Comparative Political Economy 2 Exam Paper

BSc in International Business and Politics

Copenhagen

Comparative Political Economy II

Exam April 2011

Student:

Nenad Krstevski

CPR: 131082-2945 .....................................

Project size: STU 22697

Number of pages: 10

Copenhagen, April 26th, 2011

Nenad Krstevski Comparative Political Economy II CPR: 131082-2945 Spring 2011

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Table of Contents

Introduction ......................................................................................................................................... 2

1. Structuring of the paper .............................................................................................................. 4

2. Theory: Institutional configuration in LME and CME................................................................... 5

3. Varieties of capitalism and innovation ........................................................................................ 6

4. Analysis: Fundamental innovation in Germany and UK .............................................................. 8

5. German corporate governance ................................................................................................... 9

6. Conclusion ................................................................................................................................. 10

Bibliography ....................................................................................................................................... 12

As OECD survey1 shows, fundamental innovation in Germany is still suffering. Even Germany has been

trying through changes in financial market and corporate governance law, to change its abilities for

fundamental innovation, German institutional configuration still does not enable German companies to

carry out fundamental innovation. This paper is trying to examine why the change in financial markets

and corporate governance has not enabled German companies to fundamentally innovate. In addition, I

wish to look at what global German companies can do to overcome this issue.

Introduction

Today, companies don’t face competition only from other national companies. At some point, all

companies in the developed world will face competition from the global market. This means that for a

company to be profitable or even to survive, it must have top of the line capabilities. The company to

have competitive advantage should or own the best product in terms of quality or to develop new

products and technologies. If an economy in the developed world wants to perform well, it’s important

to have those global companies that can create value for the home economy. That’s why we can show

1 OECD, 2005


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that it is beneficial for a global company to be able to produce both new products and high quality. In

the terminology of the Varieties of Capitalism (VOC) approach, high quality and new technology

transforms into fundamental innovation and incremental innovation, respectively2.

New innovation and technology is an important source of economic prosperity and growth, and that’s

accepted by many governments of the developed world. For example, Germany proclaimed the year

2004 as the “year of innovation”3. This shows that governments agree it’s important that they must

enable companies to provide fundamental innovation through country’s institutional configuration.

Due to the institutional configuration that provides them with the possibility to produce fundamental

innovation, UK firms are better at competing in global markets than German firms.4 Although Casper

and Matraves state that that’s only true for the pharmaceutical industry, it is probably true as a general

trend in other industries as well.

Many researches show that a company’s core competencies are closely related to the environment that

it operates in, that is, a company’s behaviour will be influenced by the national institutional

configuration5. This means that depending whether a company operates in a Liberal Market Economy

(LME) or a Coordinated Market Economy (CME) there will be difference in corporate strategies. These

differences between the two, CME and LME, will be analysed in a later section. Because of the scope of

the paper, I will focus on differences of the two corporate governance (ownership structure, access to

finance) regimes and labour market composure.

From research we can see that institutional differences have given companies operating in LME with an

advantage in promoting fundamental innovative environment. Opposite, companies operating in CMEs

have an institutional advantage in generate an environment for incremental innovation6. In terms of

competing in the fast changing markets, that is producing a problem for companies operating in CME. In

the analysis, UK is used as example of LME and Germany as CME. Namely Germany is an interesting case

to study because they have tried to change some of its institutional configuration in order to facilitate

fundamental innovation. In a global economy where fundamental innovation is an important source of

economic growth, a crucial challenge is raised which will be my essay main question:

2 Hall and Soskice, 2001 3 OECD, 2005 4 Casper and Matraves, 2003 5 according to the VOC approach 6 Hall and Soskice, 2001 p. 39


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When the German institutional configuration cannot provide fundamental innovation, what are the

alternatives for Germany to access fundamental innovation?

1. Structuring of the paper

On the beginning i will briefly have a section on the theories that are going to be used for the analysis

and discussion. I will compare UK and Germany in this paper, based on the theory of VOC, which states

that fundamental innovation is much more successful in LME, than in CME. First, I will analyse the

institutional configuration and labour markets7, in a LME and CME. After, I will connect institutional

configurations with what sort of innovation they improve.

Part one of the analysis will emphasis on differences in the institutional configuration of Germany and

UK, which gives UK an advantage in fundamental innovation. In part two of the analysis I will show some

OECD figures in the analysis and describe which are the changes in corporate governance that Germany

has introduced to facilitate more fundamental innovation.

Continuing, I will discuss why the tries to change the German capital market have not helped facilitate

fundamental innovation and which alternatives Germany have to access fundamental innovation. This

paper’s end is with a concluding session which sums up the findings from the discussion.

Clarification: Meaning of fundamental innovation is “shifts in product lines, the development of

entirely new good, or major changes to the production process”8 and on the other side, incremental

innovation is “market by continuous but small-scale improvement to existing product lines and

production processes”9. Fundamental innovation occurs mostly in swiftly changing environment and it’s

typically seen in bio-technology, system-based products and software industry. Incremental innovation

has its strengths in industries for engines, machine factory equipment and tools10. This means that

7 Due to the scope of this paper I have chosen to leave out institutional configuration concerning: training and

education systems, industrial relations and inter-firm relations, and will talk only in terms of access to finance, ownership structure

8 Hall and Soskice, 2001, p. 38-39 9 Hall and Soskice, 2001, p. 39 10 Hall and Soskice, 2001, p. 39


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development of new technology and vast improvements due to institutional configuration as explained

below are more likely to happen in a LME.

2. Theory: Institutional configuration in LME and CME

There are a number of factors that determine whether an economy should be classified as a LME or

a CME. According to the VOC approach, this classification depends on the institutional set up of

corporate governance11, of labour market policies, inter-firm relations and industry relations. Type of

market economy also has great implications for how a single firm will act in terms possibilities and

restraints. In order for a firm to optimize its performance, top management must recognize the

institutional configuration and adapt to it. Notice also that there many advantages and disadvantages in

both types of market economies12.

Access to finance: The way how a company can finance itself has a crucial implication for its strategic

considerations. Any company can either finance itself through public stock markets of through obtaining

a loan from a bank. In a CME finance is usually credit based, i.e. provided by a bank. By obtaining finance

through the bank, companies can make long-term investments. This is in great contrast to a LME where

companies typically are very much focused on giving surplus back to shareholders through dividends13.

Companies in a LME are depended on the stock market to raise capital. Companies in a LME must satisfy

their shareholders when making their strategy, which tend to be very focused on short-term strategies.

Ownership structure: In a company in CME there are two layers of boards. Management board is the

first, and then is the supervisory board. The supervisory board is very significant for a CME. The board

normally consists of various stakeholders in the company, for example employee representatives,

member from the bank, and labour union representatives. This structure is called “governing coalition”,

or is also referred to as an “insider-model” or co-decision model14. With strong contrast to the LME, the

CEO is given monopoly to decision-making. No consensus with stakeholders is needed to implement

11 When using the term corporate governance, I will refer to the company’s access to finance and ownership

structure 12 Hall and Soskice, 2001 p. 15 13 Casper and Whitley, 2003, p. 94 14 Hackethal, Schmidt and Tyrell, 2005 p. 398


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important strategic decisions which are usually made by top management and implement throughout

the company15.

The main difference that exist between companies operating in a CME or a LME, in terms of ownership

structure in relation to strategic decisions is characterised as the stakeholder model vs. shareholder

model, in CME and LME respectively. In the LME, top management is mostly focused on increasing

short-term value for its shareholders and does not have to take the opinions of their shareholders into

account when choosing a strategy.

Opposite, the stakeholder model states that a company must take all of its stakeholders into account

when choosing a strategy. The bank who has provided finance, wants repayment of the loan. Unions and

employee representatives wants job security of the employees on a long-term basis. Most strategies

taken by CME companies are focused on taking low-risks and planned in the long run.

Labour market: LME is strongly characterised with the mentality of “hire-and-fire”, meaning that

companies can easily hire, but also very easily and without costs get rid of employees when once they

are no longer needed.

In CME the picture is much more different, meaning that once a company has hired a worker, it is

relatively expensive to fire him/her, mainly because of the strong labour unions. In a German company

average employment time period is very high, and workers are more willing to learn firm-specific skills,

which is different from LME, where all workers are more depended on being able to sell her labour on

the market and is thus more likely to develop more general skills16.

3. Varieties of capitalism and innovation

The VOC approach guesses that LME is better at facilitating fundamental innovative processes, and CME

will have an advantage in incremental innovative processes. As the VOC explains, this is due to the

institutional configuration (access to finance, ownership structure and labour market regimes), which is

the main focus of this paper.

15 Casper and Matraves, 2003, p. 1869 16 Casper and Matraves, 2003, p.1870


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Access to finance: Stock market equity based finance or credit based through banks? Important factor

of the company’s planning horizon is the way how the company is financed. In LME shareholders wants

the company to perform well in the short run and show profitability every quarter, which is mostly done

by showing shareholders promising signs of new technologies. In pharmaceutical industry, this means a

company investing in R&D for new “Blockbusters”17. This makes the LME company more likely to engage

in fundamental innovation strategies18.

Banks are typically financiers of CME company, which means there is no short-term pressure from

shareholders. The bank wants normally its loan repaid in the long run. Thats why CME companies can

engage in long-term planning, which value incremental planning19.

Ownership structure: Due to ownership structure, big differences exist in how decisions are create in

LME and CME when a company has to decide what strategy to choose. This has major implications for

fundamental innovation. In a LME company, decisions are easily implement throughout the company,

and the top management does not have to worry much about cutting workers who work on research

projects that has failed and it’s relatively cheap to go into developing new technologies. In CME the

company has a management and a supervisory board. The bank, the unions and the employees typically

each have a representative on the supervisory board present, and in terms of fundamental innovation,

unions and employees are not likely to accept a strategy like the one for a LME company. If it is picked

such strategy, many jobs are in danger, in case of research failures. That’s why CME companies push for

more “safe” strategies that build on cumulative knowledge and incremental innovation.

Labour market: By the VOC approach, fundamental innovation in a LME happens because of the very

labour markets that inhibit incremental innovation. Firms that develop new technology and new

products can very easy hire personnel, and get rid of them if the project became un-profitable, i.e. the

cost of failure is lower. Workers are not particular willing to invest in firm-specific skills, because of this

job insecurity that is present. Besides, companies do not wish to invest resources on staff that might

have to be fired very soon. This is also known as the “hire and fire” mentality20.

17 which is a source of quick and great economic rewards, but also a risky one if the R&D

project fails 18 Casper and Matraves, 2003, p. 1869 19 Casper and Matraves, 2003, p. 1869 20 Hall and Soskice, 2001, p. 40


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Opposite, in the CME a very high level of job security of workers is an extremely important reason for

the success of incremental innovation instead of fundamental innovation. Labour unions in Germany are

extremely powerful and influential on the supervisory boards of companies and in the politics. The big

job security encourages employees to invest in firm-specific skills, due to the long-term employment.

This gives support for incremental innovation21. With this kind of a set-up of the labour market,

companies operating in a CME must to some extend consider their workforce as a fixed cost, rather than

a variable cost22. For this reason it is relatively expensive to engage in high risk R&D project that could

have produced fundamental innovation.

4. Analysis: Fundamental innovation in Germany and UK

Why Germany was not able to facilitate fundamental innovation? I will use the article of Casper and

Matraves on why the German pharmaceutical industry was outperformed by the UK pharmaceutical

industry to answer this question. The findings were very expected by the VOC approach. The German

companies were outperformed by the UK pharmaceutical firms, especially in developing completely new

“blockbusters23”. The reason for this result, as Casper and Matraves argue, is based in the institutional

configuration of corporate governance and labour markets. This includes both organizational flexibility

and ownership structure24. By VOC terminology this means that due to centralized decision making

powers of top management the UK firms were able to rapidly adapt to new developments in the

pharmaceutical industry and due to fluid labour markets UK firms could dismiss employees working on

unprofitable research projects. A German company is not able to adopt such a strategy, due to high job

protection, and because of the ownership structure, specifically the co-decision model. Representative

from the union and representative of the employees are not going to adopt a strategy that will cause

many workers to lose their jobs due to unprofitable projects.

Two other arguments have to do with different incentive schemes in the UK and regulations on research

in the pharmaceutical industry in Germany. However, Casper and Matraves found that even when these

regulations and incentive schemes were not present, German companies in the pharmaceutical industry

21 Hall and Soskice, 2001, p. 39 22 Casper and Whitley, 2003, p. 95 23 Blockbuster is a term for a new drug that where sales exceed USD 1 billion in revenue (Casper and

Matraves, 2003) 24 Casper and Matraves, 2003, p. 1877


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would still focus on technologies that are founded on cumulative knowledge instead of creating a new

“blockbuster”, and they25 refer to the institutional configuration of Germany, especially the ownership

structure of the a company.

In short, the main reason why German pharmaceuticals didn’t produce fundamental innovative drugs is,

because of how the German pharmaceuticals react under corporate governance system and labour

market policies in Germany. Not enough flexible corporate governance system and difficulties for a

given manager to implement changes and new ideas that can persuade the supervisory board. On top of

all that, the rigid labour market and too high job security for companies are setting up fundamental

innovative research projects that might not be profitable.

For a conclusion, Casper and Matraves, state that Germany knows and has recognized that it has issues

with its corporate governance structure, and has already started to change its system26. In depth

discussion of the changes in the system of corporate governance in Germany is done below. Already

companies have recognized the lack of fundamental innovation in Germany. As example, the German

originated pharmaceutical company, Aventis, is conducting most of its bio-technical research in USA27

and in cooperation with US universities28.

5. German corporate governance

With this part I want to point out that even Germany has attempted to make changes in its corporate

governance regime, that had not allowed yet to facilitate the growth of fundamental innovation. Casper

and Matraves are stating that, Germany had begun to make changes in its corporate governance regime

because Germany knew that it had problems in starting up and facilitating fundamental innovation29.

Hackethal, Reinhard and Schmidt are stating that “Germany has seen a wave of innovations in corporate

governance and the financial system over the last decade”30. The changes include a new law on insider

trading which is now illegal and some other similar changes like improvements have been made in the

German stock exchange system, providing investors with greater protection, capital gains taxes almost

removed, introduced mandatory take-over bids. All are measures to promote more private investors

25 Casper and Matraves 26 Casper and Matraves, 2003, p. 1878 27 This is done through the take-over of Marion Merrell Dow (Casper and Matraves, 2003, p. 1873) 28 Casper and Matraves, 2003, p. 1873 29 Casper and Matraves, 2003, p. 1878 30 Hackethal, Reinhard and Schmidt, 2005, p. 397


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and investment banks to become involved in the capital market, i.e. introducing more open and liberal

markets. Traditionally, very important as a source of credit and finance in the German industry were

banks, which now are slowly changing. Instead being the lender, banks are becoming more increasingly

the investor. However, the bank’s credit is the most important source of finance31.

They32 argue that even many things in corporate governance have changed, the basic set-up is the same.

Thats why the German model is far from being associated with the shareholder model that is the main

mark of the LME type corporate governance. Even investor protection and more transparency are being

introduced in the German system, still the role of private investors is quite small. The ownership

structure still is not changed very much and banks still have enormous influence on supervisory

boards33. Hackethal, Reinhard and Schmidt also state that almost none changes had been made in the

part of labour markets and industrial relations.

Casper and Matraves state that the changes in the capital market were expected to equip the German

firms with the skills to be more competitive on rapidly changing global markets34. If this statement is

compared with Hackethal, Reinhard and Schmidt statement, that this change did not really occur, the

conclusion is that the shareholder paradigm wasn’t on a primary position for German firms, which

means, according to the VOC approach that German firms still not able to encourage fundamental

innovation, because German corporate governance regime has not changed significantly. Proof got this

is the OECD report, which state that 85 % of all expenditure on R&D is directed towards incremental

innovation35.

6. Conclusion

The departure of VOC approach takes in the reality that UK institutional configuration is good at

producing fundamental innovation. But, it does not take into account what it takes to achieve such

institutional configuration, i.e. what are the pre-requisites that UK had in order to develop it liberal

market economy and it doesn’t give answer how other countries can reform their institutional

configuration so that they also can encourage fundamental innovation.

31 Hackethal, Reinhard and Schmidt, 2005, p. 401 32 Hackethal, Reinhard and Schmidt 33 Hackethal, Reinhard and Schmidt, 2005, p. 404 34 Casper and Matraves, 2003, p.1878 35 OECD, 2005


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When we look at the German case, it looks that the needed prerequisites have not been met when

Germany tried to reform its institutional configuration. If it was better described and understood the

starting point of UK‘s development in to a LME, that could be of a great help and be beneficial for

Germany to know before they start transferring their economy into a LME.

Why hasn’t the change in corporate governance had the effects desired by the German government?

The VOC approach state that the equilibrium market type is a result of the coordination among

players36. Is there a shared political goal among the actors to transform the German market economy

into a LME, is now the question. The question of why players in Germany has not cooperated is vital,

and it raises a question if there is a political desire to change the German institutional configuration.

Summary of findings:

As OECD is showing, Germany is still not able to encourage fundamental innovation and they may

recognize that they cannot create the environment that creates fundamental innovation and therefore

continue to focus on its core capabilities which are incremental innovation and high quality. More,

German companies should enter in alliances with companies from LMEs to receive the needed

fundamental innovation.

OECD has shown that there is very little fundamental innovation in Germany, as of 2005. The German

capital markets and corporate governance were tried to be reformed by the German government. But

when you look closer at the situation faced by companies, these changes has not occurred, in spite of

the government’s effort to change this37.

It is very important to mention that German global companies are competent to use the strengths

associated with both types of market economy. Thats done by locating R&D activities in a LME, and then

to benefit from the fundamental innovation that takes place in such economies. This could very well be

something that Germany should look further into in order to explore political strategies.

36 Hall and Soskice, 2001, p. 13 37 Hackethal, Reinhard and Schmidt, 2005, p. 404


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Bibliography

- Peter A. Hall and David Soskice (2001) ‘An Introduction to Varieties of Capitalism’ in Hall and

Soskice (eds) Varieties of Capitalism, Oxford: Oxford University Press, pp. 1-66.

- OECD (2005), Economic Outlook No. 77, June, Paris

- Hackethal, Andreas; Schmidt, Reinhard H.; Tyrell, Marcel.” Banks and German Corporate

Governance: on the way to a capital market-based system”, Corporate Governance: An

International Review, May2005, Vol. 13 Issue 3, p397-407

- Casper, Steven and Catherine Matraves (2003) ‘Institutional Frameworks and Innovation in the

German and UK Pharmaceutical Industry’, Research Policy 32: 1865-1879

- Casper, Steven and Richard Whitley (2004) ‘Managing Competences in Entrepreneurial

Technology Firms: A Comparative Institutional Analysis of Germany, Sweden, and the UK’,

Research Policy 33: 89-106

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Comparative Political Economy 2 Exam Paper