Theory

affiliated firms. And the descendants of the founding entrepreneurs inherited and are managing the whole group as the controlling shareholder. During the course, most of the affiliated corporations have been listed on the stock exchange with many other shareholders acquiring the stocks. On the other hand, diversified conglomerates have also developed into the M-form as in the United States and the United Kingdom. However, studies on why the different form of conglomerates has developed are rare. We discuss this issue in this section.

Khanna and Palepu (1999) showed that conglomerates have developed as substitutes for the institutions that support effective markets in capital, labor, goods and services. Alchian and Demsetz (1972) interpreted a conglomerate as an investment trust or investment diversification device. However, they did not study the specific form of conglomerate that would develop under certain conditions. While Jeon and Kim (1994) suggested that conglomerates, whether it be the M-form or the one with affiliates, have been created especially in emerging economies to solve the economic calculation problem by generating market information via internal transactions amongst the divisions or the affiliates, they did not investigate in detail as to why some conglomerates take the M-form and some others the one with affiliates.

One exception would be Chandler (1982). Chandler pointed out that, around the turn of the 20th century in the United States, managerial innovations in terms of formation of M-form occurred when the firms attempted to diversify their line of business through vertical integration. By assigning to a single integrated

division the functions of monitoring and coordinating the operations of each full line of products, the general executives at the central office could concentrate on the job of division monitoring, long-term planning for the group as a whole, and allocating resources to carry out these plans. That is, the M-form structure solved the number and complexities of decisions necessary for overall resource allocation.

Having Chandler’s argument in mind and considering the expected external and decision-making costs, we explain under what conditions the M-form conglomerate and the one with affiliates would develop. Suppose that the parent company makes a plan to start a new project with internally accumulated capital. The new project might be related or unrelated to the business line of the parent company. To carry out the project, the parent company should decide whether to establish a new division within it or to set up a new company with legal and accounting independence. We show that it depends upon whether or not the controlling shareholder exists in the parent company.

First, assume that there is no controlling shareholder as the majority shareholder in the parent company and it internalizes a new project into a new division, resulting in an M-form conglomerate. Then, the relationship between the parent company and the new division becomes hierarchical, meaning that the new division will be under the control of the parent company. The decision-making process will follow the one that would prevail in a single corporation, which is addressed in section 3.1. No additional expected external costs beyond the already existing ones will be

created.

If the parent company, on the other hand, establishes a new affiliate, the relationship between the two companies becomes contractual rather than hierarchical. The group-wide decisions to internalize the external benefits from the expanded and diversified businesses may be made at low costs through voluntary co-operation in the short-run, which is similar to the case of co-operative decisions for a concerted project among several independent firms. However, the new affiliate may behave opportunistically for its own interests over time. Then the parent company does not have any device to control the affiliate since there is no controlling shareholder in both the parent and the affiliated company. That is, the parent company would lose control of the affiliate. Therefore, decision-making costs for the whole group and the external costs that the shareholders of the parent company might assume as a result of independent decisions made by the affiliate would be high. Total costs may well exceed the benefits to be internalized through affiliation.

The final case to be considered is where the parent company with no controlling shareholder establishes an affiliate.⁷⁾ However, this situation would not persist for a long time since the agreements among the shareholders who can affect the board of directors of the parent company do not seem to be continued.

Consequently, the M-form conglomerate rather than the one with affiliates would emerge when there is no controlling shareholder in

7) For exam ple, POSC O that h as no con tro llin g shareh older owns affiliated firm s.

the parent company. The corresponding expected external and decision-making costs are summarized in <Table 1>.

<Table 1> Expected External and Decision-making Costs

M-form Affiliate No Controlling

Shareholder

External Costs low (zero) high Decision-making Costs low (zero) high Controlling

Shareholder

External Costs low (zero) low Decision-making Costs low (zero) low

Next, examine the case where there is a majority shareholder in the parent company. Assume that the majority shareholder becomes the president (CEO) as the controlling shareholder. Then a new project can be carried out either in a new division or in an affiliate. That is, a conglomerate may be developed as either the M-form or the one with affiliates. If the new project were carried out in a new division of the parent company, resulting in the M-form, decision-making structure would be the same as in a single corporation with no additional external costs beyond the preexisting ones for the shareholders of the parent company.

On the other hand, suppose that the new project is performed in a newly established affiliate. Since the controlling shareholder of the parent company is also that of the affiliate, thereby effectively owning and controlling the two companies, the relationship between the parent and the affiliated company becomes hierarchical rather than contractual. Then the decision-making costs for the

whole group will be greatly reduced since the decision-making authority is concentrated to each board of directors, whose representative is the same controlling shareholder. The external costs for the controlling shareholder will be internalized and those costs for the rest of the shareholders of both the parent and affiliated companies will be almost the same as in a single corporation. That is, the external benefits can be successfully internalized through affiliation. The costs of external and decision-making for this case are also summarized in <Table 1>.

The president of a group taking the office in the “holding company” or “group information headquarter” makes group-wide strategic decisions with the aid of his staffs, thereby decreasing the decision-making costs. A process in which all affiliates participate would produce prohibitively high decision-making costs. And if the decisions were made by a certain specific affiliate, high external costs might be imposed on the other affiliates. Of course, the president of each affiliate makes decisions on the day-to-day operations of the affiliate that would generate small or negligible external costs on the other affiliates. In this way, both the group-wide decision-making costs and external costs falling on the individual affiliates can be reduced.

Then how can the shareholders of each affiliate escape or reduce the external costs that they might bear due to the group-wide decisions? We noticed earlier that decision-making of a corporation belongs to the realm of voluntary contractual arrangement. The shareholders of each affiliate disagreeing to a certain group-wide decision made by the president have absolute freedom to exit the

corporation by selling their shares in the stock market, thereby reducing the external costs. In short, the decision-making structure of a conglomerate consisting of affiliated firms with the controlling shareholder is efficient in that it can reduce decision-making costs as well as external costs.

The decision-making structure of conglomerates is quite similar to that of federal state. In a federal state such as the United States, the president and his staff of a commonwealth with the consent of congress are mainly responsible for the nation-wide decisions that might incur a considerable decision-making cost if all states were involved and generate high external costs on the other states if those decisions were made by a certain individual state. On the other hand, each state makes decisions on its own affairs that would produce small or negligible external costs on the other states. However, unlike the institution of corporations and conglomerates, anyone who does not agree to a collective decision in the public sector cannot exit unless he emigrates to another nation. In this aspect, decision-making in the public sector differs from that in the private sector such as corporations and conglomerates where absolute freedom to exit for the individual shareholders is ensured.