.stat.gov.tw)
59
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into the production of electrical machinery for export, requiring more skilled labors
and more advanced technologies.
Figure 1: GNP %
16
10 -
Q .
z
0
< ? S > A^ A f V A ^1 A^ < ? § * * < £ C S ^
sP d P cSP oA oA CV .OA .OP .OP .OP .Op .Op .c*> .or .ot> .tf 5 .<#>
year
Figure 27 6 is the exhibit for the export-led growth hypothesis. The export-
GDP ratio in Taiwan has risen from around 9.1 percent to 35.5 percent in the 1980s
and close to 50 percent at the end of 20th century. The story of Taiwan had its root
in its colonial period; first, Taiwan exported most of its agricultural surplus to
Japan based on economic comparative advantage and political coercive power.
Taiwan is one of the examples following the typical development model of East
Asia which is well known as, -led by Japan - using exports as the engine of growth
to leverage the competitive advantage of low-wage and a relatively well-educated
7 6 Source: yearly data published by National Statistics of Taiwan, (www.stat.gov.tw)
60
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labor force to grow faster. Taiwan extended its export orientation from the colonial
period to a more modem time, and its developmental policy was successful in
transferring its excess from the agricultural sector into the industrial sector.
Economic success raises expectations, especially in high and middle-income
countries such as Taiwan who need to move from the “catch-up” or initiative phase
of development to the innovative phase; because the wage is no longer
comparatively low and the county needs to move up the value chain of production
to stay ahead of lower cost producers in the manufacturing economy.
Exports/GNP
Imports/GNP
61
Figure 2: Import and Export to GNP Ratios
60.0%
50.0%
40.0%
5 30.0%
20.0%
10.0%
0.0%
^ r # c # . < # < £>* c #
Year
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Evidence on Trade Balance and Industrial Production Index analysis
Trade Balance. In early academic research to explain the success of Asian
economic growth since 1970s, most explanations place a heavy emphasis on export
orientation. However, more and more economists have doubted this and found 1) it
is difficult to prove how export orientation could have played a significant role in
growth; 2) in a small country such as Taiwan, exports were initially too small to
have a significant effect on aggregate economic performance; and 3) some
economists argued export growth has not been associated with increased
productivity. This section and the sections that follow will provide evidence
supporting the export-growth hypothesis and will link macroeconomic performance
to more detailed microeconomic analysis based on the individual Corporation’s
performance.
We can write the GNP of an economy (Y), as comprised of consumption
(C), investment (I), net government expenditures, which is government
expenditures (G), less taxes (T), and net exports, which is exports (X), less imports
(M). As a result,
Y = C + I + G - T + X - M (1)
Since saving (S) is equal to national income (Y) less consumption (C), then
S = Y - CorC = Y - S (2)
By replacing (2) into (1), one gets S - I = G - T + X-M, IfG = T, where
the government run a balanced budget with G - T = 0, excess saving equals the
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current account surplus: S - 1 = X - M. This formula could also be interpreted as
trade balance is equal to net foreign investment. If Taiwan exports more goods
than it is imports, Taiwan has a trade surplus. Taiwan’s trade balance is positive,
meaning Taiwan’s national savings exceeds investment. Savings not invested
domestically are loaned to foreigners, who require these loans because Taiwan is
providing them more goods and services than they are providing to Taiwan. On the
other hand, if Taiwan’s has a trade deficit, Taiwan will be a net borrower in world
financial markets. By the end of 1990s, Taiwan was the 15th largest trading nation
in the world and its foreign exchange reserve was valued at US$ 161.7 billion in
December 2002, the third highest foreign reserves of any country (The Economist,
Feb 8th, 74th , 2003) and the highest on a per capita basis. Taiwan is a net lender in
world financial markets and Taiwan’s economic development relies on “surplus”
generated from international trade. Figure 3 is the time series of trade balance.
Taiwan had experienced large trade surpluses over the past decades except
in 1974 and 1975 when oil shocks had a significant impact on the world economy.
Taiwan based its economic development on exporting goods; consequently, trade
balance dropped from 25.7 to -42.6 billion NT$ 1974, -19.3 billion NT$ in 1975
and from 64 billion NT$ in 1978 to 13.6 billion NT$ in 1979 to - 17.8 billion NT$
in 1980. In fact, 1974,1975 and 1980 are the only years Taiwan has had a trade
deficit since economic take-off. However, Taiwan’s economy managed to respond
to the upturn in the US economy in the second half of 1983 after the second oil
price shock. The oil price change is closely linked to national economy and the oil
63
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prices have causal correlation with macroeconomic phenomenon; but the influences
77
could be various in different countries .
Figure 3: Trade Balance
600000 n
500000
400000
if*
\-
z
300000
c
■ 2 200000
i
100000
1071 *1976 1981 1986 1991 1996 2001
-100000
Year
— ■—Trade Balance
Jones & Kaul (1996) find Japan is the country most negatively associated
with oil price changes while Canada is much weaker in the relations between oil
price change and stock returns. Consider a small open economy and outward
development influenced by the Japanese model, it is not surprised to see a
relatively huge negative impact in Taiwan’s economy due to oil shocks, given the
77
F o r ex am p le, G jerd e & S ettem (1 9 9 9 ) fo u n d in N o rw ay th e sto c k m ark et resp o n d s p o sitiv ely to oil p rice
changes.
64
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fact the market is Taiwan is not as rational as Japan’s. The analysis regarding trade
balance influenced by oil price changes- one of important international factors -
indicates the dependent economic nature of Taiwan; with its high dependence on
trade, Taiwan is very susceptibility to changes in world prices and demand. The
economy need to respond quickly to the upturn or downturn of the world economy,
react in a politically astute manners to its major trading partners such as US and
Japan, and most importantly handled its political tension with Mainland China in
order to achieve equilibrium balance. In the past decades, Taiwan’s government has
worried about military invasion from Mainland China; and Taiwan may actually
benefit in some way from its fear of China. The Economist published the paper of
“In Praise o f Paranoid” by Christopher Anderson in November 1998:
This fear permeates everything Taiwan does. It was used to ju stify decades of
martial law and totalitarian rule after Chiang Kai-shek and his nationalist forces
retreated to the island in 1949 in flight from Mao Zedong's communists on the
mainland. It explains why a smudge of land the size of the Netherlands, with a
population of ju st 22m, has an annual defence budget of $10 billion and more
than 4m soldiers (most of them reserves). Deprived by the government in
Beijing of diplomatic recognition by any of the world's important countries,
Taiwan has been driven by fear of isolation to go to extraordinary lengths to
win friends and protectors in other ways. It has one of the world's largest
overseas propaganda machines, and is the top sponsor of all-expenses-paid
junkets for American congressional staff.
Fear also explains why Taiwan has weathered the financial crisis in much better
shape than many of its neighbours. Most other East Asian countries are in
recession, but Taiwan will notch up 4-5% growth this year (see chart), ju st a
bit below its usual figure but still fifth-highest in the world. Whereas
stockmarkets and currencies all Fear also explains why Taiwan has weathered
the financial crisis in much better shape than many of its neighbours. Most
other East Asian countries are in recession, but Taiwan will notch up 4-5%
growth this year (see chart), just a bit below its usual figure but still fifth-
highest in the world. Whereas stockmarkets and currencies all around it have
lost about half their value in the past 18 months, Taiwan's are down by a
modest 20% or so. With the exception of China, with its largely closed financial
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markets and unreliable economic statistics, Taiwan is the top performer in Asia
by virtually every measure.
Crisis? what crisis?
GDP g ro w th , % cz~) 1996
20 15 10 S
Philippines
Hong Kong
Malaysia
South Korea
Thailand
Indonesia
;-ou-i-ri G c ld rra n Tfio fc n i-ie m s t 'forecast
Until October 1997, many East Asian countries were regarded as economic
miracles. The standouts included the four Asian Tigers - Hong Kong, Singapore,
South Korea, and Taiwan. Right behind were Indonesia, Malaysia, Thailand, and
China. The increasing growth rates of real per capita gross domestic product
among those countries placed this East Asian group at the top of the world’s
growth list. The Asian reputation has suffered recently because of financial crises
and recessions since October of 1997. However, one of Asia’s so-called Tigers,
Taiwan has largely escaped the mauling many other Asian economies have
suffered. Taiwan has so far escaped with smaller currency devaluation and
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relatively modest decline in the share prices of stock market, compared to its
neighbors; economic growth remains strong. Taiwan is by all no means immune
from the force of Asian financial turmoil, considering its exports vulnerability and
small country’s market limitation. The larger exchange rate devaluation of Japan,
Korean, and other Asian currencies will undoubtedly put Taiwanese firms under
pressure. However, after it demonstrates its ability to escape and flexibility in
adjustment in facing financial crisis; studying the performance of Taiwanese firms
makes it even more interesting.
While the rest of Asia was reputed for the “Asian Economic Miracle”;
Taiwan was always and still is prepared for the worst, based on the fears of that 1)
the government would have repeated the same historical mistake - financial turmoil
of the KMT’s last years on the mainland leading to the lost control of military and
political power in China, and 2) the military invasion from Mainland China who
claims sovereignty over Taiwan. While other Asian countries used the economic
development model of high investment with high leverage; Taiwanese model was
criticized for being financially too conservative on the macroeconomic and
microeconomic levels to limit its growth’s based on the facts that 1) Taiwan was
one of the world’s lowest foreign debt ratios, 2) its banks have the lowest bad-loan
ratios in Asia and 3) its companies have one of the lowest debt-to-equity ratio
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7 8
among East Asian corporations. The study of riskiness regarding financial
structure of East Asian corporations shows:
“Korean and Japanese firms have the highest leverage among all corporate
in the group of countries, while companies in Thailand, Indonesia, and Hong Kong
also have among the ten highest leverage ratios. At the opposite extreme,
Taiwanese firms show relatively low leverage ratios. Firms in the Philippines,
Singapore, and Malaysia also have below-average ratios. The pattern across other
regions is also interesting. Western European countries typically display high
leverage ratios, with Swiss firms having leverage almost as high as Japanese firms.
In contrast, corporate in South American countries (Peru, Chile, Argentina,
Venezuela, Colombia) have low leverage, reflecting7 9 the less deep banking
systems of these countries.”
Industrial Production. Industrial Production Index (IP) is the
measurement for industrial productivity and utilization capacity of a country. High
production index represents the indication for high level of output. Consequently,
industry will enjoy higher retursn under the condition of higher production level or
higher PI. The data is obtained from Quarterly National Economic Trends, Taiwan,
The Republic of China and the base year is 1996 when production index is set to be
100. Regarding the Industrial Production Index (IP), the IP time series increases
smoothly over the past decades based on Figure 4, which shows Taiwan improves
its industrial productivity performance in a steady catch up pace by adopting
technology at the world technology frontier.
The only slowdown in growth was during the year of 1973 when oil price
shock had badly injured world economy and Taiwan was not an exception.
7 8 Stijn Claessens, Simeon Djankov and Larry Lang, “East Asian Corporate: growth, Financing and
Risks over the Last Decade”, World Bank, P.9 October 27, 1998.
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However, after oil price shock, Taiwan was able to pick up the growth and
experienced a steady growth pace due to government’s successful industrial policy.
In early 1970s to 1980s, Taiwan had transformed from an agricultural to industrial-
oriented economy and from a labor-intensive to skill and technology-intensive
economy. In 2001, industrial production accounted for 31.09 percent of Taiwan’s
GDP; manufacturing output constituted around 82 percent of total industrial
production and employed over one-fourth of the nations8 0 . Along with the
government’s policy - changing from import substitution to export promotion,
manufacturing has dominated Taiwan’s industrial sector since the mid-1960s.
Figure 4: IP Index
140
120
| 100
T 3
C
C 80
o
S
C L
1971 1976 1981 1986 1991 1996 2001
Year
♦ — IP Index
8 0 http://www.gio.gov.tw/taiwan-website/5-gp/brief/economy.htm
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The IP time series is a good reflection of the history of Taiwan’s economic
development. After the 1980s, Taiwan’s economy relied heavily on exporting
products and international trade; manufacturing industry played a crucial role and
the IP index is one of the crucial indicators. Currently, the computer and semi
conductor industries are the most globally competitive industries in Taiwan; today
it has the world’s fourth largest information hardware industry and the fourth
largest semiconductor industry. For instance, in 1999,46% of the laptop computers
in the world were manufactured by Taiwanese firms either through OEM or ODM.
Even during the Asian financial crisis, domestic industrial production was not
badly influenced, judging by the time series, the growth of IP index was slowed
down only a bit during the crisis. Compared to other time series of trade balance
or economic growth, the IP time series is rather relatively smooth over time even
during the periods of Asian financial crisis in 1997-98. In addition, this finding
indicates Taiwan’s economy grew at a constant pace.
Taiwan is a typical example of late industrializing countries; Amsden
classifies “the first and second industrial resolution” based on invention and
innovation respectively, versus “late industrialisers” which enjoyed the advantage
of looking backward by adopting new technologies without devoting resources to
develop them (Amsden, 1989). The catch-up theory argues countries at lower
levels of income have a potential to increasing productivity and economic growth
at a faster rate than countries at a high level of income would have enjoyed.
However, the potential for a country to catch up is not determined by the degree of
70
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backward looking, but by its social capabilities - institutional framework,
policymaking and political backing and the human capital and technological
congruence - the ability to adopt Western technology (Abramovits, 1989). Taiwan
began as an exporter of primary products (such as food processing, textile, and
garments), and remains dependent on commodity exports, except the export
products nowadays are more technology- and capital-intensive sectors, (such as the
production of chemicals, petrochemicals, information technology, electrical
equipments and electronics). More recently, Taiwan’s IT industry has grown from
a minor role to a major contributor to the island’s export-based economy and the
size of the domestic market is clearly an important variable in explaining the
export-based economy.
In conclusion, 1) the economic growth of Taiwan has long history of relying
on export outward development back to the colonial period and extend to the
modern economic history. 2) The relationship between export and economic
growth is positively related and export-outward policy plays a crucial role in the
economic development. This research confirmed the export-led growth hypothesis
as against some economists’ claimed of the irrelevance of export expansion. 3)
From the early 1970s to 1980s, Taiwan had transformed from an agricultural to
industrial-oriented economy and from a labor-intensive to skill and technology
intensive economy. Being one of the NICs, Taiwan has exhibited catch-up during
the periods and also Taiwanese manufacturing industry has increased the output
level as well as improving the technology and skills. This gradual developmental
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approach of expanding export, liberalizing economy, and learning new technology
has been seen as examples of various critical countries under different political
regimes. 4) Whether the countries come to developmental stage as early-bird or
late-comer, initially adopting inward-looking or import-substituting policy, the
export orientation was at first emphasized on labor-intensive agricultural and later
on non-agricultural exports. Subsequently entering into capital and technology
intensive industries are becoming the standardized prescriptions for developmental
strategy.
Taiwan is a successful example for dependent development through open
economy policies and gradual developmental approach of expanding exports.
Taiwan has improved the quantity and quality of exported commodities, from the
agricultural to the industrial sectors, from the initiative phase of development to the
more innovative phase. The KMT was incapable of governing Mainland China,
but by “learning by doing”, this “strong state” were able to exercise more
autonomy to accomplish economic reforms in Taiwan. The land reform provided
an egalitarian base in distributing the benefits of country’s growth and maintained a
low Gini indexes from o.46 in 1961 to 0.30 in 1972 (Kim, 1983). As the economy
transformed gradually to industrialization, industry absorbed a large proportion of
the labor force and because of the labor-absorbing character of assembly operations
that dominate the export-oriented manufacturing sector, egalitarian industrialization
was possible.
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Despite export vulnerability and small country’s limitations, Taiwan
accumulated trade surpluses. Taiwan has been able to maximize the flow of foreign
investment and foreign technology into its economic development. Studying the
case of Taiwan shows a possibility for peripheral countries to grow out of its
original political economy, which offers greater support for modernization theory
than to dependency theory.
Dependency theory focuses on negative external developmental factors and
social conflicting interests between classes, claiming heavy reliance on trade
structurally links local dominant classes and international ones and produces high
levels of inequality and stagnations of growth. Modernization theorists emphasis
internal factors and assumed that sources of growth are found in institutional
factors, external factors play an important role in initiating economic takeoff, but it
is the institutionalization of markets in labor, capital, and goods that determine the
possibility and sustainability of growth. In the following chapter, I analyze the
performance of national corporate economy in the developmental state of Taiwan
and how the corporate economy was shaped to for the basis for supporting the
growth process under the export-oriented economy.
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Ch4. Corporate economy under dependent development
In this chapter, I intend to identify the main characteristics of the corporate
economy in Taiwan and how those corporations evolve and behave to form the
basis for supporting the rapid growth process. Economic growth in Taiwan was
promoted through corporations. The modern corporation is different in its relation
to the state in Western society when compared to Asia. In the following chapter,
these questions are addressed: 1) How was the corporate economy shaped by its
specific political economic environment? 2) Does it show the strong will of
government and functional links with outward economic development as well as
from internally generated change with its evolutionary determinism? 3) How is the
corporate economy in Taiwan characteristically different from that of other East
Asian countries?
The Characteristic of Taiwan’s corporate economy
Taiwan’s corporate economy was characterized by predominance of small-
medium sized enterprises (SMSE) as shown in Table 6, compared with the
celebrated Japanese Keiretsu and the less familiar Korean Chaebols. Those SMSEs
highly participated in outward economic development; no matter how small size
are those Taiwanese companies, they all have to compete efficiently with larger-
size competitors under the export-oriented Asian economy. As pointed in Ch3, the
outward economic development of Taiwan was rooted under colonialism and
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expanded by KMT regime; the size distribution of Taiwanese companies was also
shaped by its unique historical background and political structure.
Table 6: Small and Medium-sized Enterprises
Years All enterprises Small & Medium-sized enterprises SMSB %
1986 751,273 737,305 98.1
1987 761,553 743,274 97.6
1988 791,592 773,511 97.7
1989 798,865 778,042 97.4
1990 818,061 794,834 97.2
1991 850,679 825,556 97.1
1992 900,901 871,726 96.8
Years Export by All
enterprises
Export by Small & Medium-sized
enterprises
Export by
SMSB %
1986 39.8 (US$ bn.) 26.4 66.3
1987 53.5 35.9 67.1
1988 60.6 36.4 60.0
1989 66.2 40.8 61.6
1990 67.2 38.5 57.3
1991 76.2 43.3 56.8
1992 81.5 45.6 55.9
Sources: Small and Medium-sized Enterprises Administration,
Ministry of Economic Affairs, Taiwan, 1993.
During the colonial period until 19248 1 , Taiwanese were prohibited from
forming corporations without Japanese participation. The factory enclave was
mainly owned and managed by Japanese and provided materials needed by
Japanese industry. It may have helped to generate a growing disciplined industrial
labor force, because Japanese tried to discipline Taiwanese labor using the same
standard of Japanese industry, the good quality of labor force in Taiwan has roots
from this period; but it was never the intention of Japanese to see the growth and
8 1 Thomas Gold, State and Society in the Taiwan Miracle (Armonk, N.Y.: M. E. Sharpe, 1986),
pp.39-40.
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development of Taiwanese corporations. Japanese zaibatsu and locally established
Japanese firms still dominated the commerce and industry of Taiwan. Most
Taiwanese were largely restricted to small-scale industry, land development and
commerce under Japanese rule, except some collaborating Taiwanese families
become rich by exploiting commercial monopolies granted by the Japanese. At
that time, small Taiwanese food-processing companies only served the main
purpose of being an agricultural appendage to the Japanese economy. One of the
biggest companies at that time, Taiwan Sugar Corporation, had only seven
Taiwanese division chiefs out of 2000 employees (Wei, p. 131, 1992). Limited in
capital resources and social status, therefore Taiwanese firms were restricted to
being small. The trend o f “being sm all” has been carried on in the government
policies o f the KM T.
After the KMT’s retreat from Mainland China to Taiwan, the Nationalist
government followed an ideology based on Sun Yat-Sen’s “three principles of
people” of combining private- and public- ownership together with an emphasis on
“equality”. The Nationalist government took over industrial production and
managed larger-scale enterprises either through state-controlled or KMT party-
controlled enterprises, similarly to that found in Leninist systems, party and state
became inextricably intervened. Small Taiwanese companies faced competition
from a government worse than its predecessor in monopolizing opportunities
though control of inputs, credit and transport. The chance of growing large was
limited.
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Taiwan and China both have the strong sense of nationalism and a strong
statist tradition. Taiwan has the strongest sense of organic nationalism in terms of
cultural and ethnic homogeneity, furthermore reinforced by the sense of being a
colony under Japanese and the constant threat from China, especially around the
1950s and 1960s when Taiwan’s economy was just about to take off. “Being
paranoid” from defeat at the hands of the communists on the mainland, the KMT
saw concentration of political power in the hands of mainlanders as the top priority
and extended this political view into the economic arena. As described by Parks
Coble , relations between the state and Chinese capitalists were “characterized by
government efforts to emasculate politically the urban capitalist and to mold the
modem sector of the economy.” The importance of “Quen-Chi” (personal
relationship interacting with society as a whole) is always an important element of
determining the political economic power in a Chinese community, no matter if it
was mingled with socialism or capitalism or both. Nationalist government
exhibited a skepticism regarding the growth of private economic power in the
hands of the local Taiwanese. Korean relied on big business supported by the
military group for industrialization and the political support was extended to the
technocrats at a relatively early stage; the KMT exhibited a skepticism regarding
the growth of private economic power in the hands of the local Taiwanese and
would rather have a handful of small entrepreneurs than hard-to-control
technocrats; unless it was carefully chosen for the national interests. Although
8 2 Park Coble, The Shanghai Capitalists. p3.
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Taiwan’s private sector grew rapidly and participated actively in international
trade; Taiwanese businessman were also well-regulated and controlled by
government intervention and industrial policy.
Taiwan’s corporate economy is characterized by the importance and
ultimate use of state-owned enterprises (SOEs). The nationalist government used
Dr. Sun’s book as a blueprint for national economic development and focused on
developing national-owned industries to promote economic growth and assure
equality.. Dr. Sun wanted to adopt a mixed economy - a social-capitalist economic
system - that by focusing on public expenditures and public-owned industry
prevented excess profit for private capitalists and monopolies and by allowing the
private enterprises to pursuit non-monopolistic profits in the market to upgrade the
economy toward more capitalist and technology-oriented. Sunist policies still
differed himself from orthodox Marxism in a way that generally facilitated private
sector industrial development, but only set constraints to some private sectors and
regulated industries either directly or indirectly related to national defense or
monopolistic and large-scale industries such as such as banking, railroad, and
aviation. He firmly believed once those industries were operated by private
individuals, they could easily manipulate the quantity and price of production to
cause economic disorder.
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As Wei Wou described in his book8 3 ,
“In the late 1940s, three categories of state-owned industries existed in
Taiwan. Industries previously owned by Japanese nationals, such as the sugar,
electric power, fertilizer, cement, paper, gold, and copper mining industries, were
operated by the Nationalist government, Industries the Nationalist government
established before 1949 moved to Taiwan with the Nationalist administration:
China Textile Corporation, Chinese Petroleum corporations, China Engineering
Corporation, and China Fisheries Corporation. State-owned industries established
after the Nationalist move to Taiwan were adapted from industries previously
operated and mismanaged by the private sector. Taiwan Steel Corporation, Taiwan
Coal Mining and Development Corporation, Hsinchu Coal Mining Bureau, and
Agricultural chemical corporation were reorganized as state corporations: China
Petrochemical Corporations, Central Taiwan Chemical Engineering Corporation,
China Steel Corporation, China Shipbuilding Corporation, Taiwan Machinery
Corporation, and Taiwan Aluminum Corporation.” (Wei, pl04, 1992)
Even today as Taiwan adopts a very western-capitalistic-like democratic
system, public enterprises still play a influential role, though economic planning
has been less extreme than in South Korea (Amsden, 1979; Wade 1984). Public
choice theorists argue SOEs and large public sectors are inefficient and ineffective;
but, in the case of Taiwan, most SOEs have a better performance than their
counterparts in private enterprise. According to the July 1998 Commonwealth
Magazine, the three biggest industrial corporations in Taiwan were, based on sales
and other criteria such as profits and debt-equity ratios, the government-owned
Chinese Petroleum Corporation, the government-owned Taiwan Tobacco and Wine
Monopoly Bureau and the formerly government-owned and recently privatized
China Steel Corporation. Nan Ya Plastics Corporation was ranked fourth and was
the largest private-owned manufacturing enterprise in Taiwan. Though Taiwan has
8 3 Wei Wou, Capitalism: A Chinese Version: guiding a market economy in Taiwan, East Asian
Studies Center, Ohio State University, Columbus, Ohio, p. 104, 1992.
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exercised less direct control over private firms, it intervenes in the economy
through a large number of state-owned enterprises in key industrial sectors. (Ho,
1978; Wade 1984).
Due to high trade dependence, Taiwan is susceptible to changes in world
prices and demand. Taiwanese companies need to respond quickly to upturns or
downturns in the world economy, reacted in a politically astute way to major
trading partners and handling political tensions with Mainland China. Taiwanese
companies try to survive and respond quickly through the “small-medium
structure”. Unlike South Korea’s Chaebols, Taiwan’s financially cautious
companies were criticized for being underleveraged. As stated in the previous
chapter, financial conservativeness was caused by political paranoia and isolation
for recognizing its Sovereignty. The Taiwanese government and Taiwanese private
enterprises have a more passive attitude for corporate financing relying on low
macro leverage8 4 and low-debt levels than take the risk of being leveraged out of
proportion, which might cause financial distress. It may limit economic growth,
but also limits financial fluctuations. Taiwan has one of the largest foreign
exchange reserves and one of the world’s lowest foreign debt ratios, its banks also
have the lowest bad-loan ratios in Asia and its companies have relatively low debt-
to-equity ratios.
8 4 The amount of foreign asset was more than seven times its foreign liability by the end of 1997. In
Taiwan foreign bank claims’ percentage of GDP was 8.5 %, 8.4%, and 7.5% by the end of
1995,1996,1997, respectively. By comparison, the figures over the same period for the other three
counties, were respectively, 18.3 %, 22.5% and 22.2 % for Korea; 24.8%, 25.6%, 39.1% for
Indonesia; and 55.4%, 53.7%, 49.5% for Thailand. Data source: Bank for International Settlements.
Annual Report.
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Taiwan has over 900,000 enterprises, with almost 97 % being small and
medium-sized by the standards of Ministry of Finance of Taiwan. (Semkow, 1994,
p.67-68) According to the Industry, Commerce and Service Census, only 12 % of
small and medium-sized were corporations in 1971 and only 29.4 % of all
companies were corporations under the Company Law in 19918 5 . Taiwan was
relatively slow in developing its corporate economy given its relatively high rate of
overall growth. Only a small percentage of all companies grow big enough to issue
securities in the TSE primary markets or have their securities traded on the OTC
secondary market. By the end of 1997, there were only 393 companies listed on
the Taiwan Stock Exchange - the non-debt securities markets to obtain capital from
the public.
South Korea favored large-scale enterprises and exercised state control
directly over banks and access to foreign capital. Taiwan exercised less direct
control over private firms and preferred small companies; the State’s relative
autonomy to use banks as instruments of state economic control was less but still
played an important role in enhancing state power. Chinese business firms depend
very much on networks of kin and friends for labor and capital; they ask core
family members for start up funds or formally or informally trade shares with
friends and distant relatives to raise capital. In raising external capital, Taiwanese
firms depend more on bank-lending and borrowing in the money markets; capital
markets for equity and debt are still relatively underdeveloped. In 1992, TSE-listed
8 5 See http://www.dgbas.gov.tw/census~n/two/HT42.HTM
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public companies raised NT$14.5 billion by issuing new shares through cash
offering, at the same year, the money that all Taiwanese companies borrowed from
bank totaled NT$550.2 billion. Yet for larger companies, Taiwan’s capital market
is dominated by equity and not by bonds, given that Taiwanese companies are more
willing to issue equity securities than bond securities. (Brian Semkow, p. 109-pl 10,
1994)
Table 7: Financial sources of Taiwanese companies
Years All companies
(Bank loans)
TSE-listed companies
(Cash Offering)
Unlisted companies
(Cash Offering)
1982 75.5 (NT$ billion) 10.2 (NTS billion) 17.5 (NTS billion)
1983 68.9 6.4 27.5
1984 55.9 4.9 4.0
1985 -12.1 6.9 27.6
1986 12.7 7.2 6.3
1987 65.8 13.7 27.0
1988 294.6 9.8 23.8
1989 221.2 16.4 68.6
1990 150.6 12.7 91.7
1991 392.8 14.7 42.9
1992 550.2 14.5 47.5
Sources:r’aiwan Stock Exchange, 1993.
Taiwan’s regulation of the flow of financial capitals and controlling private
or
sector were less direct (Hagen Koo , p. 173, 1987); corporations were responsible
for their own financial costs, therefore corporate management were more cautious
and sought to avoid any bankrupt costs. Despite having a large base of small
companies that show a high degree of strategic adaptability, there are only a few
home-grown large companies and only even fewer are internationally recognizable.
8 6 Hagen Koo, “The interplay of state, social class and world system in East Asian development: the
cases of South Korea and Taiwan” in The political economy of the New Asian Industrialism.
Frederic Deyo, ed., Cornell: Cornell University Press, 1987.
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How to finance growth of small to medium size companies and create large-scale
market recognition for brands were the two major difficult issues for the
government and business. Taiwanese companies may be incapable of becoming
larger, given limitations in existing corporate structure and culture.
The main characteristics of the corporate economy in Taiwan are: 1) small-
medium enterprises dominate due to colonialism and KMT’s nationalism, 2) small
firms aimed at international trade since the colonial period, 3) large scope of state-
owned enterprises prevent excess profit for private capitalists according to Sunist
principals, 4) political paranoid led to financial conservativeness and low macro
leverage and low-debt ratios, and 5) the low incorporation rate indicating a relative
underdevelopment of the corporate economy, while the securities markets were
relatively underdeveloped, given the growing importance of Taiwan’s economy.
The Changing Corporate Economy in Taiwan:
How Does Government Engineer Corporate Economy?
As trade grows, the magnitude and scope of necessary changes in corporate
economy in Taiwan are expected to be influential and different, based on a country-
by-country bias. In the late 1960s, Chinese economists and policy makers had just
finished the great policy debate between “import-substitution” or “export
promotion”, in another words, “ trade protectionism” vs. “trade liberalization”. The
country was changing from a development strategy of protectionism, including an
overvalued domestic currency, high tariffs, strict quantitative import control and
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87
multiple-exchange-rate system, to trade liberalization. In the 1960s, the Statute
for the Encouragement of Investment was promulgated to offer tax cut and
investment incentives; the Stock Exchange was established to facilitate allocation
of financial resources; foreign exchange controls were liberalized, private savings
and investments were encouraged; the foreign exchange rate was unified and
sharply devalued twice, form 24 NT to the US dollar to 40 NT to the US dollar. The
basic principle was “ prices were adjusted toward market-determined levels
Although Taiwan has a strong sense of nationalism and strong statist
tradition, it also depended on American aid, American trade and even American
military support backed up by the U.S. Seventh Fleet. Taiwan’s corporate
economy was strongly influenced by the American business environment. Despite
Taiwan’s authoritarian regime, KMT-led economic development aimed at a path
similar to Western Capitalist Nations through successive stages of modernization.
Economic freedoms were well defined and incentives fo r profits were guided, while
political freedom was far-reaching to meet the standard o f western society.
In 1959, U.S. Aid- a total of 1.7 billion - set out to accelerate economic
development and sustain self-generated growth for Taiwan, which later-on were
followed by a series of steps of liberalization by Taiwan’s government. Taiwan has
consistently had a trade surplus with the U.S. since 1967. In 1999, the United States
was Taiwan’s largest trading partner, taking 25% of Taiwan’s exports and
8 7 See details in Chi Schive, “How was Taiwan’s Economy Opened”, The Economics and Political
Economy of Development at the Turn of the Century: Conference in Memory of John Fei, August
1997, Taipei.
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supplying 17% of its imports. Taiwan is the U.S.’s seventh-largest trading partner
and eighth-largest export market; Taiwan’s two-way trade with the U.S. amounted
to U.S. $54.3 billion. There has been general agreement that U.S. companies
provided technology transfer through direct foreign investment or formal
technology cooperation agreements. (Denis Fred Simon, 1992, p.133) Taiwan’s
no
case exemplified Hirschman’ s rule that dependency will emerge where country A
takes a large percentage of trade from country B, but country B is a small part of
country A’s total trade; but the direct dependency of US in the 1950s and early
1960s has declined over time and Taiwan was trying to diversify in order to escape
dependency, however, some political theorists still argued it was exchanging one
form of dependency for another. Export-led growth was dependence on trade and
its effectiveness of outward development was questionable when comparing East
Asian NICs and Latin American countries; some economists argued the initial
effect of outward economic development was too small to have effectiveness.
The outward economic policy of the 1960s focused on adapting new
technology, machinery, foreign capital and management to be able to compete
internationally, au contraire to import-substitution policies, which focused on
protection of domestic market. Developed countries such as the US and Japan
were eager to move to capital or technology intensive industries, giving Taiwan a
chance to enter labor-intensive manufacturing in line with Taiwan’s comparative
advantage. Continued production of labor-intensive exports relieved
8 8 Hirschman, National Power, p.33-35.
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unemployment pressures and earned valuable foreign exchange to form capital
accumulation for further development. Though the Taiwanese firms were adopting
old technologies, through “learning by doing”, companies learned to absorb the
technologies which are new to them, search for new products and new markets, and
expand exports furthermore.
Three Export Processing Zones (EPZs) were established: Kaohsiung in the
South in 1965 and Nantze and Taichung on the West Coast in 1969. Within EPZs,
government regulations were simplified and coordinated to facilitate foreign
factory investment; on the other side, government offered industrial sites, standard
factory building, energies, and infrastructures to facilitate manufacturing. The
EPZs were a transitional device between primary import-substitution in the 1950s
(land and raw materials type of industry) to export promotion in the 1960s (labor-
based industry such as textiles or light machinery). Exports from the export
processing zones grew rapidly, from U.S. $272,000 in 1966 to US $511 million in
19748 9.
The EPZs helped Taiwan transition from peripheral and semiperipheral
status by providing cheap, disciplined labor for the world market and transformed
the labor surplus between rural and industrial sectors. To some extent, it was fair to
say those workers were exploited, especially those female workers, by working
long hours and gaining low wages; but they were so committed to job security, long
hours of hard-working and improve households’ economies, in return, after years of
8 9 Gustav Ranis, ’’Industrial development” in Economic growth and structural change, eds by Walter
Galenson, p.239.
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hard-working and capital-accumulating, some of them might start opening a small
factory run by a single family. Taiwan’s economy allowed greater space for many
small players and Taiwan’s industrial structure is consequently less polarized than
other developing countries such as Korea. In the propensity of work effort, in
terms of time devoted to work, Taiwan ranks ahead of most other developing
countries. Small factories in the EPZs facilitated a rapid increase in economic
stakes held by core countries and rapid industrialization of the rural-based industry.
In Taiwan, the economic power o f capitalists and the working class have grown in
direct proportion to the national economy and Taiwan’s developmental state has
balanced growth and social stability.
Being small, lacking technology and short of capital, Taiwanese companies
grew out of labor competitiveness. Export-expansion polices encouraged
Taiwanese entrepreneurs and government assisted private investors by providing
technology and capital. Monetary and fiscal incentives were provided to the private
sector for investing in industries through government guidance. “Stabilization’
was the first priority and the government established price stability early on and
maintained it. The political leadership made strong commitments to
macroeconomic stability, the large state-owned enterprise sector, and development
of the private sector, but without intention to build up big enterprises, in contrast to
Japanese zaibatsu or Korean Chaebol. Under KMT’s Leninist authoritarian regime,
all Taiwanese could do was involve themselves in business and industry. Yet, in
doing so, booming small-enterprises formed the middle class and transformed the
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political economy in the one party-state of Taiwan. In western society, the middle
class have a voice in government policy by wielding financial and political power.
Taiwan’s middle class, comprising 35 percent of Taiwan’s working population,
wanted a multi-party system similar to Western democracy. Government leaders
demonstrated their willingness to liberalize the authoritarian regime and politically
transitioned to democratic forms of political organization. One-party authoritarian
rule continued until 1987 when opposition parties were allowed. Taiwan’s
government lifted martial law and terminated military rule and political tutelage in
1987. On March 23, 1996, direct Presidential Elections was first held and full
democratization began. The degree of political participation and democratization
were also expanded on a path to growth based on outward economic development;
“Economic liberalization” gradually gave way to a “political liberalization” phase
and the role of the state in engineering the corporate economy has been diminishing
since full democratization. However, with deeper democratization, comes more
danger from Mainland China.
During those developmental stages, Taiwan faced serious challenges in the
changing world economy. In the late 1960s, Taiwan industrial growth generated a
steady and sizable demand for indusial materials and components. Exported goods
depended on international pricing and inputs to those industries depended on
foreign suppliers. Wanting to reduce foreign dependence, the government tried to
develop heavy and chemical industries to supply Taiwan’s needs for industrial
intermediates. Those industries are highly energy-dependent and Taiwan was
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highly dependent on imported oil. The oil crisis of 1970s severely affected the
international economy and altered Taiwan’s government policy-making in
“selecting industries”.
The oil crisis drove up the cost of Taiwan’s products, causing them to lose
their competitive edges in the world market. Taiwan had to scale down energy-
dependent industries such as steel, copper and aluminum and focus on industries
with a relative low level of energy dependence such as electronic components,
motor and machinery. Right after the oil crisis, Taiwan faced rising protectionism
in international markets and increasing competition from other Asian developing
countries for Taiwan's market share of low-cost manufacturing products. The
government soon started to promote high value-added goods in the “strategic
industries” of Taiwan; the rational of the strategy was based on exporting high
value products to offset the loss of export volume. With this changing emphasis,
Taiwan began its new stage to develop high tech industry; government established
funding for venture capital, financed high-level research and development projects.
Exports continue to grow, and it was already becoming apparent in the late
1980s without government encouragement, several firms have already taken great
advantage of opportunities from growing domestic and intentional markets. Peter
Evans has suggested countries during the second stage of ISI need to form a “triple
alliance ” between the government, private firm s and multinational corporations.
There is considerable evidence Taiwan followed this policy in establishing its
programs. Lacking formal diplomatic relations with all but 29 of its trading
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partners, Taiwan’s government also regarded the economic linkages with MNCs as
a proxy for formal international recognition90. Through technology transfer and
capital investment, Taiwan further integrated into the global economy.
In the 1990s, the country now has a far more diversified set of export
markets than it did a decade ago and the export composition has changed from
predominantly agricultural commodities to industrial goods, now accounting for
98% for its exports. Taiwan gradually moved out of labor-intensive industries and
the electronics sector has increasingly become important. Taiwan is world’s largest
supplier of computer monitors and is a leading PC manufacturer. How did Taiwan
made it through the export expansion in the late 1960s, industrial depending in the
1970s, and technological upgrading in the 1980s? The role of the State in
managing foreign technology played a key issue to local technology development
in Taiwan.
According to Ansoff and Steward (1967), if business investment on R&D
fell below a certain level, technology development was destined to fail. Amsden
(1989) points out “late industrialisers” enjoyed the advantage of looking backward
by adopting new technologies without devoting resources to develop them. Local
Taiwanese companies “borrowed” technology from “foreign companies” through
“learning by doing”. Japanese firms often signed technical cooperation agreements
9 0 Because of lacking international recognition, Taiwan’s government paid high prices for sustaining
diplomatic relationships with countries that recognize officially its sovereignty as the ROC.
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when forming a joint venture with Taiwanese firms; however, according to Chen,9 1
these technical cooperation agreements frequently involved with more “show-how”
than transfer of “know-how”. U.S. companies9 2 have provided much more actual
technology transfer - whether by foreign investment or technology cooperation
agreements. (Denis, Fred Simon, p.133, 1992) Multinational companies such as
IMB, GTE, and Wang Labs all have set up R&D facilities in Taiwan. For Taiwan,
this increases technological self-sufficiency through industrial deepening.
In order to “catch up” with advanced industrialized nations, Taiwan funded
research institutions such as the Industrial Technology Research Institute (ITRI)
and the Institute for Information Industry (III) and a huge industrial park, the
Science Park in Hsinchu in 1980s. The role of ITRI resembles the role of the
Korean Advanced Institute of Science and Technology (KAIST); once it received
foreign technology, ITRI worked to diffuse the technology into the local market.
Under some circumstances, the government has “required” technical assistance for
critical production technologies and helped upgrade local capabilities as part of the
approval process establishing a foreign-invested company. The most important
research group of ITRI is the “Electronics Research and Service Organization
(ERSO)”, which is Taiwan’s advanced research center in the field of Integrated
9 1 Chen Ting-Kuo, The effective approach of technology cooperation with foreign firms. Taipei:
Metals Industry Research Laboratory, 1978.
9 2 In the case of Japanese firms, technical cooperation became a vehicle to expand the extent of
Japanese vertical integration on the island. In many cases, Japanese firms often require a technical
cooperation agreement when forming a joint venture to obtain an additional return on the technical
know-how. Studies showed that these technical cooperation agreement frequently did not rely
involve much technology transfer of “Know-How”, but used as means to “tie up” local firms by
requiring them to buy parts and obtain an additional return. (Denis Fred Simon, p. 132)
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circuitry, particularly very large-scale integrated circuit (VLSI). With government
support, ITRI started “Taiwan Semiconductor Manufacturing Corporation
(TSMC)” in 1987, one of the world’s largest and most successful dedicated
independent semiconductor foundries. The company is listed on the Taiwan Stock
Exchange (TSE) and the New York Stock Exchange (NYSE) under the trading
symbol TSM. (Gee San9 3 , 2001)
The government set up Hsinchu Science-based Industrial Park in Taiwan’s
“Silicon Valley”. It was originally intended to attract foreign high-technology
companies and facilitate spillover effects by intrafirm movement of technology.
Initially, most firms entering the park were small, but recently, there has been
increasing involvement of larger domestic enterprises; for example, TSMC is
located in the Industrial Park. The growth of corporations in the Park (Table 8) was
the main force pushing Taiwan into high technology and the next stage of
economic development, where industries will be characterized by their skill and
knowledge intensity rather than labor intensity. IC industry is the leading industry
in HSIP.
9 3 See details in Gee San, “Human Resources and Technological Advancement”, in Taiwan’s
Economic Success since 1980. ed by Chao-Cheng Mai and Chien-Sheng Shih, Edward Elgar,
Northampton, 2001.
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Table 8: Growth of Sales in Industrial Park (Unit: Million NT dollars)
Year
!
Integrated
Circuits
Computers
&
Peripherals
Industry
Telecom,
jelectromcs
: l
Precision
Machinery
& Materials
iBio-
jtechnology
Sales
Growth
Rate
%
| '8 6 32.91 118.66 9.65 6.05 2.72 [ 0.44 170.43
['87 38.09 199.06 23.48 12.18 2.69 j ' 1.85 62.74
p 8 8 ~ " 68.08 353.26: 45.00
f 5" 9 9
3.00 4.53: 489.86 76.62
| '89 116.57 345.92s 69.85 | 1T90 : 5.81 [ 7.13 559.18 14.15
..'90 146.49 370.34 113.60 | 11.43 8.18 5.58 655.65 17.25
| '91 233.17 373.44 135.65
j 1 8 2 ,
10.46 [ 5.78 776.71 18.50
I ’ 9 2
322.14 385.71 124.48 | 20.18: 13.281 4.59 870 38 r n i i o o
1 ' 9 3 i
558.39 541.77 134.70 i 35.64 16.22 1 2.87: 1,289.59 48.28
| ’ 94 840.85 719.08 147.29 47.24 19.46
1 3 - 7 2
1,777.64 37.81
I . ’9 5 .'
1,479.50: 1,215.44s 170.02 100.29 24.92 | 2.01 2,992.18 68.32
’ 96 1,570.53 1,212.37 192.63 175.34: 0.27 f 2.47:f 3,181.47 6.36
'91 1,998.84 1,409.62 271.32 278 49 34 14 4.04 3,996 46 25.61
'98 2,308.29 1,598.94 264.48: 297 60 75.02 5.69 4,550.02 13.87
'99 3,608.01 2,008.96 323.99 513.88 47 95 6.65 6,509.44 43.1
Source: HSIP Administration, Taiwan. 2000.
The park has replaced the EPZ in overall importance and HSIP was best
exemplified by its central involvement in the island’s global information industry.
The success of the Industrial park was tremendous: 1) the companies in the Park
contributed 31% of all invention patents granted in Taiwan in 19979 4 2)
significantly higher labor productivity; and 3) higher R&D/sales95. The state plays
a leading role in linking foreign resources and R&D organizations with respect to
9 4 1997 HSIP enterprises: total manufacturers in Taiwan = 201 K USD: 68 K USD, ITRI, Genda Hu,
1998.
9 5 1997 HSIP enterprises: total manufacturers in Taiwan = (4.2% - 6.2% ): (0.9% - 1.0 %), ITRI,
Genda Hu, 1998.
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choice of technologies for development and transfer to private industry (Evans,
1987). Taiwan’s government has been attempting to maximize the flow of
multinational corporation investment and foreign technology into the local
economy and technology itself has become increasingly internationalized and plays
a more productive role in the value-added chain, either as a part of multinational
network or a independent actors. Government technology transfer policies increase
industrial efficiency by increasing these flows and reducing costs of acquiring new
technology; the institutional arrangements “by locating closely all similar high
technology companies” help reduce transaction costs and increase speed of spill
over effects.
One common argument against the growth model of NICs is found in
Young (1995) and Kim and Lau (1994,) who claim “technical progress has played
an insignificant role in post war aggregate economic growth of East Asian NICs”;
numerous papers reviving the old approach of calculating Total Factor Productivity
(TFP) were produced. Results of these studies varied and these inconsistencies
were due to different sources, which led to very widely different conclusion; this is
because capital inputs are difficult to measure and different estimates coexist.
This is illustrated by existing estimates for Taiwanese manufacturing. The
increase in labor productivity is caused either by an increase in capital per worker
or a rise in TFP. Young (1995) found TFP growth of 1.5% in Taiwan during 1966-
1990 (Young, 1995, Table 6-1), Timmer (1998) found TFP growth for Taiwanese
manufacturing is 2.1% during 1962-1963, therefore Taiwan in technically
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inefficient and growth is simply due to increase of inputs. On the other hand, Chen
and Tang (1990) claim output growth is significantly related to TFP growth;
Chuang (1996) found strong evidence to support the view that outward economic
growth leads to more productive technology, especially in Taiwan’s two-digit
industries, which empirically support our argument “the external economies are
attributed to economy-wide trade-induced learning by doing effects.” (Timmer,
p.23, 1998)
Functional links exist between the external economies and the growth of the
developmental state, given the leaning ability for the state and private business to
internally generate change with evolutional determinism. Capital intensity in
Taiwan’s manufacturing is still low compared to advanced economies;
opportunities for input driven growth are still abundant. Accompanied with rapid
increase in the level of human capital and learning from new technology (if not
creating), Taiwan’s industrialization process was successful and could be carried,
only if it could evolve within its internal structural change to meet external
demands of the world economy.
Differing Corporate Structure from other East Asian Models
Prior to the financial crisis in 1997, the economic performance of the
emerging Asian economies has been credited to very competitive Asian
corporations that were adept at exploiting new market opportunities and attracted
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considerable amounts of foreign capitol. The typical Asian corporation has been
generally viewed as having high level of ownership concentration, leverage, and
short-term borrowing; as long as investment rates kept high, these continued to
drive output growth. Risky investments need to be compensated with high rates of
return; there is also dangerous exposure to vulnerabilities. High levels of debt must
be buffered by long-term financial relationship between companies and banks,
backed-up with government’s support in the event of shocks, “Asian alliance
capitalism”. These characteristics were viewed as one reason for the East Asian
economic success.
As ex-post facto analysis of the Asian financial crisis shows the growth
model of East Asian corporations could not withstand the combined shocks of
increased interest rates, depreciated currencies and large drops in demand. How
does Taiwan’s corporate structure differ from that in other Asian countries? While
the rest of Asia was being praised for the “Asian Economic Miracle”, Taiwan was
prepared for the worst, not to repeat the same historical mistake - the financial
turmoil of the KMT’s last years on the Mainland leading to the lost control in
China. Political paranoia and financial conservativeness made Taiwanese
corporations behave differently relative to other countries in East Asia. Corporate
structure in Taiwan differs from other Asian countries in size, ownership
concentration and financing structures. Theses differences will be examined
subsequently.
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Taiwan’s private sector grew rapidly and participated actively in
international trade, yet the KMT exhibited skepticism over growth of private
economic power in the hands of the Taiwanese and wanted a number of small
entrepreneurs instead of hard-to-control technocrats; unless they were carefully
chosen for national interests. Size-related differences caused differences in the way
business are conducted.
Cohn and Lindberg observe differences between small and large firms9 6 are
as follows and Taiwan’s successes in small business somewhat consisted in
powerful exploitation of the advantages of being small:
“Greater identification of employees with the firm.
Shortened distance between topmost and lowest levels.
Greater centralization of decision-making.
Shorter cycles
Shortened feedback time.
Greater difficulty in attracting funds for expansion,
More reluctance about risk taking
Higher labor/investment ratio.
Greater concern with financial matters.
Greater owner influence.
More product-dedicated.
More one-person domination.
Lower employee turnover.
Longer tenure at all level of employments
Less sharing of decision-making.”
Large Korean corporations may be capable of using large-scale capital-
intensive investments, but SMEs of Taiwan were eager to understand the world
market’s changing demand and timely promoted products the market needed.
Taiwanese SMEs pursued niche markets with flexible production, and were used to
9 6 Theodore Cohn & Roy Lindberg, Survival and Growth, p.2. (HD 69S6C56 C.2)
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exposure to the risk of export market fluctuation. Small business tend to tie their
objectives more closely to the product line than other objectives; investment
decisions are made based on more product-related factors, not using capital to
achieve a desired rate of return. Even entry barriers were relatively lower in
Taiwan, the SMEs tended to stick with the business that launched them and didn’t
shift dramatically or diversify with limited resources of time, money and
management. Employee turnover rates were lower and employees identified
themselves more with companies. Owners of small firms have greater concern for
their money invested and survival of the firms was the first priority, not pursing
growth or profit. The cycles for product development or R&D needed to be shorter
in small firms to cooperate with the flexibility of demand side; with one exception,
the cycle for AR, the time to collect account receivables, seems longer in SMEs.
The instability of collecting Account Receivables is one common problem among
Taiwanese enterprises.
The “more reluctance about risk taking” of corproate’s incentive on
microeconomics side, plus the “political paranoia and financial conservativeness”
of government attitudes on the macroeconomic side, reinforced each other and
limited risk-taking behavior. When the economy was booming, the smaller size is
less capable of competing with large-scale companies for the market positions;
when the economy was shaky, the smaller size seems to be less vulnerable to face
the uncertainty of market, this is supported by the experiences of Asian companies
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during the Asian Financial Crisis of 1997. Even larger enterprises in Taiwan are
still relatively small by regional and international standards.9 7
Despite having a large base of SMEs, Taiwan has larger companies. Most
companies start small and after reaching a certain level, entrepreneurs begin to use
the Modem Corporation to coordinate multiple transactions and acquire capital
from securities. As to ownership structure of big companies, Berle and Means
(1932) were the first to observe separation of ownership and control; Chandler
(1977) and North (1990) documented this institutional arrangement as a remarkable
innovation of managerial capitalism marching from inefficient family firms to
modem capitalist firms; Williamson (1979) viewed ownership diffusions as a result
of organizational evolution to multidivisional forms that could administratively
control supplier opportunism. Much of the literature on the role of Modern
Corporations is based on widely dispersed ownership; however, East Asian
corporations have long been an exception to this notion. (Fukuyama, 1996; Rajan
and Zingales, 1998)
Claessens et al (2000) found in East Asian countries, there is only one
shareholder who controls more than two-thirds of all firms, separation of
management from ownership is rare, and control is enhanced through pyramid
structures and cross-holdings among firms. In the case of Taiwan, the ownership
stmcture was actually widely dispersed if we excluded the Kuomintang’s corporate
holdings, in which many of them operate in industries related to national interests.
9 7 Semkow. Taiwan’s capital market reform. 1994.p.71.
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Followed by founding father Dr. Sun’s ideology, the concentration of wealth was
undesirable and the “equality of distributional wealth” was one of the great
responsibilities for developmental state to achieve for the people. The regulatory
authorities, in particular Ministry of Finance (MOF) and Securities and Exchange
Commission (SEC), have primary tasks of in achieving greater capital-market
efficiency and in keeping investor safety. The users of the capital market are large
corporations wishing to finance growth; the suppliers to the capital market consists
primarily of individuals, and some part of institutional investors and corporations
with surplus funds in order to make portfolio investment in the securities.
Based on data of SEC Statistics Bureau in 2000, Figure 5 indicates
distribution of ownership structure in Taiwan for all TSE-listed (Taiwan Stock
Exchange) companies. As shown in Figure 5, most TSE-listed companies belong
to the categories of either “less than 10 percent” or “between 10 and 20 percent” of
total share-holding belongs to the big shareholders, in contrast to the generally high
concentration ownership of Asian countries. Furthermore, the TSE-listed
companies should be the most widely held companies in Taiwan, because non
listed public and no-public companies won’t have to subject to the prudential
regulations under Securities and Exchange Law (SEL) which regulates and
supervises the public offering and issuance of securities. The larger unlisted public
companies are narrowly held either by privately family business group or by the
government. Given the relative small numbers of incorporation rate and public
listing rate, it provided one possibility that companies are narrowly held by big
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shareholders wanted to remain control and were simply not compelled to seek
capital through public offering on the TSE, especially after the privatization of
banking system in 1992, commercial bank-lending became more accessible to
enterprises.
Figure5
O w n ersh ip S tru ctu re
250 y
£ 200 4-
ra
| 150 f-
8 100
4-
® 50 h
0
UBig sharholders
% of big shareholders
Noticeably, individual ownership of securities in Taiwan remains very high,
compared to other major exchanges where institutionalized ownership has high
percentage; the institutional investor ownership remains low with a 9.71 percent of
share of total capital in 1968, 6.88 percent of share of total capital in 1978, to 4.3
percent of share of total capital in 1993 (TSE Fact Book, 1993, p.52), which
indicated a declining amount of institutional investor ownerships. This attribute of
high individual ownership of stock market has both advantage and disadvantage
influences. On the negative side, this high individual ownership may increase the
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volatility of stock market exchange and cause the rise and fall of Taiwan Stock
Exchange (TSE). On the positive side, the diversified ownership structure may
generally be considered to promote transparent and market-based activities than the
ownership concentrated within limited numbers of big-shareholders or families.
As Krugman argued, East Asian countries tend to adopt a system of implicit
guarantees leading to incentives to choose the highest return investments regardless
of risk; but this is not true for Taiwan. Taiwan’s companies do not follow the
typical Asian growth model: high investment, high borrowing and pursing high rate
of return, regardless of risk. Taiwanese private enterprises run a low debt-equity
ratio compared to other Asian countries and a relative low capital investment rate.
Table 9 indicated the degree of riskiness inherent in the liability structure of East
Asian Corporations before the financial crisis in 1887. Most East Asian countries
have increased leverage levels and had higher level than US; compared to other
countries, Taiwanese firms had a relatively low average leverage ratio of 0.82 in
1988-1996 while Korea’s average leverage ratio of 3.367 in the same period.
Table 998: Leverage for East Asian Countries and US, 1988-1996
Country 1988 1990 1991 1992 1993 1994 1995 1996 1988-96
Indonesia n.a. n.a. 1.943 2.097 2.054 1.661 2.115 1.878 1.915
Korea 2.82 3.105 3.221 3.373 3.636 3.53 3.776 3.545 3.476
Philippines n.a. n.a. 0.830 1.186 1.175 1.148 1.150 1.285 1.129
Singapore 0.765 0.939 0.887 0.856 1.102 0.862 1.037 1.049 0.936
Taiwan n.a. n.a. 0.679 0.883 0.866 0.894 0.796 0.802 0.820
Thailand 1.602 2.159 2.010 1.837 1.914 2.126 2.224 2.361 2.008
US 0.798 0.904 0.972 1.059 1.051 1.066 1.099 1.125 1.034
9 8 Table 6, in “East Asian Corporate : Growth, Financing and Risks over the Last Decade, by Stijn
Claessens, Simeon Djankov and Larry Lang, World Bank, 1998.
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Another argument against the East Asian growth model is most East Asian
corporations recoded high sales growth over years pushed by the excessive
investments and misallocation of funds, triggering the East Asia’s financial crisis.
In the case of large corporations, shown in Table 10, Taiwan still had a relativity
low average investment of 8.7 during 1988-86, compared to Korea’s investment
rate of 13.6 during 1988-86, almost twice higher then Taiwan, which showed
Taiwanese companies were more risk-averse than other Asian countries. Taiwanese
firms were also less capital intensive in manufacturing than Korean firms.
Table 1099: Capital investment for East Asian Countries and US, 1988-1996
Country 1988 1990 1991 1992 1993 1994 1995 1996 1988-96
Indonesia n.a. n.a 12.4 13.4 8.6 15.8 13.8 11.8 12.7
Korea 15.6 13.2 19.6 11.6 11.2 12.2 12.4 13.7 13.6
Philippines n.a. n.a. 9.1 8.9 7.8 13.5 14.1 14.5 10.8
Singapore 7.8 7.4 8.8 9.6 11.3 13.4 12.5 13.5 10.4
Taiwan n.a. n.a. 14.3 8.2 8.4 8.7 11.2 8.6 8.7
Thailand 10.4 12.3 15,0 14.9 15.0 14.7 14.5 5.8 13.8
US 3.8 3.0 -1.4 4.0 4.0 6.4 3.7 3.8 3.4
The combination of high investment and relatively low profitability made
some countries eager for foreign investment; although laws and regulations
governing foreign investments were gradually liberalized, Taiwan’s government
still regulates financial markets in a very conservative way. “Unlike the Republic
of Korea, which basically eschewed the virtues of foreign investment in favor of a
9 9 Table 5, in “East Asian Corporate : Growth, Financing and Risks over the Last Decade, by Stijn
Claessens, Simeon Djankov and Larry Lang, World Bank, 1998.
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policy that emphasized technology licensing and high foreign debt, Taiwan was not
significantly apprehensive about foreign equity holding in the industrial sector.”
(Denis Fred Simon, P. 104). Even with financial liberalization undertaken since the
1980s, Taiwan stock market was relatively closed than others in the region, and
speculative foreign portfolio investment did not get a chance to touch Taiwan stock
market during the financial crisis period; Taiwan stock market still has an
adjustable ceiling managed by government. Compared to other Asian countries,
capital inflows and macroeconomic management remained stable. There is an
interesting debate about if a financial repressed system could enhance economic
growth; however this is not in the scope of this research. Our argument is that
government needs to send out a clear message. No matter under what kind of
institutional arrangements, either the so-called the state-dominated credit-biased
system (Wade, 1988, p. 134) or the market-determined-mechanism, rules should be
clearly defined and enforced to have a more efficient economic outcome.
The combination of providing more appropriate incentives and supervising
regulations for both enterprises and financial market minimize the likelihood of a
financial crisis. Non-market allocation of investment funding more easily resulted
in rent-seeking behavior, and inefficient investment. Taiwan may not have the
most sound and profoundly developed financial market, but Taiwan’s industry does
have a high turnover rate, meaning inefficient companies go out of business
without implicit guarantees. Government virtually controlled the entire banking
system to start with the developmental stage and at one time, bank loan were biased
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to the corporate sector through personnel policies or relationship, or simply
government picked a winner. After the privatization of banking industry since
1992, the government no longer exercised de facto control of the banking system.
Conclusion
The corporate economy in Taiwan is the byproduct of its unique historical
political economy. Under export-orientation, there are five main characteristics of
corporate economy in Taiwan in supporting the growth process. These are:: 1) the
predominance of small-medium enterprises due to the colonialism and KMT’s
nationalism, 2) small firms aiming at outward economy since colonial period, 3)
the large scope of state-owned enterprises aiming at preventing excess profit for
private capitalists according to Sunist principals, 4) the political paranoid leads to
financial conservativeness and resulted in the low macro leverage and low-debt of
corporate, 5) the low incorporation rate indicating a relative underdevelopment of
corporate economy and the securities markets were also relatively underdeveloped
to finance the growth of corporations, given the growing importance of Taiwan’s
economy.
Second, Taiwan made it through the export expansion in the late 1960s,
industrial depending in the 1970s, and technological upgrading in the 1980s.
Guided by state autonomy, Taiwan was able to maximize the flow of foreign
investment and foreign technology into its economic development, not being
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exploited as dependency theorists claimed. “Learning by doing" linked outward
economic development with gradual phases of industrialization as well as from
internally generated change to increase the technological self-sufficiency.
Economic freedom in Taiwan was never suppressed despite limitations on political
participation; economic plans in Taiwan were not compulsory and private sector
investments were facilitated, not prescribed. Whatever the state was planning or
encouraging, private investors were actively investing and made independent
contributions and were responsible for their decisions. Government and business
had a tight relationship, business were facilitated, not unhampered by governmental
plan bureaucracy. However, this was emphatically different from western style
laissez-faire.
Third, the growth model of corporations differs from other Asian countries
in terms of size, ownership concentration and financing structures with smaller
sized corporations that were more widely held and had low leverage and
investment. While other Asian companies may have choose the highest return
investments regardless of risk, Taiwanese grew in an externally dependent
economic environment and under internally prudent financial regulations.
Taiwan has been credited for the growth of the small-medium enterprise
and its significance in expanding the export growths. This helped Taiwan weather
the financial storm in 1997, since small firms has greater concern about survival
capacity than those capital-intensive big firms do. When firms are smaller, smaller
firms have minimal organization; the principal-agent problem is smaller and
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agency problem becomes worse as firm grow bigger. When do firms stop growing
in size? If there are increasing costs of organization, firms face limits to growth
when, at the margin, net saving derived from internal organization falls below net
benefits or organizing tasks through the free market. If the managerial skill did not
develop with the growth of corporations, and the financial decisions are still
conservative to limit the growth, then the corporate economy in Taiwan has its
limitation for further development.
“Economic liberalization” turned into a “political liberalization” phase.
Thus, political paranoia and financial conservativeness” may not hold any longer in
the future. Furthermore, what strategies do Taiwanese companies need when the
competitive advantaged in the product lines or markets become dissipated? When
Taiwan faces the challenge from economic growth of China; how to balance out the
political dilemma is another critical issue.
Understanding the growth of corporation is a key element in realizing the
progressive growth of national economy. In the next chapter, we will define the
internal structure of Managerial Corporation in which business operates nowadays;
then we will do further analysis in the following two chapters, using statistical
techniques to empirically test the relationship between company’s growth and its
internal structures such as the ownership and financial pattern.
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Ch5. The Nature of Modern Corporation
The Evolving Modern Corporation
Institutions matter. The role of the Modem Corporation differs from those
of join-stock companies in the 18th century that classical political economists
discussed. What we call the “corporation” or later described by the NIE
economists as the “firm” is an institutional change that gave an extraordinary
contribution over the years in facilitating increasing productivity in manufacturing
in the nineteenth and twentieth centuries, which was the most technologically
advanced sector. The managerial large corporation has been credited for
facilitating the economic growth.
We see the managerial corporation as our daily production organization in
all different industries as well as in all different countries, industrialized or low-
income, socialist or capitalist. Starting with Berle and Means’ The Modern
Corporation and Private Property (1932), there are many publications discussing
the emergence, development, and role of the modern business enterprise, for
example, The Managerial Revolution by James Burnham, Strategy and Structure by
Alfred Chandler and Galbraith’s The New Industrial State. The power of the large
corporations and the emergence of the professional manager both contribute to the
advantages of internalizing contractual transactions and the effects on economic
growth. Those professional managers came into those enterprises where the
technology of production required several processes to be carried on within a single
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factory, which is internalized. However, the problems introduced by the rise of the
managerial corporations are also recognized within the principal-agency constraint
for its monitoring and shrinking. In these new enterprises, a managerial hierarchy
was created to supervise the production process in order to integrate mass
production with mass distribution.
Most large-scale enterprises are organized in the forms of conventional
business corporations, in which firms are owned collectively by investors.
Economists have begun to seriously question if profit maximization is the sole
objective for the large modern corporation, when managers hold little equity in the
firm and shareholders are too dispersed to enforce value maximization. The profit
maximization assumption is violated when the principal-agent conflict exists. The
manager will pursue his own utility maximization at the expense of the owner’s
profit maximization. Berle and Means also criticized the archetype neoclassical
firm as being based on a small scale of production and the orthodoxy economics
failed to recognize the major institutional change - the emergence of large
corporation. Despite its importance and contribution to the economic activity, the
large corporate control dilemma had been main concern as a social problem.
In relating neoclassical economic theory to the real world, Berle and Means
felt neoclassical theory clearly portrays activities of firms of the American and
British economies of the eighteenth and early nineteenth centuries, not the
twentieth century. Each firm was directed by the principles of competition and
profit motive; the firm’s scale of production was small and had no power to block
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entrance of market or determine the market price beforehand. Price was determined
during the trading or bargaining process by sellers and buyers determined by
supply and demand. Hence the market was extremely competitive and price was
flexible. However, with the advent of the Industrial Revolution, small owner-
controlled and operated enterprises could have grown into large factory and large
corporations controlled and operated by managerial supervision, large corporations
dilemma exits when principal-agent conflicts persist. Market price couldn’t have
been as flexible as before the appearance of managerial corporations and the big
enterprises did sometime exercise the power to distort the wages and market prices
bringing abnormally high profits.
Neoclassical economic theory, taking the institutional framework as given,
is becoming irrelevant to the real US economy of the twentieth century. In
Neoclassical economics, the firm is a black box, represented by a production
function. Although firms have an objective, profit maximization, the neoclassical
approach focuses on aggregate firm behavior (markets) rather than the individual
firm itself. “Institution matters” and the importance of taking the corporation into
account should not been omitted. Institutional changes would necessarily arise form
internal structure change resulting from, such as the incentives, the division of
labor, decision-making and external relations.
Growth of enterprises incited the structural changes and development of
managerial corporations. Although few would dispute the claim that the modern
corporation is a remarkable institution, there is less general agreement over the
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factors consisting of its behavior, evolution and performance. In the following, we
are going to explore in detail the nature of Modem Corporation in terms of its
Corporation governance, limited liability, separation of ownership and control, and
internal structure change form U to M organization and also examined other
alternative definitions of corporations in theories.
Definitions of Modern Corporations
Legal characteristics of corporation. In modem era, the corporation is the
dominant form of organization in legal environment for business, for example, in
the USA, “corporations” own 59 percent of all business assets, including land,
buildings equipments and intangible assents such as patents or brand names1 0 0 ;
however, it is not the only form a business may take, the other major forms for
business organizations including the sole proprietorship, the partnership, and the
limited partnership. Numerically speaking, there are fewer corporations than other
forms of business, however it is the “corporation”, especially the leading
corporations dominate the business environment, mold public opinion and
influence national policy on numerous issues domestically and internationally. The
business must be incorporated and a legal process must be taken; once formed, the
corporation itself is a legal entity separate from the individuals or investors and
has a perpetual existence unless formally dissolved. Traditionally, Anglo-
1 0 0 Board of Governors of the Federal Reserve System (1994).
I l l
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American law views the corporation is a separate legal person with its own rights
and obligations, separated form those of its shareholders. The concept of the
corporation as a separate legal entity led to the acceptance of the principle of
limited liability which embraces the rule that shareholders are not liable for the
obligations of the corporation beyond their capital investment.
What are the firms, who owns the firms, what’s the governance structure of
the corporation, how do they behave and what’s the relationship between the
ownership and corporate governance? In the broadest definition of corporation in
economic literature, the “owners” include all suppliers of finance for the firm,
stockholders and other lenders as well. Legally, the shareholders in a corporation
are considered to be its owners, they invest money in the enterprises through the
purchase of stock and do not participate in the management or daily operation of
the corporation unless they occupy some executive position other than
shareholders. Lenders collected interest and principle, and the “shareholders” get
to claim the residuals of corporation income. Generally, each share of common
stock is entitled to one vote. The only corporate control that shareholders exercise
is through the election of the board of directors. Those who own sufficient shares
can indirectly control the corporation through the election of a board of directors to
carry out shareholders goal. Those who own only small amount of shares, although
able to vote, will have no effective voice in corporate affair. In large publicly held
corporations, shareholders that are dissatisfied with management may simply sell
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their shares back to the market. But in a small privately held corporation in which
there is no market for the shares and may have trouble finding a willing buyer.
Corporations must have Directors as the judicial mandate. A corporation
is organized by group of people such as officers, directors, employees, and
shareholders, all have certain functions within the corporate organization. What
distinguishes between an organization and a mere collection of individuals relies on
its structure. A mob or a crowd has no formal structure and even more it can give
rise to particular modes of behavior but cannot make a decision. From the legal
perspective, two of the most important group of member is the shareholders and the
directors. The board of directors of a corporation is vested with the duty to manage
the corporation. Traditional corporation statutes provide that “business and affairs
of a corporation shall be managed by a board of directors” in large corporation
especially, but also in many smaller ones as well. In reality, the boards of directors
are not involved in the day-to-day decision making of the business. The officers of
the corporation, who are elected by the directors, make these decisions. However,
the board of directors is legally responsible for the management of the corporation.
Typically, the board of directors meets only six or eight times per year. In fulfilling
this responsibility, the directors must operate as a board and the board only has
authority to act as a group; one or two directors could not act independently. (The
legal environment for business, p.295) What boards of directors are supposed to do
is governed under corporate law in USA that is expressed in detail in Appendix A.
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Limited liability. “Substantial industrial development took place both in
England and in the United States under legal systems imposing liability on
shareholders for corporate obligations before limited liability emerged in the
United States around 1825 and in England in 1855. Limited liability is a statutory
development that represents the triumph of the rising political power of business
interests.1 0 1 (Phillip Blumberg, p. 850) One of most important innovations of
“corporate” organizational advantage is its limited liability in legal system,
meaning shareholder are not liable for the obligations of the corporation beyond
their investment money. For three decades after the United States generally had
accepted limited liability, limited liability remained a highly controversial issue in
England. On one hand, the reluctance of the English to accept limited liability still
criticized the limited liability as speculative and fraudulent, and thus would lead to
uneconomic promotions.1 0 2 On the other hand, the need for accumulating capital to
invest in large modern business enterprise led to an increasingly larger number of
shareholders and widespread distribution of shares. With the growth of economic
activity and the increasing power of corporation, the beneficent policy of limited
liability was becoming an important consideration to investors. President Charles
W. Eliot of Harvard University once termed limited liability as “by far the most
i m
effective legal invention for business purposes made in the nineteenth century.”
1 0 1 Phillip Blumberg, Limited Liability and Corporate Groups, the journal of Corporate law, p.547,
1986.
1 0 2 Todd, Some Aspects of Joint Stock Companies, 1844-1900, 4 Economic History Reviews 46,
1932.
1 0 3 Cook, “Watered stock”, 19 Mich. Law Review 583 n.4 1921.
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The corporate form evolved based on business practice and in the face of
commercial pressures from a need for heavy investment; limited liability has
evolved as an incentive to commercial activity. Each shareholder's liability for
corporate debts is limited to the value of her shares. Nowadays, limited liability of
corporate shareholders is ultimately accepted, enforced and practiced as legal
principle in Western society as well as worldwide. In earlier stages of capitalist
development, individual capitalists played a central role in the accumulation
process; the fundamental transformation during the late nineteenth and early
twentieth centuries made the process of capital accumulation institutionalized in the
large corporation.
The arguments on the limited liability has been for a long time, as early as
in the late eighteen century, the economists such as John Stuart Mill already
advocated the idea that the limited liability of corporation facilitate investments of
saving by the middle and working classes. (See chapter 2) The popular concept of
the economic ideas was that the limited liability is a necessary stimulus to the
accumulation of capital for investment and then it is important to the creation of
securities markets. The existence of many widely held companies in the real world
mirrors this popular notion about the limited liability of corporation1 0 4 . Why choose
the corporate form to obtain Limited Liability? By definition, capitalism us usually
defined as an economic system in which the means of production are privately
1 0 4 There has been a debate about the limited liability vs. unlimited liability. Need more
information, refer to Paul, Halpem, Michael Trebilcock, Stuart Turnbull, “An Economic Analysis of
Limited Liability in corporation Law,” 30 U. Toronto L. J. 117,1980.
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held. The private ownership of the means of production involves a number of
separate functions such as “the provision of financial capital, the employment and
coordination of the factors of production, the management and administration of
the entire enterprise, and the ultimate power of making strategic decisions about
investment.” “The existence of capital markets and intervention of the principle of
limited liability makes it possible completely to separate the supply of financial
capital form all the other function, like the hiring of inputs and the functions of
routine management and administration can be almost completely delegated to
salaried employees” (Blaug, p219)
Private individuals could choose the following form to conduct the business
- proprietorship, partnership, limited partnership, and Limited Liability
Corporation. A sole proprietor need to be full responsible for all the obligations of
his company; similarly, any person in an ordinary partnership need to take full
responsibility of entire debt of the firm. Only the rule of corporate law allows the
shareholders in a corporation are liable for the money invested and the creditor
cannot demand to pay the debt out of the individual personal assets. The innovation
of Limited Liability Corporation reinforces the growth of corporate economy and
vice versa.
From Unitary to Multidivisional form. Accompanied by the Industrial
revolution, the late nineteenth century witnessed the emergence of large, single
product, multifunction corporations which were organized in a unitary (U) form
and prevalent in the industries of steel, meat-packing, tobacco, oil, etc. (Chandler,
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Strategy and Structure, 1966, chapl.) The productive activity is broken down into
a series of specialized elementary operations. This type of organization presumably
attempts to exploit potential economies of scale by using more efficient techniques
and equipment to reduce unit cost. They vindicate the investment in cost-reducing
technologies and allow workers to be more specialized. With the expansion of size
of firms, the U-form type of organization faces serious coordination and incentive
problems as concern expressed by Berle and Means when they observed the big
corporation dilemma resulting in a separation of ownership form control, which has
often been replaced by the multidivisional form of organization (M-form).
Chandler described the M-form structure was first adopted by early-
diversified firms such as Du Pont and General Motors in the 1920 and became
prevalent after World War II. In extending Chandler’s work, Williamson described
the multidivisional structure as “the most significant organizational innovation of
the twentieth century” (1985, p.279) and the M-form innovation was designed
mainly in response to the control loss experience of the large, diversified U-form
firm. M-form structures are more efficient in terms of allocating resources and
decision-making in large diverse businesses. As the size of firms grows, the
increasing returns to scale have their limits. Two example are given by Tirole
(p. 18,1988), “Machines or functional divisions related to two production units can
be advantageously pulled together only if they are not employed to their capacities.
Similarly, the savings in peak-load capacity associated with the pooling of risk and
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the law of large numbers become smaller and smaller as the size of the firm
grows.”
According to Chandler (1969), the unitary form collapsed with the
horizontal expansion of firms due to the loss of control by the top managers.
Because of the increasing variety of business and the number of divisions, the
company operated an overload and need to hire more mangers in the corporate
office. However, the top managers no longer had time to maintain personal contact
and evaluate the performance of operating officers. Basically the top management
could use two methods to control the functional division: rewarding each functional
division for good performance and supervising the divisions directly in order to
assess individual contributions. The first method faces the so-called Alchian-
Demsetz-type team problem. The sales of a product or the profits of the firm
depend on the teamwork - the sum of quality of each division’s performance. It
faced the accounting problem of separating the contributions and rewarding the
various divisions. The second method was only employed when the firm’s size
was small.
The corporate governance and control dilemma
The separation of ownership and management has both advantages and
disadvantages. Those who have capital can invest and employ it productively ever
if they are not good managers; those who can manage but lack capital However, the
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primary meaning of governance in the economic literature is the concern to
enhance the corporate performance via the supervision, monitoring, of management
performance and ensuring the accountability of management to shareholders.
Economists such as Berle and Means (1932), Marshall (1920) and even back to
Adam Smith (1776) have long traditionally discussed the underlying conflict
problem of corporate governance. For example, Adam Smith doubted the ability
of managers of joint stock to manage company efficiently and expressed his
concern about put the principal-agent problem:
“The trade of a joint stock company is always managed by a court of directors.
This court, indeed, is frequently subject, in many respects, to the control of a
general count of proprietors. But the greater part of those proprietors seldom
pretend to understand anything of the business of the company, and when the spirit
of faction happens not to prevail among them, give themselves contentedly such
half yearly or yearly dividend, as the directors think proper to make to them. This
total exemption form trouble and from risk, beyond a limited sum, encourages
many people to become adventurers in joint stock companies, who would, upon no
account, hazard their fortunes in any private copartnery!1 0 5
Furthermore, to Smith, the principal-agent problem was worsened when
joint-stock companies grew larger or even became international corporations.
The directors of such companies, however being the mangers rather of other
people’s money than of their own, it cannot well be expected, that they should
watch over it with the same anxious vigilance with which the partners in private
copartnery frequently watch over their own. Like the stewards of a rich man, they
are apt to consider attention to small matters as not for their master’s honor, and
very easily give themselves a dispensation from having it. Negligence and
profusion, therefore, must always prevail, more or less, in the management of the
affairs of such a company.. .It is upon the account that joint stock companies for
1 0 5 Adam Smith, An Inquiry into the Nature and Cause of the Wealth of Nations, vol. 2, P.264,
1776/1976 (Oxford University Press)
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foreign trade have .. .very seldom succeeded without an exclusive privilege; and
frequently have not succeeded with one. Without an exclusive privilege they have
commonly mismanaged the trade. With an exclusive privilege thy have both
mismanaged and confined.”1 0 6
The separation of ownership and executive decision-making in the joint-
stock company allows firm behavior to deviate from profit-maximizing, cost-
minimizing goals. The term “corporate governance” is narrowly applied to the
questions as “the structure and functioning of boards of directors or the rights and
prerogatives of shareholders in boardroom decision-making. (Blair, 1995,pp.3) Or
it could be more loosely defined as the “whole set of legal, cultural, and
institutional arrangements that determine what publicly traded corporations can do,
who controls them, how the control is exercised, and how the risks and returns
from the activities they undertake are allocated.” (Blair, 1995) However, we
should distinguish the term of “corporate governance” and the term “governance
structure” carefully; the governance structure is in a much broader sense; and the
terms such as structure, system, and social organization could be uses
exchangeable. (Coleman 1991,p. 8) At any time, the property-rights in an economy
are determined by a “governance structure” and the corporate control- providing
the effective restraints on managerial discretion, are governed by “corporate
governance”. The neoclassical firm is defined as a production function (a
technological construction), transaction cost economics describes the firm as a
1 0 6 Adam Smith, An Inquiry into the Nature and Cause o f the Wealth of Nations, vol. 2, P.700, 1776
(Oxford University Press)
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governance structure (an organizational construction). According to the first
definition, the firm is a technological black box in which inputs are transformed
into outputs without reference to organization. According to the second definition,
firms and markets are alternative modes of governance (Coase, 1937), and “the
allocation of activity between firms and markets is not taken as given but is
something to be derived.” (Williamson, 1996, pp.7)
Despite being an efficient economic organization, the corporate dilemma
arises from the separation of ownership from control. The structures that constrain
the manager’s pursuit of self-interest at the expense of the owners’ (shareholders’)
interests are nowadays termed the “ corporate governance ” of the company and
aim to improve management efficiency due to the principal-agent problem. Those
who study corporate governance emphasis on the need for decision-maker in the
firm being hold accountable to shareholders for their actions and how it could be
accomplished by a number of methods employed within corporate governance.
Those who have capitals can invest and employ it productively ever if they
are not good managers; those who can manage but lack capital can hire capital in
the markets. The separation of risk bearing from employment is a form of the
division of labor and the claims such as bonds or stocks that can be traded
separately from employment allows investors to diversify their investment
interests. However, the existence of large corporate control dilemma is inherent
within the nature of modem corporate form itself. To begin with, the corporate was
invented because the costs of organizing a given exchange internally are expected
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to smaller than the market transaction cost. However, the internal transfers are not
always less costly than market exchanges. As Coase (1937, p.340) points out “as a
firm gets larger, there may be decreasing returns to the entrepreneur function, that
is, the costs of organizing additional transactions within the firm any rise.” The
agency cost arise from the separation of management and risk-bearing; in a big
corporation, the holdings are widely scattered and investors will be less effective
monitors or even no investor is big enough to have incentive to monitor. The
dilemma itself became identified and one of its characteristics along with the
development of corporation. The limitations and advantages of internal transfer
versus market exchange led to the whole body of literature dealing with transaction
cost, the concept of which is analyzed in the following section.
In Conclusion, there are five ways to distinguish the modem corporations
from traditional corporations. First, traditional enterprises were normally short
lived and Modern Corporation has its owe identity and a perpetual existence unless
formally dissolves. Second, the traditional enterprises were single-unit enterprises
and Mordem Corporation is multifunctional enterprises. Third, the ownership and
management is separated. The traditional enterprises are managed by owners, and
the modem corporations are managed by managers, when a manger died or left an
office, there is another one was ready to take over. Fourth, the traditional
enterprises were financed by individual capitalist; the process of capital
accumulation in the modern corporation became institutionalized and diverse by
giving bonds or stocks. Fifth, the hierarchies that came to manage the modern
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corporation had a life of its own and have both benefits and costs for shareholders -
what we call corporate control dilemma due to the principle-agent problem.
The Alternative Definitions of Corporation
Are “firm” and “corporation” synonyms? The earlier economists discussed
the role of “corporation” more frequently and in recent economic trend, the “firm”
which is the term used more often beginning by the theory of the firm proposed by
Coase. The notions of “corporation4 4 or other alternative names such as “firm”,
“hierarchy”, “vertical integration” is by no means simple; sometimes they mean the
same thing, and sometimes they have been given various meanings in the literature.
The frequently used different definitions of the firm reflect different facets of the
notions and could be thought of as complementary, not necessarily as conflicting
concepts. The basic unit of analysis in this research is the “corporation” itself and
following we begin with examining the alternative names used in the theories of the
“firm” and the meanings that economics have given the term1 0 7 based on different
concepts. These changes in economic organization and activates were reflected in
diverse ways in the realm of economic theory.
1 0 7 Richard Poser argued that the corporation is simply one type of firm, and the legal regulation of
the corporation deals with the characteristics that the corporation shares with other types o f firm as
well as the characteristics that distinguish it form other types of firm. (Economic Analysis of law
289-292) Here, we use the term of “corporation” or “firm” in a more broad definition and these two
terms could be used interchangeably in a more loose definition.
For helpful taxonomy and analysis o f different enterprise forms, see Henry Hansmann, Ownership
o f the firm, Journal of Law. Econ & Organization 27 (1988).
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Corporation as Transaction Cost Economizer. Why so much economic
activity is carried on by firms rather than by individuals in the market? Ronald
Coase (1937) in his seminal paper on “The Nature of the Firm” pointed out the
firms are institutional arrangements for the purpose of transaction cost minimizing.
The role of transaction costs in determining the nature and behavior of economic
organization has emerged as a major issue in recent years. Transaction cost means
costs involved in ordering economic activity through voluntary exchange. The
boundary of the firm is set by the point at which internal relationship and external
market-based relationship have the same costs. To buy from market or to make
within internal structure, the decision is determined by the transaction cost and
firms are regarded as transaction cost economizers.
In his article, “ The nature of the Firm”, Coase suggests a conception of the
firm as a distinct alternative to market exchange:
Outside the firm, price movements direct production, which is coordinated
through a series of exchange transactions on the market. Within a firm, these
market transactions are eliminated and in place of the complicated market structure
with exchange transactions is substituted the entrepreneur -coordinator, who
directs production. It is clear that these are alternative methods of coordinating
production.
We use the following examples1 0 8 to contrast the two methods of organizing
production. The entrepreneur could contract with a person to supply the
component parts, with another to assemble them, and with a third person to sell the
1 0 8 Example provided by Richard Poser, Economic Analysis of Law. Chl4, 1992. Or this example
has its original roots in article by Ronald Coase, The nature of the Firm, 4 Economica. 1937.p 386-
p405. (needs to be chosen between the two)
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finished products. Or, he could hire them as employees to perform these tasks
under his direction. Each method has its costs and problems. The first requires the
details of the supplier’s performance and, if any circumstance changes, the agreed-
upon performance may not be reached and need to be renegotiated. This first
method (market) encounters the problem of high transaction cost. The second
method (the firms) involves the incentive, information, communication and
monitoring costs; or as it is so-called the agency cost. It is the agency cost rather
than the law of diminishing return that limits the efficient size of firms.
Diminishing returns only limit how much of a single product a firm can produce
efficiently.
However, some economists argued, as Steven Cheung put it, “It is not quite
correct to say that a ‘firm’ supersedes ‘the market’; rather, one type of contract
supersedes another type. It is more important to ask why contracts take the forms
observed and what are the economic implications of different contractual and
pricing arrangements, rather than to press the issue of what is or is not a firm”
(Jensen and Meckling1 0 9 , 1976)
Corporation as “nexus of contracts”. In corporations, there are many
participants such as production employees, managers, equity investor, debt
investor, and holders of warranty.. .etc. They often participate voluntarily and
those arrangements are made upon contracts and on positive law, not on corporate
law or the status of the corporation as an entity. Often the corporations are
1 0 9 Jensen and Meckling, “Theory of the Firm: Managerial Behavior, Agency cost and Ownership
structure”, Journal o f Financial Economics 223-33.
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regarded as a “nexus of contracts” of a set of implicit and explicit contracts. The
firm is defined as a “ nexus of contracts” which was first used by Jensen and
Meckling (1976), where economic agents try to minimize exchange costs and
competition between various contractual arrangements leads to equilibrium in the
form of the firm.
The firm is a long-run contract relationship. “The Williamsonian theory of
long-run relationship suggests that firms should write long and detailed contracts
where that is feasible and not too costly, and that the incentive to do so increases
with the lack of ex-post outside opportunities and the specificity of investment.”
(Jean Tirole, p.28 the theory of the firm). For example, when a supplier must
design products specialized to a buyer’s particular order, once the tow parties have
traded, for the benefit of the current and future trading, those two party staying
together can yield a surplus relative to trading with other parties. According to
Williamson, asset specificity is a fundamental force for the creation of transaction
cost and the consequent replacement of markets with corporate organization.
However, in practice, contracts are not necessarily complete if the
conditions of bounded rationality, asset specificity, and opportunism are present;
then the firm is regarded as an incomplete contract. Coase (1937) and Williamson
(1975) have distinguished three types of transaction cost associated with
contracting. First, in a complex and unpredictable world, some contingences are
hard to think ahead at the contracting date. Second, even all contingencies are
foreseeable, there are just too many to write completely into the contract. Third,
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monitoring and enforcing contracts may be costly. As a result of these three
contracting cost, a contract may be incomplete and also be short-term to specify the
parties’ obligations only up to some date. Because writing a good contract is itself
costly, in an incomplete contracting world, to determine what happens in an
unspecified contingency could be resolved by external arbitration in the setting of
dispute or by the authority to redistribute the gains from trade.
Corporation as Vertical integration. Another name for the firm is
vertical integration. Vertical integration refers to the situation where a firm
produces some input into its final output. The inputs could largely include the raw
materials, or services such as legal counseling, or some channel distributions such
as warehousing or even retail outlets. Similar reasoning as we discussed before in
how to set boundary of a firm, instead of purchasing the inputs form another firm,
the decision to make rather than buy is simply the decision to organize the
production through firms rather than through contract.
Should a business function be vertically integrated? Increasingly,
economists have acknowledged this is the wrong question. The right question is
“to what degree a function should be integrated, whereby integration is a
continuum anchored by the options of market and hierarchy (Williamson, 1985).
Movement along the continuum from market contracting to unify governance is
accompanied by an increased degree to which resources are placed at hazard. The
firm is compensated for this by an increased level of control it presumable will use
“correctly” to generate superior profit outcomes. The central questions of
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transaction cost analysis are twofold: When will the firm need more control (that
is, when do lower-control outcomes becomes less desirable), and when will the
benefits of increased control more than offset the costs of resource commitment and
risk?
This vertical integration view credits firms with superior access to
information and greater managerial control and flexibility. In Markets and
Hierarchies. Oliver Williamson (1975, p29-30) ascribes to the firm superior
auditing and conflict resolution properties: internal auditors are believed to have
superior access to the information necessary for decision-making; and internal
dispute resolution mechanisms are perceived as more responsive to changing
circumstances than court adjudication, structure of exchange have also formed the
basis for formal models of the vertical integration decision, such as Kenneth
Arrow's analysis that treats integration s “essentially a way of acquiring predictive
information”.(Joumal of Law and economics. 1988.p. 183)
It is not always without ambiguity to distinguish the horizontal and vertical
aspects of a firm’s size. The horizontal dimension refers to the scale of production
in a single-product firm or to its scope in a multiproduct one. The vertical
dimension reflects the extent to which goods and services that can be purchased
form outsiders are produced in house. A wallpaper manufacturer merging with
another wallpaper manufacturer or a tile producer engages in horizontal integration;
a winemaker purchasing a bottle or cork factory engages in vertical integration.
Horizontal integration may also be motivated by the desire to exercise monopoly
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power. The obvious example is a merger of two firms producing the same product
is often meant to increase profitability by making the firm a price maker, not a price
taker. Such mergers were prominent during the great merger wave in the 1990s
and increased with closer integration of world markets through finance and trade.
Corporation as Authority. Philosophers as diverse as John Lock and Karl
Marx were concerned about the abuse of power caused by the concentration of
property in the King (government) or in the capitalist (business). This diffusion of
power reflected their concern that an all-powerful central government could easily
abuse its authority; however, concentrations of power are not limited to the
government. New concentrations of power arose in the late nineteenth century as
very large corporations developed. Before the Industrial Revolution, most
businesses produced products sold by the maker directly to the purchaser. With the
growth of mass production techniques tied to improved systems of delivering
goods, many businesses grew larger.
Coase says “If a workman moves from department Y to department X, he
does not go because of a change in relative prices, but because he is ordered to do
so. The distinguishing mark of the firm is the suppression of the price mechanism.”
Armen Alchian and Harold Demsetz offered a major indictment of authority-based
theories of the firm in their 1972 article: “It is common to see the firm
characterized by the power to settle disputes by fiat, by authority, or by disciplinary
auction superior to that available in the conventional market. This is delusion. The
firm does not own all its inputs. It has no power of fiat, no authority, no
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disciplinary action any different in the slightest degree from ordinary market
contracting between any tow people. I can “punish” you only by withholding
future business or by seeking redress in the court fir any failure to honor out
exchange agreement. That is exactly all that employer can do. He can fire or sue,
just as I can fire my grocer by stopping purchases from him or sue him for
delivering faulty products.”
Many institutional economics shared the same thought that power is seen as
a mean by which corporations shape society and how society shapes corporations.
As mentioned in literature review, “unlike Marxists, Institutionalists do not reject the
capitalist system because of the power asymmetries between capital and labor.
Instead, they see power as part of an evolutionary process by which capitalism has
changed from the individual proprietorship system used in classical economics to one
in which power is wielded by corporations and individual workers come together to
form a "countervailing power" within unions.”
Conclusion
“Corporations” are the dominant economic and social institutions of our
day. We identified five characteristics of Modern Corporations: 1) the corporation
itself is a legal entity separate from the investors, 2) Corporations mush have
Directors as the judicial mandate, 3) Corporation is bounded with limited liability,
4) it hierarchy structure has been transformed from unitary to multidivisional from,
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5) the separation of ownership and management and its control dilemma. By
extending the conception of “transaction and information cost economics, we
could conceptualize this economic organization in many way: Corporation as
Transaction Cost Economizer, Corporation as “nexus of contracts”, Corporation as
Vertical integration and Corporation as Authority. In this chapter, I gave clear
definitions of Modem Corporation on which the empirical tests are run through in
the following research. In next chapter, I will furthermore explore in detail on the
incentive problems in the theories of firms, external constraints within the control
dilemma, and how to transfer the control type hypothesis (management-controlled
corporations perform differently from the owner-controlled corporations) into
testable growth hypothesis (management-controlled corporations perform grew
faster than from the owner-controlled corporations), to see if the Modem
Corporation is an efficient economic organization in the developmental state of
Taiwan.
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Ch6. The Impact of Control Type and the Growth of Corporation
“The Americans adjusted commercial law to meet the need of a rapidly expanding
economy and a federal polity. They made increasing use of the incorporated stock company
developed in the sixteenth century by the British to promote oversea trade and colonization and used
in the eighteenth century to manage ancillary or utilities operations such as docks, water works, and
the like.... Before the 1840s there was no revolution in the ways of doing business in the United
States. The great transformation was to await the coming of new technologies and markets that
permitted a massive production and distribution goods. Those institutional changes which helped to
create the managerial Capitalism of the twentieth century were as significant and as revolutionary as
those that accompanied the rise of commercial capitalism a half a millennium earlier.. .The
appearance of managerial capitalism has been, therefore, an economic phenomenon.” (Alfred
Chandler, p i6, 1977)
Introduction
As discussed in the preceding section, the emergence of the Modem
Corporation brought the first generation of corporate managers and the growth of
managerial corporations raised the principal-agent problem. The separation of
ownership and management is one of the most distinguished features in the Modem
Corporation, and that separation has brought both advantages and disadvantages.
Those who have capital can invest and employ it productively ever if they are not
good mangers; those who can manage but lack capital could invest efficiently and
increase the profitability. When the owner of the firm hires an agent, he might hire
a shirking manager with different incentive, which has been interpreted as a
principal-agent problem. The primary concern of corporate governance is to
enhance the corporate performance via the supervision, monitoring, of management
performance and ensuring the accountability of management to shareholders. The
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main purpose of this empirical test was to replicate Berle and Means on the
separation of ownership from control and its effect of firm’s growth
In traditional economic theory, the firm is a “black box” operated so as to
be at equilibrium when marginal inputs equal to marginal outputs, thereby
maximizing profits or more accurately, present value. The most important
implication of Berle and Means was that the fundamental assumption of profit or
present value maximization should be modified by taking into account of the
separate interest of the management due to the separation of ownership from
control. Berle and Mean’s founding may have helped bring forth interesting works
such as Baumol’s theory of sales-maximizing and Williamson’s theory of utility-
maximizing managers. However, seventy years later most economists continue to
apply traditional profit maximizing theory as if Berle and Means had never written.
This chapter examines 1) the agency theory of managerial ownership, 2) the
impact of ownership structure and its relation to the firm’s growth capability, and
3) tires to identify the empirical validity of the control type hypothesis, a
hypothesis originated from Berle and Mean’s Modern Corporation and Private
Property, implying that management-controlled corporations perform differently
from owner-controlled corporations. In this research, we address to the following
questions: how important are managerially controlled firms?
(1) Does a management-controlled corporation grow faster than owner-
controlled corporations, even if the agency problem exists?
(2) What is the evidence that different forms of ownership result in different
performance by firms?
(3) Is there a difference between the outcome of the corporation in the
developing country and developed country?
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Separation of Ownership and Management in Managerial Corporation
How important are managerially controlled firms? “Institutions provide the
incentive structure of an economy; as that structure evolves, it shapes the direction
of economic change towards growth, stagnation, or decline.” (North, 1991) The
role of Modem Corporation differs than those of join-stock companies in 18th
century as classical political economists ever experienced in the new dimension
taken by the increasing numbers, size and complexity of the companies.
The importance of corporation in economic development is to be illustrated
best by looking at the USA example; because the United States is probably the
most prosperous and industrialized country of the world. From the beginning of
founding the country, commerce became synonymous importance with freedom in
America. Because British tried to monopolize in selling goods on shores and
preventing local manufacture, the American economy started out as an agricultural
economy and relied heavily on imports for most manufactured products. In two
centuries, this country has been modernized into an industrial giant. Employment
rate in agriculture declined from 95 percent of the total in 1776 to 50 percent in
1876, and declined further to only 4 percent in 1975. The relatively increasing
employment in manufacturing was 20 percent in 1876, 44 percent in World War II
and about 25 percent in 1975. (Jules Backman, 1976) “Enterprises organized under
the corporate form accounted for 97.5 percent of total business receipts in
manufacturing, 87.1 percent in mining, and 92.7 percent in regulated industry in
1965.” (Oliver Williamson, corporate control and business behavior, p.5). What
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we call the “corporation” or later described by the economists the “firm”, facilitated
the increasing productivity in manufacturing in the most technologically advanced
sector. The managerial large corporation has been credited for facilitating the
economic growth.
In The Modern Corporation and Private Property. Berle and Means were
first to distinguished the separation between management, ownership and control.
They criticized that the archetype neoclassical firm was one based on a small scale
of production and the orthodoxy economics failed to recognize the major
institutional change - the emergence of large corporation. The book showed that by
1930
(1) roughly three quarters of the business wealth of this country was
already held by corporations; (2) practically half of this corporate
wealth was controlled by the 200 largest; (3) a substantial part of
this wealth involved a separation between ownership and control;
and (4) the free market system had shifted from one dominated by
markets in which competition was among the many to a system of
such markets combined with markets in which competition was
among the few, with significant market power in the hands of
management’s. (Means 1983,469)
According to the theory of perfect competition which was first developed
by Adam Smith, prices are determined by the invisible hand of market forces and
not by individual firms due to competition among many small producers. It is the
hunt for profit which produces these prices. To paraphrase Adam Smith in the
Wealth o f Nations, it is not because of man’s inherent goodwill that we get our
food, clothing or shelter. Instead it is the blind pursuit of individual self-interest
and the making of rational choice which provides these items in sufficient
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quantities and at the lowest possible cost. Traditional economists view that the
utility function of owners and managers are synonymous; therefore both of them
try to maximize the firm’s profitability. However, starting with the work of Berle
and Means (1932), economists have begun to seriously question if profit
maximization is the sole objective for the large modern corporation. In particular,
Berle and Means (1932,p.69) claimed that “as the ownership of corporate wealth
has become more widely dispersed, ownership of that wealth and control over it
have come to lie less and less in the same hands.” With the increasing dispersion
of large Modem Corporation, the manager might pursue his own utility
maximization at the expense of the owner’s profit maximization. The profit
maximization assumption is violated when the principal-agent conflict exists.
Modem corporations are characterized by the separation of ownership and
control and there has been a raucous debate in the economics literature about the
effect of this separation. The incentive problem arises when decision making in a
firm is in the hands of managers who are not the firm’s security holders.
Incentive Problems and Theories of the Firms
According to Means, ownership is synonymous with the stockholders while
“management of the corporation consisted primarily of the senior and junior
officers and the board of directors [and] control was the power to direct the
corporation’s activities and determine the distributions of corporate profits.” (Lee
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1990, p.680) It is management which exercises control, according to Means, not
the owners. Incentive problems arise in situations where ownership and control of
economic resources are separate and monitoring costs are non-negligible. As those
who exercise control are not those who own, there can be differences in the
incentives for mangers and those of shareholder (owner). For example, managers
are interested in building up a vast corporate empire while shareholders are
interested in expected profits. The objective of maximizing profits is no longer
appropriate. This can lead to a clash between these two desires and an imbalance
between saving (the purchase of securities by shareholders) and investment (the
purchase of capital goods by companies). Even within the same group of
shareholders, the one whose interest is short-term return will have different interest
than those one who have long-term investment goals such as education fund or
retirement plan. What is left in place of profit maximization is the need to be taken
into consideration of various goals involved within the corporation.
In 1966, Fritz Machlup was the first to bear the title of “Theories of the
firms: Marginalist, Behavioral, and Managerial. “ He made the classical
distinguish for theories of the firms and this division was widely followed in
subsequent discussion. Viewing “firm” as an individual who tries to maximize the
money profits is the central assumption of Marginalist theory. Behavioral and
Managerial theories of the firm (Baumol [1959]; Simon [1959]; Cyert and March
[1963]) both reject the classical model of an entrepreneur (owner-manager) who
single-mindedly operates the firm to maximize profits. Both of theories face the
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fact that corporations operate in an environment that places constraint upon their
behavior and focus on explaining the behavior of business firms in a broader
explanatory project than Marginalist theories have defined. Marginalist theories
basically are the price theories; on the other hand, Behavioral and Managerial
theories are not focusing on the aggregate price, but on the determinant of corporate
goals and the determinations of corporate behavior. However, Behavioral theories
are concerned to picture the actual decision-making process of managerial
corporation. Managerial theory focus more on the motivations of a manager and
claim that difference of ownership and control structures have significant
influences on economic performance of the firm. What Oliver Williamson1 1 0
called, Behavioral theory is a “realism in process” and Managerial theory is more a
“realism in motivation”.
More recently the literature has moved toward theories that view the firm as
a set of contracts among factors of production. Alchian and Demsetz (1972) and
Jensen and Meckling (1976) are the best examples; the antecedents of their work
date back to Coase (1937, 1960). This literature is also characterized under the
rubric of property rights because they focus on the effect of distributional rights in
the organization established by contracts. Ronald Coase (1937) in his seminal
paper on “The Nature of the Firm” pointed out that the firms are institutional
arrangements for the purpose of transaction cost minimizing. Transaction cost
means the costs involved in ordering economic activity through voluntary
1 1 0 Oliver Williamson, The Economic o f Discretionary Behavior: Managerial Objectives in a Theory
o f the Firm. P6. (Chicago: Markham Publishing, 1967)
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exchange. The boundary of the firm is set by the point at which whether internal
relationship is more expensive than an external market-based relationship or not.
To buy from market or to make within internal structure, the decision is
determinated by the transaction cost. In his article, “ The nature of the Firm”,
Coase suggests a conception of the firm as a distinct alternative to market
exchange:
Outside the firm, price movements direct production, which is
coordinated through a series of exchange transactions on the market.
Within a firm, these market transactions are eliminated and in place of the
complicated market structure with exchange transactions is substituted the
entrepreneur -coordinator, who directs production. It is clear that these are
alternative methods of coordinating production.
In general, because of bounded rationality, transaction costs and other
reasons for market imperfection, a fully complete contract is never going to be fully
carried out, whatever the different economists theories may say to the theories of
“firm” or “corporation”. If this view is correct, the company contract with every
person it deals with; however, the “voluntary contracting” is hard to achieve the
optimal allocation. Then, if it’s so, the effect of “separation of ownership and
management” is in doubt; if this distinguished feature makes the Modern
Corporation an efficient institutional arrangement? Besides, the asymmetric
information resulting from the divorce of ownership from control itself, if this is
sufficient enough to imply different business behavior between “management-
controlled” and “owner-controlled” corporation is another question. To assert that
managers are motivated to pursue self- interest is one thing, whether or not we can
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actually observe those behaviors of a manager deviating from the stockholder’s
interest is another issue. Therefore, the actual effects on “the separation of
ownership and control” remain undetermined.
Control Type, Growth Hypothesis and External Constraints
Does a management-controlled corporation grow faster than owner-
controlled corporations, even if the agency problem exists? Firms (corporations)
provide owners with a managerial structure enabling the reduction of transactions
costs through supervision of workers and the production process, but they also
create a principal-agent problem and increase the costs of monitoring managers.
When the ownership of the corporation is widely dispersed, stockholders have little
ability to monitor and discipline the performance of managers. A large and
incasing share of large corporation are controlled by self-perpetuating managers,
who determine their own destinies and treat their stockholders like creditors. This
“separation of ownership and control” are asserted to have large effect on corporate
behavior due to widely divergent interests of management and stockholder. This
assertion was generally thought to imply the control type hypothesis that the
management-controlled corporations perform differently from the owner-
controlled corporations.
However, pursuing self-interests is an axiom regarding the incentives of
corporation managers, it is too general to have empirical content. To strengthen the
empirical content of the control type hypothesis, it is necessary to be more specific
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about a manager’s incentive in terms of measurable goals. Several incentive
theories of management have been proposed in the literature concerning how the
goals of management deviate from the traditional profit maximization, such as
Baumol’s sales volume (1967), or Marris’ growth rate (1967), Mosen and Down’s
lifetime income (1965) and Williamson’s staff expenditure (1972). All of these
hypothesized goals of management are positively related with one or more of the
manager’s five P’s, in terms of Pay, Perquisites, Power, Prestige and Patronage.
(Santerre and Neun, 1993). This paper considers Marris’ growth hypothesis and
uses the growth rate to characterize the goal of the managers partly because the
growth rate data is easier of access. Thus the control type hypothesis can be
narrowed more specifically into what we call the growth hypothses: a management-
controlled corporation grows faster than an owner-controlled corporation
Even if there is a possibility for a manager to pursue his own interest at the
expense of the shareholders’ interest, the corporation may have imposed some sort
of discipline power of the product market constraint etc.; he may not be able to
deviate from the stockholders’ interest even he has the incentive. For instance, if
the product market is highly competitive, managers are forced to behave efficiently
(minimize cost and maximize benefit), otherwise the corporation fails to survive in
the market, even the ownership and control are separated, we may not observe
selfish managers behaving against stockholders’ interest. There are also some
conditions that are favorable for the selfish mangers to seek out their own interest.
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Several possible situations may allow managers to behave differently from the
desires of the owners. This may occur when:
(1) the corporation possesses certain market power in the product market
(Williamson, 1963);
(2) the objective of the corporation is ambiguous (Leibenstein, 1960);
(3) the capital market is imperfect (Smiley, 1976);
(4) there is imperfect mobility in the managerial job market (Fama, 1980);
and
(5) the manager receives an incomplete incentive contract (Jensen and
Meckling, 1976).
The growth hypothesis is a proposition that is related to the incentives or
goals of management. Whether or not a management-controlled corporation
actually grows faster than an owner-controlled corporation not only depends on the
discipline power of the product market, but also on the external growth constraints.
Though managers in a management-controlled corporation are assumed to seek
faster growth for their own interest, their selfish behavior cannot be completely
exempted from certain external constraints. In the following section, we discuss
two kinds of external growth constraint generally faced by mangers: the safety and
managerial resources constrains.
The safety constraint disciplines managers’ selfish behavior through two
kinds of job tenure threat: stockholders’ revolt and the risk of the corporation being
taken over. Assuming that the stockholders’ goal is profit (a commonly asserted
stockholders’ interest in the literature), managers must attain enough profit to make
stockholders happy but need not to attain the maximum profit. “Satisfactory profit”
often suffices due to the following two reasons. First, it is practically very difficult
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to judge whether managers are pursuing maximum profit or not. Maximum profit
is such an ambiguous goal of the corporation, in contrast to sales as the corporation
goal. Second, even if some stockholders are aware that managers fail to secure the
maximum profit, the opportunity cost to unite a large number of stockholders to
replace the current management can be so high that stockholders are better off to be
content with satisfactory profit and tolerate managers’ selfish behavior. The
concept of “satisfactory profit” is not new; it has been used by Baumol (1967) and
Williamson (1972) to characterize the behavior constraint of managers. Mosen and
Downs also discuss a similar concept (p.232). As for the threat of a corporate
takeover, Marris was the first one to note that the risk of a takeover might
effectively discipline managers’ behavior. One way to reduce this risk is to attain
satisfactory profits. In short, management cannot pursue the growth of corporation
without concern for profit.
Satisfactory profits not only mean job tenure but also relate to the
corporation’s financial ability to grow. It is well known that retained earning is one
of the major sources of financing investments. Moreover, the possibility of
external financing depends upon a firm’s debt payback potentiality. Profits are
certainly one important indicator. Even more, in the contractual view of the firm, it
is generally argued that the easiest way to monitor agents (managers) is to make the
manger a residual claimant. Residual claimancy is to relate the manager’s reward
directly to the profits either by making the manager a shareholder or by tying his
remuneration to profits.
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Another kind of external growth constraint, suggest by Penrose (1959), is
the so-called managerial resources constraint. Penrose argues that managers’
ability to evaluate and coordinate investment projects is a crucial factor in
determining the rate of growth. The lack of managerial resources has been used to
explain why a corporation may grow continuously rather than maintain a particular
size for a period of time after a giant growth. It is certainly difficult to quantify
Penrose’s managerial resources constraint. The paper suggests also using the
executive compensation of managers and the size of the firm as proxy variables for
the following two reasons. First, since the cross sectional differences in
compensation among firms may serve as an indication of opportunity costs to the
firm trying to hire more qualified managers, the compensation data should reflect
more or less the differences in the endowments of managerial resources. Secondly,
since the firm will accumulate managerial resources from the previous growth
experience (from learning by doing), the larger the size, the more affluent the
managerial resources.
The foregoing discussion about the external growth constraints leads to the
following important implications. Management will successfully deviate from the
stockholders’ goal to pursue growth only if the external growth constraints are not
binding. Being lack of managerial resources and facing job tenure threat from a
stockholders’ revolt or being taken over due to unsatisfactory profits, will
effectively discipline managers’ behavior of pursuing their own interest - the
growth of corporation growth. In this case, the corporate control type should not
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matter and we should not expect to observe different growth behavior between
owner-controlled and management-controlled corporations. Test for the growth
hypothesis can be misleading if one fails to take account of the external growth
constraints.
This paper criticized the testability o f the control type hypothesis on a more
fundamental ground: we argue that testing of the control type hypothesis require
more than a dummy variable regression. To begin with, it is not clear from the
book why the separation of ownership and control in large corporation results in
conflicting interests between management and stockholders. As Stigler and
Friedland criticized, “ the burden of supporting this proposition (of conflict
interests) was assumed in a peculiar fashion by Berle” and “the actual incentives
and behavior of corporate officials received no systematic attention in the entire
volume” (1983, p.238); hence the real importance of the separation of ownership
and control in the operation of business is in suspect. It is plausible to think that
the separation of ownership and control creates what we now so-called the agency
problem resulting from asymmetric information concerning the true behavior of
corporate managers. Consequently, if the ownership of the corporation is widely
dispersed, stockholders have little ability to monitor and discipline the performance
of managers. Nevertheless, the asymmetric information resulting from the divorce
of ownership from control itself, is it sufficient enough to imply different business
behavior between “management-controlled” and “owner-controlled” corporations?
It is worthy of emphasizing again that the growth hypothesis is a proposition
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concerning the incentive theory regarding probable behavior of managers; whether
or not a management-controlled corporation actually grows faster depends the
discipline power of the external growth constraint.
This paper intends to examine the empirical validity o f the growth
hypothesis that a management-controlled corporation grows faster than an owner-
controlled corporation - a hypothesis originated from Berle and Mean’s “Modern
Corporation and Private Property”. By sorting data via the use of discriminant
analysis, we explicitly take “the growth constraints” into consideration and divide
the data into two separate groups of corporations. Within each group, we run the
regression separately to determine the real impact of control type on the growth of
corporation and examine the empirical validity of the growth hypothesis.
Data and Test Result on Corporations of USA ( I )
We obtained cross-sectional sample corporations from Table A1 of Stigler
and Friedland’s (1983)1 1 1 . Of them, 41 are owner-controlled and 29 are
management-controlled corporations. The data set in Table A1 of contains of three
variables: 1) corporation assets, 2) profits, and 3) average executive compensation
of the three highest-paid executives. These three variables are used to perform
Discriminant analysis in order to discriminate corporations into two classes:
corporations with strongly binding growth vs. corporations with weakly binding
1 1 1 Stigler and Friedland, 1983, The Literature of economics: the case of Berle and Means, Journal
of Law and Economics: the case of Berle and Means, Journal and Economics 36, 237-268.
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growth, denoted as class S and W respectively. After sorting those sample
corporations into class S and W, we use dummy variable to capture a corporation’s
control type and estimate a dummy variable regression for each class separately. If
the growth hypothesis is valid, we expect to find a significant t statistic of the
dummy variable coefficient in class W regression. On the other hand, the t statistic
is expected to be insignificant in class S regression. Due to the strongly binding
growth constraints, the discretionary power of managers will disappear and
manager’s behavior won’t deviate from the stockholder’s interest, not because he
don’t want to, but because manager is strongly bounded not to pursue his own
interest.
How do we classify a firm into either a management-controlled or an
owner-controlled firm? The corporate control type is commonly defined by how
dispersed stock ownership is. Therefore, a corporation is said to be an owner-
controlled corporation if one or few groups hold more than “x” fraction of the
voting stock and the remainder is widely dispersed; otherwise it is management-
controlled. The question is where to draw a line to separate owner-controlled from
management-controlled corporations. Obviously, it is very subjective to set x equal
to 20 percent as Berle and Means did. Lamer (1966) and Gorden (1961) used
equally arbitrary criterion to choose x equal to 10 and 3 percent respectively. Since
we have no better way to resolve this issue, we take this data set as given with the
caution that our empirical result are not independent of the quantitative definition
of corporate control type. Here, we follow the Berle and Means’ definition
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regarding the control variable in both cases of USA and Taiwan; we set x equals to
20 percent. The company is owner-controlled if one or few groups hold more than
20 percent of the outstanding issued stocks; otherwise it is management-controlled
company.
How do we choose variables to characterize the strength of the external
growth constraints, in another words, how do we define growth constrains which
disciplines managers’ behavior? Profits are certainly one important indicator; as
we explained before, whether managers are pursuing their own interests, at least,
they must attain “satisfactory profit” to make stockholders happy and run company
financially sufficiently for his own job security concern; a manager will not pursue
his own interest at the expense of job tenure. The paper suggests also using the
executive compensation of managers and the size of the firm as proxy variables for
external growth constrains based on the reasons that size is a good indicator for the
managerial resources and executive compensation is linked to the residual
claimancy of managerial behavior in which the is cretionary power of external
1 1 0
constraint could be represented .
Test Results. Based on the profits, executive compensation and the size,
STATISTICA discriminate analysis program is executed to classify sample
corporations into two classes with equal prior probability. Results summarized in
Table 11 show that 14 of the 41 owner-controlled firms are assigned into class W
and 27 of them are assigned into class S. 14 of 39 manager-controlled firms are
1 1 2 See more detailed discussion on page 13-15 regarding the control type, growth hypothesis and
external constrains.
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sorted into class W and 15 of them are sorted into class S. Note that the average
profit rate of the corporations in class W is twice as much as that of class S;
however, the profitability of management-controlled in either class is not
necessarily lower than owner-controlled corporations. There is no evidence that
management-controlled and owner-controlled corporations behave differently in
either class in terms of profitability.
Table 11 Discriminant Analysis (US)
Class W Class S
Number of owner-controlled 14 27
Number of manager-controlled 14 15
Ave. Profit rate (%) 0.12 0.06
Ave compensation ($ housands) 199.04 67.01
Ave. Size ($millions) 418.36 163.13
Next, we run a dummy variable regression for each class separately. The
dependent variable is the average growth rate in terms of fixed assets during 1924-
1929, complied from Moody Industrial Manuals, various years. There are two
explanatory variables in the regression, the control type (TYPE), and age of the
corporation (AGE). Control type is a dummy variable, which takes zero value for
an owner-controlled corporation, and a value of one for management-controlled.
Given the year when a corporation was first established (also available from
Moody’s Industrial Manuals), the age of the corporation is measured in terms of the
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deviation form the sample mean 1901.97. For example, Du Point was established
in 1915, the age of Du Point is thus 13.03; American Sugar Refining was
established in 1891, hence its age is -10.97. Including AGE as an explanatory
variable is due to Mueller’s life cycle theory (1972) that younger firms tend to
grow faster, since younger corporations have positive AGE by construction, we
predict that the coefficient of AGE is positive. Regression estimations are
summarized as follows.
Class W Regression:
Growth = 0.0845 + 0.2033 Type + 0.0082 AGE
(1.061) (1.815) (2.071)
R = 0.233 N =28, (the t statistics are included in parentheses).
Class S Regression:
Growth = 0.0518 + 0.00757 Type + 0.0021 AGE
(2.328) (0.206) (1.789)
R2 = 0.08 N= 42, (the t statistics are included in parentheses).
In class W regression, all the estimates coefficients have rights signs. For
the one tailed t test, t value of Type and Age are significant at the 5 % and 2.5 %
level respectively. Our regression results show that a management-controlled
corporation does grow about 20 % faster than an owner-controlled corporation; and
the younger the firm, the faster it grows.
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In class S regression, the t statistic of Type is insignificant and the
coefficient is small as we predicted if the corporation is strongly bounded by the
growth constraint than a management-controlled corporation does not perform
differently form an owner-controlled corporation in terms of the growth rate.
We also tried average growth rate in total assets as a dependent variable,
the results (not reported here) make little difference. Moreover, if we ignore the
external growth constraints and thereby estimate just one regression for all 70
observations, the growth hypothesis can be rejected due to insignificant t statistic of
Type. We have tested the empirical validity of the growth hypothesis, a narrowed
view of Berle and Means’ control type hypothesis. Since the managers’ incentives
to grow is unobservable when the corporation growth is bounded due to
constrained managerial resources. It is essential to take account of these growth
constraints before testing the growth hypotheses. We accomplished this through
the discriminant analysis. Our results support the hypothesis that management-
controlled corporations grow faster than owner-controlled corporations in the class
W, meaning the growth constraint is bounded, in the USA business environment.
In the following section, the same method is applied to test the sample corporations
of Taiwan. However, given the development of incorporation of Taiwanese
companies are relatively slow and new; the empirical results between the developed
(USA) and developing countries (Taiwan) are predictably quite different.
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Data and Test Result on Corporations of Taiwan (II)
We obtained 300 cross-sectional sample corporations from the public traded
companies at Taiwan Stock Exchange (TSE). Of them, 147 are owner-controlled
and 155 are management-controlled corporations. A company that publicly traded
at TSE is required by Company Law and Securities and Exchange Law (SEL) to
disclose financial information and ownership structure change. The data set
consists of corporation assets, profits, and shares hold by managers (the average
executive compensation of the three highest-paid executives are not publicly
disclosed in Taiwan). Same procedures are run as in the case of USA corporations.
These three variables - corporations assets, profits and shares-holding by managers
- are used to characterize the strength of the external growth constraints and
Discriminant analysis is performed in order to classify sample corporations into
two classes: corporations with strongly binding growth constraints (class S) and
corporations with weakly binding growth constraints (class W).
How do we classify a firm into either a management-controlled or an
owner-controlled firm in the case of Taiwan? As we mentioned in previous
section, we set x equals to 20 percent and followed the traditional classification
from Berle and Mean. The data collected from the publication of “Management of
Securities Commission”1 1 3 and “ Review of Investment information on TSE-traded
1 1 3 Source: http://www.SFC.gov.tw. Vol. 20, N ol, 2002.
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companies”1 1 4 was given as we require by definition and fit into our classification.
We classified Taiwanese companies into two categories: the owner-controlled and
the management-controlled. If one or few groups hold more than 20 percent of
total outstanding stocks of the company, then that’s owner-controlled; large
shareholders tend to be the directors on the board, the executives of the firm and the
relatives to each other. If the ownership structure is diversified into lots of small
outside stockholders (no individual or group has more than 20 percent of total
outstanding stocks) and delegate the decision-making to corporate managers, that’s
the management-controlled type of corporation
Test Results. Based on the profits, executive share-holdings and the size,
again, STATISTICA discriminant analysis program is executed to classify sample
corporations into tow classes W (weak growth constraint) and S (strong growth
constraint). Results summarized in Table 12 show that 139 of the 146 owner-
controlled firms are assigned into class S; only 7 are assigned into class W. 145 of
the 154 manager-controlled firms are sorted into class S and only 9 of them are
sorted into class W; this means all most all the corporations fit into the class S;
therefore, we claim the corporations in Taiwan are very well bounded by growth
constraint, meaning the manager won’t deviate from owner’s interest and most
likely will be seeking owner’s interests. So we will delete the class W and only run
the dummy variable regression on S. Note that the average profit rate of the
corporations in class W is much higher (almost more than twenty times higher)
1 1 4 Source: http://www.smartnet.com.tw. 2002 No.12.
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than that of class S. In the previous case of US companies, the average profit rate
of the corporations in class W is only twice as much as that of class S.
Table 12 Discriminant Analysis (Taiwan)
Class W Class S
Number of owner-controlled 7 139
Number of manager-controlled 9 145
Ave. Profit rate (%) 4.38 0.15
Ave Executive’s share 9613613 1282260
Ave. Size (NT millions) 193710 11700
Instead of running a dummy variable regression for each class separately, in
the case of Taiwan, we only run the regression on the class S and delete the class
W. The dependent variable is the average growth rate in terms of fixed assets in
the 2000, complied from the data published by TSE. There are two explanatory
variables in the regression, the control type (TYPE), and age of the corporation
(AGE). Control type is a dummy variable, which takes one value for an owner-
controlled corporation (in the case of US, we set value one for management-
controlled to capture the importance of managerial ownership structure; vice versa).
Regression estimations are summarized as follows (the t statistics are included in
parenthesis).
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Class S Regression:
Growth = - 3.57 + 0.23 Type - 0.05 AGE
(2.328) (3.74) (0.76)
R2 = 0.22 N= 284
Because the development of incorporation of Taiwanese companies are
relatively slow and new; we predict the empirical results between the developed
(USA) and developing countries (Taiwan) could be quite different. In the case of
Taiwan, the result of regression shows that an owner-controlled corporation does
grow about 23% faster than management-owned corporation, and the coefficient of
AGE is negative, meaning that the older and more well-established firms indeed
grow faster. Au contraire, in the case of US, it does show that the management-
controlled corporation grows about 20% faster and the coefficient of AGE is
positive, meaning that the younger the firm is, the faster it grows.
In conclusion, I have tested the empirical validity of the growth hypothesis,
a narrowed view of Berle and Means’ control type hypothesis. Since the managers’
incentives to grow is unobservable when the corporation growth is in adversity due
to constrained managerial resource or merger profits, it is essential to take account
of these growth constrains before testing the growth hypothesis and we
accomplished this through the use of discriminant analysis. The finding are
summarized in the following:
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Within the class W of corporations in US, the growth constraints are
weakly binding; I find that the management-controlled corporations indeed grow
faster than owner-controlled corporations in the case of USA. But, in the case of
Taiwan, all most of corporations fall into the class S, the growth constraints are
strongly binding; within the class S, the owner -controlled corporations grow faster
than management-controlled corporations.
As the result of Taiwan’s empirical test is dramatically different than the
hypothesized results (that manager-controlled companies grow faster than owner-
controlled companies), it is possible that this is due to the greater entrepreneurial
risks assumed by successful entrepreneurs. It must be realized that there is a
“survivor bias” in that companies that go out of business are not accounted for. As
such, entrepreneurial firms (owner-controlled) may be exhibiting greater growth
because of the risk-taking nature of these individuals, while manager-controlled
firms any choose to retard growth for precisely the reason that they do not wish to
see the companies potentially fail and so do not take proper business risks.
Therefore, the owner-controlled companies in Taiwan grow faster than
management-controlled companies.
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Ch7. Financial Factors and the Growth of Corporation:
Cross-Sectional Examination in 1997 and 2003
The previous chapter is an empirical study of the relationship between
control type and growth of corporations in Taiwan’s; now the research turns to
another perspective to realize the relations between financial factors and the growth
of corporations. The growth of East Asian Economy has become the subject of
intense research since 1980s to search for the causes of “Asian Miracle”. However,
after the East Asian financial crisis in 1997, ex-post explanations of what caused
the Asian crisis have been featured. How does the East Asian Corporation finance
its growth and what went wrong in those financial decisions? One common
argument was the rapid growth of Asian corporations was unsustainable due to
excessive investment, financed by excessive borrowing, poor profitability, reflected
in low and declining returns on equity. (Pomerleano1 1 5 , 1998)
Generally East Asian corporations were viewed as very competitive and
adept at exploiting new market opportunities; if the production decision is
independent of the financing decision, as long as the companies kept the profit-
maximizing production plan on the firms, the value of firm will not be affected by
the borrowing or lending decision. If the famous MM theorem of irrelevance of
corporate financial holds and translate it into saying that “the market value of the
firms will be the same for, if not, there is an arbitrage opportune there for the
taking. Consequently, arbitrage enforces that the value of the firms to be identical,
1 1 5 Michael Pomerleano, The East Asia and Corporate Finances: the Untold Micro story. Working
paper, World Bank, October 1998.
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whatever, the composition of the firms’ financial structure.” 1 1 6 Then why the rapid
growth of Asian corporations was unsustainable due to its financial structures?
Does Taiwan’s corporate behavior differ than other Asian countries? Does
the growth of companies in Taiwan are financed with quite well profitability or
unbearable rate of return? In chapter 4 ,1 answered the question on
macroeconomic level by looking at its political paranoia and financial
conservativeness- the low macro leverage and low-debt of corporations, which
might limit the growth of corporations, but helped weather the finical storm in
1997. Here, in this chapter, the focus is the empirical analysis on the firms level
data on microeconomic level. I intend to identify which financial factors are
important for driving the common variation in enhancing company’s performance.
If the common shared variation in Taiwan’s companies can be traced to a small set
of underlying pervasive forces, then these factors serve as key elements for the
success of company, which might help provide additional perspectives in
understanding the determinations of corproate’s performance and financial
structure. The following questions have been addressed:
(1) How can we use financial data to analyze corproate’s performance?
(2) How can statistical techniques be applied to evaluate assess its financial
standing?
(3) Is there any different financial pattern before and after 1997?
(4) How corporations in Taiwan finance the corproate’s growth?
By examining the financial data of cross-sectional companies in 1997 and
2003, the objects of this paper is to search for the determinations of corproate’s
1 1 6 http://cepa.newschool.edu/het/schools/finance.htm
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growth rate, assess the impact of certain financial pattern and identify the variations
at different time periods of 1997 and 2003.
Financial Data and Prior Statistical Analysis
How to investigate corporate performance based on the financial statements
generated by business firm? The design and purpose of this paper is
straightforward and intuitive; we are trying to analyze a firm’s overall performance
in a meaningful as well as statistically convenient way. If you were a financial
manager or investor, when you looked at the three major financial statements:
balance sheet (BS), the income statement (IN) and the statement of cash flows
(CF); you were looking at numerous financial variables, and possibly highly
correlated, indicating a potential problem of multicollinerity. How to run a
penetrating financial analysis based on the information contained in those
numerous financial variables, while facing multicollinerity threat, and how to
abstract the financial variables which could best represent and keep the most
information out of the original data set?
Traditional financial ratio comparisons are widely used by practitioners in
business to check the financial health of a business enterprise. Although ratios are
useful tools, but the interpretations of numbers are subject to individual judgment
and also “arbitrary rule of thumb”. Conformance to industry composite ratios does
not necessarily provide enough information for explanations in the difference of the
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financial pattern between the individual firm and industry composite. Various
Researchers have tried to bridge the gap by linking the traditional financial ratio
analysis with the more rigorous statistical techniques; most of these studies focused
on the bankruptcy-prediction context and the corporate bond ratings.
• • 117 •
William Beaver searched for a univariate predictive ability of ratios in
detecting bankruptcy potential and concluded that the cash flow to debt ratio was
the best single ratio predictor. Edward Altman extended the analysis to a
multivariate discriminant analysis (MDA) based on the financial ratio data to
develop a liner model that could best discriminate between the Bankrupt firms and
Non-Bankrupt firms and established a bankruptcy prediction model. MDA is well
suited to many finance problems, particularly for the dependent variable known as
a priori group membership such as bankrupt or non-bankrupt, acquired and non
acquired. MDA technique was followed by the researches in Lane1 1 8 , Edmister1 1 9 ,
Pinches and Mingo1 2 0 . While other studies analyzed a relatively heterogeneous
group of large firms, Edmister confined his study to small firms also utilizing a
MDA analysis. Pinches and Mingo developed the MDA model incorporating six
variables to classify the bond ratings. The general conclusion from prior research
was that several selected financial ratios have predictive and descriptive utility
1 1 7 William Beaver, “Financial Ratios as Predictors of Failure”, and Empirical Research in
Accounting: Selected Studies 1966. Journal of Accounting Research. 1967, pp.71-111.
1 1 8 Lane, Sylvia, “Submarginal Credit Risk Classification”, Journal of financial and Quantitative
analysis, vol. 7 (January 1972), pp. 1379-1386.
1 1 9 Robert Edmister, “An Empirical Test of Financial Ratio Analysis for Small Business Failure
Prediction”, Journal of Financial and Quantitative Analysis. Vol.7, 1972, pl477-1494.
1 2 0 George Pinches and Kent Mingo, “A Multivariate Analysis of Industrial Bind Ratings”, Journal
of Finance, vol.28, 1973.
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was that several selected financial ratios have predictive and descriptive utility
191
when properly used.
One common problem experienced in empirical studies is
“multicollinearity’ coincident with using MDA with financial ratios, violating a
basic assumption: independent variables are supposed to be mutually uncorrelated.
Though moderate violation of this assumption does not significantly impair results,
when variables are highly collinear, weights in the resulting model are highly
unstable, and the model tends to be highly sample sensitive and difficult to
199
interpret. “This problem was evident in the bankruptcy study by Altman and the
19T
merger study by Monroe and Simkowitz. Altman noted high multicollinearity in
the ratio set from which he derived a discriminant model. He emphasized a need to
choose variables for the model carefully, and his selection was achieved through a
large number of computer-running trials. Monroe and Simkowitz experienced
similar problems, and no ratios measuring leverage, liquidity, or profitability
entered the final discriminant function. They explained the multicollinearity they
observed in the data was the reason why leverage was omitted, but they reasoned
1 2 1 “Multiple discriminant analysis can be employed as both a descriptive and predictive technique.
Descriptive uses include the investigation of mean group differences and the overlaps among
groups, while predictive uses center around the formation of classification schemes to assign objects
(bond in this instance) to appropriate groups. (Pinches and Mingo, A multivariate analysis of
industrial bond ratings, 1973, vol.28, p2. the journal of finance.)
1 2 2 Morrison, Donald F. Multivariate statistical methods. McGraw-Hill Book Company, 1967.
1 2 3 Monroe, Robert and Michael Simkowitz. “Investment Characteristics of Conglomerate Targets:
A Discriminant Analysis.” Southern Journal of Business, 1971.
161
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liquidity and profitability were omitted because they were not important
discriminators.” (Donald, Stevens, 1973, pl52)1 2 4
Another issue with those empirical approaches was selection of independent
variables. How to select explanatory variables from numerous financial variables
contained in balance sheet and income statement, which could best represent and
keep the most information out of the original data set? Researchers usually set up
criteria for choosing variables according to data availability, existing empirical
studies in the area, and financial charerestics that are related to the design of
research. By selecting a single or a few ratios from financial data set, the
researcher has sought to identify an underlying theoretical assumption or statistical
model, which describes the salient characteristics of firm’s activities and in which
each financial ratio conveys unique information about those activities. Since the
empirical validity of financial ratios is not fully explored, existing theory may not
inherently reflect all the relationships among individual ratios and presumed
statistical model may not be established at the time of research. Without full
knowledge of the empirical relationship existing among individual financial ratios,
attempts to draw meaningful and thoughtful selection of variables are not
necessarily achieved. As a consequence, the ratios chosen for study are often
neither exhaustive nor exclusive in their ability to describe firm behavior, and
accordingly may not best represent and keep the most information out of the
original financial data set.
1 2 4 Donald Stevens, “Financial Characteristics o f Merged Firms: A Multivariate Analysis”, the
Journal of Financial and Quantitative Analysis, V0I8. 1973)
162
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After careful consideration of the nature of the problem and of the purpose
of the paper, principal components analysis (PCA) was chosen as the appropriate
statistical technique. Principal component analysis is a statistical tool, which has
already been used by psychologists for many years, and gaining popularity recently
among economists. Two properties in PCA play important roles in statistics and
serve the main purposes of this investigation. First, it’s a technique in an attempt to
reduce the high correlations among the variables; second, the explanatory variables,
either theoretically relevant or irrelevant, could be designated as having causal
characteristics if they were statistically significant, then interpreted literally into the
investigation. Principal Component Analysis does not need a specific statistical
model of the observed variables and focuses on explaining the total variation in the
observed variables on the basis of the maximum variance properties of principal
components. The PCA approach could reveal potential relevancy of financial
variables in describing the firm’s financial structure, and a few new variables or
components, not existing in presumed model, may be initiated by this approach.
Principal Component Analysis
PCA is a statistical technique that linearly transforms a large number (p) of
independent variables into a systematically reduced smaller set (k) of uncorrelated
components. These “principal components” are a linear combination of the original
variables, and these components have the desirable statistical properties of being
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uncorrelated with each other and explaining a maximum amount of the variance
from the original ones, which represents most of the information into the original
set of variables. The goal of this PCA technique is parsimony in order to reduce
the dimensionality of the original data set. If there are p variables in a database,
each variable could be regarded as constituting a different dimension in a p-
dimensional hyperspace and multi-dimensional hyperspace is often difficult to
conceptualize. If we could summarize multivariate attributes from p to a much
smaller set of k derived variables with minimal loss of information, it is useful in
knowledge discovery to enhance our understanding of the structure of the original
data set composed of a large number of correlated variables. In PCA, scoring all
observations based on a composite index and clustering similar observations
together based on multi-attributes are applied to reduce dimensionality.
Algebraically, the first principal component yi is a linear combination of xi,
p
X 2,...xp, so yi = anxi+anX 2 + ...+ aipXp = EaijXj such that the variance of yi is
i =1
maximized given the constraint that the sum of the squared weights is equal to one
p 2
(af ai = 1 or E an = 1). If the variance of yi is maximized, then so is the sum of
i=i P
squared correlations of yi with the original variables xi, X 2 ,... xp ( S r y > x j). By
i =1
partitioning the total variance, principal components analysis finds the optimal
weight vector (an, a^,... aip ) and the associated variance of yi which is usually
denoted by A ,.1 2 5 ( James Steven, 1995, p. 363). Then the variance of yi is equal to
the largest eigenvalue of the sample covariance matrix; yi is called the first
principal component that accounts for the maximum account of variance.
1 2 5 P. 11, Principal Components Analysis, George Dunteman, Sage University Paper.
164
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(Morrison, 1976, p.224) The procedure continues to find a second linear
combination, yi = a^xi +a2 2X 2 +...+ a2P xp , a2' a2 = 1 as for the first component, so
that it accounts for the next largest amount of variance, after the variance
attributable to the first component has been removed in the system. The third
principal component is constructed to be uncorrelated with the first two and
account for the their largest amount of variance in the system, etc. Thus, yi; y2 . .. yp
are all uncorrelated with each other, meaning the Pearson correlation between y i
yi... yPisO.
Although this process can be continued until as many components as
variables have been calculated, we would have to ask how many principal
components need to retain? According to the criteria in textbook of James
196
Stevens , there are four methods than can be used in deciding how many
components to retain and we summarize as following:
1. Probably the most widely used criterion is that of Kaiser (1960s): Retain
only those components whose eigenvalues are greater than 1.
2. A graphical method called the scree test has been proposed by Cattell
(1966): the recommendation is to retain all eigenvalues in the in the sharp
descent before the first one on the line where they start to level off.
3. There is a statistical significance test for the number of factors to retain
developed by Lawley (1940); however, as with all statistical test, it is
influenced by sample size, and large sample size may lead to the retention
of too many variables.
4. Retain as may factors as will account for s specified amount of total
variance; generally one would want to account for at least 70%1 2 7 of the
total variance of more; some investigators may set up to 80% or 85% of the
total variance.
1 2 6 P.366, Applied Multivariate Statistics for the Social Sciences, third edition, James Stevens.
Lawrence Erlbaum Associates, Publishers.
1 2 7 For example, Jolliffe’s (1972) criterion of X is 0.7 and Kaiser’s (1960) criterion o f X is 1.
165
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In this research, we set the criteria about 75% or more to account for most of the
variance in the original set of variables and the eigenvalues of those components
need to be greater than one.
Also it should be noticeable that the new PCs are arbitrary up to a linear
transformation of being measured on a standardized scale for statistics
convenience. After transformation, the main task becomes that of interpreting the
new components to see if they correspond to meaningfully identifiable patterns as
well as being statically convenient. Usually the new variables (PCs) are readily
interpretable, but sometimes they are un-interpretable. In this research, we hope
that the independent variables could be reduced to a much smaller number of PCs
with five or less and meaningful interpretations of patterns could be accomplished.
If not, the principal components can be rotated to a more interpretable structure by
varimax or other rotation algorithms; both the un-rotated and rotated solutions
explain exactly the same amount of variations in variables. Marion Chiattello1 2 8
pointed out that rotated factors whether oblique or orthogonal, represent an attempt
further to delineate distinct clusters of relationships in the data, if they exist.
Rotating is sometimes particularly helpful when there is a problem interpreting the
more general principal component factors.” (Robert Saunders1 2 9 , 1974, p. 1053)
1 2 8 Chiattello, M.L. “On the use of principal component analysis to interpret cross sectional
differences among commercial banks: A Comment.”, Journal of financial and quantitative analysis.
December 1974.
1 2 9 Robert Saunders, “Further comment: cross-sectional differences among commercial banks”,
Journal of financial and quantitative analysis, December 1974, p. 1053.
166
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Or another solution is to select a subset of variables to represent the total set of
variables, while facing the interpretation problem. McCabe (1984) called these
principal variables, instead of principal components', one variable could be selected
to represent each of principal components. We can either select the variable with
highest loading on each retained principal component or delete variables with high
1 1 f )
weights on discarded small components . (Jolliffe, 1972 & 1986)
Data and Definition of Variables
We obtained the primary 120 cross-sectional companies from list of
performing-well companies published in Common Wealth Magazine in the years of
1997 and 2002, and 25 performing-poor companies published in Taiwan Stock
Outlook at the same time periods. Then data were screened to exclude companies
with missing observations in 1997 and 2002 for the relevant financial statement
items. This screening resulted in a combined final sample of performing-well and
performing-poor companies, which totals 114 corporations in 2002 and 93
corporations in 1997. The explanatory variables of this study were public
information that could be collected and computed from published annual financial
statements by Taiwan Stock Exchange Committee (TSEC). Eighteen explanatory
1 3 0 We assume that components with small variables are unimportant; therefore variables with high
loading on them are likewise unimportant. There are more details in selecting a subset of variables;
see Jolliffe I. T., 1986, “principal Component Analysis”, New York: Springer-Verlag or Jolliffe I.T.
“Discarding variables in a principal component analysis”, Applied Statistics, vol.21, no2, p.160-173,
1972.
167
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variables are complied and selected from the multitude of available ratios in 1997
and 2003. These variables were chosen among those most frequently specified,
previously examined and theoretically believed to reflect differences in
corporation’s performance. These variables were listed and defined in the
following:
Variable A: Sale Growth Rate
Variable B: Total Asset
Variable C: Net Sales
Variable D: Return on Asset1 3 1 (ROA = EBIT/Total Asset)
Variable E: Return on Equity (ROE = Net Income/Total Equity)
• • 1 3 7
Variable F: Gross Margin (gross pro fit/sales)
Variable G: 01 % (operating costs minus depreciation/ total sales plus other
trading incomes)
Variable H: Current ratio (current assets/ current liabilities)
• * 1 3 3 • •
Variable I: Acid test (cash plus marketable securities plus
receivables/current liabilities or current assets minus stocks/current
liabilities)
Variable J: D/E ratio (L-T debt plus values of leases/Total Equity)
Variable K: Time Interest Earned (EBIT plus depreciation/interest earned)
Variable L: Days - A/R (average receivables/average daily sales)
Variable M: Days - Inventory (cost of goods sold/average inventory)
Variable N: Days- A/P (average payable/average daily sales)
Variable O: Working Capital1 4 (Cash, cash deposits, stocks and debtors,
itemized in the funds flow statement. Also known as circulating capital.)
1 3 1 Some profitability can be linked. The return on assets depends on the firm’s sale-to-asset and
profit margin, (income/assets = (sale/assets) x (income/sale), See Principle of Corporate Finance, Ch
27, 2001 Richard Brealey and Stewart Myers. Mc-Graw-Hill, Inc.
1 3 2 All firms would like to earn a higher return on assets. But we find the fast-food industry, which
turn over their capital frequently, tend to operate on low profit margins. For example, hotels have
relatively low sales-to-assets ratio, tend to operate on high profit margins.
1 3 3 Some assets are closer to cash than others. If trouble comes, inventories may not sell at anything
above fire-sale prices. Trouble typically comes because the firm can’t sell its finished product
inventory for more than production cost. Thus, managers often focus only on cash, marketable
securities, and bills that customers have not yet paid. (See Principle of Corporate Finance, Ch 27,
2001 Richard Brealey and Stewart Myers. Mc-Graw-Hill, Inc.)
1 3 4 Net working capital can be measured more accurately than other assets. Also the level of net
working capital can be adjusted more rapidly to reflect temporary fluctuations in sales. Thus
managers sometimes focus on how hard working capital has bee put to use.
168
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Variable P: Working Capital/ Total Asset
Variable Q: Long-Term Liability/ Total Asset
Variable R: Sale/ Net worth
Those variables represented the overall financial dimensions of corporation
in a variety of ways. All were very essential financial variables taught in business
school and practiced in financial field. There was no consistent statistical or logical
superiority for particular independent variables among the alternatives; and there is
no pre-determined structure or underlying statistical model of the observed
variables. Due to the nature of data, those explanatory variables were inter
correlated with each other in a complex way, some with small correlation and some
with high correlation (the zero-order coefficients close to 0.8). Some of our
financial variables may be in fact describing related dimensions of the same
phenomenon; this multicollinearity is certainly a concern to financial data and
cause trouble if we attempt to estimate the regressions with straightforward least-
squares.
In order to condense the widely diverse financial data, a method on
dimension reduction such as principal component analysis appears to be necessary.
Accordingly, the 18 variables would be introduced into PCA, then they can be
transformed to a few new principal components and those new principal
components can be used as the independent variables to be tested in regression
analysis to determine the relationship between financial factors and company’s
growth rate.
169
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Empirical Result of PCA
PCA is a data reduction Method, allowing the reduction of /^-dimensions of
complex interrelationship existing in original data to a few distinct dimensions or
general patterns. While interpreting the PCA, we are generally interested in a better
understanding of the regularity in the data and searching for the following: (1)
what’s the number of distinct common factors, (2) how the original data is grouped
in those common factors, (3) and how to give a meaningful interpretation in terms
of the research problem at hand. (Donald Steven, 1973, p. 152)
The first step is to decide how many factors to be extracted. In Graphs 1 &
2, the scree tests were plotted. The plots of Eigenvalues for years of 1997 and
2003 both looked very similar. The Eigenvalues of all factors needed to be equal to
or greater than 1.00 and factor with an Eigenvalue slightly below 1 .oo was omitted.
As you can see, the point where “the continuous drop in Eigenvalues levels o ff’
suggests that the cutoff point should be either at factor 5 or factor 6. The
justification for stopping the factoring process in a PCA might be either the
insignificance of the remaining factors or the remaining factors are not
differentiable from another1 3 5 .
In Table 13 and Table 14, it indicated the Eigenvalues, percent of total
variance, cumulative Eigenvalues and cumulative percent, which was accounted for
by each factor. The retention of five factors accounted for 74 percent of the total
1 3 5 John Meyer, “An Experiment in the Measurement o f Business Motivation,” the review of
economics and statistics, vol.49, No 3, 1967, p.307.
170
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variance in 1997 and 75 percent of total variance in 2003. In this study, almost 75
percent of the variance was accounted for and was preserved in the five factors,
which also implied that the remaining variances are either error variance or “noise”
and not dominant enough to indicate the dimensionality of common factor space.
Graph 1 (1997)
Plot of Eigenvalues
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
0.5
0.0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Number of Eigenvalues
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
Graph2 (2003)
Plot of Eigenvalues
6.5
5.5
5.0
4.5
4.0
j 3.5
£ 3.0
2.5
2.0
0.5
0.0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Number of Eigenvalues
t 'i/'
By most of frequently used criterion for PCA and by the rule of “lowest factorial
1 ' X l
complexity” , the number of distinct factors was made to retain the first six
1 " 2 C
factors for the year of 1997 and to retain the first five factors for the year of
2003, which we assumed that will yield the most interpretable common factor
patterns.
1 3 6 The criterion was listed in detail on p.8.
1 3 7 J.B. Carroll, “Biquartimin Criterion for rotation to Oblique Simple Structure in Factor Analysis,”
Science No 126,1957, pi 114-1115.
1 3 8 In 1997, it suggests a possible sixth financial dimension exists. Factor Six adds additional 7
percent to the explained portion, and there is only one highly loaded variable L (Days-A/R) in this
vector. Since the vector individually add a relatively smaller amount to the total amount of variance
explained, it will not detract from the analysis of grouping financial ratios to pass over it without
comment.
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Table 13 (1997)
STAT. E ig e n v a lu e s (1997 new com bined d a t a . s t a )
FACTOR E x t r a c t i o n : P r i n c i p a l com ponents
ANALYSIS
% t o t a l Cumul. Cumul.
E ig e n v a l V a r ia n c e E ig e n v a l
Q .
O
1 5.0903 29. 9429 5.0903 29 .9 4 2 9
2 2.54845 14.9909 7.63875 44 . 9338
3 2.42207 14 .2475 10.0608 59 .1 8 1 3
4 1.81884 10.6991 11.8797 69.8803
5 1.37465 8 .0 8619 13.2543 7 7 .9665
6 1.03963 6.11548 14.2939 84.082
Table 14 (2003)
STAT. E ig e n v a lu e s (2003 new com bined d a t a . s t a )
FACTOR E x t r a c t i o n : P r i n c i p a l com ponents
ANALYSIS
% t o t a l Cumul. Cumul .
E ig e n v a l V a ria n c e E ig e n v a l
O .
O
1 5.80263 34.1331 5.80263 34 . 1331
2 2.08822 12.2837 7.89085 46. 4168
3 1.86591 10.9759 9.75675 57. 3927
4 1.76465 10.3803 11.5214 67 .773
5 1.44527 8 . 50159 12.9667 76. 2745
The Information about the grouping of the ratios with the factors and about
the interpretation of the factors themselves is presented in the factor loadings
matrix listed in the below Table 15 and Table 16. This research intends to obtain
pattern of loadings on each factor that is as diverse as possible, lending itself to
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110
easier interpretation. A varimax rotation is performed in order to have a clear
pattern of loadings and a simple factor structure to interpret.
Table 15: 1997
STAT. Factor Loadings (Varimax normalized)
FACTOR E x tractio n : P rin c ip a l components
ANALYSIS (Marked loadings are > .700000)
Factor Factor Factor
V ariable
VAR H
VAR I
VAR K
VAR J
VAR L
VAR M
VAR N
VAR P
VAR
Q
VAR R
VAR D
VAR E
VAR F
VAR G
VAR B
VAR 0
VAR C
E xpl.Var
Prp.T otl
1
0.196081
0.253163
0.322891
-0.244290
-0.04216
-0.06106
0.050448
0.111592
-0.01901
-0.01028
.852460*
.863803*
.730525*
.788110*
0.03848
0.146782
0.077044
2.944034
0.173178
2
.909102*
.899056*
0.501465
-0.268178
0.08872
-0.069189
-0.054766
0.458481
-0.307383
0.054859
0.351239
0.233434
0.049372
0.114898
-0.087542
0.590029
-0.002145
2.830814
0.145524
3
-0.227783
-0.177854
0.065912
.758516*
0.089155
-0.028316
0.023521
-0.197166
.849394*
.877277*
0.038471
0.084309
-0.412001
-0.196663
-0.212801
-0.120619
0.056764
2.482536
0.146032
Factor
4
-0.112971
0.126353
-0.014865
0.002883
0.001253
-.939917*
-.825736*
-.787370*
-0.089207
0.183477
0.104971
0.093668
-0.176726
-0.171536
0.001897
-0.346207
0.133314
2.473902
0.145524
F a c t o r
5
0.031594
0.03038
0.035813
-0.158823
0.265274
-0.000649
0.051736
0.003334
0.240501
0.109363
0.062478
0.057265
-0.180546
-0.239271
-.940295*
-0.588328
-.916772*
2.339074
0.137593
F a c t o r
6
0.054331
0.103046
-0.380606
0.257281
.850616*
0.059332
-0.129762
0.177567
0.100590
-0.163379
-0.222169
-0.195037
0.225894
0.105024
-0.068055
-0.014914
-0.179989
1.223576
0.071975
1 3 9 The most standard computational method of rotations to bring about simple structure is the
varimax rotation (Kaiser, 1958); others are quartimax, biquartimax, and equamax (see Harman,
1967).
Harman, Harry H, Modem Factor Analysis, Chicago, University of Chicago Press, 1967.
174
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Table 16: 2003
STAT. F a c t o r L o ad in g s (Varimax n o rm a liz e d )
FACTOR E x t r a c t i o n : P r i n c i p a l com ponents
ANALYSIS (Marked l o a d i n g s a r e > .700000)
F a c t o r F a c t o r F a c t o r F a c to r F a c t o r
V a r i a b l e 1 2 3 4 5
VAR H .941469* 0.078292 0.038163 0.036623 0.101367
VAR I .913962* 0.122204 0 .099666 0.033041 0.119812
VAR J - 0 .1 4 6 1 9 9 -0 .2 5 8 9 3 7 . 854284* -0 .0 3 3 3 2 4 -0 .0 7 3 8 0 4
VAR K -0 .0 4 4 8 8 0.471271 0.178594 -0 .2 2 8 4 5 4 0.079708
VAR L 0.164222 -0 .1 4 6 4 8 -0 .2 3 0 2 2 3 -0 .6 4 0 7 7 6 -0 .2 1 9 5 4 4
VAR M -0 .0 6 1 4 8 8 - 0 .1 6 0 3 2 9 -0 .0 7 7 8 0 9 -.7 2 2 4 3 7 * 0.018813
VAR N -0 .1 3 3 8 4 3 0.150785 0.206039 -.8 0 0 9 8 1 * -0 .0 6 8 8 8 6
VAR P 0.635992 0.336313 -0 .2 4 4 6 9 2 0.011682 0.130231
VAR
Q
-0 .6 0 0 3 0 7 0.001036 0.442774 -0 .4 5 3 6 6 8 -0 .1 4 4 8 4 2
VAR R 0.105684 0.013453 .931633* 0.115654 -0 .1 2 5 9 7 8
VAR D 0 .210046 .834448* -0 .2 6 1 8 0.152303 0.139275
VAR E 0.174583 .748566* -0 .5 4 2 4 2 9 0.175815 0.14035
VAR F 0.37853 0.565795 -0 .1 9 1 0 4 0 .467826 0.066238
VAR G 0.329175 0.652509 -0 .0 2 2 3 8 2 0 .5 0569 0.079691
VAR B 0.099871 -0 .0 7 2 7 5 2 -0 .1 7 3 0 3 7 0.161054 .905642*
VAR O 0.448918 0.185937 -0 .1 3 9 0 1 9 0.015339 .784084*
VAR K 0.024627 0.267041 0.013894 0.056218 .876494*
Expl,.V ar 3.108114 2 . 607117 2. 447686 2.407167 2 .3 9 6 5 8 9
P rp . T o t l 0.18283 0.15336 0.143982 0.141598 0.140976
The numbers in the columns are factor loadings or more technically, the
coefficients of each factor are a linear combination of all financial variables in the
analysis. In interpretation, we are able to sum up the information contained in all of
the data (114 firms, 18 ratios) through the definition of new variables of synthesis
so that the financial dimensions derived from the PCA would describe certain basic
175
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financial characteristics of corporations and keep the lost information minimal.
Each company will be defined by a value of these new synthetic variables
(principal components) instead of by 18 ratios.
The factor loadings present the most important information on which the
interpretation of factors is based. The similarity of each variable with each of the
empirically derived factors is indicated by the variable’s factor loading, which can
be simply interpreted as the correlation between the original variable and the
particular factor. Hence, the closer to zero is the loading, the lesser is the
association between the specific variable and the variable pattern reflected by the
vector; au contraire, the closer to unity is the loading, the stronger is the association
between the specific variable and the variable pattern reflected by the vector.
Similar to correlation coefficients, negative signs indicate inverse relationship. The
factor loading in each factor represents an ordinal measure of the degree to which
the variable is involved in that specific component1 4 0 . Most of the factor
interpretations depend on sign, and ordering of the factor weights. In general, the
first vector delineates the most important variable relationship in the data; the
second vector, the next important relationship, etc. Ideally the financial groups
should possess high internal homogeneity with group and high external
heterogeneity between groups; each financial ratio should have a high factor
loading on at most on one factor.
1 4 0 The total combinations of variables are referred to as vectors, components, factors or
eigenvector.
176
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In the following, our task becomes that of interpreting the components to
see if they correspond to meaningfully identifiable pattern as well as being
statically convenient. In 1997, Principal component one (Factor one) shows the
highest loadings for the variables D (ROA), variable E (ROE), variable F (gross
margin), and variable G (operation income change) and other variables with low
loadings to show a low degree of involvement in that particular factor pattern. In a
more specific term, the first two variables could be labeled as “Return on
Investment” and the latter two could be labeled as “Profit Margin Ratios”; in a
more general term, Factor one could be virtually interpreted as the financial
dimension of “Return on Investment”. The second principal component (factor
two) was marked by high loadings on variable H (current ratio) and variable I (acid
ratio), classified into category of short-term liquidity. Respectively, the third,
fourth and fifth principal components were described as the categories1 4 1 of “long
term solvency”, “capital turnover” (or “capital intensiveness”), and “size of
corporation”.
By examining the factor loadings and the clustering of the financial ratios,
finical data in 2003 could be grouped into identical five financial ratio categories
with different sequential order, namely, “short-term liquidity” for factor one,
“return on investment” for factor two, “long-term solvency” for factor three,
“capital turnover” for factor four and “size of corporation” for factor five. We
1 4 1 The components o f the ratios are defined by flowing the classification of previous study in the
“financial pattern in industrial organizations” by George Pinches, Kent Mingo and Kent Caruthers,
the journal of finance. vol28, no2., 1973.
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observe that there is a cross-sectional stability of the ratio groups over time, in
terms of the consistency of factor loadings and the percent of total variances
accounted for by all variable patterns that are linked to specific variable
interrelations.
For example, “return on investment” was the most dominant common factor
in 1997 and had a variance1 4 2 of 2.9 and account for 17 percent of the total
variance, with high loading of 0.852460 on variable D and 0.863803 on variable E.
In 2003, although “return on investment” became second dominant factor, still had
similar decomposition with a variance of 2.6, 15 percent of the total variance, high
loading of 0.83448 on variable D and 0.748566 on variable E. In 1997, the short
term ratio group was the second dominant factor, had a variance of 2.8 and
accounted for 16 percent of the total variance, with highest loading of 0.90912 on
variable H and second highest loading of 0.899056 on variable I. In 2003, due to
the slight change of decomposition, the short-term liquidity became the most
dominant factor, had the variance of 2.8 and 16 percent of the total variance, with
highest loading of 0.941469 on variable H and second highest loading of 0.913962
on variable I. The first two patterns, “Return on Investment” and “short-term
liquidity” were consistent and stable, indicating fairly widespread involvement
among cross-sectional corporations in Taiwan between 1997 and 2003. The other
three categories of “long-term solvency”, “capital turnover”, and “size of
corporation4 4 were all identified as factor 3, 4 and 5 in 1997 and 2003, demonstrated
1 4 2 The amount o f variance explained by each rotated component is the sum o f the squared loadings
shown in the column.
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the similar composition in terms of (1) the size of the factor loadings, (2) the
presence of specific financial variables in the same category and (3) the percent of
total variances accounted for by all variable patterns that are linked to the specific
variable interrelation.
On the other hand, few important changes in sign or hierarchical ordering of
the factor weights were observable. In 1997, the “capital intensiveness” was
described by variables M with high loading of 0.939917, variable N with loading of
0.825736, variable P with loading of 0.787370. However, in 2003, the capital
intensiveness was identified by same variables M with loading of 0.722437,
variable N with loading of 0.00981, but different in variable P with low factor
loading of 0.011682, indicating a downward shift between involvement of variable
P (working capital/sales) and the derived factor (capital intensiveness). Besides,
there were few ratios, such as variable L (the turnover rate of account receivable)
did not group into any specific dimensions of principal components.
The reasons for those financial variables not to be grouped into any single
category were due to either that the activities of a firm indicated by these ratios
could be adequately measured by other financial ratios which have already been
grouped into specific categories, or that each of these ratios measured a unique
characteristic of a firm’s activities and thus lacked empirical similarity with other
financial ratios. This might be the case for factor 6 in 1997 (see Appendix 1),
although, as was pointed in the previous section, we excluded safely the factor 6 as
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common financial patterns for both years of 1997 and 2003 in order to have lowest
factorial complexity.
In 1997, the factor 6 was identified alone by variables L, with only one high
loading of 0.85016 and all other extremely low loadings on others, which explained
6 percent of total variance. This financial pattern could be possibly labeled as
“Receivable intensiveness” to describe the unique financial dimensionality of
company. In 2003, there was no sign of other remaining factors to exist; variable
L was not dominant in any of five components and thus lacked empirical similarity
with other financial ratios. The “capital intensiveness” and “receivables
inventiveness” are the least stable financial patterns.
The instability reflected either on Account Receivable or Working Capital
was concerned with the fluctuation of cash flow. The corporations were viewed as
a reservoir of liquid asset, supplied by inflows and drained by outflows. The ability
to generate stable amount of cash flow was challenging for Taiwan’s company in
terms of financial stability, especially for the corporations of small country mainly
aimed at outward economy toward export-led growth.
Regression Aanalysis of Financial Factors
The research furthermore investigated the impact of financial factors on the
growth of corporation. In developing a final model, multiple regressions were
employed in conjunction with the factor analysis results in testing for significant
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beta-financial data relationships with growth rate. It would be misleading to
attribute an observed difference in the dependent variable solely to that in a single
independent variable when the latter is part of a complex of factors working
together. We use the five common factors as more specified explanatory variables
to properly interpret repressors in a regression equation. Regression summary was
listed as follows.
Table 17: 1997
Regression Summary for Dependent Variable on growth rate
Beta t p-value
i v r n Ki 0.203305 1.994502 0.049302
FACTOR2 0.047702 0.467973 0.641001
FACTOR3 -0.15303 -1.50127 0.136991
FACTOR4 -0.04486 -0.4401 0.660981
FACTOR5 0.115061 1.128792 0.262161
FACTOR6 -0.18588 -1.82351 0.071741
R2 = 0.17, N=92
Table 18: 2003
Regression Summary for Dependent Variable of growth rate
FACTOR1
FACTOR2
FACTOR3
FACTOR4
FACTOR5
Beta
R
0.061133
-0.0358
0.210298
- 0.09, N - 114
t
-0.66182
1.98967
0.664689
-0.38924
2.286539
p-value
0.509498
0.049155
0.507666
0.697863
0.024173
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In 1997, factor 1 represented the economic meaning of return on
investment; in 2003, factor 2 and factor 5 were identified with meaning of return on
investment and the size of corporations. We found that the firm’s growth1 4 3 is not at
random in nature. There is a positive significant relationship between corproate’s
growth rate and the return on investment with coefficient of 0.20 in 1997 and 0.18
in 2003. One of the ex-post explanations of what caused the Asian crisis was that
the rapid growth of Asian corporations was unsustainable due to the poor
profitability, reflected in low and declining returns on equity. There is no evidence
in our empirical result to support this argument. In the case of Taiwan, the
variability of financial pattern on rate of return is the most stable among others and
the growth of corporation is financed by the increasing company’s profitability.
Another finding was that after the financial crisis, “the size of corporation”
also plays an important role in determining the growth of corporations, with an
estimated coefficient of 0.21 at significant level of 2%. The empirical results
suggest that bigger companies have more successful rate in financing company’s
growth. “Does bigger company grow faster than smaller company?” This is the
same old question and it appears to be no general agreement on firm’s growth
theory.
Gibrat’s Law claims that firm’s growth is a random growth process.
“Gibrat’s law of proportionate effect” states that the probability of a given
proportionate change in size during a specified period is the same for all firms in a
1 4 3 Gilbrat’s Law states that a firm’s growth is a random.
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given industry; the smallest firms has the same change of growing or shrinking as
the industry’s largest firms. Jovanovic’s (1982) “learning model” claimed that
efficient firms (that is, firms with able managers) grow over time. Jovanovic’s
model predicts that the annual growth rate of a firm will depend on the accuracy of
the manager’s predictions regarding his ability, as well as the price of the product.
As a successful firm matures, its manager’s estimate becomes increasingly
accurate; this reduces the probability that next period’s output will be widely
different from this year’s. Therefore, firm growth decreases with firm age when
firm size is held constant. Bigger firms are more efficient and have less room for
further increases; firm growth decreases with firm size. Most of these studies are
based on samples of the largest firms in the advanced economy.
In the context of developing country, our empirical study finds that
Taiwan’s company growth with the increase of company’s size, defined by total
asset, working capital and the net earned money. Given the development of
incorporation of Taiwanese companies are relatively new, one possible explanation
lies on that this empirical result demonstrates the relatively new experience of
learning ability; firms are not so well matured and there still have plenty of room
for further increases.
The concluding remarks are summarized as follows. We have tested the
empirical validity of PCA technique, aids in summarizing the general pattern of
financial variables. The analysis of variations in 1997 and 2003 reveals that the five
financial ratio groups posses a high degree of cross-sectional stability. The
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financial patterns among corporations in Taiwan did not vary much before and after
1997 Financial Crisis. Only with one exception within the financial group of
capital intensiveness, that instability reflected either on Account Receivable or
Working Capital might be caused by the difficulty to sustain stable amount of cash
flow.
Generally, we believe that a country can significantly improve upon their
existing financial system, by reducing the likelihood of financial instability and
facilitating long-run economic growth. The financial stability is often
acknowledged as a contributing part to the healthy financial system in a country.
This finding corresponded implicitly to we mentioned before in the first paper,
what contrasts Taiwan from most with other Asian economy was its political
paranoia and financial conservativeness, which might limit the growth of
corporations in some way, but also help weather the financial storm in 1997. In
short, there is a positive significant relationship between corproate’s growth rate
and the return on investment for years of 1997 and 2003 and a positive relationship
between corproate’s growth rate and “the size of corporation”. Bigger companies
with more financial resources operate company in a more efficient way and pursing
more successes in company’s growth.
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Ch8 Conclusion
Many of the newly industrializing countries of East Asia, which achieved
successful economic growth since the 1960s, have suffered thereafter from 1997’s
East Asian financial crisis, yet Taiwan seems to have escaped from the crisis with
relatively little damage to its economy, at least for now. How does Taiwan form
the basis for supporting the growth process and maintaining smooth economic
growth for years? This research conducted an empirical, historical, institutional
country-specific study of the actual process of development in Taiwan, intending to
search for the growth model of Taiwan economy. A number of different theories
have been put forth to explain the Asian economies; I have emphasized a different
perspective - the development of the national corporate economy and the growth of
the corporation at the firm level was caused by channeling the engine of national
growth towards the corporate economy. From my point of view, there is a rich
potential field of research that connects literature on firm growth theory to theories
of economic development. This dissertation has contributed to knowledge in this
area by not only focusing on theoretical thinking and historical evidences, but also
questioning the empirical validity of the growth theory of the firm in terms of its
ownership and financial structure- what were the relationships between “the
control type and the growth of firm” and between “the financial factors and the
growth of firms”. This chapter will conclude the findings based on analysis and
the empirical study as follows.
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Dependency is not always evil; there is a possibility for the developmental
state to guide its economic development within its dependence in the world system
and through an outward economic policy. As I demonstrated, economic growth
could grow positively with trade dependency in the case of Taiwan. There are
some common elements among the East Asian economies. Trade dependence
between East Asian and Pacific countries is among the highest in the world; in
general, economies that are more open to international trade generally have higher
rates of growth in GDP1 4 4 . Taiwan is not an exception to this commonality;
furthermore Taiwan has been historically emphasized on export-led growth, even
traced back to the colonial period since 1900s. As I described in chapter 3, the
major task of the colonial government was to extracts the agricultural surplus and
this outward orientation due to Japan’s interest in extracting an “export surplus”
helped build up the foundation of the Taiwanese rural economy. In the debate of
“Modernization theory vs. Dependency theory”, Taiwan is providing a successful
example for dependent development, and against dependency theorists who claim
that extraction of surplus led only directly to economic stagnation.
Second, all of the Asian NICs have rapid growth of physical capital stock
and put the role of “high investment” as one key factor in determining Asian
economic growth model. So-called “accumulation” theories (Young 1993, Kim
1 4 4 Do open economies growth faster than closed economies? Almost all empirical growth studies
have given an affirmative answer to this question. Although the study in “trade openness and
economic growth” is a highly debated topic; some empirical results such as Romer (1990) and
Grossman and Helpman (1990) may suggest an ambiguous relationship between trades restriction
and growth rates (Halit Yanikkaya, 2002, p.57-60) Here, the interpretation of positive effect
between “growth and trade” is based on the fact of phenomenal differences among the growth rates
of the East Asian and the Latin American over the last several decades.
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and Lau 1994, Krugman 1994) claim what lies behind rapid development is simply
these high investments to move these country’s economies along with their
production function. If these arguments were right, then there is little room left for
credit assigned to the growth factors by entrepreneurship, learning, management, or
corporate governance as long as economies keep shifting to more capital and
education intensive way of production. This study believes institutional settings,
ownership structures, and financial patterns all have influences on the growth of
corporations in Taiwan. Although its debatable among scholars whether export
orientation effectively contributes to economic growth, this dissertation argues in
favor of the positive linkage between trade and growth, and the corporate behaviors
correspond accordingly to interact with government policy under the export-
oriented Asian economy to pursuit the growth.
In chapter 3, this study presented how corporations in Taiwan grew out of
its initial political economy. Taiwan was facing the difficulties in changes hands
from Japanese to Chinese Mainlanders. The turmoil caused by this period of
political and economic changes had long-term influences on the structure of
corporate economy that has developed into. Economically, Taiwan suffered from
high inflation rate, almost zero economic growth, sudden increasing population,
currency, monetary and fiscal crisis; politically, Taiwanese people faced the
mainland authorities operated Taiwan through a military governor and the political
uncertainly caused by the mismanagement of central government. Helped by U.S.
Aid in 1950s and gradually pushed by the export expansion, Taiwan’s economic
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growth started to take off in the early 1960’s and have made progress
comparatively in the world economy by the end of 1990s. For the people and
government in Taiwan, it has been a long process and more gradually to gain its
economic growth accompanied by political democratization; and these
consequences are now altering the government’s economic policy in providing
incentive to growth and company’s behavior in pursuing the growth of corporation.
Five main characteristics of Taiwan’s corporate economy has been identified in
chapter 4 “the corporate economy under dependent development”. The growth
patterns of the Taiwan’s enterprises differ from those of Korea or Japan in a way
that business are more reluctance about risk taking and government regulates
business in a more conservative way. The growth mode of Taiwanese companies
wasn’t high-risk taker and needed to be compensated with proper rate of return,
which later has been empirically proved in the chapter 7 “the financial factor and
the growth of corporations”.
Furthermore, I argued that, defined by its initial political economy, that
Taiwan has no other choice but develop the export-led policy to start the path of
growth. Taiwan did try the inward-ISI policy in the beginning and suffered from
the consequences of ISI policy; but it learned its lesson quickly and switched to the
out-ward economy development in 1960s; As we demonstrated that the economic
growth could grow positively with the trade dependency in the case of
developmental state of Taiwan. The export-led growth was dependent and exposed
to the vulnerability of external factors and its effectiveness of outward development
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was questionable when we compared the East Asian NICs and Latin American
countries; some economists even argued the initial effect of outward economic
development was too small to have effectiveness. However, as I documented,
beginning in 1949, Taiwan did not fulfill the conditions for catching up to western
modernization due to the withdraw of the Japanese and disorganization produced
by the Chinese civil war. In the case of Taiwan, being a small country with poor
resource endowments, without external forces to facilitate market expansion,
capital accumulation and technology transfer, possible growth couldn’t even
happen in the first place within initial conditions and internal societal structures.
Keep in mind the KMT was incapable of governing Mainland China, but by
“learning by doing”, this “strong state” were able to exercise more autonomy to
accomplish economic reforms in Taiwan. Land reform provided an egalitarian base
in distributing the benefits of country’s growth. The authoritarian state prevented
labor from organizing on behalf of its economic interest, but was able to implement
and extend the equalizing impetus generated by land reform. In Taiwan, the
economic power of capitalists and the working class both have grown in direct
proportion to the expansion of the national economy and the Taiwanese
developmental state has been more concerned with balanced growth and social
stability.
Growing out of dependency needs to be also accompanied with right
incentives for economic gain. Enforcement of property rights depends on power;
therefore the state needs to define the basic structure of property, arbitrates disputes
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and enforces rules. If the rules are clearly defined within the economic system by
regulating who gets rewarded and who gets punished, then the more favorable
outcome will be for individuals as well as for nation wealth. What contrasts
Taiwan from most with other Asian economies was its political paranoia and
financial conservativeness, which may limit economic growth in some way, but
helped strongly influence State will in regulating and enforcing rules of economic
transactions in order to achieve existing equilibrium. In my empirical chapter on
“The impact of control type and the growth of corporation”, I also found almost all
corporations in Taiwan fit into the class S, meaning Taiwanese corporations are
bounded by growth constraints, given the incentive structure of its corporate
economy, regulated by the developmental state of Taiwan, this finding strengthens
my argument Taiwan’s government regulated more strictly the incentive structure
of the economic system.
Based on bounded rationality, individuals compete to maximize utility with
a given set of rules, but also try to change rules for more favorable outcome than
were possible under the old regime. My argument is the government needs to send
out a clear message. No matter under what kind of institutional arrangements,
either the so-called the state-dominated credit-biased system or the in the market-
determined-mechanism, the rules for residual claimants (who have a right to the net
income of an activity) and default responsibility (have a punishment due to the
failure of activity) should be clearly defined and enforced to have a more efficient
economic outcome.
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Despite being an authoritarian regime, the KMT-led economic
developments consistently aimed to pursue a liner path similar to the Western
Capitalist nations’ experience through successive stages of development toward
modernization. In Taiwan’s example (see Ch. 4), economic freedoms were well
defined and incentives for profits were guided, while political freedom was far-
reaching to meet the standard of western society. The degree of political
participation and democratization were also expanded on a path to growth based on
outward economic development; the “economic liberalization” gradually brought
up into a “political liberalization” phase and the role of state in engineering the
corporate economy has been diminishing since the full democratization.
Paul Krugman has argued the rapid growth of East Asia was driven by
increases in inputs, not by the productivity; and so, due to diminishing rate of
return, the success of East Asia growth wouldn’t be sustained. But the results of
Total Factor Productivity studies vary and it is difficult to support the Krugman
hypothesis conclusively. It is evident some developmental states have exhibited
catch-up ability by increasing the manufacturing output level as well as improving
the technology and skills. Taiwan has upgraded the quality of human capital in
order to realize the full productive potential of technology, such as the Integrated
Circuit industry. Besides, using “capital accumulation” to purist national growth
has been long even in the success of developmental experience in Western society.
It is no doubt a developing country, especially a small sized one on the dependent
periphery, would try to catch up by putting more inputs, in the beginning of the
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developmental stage, to move its economy along with its production function. On
the other hand, the capital intensity in manufacturing in Taiwan is still relatively
low, hence opportunities for input driven growth are still abundantly available.
One characteristic of Taiwan corporate economy is that Taiwan’s export-
oriented development has been dominated by small- to medium-sized enterprises;
and the trend of “being small” has its historical root since Japanese colonialism and
has been carried on into the next governmental policies of KMT. There are only a
small percentage of all companies that grow large enough to be listed on the Taipei
Stock Exchange. But almost all corporations in Taiwan are well bounded by
growth constraints, meaning the manager won’t deviate from the owner’s interest
and most likely will be seeking owner’s interests. As pointed out in the size-related
differences, smaller firms tend to have greater owner influence and greater concern
with financial matters. Those smaller firms grew out to be bigger firms, but the
management style is still bounded to the mentality derived from “being small”;
managerial skill did not develop with the corporate growth and decisions are still
made with the hands of the owner. Managers behave like owner of smaller sized
company and are reluctant about risk taking. Managers identify themselves with
the companies and more concerned with survival rate than growth rate. In Taiwan,
the state’s roles in regulating the flow of financial capitals and controlling private
sector were less direct; in another sense, corporations were more responsible for
their own financial costs, therefore managements were more cautious to avoid
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bankruptcy, which helped explain why Taiwanese companies better weathered the
financial crisis in 1999.
Even though the ownership structure of TSE-listed companies in Taiwan is
widely diversified and delegates decision-making to corporate manages, the
managers did not behave like the managers in the big corporation in US. We found
that within the class W of corporations in US, where growth constraints are weakly
binding, management-controlled corporations indeed grow faster than owner-
controlled corporations. As the result Taiwan is dramatically different than the
hypothesized results; owner-controlled companies in Taiwan grow faster than
management-controlled companies. This is due to the greater entrepreneurial risks
assumed by successful entrepreneurs. Entrepreneurial firms (owner-controlled)
exhibit greater growth because of risk-taking nature, while manager-controlled
firms in Taiwan choose to retard growth for precisely the reason that they do not
wish to see the companies potentially fail. The combination of providing more
appropriate incentives and supervising regulations for both enterprises and financial
market minimize the likelihood of a financial crisis.
Krugman has further argued Asian countries tend to adopt a system of
implicit guarantees leading to incentives to choose the highest return investments
regardless of risk; but this is certainly not the case in Taiwan. Taiwan’s companies
did not follow the typical Asian growth model: high investment, high borrowing
and pursing high rate of return, regardless of risk. Au contraire, Taiwanese private
enterprises run a low debt-equity ratio, with a greater concern of risk, and a relative
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low capital investment rate, compared to other Asian countries. There is a positive
significant relationship between corporate growth rate and the return on investment
for years of 1997 and 2003 and a positive relationship between corproate’s growth
rate and “the size of corporation”. Growth of corporations in Taiwan are financed
by higher rates of return and with an increasing size defined by total asset, working
capital and net earned money. Financial patterns among corporations in Taiwan
did not vary much before and after the 1997 Financial Crisis, which is consistent
with the claim the Taiwanese developmental state aimed at developing the national
corporate economy with balanced growth and social stability. In general, financial
stability is often regarded as positive sign for facilitating long-run economic
growth. Only with one exception within the financial group of capital
intensiveness, that instability reflected either on Account Receivable or Working
Capital might be caused by the difficulty to sustain stable amount of cash flow,
which became a common problem for both SMEs and TSE-listed companies
(bigger size).
Future research could focus on the perspective of corporate governance to
continuously explore the growth factors in Taiwan’s corporate economy. The
success in the past did not guarantee the success in the future; the evolutionary
process of corporate economy is the feature of modern corporations. Being a
dependent country, the way of government’s engineering its corporate economy
and how the enterprise shall be accommodating according to the external change
are always a challenge of pursing growth.
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Creator Chen, Hui-Ru Ellen (author)

Core Title The corporate economy and growth of corporations in Taiwan

Degree Doctor of Philosophy

Degree Program Political Economy and Public Policy

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag economics, general,OAI-PMH Harvest

Language English

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Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-566507

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