Aoki Firma Japoneza

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American Economic Association

Toward an Economic Model of the Japanese FirmAuthor(s): Masahiko AokiSource: Journal of Economic Literature, Vol. 28, No. 1 (Mar., 1990), pp. 1-27Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/2727189 .Accessed: 21/10/2013 04:00

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Journal of Economic LiteratureVol. XXVIII (March 1990), pp. 1-27

T o w a r d n conomic o d e l of t h

apanese i r m

By Masahiko AokiStanford University

andKyoto University

I owe a great deal to Professor Moses Abramovitz who suggestedthat I write this article. I appreciate his constant encouragementand guidance which aided me throughout its preparation. I am alsoindebted to three anonymous referees of the Journal and to ProfessorsRyutaro Komiya and Michael Riordan for their critical commentsand helpful suggestions. Needless to say, I am solely responsible forthe views expressed in this paper.

OVER THE LAST DECADE a considerableeconomic and management litera-

ture has been produced in English deal-ing with various aspects of Japanese firmsand with comparisons with their Westerncounterparts. The wide-ranging subjectmatter covered in the literature may beindicated by reference to the followingrepresentative works: James Abegglenand George Stalk (1985, ch. 5) and Ya-suhiro Monden (1983) on the kanban

system just-in-time method) and otherpractices of manufacturing operations;Masahiko Aoki (1986, 1989) and HideshiItoh (1987) on the nonhierarchical mech-anism of operational coordination; Har-vey Leibenstein (1987), James Lincoln,Mitsuyo Hanada, and Kerry McBird(1986), and Toshiaki Tachibanaki (1987)on the nature of internal hierarchies; Ka-zuo Koike (1984, 1988, 1989) and HaruoShimada and John Macduffie (1986) on

skill formation systems on the job and1

on shop-floor industrial relations; Tai-shiro Shirai (1984) on enterprise union-ism; Masanori Hashimoto and John Rai-sian (1985) and Jacob Mincer and YoshioHiguchi (1988) on employment durationand tenure-wage profile; Richard Free-man and Martin Weitzman (1987) andJohn Taylor (1989) on the bonus system;Akiyoshi Horiuchi, Frank Packer, andShinichi Fukuda (1988), Paul Sheard(1989), and Erik Berglof (1989) on bank-

oriented financing and the main bank sys-tem; Albert Ando and Alan Auerbach(1988) and B. Douglas Bernheim andJohn Shoven (1989) on the cost of capital;Aoki and Nathan Rosenberg (1989), Ken-ichi Imai, Ikujiro Nonaka, and HirotakaTakeuchi (1985), and Eleanor Westneyand Kiyonori Sakakibara (1985) on R & Dorganization and rapid product devel-opment; Banri Asanuma (1985, 1989)and Seiichi Kawasaki and John McMillan

(1987) on subcontracting; Abegglen and

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2 Journal of Economic Literature, Vol. XXVIII (March 1990)

Stalk (1985, ch. 8), Aoki (1984a, 1988a),and Ryutaro Komiya (1987) on the natureof Japanese management.

This list of representative papers is in-complete and possibly biased, but it iscertainly sufficient to indicate the richvariety of subject matter studied in thegrowing literature on Japanese firms.The aim of this paper, however, is notto present an exhaustive survey of theliterature, but rather to provide a uni-fied treatment of various features of Jap-anese practices and to suggest a consis-tent economic model that explains how

Japanese firms operate and what theyachieve. This paper leaves the more de-tailed assessment of their comparative ef-ficiency to future studies, but the under-lying presumption is that one of theimportant sources of the industrialstrength (and weakness in certain re-spects) of the Japanese economy can befound in the micro-micro (internal) struc-ture of firms. Thus the theme of this pa-per is parallel to that of a recent study

by the MIT Commission on industrialproductivity (Michael Dertouzos, Rich-ard Lester, and Robert Solow 1989) deal-ing with the comparative assessment ofthe American productive performancewith strong emphasis on the impact oforganizational factors.

This paper asks such questions as: Isthere any logical connection between the

Japanese mode of internal operationand coordination on the one hand andthe so-called Japanese employment sys-tem on the other? Is the bank-orientedbusiness financing related to the internalstructure of Japanese firms in any essen-tial manner? If so, how, and what areits implications for the nature of manage-ment and behavior of firms? The modelthat emerges to answer these questionsturns out to be somewhat at odds withthe standard contractual model of thefirm that now prevails in the Anglo-American theoretical literature. Is this

because the Japanese model is culturallyunique? Or, given the competitive chal-lenge posed by Japanese firms in global

markets, does the difference suggest aneed to broaden the scope and reorderthe focus of the theory of the firm? To-ward the end of this essay, I will touchbriefly on these issues as well.

The organization of this paper is as fol-lows. Section I describes a few importantexamples of operational practices in Japa-nese firms and suggests that horizontalcoordination among operating unitsbased on knowledge sharing, rather thanskill specialization, is an important inter-nal characteristic of Japanese firms. Italso makes an elementary inquiry intothe efficiency implications of horizontalcoordination. The employees of Japanesefirms are, nonetheless, arranged in a hi-erarchy of rank, and Section II arguesthat Japanese firms depend on employeecompetition to achieve higher statuswithin their hierarchies of rank as a pri-mary incentive device. The hierarchicalnature of the incentive scheme, there-fore, complements the nonhierarchicaltendency of operational coordination andso helps maintain organizational effec-tiveness and integrity. Section III dealswith the nature of financial control overJapanese firms in a bank-oriented finan-cial system. It contends that the financialand internal characteristics of Japanesefirms are closely related to, and comple-ment, each other. Section IV proposesthat, as a result of this complementarity,the managerial decisions of Japanesefirms are subject to the dual influenceof financial and employee interests. Itdiscusses the nature and behavioralconsequences of mutual commitmentsbetween management, on one hand, andemployees and banks, on the other. Fun-damental theoretical propositions devel-oped in Sections I through IV are sum-marized in the form of three DualityPrinciples. Section V contains concluding



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Aoki: Toward an Economic Model of the Japanese Firm 3

remarks. The Appendix describes the useof supply contracting by Japanese firmsand relates this use to other aspects ofJapanese companies. Because of spacelimitations, detailed data supportingstated stylized facts are not presented inthis paper. They appear in works citedabove and in my recent book (Aoki1988a). Moreover, I limit references toworks available in English.

I. Horizontal Coordination

A key to an understanding of Japan's

industrial performance can be found inthe ability of firms in certain industriesto coordinate their operating activitiesflexibly and quickly in response to chang-ing market conditions and to changes inother factors in the industrial environ-ment, as well as to emergent technicaland technological exigencies. Represen-tative Japanese firms have cultivated anability for rapid response by developingan internal scheme in which emergent

information is utilized effectively on-siteand in which operating activities are co-ordinated among related operating unitson the basis of information sharing. Inthis section, I first illustrate this claimwith three examples drawn from operat-ing practices in the automobile and steelindustries and from R & D activities inmanufacturing industry generally. I thencharacterize generic aspects of these andother examples as a mechanism of hori-

zontal coordination that stand in contrastwith the more familiar mechanism ofhierarchical coordination. I summarizesome results of a comparative analysis ofthe relative information efficiency of thetwo coordination mechanisms; and finallyI discuss their implications for under-standing and interpreting Japanese in-dustrial performance. I am aware thatany attempt to draw general propositionsfrom specific examples runs the risk ofsmall sample bias. But the following ex-

amples are drawn from many observa-tions made recently in the course of plantvisits and interviews with engineers andmanagers, and I am reasonably confidentthat they represent widespread and gen-eric elements of Japanese practice.' AlsoI believe that the significance of the com-parative analysis to follow is very hardto grasp without breaking open the econ-omists' black box of the production func-tion and gaining a concrete image of howfirms operate without a rigid hierarchicalorder.

A. Examples

1. Production Scheduling-An Au-tomobile Industry Case. A number ofstudies based on rather crude accountingmethods claim that the automobile in-dustry represents a case in which Japanhas caught up with the forerunners inproduction cost efficiency and is now it-self running ahead very fast. (Accountingstudies conducted up to the early 1980sare surveyed in Robert Cole and Taizo

Yakushiji 1984. Michael Cusmano 1985provides a more careful estimate ofJapanese producers' comparative per-formance within the framework of ac-counting.) Melvin Fuss and LeonardWaverman (1985) have recently castdoubt on such assertions and haveclaimed, on the basis of elaborate econo-metric analysis, that even in 1980 Japa-nese industry was only slightly moreproductive at normal capacity utilization

1 Between September 1987 and August 1989, I in-terviewed managers and engineers of about 50 Japa-nese manufacturing irms and banks. In particular,I conducted intensive studies, which included plantvisits, of the following firms: Nippon Steel Corpora-tion, Matsushita Electric Industrial Co., Ltd., SonyCorporation, Honda Motor Co., Ltd., Toyota MotorCorporation, Omron Tateisi Electronics Co., KyowaHakko Kogyo Co., Ltd., Tonen Corporation, IBMJapan, Ltd., Kajima Corporation, Ohbayashi Corpo-ration, Toray Corporation, he Sumitomo Bank, Ltd.,and the Sanwa Bank, Ltd. A small portion of inter-view records have been published in Aoki, Koike,and Iwao Nakatani 1989).



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rates in spite of the apparent cost effi-ciency of Japanese producers. Becausethe automobile industry is characterized

by significant quasi-fixed factors, such ascapital plant, administrative and design-ing jobs, and product-specific manufac-turing facilities, shifts in consumers'tastes or an economic downturn can havesevere effects on cost efficiency. Fuss andWaverman maintain that long-run totalfactor productivity growth during the1970s has been underestimated by an or-der of 30 to 40 percent for North Ameri-can producers in accounts that neglect

the effects of undercapacity utilization.It may be questioned, however,

whether it is appropriate to dismiss inad-equate capacity utilization among NorthAmerican producers at that time simplyas short-run disequilibrium that had nobearing on understanding the nature ofcomparative cost efficiency. I rathermaintain that the organizational abilityof firms to generate a product mix at-tuned to unpredictable market demands

and emerging technology without gener-ating an excessive under-utilization ofequipment and a large stock of productand in-process inventories may be quiterelevant for the comparative assessmentof the organizational efficiency of firms.In the stable oligopolistic markets forwhich fairly standardized products aresupplied, short-run market demandsmay be reasonably predictable. Undersuch a situation, a short-run productionplan may be fixed firmly for a certainperiod of time, based on the manage-ment's prior knowledge of market de-mands. The whole production processmay be divided into a series of special-ized functions, each standardized, andeach work unit may be required to per-form exclusively the specific jobs dictatedby the prior plan. Ex post adaptation toactual market conditions may be accom-plished through the adjustment of prod-uct and in-process inventories. Under

the said market condition, such internalcoordination-the H-mode-may be ableto exploit the informational efficiency of

hierarchical coordination and economiesof specialization.2The efficiency of the H-mode of coordi-

nation may become problematical, how-ever, when diverse consumers' tastescome to demand a variety of products,when demands shift in a volatile fashionfrom one variety to another, and whenthe need to deliver ordered productswithout delay becomes imperative forgaining a competitive edge. How have

Japanese auto producers responded tothese challenges and consequentlygained competitive advantage? In theconcrete case of a representative autoproducer, manufacturing coordinationtakes place roughly as follows:

The central production planning officedrafts the quarterly and monthly produc-tion plans for each factory, based on itsmarket demand forecasts, and presentscorresponding procurement plans to out-side suppliers. These prior plans provideonly a general guideline, however. Theintegrated production-delivery plan fora ten-day period is prepared by the com-modity-flow office on the basis of ordersfrom regional and overseas dealers. Inresponse to this plan, the engineeringoffice of each factory prepares a sequenceof daily production schedules. The dailyschedule is then adjusted two days priorto actual productioxi n response to actualcustomers' orders transmitted from deal-ers to the factory through the on-line net-work system (the daily adjustments ).On the final assembly line, wagons, two-door hatchbacks, and four-door sedanswith red, beige, and white bodies; withleft-hand (for export) and right-hand (fordomestic) steering wheels; with a varietyof transmissions, engines, and options;

2 For a discussion of efficiency of hierarchical coor-dination, see Oliver Williamson 1985, ch. 9; Aoki1988a, ch. 2.2



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horizontal coordination among relatedprocesses also seems to be essential. Letus illustrate this from the quality control

point of view.Consider, for example, the related pro-cesses of casting and rolling. In the West-ern plant, linkage is patterned after theH-mode. That is, the engineer at thequality control office sets engineeringspecifications for each process (e. g., amineral composition for the casting pro-cess and heating temperature for therolling process) according to his prior en-gineering knowledge. Each process man-ager is required to implement the direc-tive and is relieved of responsibility ifhe realizes the given target within a cer-tain error margin. On the other hand,the engineer would not step into theworkshop. But for continuous processesthere may well be a quality defect prob-lem that can be detected only at the endof the rolling process, but that originatesfrom a scar of the equipment at the con-gealing step of the casting process. Whocan discover this problem, pinpoint itssource, and institute a remedy to preventits recurrence? If the engineers isolatethemselves from workshops and if pro-cess control is segmented and relegatedto each process manager, it is indeed dif-ficult to cope with such problems.

At a representative Japanese plant, anintegrated engineering control room

exists side by side with the engineeringoffice for each workshop. They are nothierarchically ordered in terms of status.In fact, there is often a rotation of person-nel between the two to facilitate knowl-edge sharing among them and discouragethe development of shop-centered inter-ests. The integrated control room and theworkshop office are differentiated only byprimary responsibility. That is, the inte-grated engineering control room is re-sponsible for locating and solving cross-shop problems through discussion andbargaining with offices in charge of indi-

vidual workshops. In the actual solutionof cross-shop problems the control roomacts like a coordinator at the same hori-

zontal level with the workshops. This or-ganizational device is said to be one ofcentral foci of recent technical assistanceby Japanese steel manufacturers toAmerican and other steel manufacturers.

3. Product Development. The devel-opment of any new product proceeds ina hierarchical order: It starts with thebasic conceptualization of the new prod-uct and its analytic design and proceedsto the successive phases of detailed de-

sign; prototype fabrication, testing, andredesign; mass production and shipping;and marketing. Such development pro-cesses may be also characterized by vari-ous feedback loops. The first conceptuali-zation of a new product may arise fromrecognition of a potential market oppor-tunity prompted by marketing activity.Engineering experience at the testingphase and service experience at the after-sales maintenance phase may be fed intothe redesign phase. These features maybe thought of as universal phenomena.3Yet there seems to be a subtle differencebetween representative Western manu-facturers and Japanese manufacturers inthe ways that feedback mechanisms areutilized (Aoki and Rosenberg 1989; Imai,Nonaka, and Takeuchi 1985).

In the case of a representative Ameri-can computer manufacturer, each devel-opmental phase is made clearly distinctin such a way that the transition fromone phase to the next is subject to a strictindependent phase-review. The phase-review is carried out from the viewpointof engineering as well as business (cost,marketability, etc.). It is therefore con-ducted by a group of people drawn from

3 For a model of innovation incorporating the feed-back mechanism as an essential element see StephenKlein and Rosenberg (1986). For an application ofthis model

(thechain-linked

model)to the U.S. -

Japan comparison, see Aoki and Rosenberg (1989).



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various internal divisions, such as themanufacturing division, the patent sec-tion, the sales and services engineering

division. If a development project at onestage does not pass the review, it cannotnormally proceed to the next stage. Itmay happen that representatives fromthe manufacturing plant participate inthe early design phase, but in such casethe internal transfer payment for partici-pating personnel is to be made from thedevelopment department to the plantand the independence of each phase iskept clear. The feedback loop for rede-

sign is also formalized. If some engineer-ing change occurs at the factory level,this information is fed back to the designdepartment, which formally redrafts thedesign accordingly and files the reviseddesign into the corporate developmentand production record system so thatthe same updated engineering specifica-tion is automatically available to all facto-ries and service and maintenance divi-sions all over the world.

At representative Japanese manufac-turers as well, phase-review systems ofvarious kinds are normally instituted.But the transition from one phase to thenext is in general more flexible and differ-ent phases are actually intermeshed andoverlapped. For example, there is moreinteraction between design engineersand plant engineers at the early phaseof design and it is often difficult to saywhere the phase of prototype fabricationand testing actually starts. Very often,the design laboratory is located at thesite of the plant and there is even a rota-tion of engineers between the design lab-oratory and the plant engineering office,which facilitates informal informationsharing between the two. Also the engi-neer who has been responsible for thedesign of a new product, but who possi-bly has passed the peak of his productiv-

ityin

design and development may betransferred to a plant as a line manager

responsible for the manufacturing phaseof the new product (Westney and Sakaki-bara 1985). This practice motivates the

design engineer to be very attentive tosuggestions and opinions from the plantlevel in order to avoid the embarrass-ment he would face if engineering prob-lems occur at the manufacturing phasebecause of a design flaw.

In the case of one auto manufacturer,the development team is called the SEDteam, which is composed of membersfrom the sales, manufacturing engineer-ing, and development divisions. This

cross-disciplinary team is organized at avery early phase of product developmentand carries out development processesto the very end as a group. In otherwords, feedback loops are internalizedwithin the team. As much as possiblecross-jurisdictional problems are dis-cussed and solved collectively at everyphase of development. A developed proj-ect is proposed for the formal phase re-view by executive managers, who are alsodrawn from SED divisions, only if theplan is adequately matured. By contrastwith the Western manufacturer's casedescribed above, the Japanese reviewcommittee is said not to exercise a deci-sive autonomous judgment. Without anyvalue judgment at this point, one maysay that feedback loops of developmentprocesses or, more generally speaking,horizontal coordination among variousorganizational units, are more intense,yet tend to be more informal (undocu-mented) in the Japanese case.

B. Theory and Interpretations

These examples of industrial practicesin Japan suggest that the coordinationmode that operates within representativeJapanese firms differs from the traditionalmodeling of organizational hierarchies-

the H-mode. Let us now try to identifythe fundamental differences between the



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two modes by focusing on a few impor-tant factors and examine how the relativecost efficiencies of the two can differ in

various environments. Doing this, oneis bound to commit the sin of oversimpli-fication. But the point here is to makeit clear that the cost function of the firmis not exogenously and solely determinedby an engineer's blueprint; it also de-pends on organizational and human fac-tors. I shall, therefore, venture to offera sharp theoretical formulation of non-hierarchical coordination and then inter-pret its performance characteristics inthe context of the Japanese economy.

The H-mode has two essential fea-tures: (1) the hierarchical separation be-tween planning and implemental opera-tion and (2) the emphasis on theeconomies of specialization. That is,planning, such as for production schedul-ing, manufacturing process control, andcommodity development is entrusted toan office at the top level of each function(e.g., the production planning office, theengineering office, the development lab-oratory) which is supposed to have spe-cialized prior knowledge (on markets, en-gineering know how, etc.). Let us callthis planning prior planning. Prior plan-ning is fixed for a certain period of timeand implemented by operating units ofthe lower levels (e.g., workshops, plant),each of which is assigned a hierarchicallydecomposed special operational function.Any random event during the implemen-tation period may be coped with by apriori devices (e.g., buffer inventories,troubleshooting specialists such as relief-men and mechanics), and new knowl-edge that emerges may be used only forthe next round of planning by the higheroffice.

Consider an alternative mode reflect-ing aspects of Japanese firms-let us callit the J-mode, which has two main fea-tures:

(1)the horizontal coordination

among operating units based on (2) the

sharing of ex post on-site information(learned results). That is, prior planningsets only the indicative framework of op-

eration. As new information becomesavailable to operating units during theimplementation period (e.g., customers'orders at dealers, quality defect prob-lems that become apparent at a work-shop, engineering problems associatedwith development of a new product thatbecome evident only at the plant site),prior plans may be modified. But in orderfor on-site information to be utilized ina way that is consistent with the organiza-tional goal, adaptation must be coordi-nated among interrelated operatingunits.

In the J-mode, on-site information maybe better ultilized for the realization oforganizational goals (more formally, onemay say that the J-mode can generateinformation value by the use of ex postinformation). Such a gain, of course, isnot costless. In the J-mode, economiesof specialization of operational activitiesare sacrificed, for-some portion of timeand effort of the operating units needsto be diverted for acquiring new informa-tion (i.e., learning) as well as for commu-nicating and bargaining with each otherfor coordination. Such costs may be re-duced by the development of informationtechnology: hardware, software, and hu-manware. Therefore, the comparativeadvantage of the H-mode and the J-modedepends on such factors as the learningability of personnel, the ease of commu-nication among operating units, and thedegree of economies of specializationwith regard to the variety and volatilityof market demand. Aoki (1986, 1989) andItoh (1987) (see also Jacques Cremer1989) examined the advantages and dis-advantages of the two modes and cameup with the following noteworthy propo-sition: When environments for planning(e.g., markets, engineering process, de-velopment opportunity) are stable, learn-



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ing at the operational level may not addmuch information value to prior plan-ning, and the sacrifice of economies of

specialization in operational activitiesmay not be worthwhile. On the otherhand, if environments are extremely vol-atile or uncertain, decentralized adapta-tion to environmental changes may yieldhighly unstable results. In both these twocontrasting cases, the H-mode may besuperior in achieving the organizationalgoal. In the intermediate situation, how-ever, where external environments arecontinually changing but not too drasti-

cally, the J-mode is superior. In this case,the information value created by learningand horizontal coordination at the opera-tional level may more than compensatefor the loss of efficiency due to the sacri-fice of operational specialization.

This result is consistent with the often-stated suggestion that the hierarchicalmode of coordination based on a highlydeveloped specialization scheme, whichprevailed in the American steel and autoindustries until the late 1960s, lost itsadvantage in the face of product variationand weakening oligopolistic control (Mi-chael Piore and Charles Sabel 1984).Economies of specialization may be ex-ploited more favorably for the stable andlarge-scale production of standardizedcommodities, but not for the small- andmedium-batch production of varieties ofproducts in a high-volume assembly pro-cess where thousands of independentsteps must be coordinated. These mar-kets are precisely the ones where Japa-nese manufacturers exhibit strong com-petitive capabilites; however, in simplerprocesses, such as a foundry, where per-haps thirty operational steps are re-quired, the Japanese advantage is slight,and sometimes non existent (Abegglenand Stalk 1985, p. 61).

These propositions are consistent withthe observation that Japanese manufac-turers have shown relative strength in

process innovation, as exemplified in thesteel industry, to which intense interac-tions between engineers in the develop-

ment laboratory and engineers, and evenworkers, at the factory site may contrib-ute (Edwin Mansfield 1988). On theother hand, Japanese manufacturers havenot shown a conspicuous advantage inhighly uncertain innovations involvingnew conceptualizations of market poten-tial and highly specialized scientific ap-proaches. Nor have they acquired a com-petitive edge in industries where thereis customized production of newly de-

signed products, such as in the aerospaceindustry (David Mowery and Rosenberg1985).

It is obvious that greater efficacy ofcommunications and learning at theopertional level tends to favor the J-moderelative to the H-mode in a large andperhaps growing sector of industry. It isinteresting to note, in this connection,that the J-mode of horizontal coordina-tion based on shared learning at the fac-tory site has emerged and developed inthe last two decades or so by relying onhighly qualified and diligent blue-collarworkers who have formed the core of thework team. They were mainly recruiteddirectly out of high schools in the 1950sand early 1960s when the share of malepersons who found employment right af-ter junior high school was still as highas 45 to 25 percent depending on busi-ness cycle conditions (currently less than4 percent). Now that the economic obsta-cles for qualified and motivated youthsto advance to higher education have beenvirtually removed, a serious challengefacing representative manufacturingfirms in Japan today is to recruit highlyqualified blue-collar workers.

The J-mode as practiced by Japanesefirms has one feature in common withadvanced Western firms as exemplifiedby the American computer manufacturerdescribed in example (3) above, that is,



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would justify doing so. The problem ishandled on the spot, possibly with thehelp of neighboring workers, subfore-

men, and so on, but not by calling inoutside specialists such as mechanists.The integration of operating skill with au-tonomous problem-solving capability canbe assured only when the worker has agood understanding of the relevant workprocess as a whole, rather than only acertain aspect of it. Such general under-standing in turn may be nurtured bymaking the worker familiar with manyrelated aspects of the work process. This

is a point that Kazuo Koike has rightlyemphasized in a series of influential pa-pers (Koike 1984, 1988, 1989).

3. In examples (2) and (3) in the lastsection, it was pointed out that the prac-tice of job rotation of engineers amongdifferent engineering offices as well asbetween engineering jobs and supervi-sory jobs at the factory facilitates theknowledge sharing needed for horizontalcoordination among different phases ofengineering and development processes.For similar and other purposes, white-collar workers on the lifetime career track(and sometimes even blue-collar work-ers) are rotated among various jobs indifferent offices and workshops every fewyears. Such rotation familiarizes workerswith various jobs and enhances their abil-ity to process and communicate informa-tion needed for the efficient operationof the J-mode. Regular rotation also pre-vents workers from identifying them-selves strongly with the interests of spe-cific jobs, workshops, plants, and officesso that the development and assertionof local interests inconsistent with the or-ganizational goal are restrained.

These factors point to two importantneeds: (1) the design of incentives nottightly related to a specific job category,but that motivate wide-ranging job expe-rience among employees; and (2) the de-velopment of a personnel office that ad-

ministers such incentives and is also re-sponsible for personnel posting, includ-ing interjurisdictional rotations, with an

eye to the firm's long-run organizationalgoals.As for the first, Japanese firms have

developed rank hierarchies as a primaryincentive device, which Aoki (1988a, ch.2) describes in some detail (also see Ron-ald Dore 1973 for a classical description).The essential idea may be summarizedas follows. There are usually separaterank hierarchies for blue-collar workers,white-collar workers, and engineers, as

well as one for the supervisory and mana-gerial employees above them. Each rankcarries a certain level of pay, but not aspecific job. Therefore employees in thesame rank may be doing different jobs.For instance, an engineer at the inte-grated process control office, an engineerat development laboratory, and an engi-neer at the plant site may well be in thesame rank and receive identical pay (pos-sibly with minor allowances for particularjobs). New entrants to the firm who arejust out of school are placed at appropri-ate ranks in the nonmanagerial rankhierarchies determined by their years ofeducation.

After entry at an identical startingpoint for a certain educational credential,employees compete for promotion inrank throughout their careers. The crite-ria for promotion are years of service andmerit, with the latter not specifically re-lated to particular jobs but to broadly de-fined problem-solving abilities, commu-nication skills, and so on. The speed ofpromotion for all employees is the sameearly in their careers, however, as youngemployees are considered to be in train-ing and their aptitude for the firm's spe-cific implementation of the J-mode is be-ing tested. Differences in speed ofpromotion among employees becomesmore apparent, however, in midcareer(say, after employees reach their mid-



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30s). So, the fast flyer among blue-collarworkers may reach the top rank in hislater 30s (and proceed to supervisory

ranks afterward), while the slow movermay reach the top rank only a year beforemandatory retirement at age 60. Promo-tion criteria become stricter particularlyfor white-collar employee as his careeradvances and if an employee does notexhibit continual progress he or she maybe separated in mid to late career, al-though an honorable exit is usually ar-ranged by the employing firm by postingthe employee in a less promising quasi-

outside job at a minor subsidiary or otherrelated firm. Thus the mystifying notionof life-time employment and the sen-iority system tells only half of the truth.Also it may be noted that in the late1980s, the personnel departments ofsome large Japanese firms have begunofficial recruiting of midcareer specialistsand skilled workers from other firms asthe shortage of such staff has becomemore pronounced.

The ways in which rank hierarchyworks as an incentive, that is, the waysin which it copes with the problems ofmoral hazard (the possibility of employ-ees' shirking in the absence of propermonitoring), adverse selection (the diffi-culty of hiring the right workers, whosequalifications cannot be known with cer-tainty prior to employment), and theprovision of motivation for wide-rangingfirm-specific learning and teamwork canbe rigorously analyzed in the light of re-cent development of the incentive litera-ture, and the theories proposed may betested (see Aoki 1988a, ch. 3 for the theo-retical analysis of Japanese employmentpractices and the relevant literature).From the theoretical point of view, onepoint should be stressed here: The exis-tence of a credible threat of dischargewhen the employee does not meet thecriteria for continual promotion plays animportant role in enabling the rank hier-

archy to operate as an effective incentiveto curb shirking. A discharge in mid-career may point to some negative attri-

butes of the discharged so that he or shemay not be able to gain equivalent rankoutside, when information about him orher is not perfect. So an employee mustcompare short-run gains from shirkingwith potential losses in wealth due to dis-charge and consequent demotion. Asstated above, in fact, lifetime employ-ment and seniority advancement arenot automatic. Otherwise, they wouldnot be effective as incentives.

Theoretical analysis (e.g., BentleyMacLeod and James Malcomson 1986)shows, however, that actual dismissal asa disciplinary measure seldom needs tobe observed, insofar as the rank-hierar-chy system operates well as an effectivemonitoring mechanism. Also, the possi-bility of promotion gives employees apositive incentive to learn within the con-text of their employing firms, and thepotential loss of seniority and of retire-

ment compensation related to durationof employment discourages the midca-reer exit of trained employees. As a re-sult, the duration of employment tendsto be relatively long for Japanese workers(e.g., Hashimoto and Raisian 1985;Mincer and Higuchi 1988). But, howmuch of the seniority rise in employee'sincome is due to learning achievementand consequent productivity increase(which is explained by human capital the-ory) and how much to bonding for dili-gence (which is explained by monitoringtheory) is still to be empirically settled.

In order to administer rank hierar-chies, Japanese firms have developed thepersonnel department as an importantinstitution. This department has full con-trol of the recruitment of new employeesfor career tracks out of school, designsand runs rank hierarchies (pay scale andpromotion criteria), and rotates white-collar workers with an eye to the wider



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ganizationally effective, either their coor-dination or their incentive mode needsto be hierarchical, but not both. Com-

paratively speaking, Japanese firmstend to be less hierarchical in the coor-dination mode, while they rely uponrank hierarchies in their incentive sys-tem.

III. The Nature of Bank-orientedFinancial Control

In this section, I take up the financialaspect of Japanese firms and examine itscharacteristics. I argue that there is aclose and logical symmetry between theinternal organizational aspect and the fi-nancial control aspect of Japanese firms,and I summarize this symmetry as theSecond Duality Principle. As regards thefinancial control aspect, I need to explainthe following two stylized facts. I regardthe two as parts of a unified and consis-tent system, even if they do not appearto be necessarily consistent internallyand mutually from the orthodox neoclas-sical (contractual) view of financial con-trol (for detailed data supporting the styl-ized facts summarized here, consult Aoki1988a, ch. 4).

.1. In Japan, banks (city banks, trustbanks, local banks, and others-eachspecialized in different business activitiessubject to regulation and administrativeguidance by the Ministry of Finance) areallowed to hold stocks of nonfinancialcompanies up to the maximum of 5 per-cent of the shares of each stock. Financialinstitutions as a whole (including insur-ance companies) own about 40 percentof the total stock outstanding of listedcompanies, but there is usually one or afew influential city banks for each listedcompany that own up to, or close to, themaximum. There is also one city bankfor each company among its major stock-holders, called the main bank, which hasthe closest tie in terms of cash manage-

ment, as well as short-term (and long-term) credits. The main bank plays therole of manager of a loan consortium

when a group of banks extends majorlong-term credit to the company, and itis responsible for closely monitoringthe business affairs of the company. Ifthe company suffers a business crisis, themain bank assumes major responsibilityfor various rescue operations, which in-clude the rescheduling of loan payments,emergency loans, advice for the liquida-tion of some assets, the facilitation ofbusiness opportunities, the supply ofmangement resources, and finally reor-ganization, to secure the claims of theconsortium (Sheard 1989). In the normalcourse of events, however, the main bankexercises explicit control neither in theselection of management nor in corporatepolicy making. Well-run companies thatincur little or no debt from banks appearto be virtually free from banks' interven-tion, and their managements enjoy thehighest degree of autonomy.5

2. Because a large proportion of theequities held by banks and other corpo-rate entities are extremely stable, themanagements of Japanese firms are insu-lated from takeover raids through theopen market. Individual stockholders,who own only about 30 percent of out-standing total equities of listed compa-nies, do not have any effective voice inthe corporate governance structure. Aslong as a company is well run, top man-agement is selected by the outgoing pres-ident (or chairman) rom among the firm'sown managerial corps. Thus top manage-ment is considered to be the highest rankfor the career advancement of employ-

5For instance, 15 percent of the stock of ToyotaMotor Corporation is owned by three city banks,Tokai, Mitsui, and Sanwa, but there is no collusionon the part of these banks to influence the corporatedirection and management selection by Toyota. They

do, however, woo Toyota management competitivelyfor commercial dealings.



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ees. From this observation, some authors(e.g., Abegglen and Stalk 1985; Komiya1987, 1989) infer that Japanese firms are

run virtually in the interests of employ-ees subject to some degree of financialconstraint. At the same time, however,individual stockholders have enjoyed thehigh annual after-tax real market rate ofreturns to stockholding of 11.7 percent(the standard error 18.5 percent) over theperiod 1963-86 (see Aoki 1988a, pp. 113-16). The economic interests of individualstockholders do not seem to be entirelyneglected at least ex post.

Thus there seem to be paradoxes. Onthe one hand, banks are major stockhold-ers of companies, but they do not appearto exercise vertical control over manage-ment of these companies and they remainas silent business partners in good profitstates. Their power becomes visible onlyin bad states. On the other hand, eventhough the individual stockholders haveonly apparently weak control over firms,they are de facto beneficiaries of Japanese

firms. But these are paradoxes only fromthe viewpoint of orthodox financial the-ory in which stockholders are assumed(or at least ought) to control managementthrough the corporate governance struc-ture as well as the threat of market disci-pline (i.e., takeover raids). But this doesnot mean that Japanese firms are com-pletely free of financial control (monitor-ing).

First, let us note that main bank's con-trol manifests itself in bad profit states.If the profit of a company starts to de-

cline, the main bank is able to detectthe problem at a rather early stagethrough information gained from themanagement of commercial accounts,short-term credits, long-term personalcontacts with top management of thecompany and its business partners, andso on, because of its special position.7Tacit and explicit pressure for the inter-nal overhaul of management would beinitiated in exchange for various types

of rescue operations as noted before. Ifbad states continue, the main bank maydecide to take over management throughthe governance structure of the company(stockholder's meeting, board of direc-tors). Recent experiences indicate, how-ever, that banks do not change the funda-mental nature of internal management,but rather hand over top managementafter recuperation to internally promotedemployees (see Richard Pascale and

Thomas Rohlen 1983 for an interestingcase study of the bank takeover ofMazda).

It is because of this possibility of banktakeover that I have adopted a definitionof the main bank, which focuses on itsrole as a major stockholder as well as amain lender (or manager of a loan consor-tium). I would argue that although in thenormal state bank control is not visible,the potential threat of bank takeover mayplay an important monitoring functionwhen the financial system is viewed asa whole. A recent contribution by Phi-lippe Aghion and Patrick Bolton (1988)is suggestive in this regard. Aghion and

6 For a more detailed estimate of the market rateof stockholding based on firm-based data, see Andoand Auerbach (1988). Taking into account both taxesand risk premia, Bernheim and Shoven (1989) at-tempt to estimate the cost of capital for Japanesefirms. Whether the ex ante cost of capital facing Japa-nese firms is relatively lower or higher than theAmerican counterpart has not been empirically set-tled yet and is still controversial in spite of an oftenmade allegation that the cost is relatively lower (e.g.,George Hatsopoulos, Paul Krugman, and LawrenceSummers 1988). See Aoki (1988a, pp. 112-13) for acriticism of the casual comparison of costs of capital

between different economies based on raw data unad-justed for different tax and accounting conventions.

7 In the bank-oriented system in Japan, a singlebank, that is, the main bank, monitors the companyclosely as the major cash manager-creditor-stock-holder so that it is in a position to detect a problemearly. In contrast, at the time of near bankruptcy ofChrysler, about 400 banks had extended credit to

Chrysler and no bank was aware of the magnitudeof the problem until the real crisis became evident.



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Bolton argue that the essence of debtcontracts lies neither in its return charac-teristics (such as fixed-interest claims

combined with bankruptcy risk) nor indefining a liquidation point, but in thefollowing arrangement regarding thetransfer of control: As long as good profitstates continue, the outside investor(bank) does not intervene and insidemanagement continues to manage; other-wise the outside investor (bank) takesover management and reorganizes.Within the specific context of theirmodel, they showed that such a financial

system can achieve ex ante a Pareto supe-rior outcome under certain conditions.The external investor with control rightsmay be excessively risk-prone in goodprofit states, while inside managementmay be excessively wasteful in bad statesby trying to survive at the creditors' ex-pense.

Needless to say, the Japanese situationis much more complicated than theAghion-Bolton model. Also Aghion andBolton's analytical result does not implythat bank-oriented financial control is al-ways efficient. But one cannot deny thatin Japanese practice there is a close posi-tive correlation between the degree ofmanagement freedom from bank controland the level of corporate profits. Be-cause internal management naturallyabhors external interference by themain bank, and bank control is a humili-ating blow to the failed manager, man-agement aspires to pursue high profits.It may thus be considered that corporateranking by profit is an effective disciplineexercised over the apparently autono-mous management of Japanese firms,even though its form is different fromthat envisioned in the orthodox Anglo-American financial literature (hierar-chical control of stockholders through thecorporate governance structure com-bined with market-oriented incentivecontracting for managers and the threat

of takeover).8 This observation suggeststhat the nature of the financial controlover Japanese firms is symmetric to that

of the internal control within them:There is no clear hierarchical division be-tween corporate control and managerialoperation. Financial control by bank cumstockholders concerning corporate direc-tion is exercised only in a business crisis.Otherwise corporate decision is dele-gated entirely to management on-site.Management, however, is indirectly dis-ciplined through competition over rank-ing, this time, ranking of firms by corpo-

rate profits. A question may then beraised. Is there any logical reason for thesaid symmetry: weak-decision hierarchycum incentive-ranking hierarchy (WDIR)both in the internal and financial aspects.In other words, can a WDIR-type inter-nal structure be combined effectivelywith a non-WDIR-type financial systemas envisioned in the orthodox finance lit-erature?

First, note that in order for horizontalcoordination within internal organizationto operate most effectively (in the senseof being able to achieve organizational

8 It is doubtless true that North American manag-ers are potentially more vulnerable to takeover raids.There are, however, some interesting developmentsthat may suggest a convergent phenomenon. First,the growth of institutional stockholding such as bypension funds in the U.S. tends to stabilize a largeproportion of the ownership of major firms' equities.As a result, a closer relationship between manage-ment and major institutional investors based on thesharing of business information may emerge. Also,in the U.S. the spread of leveraged buyouts hasbrought in many of the features associated with bank-oriented financial contracting, such as a high debtratio and combined debt and equity holdings (stripfinancing). In the case of a management leveragedbuyout, management becomes more insulated frompossible raids by outsiders, but vulnerable to banks'controls when the firm's performance deteriorates(Erik Bergl6f 1989). Whether these phenomena aretemporary or not (except for the growth of pensionfunds and its implications) is not yet clear, but, to-gether with increasing reliance of Japanese firms onbond financing abroad, the distinction between thebank-oriented system and the market-oriented finan-cial system is becoming somewhat blurred.



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goals), management decision needs to becontinually adapted in response to on-site information available at all levels of

the functional hierarchy. Further, organ-izational goals themselves may need tobe adjusted in response to employees'voice. In this way, a sense of joint effortis created so that employees' active coop-eration in horizontal coordination may beelicited. This amounts to a set of mutualvertical commitments in which manage-ment recognizes the interests of employ-ees and, in return, employees exertgreater effort. Commenting on my previ-

ous work (Aoki 1986) Leibenstein wrote:We are likely to find that a high degree

of mutual vertical commitment createsa sense of common objectives and a con-cern for the results beyond one's ownjob, which in turn is likely to supporthorizontal coordination on productiongoals. . . . Thus while I agree with Aokion the importance of horizontal coopera-tion I would argue that where horizontalcooperation on production goals flour-

ishes it is likely to be a consequence ofa high degree of mutual vertical commit-ments (p. 170).

Toward the end of the next section, Iinquire more precisely into the logicalstructure of the mutual vertical commit-ments which can yield a Pareto superioroutcome for financial and employees' in-terests. Anticipating that, I only maintainhere that the sharing of knowledge, aswell as the partial identification of inter-ests, across various levels of internal or-ganization is essential for facilitatingvertical interactions, especially for man-agement to absorb information and de-mands at the lower level, for corporatedecision making. The internal selectionof management through promotionalranking may serve as an effective mecha-nism by which such knowledge sharingand interest identification are nurturedon the basis of the sharing of experiences.Further, rank hierarchy as an incentive

device becomes fully operative only if theinternal promotion ladder for employeesextends to as high as the top executive

position. And, the autonomy of internalmanagement from external financial in-terests is guaranteed under the WDIR-type financial control as long as the profitstate is satisfactory.

From the perspective of incentive aswell, the WDIR symmetry seems to belogical. Under an employment contractestablished in the context of a rank hier-archy, operating employees tend to beassociated with a particular firm on a

more or less permanent basis becausemidcareer mobility (exit) may be costly(Hashimoto and Raisian 1985; Mincerand Higuchi 1988). Their lifetime wealthis at stake with the employing firm inthe form of future claims for senioritypayments and retirement compensationsand this wealth is not salable. Opportuni-ties for risk diversification are thus lim-ited. There needs to be a mechanism,therefore, that insures employees to

some degree against firm-specific risk.Because of the stable concentration ofstockholding, as well as continual infor-mation flow between firms and banks inthe context of the WDIR financial sys-tem, the reorganization of a troubled firmby the main bank may occur sooner thanunder the market-oriented financial sys-tem and this may mitigate the risk ofbankruptcy (Berglof 1989). In fact, thebankruptcy of companies associated witha reputable main bank rarely occurs inJapan. Horiuchi, Parker, and Fukuda(1988) tried to refute empirically the in-surance hypothesis regarding the mainbank. But the function of a monitor andthat of an insurer against bankruptcy riskby the main bank are not necessarily mu-tually exclusive. At the time of the rescueoperation, the main bank normally bearsmore than proportional costs in compari-son to other members of the consortiumand this may be explained by the suppo-



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sition that the main bank's reputation asa good and responsible monitor is at stake(Aoki 1988a, pp. 142-49, 232-33). On theother hand, managers and operating em-ployees are relatively mobile across firmsunder Western-type employment con-tracting, but well-developed securitiesmarkets can provide an efficient mecha-nism through which individual wealth-risk is diversified and thereby reduced.Therefore I claim the following:

The Second Duality Principle: The inter-nal organization and financial control of

the Japanese firm are dually character-ized by weak-decision hierarchy and in-centive-ranking hierarchy. This dualityis not accidental.

IV. Dual Control over CorporateManagement Decision

In this section I discuss questions con-cerning the goals and purposes of Japa-nese management. We have seen in thelast section that Japanese managementis relatively independent of external fi-nancial control in making corporate deci-sions. This freedom, however, exists onlyso long as a satisfactory state of profitsis maintained. Should that state be seri-ously compromised, the external powerof the main bank, which stands in thebackground, will be exercised. This sub-stantial, if constrained, freedom of Japa-nese management poses a question: Is

the conventional profit-maximizingob-

jective itself routinely qualified by an ad-mixture of other goals? Does it apply onlyas a subsidiary constraint on the pursuitof other goals? Some influential econo-mists argue in that way, for example, Ko-miya, who advances the hypothesis, asa first approximation, that a Japanese firm

chooses the amount of output and theamounts of labor and capital inputs soas to maximize income per employee

. . . after the payment of a fixed shareof profits to stockholders (1989, p. 115).

Such a presumption essentially boilsdown to the model of a worker-controlledfirm that postulates the maximization ofincome per worker since the profit mo-tive is assumed not to have any directimpact on the decisions of corporate man-agement. I predict, however, that it willbe difficult to sustain such a hypothesis,if its implications for corporate behaviorare empirically tested. For example, thehypothesis implies that to protect the in-terests of incumbent employees thegrowth rate of the worker-controlled firmwould be slower than that of a profit-max-imizing firm (Anthony Atkinson 1973), anunlikely situation in Japanese firms.

On the other hand, there are reasonsto believe that employees as a group con-stitute assets specific and internal to thefirm. We have seen that Japanese firmsrely upon a system of horizontal coordi-nation in which employees at the opera-tional level actively participate. Also Ihave argued that the information-pro-cessing and communicative abilities ofparticipating employees are nurturedlargely through learning by doing in thecontext of a firm-specific coordinationnetwork. Such abilities cannot be ac-quired in ready-made form prior to mem-bership in the network and their valuescannot be thoroughly realized in isolationfrom it. In other words, skills effectivefor the creation of information value inthe context of horizontal coordination

maynot be

classifiable alongwell-defined

job categories, for which market con-tracts transferable between firms can beunambiguously written. One may reasonthen that employees of Japanese firmsas a group become assets specific to theinternal network and that rewards forthem are internally determinable (sub-ject to possible external constraints) andpayable out of the value generated bythe network net of costs due to the train-

ing of employees, the sacrifice of econo-mies of specialization, and so on.



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If so, however, the following hypothet-ical question may be raised from anotherangle: Why do employees not purchase

the physical assets necessary to maintainthe network through debts and replicatethe network, guaranteeing to themselvesits whole value? In short, why would anemployee-controlled firm not be cre-ated? This question arises not only outof intellectual curiosity alone, for someauthors do argue that Japanese firms arein effect managed on behalf of their em-ployees. Yet there are reasons that makeit difficult for employees to control their

firms explicitly and entirely. One is theobvious limitation of the availability offinance for the purpose of creating theemployee-controlled firm. It may be re-called that monitoring by the main bankis particularly effective because of its dualposition as a major creditor and a mainstockholder. Since potential creditors areexcluded from equity ownership of theemployee-controlled firm, however, theymay not feel as secure in providing credit

and reluctant to do so.Further, to convince all employees to

move to the new clone firm, they mustagree on how to divide up the value ap-propriated by the firm. This division in-volves costs of collective choice whichmay be prohibitively high, specificallywhen the employees are not homoge-neous. Also, George Mailath and AndrewPostlewaite (1988) argued that if thereare intangible gains that employees get

from the firm (as distinguished from thenetwork as such) and that they cannoteach verify, they may be induced to exag-gerate their reservation wages (that is,the wage at which they would move tothe proposed clone firm) and that an at-tempt to induce truthful revelation maymake a proposal for a new viable em-ployee-controlled firm untenable. Thiswould be especially true when the sizeof the network becomes very large. Suchprivate reservation wages, for example,

may take the following forms. The perfor-mances of employees of the Japanese firmare evaluated and rewarded in the longrun by the elaborate and admittedly im-partial personnel administration systemcrystallized in the hierarchy of ranks, andthis may provide to workers the long-runsecurity and the sense of fair treatmentthey desire. It does not seem obvious,however, how the egalitarian idea of theemployee-controlled firm and the cen-tralized management of hierarchy ofranks can be made mutually compatible.Also, the loss of the main bank's services

in monitoring management may imposecosts of monitoring management on eachemployee in terms of time, effort, andresources. Such costs may be private in-formation.

The discussion in the preceding twoparagraphs is admittedly hypothetical,but it may help us understand that theimpact of financial control over Japanesefirms cannot be neglected entirely evenif employees are network-specific assets.

A portion of the value created by thenetwork thus accrues to financial inves-tors who supply finance and monitormanagement. On the other hand, if em-ployees' reward cannot be entirely deter-mined by external market competition,but is negotiated internally, employees,too, would be interested in how corpo-rate decisions are made. Corporate deci-sions would have an impact on workers'short-term and long-term positions in the

rank hierarchies that define their life-time earnings. Employees are not onlyinterested, they are also able to exerciseinfluence on corporate decisions. Whenemployees are promoted to be executivemanagers, their motives may well remainmixed and contain a carry-over from theirlonger careers as employees in the lowerranks. It is true that, as executive manag-ers, they must give attention to profitmaking in order to maintain their ownposition and autonomy. Yet they may re-



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tain a degree of identification with theinterests of employees and a degree offreedom to support them.

Further, for financial interests as well,it may be reasonable to leave open thepossibility of mutually beneficial ex-change between the levels of employees'earnings and effort, on one hand, andthe direction of corporate decision mak-ing, on the other. For example, employ-ees may be willing to trade off currentearnings and expend more effort forhigher job security, which may also raisethe profit level. Further, such exchange

may help preserve the network-specificassets as well, which would be mutuallybeneficial in the long run. Therefore, wepropose the following hypothesis, mak-ing its behavioral implications subject tofuture empirical testing.

The Third Duality Principle. The corpo-rate management decisions of Japanesefirms are subject to the dual control (in-fluence) of financial interests (ownership)and employees' interests rather than tounilateral control in the interests of own-ership.

It may be noted that this propositiondeparts not only from the usual neoclassi-cal presupposition, but also from the

share system view of Martin Weitzman(1984), although Weitzman claims thatthe Japanese economy is the only indus-trial economy in the world with anythingremotely resembling a share system (p.76). The essential difference lies in thefact that in the model I propose, not onlydistributive shares but also corporate de-cision making is implicitly or explicitlysubject to sharing. In Weitzman's theo-retical design, only the share parameterdefining the division of value-added be-tween profit and workers' earnings is sub-ject to bilateral agreement. After suchagreement, corporate decision making,such as on the size of employment, isthe prerogative of management who aredriven exclusively by the profit motive.

If the marginal return from a worker isdiminishing, yet the share parameter isfixed ex ante at less than one, income

per worker is ever diminishing as the sizeof employment increases. On the otherhand, when marginal returns are posi-tive, management is induced to expandthe size of employment. I find it unrealis-tic to imagine that unions (at least theJapanese enterprise union) fail to recog-nize the subsequent outcome of agreeingwith the Weitzman's share contract,namely that they lose control over re-muneration per worker. I would main-

tain that the hypothesis of dual controlby financial and employees' interestsover corporate decision making is a morereasonable one, once the network speci-ficity of employees' skills is accepted.

Questions to be asked next are as fol-lows: How do firms behave under dualcontrol? Is there any qualitative or quan-titative difference between the implica-tions of dual control and unilateral own-ership control in how firms are run? How

is dual control exercised? What role domanagement and employees each play?

First we note that employees as agroup can withdraw cooperation in hori-zontal coordination if they feel that theyare not treated fairly by managementin pecuniary rewards and corporate deci-sion making. On the other hand, themain bank as the major creditor cumstockholder can threaten managementwith the discipline of bank takeover if asufficient level of profits over time is notassured.9 Further, management's social

9 Strictly speaking, there is a question as towhether there is any conflict of interest between themain bank as a creditor cum stockholder and theindividual stockholders. This problem is investigatedin Aoki (1984b; 1988a, pp. 127-38) within the frame-work of a miniature general financial equilibriummodel incorporating features of taxes and financialregulation in Japan. This analysis indicates that thebank prefers its portfolio company to rely more ondebt financing than on equity financing than individ-

ual stockholders would do and that the conflict hasbeen resolved in favor of the bank, although less sosince the mid-1970s.



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prestige and autonomy are enhanced ifthe managed firm stands higher in corpo-rate profit ranking. We may thereforesuppose that the distribution of a firm'srevenue between employees' earningsand profits reflects either the relativebargaining power of the enterprise unionvis-a-vis management acting in the inter-ests of profits or the notion of fairnessby management.'0 Further, let us imag-ine that management strikes a balancebetween employees' interests and finan-cial interests in making corporate policy.Finally, suppose that, to the degree thatemployees trust management corporatepolicy making to be fair, they supplymore effort in operating activities andhorizontal coordination than would beexpected under the competitive wagesystem (i. e., more effort than maximizing

individual labor surplus obtained byequating the marginal value disutility ofeffort with the wage rate).

Such mutual commitments by manage-ment and the employees are expected

to yield a Pareto superior outcome underthe assumption of network specificity ofhuman assets. The following are some

of their behavioral implications, in whichthe stockholder-controlled firm refersto a firm that maximizes the stock value(the present value of a stream of futureprofits) of the firm under the competitivewage system.

1. The dually controlled firm pursuesa higher growth rate (or somewhat moreloosely speaking, tends to have a longerhorizon) in investment decision makingthan the stockholder-controlled firm fac-ing the same level of employees' currentearnings, because the former takes intoaccount employees' extra benefits fromthe growth of the firm in the form ofenhanced future promotion possibilitiesin their rank hierarchies (Aoki 1988a, pp.164-66).

2. The dually controlled firm sets theamount of employment at the level atwhich the marginal value product of anadditional worker is equal to a worker'searnings minus the marginal rate of animplicit unemployment insurance pre-mium. Thus if the employees' fear of un-

employment is positive, the dually con-trolled firm provides a higher degree ofjob security than the stockholder-con-trolled firm (Aoki 1988a, pp. 174-76).

3. In order to protect the interests ofincumbent employees, the dually con-trolled firm tends to limit the expansionof the work force relative to the growthof value-added by spinning off relativelylabor-intensive activities to relatively

10 If the management's notion of fairness s repre-sented by Nash's ormulation f symmetry n his axio-matic approach to bargaining (Nash 1950), on onehand, and if the relative bargaining power of theunion is measured in terms of boldness as formu-lated in cooperative game theory, the distributiveoutcomes predicted by the two approaches re identi-cal (see Aoki 1984a, ch. 5).

11Let us imagine as a thought experiment that

management ormulates corporate policy by weight-ing the policy optimal o the representative employeeand the policy optimal o long-run profit making i.e.,the present value of the future stream of profits),with weights being given by each distributive sharein firm-specific quasi rent. I call this policy makingthe weighting rule (Aoki 1984a, pp. 74-80). Fur-ther, assume that the employees supply the level ofeffort that maximizes collective value surplus byequating the marginal value utility of effort with themarginal value product (not the wage rate). Whenthe utility function of the profit claimant and that ofrepresentative employee are both the constant pureboldness type in the sense defined in Aoki (1984a,pp. 74-77), this idealized

constellation of mutualcommitments can be proven to yield the outcomeknown as the generalized Nash bargaining solution,

with weights given by distributive shares (see Aoki1984a, ch. 6; 1988a, ch. 5 for a proof. As is wellknown, the Nash bargaining solution is the only oneoutcome that satisfies the set of axioms that JohnNash (1950) imposed on the efficient and fair (sym-metric) arbitration to fulfill. Also, the recent develop-ment of game theory showed that, under certain con-ditions, an equilibrium of a noncooperative two-person bargaining game, known as the perfect sub-game equilibrium, exhibits qualitatively equivalentcharacteristics with the generalized Nash bargainingsolution (Ken Binmore, Ariel Rubinstein, and AsherWolinsky 1986). Although the idealized constructgiven above may appear

arbitrary at first, its behav-ioral implications may well stand up to variant institu-tional assumption.



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lower wage subsidiaries or outside suppli-ers, 12 as well as leaning more toward cap-ital-intensive technology than the stock-

holder-controlled firm (Aoki 1988a, pp.166-74; Hajime Miyazaki 1984).4. If the implicit unemployment insur-

ance premium payable by employees ishigh, the dually controlled firm chooseswork sharing rather than layoffs as a firstresponse to bad business conditions (Aoki1988a, pp. 176-81).

5. The dually controlled firm seeks in-novative opportunities by developing anin-house knowledge base rather than

pursuing breakthrough innovation re-quiring an entirely new organization ofits research and development team (Aoki1988a, pp. 237-52; Aoki and Rosenberg1989).

Theoretically speaking, the dually con-trolled firm may be viewed as a mixtureof the conventional neoclassical model(the N-model) of the stockholder-con-trolled firm and the model of the worker-controlled firm (the W-model) in themanner of Domar-Ward (Aoki 1984a, ch.5). It is well known that the worker-con-trolled firm tends to limit the size of thelabor force in order to increase the proba-bility of job security in comparison to theconventional N-model (Miyazaki 1984).The behavioral characteristics of the W-model may help us understand proposi-tions (2) through (4) intuitively. Proposi-tion (1) appears to run counter to thischaracteristic, but note that this proposi-tion is stated in comparison to a firm thatchooses a growth rate solely to maximizeits stock price after having made its wagebargain. Efficiency requires the conjointdecision of wage rate and growth ratewhen employees become assets internalto the network, because employees may

be willing to forgo the current earningslevel for future benefits made possibleby promotion in the rank hierarchy.

Proposition (5) may be understood byconsidering that engineers and research-ers who have firm-specific knowledge areconstituent members of the dually con-trolled firm.

The characterizations above may seemto imply that employees are the only ben-eficiaries of the dually controlled firm.But this is not so. As employees in thedually controlled firm may be inducedto trade off the level of current earnings,

make investment in training, and committo the higher level of effort for those ben-efits indicated above, the profit level isexpected to rise as well. In other words,once employees become network-spe-cific assets, mutual commitments of em-ployees and management would yield aPareto superior outcome.

V. Concluding Remarks

In preceding sections, I described amodel of a Japanese firm based on styl-ized facts, the essence of which is sum-marized in the three Duality Principles.This model-the J-model-is in many re-spects different from models of the firmconstructed by Western economists. Ar-chibald described the current state of thetheory of the firm in his contribution toThe New Palgrave: A Dictionary of Eco-nomics: It is doubtful if there is yet gen-eral agreement among economists on thesubject matter designated by 'theory ofthe firm,' on, that is, the scope and pur-pose of the part of economics so titled(1987, p. 357). It would be fair to say,however, that agency theory is currentlyone of the most influential theories onthe firm, especially among Anglo-Ameri-can theoretical economists.

According to this theory, the firm isconceived as a nexus of (agency) con-tracts (Michael Jensen and William

12 See the Appendix for the structure of differentialearnings observed between the parent firm and itssatellite firms. As described in the Appendix, how-ever, the use of a lower wage is only one aspect ofsubcontracting among many others.



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Meckling 1976). In an agency contract,the entity called the principal delegatesdecision making for realizing its own ob-

jective to the agent who may have supe-rior on-site information, but differentpreferences. The principal tries to con-trol the latter's action by the design ofan appropriate incentive contract. Theultimate principal of the firm is its owner,or the stockholders in the context of themodern corporate firm, and its agent ismanagement. Management is then con-ceived to operate hierarchically througha chain of incentive contracts, with man-agement of the higher level acting as thesurrogate for the ultimate principal andthat of the lower level as the agents ofhigher-level management. At the bottomof the hierarchy, management controlsoperating employees through incentivecontracts.

An agency contract may be written inmany ways, but its design is conditionedby outside markets in one important way:the principal cannot induce the agent toenter a contractual relation unless theprincipal guarantees the agent at leastthe level of its reservation utility deter-mined by outside opportunities. Finally,the stockholders' rights to control man-agement are market-transferable so thatthe bidding among investors will ulti-mately lead to the maximization of firm'svalue subject to the inevitable costs in-curred in the chain of agency contracts( the agency loss ).

Thus the essential factors of the agencymodel of the firm are summarized as: (1)hierarchical decomposition of controloriginating at stockholders (H-mode); (2)market-conditioned incentive contract-ing; and (3) the control of the manage-ment decision according to the valuemaximization criterion. Compare thesewith the three Duality Principles for theJ-model. Between them, clear differ-

ences are evident. Why are there thedifferences? Is that because the J-model

is culturally unique and useful only as atool for a microanalytic understanding ofthe Japanese economy?

One of reasons why many Anglo-Amer-ican economists are comfortable with theagency model as the model of the firmand why I am presenting the J-modelas a tool for understanding the workingsof the Japanese economy is doubtless thatthere are differences in the ways thatfirms are run in the West and in Japanand that the models reflect some aspectsof those real differences. But, are thesedifferences absolute? Are they more im-portant than the possible commonalitythat may not be taken into account byeither of the models? If there is a conver-gent trend between the West and Japan,does it not mean that the J-model andthe agency model represent only proto-types to be absorbed into a more generalhybrid model of the firm?

The primitive comparative analysis ofthe H-mode versus the J-mode of coordi-nation summarized in Section I indicatedthat the relative efficiency of these twoprototype models depends on various en-vironmental parameters such as definingthe nature and volatility of consumer de-mands, the degree of market concen-tration, the technology involved in theproduction process, and possibly govern-ment regulation. Therefore if only effi-ciency matters (and if relevant govern-ment regulations are alike across nationaleconomies), we would observe differentcoordination patterns across markets. Inspite of the increasing globalization ofmarkets the fact that we have been ob-serving a relatively similar coordinationmode within each economy, but rela-tively dissimilar patterns in the West andJapan, may have to do with historical,cultural, and regulation factors. As indi-cated just before the description of thefirst Duality Principle, the maintenance

of organizational integrity in the contextof individualistic values in the West (par-



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ticularly in North America) may have ne-cessitated contractual agreement on themore hierarchical structuring of internal

coordination. On the other hand, in Ja-pan, respect for differentiated status byattributes (sex, age, seniority, familybackground, etc.) and level of traininghas been a dominant traditional socialvalue. A superior in Japan may thereforebe more comfortable in delegating actualdecision making to his subordinate. Alsowithin a small group, horizontal coordi-nation rather than clear job demarcationtends to emerge spontaneously in Japan,

possibly because of the collective mem-ory of the traditional agrarian customsand values (Aoki 1988b).

Having admitted that there are somecultural and historical traits in the waysthat firms operate in each economy andthat the efficiency criterion is not the onlyfactor shaping the ways that firms arerun, however, I would maintain thatthere is an important element of con-scious design in viable business organi-

zations. For example, small group dy-namism per se, to which culturalanthropologists attribute the role of adriving force in Japanese organization(e. g., Chie Nakane 1970), cannot be ef-fective in the context of large organiza-tions. A coherent, self-centered groupmay develop and assert its own interestsat the sacrifice of organization goals.Managements of Japanese firms havetaken pains to combat such tendenciesby consciously designing intergroup co-ordinational mechanisms (the kanbansystem is but one example), shifting theemphasis from seniority to merit ac-quired by experience as a promotion cri-terion. They have transformed the sen-iority-oriented rank hierarchies intoforms compatible with an organization-wide competitive drive, and so on. Thesharing of rents and the commitment toemployees' interests in corporate policymaking are no longer considered an ex-

pression of paternalistic benevolence ofthe management or owner, but can beregarded as a means to elicit employees'

cooperation and diligence. Many ele-ments of the J-model should now be re-garded as serious objects of economicanalysis, particularly in view of Japaneseindustrial and technological challengeson the global scale.

As indicated in preceding sections, therelative merits of horizontal versus hier-archical coordination, market-orientedincentive contracting versus rank hier-archy, bank-oriented versus market-

oriented financial control are not yet soclear-cut, however, and comparativeanalysis dealing with such issues has onlyjust begun. Meanwhile, there is a greatertendency toward a convergence of organ-izational form and practice because ofthe strong force of natural selection oper-ating through international market com-petition as well as deregulation withinand across national boundaries.'3 Phe-nomena similar to some aspects of J-

model have emerged in the West sponta-neously or as a result of conscious design,while some elements of the agency andother contractual modeling are becomingever more visible in Japan. From thisangle, the J-model may provide a newanalytical insight into the working ofnewly emergent-or latent-phenomenain the Western economy. And similarly,the agency model may be helpful for un-derstanding some aspects of Japanese or-ganization. But, in the future the J-modelis perhaps fated to be subsumed underthe yet to be developed general theoryof the firm, and so is the agency model.

APPENDIX

Quasi ntegration: The Supplier Relation In the man-ufacturing ndustry, which involves many steps in aproduction process, Japanese firms tend to spin offsubsidiaries and rely upon subcontractors or the sup-

13 See footnotes 4 and 8 for some details concerningthis trend.



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