Friday, April 20, 2018

Cleanse the Temple! Buddhist Monks versus Local Officials in China

Sometimes social science is born from observing simple puzzles. Consider this one: In China, many attractive temples charge admission fees that are obviously higher than is needed for maintenance and the feeding of monks, but other temples do not. What is going on? The fees are for the local government, which sees a famous temple as a way to get revenue without taxing the local people. But what is convenient for the local government is a moral outrage for the monks and many locals, who will sometimes successfully mobilize against the fees. The interesting question is why they can defeat the fee-collecting government officials sometimes but not always. 

In a recent article in Administrative Science Quarterly, Lori Qingyuan Yue, Jue Wang, and Botao Yang look at this question to find out how popular movements based on moral and religious principles contend with pressures from the government and market forces. The battle is unequal because the government has the power of formal authority and markets have the persuasive power of money. The popular movement has none of these, only moral outrage. The contention is particularly unequal in an authoritarian state, where outrage does not translate into power through elections, and illegal forms of protest can be dealt with harshly.

The answer to this question, like many questions about society, lies in how organizations work. The government organization is one side of the story, and there the main issue is that it has many layers – local and central parts of the state. The central state cannot govern locales effectively and prefers to stay away, but it also wants economic development and social peace. Knowing this, the local government officials can ratchet up fees when their areas are economically backward, but they need to reduce them when the protests are loud enough to catch the attention of the central state.

The other side of the story is the organization of protests. Here, the religious leaders did the obvious thing – founded an organization with the specific goal of reducing fees. But protesters don’t just make their own organizations, they also use existing ones. Here, the press was used, though in an authoritarian state the companies that hire journalists and publish newspapers or TV programs are not the most useful. They are too accountable to the state to be able to do much. Instead, the effective organizations are the providers of social media, because they allow the protestors to make themselves heard both by other potential protestors and by the state, which monitors social media protests to understand social unrest and censor its expression. 

So a battle may look like a contest between a union of markets and local governments on the one side and the moral outrage of individuals on the other, but that is not its true nature. There are organizations on both sides, and this is true for any conflict that each side really wants to win.

As I suggested in the title, the conflict between markets and morality is an old one. Two gospels mention Jesus driving merchants out of the temple and overturning their tables. It is a good story, but it is no longer how conflicts are won. People don’t get results; organizations do.

Thursday, April 12, 2018

Business Schools as Seminaries: Firms Practice the De-diversification We Teach

I know that business schools don’t educate priests, so calling them seminaries is provocative. The provocation is based on facts, and these facts deserve attention. Like any other form of education, business schools teach strongly held beliefs on how the world works and why some actions are better than others. By the way, what I just said is not equally true for all kinds of education. For example, science places more emphasis on how the world works, while engineering places more emphasis on what actions are best. Business schools are even more engineering than engineering departments, because students taking MBA degrees are very interested in knowing what to do to become successful, and they prefer short explanations of why the sources of success are connected with how the world works.

This is important because the actions taken by those few MBAs who become CEOs of major corporations are very consequential, so business schools are also very consequential. What we teach is practiced by firms, both when it is right and when it is wrong. A recent paper in Administrative Science Quarterly by Jiwook Jung and Taekjin Shin looks at how business schools were behind the largest change in firm structure in recent history: the breaking up of diversified corporations into smaller specialist firms.

This change is literally a textbook case of what firms should do. According to finance theory of capital markets, investors are better off diversifying by buying many specialist firms than a single diversified firm. According to the economic theory of managers, firms are more valuable when they are so specialized that it is easy to reward and punish CEOs based on how well they do. The combination of these two theories moved into business schools in the 1970s and has stayed there ever since. Jung and Shin discovered an easy way to measure its effect: In the exact same time period, firms led by CEOs with MBAs from before the 1970s kept diversifying, and firms led by CEOs with MBAs from the 1970s onward were de-diversifying. The CEOs were practicing what their business schools preached.

Does this sound like a good effect of education, or is there anything scary about it? We like people to choose the right actions based on knowledge of how the world works. Business schools have a special responsibility because some of the people we educate become very important for the society and economy. So this seems like a good outcome: for anyone who believes what business schools teach, it was great that businesses became less diversified.

Here is the scary part. Any form of science is wrong or incomplete sometimes, especially if it is a young science like the branches of knowledge that business schools teach. Remember when all the finance professors thought the economy was healthy, just before the financial crisis? It gets even worse when our graduates learn what actions are best but prefer short explanations of how the world works. Remember when all investment advisors loved web businesses, just before the dot-com bust? If we teach too confidently, trouble will follow.

De-diversification sounds like a safe case, because there is pretty good evidence that diversified firms are worth a little less than de-diversified ones. But we should keep in mind that even this case isn’t entirely clear. The de-diversification took place during a time period when changes in competition law enforcement meant that buying competitors and increasing prices became easier and a better use of money than diversifying. Also, for firms heavily engaged in product development, some diversification can be a significant advantage, as another recent ASQ paper has shown. Even the best of our knowledge can be changed as we continue to learn. That’s how science works, and that’s why teaching should be done with some modesty.

PS: For those who wonder about the picture of this blog: Martin Luther was a professor and a priest.

Jung, Jiwook, and Taekjin Shin. 2018. "Learning Not to Diversify: The Transformation of Graduate Business Education and the Decline of Diversifying Acquisitions." Administrative Science Quarterly, forthcoming.

Sunday, April 8, 2018

Do We Trust the Firefighter Who Finds Fires or Books Exciting?

One of the most studied and least understood aspects of life is how people decide to trust each other. Trust is not much on our minds in daily life, but that is because trust is not needed for most of what we do. When shopping, we know that a credit card payment probably won’t lead to fraud later on and that the change we get when paying with bills is not fake currency. In traffic, trusting others is more important, but we generally trust that other drivers know the rules of the road, except perhaps if we’re on a bike.

In some areas of life, trust is very important, including on the job. Even in occupations that are mostly safe, every now and then there may be dangerous situations in which trust in others is important. Trust matters because danger triggers a fight-or-flee dilemma: you can try to solve the problem, at some risk to yourself, or you can escape and let the problem get worse. When solving a dangerous problem calls for teamwork, it is important that everyone makes the same decision.

This type of trust is the inspiration behind a recent paper in Administrative Science Quarterly by Michael Pratt, Douglas Lepisto, and Erik Dane. They looked at firefighters, whose occupation calls for risky teamwork. They have to trust that others will “have their back” in fighting a fire when the situation gets dangerous, so that each can rely on the other. Firefighting is especially interesting because firefighters don’t actually spend much time fighting fires. The increased fire safety of buildings and the need to have enough firefighters on the payroll in case of large fires means that they spend most of their time waiting for calls or handling emergencies that have nothing to do with firefighting. Helping cats down from trees is mostly a myth, but vehicle accidents, gas leaks, and emergency medical assistance are facts of life – firefighters can often get to a scene before the ambulance.

The problem with having safe buildings is that firefighters have little direct evidence from fighting fires together of whom they can trust – when they’re called to the scene of a fire, they may not have ever seen each other fight fires. That means they have to operate on trust derived from indirect evidence. I started by saying that trust is well studied and little understood. One thing we do know is that when people try to decide whom to trust, they look for signs of trustworthiness. When this happens in occupations, the signs may not make sense to outsiders, but they are very real for the people involved. The firefighters in this research tried to understand where their colleagues were coming from, both in their backgrounds and in their attitudes toward the everyday chores at the firehouse. Based on small or large signs they picked up in their early interactions with a newcomer, they would put the newcomer into a small set of categories. And here is where the interesting part lies, because the categories did not inspire the same amount of trust.

The firefighter who has a college education? That one is the “book-smart” type and is not  a commonsense type whom you can trust to think quickly and do the right thing in a dangerous situation. The firefighter who buys his own scanner and goes to fires even when he’s off duty? That would be a “spark,” who has the right motivation but is too excitable and thus is only warily trusted.  Less trusted is the “paycheck” firefighter, who is there for only one reason and likely won’t take risks to help a fellow firefighter out of a burning building. So who is trusted most? For firefighters it is the “worker” type, who they see as always reliable and careful – someone who combines the professionalism of a (good) plumber with the discipline of a soldier, who checks the equipment, cleans up, or does whatever else needs to be done when there are no calls. So the answer to the question of who do you trust is that if you are a firefighter, you probably don’t fully trust the colleague who is just book smart, the one excited by fires, or the one who’s there for the paycheck.

If you are not a firefighter, the answer to the question is different. You don’t know who to trust, and you can’t tell who is of what type. That’s part of how organizations work, because they contain occupations and jobs that have internal codes understood by few others, including management. That’s one reason why managers should be careful not to judge quickly when they see behaviors they don’t understand. Look inside the thinking of the people responsible, and things make more sense.

Pratt, Michael G., Douglas A. Lepisto, and Erik Dane. "The Hidden Side of Trust: Supporting and Sustaining Leaps of Faith among Firefighters." Administrative Science Quarterly, forthcoming.

Wednesday, April 4, 2018

#mefirst: Female Executives Are Superior to Male Executives in Societies that Discriminate against Women

Here is an unusual business idea. Suppose you are a business in a society that discriminates against a group of people, such as women. Why not hire and promote members of that group—not because you can pay them less, but because their talent, dedication, and way of thinking make them different than others in ways that can be beneficial to your organization? Is this done anywhere, and does it increase organizational performance?

In a recent paper in Administrative Science Quarterly, Jordan Siegel, Lynn Pyun, and B. Y. Cheon looked at firms that promote women into upper mid-level and senior managerial positions in South Korea. At those levels, there are few women in a typical Korean firm because of a significant social bias against women having roles of responsibility outside the family. Using the best data and methods available to us for analyzing firms’ profitability, they could precisely measure the effect of having female executives. Add 10 percent women at the top level, and you will get a 1-percent increase in returns on assets. In case you wonder, a 1-percent increase in profitability is a lot of money, and it is easy to add 10 percent female executives because most Korean firms don’t have any.

What is going on here? Obviously, the increased profits aren’t explained by what female executives are paid compared with male counterparts. Executive payment (at least in Korea) adds up to only a tiny fraction of the profitability we are seeing here. Siegel, Pyun, and Cheon asked observers who know how businesses operate, and they got some interesting answers. The most important is that women think differently, and think more independently, than men. The different way of thinking is typical of people who have different roles in society, and it is the reason we often want decision-making groups to be diverse. More kinds of people mean more ideas, and diversity is kind of low when the average executive team has 2.5 percent women.

Independent thinking may seem like a somewhat radical explanation, but it makes sense in this study for both a general reason and a more specific one. In general, people who are discriminated against need to think on their feet because doing well in the workplace is not something that happens based on who they are: it depends on what they do, and in particular what they do differently. The promoted female executives did well because they were special. Also, there was a specific reason that independent thinking led to greater success in this study: young men in Korea have to serve in the military, where independent thinking is strongly discouraged and following orders is encouraged. Female executives have a creative advantage over male executives in this context.

So if firms in such societies can gain so much advantage by promoting women, why don’t they all do it? There are many reasons for not breaking with a norm of discrimination, starting with ignorance. Firms don’t know that female executives are superior (which is why this research was needed), and they may not even recognize that there are few women among their executives. After all, being male is normal for an executive.

Still, some firms in this study did hire and promote female executives, and many of them were foreign. Does this mean that discrimination is absent in the homelands of these foreign firms? No. Most of the foreign firms were multinationals with hardly any women in their home country among their top executives. Discrimination against women may have been weaker in their home country than in Korea, but just as importantly, they had discovered the benefits of promoting women in Korea. Discrimination in society seems to be easier to overcome if it is costly—not a highly virtuous conclusion, but one with some hope at least.

It was fun for me to read this research. I had the idea of doing a research project like this a long time ago when I worked in Japan. I was too busy with other projects to do it and did not check whether there were data available that would have made it possible. Now it has been done, and the results confirm what I expected.

Jordan, Siegel, Pyun Lynn, and B. Y. Cheon. 2018. "Multinational Firms, Labor Market Discrimination, and the Capture of Outsider’s Advantage by Exploiting the Social Divide." Administrative Science Quarterly, forthcoming.

Thursday, March 22, 2018

Why Can a Firm Like Samsung Do Well? Compare and Compete

Take a look at the product line graph of Samsung Electronics pictured here. As I am sure you know from entering any consumer electronics store, they have all sorts of entertainment systems including large TVs, a lineup of high-performance mobile phones, computers and peripherals, cameras, and even washers and dryers. In addition to that, they make many of the electronics that go into these devices, such as microprocessors, memory, and other semiconductor devices. For businesses they supply a broad range of communications equipment both wired and wireless. They are the archetypical diversified corporation that is not supposed to exist anymore and that in many economies (such as the U.S.) has been dismantled and sold at a profit. But they still hold together.

It is not because of friendships among managers – the way to get promoted is to do better than your peers, so it is a fiercely competitive company internally. Compare your performance with the nearest department, function, or division, and find a way to do better than it. But if the diversified corporation isn’t a way to bring people working on different but related businesses together in a somewhat friendly way, what is it for? The departments or divisions might as well be different corporations, because they would definitely compare and compete then too. In a recent paper in Administrative Science Quarterly, Oliver Baumann, J. P. Eggers, and Nils Stieglitz found a key to the answer. Interestingly, it is exactly through competition that such corporations can do well. They are unique because both the type of competition and awards from competition are nearly the opposite of what you see between independent companies.

The type of competition is nearly opposite because corporations that compete want to win the support of customers, but divisions that compete want to win the support of headquarters. The awards from competition are nearly opposite because customers provide cash from purchases, but headquarters provide budgets to operate and invest. The two are different because headquarters’ money can be directed into specific activities such as research and development, which helps the division explore new grounds. Customers’ money can do the same, but it has many other uses including the simple option of using it to spend more to win customers’ support for exactly the same products.

This matters because a smart headquarters knows that an ambitious division that wants to win can make smart and aggressive investments in technologies. Often these will be too ambitious, so the division ends up losing money, but there is a solution to that. As long as the corporation has divisions with complementary products, there is usually a benefit to some other division as well. What is required is complementarity among divisions so that both winner and loser investments for one division can become winner investments for the corporation. Look at the Samsung product line again. It is full of complementarity. There are devices using the same parts, exploiting similar intellectual property, and shaping complementary customer preferences. The diversified firm still has some life left if it remembers to compete, compare, and invest in technology.

Friday, March 16, 2018

Do Auditors Prevent Fraud by Firms? It Depends

The relationship between an auditor and the audited firm has always been interesting. Auditors are supposed to check the firm’s financial accounts and approve them, which lets others such as investors and the state know that the firm is not misrepresenting any information. They have some other duties as well, but you could say that auditors save the investors from seeing artificially high profits and the taxman from seeing artificially low profits. So who hires the auditor, the investors or the state? The firm does. That’s why it gets interesting, because it means that the auditor is implicitly hired to keep the firm within the rules for investors and the state while serving the interests of its management.

In a recent paper in Administrative Science Quarterly, Aharon Mohliver looks at an even more interesting part of this relationship by doing research on the role that auditors played in first condoning, then spreading, and finally extinguishing a questionable practice firms began to use when changes in the tax code affected their ability to pay managers above a $1 million cap without subjecting them to significant tax liabilities. At first the practice was questionable but not illegal, and auditors in some local offices helped their client firms start using it. The findings tell a very informative story of how auditors pay close attention to the interests of the managers who hire them, and also to the fine line between legal and illegal.

The questionable practice is called stock-option backdating. Stock options are often given to managers because they let managers earn higher income if the value of the firm increases, and to make them fair they are often given (for free, of course) at the exact value of the firm on the day they are given. In MBA-speak, those options have upside potential, no downside potential, and are incentive compatible. In plainer words, they reward managers for effective management but don’t punish failure. Firms report the costs of stock options as compensation expenses.

What I just explained is a regular stock option, without backdating. A backdated stock option looks just the same, but in reality it has been assigned an earlier formal date than when it was given, and that formal date somehow turns out to be a day just before the firm had a big increase in value. Through what seems like a very lucky dating of the option, the managers getting the backdated stock option earn significant sums of money not taxed as regular income. Backdated stocks are a trick for compensating managers at the expense of investors. They are a form of fraud, and though they were unethical from the start, initially there were no laws or rules against backdating so they were not yet illegal. (There were no rules because no one making rules had thought of backdating stock options.)

So the auditors stepped in. They spread knowledge of backdating from one client to the next, especially if clients were part of their local and dense communication networks. They were also sensitive to lawmakers, however, so this spreading of backdating was strongest when the uncertainty about the legality of backdating was greatest. When it became more certain that backdating would be made illegal, the auditors stopped spreading the backdating trick, and when it actually became illegal they stopped its use in the firms that had already started using backdating. So, auditors follow written law very well, are neutral to law that will soon happen, and are willing to help management profit from legally questionable conduct. Nice to know if you happen to be a manager, investor, or lawmaker. If you are an auditor you probably know it already.

Mohliver, A. How Misconduct Spreads: Auditors’ Role in the Diffusion of Stock-option Backdating. Administrative Science Quarterly, forthcoming.

Thursday, March 8, 2018

Follow the Money: How Endorsements Influence Entry

Applications are part of life. Some are minor, like applying for a library card; some are consequential, like applying for a job. Often the consequential ones involve selection of a few from many, like applications for work or study admission. We usually think that they should be decided based on merit. Partly this is because we care about fairness, and partly it is because the selection matters for the workplace and the school too, not just for the applicant. Selecting the best should give the best results.

So what exactly is the purpose of having others endorse your application? Maybe you have never done that, but it is common for applicants to have others contact individuals who could sway the decision. Is it a way of cheating, by bypassing the evaluation of merit? Is it a way to get attention so the merit gets considered more carefully? Or is it simply useless? The question is important because so many crucial decisions happen through application processes in which some but not all applicants are endorsed. A recent paper in Administrative Science Quarterly by Emilio J. Castilla and Ben A. Rissing has looked closely at what happens, using applications to an MBA program as their data. The results are interesting.

The dim view of endorsements as saying nothing (good) about quality is at least partly true. The endorsed applicants were sometimes (not always) rated as stronger “on paper” as seen through CVs but often were scored lower than the non-endorsed applicants in interviews. Yet in the end, endorsed applicants were more likely to be selected for program admission – twice as likely, in fact. Clearly, getting endorsed is a good idea for those who are almost good enough to make it based on merit. This is not because their applications are examined more carefully. There was no evidence that the same qualification was discovered more easily when the applicant was endorsed. Instead, the endorsed applicant was more likely to be selected even if his or her qualifications were good but not the best.

Maybe there is something about the endorsed applicants that test scores and interview responses can’t discover? Well, Castilla and Rissing also looked at what happened later. Among those who got admitted, the endorsed applicants were no more likely to receive awards. Or get higher grades. Or get higher salary or signing bonuses in their first jobs. Or have higher salary growth. Essentially they were the same as non-endorsed applicants in their performance after being admitted, both at school and after school.

But there were two differences. One seems minor but is interesting. Endorsed applicants were more likely to lead a student club while in the program. Maybe endorsement is a sign of good citizenship? The other is not minor at all. Endorsed applicants gave larger donations to the school five years after graduation. So in a way, it is better to select endorsed applicants, but it is in a follow-the-money way. They repay the favor of being selected, while those who were selected purely on merit have less reason to pay back – or maybe they have less (family) money.

Castilla, Emilio J., and Ben A. Rissing. 2018. "Best in Class: The Returns on Application Endorsements in Higher Education." Administrative Science Quarterly, forthcoming.