journal of management policy and practice

Journal of Management Policy and Practice

North American Business Press Atlanta – Seattle – South Florida - Toronto

Journal of Management Policy and Practice

Editor Dr. Daniel Goldsmith

Founding Editor

Dr. William Johnson

Editor-In-Chief Dr. David Smith

NABP EDITORIAL ADVISORY BOARD

Dr. Nusrate Aziz - MULTIMEDIA UNIVERSITY, INDIA Dr. Andy Bertsch - MINOT STATE UNIVERSITY Dr. Jacob Bikker - UTRECHT UNIVERSITY, NETHERLANDS Dr. Bill Bommer - CALIFORNIA STATE UNIVERSITY, FRESNO Dr. Michael Bond - UNIVERSITY OF ARIZONA Dr. Charles Butler - COLORADO STATE UNIVERSITY Dr. Jon Carrick - STETSON UNIVERSITY Dr. Mondher Cherif - REIMS, FRANCE Dr. Daniel Condon - DOMINICAN UNIVERSITY, CHICAGO Dr. Bahram Dadgostar - LAKEHEAD UNIVERSITY, CANADA Dr. Deborah Erdos-Knapp - KENT STATE UNIVERSITY Dr. Bruce Forster - UNIVERSITY OF NEBRASKA, KEARNEY Dr. Nancy Furlow - MARYMOUNT UNIVERSITY Dr. Mark Gershon - TEMPLE UNIVERSITY Dr. Philippe Gregoire - UNIVERSITY OF LAVAL, CANADA Dr. Donald Grunewald - IONA COLLEGE Dr. Samanthala Hettihewa - UNIVERSITY OF BALLARAT, AUSTRALIA Dr. Russell Kashian - UNIVERSITY OF WISCONSIN, WHITEWATER Dr. Jeffrey Kennedy - PALM BEACH ATLANTIC UNIVERSITY Dr. Dean Koutramanis - UNIVERSITY OF TAMPA Dr. Malek Lashgari - UNIVERSITY OF HARTFORD Dr. Priscilla Liang - CALIFORNIA STATE UNIVERSITY, CHANNEL ISLANDS Dr. Tony Matias - MATIAS AND ASSOCIATES Dr. Patti Meglich - UNIVERSITY OF NEBRASKA, OMAHA Dr. Robert Metts - UNIVERSITY OF NEVADA, RENO Dr. Adil Mouhammed - UNIVERSITY OF ILLINOIS, SPRINGFIELD Dr. Roy Pearson - COLLEGE OF WILLIAM AND MARY Dr. Veena Prabhu - CALIFORNIA STATE UNIVERSITY, LOS ANGELES Dr. Sergiy Rakhmayil - RYERSON UNIVERSITY, CANADA Dr. Fabrizio Rossi - UNIVERSITY OF CASSINO, ITALY Dr. Robert Scherer – UNIVERSITY OF DALLAS Dr. Ira Sohn - MONTCLAIR STATE UNIVERSITY Dr. Reginal Sheppard - UNIVERSITY OF NEW BRUNSWICK, CANADA Dr. Carlos Spaht - LOUISIANA STATE UNIVERSITY, SHREVEPORT Dr. Ken Thorpe - EMORY UNIVERSITY Dr. Robert Tian – SHANTOU UNIVERSITY, CHINA Dr. Calin Valsan - BISHOP'S UNIVERSITY, CANADA Dr. Anne Walsh - LA SALLE UNIVERSITY Dr. Thomas Verney - SHIPPENSBURG STATE UNIVERSITY Dr. Christopher Wright - UNIVERSITY OF ADELAIDE, AUSTRALIA

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This Issue

Ethical Issues in Electronic Waste Disposal: Philosophical Analysis and Proposed Solutions .......... 11 William I. Sauser, Jr., Lane D. Sauser, Ronald R. Sims In 2009 the CBS News magazine, 60 Minutes, broadcast a shocking story titled “The Wasteland.” Reliable sources from the published literature confirm the basic facts of the story and raise important ethical issues regarding electronic waste (e-waste) disposal. This article poses an ethical question based on this 60 Minutes story and examines it from four philosophical viewpoints: Individualism, Utilitarianism, Justice, and Moral Rights. The authors provide their own viewpoint, discuss solutions to the problem that have been provided by others, and look at the role those in the executive suite should play to help address the e-waste disposal problem. A Schumpeterian View of the U.S. Housing Crisis ................................................................................ 25 Bruce A. McDaniel Joseph A. Schumpeter explains the institutional conditions that expand sectors of the economy, over expand those sectors and then cause the collapse to the market. He used as an example the stock market expansion, the overexpansion and then the collapse associated with the stock market crash of 1929. That analysis can be applied to the real estate market expansion into the 1990s; and the collapse of the real estate market of the fall of 2006. There are a great many similarities between the events leading to the 1929 stock market crash and the 2006 real estate market collapse. There are three institutional factors that combined to create the largest real estate price decrease in U.S. history. Participation by individual buyers with no regard toward the quality of the investment; government encouragement of real estate purchases through expansion of the Community Reinvestment Act; as well as the banking institutions competing for increasingly bad loans sold in the secondary market all helped bring about the collapse in the real estate market and the resulting “Great Recession” of 2007. The Home Mortgage Loan Crisis: A Lesson in Ignoring Sunk Costs .................................................. 30 Bhavneet Walia The present paper discusses the home mortgage crisis as a lesson in ignoring sunk costs. In a spot sense, the crisis caused prior mortgage payments to become a sunk cost for millions of Americans. Of those households with an “underwater” mortgage loan, however, the foreclosure rate is estimated to be less than twenty percent. Using these numbers and quotes made by homeowners, the study discusses the consequence of failing to ignore sunk mortgage loan repayment costs. Particularly, such a logical failure likely impedes millions of homeowners from choosing to foreclose—even when it is optimal to do so. Optimal foreclosure is often considered to be a matter of one’s solvency. During times of market downturn, however, the issue of sunk mortgage repayment costs is also relevant.

Slack and R&D Strategy: The Effect of Slack on Internal R&D and External R&D, and Innovation .............................................................................................. 33 Sang Kyun Kim, Hyuksoo Cho, Hinh Khieu Firms use their internal resources effectively and efficiently in order to achieve innovation, but not all types of resources trigger the same level of innovation. We provide a new insight to understand the relationship between slack resources and R&D strategy by suggesting a new typology for slack resources: tangible and intangible slack. Building on resource-based view, we propose that tangible slack leads to more external R&D activities (external knowledge acquisition) and results in radical innovation, while intangible slack facilitates more internal R&D activities and results in incremental innovation. Implications for future research are discussed. Are Discretionary Accruals a Good Measure of Audit Quality? .......................................................... 43 Essam Elshafie, Emmanuel Nyadroh Numerous studies use discretionary accruals (DA) as a proxy of audit quality; yet, there is no conclusive evidence on whether DA are a good proxy for audit quality. To test whether DA are a good measure of audit quality, we examine the association between DA and five measures of audit quality, namely; the likelihood restatement, f4 audit, negative internal control report, going concern opinion, and auditor’s industry specialization. The results show that while there is an association between DA and each of the first three audit quality measures, such an association is absent in the case of each of the last two. These mixed results indicate that DA are not necessarily a good measure of audit quality. Managing Tourism: A Municipal Enterprise and Unfulfilled Financial Hopes ................................. 60 António Martins The municipality of Coimbra, located in Portugal, commissioned, in 2004, a study about tourism promotion in its area of influence. The report recommended that activities related to tourism promotion should be taken out of the structure of the council and a municipal enterprise should be set up. The purpose of this paper is to present how the enterprise was justified at its inception, hopes expressed in the action plan were too optimistic, and reasons for the unfulfilling of expectations. The analysis will focus on problems arising in the setting up and implementation phases, and will draw lessons for public entities engaged in tourism promotion with strategies of setting up autonomous businesses. Organizational Opportunities Endemic in Crisis Leadership .............................................................. 72 James E. Prewitt, Richard Weil Reactive leadership and crisis management have been synonymous for years. This flows from the belief that crisis is unpredictable and unexpected, which is simply not true. Crisis has its genesis in the values, beliefs, culture, or behavior of an organization which become incongruent with the milieu in which the organization operates. A leader, who is able to read the signals of looming crisis and understands how to harness the exigency brought on by the situation, can diminish the potential dangers and take full advantage of the resulting opportunities.

Industry and Firm Influences on Performance: Evidence from Polish Public Firms ........................ 88 Zbigniew Matyjas This study examines the influence of industry and firm effects on performance of Polish listed companies. The study is based on the data on 387 companies listed on the Warsaw Stock Exchange in the period 2007-2010. Each of them has also been classified into a specific industry according to the Polish PKD classification (similar to NACE Rev.2). The results of this research show that industry effects have non-significant influence on companies' performance while one of the used models (with ROA as a dependent variable) showed significant influence of company effects. A Synthesis of Leadership Theories and Styles ...................................................................................... 97 Eric A. Landis, Deborah Hill, Maurice R. Harvey Discussion is often heard concerning the downward spiral of modern organizations due to inadequate, uninspired leadership; hence, it is imperative to continue to focus attention on the many various theories of leadership that have been employed throughout history. It is crucial to place exceptionally talented, knowledgeable leaders in positions of prominence in modern organizations in order to expect and ensure optimum success. “Leadership is one of the most widely talked about subjects and at the same time one of the most elusive and puzzling” (Wren, 1995, p. 27). As the notion of exemplary leadership is advanced, the challenge is to find ways to teach people how to become prestigious, creative leaders in today's challenging business society. In striving to accomplish this goal, a succinct review of the history of leadership theory will be analyzed and synthesized, providing an in-depth exploration of leaders past and present. “There are almost as many different definitions of leadership as there are persons who have attempted to define the concept” (Bass, 1990, p.11). Leadership has been described “in essence, a process: a series of actions and interactions among leaders and followers which lead to the attainment of group goals” (Wren, 1995, p. 325). In an effort to thoroughly comprehend the different theories reviewed, this article will focus on the theories of leadership and define strategies that will maintain a collaborative working relationship and respectful team environment in a group setting. Do Mobility Barriers Affect the Strategy-Performance Relationship? A Study Based on Chinese Listed Pharmaceutical Companies ......................................................................... 101 Xiao Duan, Zhan-Ming Jin Literature shows that mobility barriers can maintain existing performance differentials across strategic groups. We propose that mobility barriers also play a moderating role in the strategy-performance relationship. Our sample contains Chinese listed pharmaceutical companies during 2010 to 2011. One of our findings is mobility barriers do not necessarily bring performance differentials. Another finding is the strategic choice between cost leadership and differentiation has opposite effects on firms on the two sides of a mobility barrier, and sales strategy also has different effects on them. Partitioned by mobility barriers, firms ought to consider their relative positions when making strategic decisions.

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Ethical Issues in Electronic Waste Disposal: Philosophical Analysis and Proposed Solutions

William I. Sauser, Jr.

Auburn University

Lane D. Sauser Auburn University

Ronald R. Sims

College of William and Mary

In 2009 the CBS News magazine, 60 Minutes, broadcast a shocking story titled “The Wasteland.” Reliable sources from the published literature confirm the basic facts of the story and raise important ethical issues regarding electronic waste (e-waste) disposal. This article poses an ethical question based on this 60 Minutes story and examines it from four philosophical viewpoints: Individualism, Utilitarianism, Justice, and Moral Rights. The authors provide their own viewpoint, discuss solutions to the problem that have been provided by others, and look at the role those in the executive suite should play to help address the e-waste disposal problem. THE 60 MINUTES STORY

On August 30, 2009, the CBS News investigative television magazine, 60 Minutes, broadcast a shocking story titled “The Wasteland.” The 13-minute broadcast may be viewed in its entirety at http://www.cbsnews.com/video/watch/?id4586903n. The transcript of this broadcast, “Following the Trail of Toxic E-waste,” published by CBS on November 9, 2008, and updated on August 27, 2009, can be found at that same website. The story traced a container of cathode ray tubes (CRTs) from a computer recycling facility near Denver, Colorado, USA, to a town in China named Guiyu, where the CRTs had been shipped illegally. There the CRTs were being smashed, crushed, and washed in acid by unprotected peasant laborers who were extracting precious metals while being exposed to toxic chemicals in unsafe conditions. The waste from this process was being released untreated into the town’s air and water supply. This broadcast and transcript are the sources for the discussion in this article. THE FACTS

Is the CBS (2009a, 2009b) story cited above an example of sensationalistic journalism, or do the facts support the key points of the story as laid out above? Frankly, there is no shortage of information about this topic. Rather than providing here a comprehensive review of this voluminous literature, we have listed below some of the key facts related to electronic waste disposal that are attested to in such credible

Journal of Management Policy and Practice vol. 15(2) 2014 11

http://www.cbsnews.com/video/watch/?id4586903n�

sources as publications of the U.S. Environmental Protection Agency, the U.S. Government Accountability Office, and the Basel Convention on the Control of Transboundary Movements of Hazardous Wastes and their Disposal, as wel l as National Geographic Magazine, Smithsonian, Environmental Impact Assessment Review, and Libraries and the Academy. Here, then, are some key facts, quoted verbatim directly from these sources: “More than 40 years ago, Gordon Moore, co-founder of the computer chip maker Intel, observed that

computer processing power roughly doubles every two years. An unstated corollary to ‘Moore’s Law’ is that at any given time, all the machines considered state-of-the-art are simultaneously on the verge of obsolescence.” (Carroll, 2008, p. 1)

“The electronic industry generates nearly $2 billion a year, and it’s no small wonder. Americans own nearly 3 billion electronic products. For each new product that comes along, one or more becomes obsolete. Consequently, we’re storing or discarding older electronic products faster than ever…. In 2005, the Environmental Protection Agency…estimates that between 26-37 million computers became obsolete…with about two-thirds of those still in working order…” (U.S. Environmental Protection Agency, 2008, p. 1)

“Data indicates that a large majority of CRT monitors and TVs (61 percent) that were collected for recycling are exported for the purpose of producing remanufactured or refurbished TVs and CRT monitors…. Industry experts…report that about 30% of the material destined for remanufacturing abroad is not technically suitable for remanufacturing and has to be recycled or disposed. The recycling or disposal of unsuitable units occurs abroad.” (U.S. Environmental Protection Agency, 2008, p. 11)

“Disposing of e-waste in the United States is problematic because we do not have sufficient facilities or technologies currently in place to properly recycle or dispose of this material—but neither do most developing nations. Poor people and people of color experience the ramifications of improper e-waste disposal more than others because they have fewer resources and are correctly perceived as being less capable of resisting such violations.” (Zazzau, 2006, pp. 103-104)

“A PC may contain up to 4 g of gold and other valuable materials that can be recovered at a profit, particularly if the work is done in low-income countries. However, a P C also contains toxic substances such as l ead, mercury, arsenic, cadmium, selenium, and hexavalent chromium.” (Hilty, 2005, p. 431)

“There are highly toxic substances in e-waste such as cadmium, mercury, and lead…. However, e-waste also contains valuable substances such as gold and copper. Recovering these metals from e-waste has become a profitable business, resulting in global, transboundary trade in e-waste. Countries such as China and India face a rapidly increasing amount of e-waste, both from domestic generation and illegal imports. For emerging economies, these material flows from waste imports not only offer a business opportunity, but also satisfy the demand for cheap second-hand electrical and electronic equipment. In addition, the lack of national regulation and/or lax enforcement of existing laws are promoting the growth of a semi-formal or informal economy in industrializing countries. An entire new economic sector is evolving around trading, repairing and recovering materials from redundant electronic devices. While it is a source of livelihood for the urban and rural poor, it often causes severe risks to humans and the local environment. Most of the participants in this sector are not aware of the risks, do not know of better practices, or have no access to investment capital to finance profitable improvements.” (Widmer, Oswald-Krapf, Sinha-Khetriwal, Schnellmann, & Boni, 2005, p. 438)

“The most prominent example of an international initiative stemming against this…is the 1989 Basel Convention…. The convention puts an onus on exporting countries to ensure that hazardous wastes are managed in an environmentally sound manner in the country of import. Apart from Afghanistan, Haiti, and the United States of America all 164 signatory countries have ratified the convention….” (Widmer et al., 2005, p. 438)

“Because hazardous wastes pose such a potential threat to human health and the environment, one of the guiding principles of the Basel Convention is that, in order to minimize the threat, hazardous

12 Journal of Management Policy and Practice vol. 15(2) 2014

wastes should be dealt with as close to where they are produced as possible. Therefore, under the Convention, transboundary movements of hazardous wastes…can take place only upon prior written notification by the State of export to the competent authorities of the States of import or transit (if appropriate). Each shipment of hazardous waste…must be accompanied by a movement document from the point at which a transboundary movement begins to the point of disposal. Hazardous waste shipments made without such documents are illegal.” (Basel Convention, 2010, p. 1)

“Guiyu is an established [e-waste] recycling centre, made up of many small-scale enterprises. Investigations…indicated that the growth of this industry has led to serious environmental and health impacts in the area…. The potentially hazardous recycling practices witnessed in Guiyu included the manual and unprotected removal of printer cartridge toner, the open incineration of wires to recover copper, the de-soldering of printed wiring boards, and the use of acid baths to retrieve gold and other components. Children were also seen employed in sorting plastic chips for recycling. In addition…large amounts of materials and residues were being dumped in fields, rivers, and irrigation ditches…. Due to groundwater pollution, Guiyu’s drinking water has been delivered from a nearby town since approximately 1 year after the appearance of the [e-waste] industry. Further…a large proportion of the [e-waste] found in Guiyu originated in the USA, Japan and Europe.” (Hicks, Dietmar, & Eugster, 2005, pp. 461-462)

“Investigators…videotaped men, women, and children in the Chinese village of Guiyu extracting copper yokes from monitors with chisels and hammers. Squatting on the ground, they liberated chips and tossed them into plastic buckets. Black smoke rose from burning piles of wire. The workers, who wore no protective gear, reportedly swirled a mixture of hydrochloric and nitric acid—caustic, highly poisonous chemicals—in open vats, trying to extract gold from components. Afterward, they dumped the computer carcasses and the black sludge into fields and streams. Tests on the soil and water showed levels of lead, chromium and barium that were hundreds of times higher than those allowed by U.S. and European environmental health standards. The accumulating chemicals have contributed to high rates of birth defects, infant mortality, blood diseases and severe respiratory problems, according to Chinese media.” (Royte, 2005, p. 2)

“[Guiyu’s e-waste] processing industry…is now more than a decade old and involves approximately 80% of the families in the area. Guiyu residents have made substantial profits from the industry, which is controlled by local family groups. Actual recycling and treatment, however, is carried out by poorly paid migrant workers from outside the area who are willing to put up w ith the inferior conditions and the hazards of [e-waste] processing. These workers numbered more than 100,000…. Interviews at the local hospital show that Guiyu suffers from many cases of respiratory tract infection and kidney stones, and that the incidence of these health problems is higher among migrant workers.” (Hicks et al., 2005, p. 462)

“For some people it is likely too late; a cycle of disease or disability is already in motion. In a spate of studies released last year, Chinese scientists documented the environmental plight of Guiyu…. The air near some electronics salvage operations that remain open contains the highest amounts of dioxin measured anywhere in the world. Soils are saturated with the chemical, a p robable carcinogen that may disrupt endocrine and immune function. High levels of flame retardants called PBDEs—common in electronics, and potentially damaging to fetal development even at very low levels—turned up in the blood of the electronics workers…. It is next to impossible to gauge how much e-waste is still being smuggled into China, diverted into other parts of Asia, or—increasingly—dumped in West African countries like Ghana, Nigeria, and Ivory Coast.” (Carroll, 2008, p. 3)

“Some exported used electronics are handled responsibly in countries with effective regulatory controls and by companies with advanced technologies, but a substantial quantity ends up in countries where disposal practices are unsafe to workers and dangerous to the environment. Recent surveys made on behalf of the United Nations found that used electronics exported from the United States to many Asian countries are dismantled under unsafe conditions, using methods like open-air incineration and acid baths to extract metals such as copper and gold. GAO observed thousands of requests for these items on e-commerce Web sites during a 3-month period—mostly from Asian


countries such as China and India but also from some in Africa.” (U.S. Government Accountability Office, 2008, p. 1)

“Items with cathode ray tubes (CRT) are particularly harmful because they contain 4 pounds of lead, a known toxin. To prevent this practice, since January 2007 EPA began regulating the export of CRTs under its CRT rule, which requires companies to notify EPA before exporting CRTs.” (U.S. Government Accountability Office, 2008, p. 1)

“U.S. hazardous waste regulations have not deterred exports of potentially hazardous used electronics, primarily for the following reasons: Existing EPA regulations focus only on CRTs…. Companies easily circumvent the CRT rule…. EPA’s enforcement is lacking.” (U.S. Government Accountability Office, 2008, p. 1)

“Computers are not the only electronic hardware hounded by obsolescence. A switchover to digital high-definition television broadcasts is scheduled to be complete by 2009 [Authors’ note: This is now in effect in the U.S.] rendering inoperable TVs that function perfectly today but receive only an analog signal. As v iewers prepare for the switch, about 25 million TVs are taken out of service yearly. In the fashion-conscious mobile market, 98 million U.S. cell phones took their last call in 2005 [Authors’ note: This was even before the advent of multiple generations of ‘smart phones,’ which have made hundreds of millions more mobile phones obsolete]. All told, the EPA estimates that in the U.S. that year, between 1.5 and 1.9 million tons of computers, TVs, VCRs, monitors, cell phones, and other equipment were discarded. If all sources of electronic waste are tallied, it could total 50 million tons a year worldwide….” (Carroll, 2008, p. 1) [Authors’ note: In 2009, discarded TVs, computers, peripherals (including printers, scanners, fax machines), mice, keyboards, and cell phones totaled about 2.37 million short tons, according to the U.S. Environmental Protection Agency, 2011]. From the facts cited above, it should be crystal clear that the story presented by CBS News in the 60

Minutes broadcast was accurate. Reliable sources indicate that large quantities of e-waste originating in the United States of America and other developed nations are being shipped—in some cases illegally—to places like Guiyu, China, where they are recycled using crude methods that expose workers and the environment to toxic substances.

THE ETHICAL QUESTION

The ethical question we seek to answer in this article is as follows: ‘Is it ethical to ship (sometimes illegally) electronic waste from a wealthy developed nation—like the United States of America—to less developed areas of the world—like rural China—where it is recycled and disposed of in a manner that is harmful to workers’ health and damaging to the surrounding environment?’ In short, should actions like those described in the CBS (2009a, 2009b) story be allowed to occur in today’s world? PROFESSIONAL STANDARDS

Before examining this question from the perspective of several ethical viewpoints taught in American business schools we here note some of the ethical standards adopted by Information Technology specialists in the codes they have published. How do these standards apply to the 60 Minutes story? Stamatellos (2006, pp. 125-152) shares ethical codes adopted by several important professional associations in the field of Information Technology, including those of the Association for Computing Machinery, the Institute of Electrical and Electronics Engineers, the Data Processing Management Association, and the Institute for Certification of Computing Professionals. These four important professional associations stand united in their efforts to protect the public from any harm that might result from the type of recycling efforts that appear to be in use in Guiyu. Professionals in these associations would likely be shocked with the harmful methods being used to dispose of electronic waste in the Guiyu recycling operations—and in similar crude recycling operations in other underdeveloped parts of the world: crushing, burning, and washing computer components with acid in a manner that exposes both


workers and their environment to very unsafe conditions. The operations described in the 60 Minutes story would likely fail miserably to pass muster if inspected by any members of these professional associations. So should they be allowed to exist in the modern world? That is the question addressed in the section below. How might the philosophical guidance for making ethical decisions typically taught in American business schools help us to make a proper decision in this practical situation? THE PHILOSOPHICAL ARGUMENTS

Not every business leader has attended college, of course, and not all who have earned college degrees majored in business. However, those who have earned degrees in business from accredited American universities have received at least an introduction to moral philosophy as it relates to business. Some have taken a course in business and society, business ethics, or classical ethics; almost all have dealt with case studies and other assignments that have ethical implications in their core business classes. In his undergraduate-level chapter on business ethics Schermerhorn (2010, p. 91) presents “four views of ethical behavior that philosophers have discussed over the years—the utilitarian, individualism, moral rights, and justice views.” He states further, “depending on which perspective one adopts in a given situation, the resulting behaviors may be considered ethical or unethical” (p. 91). Here are the four views, posed in terms of the critical question one asks to determine whether or not an action is ethical: Individualism view—Does a decision or behavior promote one’s long-term self-interests? Utilitarian view—Does a decision or behavior do the greatest good for the most people? Justice view—Does a decision or behavior show fairness and impartiality? Moral rights view—Does a decision or behavior maintain the fundamental rights of all human

beings? (Schermerhorn, 2010, p. 91) As Schermerhorn (2010) describes these four views in his text, it is apparent that the individualism

and utilitarian views are among those aspects of “applied ethics” or “normative ethics” that Stamatellos (2006, p. 8) classifies as “consequentialist” (p. 11) in that they focus on the consequential outcomes of the decision or behavior. The individualism view is egoistic in nature, since it seeks to maximize long-term benefit to a single individual—the decision maker (Longenecker, McKinney, & Moore, 1988; Shaw & Barry, 2010, p. 59); the utilitarian view, on the other hand, seeks to produce “the greatest good for the greatest number” of people (Cavanagh, Moberg, & Velasquez, 1981, p. 365). The justice view, as described by Schermerhorn (2010), is a rule-based system in that it “is based on the belief that ethical decisions treat people impartially and fairly, according to legal rules and standards” (p. 92). While this system apparently equates ‘ethical’ with ‘legal,’ it does appear to offer a way to challenge the legal standards if they are deemed to be unfair with respect to ‘distributive justice,’ which Schermerhorn says “involves the degree to which outcomes are allocated fairly among people and without respect to individual characteristics based on ethnicity, race, gender, age or other particularistic criteria” (p. 92). As long as l aws are considered distributively just, this system examines the extent to which ‘procedural justice’ is apparent—“the degree to which policies and rules are fairly administered” (p. 92). Finally, the moral rights view appears to be a Kantian or deontological view, since it “is done from a sense of duty…based on good intentions which are rationally recognized by the moral agent independently of the consequences of the action or the preferences of the agent” (Stamatellos, 2006, p. 13).

Each of these four ethical views has strengths and weaknesses, of course. For example, Schermerhorn (2010, p. 93), Shaw and Barry (2010, p. 71), and Stamatellos (2006, p. 13) all point out that the moral rights view must be based on non-contextual universalism, and thus is not subject to any form of cultural relativism. According to Schermerhorn, “Critics of such a universal approach claim that it is a form of ethical imperialism, an attempt to externally impose one’s ethical standards on others” (p. 93, emphasis in the original). ‘What human rights are universal,’ a critic of this system might ask, ‘and who gets to decide?’ What is viewed as a basic human right in one culture might not be accepted as such in another. Some actions that produce moral outrage in one culture may simply be shrugged off in another. Given that each viewpoint has its inherent strengths and weaknesses, most business ethicists recommend the use


of a combination of all of them in a sort of mixed framework (Stanwick & Stanwick, 2009, p. 8) or hierarchical ‘decision tree’ approach (Cavanagh et al., 1981). Stamatellos (2006) says, “In other words, no theory will automatically make the decision for the moral agent” (p. 16).

How might each of the four ethical viewpoints described by Schermerhorn (2010)—the four to which most American business students are exposed in college—be applied to the specific situation at hand? Let us explore each in turn and see how each relates to the 60 Minutes story. The Individualism View: Does This Behavior Promote My Long-Term Self-Interests?

Stanwick and Stanwick (2009) classify this as a teleological viewpoint based on t he philosophical writings of Plato, Thomas Hobbes, and Ayn Rand, which support a concept known as ‘ethical egoism.’ Their comments on this approach are as follows:

Ethical egoism is based on the belief that every individual should act in a way to promote himself or herself if the net result will generate, on balance, positive rather than negative results…. Of course, individuals who abide by the philosophy of ethical egoism may have different interpretations of what would be considered on ba lance an action that is good for others as well as themselves. Some ethical egoists may argue that based on their own perceptions, all of their actions on balance generate more positive than negative benefits. This level of rationalization may evolve into the justification that pursuing a person’s self- interest is necessary to generate a positive outcome for others. (Stanwick & Stanwick, 2009, p. 5)

Longenecker et al. (1988) report that this viewpoint of individualism is favored by many

entrepreneurs, and they fear it is becoming more predominant among younger business professionals (Longenecker, McKinney, & Moore, 2001). Apparently the idea is that if each person looks after his or her own interests, this free competition of entrepreneurial actions will result in the best outcome for society as a whole, since the economic marketplace will sort out these actions such that the most beneficial will prevail. We cannot help but note the similarity of this perspective to Adam Smith’s concept of unbridled capitalism, in which the ‘invisible hand’ of the marketplace guides business decisions such that they result in the best economic result for society as a whole (Smith, 1776/2003, p. 572).

From this perspective, it is likely that the business decisions and actions described in the 60 Minutes story would be considered ethical. There can be little argument that the advent of the information age has been enormously beneficial in terms of communication, commerce, and entertainment worldwide, thus computers themselves are not an evil invention, nor should their manufacture be curtailed. The market for newer and faster computer hardware is huge worldwide, thus the manufacture of new equipment—which in turn makes older equipment obsolete—is ever increasing. Obsolete equipment must be disposed of somehow, and American landfills and storage facilities are filling up fast, so what is more logical than sending obsolete equipment overseas? It may be useful to people in developing nations (thus bridging the Digital Divide “between ‘the poor in information’ and ‘the rich in information’” discussed by Stamatellos (2006, pp. 1-2), and it is a more economical means of dealing with the problem than using the very expensive (albeit much safer) computer recycling methods employed within U.S. borders. ‘Those who collect and ship CRTs to other nations for recycling are actually doing far more good than harm,’ persons adhering to the individualism view might argue.

Similarly, the entrepreneurs in Guiyu would rationalize their actions by declaring that they are providing a way to earn a living for poor peasants who would otherwise likely starve. How might they respond to the statement made by the Greenpeace guide quoted in the 60 Minutes story (CBS, 2009a)? “Desperate people will do desperate things, but we should never put them in that situation…. It’s a hell of a choice between poverty and poison. We should never make people make that choice.” Their likely response: ‘These people have the free will to make a choice, and they have chosen to work in the recycling operation. At least we are providing them with a way to keep themselves and their family


members from starving.’ If questioned about the morality of their actions, they would likely respond, ‘You are practicing ethical imperialism. The moral values of your organization—Greenpeace—do not apply in this cultural milieu.’ When asked to consider the long term self-interests of their behavior, they would likely reply, ‘My family and I will not be among those who starve, and the likelihood of our being harmed by the adverse health and environmental impacts of the recycling methods we use are minimal, since we ourselves do not touch the materials being recycled, nor do we drink the polluted water. We’ll take that chance, and it’s our choice.’

We cannot accept the rationalizations of this ethical viewpoint, and find ourselves in agreement with Stanwick and Stanwick (2009), who observe:

Those who argue against ethical egoism state that part of the connection of the actions that motivate an individual also require certain obligations of an individual. Moreover, human motivation is primarily based on purely selfish factors, meaning that there should also be non-selfish factors that motivate individuals and make them unique human beings. (Stanwick & Stanwick, 2009, p. 5)

As behavioral scientists and business professors, we are all too aware of the capacity of human beings

to rationalize any behavior as ‘best for myself and others,’ even when that behavior may have a devastating impact on others (and sometimes on oneself). Furthermore, human beings typically lack the capacity to take a long-term viewpoint, to consider rationally all the possible effects of their actions, or to defer immediate gratification for long-term gain. History has proven time and again that unbridled egoism has harmed the lives of millions. That is why there must be moral controls on business actions, imposed either voluntarily or by law (Sauser, 2008b).

The individualism view would not, in our opinion, provide proper moral guidance to the decision makers in this 60 Minutes story. Instead, it would likely lead to a continuation—or even an increase—in the use of the unsafe recycling methods described in the 60 Minutes story. (The only exception we see to this statement is if the decision makers find that the penalties for breaking the law are so high that they outweigh personal gain through profit. Under the present circumstances, it is unlikely this will happen any time soon. Besides, that would bring the justice view into the mix.) Thus we reject the individualism view as the appropriate philosophical guide for decision-making in situations like this 60 Minutes story. The Utilitarian View—Does This Behavior Do the Greatest Good for the Most People?

Stanwick and Stanwick (2009) trace this view to Jeremy Bentham and John Stuart Mill, and comment, “Utilitarianism is based on the principle of utility where each person’s actions add to the overall utility of the community impacted by those actions. As a result, utilitarians will focus on the net result of their actions….” (p. 5). If the net impact of a business decision or action is good (no matter the original intent of those taking the action), then the decision or action is ethical, according to this viewpoint. If the net impact is bad, then it is unethical. Stanwick and Stanwick (2009) quickly pounce on the major shortcoming of this view:

Those who oppose the utilitarian viewpoint state that it would be difficult to ever properly evaluate the effectiveness of utilitarianism because it is practically impossible to determine what would do the greatest good for the greatest number. They also argue that there will be some inherent contradictions with this theory. By stating that the actions support the greatest good f or the greatest number, it begs the question whether the minority that does not receive the greatest good would be treated unfairly. (Stanwick & Stanwick, 2009, p. 5)

Furthermore, one must ask about this view of ethicality: Who decides what is good? Who is in the omniscient position to calculate what is the greatest good? How many people may be harmed, and to what extent, in order to bring about what is judged good for the others? Is there some mathematical


formula to help us with this decision? (Advocates of cost-benefit analysis would say there is, if we can quantify ‘good’ and determine with a high degree of confidence its probability of occurrence.)

From this view of ethicality, the actions and decisions in the 60 Minutes story would likely be classified as ethical for many of the same reasons (rationalizations!) summarized above. There is no question that the growth of the computer industry has brought about much good across the world, and—if the worth of this good to humankind could somehow be calculated—it would likely overwhelm the cost of the harm that is being done to the workers in Guiyu and their counterparts in other developing nations. What is the net worth of potential harm to 100,000 Chinese peasants in contrast to the tremendous value to humankind resulting from the growth of the computer industry? In the absence of moral outrage, this cold and calculating approach to making business decisions would leave just about everyone in the 60 Minutes story helpless to halt the crude and dangerous recycling practices taking place in Guiyu. The ‘invisible hand’ of the market would not stop it, and neither would those who are profiting enormously from it. (If it were not profitable, this enterprise would have dried up long ago.)

Just as we rejected the individualism view as a proper guide to decision-making in this circumstance, so also must we reject the utilitarian view as a personal guide for making an ethical decision here. While the value of the computer industry for the common good of humanity worldwide may overwhelm the cost of the harm being done to 100,000 or so Chinese, Indian, and African peasants in places like Guiyu and other poverty-stricken parts of the world, we cannot in good conscience condone these unsafe practices.

The Justice View—Does This Behavior Show Fairness and Impartiality?

Here at last we seem to be getting somewhere. Stanwick and Stanwick (2009) classify this as a deontological approach based on the social contract theories of John Locke and Jean-Jacques Rousseau. They note:

Contractarianism holds the view that membership in society comes with certain duties and responsibilities. As a result, individuals agree to the norms of society by establishing a social contract with the other members of the society. The underlying principle of contractarianism is to have [guiding] principles that are fair to everyone. As a result, if the principles are fair, everyone in society should agree to abide by the principles. (Stanwick & Stanwick, 2009, p. 7)

In practice, of course, it is virtually impossible to determine guiding principles and establish social contracts with which everyone will agree, so the justice view often manifests itself in practice as a system of laws, rules, and regulations drawn up to reflect the prevailing norms of society, with sanctioned punishments imposed on those miscreants in society who do not abide by the prevailing norms.

Putting aside for a moment the important question of who makes and enforces the rules, let us consider the three aspects of justice outlined by Schermerhorn (2010) in his exposition of the justice view. He states:

Procedural justice involves the degree to which policies and rules are fairly administered…. Distributive justice involves the degree to which outcomes are allocated fairly among people and without respect to individual characteristics based on ethnicity, race, gender, age, or other particularistic criteria…. Interactional justice involves the degree to which people treat one another with dignity and respect. (Schermerhorn, 2010, p. 92, emphasis in the original)

Let us consider how each of these three aspects of justice might apply as a guide for ethical behavior

in this case. The concept of procedural justice suggests that, once a law has been adopted, it should be applied and enforced fairly in every instance. If deceiving customers about how their computers would be recycled (as the recycling company allegedly did to the people of Denver in the 60 Minutes story) is illegal fraud, then the company should be punished. If the CRTs being shipped to China, India, and Africa


are being done so in violation of U.S. Environmental Protection Agency rules (as the U.S. Government Accountability Office, 2008, claims), then those who are doing so are breaking the law and must be punished—if they are caught! If China truly has laws forbidding the unsafe recycling of computers and other e-waste (as is claimed by Hicks et al., 2005), then they should be enforced in Guiyu (and elsewhere in China)—if the government actually can enforce them!

From the perspective of procedural justice, then, it appears that many of the actions occurring in the 60 Minutes story clearly are unethical. Consideration of distributive justice and interactional justice concepts leads to the same conclusion: Clearly the outcomes of the actions in the 60 Minutes story are not being distributed fairly—the wealthier nations and people are deriving the benefits, while those in poverty are bearing the burdens of environmental and personal harm. Likewise, it can hardly be claimed that the Chinese peasants who work in the Guiyu recycling operations are being treated with dignity and respect when they are not being provided safe working conditions, protective clothing, or even information about the damage to their health (and that of their unborn children) that is likely to result from exposure to toxic materials while they do this work.

From a justice view, then, it appears that the behavior described in the 60 Minutes story would be considered unethical. Let us not be too quick to endorse this view uncritically, however; it may not be the ultimate guide to making moral decisions that it seems. Above we set aside momentarily the important question of who makes and enforces the rules, but now we must take it up again. The Basel Convention, for example, appears to be a clear rule prohibiting the unregulated transport of e-waste across national boundaries; after all, 164 nations signed the international treaty. However, as noted previously, the United States of America—the leading exporter of e-waste—is one of three nations (the others being Afghanistan and Haiti) that has not ratified the Basel Convention, thus it is not binding on U.S. exporters. While the U.S. Environmental Protection Agency did begin regulating the export of CRTs (but not other e-waste) in 2007, the U.S. Government Accountability Office (2008) claims that the EPA’s enforcement of these regulations is spotty at best. Thus, while the justice view appears to be a solid foundation for determining that the practices occurring in the 60 Minutes story are unethical, it may not always be an effective means of stopping those behaviors in practice. Also, if China, India, and other net importers of e-waste have weak environmental protection and worker safety laws—or if they do not enforce them stringently—crude recycling methods like those described in the 60 Minutes story will likely continue unabated.

The Moral Rights View—Does This Behavior Maintain the Fundamental Rights of All Human Beings?

This is another deontological framework; according to Cavanagh et al. (1981) it stems from the social contract theory of John Locke and (especially) the moral philosophy of Immanuel Kant. Stanwick and Stanwick (2009) point out that Kant’s concept of moral duty goes beyond mere legalism to include the idea of free will:

Kant argued that the free will to make decisions that were considered rational needed to be converted into a universal will…. The linkage Kant made was to consider his principle pertaining to free will based on the philosophy that an individual should act in a way in which one would expect everyone to act if it were a u niversal will and to treat other individuals as the end, not the means to an end. (Stanwick & Stanwick, 2009, p. 7)

Stamatellos (2006) continues this line of thinking:

A rational agent has to rely on the objective moral principles of a universal moral law and not on subjective moral principles of personal preferences. Kant states that an ethical system, in order to be effective, has to be universally true and valid for all rational agents. Thus, the ‘moral law’ has to be based on a priori and unchanging moral principles independent of arbitrary personal beliefs, relative cultural customs and unpredictable circumstances. (Stamatellos, 2006, p. 13)


This is certainly an appealing approach, but we must point out that the moral rights view has its own particular shortcomings. The most glaring of these is the fact that there is no universally accepted statement of human rights! Each of us may have his/her own set of beliefs about universal human rights, but how can any one of us impose his/her own beliefs on ot hers without being accused of ‘ethical imperialism?’ For example, if we rely on the Golden Rule (‘Do unto others as you would have them do unto you.’) as a universal principle and seek to apply it to the situation in the 60 Minutes story, we could be accused of seeking to apply Christian ethics in a non-Christian cultural context, such as the People’s Republic of China—and be labeled an ethical imperialist! This would likely be the case even though the Golden Rule, or a close variant of it, appears in the religious scriptures of “all the great religions of the world” including Hinduism, Judaism, Christianity, Buddhism, Confucianism, and Islam (Shaw & Barry, 2010, p. 12).

Perhaps the closest document we have to a universally accepted statement of human rights is the Universal Declaration of Human Rights (UDHR) adopted by the United Nations General Assembly on December 10, 1948 (Bailey, 2010). Of utmost importance to the situation presented in the 60 Minutes story, Article 23, item 1, of the Universal Declaration of Human Rights reads as follows: “Everyone has the right to work, to free choice of employment, to just and favourable conditions of work and to protection against unemployment” (United Nations General Assembly 1948, emphasis added). This Article, in combination with Articles 1 and 2—which assert universal rights to human dignity “without distinction of any kind, such as race, colour, sex, language, religion, political or other opinion, national or social origin, property, birth or other status”—appears to add the weight of universal moral rights to the aspects of justice discussed in the section above. When taken alongside the language of the four Information Technology ethical statements cited above, it appears that the moral rights view provides ample guidance upon which to base a decision that the practices described in the 60 Minutes story are unethical and should be discontinued.

THE AUTHORS’ STANCE

It should come as no surprise that the authors of this article are morally outraged by the behavior described in the 60 Minutes story. From the joint perspectives of the justice and the moral rights views, we believe the actions of the key parties in the story to be clearly unethical. If it can be proven that the recycling company did indeed knowingly ship the container of CRTs to Hong Kong—whether legally or illegally—then fraudulent and deceptive business practices are in evidence, since the citizens of Denver were told that the computers they turned in for recycling would be processed in the United States; they were not told that any components—including CRTs—would be sent abroad. If the container of CRTs was shipped without a permit from the U.S. Environmental Protection Agency (as does appear to be the case), then this recycling company (along with any other companies caught in the U.S. Government Accountability Office’s investigation that shipped CRTs without permits) have broken U.S. law, and this also is unethical. Without question we believe the recycling operators in Guiyu have behaved unethically by exposing workers to unsafe working conditions and by harming the environment, and thus risking the health and safety of untold numbers of Chinese citizens. This is clearly counter to the concept of sustainability, since the practices occurring in Guiyu are very harmful to persons and the environment, and have already caused much damage (Hicks et al., 2005).

Are the governments of the United States of America and the People’s Republic of China also complicit in unethical behavior? If the U.S. Environmental Protection Agency is not enforcing its own CRT exporting rule, and if the PRC is not inspecting incoming cargo properly, then yes, they are indeed. Furthermore, if China does truly have laws to protect workers involved in computer recycling but is not enforcing them, then the same charge applies—the PRC is complicit in unethical behavior. It is not enough to promulgate laws, regulations, and rules to protect the weaker members of society—these standards must also be enforced if justice is to prevail!

Are there not also millions of people around the world who are in some sense to blame for the tragedy taking place in Guiyu and similar sites in developing nations of Asia and Africa? Do not all users of


computers also bear some guilt for allowing practices like those described in the 60 Minutes story to continue? From a moral rights perspective, we believe all computer users must become aware of the problems surrounding e-waste disposal, and become involved in finding and implementing solutions to resolve them. We—the citizens of wealthy, developed nations—are certainly enjoying the benefits of computers in the information age; should we not also be bearing our fair share of the burdens of e-waste disposal?

We return now to the specific ethical issue we are seeking to address in this article: ‘Is it ethical to ship (sometimes illegally) electronic waste from a wealthy developed nation—like the United States of America—to less developed areas of the world—like rural China—where it is recycled and disposed of in a manner that is harmful to workers’ health and damaging to the surrounding environment?’ In short, should actions like those described in the 60 Minutes story above be allowed to occur in today’s world? Our answer is: No!

POTENTIAL SOLUTIONS

It is beyond the scope of this article to provide a detailed plan for resolving all the ethical problems raised in the 60 Minutes story, but we would be remiss if we did not at least cite some of the solutions proposed by others. Perhaps the most comprehensive research study on this topic was co nducted by Widmer et al. (2005) and published in the Environmental Impact Assessment Review. Widmer and colleagues examined practices in use worldwide and produced a l ist of possible approaches for dealing responsibly with electronic waste. Their list of approaches and examples includes product take-back programs, regulatory approaches, voluntary industry practices, and economic instruments (Widmer et al., 2005, p. 447). By choosing among these approaches—and combining them optimally in a manner tailored to meet specific needs—governments, industry partners, and consumers can build a system to reduce electronic waste, recycle it when possible, and dispose of it safely. Other excellent possible solutions have been provided by the U. S. Environmental Protection Agency (2000, 2011). Our point here is that there has been a great deal of thought put into this problem already and possible solutions are at hand—if there is enough moral will among governments, producers, recyclers, and the populace to put an effective system into operation. Consider the impact groups of consumers, in partnership with industry leaders, can have if they consciously choose how their unwanted electronic equipment is to be dealt with and demand that action.

Industry self-regulation has been defined as a regulatory process whereby an industry-level, as opposed to government- or firm-level, organization sets and enforces rules and standards relating to the conduct of firms in the industry (Gupta & Lad, 1983). Self-regulation can be effected through initiatives such as codes of conduct, reporting activities, and certification schemes (Albareda, 2008; Adobor & McMullen, 2013). Unlike industry self-regulation by firms in a specific country, global self-regulatory regimes are transnational and involve firms from different countries agreeing to a global code of conduct in all the markets in which they do business (Adobor & McMullen, 2013).

Might a concerted effort among responsible consumers and industry partners across the world lead to a possible solution? Adobor and McMullen (2013) have demonstrated the effectiveness of global voluntary industrial self-regulation and certification schemes with respect to curbing the distribution of ‘conflict diamonds.’ They argue that global self-regulation is preferable to imposed governmental regulation, and suggest (with due caution, of course) that self-regulation be considered in cases where powerful industrial partners—in combination with morally outraged consumers—can take global action to solve global ethical issues. This, in turn, establishes a critical role for members of the executive suite of responsible organizations (Sims, 2005; Sauser, 2008a). What must these business executives do t o address ethical issues related to e-waste? We turn to that critical question in the concluding section of this article.


THE ROLE OF THE EXECUTIVE SUITE WITH RESPECT TO E-WASTE

As e-waste continues to grow, organizations and those in the executive suite will increasingly encounter problems of ethics and conduct with respect to e-waste. How can these problems be addressed when no country has jurisdiction? In many cases, like those of other global industries (for example, the diamond industry noted above), executives in the electronics industry must first commit to forming self-regulating efforts and adopt operational e-waste guidelines, codes of conduct, reporting, and perhaps other collective governance or global mechanisms. In our view, those in the executive suite should at a minimum band together to encourage the United States to ratify the Basel Convention on the Control of Transboundary Movements of Hazardous Wastes and their Disposal.

The normative literature on collective action (Olson, 1965; Ostrom, 1990) shows that self-organized attempts at collective action are not easy, yet they may provide the most effective solutions to global ethical issues like the disposal of e-waste. Collective action efforts like the Basel Convention on the Control of Transboundary Movements of Hazardous Wastes and their Disposal, the Kimberley Process, and the Equator Principles (see Adobor & McMullen, 2013), offer best practices and guidelines which in our view are generalizable and helpful to those executives who are interested in addressing the ever growing e-waste crisis. We believe that crisis can best be addressed by those in the executive suite by taking the courageous actions offered below:

1. Assure commitment from top management for an organizational culture of ethicality related to e-waste management throughout its lifecycle (i.e. electronics manufacturing, organizational use, reuse/recycling and disposal);

2. Construct a written code of standards for behavior related to e-waste management; 3. Communicate the standards of conduct related to e-waste management effectively throughout the

organization (and the industry); 4. Conduct ongoing training and education programs with respect to business ethics, sustainability,

and corporate responsibility as they relate to e-waste; 5. Designate a compliance officer with clear responsibility for enforcing the e-waste standards to

include ensuring that the organization regularly conducts an e-waste management audit; 6. Establish a process for reporting violations of the standards of conduct; 7. Maintain confidentiality and ‘whistle blower’ protection; 8. Actively investigate all reported violations regarding disposal of e-waste—in short, aggressively

track the e-waste once it moves beyond the organization; 9. Ensure effective enforcement, compliance, and e-waste oversight programs; 10. Ensure due diligence and active investigation by the organization’s board of directors (and

industry leaders) related to e-waste management; 11. Monitor and audit electronic waste transactions; and 12. Attend carefully to the law and make certain that all e-waste actions, policies, and procedures are

conducted lawfully and according to accepted industry and global standards. As we see it, a major role of the executive suite is to integrate these ethical e-waste best practices into

the very fiber of the organization such that employees at all levels naturally support them and live by them. This means that ethicality must be a co re component of the organization’s culture of character (Sauser, 2008a), and ethical disposal of e-waste must become a core value of the organization.

With respect to the case at hand, we encourage the United States of America to ratify the Basel Convention on the Control of Transboundary Movements of Hazardous Wastes and their Disposal. If this is beyond the political will of the nation, we recommend at a minimum enforcing effectively the CRT rule that the EPA already has in effect. The People’s Republic of China (and other nations where recycling operations are located) should at a minimum implement safety standards for recycling workers, provide them with protective clothing and gear and inform them of the hazards of their work. Environmental standards also must be put in place and enforced such that recycling methods like those in use in Guiyu will not continue to foul the environment.


Note that we are not interested in depriving the Chinese peasants of work; we are suggesting instead that their dignity be restored and their working conditions be made safe, as the Universal Declaration of Human Rights specifies. Perhaps the c-suite executives of the computer industry and other electronics manufacturers who are profiting so greatly from the introduction of new hardware—and the consumers and organizations that are enjoying enhanced productivity and quality of life from ever more powerful computer equipment—will help finance the environmental clean-up of sites like Guiyu and provide the resources to improve the plight of the persons who work there. After all, that is the way we would like to be treated, and in our view it is the ethical and moral thing for executives who occupy the c-suite to do.

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A Schumpeterian View of the U.S. Housing Crisis

Bruce A. McDaniel University of Northern Colorado

Joseph A. Schumpeter explains the institutional conditions that expand sectors of the economy, over expand those sectors and then cause the collapse to the market. He used as an example the stock market expansion, the overexpansion and then the collapse associated with the stock market crash of 1929. That analysis can be applied to the real estate market expansion into the 1990s; and the collapse of the real estate market of the fall of 2006. There are a great many similarities between the events leading to the 1929 stock market crash and the 2006 real estate market collapse.

There are three institutional factors that combined to create the largest real estate price decrease in U.S. history. Participation by individual buyers with no regard toward the quality of the investment; government encouragement of real estate purchases through expansion of the Community Reinvestment Act; as well as the banking institutions competing for increasingly bad loans sold in the secondary market all helped bring about the collapse in the real estate market and the resulting “Great Recession” of 2007. SCHUMPETER’S THEORY OF THE ECONOMIC CRISIS

In the late 1990s and early 2000s the United States residential housing market experienced very rapid price appreciation; in many cases annual double digit percentage increases. These rapid price increases peaked in early 2006 and decreases in prices followed with very rapid price declines starting in late 2006. On December 30, 2006, the Case Shiller Home Price Index reported the largest real estate price decline in U.S. history. (Case Shiller)

The importance of the residential housing market and real estate in general, is that it is a l eading indicator of the general economy. I n most recessions in the U.S. economy since the great depression, each recession was preceded by a decline in the real estate market. Also, in most recoveries since the great depression, the recovery was p receded by a r ecovery in the real estate market. ( McKinsey and Betts). It seems obvious that what has been termed the ‘Great Recession’ of 2007 (National Bureau of Economic Research) was caused by the rapid deterioration in the U.S. real estate market. Also, what can be hypothesized is that a full recovery in the U.S. economy will not occur until there is a recovery the U.S. real estate market.

In the 1930s, Joseph A. Schumpeter outlined the scenario by which sectors of the economy over expand collapse, and recover. In general, he described how a market would expand, drawing new entrants into this particular area of the market. These individuals would not understand the particular area of the economy but rather would usually have a ‘get rich quick’ philosophy as prices, returns and profits were rapidly increasing. Schumpeter further elaborated that at some point when participants cared little about the particular market but rather were more concerned with quick profits, the market in that area would then over expand and the weight of all the new investors would collapse that particular market. The get


rich quick investors would lose their investments and only those who fully understood that area of the market and were prudent in their economic activities would be able to ‘hold on’ and endure the economic collapse (Schumpeter, 1949). As a result, after the ‘weeding out’ process was complete and the market started to rebound, those left in the market would experience ‘temporary monopoly profits’ (Schumpeter, 1934).

Although Schumpeter used the rapid price increases in the stock market as the basis for the analysis of the overexpansion and collapse of the stock market leading up to the 1929 stock market crash and the resulting Great Depression, it is easy to apply the same analysis to the events leading up to the collapse in the real estate market in the fall of 2006. The history preceding each of these two events has a great deal of similarities. First, the lack of economic knowledge of individuals in the particular area of investments was similar. The over investment for the sole purpose of ‘get rich quick’ attempts to gain profits were similar. Second, the lack of government action to help regulate the out of control segment of the economy and even governmental encouragement of uninformed individuals was quite similar. And third, the banking industry with small margin requirement in the 1920s and the industries loans to marginally or unqualified borrowers in the 1990s and early 2000s was quite similar. Furthermore, the over expansion and eventual collapse of each market is quite similar.

This paper will use Schumpeter’s analysis to describe the three institutional areas where participants can be identified as those who contributed to the over expansion in market causing its collapse. These participants include not only individual home buyers but also participation from the banking industry as well as the federal government. CONSUMER SPECULATION AND INDIVIDUAL GREED

In 1929 the U.S. stock market was fueled by participants who purchased stock with little knowledge or concern about the company that issued the stock. The purchaser’s attitude was that since all stock would continue to rise, the particular stock was of little concern. This frenzy was fed by individuals who had no knowledge of the stock market. From the local shoeshine attendant, the grocery store clerk, the house cleaning maid to anyone who had a few dollars to spare, all were buying random stock with little or no regard to the quality of the investment.

Likewise, consumer speculation began to appear in U.S. real estate by the mid to late 1990s. Individuals assumed that any real estate purchased would reap great returns in very short time periods. This “irrational exuberance” (Schiller) was fueled by the belief that all who applied could qualify for a home mortgage. As a result of this irrational economic behavior on behalf of many individuals, increasing number of individuals began applying and qualifying for home loans that were far beyond their respective income flows. Individuals could qualify for a much more expensive home when the interest rate was low or even zero for two or three years; when little or no down payment was required; and when sometimes the individual home buyer even received cash back at the closing of the mortgage.

The 1990s and early 2000s was a t ime of substantial economic prosperity. Most sectors of the economy were swept up in an almost universal thinking that the new millennium would always be prosperous. Although California had a real estate crash, it was rebounding and therefore the thought was that all real estate would reap large financial gains. Factors adding to this almost universal thinking included ready access to all real estate markets through the internet; the capitalist explosion in many parts of the world including wealth generation through private property ownership; the growth of wealth from successful entrepreneurs; the “Baby Boom” generation buying second homes in preparation for retirement; as well as a general optimistic economic forecast by almost all media outlets.

This consumer speculation and individual greed allowed home buyers to falsely believe that they could buy a home far beyond their long term ability to own. However, the common perception was that in two or three years the price appreciation for the real estate property would allow the owner to sell the property at a l arge financial gain. This belief even worked at the beginning of the real estate boom. However, this approach is like a pyramid that works only so long as there are continuously more buyers than sellers. Once the steady stream of new buyers evaporated, sellers had no one to purchase their over


inflated properties and real estate foreclosures followed leading to the real estate market collapsed. This set of events is strikingly similar to the events and conditions that led to the collapse in the stock market in 1929. Over speculation and greed were major factors in both economic events. GOVERNMENT OVERSTIMULATION

During President Carter’s administration, he pushed through congress a bill which would help reverse the increasing urban blight in large metropolitan cities. The Community Reinvestment Act provided for subsidized home mortgage interest and small or sometimes zero down payments for houses identified in areas termed ‘urban blight’. This act allowed for ownership of residential dwellings to be transferred from landlords of tenement dwellings to owners who resided in those houses. This act successfully transformed many rundown tenement houses into homes that were better cared for with grass, paint, repairs and home pride.

The community Reinvestment act was a huge success by almost any standard. This act was a way to allow individuals with modest incomes to become home owners and begin to acquire wealth and achieve part of what has been termed the American Dream (home ownership). The overall success for the Community Reinvestment Act (1977) encouraged the U.S. Congress to extend the Acts boundaries outside urban blighted areas. Herein lies the problem of the federal government actually contributing to the over expansion in the real estate market. At least six times after the Act became law, (1989, 1991, 1992, 1994, 1995, 19999 and even as late as 2005) congress continues to push the Act into broader and broader applications. Eventually, any prospective home buyer in any location could purchase a home with little or no down payment, at in interest rate that was very low or sometimes zero for up to three years and often the home buyer received a cash refund at the closing of the mortgage for the property. Congress encouraged banks to make more residential property loans and chastised banks that were not lending money for residential property to marginally or under qualified borrowers. The Community Reinvestment Act had marginally qualified or under qualified borrowers become an avenue for a massive increase in residential property loans for second homes in recreation and resort areas, in upscale and high end neighborhoods and in virtually all areas in the U.S. This governmental encouragement of home ownership regardless of financial ability, obviously led to the drastic over expansion in the real estate market where many regions of the U.S. experienced double digit percentage annual appreciation values. This governmental encouragement, direct involvement and pressure toward the banking industry to continue marginally qualified loan approvals was a direct cause of the over expansion and then collapse in the real estate market in the fall of 2006.

The institutional rigidity of congress has allowed it to never acknowledge nor accept any responsibility for this over expansion and subsequent collapse of the real estate market. Instead, blame has continuously been pushed on va rious parts of the economy, even though there were those who expressed warnings to congress about their actions. On July 16, 2002, it was Ron Paul who saw the actions of congress as detrimental to the real estate market. Regarding the eventual collapse of the real estate market, Ron Paul stated “These losses will be greater than they would have been had government policy not actively encouraged over investing in housing (Paul).”

Belatedly, congressional attempts to control the banking industry in regard to real estate with legislation such as the (Dodd-Frank Act) that came after the collapse in the real estate market did not help eliminate the “Great Recession”. In fact, this bill as well as a g eneral government tightening of lending regulations is hindering economic recovery by making it more difficult for qualified borrowers to attain loans in all areas of the economy.

The collapse of the real estate market and the resulting “Great Recession” was not a market failure but rather in great part a failure of government to regulate the banking industry BEFORE the collapse in the real estate industry; a failure of government to self-regulate the over expansion in its Community Reinvestment Act; and by the failure of government to promote the tried and true criteria for a real estate loan of twenty percent down and proof of financial ability to meet the monthly mortgage payments.


BANKING INDUSTRY COMPETITION FOR BAD LOANS

As the residential real estate market continued to expand there was increased pressure in the banking industry to secure a greater number but less qualified loans. These loans were bundled with even more marginal credit card debt and sold in the secondary loan market. Banks paid little attention to the quality of the loans knowing that ownership would immediately be passed on in the secondary market. Buyers of these bundled loans assumed that real estate would continuously appreciate and therefore the loan value would always exceed the loan amount.

The banking institution continuously competed for more residential real estate loans and this competition placed increasing pressure on banks to offer lower interest rates to attract potential home buyers. The end result of this increased competitive pressure was a zero interest rate for several years with future increases in interest rates to a more normal long run rate. Banks began to view themselves less as lending institutions and more as real estate closing agents. The theory was that banks could profit more from increasing their weekly closing numbers and collecting closing costs than from the low interest charges on the loan. Banks more and more became closing agents and less and less financial institutions collecting interest on loans.

The banking industry increasingly became transfer agents, closing residential home loans, transferring those mortgages to national financial institutions including Fannie May, Freddie Mac, Enron and others. The risk was transferred with the mortgage as local banks profited from increasing numbers of real estate closings and the related charges. Local banks could close several mortgage loans each day, dozens per week and reap tens of thousands of dollars each week without regard to the quality of real estate loans that they were approving. Obviously, this disregard for the quality of the real estate loans would ultimately add to the collapse of the real estate market and ultimately bring about the ‘Great Recession.’ Unintended Economic Consequences (The Forgotten Analysis)

The economic analysis of an economic catastrophe like the collapse of the real estate market and the resulting ‘Great Recession’ usually ends with the above analysis. The bad guys, like risk taking individuals taking on excessive leverage and over investing by financial institutions are financially punished by incurring economic losses and the economy moves on. However, there are several economic consequences that hurt individuals who were in no way excessive risk takers, gamblers leveraging economic future or individuals making bad economic decisions.

A typical example of economic impact on non -participants in the economic frenzy leading to economic collapse would be the millions of homeowners who, in an attempt to provide the American Dream for their family, saved twenty percent of the purchase price of a home as a down payment and had provided proof of the ability to meet the monthly mortgage obligations. This group included a typical family of four with both adults gainfully employed, providing adequate housing for the family. Because the collapse of the real estate market led to the “Great Recession’ and the resulting double digit unemployment, many of these ‘responsible’ households became part of the unemployed. As a result, these families had their homes foreclosed, were forced to move out of their residences and lost most if not all of their wealth. This is but one example of the many economic impacts of unregulated over expansion.

In addition to the millions of home owners negatively impacted by the ‘Great Recession’ which was a direct result of the crash in real estate prices, the impact has been felt by tens of millions of people throughout the entire economic system. Examples include not only the direct impacts to homeowners and financial institutions mentioned above but include all types of commerce. To mention a few, furniture stores, grocery stores, automobile dealerships, and service centers supporting all of the above areas of commerce were negatively impacted by the over expansion and subsequent collapse of real estate prices. Many of these individuals lost wealth; often their homes and many were forced into bankruptcy as a result. This is but one example of the many institutional impacts of unregulated over expansion.

This example of the economic results of unregulated over expansion in the real estate market is most often overlooked and not taken into account when the economic causes and consequences are discussed.


However, it is one of the most important part of the analysis. These institutional impacts clearly affect the entire economy and cause major economic and social consequences through the economic system. REFERENCES “Case Shiller Home Price Index” December 30, 2006 Dodd-Frank Act, 111th Congress 1st Session (HR4273) McKinsey and Betts (2011). The Essentials of Real Estate Economics, 6th Ed., Southwestern National Bureau of Economic Research, The Great Recession began in December 2007 Paul, Ron: address to the House of Representatives, July 16, 2002 Schiller, Robert (2005). Irrational Exuberance, Princeton University Press Schumpeter, Joseph A. (1934). The Theory or Economic Development, Harvard University Press Schumpeter, Joseph A. (1949). “Science and Technology” American Economic Review Vol. 39


The Home Mortgage Loan Crisis: A Lesson in Ignoring Sunk Costs

Bhavneet Walia Western Illinois University

The present paper discusses the home mortgage crisis as a lesson in ignoring sunk costs. In a spot sense, the crisis caused prior mortgage payments to become a sunk cost for millions of Americans. Of those households with an “underwater” mortgage loan, however, the foreclosure rate is estimated to be less than twenty percent. Using these numbers and quotes made by homeowners, the study discusses the consequence of failing to ignore sunk mortgage loan repayment costs. Particularly, such a logical failure likely impedes millions of homeowners from choosing to foreclose—even when it is optimal to do so. Optimal foreclosure is often considered to be a matter of one’s solvency. During times of market downturn, however, the issue of sunk mortgage repayment costs is also relevant. INTRODUCTION

The recent home mortgage crisis has provided several potential economic lessons to economists,

policy makers, and members of the American public at large. Prominent among these is the lesson of ignoring sunk costs. A sunk cost is one that has already been incurred and cannot be recovered by any sort of pursuant behavior. Given that they cannot be recovered, sunk costs should be ignored in any type of marginal decision-making. Examples of sunk costs include wedding receptions, DVD p urchases (Landsburg 2008), and concert tickets (Frank 2003; Potter and Sanders 2012). In contemplating the termination of a wedding plan, one should not consider how many non-refundable dollars were paid to the caterer. In contemplating the premature termination of a movie viewing, one should not consider how much was paid for the DVD. In contemplating whether to attend a rain-plagued concert, one should not consider the cost of the ticket. Staw and Hoang (1995) show that National Basketball Association teams are unable to ignore sunk costs in making roster and playing time decisions. If a team drafts two players who turn out to be of poor quality, for example, the higher drafted player is expected to receive more opportunity to “prove himself,” ceteris paribus. In marginal decision-making, an optimal decision involves only the consideration of marginal (additional) benefits and marginal (additional) costs.

In a spot sense, past mortgage loan repayments can sometimes be considered as sunk costs. This is true because they have already been incurred and provide no guarantee that the homeowner will preserve market equity in the home. This point is important given the large number of individuals who are “underwater” on a mortgage loan (i.e., the outstanding mortgage loan liability is greater than the current market value of the home) and considering whether it is best to default.

A recent USA Today article (“On Helens Pouroff Ave., escaping falling home prices,” June 12, 2011) profiles a neighborhood in Las Vegas—Helens Pouroff Avenue—that experienced markedly declining home values during the course of the home mortgage crisis. Between 2006 and June 2011, houses in the neighborhood declined in sale price from an average of $385,000 to an average of $180,000. The article


states, “Dayna and Scott Merritt ask themselves almost every day if they should keep paying their mortgage…Since the 69 new homes on this street were sold in 2006, almost half the owners have defaulted on their mortgage.” According to the article, there are many millions of families who, like the Merritt family, continue to pay on a mortgage loan despite being “underwater.” In June 2011, an estimated 11 million U.S. homeowners were underwater on their mortgage. Of those, market researcher CoreLogic predicts that 2 million will go into foreclosure or distressed sales. It is perhaps difficult to explain the abundance of “Merritts” in the United States (i.e., those loyal to an investment that has gone bad) without considering the role of sunk costs.

DISCUSSION

When deciding whether to default on a mortgage loan, one should consider the market value of the

home against the value of the outstanding liability. With limited exceptions, we can say that one should always foreclose upon a house when the market value of the house has slipped “sufficiently” below the outstanding mortgage liability. Let us explain this statement by assuming an individual, Fred, who has owned a house for a few years. Fred bought the house for $230,000 and owes the bank $190,000 in outstanding mortgage liability. Due to market downturn, the house now has a market value of only $155,000. What is Fred’s best course of action in this case given that a) he is solvent to continue paying the loan, b) he wishes to maintain the same level of housing for the lowest “price”, and c) he has no emotional attachment to his current house? If Fred is not apt to ignore sunk costs, he might be tempted to commit the following fallacy:

I’ve already paid off $40,000 on the house and can only save $35,000 (minus the cost associated with discounting my credit rating) by defaulting and buying a similar house. As $40,000 is greater than $35,000, I should stick to my present home.

In failing to ignore sunk costs, Fred is foregoing a real $35,000 benefit in favor of an imagined $40,000 benefit. As the market adjustment has eroded Fred’s “paper equity” (i.e., purchase price minus outstanding liability) plus $35,000, it is correct for Fred to view the $35,000 (minus the cost associated with damaging his credit rating) as a net benefit rather than as a gross benefit.

Subject to thickness of housing market, Fred is best off if he defaults on his current mortgage loan, loses his current house, and buys or rents a similar house for $155,000 (or the rental equivalent of this price). In doing so, Fred will receive the same housing quality for a “price” that is $35,000 less. Of course, Fred will damage his credit score in maneuvering this transaction. However, he should make the trade if credit score preservation is worth less than $35,000 in present value terms. Given his objectives, Fred’s relevant information set involves the marginal cost of remaining in his current house and the marginal cost of trading his current house for a similar one. It does not directly involve the starting value of the home, the number of dollars he has spent on mortgage loan repayment (of principle and interest), or his ability to repay the loan. Previous payments of the liability are relevant to the issue of optimal loan default only insofar as they have reduced the outstanding liability. Fred’s switching rule for housing is as follows:

FIGURE 1: SWITCHING RULE INEQUALITIES

𝑆𝑤𝑖𝑡𝑐ℎ 𝑖𝑓: 𝑀𝐶𝑆𝑤𝑖𝑡𝑐ℎ𝑖𝑛𝑔 < 𝑀𝐶𝑆𝑡𝑎𝑦𝑖𝑛𝑔 𝑆𝑡𝑎𝑦 𝑝𝑢𝑡 𝑖𝑓: 𝑀𝐶𝑆𝑤𝑖𝑡𝑐ℎ𝑖𝑛𝑔 > 𝑀𝐶𝑆𝑡𝑎𝑦𝑖𝑛𝑔

Another way to put this rule is as follows.


FIGURE 2: SWITCHING RULE INEQUALITIES DECOMPOSED

𝑆𝑤𝑖𝑡𝑐ℎ 𝑖𝑓: 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑐𝑜𝑟𝑒 𝑐𝑜𝑠𝑡 < 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑆𝑡𝑎𝑦 𝑝𝑢𝑡 𝑖𝑓: 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑐𝑜𝑟𝑒 𝑐𝑜𝑠𝑡 > 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

Let us assume that Fred’s credit score cost of switching houses is $5,000. If he ignores sunk costs, he

will switch houses. He will do so because his outstanding liability ($190,000) is greater than the sum of his current market value and credit score cost of switching ($160,000). Moreover, Fred will be $30,000 richer for his decision. Individuals who fail to ignore sunk costs follow a different rule. Such decision-makers feel that sunk costs should have resulted in benefit. Therefore, they act as if sunk costs did result in benefit. For example, an NBA team believes that a top draft pick should benefit them. When a top draft pick turns out to be of low productivity in the NBA, however, most teams act as if that pick has benefited them by giving him additional playing time opportunities. Similarly, a homeowner does not wish for his or her mortgage payments to be of no benefit in terms of accruing market equity. When such an outcome occurs, therefore, it appears that many homeowners act as if their mortgage payments did accrue market equity. Such a homeowner follows this alternative rule.

FIGURE 3: SWITCHING RULE WHEN SUNK COSTS ARE NOT IGNORED 𝑆𝑤𝑖𝑡𝑐ℎ 𝑖𝑓: 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 + 𝑠𝑢𝑛𝑘 𝑐𝑜𝑠𝑡 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑐𝑜𝑟𝑒 𝑐𝑜𝑠𝑡 < 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑆𝑡𝑎𝑦 𝑝𝑢𝑡 𝑖𝑓: 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 + 𝑠𝑢𝑛𝑘 𝑐𝑜𝑠𝑡 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑐𝑜𝑟𝑒 𝑐𝑜𝑠𝑡 > 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

If Fred erroneously recognizes sunk costs as realized benefits, he will stay put in his current home. He will do so because his outstanding liability ($190,000) is less than the sum of his current market value, sunk cost, and credit score cost of switching ($155,000 + $40,000 + $5,000 = $200,000). In recognizing the sunk cost, Fred will be $30,000 poorer than if he had switched rather than $10,000 richer. Staying in his current home does not bring ($40,000 of) value to his prior mortgage payments. CONCLUSION

As was stated in the opening passage, approximately 11 million borrowers in the United States were

underwater on their mortgage as of June 2011. Of these, an estimated 2 million will default on t heir mortgage loan. It is likely that many of the estimated 2 million will simply be unable to continue paying their loan due to insolvency. Therefore, we can infer that relatively few solvent, underwater borrowers choose loan default. Could it be that the other 9 million are “under shallow water” such that the credit cost of defaulting is greater than the amount by which they are under water? This may be true in some cases. However, it is likely that many borrowers simply refuse to ignore sunk mortgage repayment costs. Like Fred or the Merritts, these individuals may be trying to redeem a sunk cost. REFERENCES Frank, R. (2000). Microeconomics and Behavior. 4th Edition. McGraw-Hill. Landsburg, S. (2008). Price Theory & Applications. 7th edition. Thomson South-Western. Potter, J., & Sanders, S. (2012). Do Economists Recognize an Opportunity Cost When They See One? A

Dismal Performance or an Arbitrary Concept?.Southern Economic Journal, 79(2), 248-256. Schmit, J. (2011). “On Helens Pouroff Ave., escaping falling home prices.” June 12, 2011 USA Today

Online Edition, Available at: http://www.usatoday.com/money/economy/ housing/2011-06-12-mortgage-default_n.htm

Staw, B. M., & Hoang, H. (1995). Sunk costs in the NBA: Why draft order affects playing time and survival in professional basketball. Administrative Science Quarterly, 474-494.


Slack and R&D Strategy: The Effect of Slack on Internal R&D and External

R&D, and Innovation

Sang Kyun Kim Sungkyunkwan University

Hyuksoo Cho

Chungnam National University

Hinh Khieu University of Southern Indiana

Firms use their internal resources effectively and efficiently in order to achieve innovation, but not all types of resources trigger the same level of innovation. We provide a new insight to understand the relationship between slack resources and R&D strategy by suggesting a new typology for slack resources: tangible and intangible slack. Building on resource-based view, we propose that tangible slack leads to more external R&D activities (external knowledge acquisition) and results in radical innovation, while intangible slack facilitates more internal R&D activities and results in incremental innovation. Implications for future research are discussed. INTRODUCTION

Innovation and resources are the core concepts of theories in the organization and strategic management field. Innovation has been explained as the result of a firm’s operation because it explains a significant portion of firm performance (Roberts, 1999). It is also important to know that innovation represents how well a f irm adapts to an external environment by changing organizational structure and developing new technologies and products. Under a dynamic environment, firms are required to become innovative to obtain competitive advantages (Nohria & Gulati, 1996). In this perspective, resources provide the foundation of a firm’s innovation.

Where do resources come from? Firm resources can be anything that firms can use to conceive and implement their strategy (Learned, Christensen, Andrews, & Guth, 1969). It includes all types of assets, capabilities, organizational processes, firm attributes, information, knowledge, etc. (Barney, 1991). Of these resources, there are two types – normal and slack. Normal resources are of the type that is used for regular operations of the firm such as the amount of cash holdings to pay for normal payables. Slack resources, which prior studies have recently focused on (Bourgeois, 1981; Cheng & Kesner, 1997; Cyert & March, 1963; Daniel, Lohrke, Fornaciari, & Turner Jr, 2004; George, 2005; Love & Nohria, 2005; Nohria & Gulati, 1996; Sharfman, Wolf, Chase, & Tansik, 1988; Singh, 1986; Tan & Peng, 2003) refer to the excess of what a f irm needs for its regular, day-to-day operations. Unused capacity, redundant employees, and unnecessary capital are examples of slack resources (Nohria & Gulati, 1996). Firms use


these slack resources to adapt to environmental changes (Bourgeois, 1981). Each firm has a different level of organizational slack depending on the degree to which the firm operates effectively and efficiently (Nohria & Gulati, 1996).

In terms of innovation, prior research focuses only on i nvestment of slack resources in internal research and development (R&D) or search behavior of firms (exploitation vs. exploration) (see Voss, Sirdeshmukh, & Voss, 2008). Although slack resources can be used in internal or external R&D, the literature that explores the relationship between slack and innovation implicitly assumes that firms use slack resources internally to improve their capability of innovation (Nohria & Gulati, 1996, 1997; Tan & Peng, 2003). While innovation increases firm performance, not all firms invest in R&D activities, and the innovative firms do not engage solely in internal R&D. This limitation of extant research leads to the following research question: How do firms leverage their slack resources internally and externally in order to achieve innovation?

In this paper, we investigate the impact of slack resources on the strategic choice for innovation by suggesting a n ew typology which categorizes slack resources into two groups: tangible and intangible slack. Then, we propose which type of slack resources (tangible and intangible slack) facilitates which types of R&D activities (internal and external R&D) for innovation. Overall, this study contributes to the understanding of the determinants of internal R&D and external knowledge acquisition from the resource-based perspective.

The paper is organized into the following sections. The first discusses the concept of slack and innovation, and reviews related literature. In the second section, the paper discusses two types of R&D activities and proposes a s pecific association between two type of slack resources and R&D activities. The final section contains the discussion, limitation, and future research. THEORETICAL FOUNDATIONS AND LITERATURE REVIEW

According to Nohia and Gulati (1996, p.1246), slack is defined as “the pool of resources in an

organization that is in excess of the minimum necessary to produce a g iven level of organizational output.” The role of slack in organizations has been extensively researched. Empirical studies in performance literature suggested that slack directly affects performance (Nohria & Gulati, 1996). However, this conclusion was controversial to conclusively explain the relationship between slack and firm performance because the findings varied from positive to mixed relationships. Later, Daniel et al. (2004) found the overall positive effect of slack on firm performance from meta-analysis. They also proposed firms should pursue an appropriate level of slack for high performance within their industry. Also, Love and Nohria (2005) suggest that downsizing lead to improved performance for firms with high level of slack.

In the innovation literature, there have been debates about the impact of slack on innovation. On one hand, proponents support the positive side, claiming that slack allows firms to engage in new innovative projects which might not be possible under resource-constrained environments (Cyert & March, 1963). The logic is that previous success generates slack which plays a role of seeds in innovation activities (i.e. creative and innovative experimentation), while the investment in R&D activities is hardly allowed in the situation of scarcity and under poor performance (Bourgeois, 1981; Cyert & March, 1963). Additionally, the excess resources reduce conflict in decision making, decrease the information processing needs of a system, and encourage new R&D projects (Bourgeois, 1981). On the other hand, opponents propose that slack negatively affects a firm’s innovation because slack might lead the firm not only to a lack of incentive for innovation, but also to unproductive R&D projects which do not yield benefits (M. C. Jensen, 1996; Leibenstein, 1969). In that sense, organizational slack is wasteful as i t serves managerial self-interest, incompetence, and laziness rather than acts as a buffer for organizational adaptation. To the end, this theoretical debate leads to a n ew approach, a cu rvilinear relationship studied by Nohria and Gulati’s (1996, 1997). Unlike previous studies, they suggest an inverse U-shape relationship in which too little slack and too much slack are bad for innovation. Too little slack discourages investment in R&D projects of which the success is uncertain, while too much slack is likely to result in complacency, which


decreases the success rate of R&D projects due to a lack of discipline and incentives. Although there are different approaches to explaining the slack-innovation relationship, all research is likely to support the notion that slack allows organizations to engage in R&D activities to obtain higher performance from innovation activities.

Despite of extensive research in the topic of slack, it is still not clear how slack resources influence a firm’s R&D strategy. Firms pursue either external R&D or internal R&D, or both (See Table 1). External R&D broadly implies an engagement in R&D projects with other firms. First, a firm implementing external R&D strategy may form a partnership to develop a new product or technology. For example, Veugelers and Cassiman (2005) found that R&D cooperative agreements between a firm and an university are formed whenever risk is not an important obstacle to innovation and typically serve to share costs. Second, firms also obtain the external sources for innovation through outsourcing or mergers and acquisitions. Hitt, Hoskisson, and Ireland (1990) discuss the theoretical implication of the relationship between mergers and acquisition and innovation, and suggest that access to external knowledge through mergers and acquisition allow the acquired firms not only to enter a new market, but also to obtain a larger market share in an existing market (Hitt et al., 1990). In contrast, internal R&D refers to the research and development activities within a firm boundary. Firms with internal R&D strategy invest its resources in internal R&D projects in order to obtain innovation. Given that acquisition and internal R&D are considered two ends in the boundary expansion activities (Santos & Eisenhardt, 2005) and that we are interested in the binary decision of R&D strategy, external R&D in this paper implies an acquisition of external knowledge for innovation.

Literature in innovation has extensively studied the factors that influence a f irm’s strategic choice between internal and external R&D (Cassiman & Veugelers, 2006; Del Canto & Gonzalez, 1999; Hitt et al., 1990; Piga & Vivarelli, 2004; R. Veugelers, 1997; R. Veugelers & Cassiman, 1999; Reinhilde Veugelers & Cassiman, 2005). Using an exploratory analysis, Piga and Vivarelli (2004) explored the drivers of external R&D, and suggested that the potential drivers of external R&D include public ownership, public subsidies, and outsourcing in purchases, firm size, diversification, customer concentration, outsourcing in sales, competition from large firms, and control over other firms within a business group. Scholars also investigated organizational and environmental contingencies that impact a firm’s binary decision for R&D strategies. For example, the decision depends on the firm’s absorptive capacity (R. Veugelers, 1997) and resource constraint situation (Hitt et al., 1990). Specifically, Hitt and his colleagues found that when a firm is faced with a resource constraint situation, top managers tend to invest fewer resources in internal R&D (Hitt et al., 1990) and are rather inclined to find sources for innovation from external organizations or institutions.

In the high tech industry, most firms conduct both internal and external knowledge acquisition activities simultaneously. These activities are complementary in that the marginal return of one activity increases as t he intensity of the others increases (Cassiman & Veugelers, 2006). Possession of internal sources (i.e., know-how, patents, absorptive capacity) contributes to the marginal return of external knowledge acquisition strategies because sufficient in-house R&D capability is essential to absorb and utilize externally acquired knowledge (Cohen & Levinthal, 1990). In addition, access to external know-how may leverage the efficiency of internal R&D activities as long as a firm is willing to accept external knowledge (Cassiman & Veugelers, 2006). Therefore, both internal and external R&D activities could lead to value creation and overall stronger competitive advantages.

Similarly, prior research on R&D strategy has examined the influence of external and environmental factors on the binary strategic choice between internal R&D and external R&D, while the literature needs more investigation from an impact of internal resources (Del Canto & Gonzalez, 1999). From the resource-based perspective, Del Canto et al.(1999) find that intangible factors are the main determinants of the probability of a firm carrying out internal R&D. Although intangible factors are examined as a determinant of internal R&D, it is still unexplored how both tangible and intangible slack resources affect the decision of internal versus external R&D activities. Therefore, this research attempts to fill this gap by suggesting the relationship between two types of slack resources and two types of R&D strategy, contributing to more understanding of firms’ use of excess resources in R&D activities.


FIGURE 1 RELATIONSHIP BETWEEN TWO TYPES OF SLACK RESOURCES

AND R&D STRATEGY, AND INNOVATION

SLACK, R&D STRATEGY AND INNOVATION

We set boundary conditions and assumptions which are necessary to make an argument about how a

variation of internal resources are associated with strategic choices for R&D: (1) All organizations have at least some level of slack resources; (2) Slack plays a role of a buffer for organization adaptation; (3) Organizations pursue at least one type of R&D activity (internal or external); (3) There is a heterogeneity of internal resources between organizations. Under these assumptions and boundary conditions consistent with those of resource-based view (RBV), we propose the specific relationship between slack and R&D strategy below.

Many previous studies in organizational slack selected three types of slack resources (Daniel et al., 2004; Cheng and Kesner, 1997; Bourgeois and Singh, 1983; Bromiley, 1991; Hitt et al., 1990). They divide slack into three categories – available, recoverable, and potential – according to their availability. However, the categorization interprets organizational slack from a financial perspective, which makes it relatively easy to measure organizational slack. To stay consistent with the purpose to find the effect of slack resources on the decision between internal and external R&D, this paper proposes two new terms of resource-based categories: tangible and intangible slack.

The definitions of tangible and intangible slack are defined similar with tangible assets and intangible assets. According to Wernerfelt (1989) and Barney (1991), tangible assets refer to the organizational fixed and current assets which have a fixed long run capacity. Based on this definition, tangible slack is defined as the tangible resources used more than necessary for the normal efficient operation of an organization. Examples include excess capital, plants, equipment, land, other capital goods and stocks, debtors and bank deposits. In contrast, intangible slack refers to excess intangible resources used more than necessary for normal efficient operations of an organization, for instance, unused intellectual property (old-fashioned skills and knowledge, and unused patents).

From RBV, innovation can be obtained not from searching the external environment for opportunities, but from looking inside to create core competencies of the organization (Del Canto & Gonzalez, 1999). Then, it would be an interesting question that when organizations have tangible slack, which strategic choice of R&D strategy would be preferred to support innovation? Tangible Slack Tangible Slack and External R&D Activity

A characteristic of tangible assets is that they are transparent and relatively weak at resisting duplication of efforts by competitors (Grant, 1991). For example, organizations with excess capital (a form of tangible slack) can invest in building additional plants as long as this activity is in line with their strategies and goals. We posit that the source of external R&D comes from tangible slack, such as low debt or high current ratio, rather than intangible slack. Low debt ratio and high current ratio, which have

Weak

Tangible Slack

Intangible Slack

External R&D

Internal R&D

Strong

Radical Innovation

Incremental Innovation


been used to measure tangible slack resources (Bourgeois, 1981), indicate more discretion in making decisions, while firms experiencing resource constrained situations have limited choices. With high levels of tangible slack, external R&D through acquisition is preferred to internal R&D in that it is an effective means for gaining control of others’ technology, value appropriation from their inventions and faster access to diverse markets with acquired technologies (Capron & Pistre, 2002). In the same vein, Jensen (1986) suggested that a h igh level of cash flow is more likely to make an acquisition and Voss et al. (2008) proposed that financial slack increases a firm’s effort for exploration rather than exploitation.

Another benefit is potential high returns from radical innovation through broader searching activity beyond its core technological field. Through acquisition of external knowledge and technology, the firm enables to explore new opportunities and expand its research focus from the core business to non-core business. The diverse sources newly available from acquisition of firms in the related and unrelated business field could be integrated with the existing sources and result in more radical innovation beyond the firm’s innovation trajectory. As high profitability increases liquidity of the firm, high liquidity encourages investments in external R&D activities in order to obtain high rate of returns derived from radical innovation. Therefore, the access to external knowledge and the potential high profitability of radical innovations and underline the advantages and importance of external R&D.

Tangible Slack and Internal R&D

The availability of resources in large companies is relatively higher than that in small or medium size companies. There might be efforts to reduce slack by projecting these resources into new projects. Internal R&D is one solution to consume excess slack. Reinvestment of excess internal resources results in the efficiency and effectiveness of operations so that they become more flexible to the dynamic environment. By maintaining appropriate level of resources, firms can avoid becoming oversized and bureaucratic organizations. The proper level of slack gives the firms flexibility, but too much slack hampers performance by leading to inefficiency (Nohria & Gulati, 1996). Thus, large companies tend to have high level of tangible slack which allows investing in internal R&D activities to reduce slack. However, the success of R&D activities requires an investment in highly sophisticated technical equipment which devotes to the intensity of the capital (Del Canto & Gonzalez, 1999). Pursuing external sources for innovation, such as buying a company in a different industry, mitigates the motivations of carrying out internal R&D. The cost of ‘buying’ is relatively higher than the cost of ‘making’(Cassiman & Veugelers, 2006), but the availability of excess capital (slack) encourages the firm to pursue external R&D strategy. Further, unlike external knowledge acquisition, internal R&D is related to a significant portion of incremental innovation than to radical innovation (Nagarajan & Mitchell, 1998). The characteristics of internal R&D, such as n arrow search, the limited sources of innovation, and technological trajectory are more likely to support developing and improving existing technology and products.

In short, tangible slack leads to both internal and external R&D, but the advantages of external R&D and the property of tangible resources would weigh more on carrying out external R&D through acquisitions. Therefore, we propose that tangible slack resources are positively related with external R&D activities (see Figure 1).

Proposition 1: A firm with high levels of tangible slack would engage more in external R&D than in internal R&D, which results in more radical innovations.

Intangible Slack Intangible Slack and Internal R&D

Unlike tangible slack, intangible slack resources may have different effects on the decision of R&D activities. First, it is necessary to understand the property of intangible slack and assets in that the two are closely related and at the core of the RBV discussion. Intangible assets represent the difference between the balance sheet valuation and stock market valuation of publicly listed companies (Grant, 1991) such as patents in the pharmaceutical sector. Intangible assets have relatively unlimited capacity and firms can


exploit their value by using them in-house, renting them, or selling them (Wernerfelt, 1989). They are relatively resistant to duplication or imitation efforts by competitors, at least in the short run, because intangible assets, like intellectual property, are generally inherently complex, firm-specific, and legally protected.

Intangible slack is different from intangible assets. Intangible slack, such as overhead, old-fashioned knowledge1 and information which is no longer useful for innovation, human resources, and routines, may impede for a firm to achieve the optimal operation of business. Simultaneously, intangible slack resources also have their own value and have the potential of value creation effect, especially when they are utilized for innovation purposes. Intangible slack indeed help firms engage in more internal R&D than in external R&D, and the firm uses its accumulated intellectual resources in its internal R&D projects to maximize its innovation productivity because of advantages of internal R&D. First, internal R&D reduces the risk of exposure of knowledge and technology, which fits the ownership property of intangible slack, even though it might negatively affect the performance (Hall, 1989). That is, firms protect their ownership of old-fashioned technology by patenting and are likely to keep renewing the duration of protection from imitation. What drives the expenditure for such old-fashioned technology would be the possibility of application for a future innovation. As such, the accumulation of old-fashioned knowledge and technology is likely to be treated as a source for the innovation rather than useless property, even though they hamper the optimal operation.

Second, as t he valuable, rare, inimitable, lack of substitutable assets is necessary to achieve sustainable competitive advantage (Barney, 1991), intangible slack, such as technology and information, also involves some of those characteristics. For example, the technique of how shoes are made was developed a long time ago. A company with this technique no longer considers it the core technology to obtain sustainable competitive advantage. However, R&D activities often convert the old-fashioned knowledge to a new core knowledge which enables the firm to derive more profit. That means intangible slack resources can be transformed to support R&D activities. Thus, intangible slack is valuable. A firm with specific and superior information and technology, which are of relatively low value to other firms, is likely to keep its technology and information internal because the exposure of technology to other organizations might result in a significant loss of both profitability and competitive advantages. Also, the tacit nature of information and technology contributes to motivating internal R&D. Therefore, internal R&D is likely to control the technology and information within its firm boundary to protect intangible assets.

Third, the synergy effect would be higher if intangible slack is related to core competences. Within the organizational boundary, the core knowledge and technology can lead synergy to develop incremental innovation in terms of the existing product and technology. Banbury and Mitchell (1995)’s work emphasizes the importance of incremental innovation. They find that the more often an industry incumbent is among the first to introduce important incremental product innovations, the greater its market share in the industry and in turn reduces the likelihood of business dissolution. Like the previous example, internal R&D can change slack into a useful asset through incremental innovations rather than radical or breakthrough innovations. Intangible Slack and External R&D

On the other hand, some intangible slack also encourages external R&D. For example, highly routinized work impedes the innovation, and motivates engaging in external R&D contracts with other organizations with less routinized works. The literature in organizational learning and evolution argues that as organizations repeat routines, they tend to exploit existing knowledge and capabilities, and remain in the current position without significant changes (Benner & Tushman, 2002; Levinthal, 1997; March, 1991). Reinforcing core capabilities creates strong routines that impede the organizational change by making it difficult for organizations to follow environmental changes (Leonard-Barton, 1992), as well as strong inertia. The decreased performance derived from a lack of adaptation to new environments and strong inertia is likely to lead to external search for innovation. Ahuja and Lampert (2001) argue that by experimenting with novel, emerging, and pioneering technologies, firms can overcome a familiarity trap,


maturity trap, and propinquity trap2, and create breakthrough inventions. It is expected that the external sources for innovation will enhance the ability to respond to the environment and reduce the inertia within organizations.

Overall, we suggest that although intangible slack is related to both internal and external R&D together, intangible slack facilitates engaging in internal R&D more than external R&D because of high risk of information leakage and loss of firms’ competitive advantages.

Proposition 2: A firm with high levels of intangible slack would engage more in internal R&D than in external R&D, which results in more incremental innovation.

DISCUSSION AND IMPLICATION

Improving innovation performance has become one of the main concerns to top managers in a firm.

Building on resource based views, this study discusses how resource portfolio of a firm influences its strategic choice between internal R&D and external R&D strategy. It is argued that slack resources should be considered an essential factor in making a decision for R&D strategy and achieving innovation. Although firms pursue complementarily both internal investments for innovation and external R&D, tangible slack facilitates acquiring external knowledge and leads to more radical innovation, while intangible slack is positively associated with internal R&D, resulting in more incremental innovation. With the unique characteristics of two types of slack resources, the accessibility of external resources and the risk of exposure of intangible assets provide appropriate rationale to understand a firm’s R&D strategy.

This paper contributes in two important ways to slack and innovation literature. First, we introduce a new typology of slack resources. Prior studies that investigated the effect of slack on innovation show inconsistent results. Recently, scholars in strategic management field developed and suggested an alternative definition or a new typology of slack resources (Mousa & Reed, 2013; Voss et al., 2008). This paper is in the line with such research effort to refine the existing concepts of slack and its effect on a firm. Second, we su ggest that slack-driven R&D activity influences overall radicalness of innovation. Rather than arguing a simple positive or negative effect of slack on innovation, we propose that R&D strategy motivated by excess resources results in innovation with different level of radicalness, and emphasize that a firm accomplish breakthrough innovation when the firm has sufficient financial capital and access to newly acquired knowledge which was not available before.

For practical perspectives, it is significantly important to evaluate the level of slack using its resource portfolio. Typically, firms do not recognize their slack resources unless they face decreased performance. When a firm has high levels of slack, it should make a strategic plan to use and reduce the slack resources in a way to obtain a competitive advantage and enhance its innovation performance. The available and utilizable slack can be used to enhance innovative performance by engaging in internal R&D or external R&D. The criteria between two options would be based on the portfolio of slack, as well as their strategic objective in R&D activities. Firms with high tangible slack resources may pursue external R&D by using liquidity in order to gain access to external sources with a goal of developing radical innovation. In contrast, firms with high intangible slack resources would tend to pursue internal R&D. Carrying out internal R&D projects with intangible slack will result in incremental innovation and reduce the risk of exposure of knowledge and information. Therefore, to apply the proposed relationship from this study in a real world, managers are recommended to test intangible and tangible slack resources. If the strategy allows, investment of slack resources in innovation would be one of the best choices to adapt to dynamic environments and to obtain a competitive advantage.

There are several limitations of this research. First, the time effect on internal and external R&D is not taken into account. The external knowledge obtained from acquisitions might encourage in-house internal R&D because such external sources can not only be perceived as internal source for innovation completely after acquisitions and mergers but can also enhance firm’s capability to pursue internal R&D. With a high quality of capability, organizations are likely to engage more in internal R&D. So, the time


effect on the decision between internal and external R&D would be a fruitful future research topic. Second, this paper does not address the choice of target firms when organizations engage in the external R&D. The characteristics of target firm and its relationship with acquiring firm potentially influence innovation productivity in the future. For example, it is expected that strategic fit among diversification strategy and R&D strategy enhances the acquiring firm’s innovation productivity (Kim, Arthurs, Sahaym, & Cullen, 2013). Third, our propositions need to be validated with empirical supports. To overcome those limitations, future research may build panel data and test causal relationship among resource portfolio, R&D strategy, and breakthrough innovation.

At last, the future studies could integrate all the determinants of R&D activities, including internal and external factors, as well as environmental factors. For example, existing studies find that strategy and competition are related to R&D activities (Piga & Vivarelli, 2004). Of course, both the resource-based perspective and economic perspective would provide good t heoretical implications in the integration. Therefore, synthesizing these determinants from the previous studies with findings from this research would shed more light in our understanding of corporate R&D activities. ENDNOTES

1. Old-fashioned knowledge indicates knowledge or technology that is very old and no longer used in the organization.

2. Familiarity trap refers to a tendency to favor the familiar over the unfamiliar. It can be overcome by experimenting Novel technology which is new or unfamiliar to the firm, even though they possibly have existed in the industry before. Maturity trap is defined as a tendency to prefer the mature over the nascent. Experimenting emerging technology reduces maturity trap. At last, propinquity trap is a tendency to search for solutions that are near to existing solutions rather than search for completely de novo solutions. It can be solved by pioneering a new technology (see Gautam Ahuja & Morris Lampert, 2001)

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Are Discretionary Accruals a Good Measure of Audit Quality?

Essam Elshafie Northeastern Illinois University

Emmanuel Nyadroh

Northeastern Illinois University

Numerous studies use discretionary accruals (DA) as a proxy of audit quality; yet, there is no conclusive evidence on whether DA are a good proxy for audit quality. To test whether DA are a good measure of audit quality, we examine the association between DA and five measures of audit quality, namely; the likelihood restatement, f4 audit, negative internal control report, going concern opinion, and auditor’s industry specialization. The results show that while there is an association between DA and each of the first three audit quality measures, such an association is absent in the case of each of the last two. These mixed results indicate that DA are not necessarily a good measure of audit quality. INTRODUCTION

Knapp (1991) and Schroeder et al. (1986) indicate that despite the importance of the audit quality concept, it is not explicitly defined by technical standards nor, have researchers arrived at a consensual understanding of its meaning. Francis (2011) explains that audit quality is a complex concept and cannot be reduced to a simple definition; however, he indicates that “audit standards imply that audit quality is achieved by the issuance of the “appropriate audit report on the client’s compliance with Generally Accepted Accounting Principles.” He also states that a good audit is “one in which the auditor complies with auditing standards and issues the correct opinion regarding the client’s financial statements at an appropriate level of audit risk.” He i ndicates that audit quality is affected by factors included in a framework he has introduced that includes testing procedures, team personnel, audit processes, accounting firms, audit industry, and institutions that affect auditing, such as AICPA, PCAOB, FASB, etc.

DeAngelo (1981) defines audit quality as “the market assessed joint probability that a given auditor will both (a) discover a breach in the client’s accounting system and (b) report the breach.” She indicates that audit quality is positively associated with auditor independence. On the other hand, audit failure is defined as: “issuing an erroneous audit opinion as the result of an underlying failure to comply with the requirements of Generally Accepted Auditing Standards” (Arens et al., 2008). PCAOB Audit Standard No. 7 (AS7) addresses the issue of engagement quality review. The objective of this standard is to provide guidance for those who perform a second-partner review of audit or review engagements quality. This standard provides a definition of an audit deficiency. It states: “A significant engagement deficiency in an audit exists when (1) the engagement team failed to obtain sufficient appropriate evidence in accordance with the standards of the PCAOB, (2) the engagement team reached an inappropriate overall


conclusion on the subject matter of the engagement, (3) the engagement report is not appropriate in the circumstances, or (4) the firm is not independent of its client.” From these definitions, we can identify major characteristics of a high audit quality, namely: issuing an appropriate opinion by an independent firm, while following auditing standards. Since in most cases, data on whether the auditor followed the standards is not readily available, the majority of the audit research articles that address audit quality use discretionary accruals (DA) as a proxy for audit quality, despite the fact that DA may not be the best measure of audit quality. For example, Francis (2011) indicates that “while earnings quality is an important stream of research in financial accounting, it could be argued that earnings-quality metrics are not an appropriate measure of audit quality.” He explains that financial statements of firms with extreme value of earnings quality measures, not necessarily imply that such financial statements are misstated.

In his top 10 wish list for audit research, Nusbaun (2007) identifies “the meaning of improving audit quality” as an important area for future research. He adds that “we need to begin by addressing more fundamental questions: What is quality? What does it mean to bring quality to an audit?” The importance and implication of our paper stem from these questions.

The purpose of this paper is to examine whether DA are really a relevant proxy of audit quality or whether they are used for lack of data on other measures of audit quality. The concern is that DA are used extensively in the accounting and auditing research as a “silver bullet” to measure or serve as a proxy for many things. In addition to audit quality, they are used as a proxy for earnings quality (Bedard et al., 2012), accounting conservatism (Ahmed et al., 2002), auditor conservatism (Ajona et al., 2008), etc. The lack of empirical evidence that supports the robustness of DA as a measure of all these variables, especially audit quality, drives our research question. Our study is the first, to the best of our knowledge, to attempt to address whether DA are a good measure for audit quality.

Chambers and Payne (2011) address whether the quality of accruals, measured by their persistence, relates to an audit quality attribute which is Big N f irm independence. Their research does not address directly whether DA i s a p roxy for audit quality. In this paper, we hypothesize that if DA are a good measure of audit quality, then they should be highly associated with other indicators of audit quality, such as the likelihood of restating the company’s financial statements (Stanley and DeZoort, 2007), performing the audit by one of the Big N firms (Lennox, 1999), the likelihood of issuing a going concern opinion (Carey and Simnett, 2006; Knechel and Vanstraelen, 2007), the level of industry specialization (Balsam et al., 2003), and the efficiency of the internal control.

Data on entities with restatements of financial statements, going concern reports, negative internal control reports, are collected from AUDIT ANALYTICS, and the necessary financial data for these entities are collected from COMPUSTAT over the period, 1995 to 2010. The accruals are estimated using the Modified Jones Model (Dechow et al., 1995). The results of examining the association between DA and these measures are mixed. While the associations between DA an d the restatements of financial statements, audit by Big 4 firms, and negative internal control reports are in the expected direction, the association between DA and going concern opinions is insignificant and the association of DA with the industry specialization of the audit firms is in the opposite direction.

BACKGROUND AND HYPOTHESES DEVELOPMENT

Allen and Woodland (2010) find that even though higher education requirements (150 hours) lead to

increase in audit fees, it does not affect audit quality as measured by DA. Using a sample of Taiwanese companies, Chen et al. (2008) examine whether audit firm/partner tenure affects earnings quality measured by performance adjusted DA. Contrary to the arguments supporting Sarbanes-Oxley Act’s 5 year partner rotation requirements, Chen et al. (2008) find a negative association between audit firm/partner rotation and DA. However, Chi et al. (2009) criticize this article and indicate that the research sample period used by Chen et al. (2008) is prior to 2003 when partner rotation in Taiwan was voluntary; therefore, the results do not reflect the effect of mandatory auditor rotation on earnings quality. Instead, Chi et al. (2009) examine audit quality after 2004 when partner rotation became mandatory. Using performance-matched abnormal accruals as a proxy for audit quality, they do not find that partner


rotation enhances audit quality. Also, Manry et al. (2008) address the association of audit quality and partner tenure. They use DA as a measure of audit quality and they also provide evidence on the increased audit quality with the length of partner tenure.

Balsam et al. (2003) extend the research on audit quality and earnings quality. They state that: “because auditor quality is multidimensional and inherently unobservable, there is no s ingle auditor characteristic that can be used to proxy for it,” and that: “Earnings quality is a concept that does not have a common definition in the literature.” They use auditor industry specialization as a proxy of audit quality and two measures of earnings quality, namely, DA and earnings response coefficient. Their findings generally support a positive relation between earnings and audit quality measures. Choi, Kim, Kim, and Zang (2010) examine the effect of office, not firm, size on audit quality measured by unsigned DA; they find that office size has a positive effect on bot h audit quality and audit fees. Using the magnitude of absolute DA, Choi, Kim, and Zang (2010) study the association between abnormal audit fees and audit quality. They find that the association between the two is asymmetric. That is, for abnormally low audit fees, there is no significant association, but for positive abnormal audit fees, the association is negative. This means that the auditors’ incentive to perform quality audit work is based on t he amount of fees received. Becker et al. (1998) do not use DA as a measure of audit quality, but as a measure of earnings management, and use firm size as a proxy for audit quality. They find that non-Big six audit firms’ clients report income-increasing DA more than big-six clients. In addition, they report that non-big six firms allow their clients more accounting flexibility that lead to a higher level of earnings management.

We notice from this brief literature review that some studies examine the association between audit quality and DA as variables independent from each other (e.g., Becker et al., 1998), while other studies use DA as a proxy or a measure of audit quality (e.g., Allen and Woodland, 2010). This inconsistency is another motivation for our study.

Restatements of Financial Statements

Francis (2011) shows that restatements indicate a higher rate of low-quality audits. Also, Gunny and Zhang (2009) indicate that clients of audit firms, which Public Company Accounting Oversight Board (PCAOB) reports as having failed to discover a significant departure from GAAP, are more likely to have a subsequent restatement of earnings. This implies that there is a n egative association between restatements and audit quality. Also, Chen and Chi (2009) study the restatements of financial statements and the auditor’s industry expertise. Even though they find no evidence that firm-level experts lower the likelihood of accounting restatements, the results of their study indicate a negative association between signing partner expertise and accounting restatements. Romanus et al. (2008) examine the effect of auditor’s industry specialization on audit quality. They measure audit quality by the likelihood of accounting restatements. They state that: “Restatements provide more direct evidence that the auditor failed to either detect or report an accounting treatment that is inconsistent with GAAP than other common proxies for audit quality such as accrual-based metrics (DeFond and Francis 2005).” All of these studies use accounting restatements as an indicator of audit quality. Therefore, if DA are a proxy for audit quality, they are expected to be associated with the restatements of financial statements. Based on this we examine the following hypothesis:

H1: There is a significantly positive relationship between the level of DA and the restatements of companies’ financial statement.

Going Concern Opinion

Another measure of audit quality is issuing a going concern opinion (Carey and Simnett, 2006). Lennox (1999) uses the going concern opinion to measure auditor reporting accuracy. Also, Francis and Yu (2009) test the prediction that larger offices of Big 4 firms have higher quality audits by measuring the likelihood of larger offices issuing more going-concern reports. That is, they measure audit quality by the likelihood of audit firms issuing going concern opinion. Then, if the DA are a good proxy for audit


quality, there should be a lower level of DA when a firm receives a going concern opinion, i.e., a negative association between the DA and the going concern opinion. Thus we stipulate the following hypothesis:

H2: DA tend to be lower for companies receiving going concern opinions.

Big 4 Audit Firms

Lennox (1999) documents that the Big 4 firms issue more accurate audit reports than do the non-Big 4 accounting firms. Arguing that big firms have more to lose in case of litigation, Dye (1993) indicates that these firms will provide higher audit quality. Francis and Yu (2009) find that larger offices of Big 4 firms provide higher quality audits. Knapp (1991) finds that audit committee members perceive auditor size and tenure to have a significant influence on the quality of the audit service. These studies suggest a positive relationship between audit quality and Big 4 audit. Therefore, if DA measure audit quality, Big 4 clients should have significantly lower DA. Hence our third hypothesis is stated as follows:

H3: DA are lower in companies receiving Big 4 audits.

Internal Control Efficiency

Internal control (IC) is defined as a set of policies and procedures that are designed and implemented by the management of an entity to help achieve the entity’s goals in terms of reliable financial reporting, efficient operations, and following laws and regulations. Sarbanes-Oxley Act of 2002, section 404, requires management of accelerated filers to issue a statement on the effectiveness of each filer’s the IC and the auditors of accelerated filers to obtain an understanding, audit, and issue an opinion on the effectiveness of the IC systems of these entities. We assume that an auditor issuing a negative IC opinion is a sign of a high level of auditor independence, and, therefore if the DA reflect audit quality, they should be low in entities receiving negative IC opinions.

H4: DA are low in firms after receiving IC negative report.

Industry Specialization of Audit Firms

Balsam et al. (2003) find clients of industry specialist auditors have lower DA. Romanus et al. (2008) list several studies that provide evidence that industry specialization appears to enhance the auditors' error detection and mitigate the use of accruals-based earnings management. Jensen and Payne (2005) use industry experience levels (industry expertise) as a proxy for auditor quality in examining the links between audit service procurement, audit quality, and audit fees. We reexamine these findings by testing the following hypothesis:

H 5: DA are lower in a company which is audited by a firm with a high level of industry specialization.

RESEARCH METHOD AND RESULTS

A unique feature of this paper is that we relate different audit quality measures to DA; therefore, we

collect several data sets on each of these measures, namely: restatements of financial statements, going concern opinions, internal control negative reports, industry specialization of audit firms, and Big 4 audits. To test the first three hypotheses, we collected data from AUDIT ANALYTICS, then we collect samples that have observations on r estatements, going concern opinions, and internal control negative reports, then we match them with firms that are free of these attributes based on 4 digit SIC code and size measured by total assets. Data on the matching groups are collected from COMPUSTAT. For testing hypotheses related to the Big 4 audit firms and the industry specialization, data are collected from COMPUSTAT.


The following model is used to examine all five hypotheses:

AQF it = α + β1 DA it + β2 ln_TA it + β3 ROA it + β4 DTEQ it + β5 MKBK it + β6 IND it + β7 BIG4 it + ε it (1)

Where, for each company I in period t, AQF it is the audit quality factor, DA it is the discretionary accruals, ln_TA it is the natural log of the total assets to control for the size of the entity, ROA it is return on assets to control for the profitability, DTEQ it is debt to equity ratio to control for the leverage, MKBKit is the market value to book value ratio to control for the growth, IND it is the industry controlled by the SIC code to control for the company’s industry, and BIG4 it is a dummy variable that equal 1 if the auditor is one of the Big 4, and 0 otherwise, to control for the accounting firm size. DA it are estimated following Dechow et al. (1995), as we use the Modified Jones Model to estimate the DA as follow: ACC it / TA it-1 = α 0 /TA it-1 + α 1 (Δ Revenue it - Δ AR it) /TA it-1 + α 2 PPE it /TA it-1 + ε it (2) where, for each company i and period t, ACC it is the accruals, measured, in (3), as the change in current assets minus the change in current liabilities, minus the change in cash and cash equivalent, plus the change in short term debt included in the current liability, and minus the depreciation expense; TA it is the total asset it; Δ Revenue it is the change in revenue; and PPE it is the level of gross property, plant, and equipment. ACC it = Δ CA it – Δ CL it – Δ CASH it + Δ STD it – DEP it (3) Restatements of Financial Statements

We start with data on all positive and negative restatements from AUDIT ANALYTICS 1995 to 2010. Total number of observations was 11,355 observations. After removing observations missing tickers or other relevant variables we are left with 5,194 observations. After merging these observations with data from COMPUSTAT and removing other missing observations, we have 2,940 observations left. Then we r emove observations of firms in the financial services industries (SIC code 6000-6999), with 1,806 usable observations left. We match the firms in this usable set with firms with no financials statement restatements based on the SIC code and size (10% over or under of the total assets). After removing observations without a match, and removing the upper and lower 1% of the variables used in the model, we are left with a total of 3,861 observations. Table 1 shows descriptive statistics of the main variables. Panel A shows the descriptive statistics for all firms in the sample, while Panel B and C show the descriptive statistics for companies with restated financial statements and companies without restated financial statements, respectively. Comparing the DA l evels on average in companies with versus companies without restatements, the results in panel B show that firms with restated financial statements have a mean DA of 0.02 which is larger than that in Panel C of the companies without restated financial statements, -0.05, which is in the same direction expected under our first hypothesis, H1.


TABLE 1 DESCRIPTIVE STATISTICS FOR THE RESTATEMENTS

Panel A - All firms with and without restatements: Variable N Mean SD Min Max Discretionary Accruals 3861 -0.03 0.19 -1.44 0.97 Current Assets 3861 331.87 847.50 0.00 14509.00 Current Liabilities 3861 216.98 656.53 0.02 8120.35 Cash 3861 110.29 368.74 0.00 10110.00 Short Term Debt 3861 40.77 182.24 0.00 3678.66 Depreciation 3861 4505 133.53 0.00 2199.00 Sales 3861 841.51 2551.85 0.00 51760.00 Net PPE 3861 366.46 1272.52 0.00 16675.69 ROA 3861 -13.02 44.79 -399.22 34.49 Total Assets 3861 958.76 2561.34 0.65 23754.00 Debt to Equity 3861 61.41 139.39 -659.72 1274.42 Market to Book 3861 3.33 5.62 -28.37 54.31 Panel B - Control group (firms with restatements of financial statements): Variable N Mean SD Min Max Discretionary Accruals 1806 0.02 0.17 -1.32 0.89 Current Assets 1806 312.26 825.27 0.00 9267.00 Current Liabilities 1806 206.53 639.77 0.02 7484.40 Cash 1806 99.55 313.43 0.00 4674.00 Long Term Debt 1806 39.49 180.39 0.00 3678.66 Depreciation 1806 42.92 127.56 0.00 1599.00 Sales 1806 818.71 2624.45 -26.48 51760.00 Net PPE 1806 348.16 1195.21 0.00 16675.69 ROA 1806 -16.56 49.60 -399.22 33.10 Total Assets 1806 925.20 2480.01 0.85 23184.73 Debt to Equity 1806 63.24 152.86 -659.72 1268.24 Market to Book 1806 2.83 5.27 -26.12 52.73 Panel C - Matching group (firms without restatements of financial statements): Variable N Mean SD Min Max Discretionary Accruals 2055 -0.05 0.19 -1.43 0.58 Current Assets 2055 349.09 915.44 0.00 14509.00 Current Liabilities 2055 226.17 670.94 0.04 8120.35 Cash 2055 119.74 411.10 0.00 10110.00 Long Term Debt 2055 41.91 183.88 0.00 3227.82 Depreciation 2055 46.91 138.56 0.00 2199.00 Sales 2055 869.06 2486.71 0.00 37406.00 Net PPE 2055 382.54 1336.85 0.00 15833.00 ROA 2055 -9.91 39.84 -342.99 34.49 Total Assets 2055 988.24 2630.99 0.65 23754.00 Debt to Equity 2055 59.81 126.27 0.00 1274.42 Market to Book 2055 3.77 5.88 -28.37 54.31 Discretionary Accruals, using Modified Jones Model, are the residual in model (2) run with no intercept, Current Assets are year-end current assets (COMPUSTAT item A4 ), current liabilities are the year-end current liabilities (COMPUSTAT item A5 ), cash is cash and cash equivalent (COMPUSTAT item A1), Long Term Debt is


(COMPUSTAT item A9), Depreciation is depreciation and amortization expense (COMPUSTAT item A14 ), Sales are net sales (COMPUSTAT item A12), Net PPE is net property plant and equipment (COMPUSTAT item A8 ), ROA is return on assets (COMPUSTAT item A237 divided by item A6 m ultiplied by100 ), Total Assets (COMPUSTAT item A2), Debt to Equity is the long term debt to shareholders equity ratio (COMPUSTAT item 100 x (COMPUSTAT item A9 / (COMPUSTAT item A60 + COMPUSTAT item A130) ), Market to Book ratio of a company’s market value to its book value.

TABLE 2 RESTATEMENTS AND DISCRETIONARY ACCRUALS

RESTAT it = α + β1 DA it + β2 ln_TA it + β3 ROA it+ β4 DTEQ it + β5 MKBK it + β6 IND it + β7 BIG4 it + ε it Parameter Variable Estimate t-statistic p-value Intercept 0.975 25.58 <0.000 DA 0.456 11.78 <0.000 ln_TA 0.040 9.89 <0.000 ROA -0.001 -6.44 <0.000 DTEQ 0.001 1.56 0.118 MKBK -0.006 -4.54 <0.000 BIG4 -0.641 -30.19 <0.000 SIC 0.000 1.83 0.069 Adj-R2 = 24.17% F-test = 176.76 p < 0.0001 Where RESTAT is a dummy variable that equals 1 if the entity restated its financial statements and zero otherwise, ln_TA is the natural log of total assets, ROA is return on assets, DTEQ is debt to equity, MKBK is the ratio of market to book value, Big4 is a dummy variable that equals 1 i f the audit firm is one of the Big 4, and zero otherwise, and SIC is the 4-digit SIC code.

The results shown in Table 2 show significant and positive coefficient of the DA which supports H1; there is a si gnificant association between DA and audit quality measured by the likelihood of the restatement of the financial statements. Going Concern Opinion

We collect data from AUDIT ANALYTICS on companies that received going concern reports. Total number of observations over the period of January 1, 1998 to December 31, 2011 is 35,542 observations. After deleting observations with missing tickers, only 9,968 observations are left. After removing observations on firms that use financial reporting standards other than U.S. GAAP, 9,643 observations are left. Of those, only 493 firms have data in COMPUSTAT database. Most of the missing firms are registered in the over the counter (OTC) market. After getting the COMPUSTAT data on matching companies and removing observations with missing accruals variables, only 721 observations are left. Table 3 shows the descriptive statistics for these companies.


TABLE 3 DESCRIPTIVE STATISTICS FOR THE GOING CONCERN

Panel A - All firms with and without going concern reports: Variable N Mean SD Min Max Discretionary Accruals 721 -0.04 0.55 -4.04 6.20 Current Assets 721 136.95 400.22 0.03 1806.03 Current Liabilities 721 125.42 434.96 0.05 6341.47 Cash 721 46.43 142.03 0.00 1248.00 Short Term Debt 721 49.46 271.96 0 5164.31 Depreciation 721 19.40 75.03 0 1301.10 Sales 721 365.19 1263.16 0 14995.00 Net PPE 721 167.87 628.21 0 7944.46 ROA 721 -161.07 364.93 -4400.00 138.03 Total Assets 721 415.03 1282.05 0.27 12009.63 Debt to Equity 721 46.80 207.38 -1243.56 1206.24 Market to Book 721 2.90 14.20 -78.90 111.66 Panel B - Control group (firms with going concern reports): Variable N Mean SD Min Max Discretionary Accruals 493 -0.05 0.50 -4.04 5.04 Current Assets 493 138.46 386.52 0.03 3239.00 Current Liabilities 493 140.89 453.87 0.05 6341.47 Cash 493 47.21 145.46 0.00 1248.00 Short Term Debt 493 64.65 324.46 0 5164.31 Depreciation 493 19.90 77.59 0 1301.10 Sales 493 374.54 1247.56 0.00 14995.00 Net PPE 493 171.47 621.92 0 6933.80 ROA 493 -89.96 149.56 -13.11.45 32.30 Total Assets 493 413.60 1255.17 0.27 12009.55 Debt to Equity 493 47.75 235.84 -1234.56 1206.24 Market to Book 493 2.91 14.92 -.69.75 111.66 Panel C - Matching group (firms without going concern reports): Variable N Mean SD Min Max Discretionary Accruals 228 0.02 0.65 -3.80 6.20 Current Assets 228 123.62 403.62 0.21 4806.03 Current Liabilities 228 85.73 367.47 0.17 4944.03 Cash 228 40.81 130.56 0 1232.55 Long Term Debt 228 17.31 78.29 0 772.26 Depreciation 228 17.17 61.23 0.02 565.44 Sales 228 321.68 1113.61 0.00 12780.70 Net PPE 228 164.60 642.95 0.00 8021.27 ROA 228 -40.66 104.88 -1228.59 24.34 Total Assets 228 395.81 1254.14 0.65 10322.13 Debt to Equity 228 49.97 138.74 -472.45 831.56 Market to Book 228 2.22 12.98 -114.79 65.25 Discretionary Accruals, using Modified Jones Model, are the residual in model (2) run with no intercept, Current Assets are year-end current assets (COMPUSTAT item A4 ), current liabilities are the year-end current liabilities (COMPUSTAT item A5 ), cash is cash and cash equivalent (COMPUSTAT item A1), Long Term Debt is


(COMPUSTAT item A9), Depreciation is depreciation and amortization expense (COMPUSTAT item A14 ), Sales are net sales (COMPUSTAT item A12), Net PPE is net property plant and equipment (COMPUSTAT item A8 ), ROA is return on assets (COMPUSTAT item A237 divided by item A6 multiplied by100), Total Assets (COMPUSTAT item A2), Debt to Equity is the long term debt to shareholders equity ratio (COMPUSTAT item 100 x (COMPUSTAT item A9 / (COMPUSTAT item A60 + COMPUSTAT item A130) ), Market to Book is the ration of a company’s market to it book value.

The results in Panels B and C show that the DA level is higher in firms receiving going concern opinion compared to those that did not receive it, which seems to support our hypothesis H2.

TABLE 4 GOING CONCERN AND DISCRETIONARY ACCRUALS

GC it = α + β1 DA it + β2 ln_TA it + β3 ROA it + β4 DTEQ it + β5 MKBK it + β6 IND it + β7 BIG4 it + ε it Parameter Variable Estimate t-statistic p-value Intercept 0.641 25.54 <0.000 DA -0.043 -1.20 0.230 ln_TA 0.003 0.29 0.774 ROA -0.001 -3.62 <0.001 DTEQ 0.001 0.69 0.487 MKBK -0.001 -0.45 0.652 BIG4 -0.009 0.21 0.833 SIC -0.000 -0.48 0.632 Adj-R2 = 1.6% F-test = 2.75 p = 0.009 GC is a dummy variable that equals one if the entity received a going concern report and zero otherwise, ln_TA is the natural log of total assets, ROA is return on assets, DTEQ is debt to equity, MKBK is the ratio of market to book value, Big4 is a dummy variable that equals 1 if the audit firm is one of the Big 4, and zero otherwise, and SIC is the 4-digit SIC code.

In Table 4, the coefficient of the DA is negative. Even though the sign of the DA coefficient is in the expected direction, the coefficient is insignificant. Therefore, the results do not appear to provide support for our hypothesis H2. Big 4 Audit Firms

In his study of the effect of audit quality on the pricing of DA, Krishnan (2003) uses Big 6, as an indicator of high audit quality. He finds that value relevance of DA is greater for firms audited by Big 6 firms. To test H4, we collect data from COMPUSTAT on all active firms from January 1, 1998 t o December 31, 2011. Total number of observations is 134,400. After removing observations with missing variables, 52,193 observations are left, and after removing the upper and lower 1% of variables used in the model, 47,092 observations left. Of these observations, 32,603 are Big 4 audit firms and 14,489 are for companies audited by non-Big 4 audit firms. Table 5 shows descriptive statistics for both groups of companies audited by Big 4 a nd non-Big 4 a udit firms. Results in Panel B and Panel C show that companies audited by Big 4 firms are large in terms of their assets, sales, and PPE. Also they are more profitable on average, and have higher growth potentials as measured by the market to book ratio. In addition, the results show that they have lower levels of DA.


TABLE 5 DESCRIPTIVE STATISTICS FOR BIG 4 DATA

Panel A - All companies audited by Big 4 audit firms and non-Big 4 audit firms: Variable N Mean SD Min Max Discretionary Accruals 47092 -0.01 0.22 -2.26 2.59 Current assets 47092 808.03 2389.84 0.00 42778.03 Current Liabilities 47092 571.95 1819.86 0.00 31538.00 Cash 47092 247.90 960.04 -0.16 31600.00 Short Term Debt 47092 109.62 487.41 -882.00 11251.27 Depreciation 47092 107.99 353.93 0.00 7951.61 Sales 47092 2054.57 6324.70 0.00 137634.00 Net PPE 47092 895.32 3047.42 0.00 51444.79 ROA 47092 -22.58 106.81 -1723.34 36.22 Total Assets 47092 2414.85 6650.65 0.06 61519.25 Debt to equity 47092 48.42 117.98 -644.64 945.22 Market to Book 47092 2.89 5.94 -44.38 61.92 Panel B - Control group (Companies audited by Big 4 audit firms): Variable N Mean SD Min Max Discretionary Accruals 32603 -0.01 0.15 -2.26 2.16 Current Assets 32603 1123.93 2777.25 0.00 42778.03 Current Liabilities 32603 800.16 2123.51 0.00 31538.00 Cash 32603 342.94 1123.81 -0.16 31600.00 Short Term Debt 32603 152.25 572.23 -882.00 11251.27 Depreciation 32603 150.73 412.58 0.00 7951.61 SALE 32603 2878.27 7402.85 0.00 137634.00 Net PPE 32603 1258.00 3579.97 0.00 51444.79 ROA 32603 -6.05 49.88 -1706.42 36.15 Total assets 32603 3381.00 7727.09 0.07 61519.25 Debt to equity 32603 58.23 114.15 -644.64 945.22 Market to Book 32603 3.06 4.97 -43.98 61.78 Panel C - Matching group (Companies audited by non-Big 4 audit firms): Variable N Mean SD Min Max Discretionary Accruals 14489 -0.02 0.32 -2.25 2.59 Current Assets 14489 97.18 690.90 0.00 24531.99 Current Liabilities 14489 58.43 486.49 0.00 19707.04 Cash 14489 34.05 296.23 -0.01 13408.17 Short Term Debt 14489 13.71 148.50 -0.00 5656.00 Depreciation 14489 11.82 103.76 0.00 4023.60 Sales 14489 201.09 1318.02 0.00 49576.43 Net PPE 14489 79.21 618.96 0.00 28983.36 ROA 14489 -59.788 171.70 -1723.34 36.22 Total assets 14489 240.83 1606.21 0.06 48440.07 Debt to Equity 14489 26.35 123.38 -643.43 941.90 Market to Book 14489 2.45 7.68 -44.38 61.92 Discretionary Accruals, using Modified Jones Model, are the residual in model (2) run with no intercept, Current Assets are year-end current assets (COMPUSTAT item A4 ), current liabilities are the year-end current liabilities (COMPUSTAT item A5 ), cash is cash and cash equivalent (COMPUSTAT item A1), Long Term Debt is


(COMPUSTAT item A9), Depreciation is depreciation and amortization expense (COMPUSTAT item A14 ), Sales are net sales (COMPUSTAT item A12), Net PPE is net property plant and equipment (COMPUSTAT item A8 ), ROA is return on assets (COMPUSTAT items (COMPUSTAT item A237 divided by item A6 multiplied by100), Total Assets (COMPUSTAT item A2), Debt to Equity is the long term debt to shareholders equity ratio (COMPUSTAT item 100 x (COMPUSTAT item A9 / (COMPUSTAT item A60 + COMPUSTAT item A130) ), Market to Book is company’s market value to its book value.

As predicted, Table 6 shows that the DA coefficient is significantly negative, which means that the DA levels are lower in companies audited by the Big 4; these results support our hypothesis H3.

TABLE 6 BIG 4 AND DISCRETIONARY ACCRUALS

BIG4 it = α + β1 DA it + β2 ln_TA it + β3 ROA it + β4 DTEQ it + β5 MKBK it + β6 IND it + ε it Parameter Variable Estimate t-statistic p-value Intercept 0.129 21.26 <0.000 DA -0.059 -7.38 <0.000 ln_TA 0.104 139.94 <0.000 ROA -0.001 -1.55 0.120 DTEQ 0.000 -7.81 <0.000 MKBK -0.003 10.79 <0.000 SIC 0.000 2.06 0.040 Adj-R2 = 33.99% F-test = 4043.13 p <.0001 Big4 is a dummy variable that equals one if the audit firms is one of the Big 4 firms and zero otherwise, ln_TA is the natural log of total assets, ROA is return on assets, DTEQ is debt to equity, MKBK is the ratio of market to book value, and SIC is the 4-digit SIC code. Internal Control Weaknesses

From AUDIT ANALYTICS, we co llect 2,373 observations with negative internal control reports, over the period 2004 to 2011. Of these observations, only 1,525 companies have tickers, 993 of those companies are listed in the COMPUSTAT with available data. We pick a matching sample based on the same 4 digit SIC code and a total assets within 10% higher or lower. The matching sample contains 537 observations. The descriptive statistics for the control, matching, and total sample are shown in Table 7. Results in Panel B and C show that firms receiving qualified internal control reports have lower levels of DA. While both groups of companies are similar in term total sales and total assets, there is a difference in the about of DA. Panel B shows that the DA ar e lower in companies receiving IC qualified report, compared to companies receiving unqualified IC report, these results are in line with our hypothesis H 4.


TABLE 7 DESCRIPTIVE STATISTICS FOR THE INTERNAL CONTROL WEAKNESS DATA

Panel A - All Observations with and without internal control weaknesses reports: Variable N Mean SD Min Max Discretionary Accruals 1530 -0.01 0.12 -0.54 0.79 Current assets 1530 571.57 1261.27 1.48 21956.00 Current Liabilities 1530 355.22 897.25 0.46 9299.00 Cash 1530 213.24 606.67 0.00 15386.00 Short Term Debt 1530 60.98 251.95 0.00 5164.31 Depreciation 1530 66.02 65.19 0.04 1505.43 Sales 1530 1265.65 3468.49 0.00 60553.00 Net PPE 1530 483.86 1362.37 0.25 15011.00 ROA 1530 -1.99 18.33 -111.91 27.61 Total Assets 1530 1495.59 3218.00 16.93 28498.00 Debt to Equity 1530 51.59 103.28 -423.92 1218.31 Market to Book 1530 2.91 3.40 -14.09 34.13 Panel B - Control group (Observations with internal control weaknesses reports): Variable N Mean SD Min Max Discretionary Accruals 993 -0.01 0.10 -0.54 0.66 Current Assets 993 557.99 1122.22 1.48 14518.00 Current Liabilities 993 360.62 873.30 0.46 8834.00 Cash 993 188.82 401.84 0.00 3805.84 Short Term Debt 993 65.99 275.99 0.00 5164.31 Depreciation 993 66.42 162.01 0.06 1448.16 Sales 993 1274.25 3409.55 0.00 60553.00 Net PPE 993 464.61 1199.26 0.69 13767.79 ROA 993 -2.11 17.28 -110.25 27.61 Total Assets 993 1495.52 3107.67 16.93 27379.73 Debt to Equity 993 54.87 105.69 -280.68 956.05 Market to Book 993 2.70 3.14 -11.02 32.11 Panel C - Matching group (Observations without internal control weaknesses reports): Variable N Mean SD Min Max Discretionary Accruals 537 0.01 0.15 0.52 0.799 Current Assets 537 596.70 1485.33 3.44 21956.00 Current Liabilities 537 345.23 940.66 .28 9299.00 Cash 537 258.39 864.81 0.00 15386.00 Short Term Debt 537 51.70 199.94 0.00 2734.29 Depreciation 537 65.27 171.06 0.04 1505.43 Sales 537 1249.73 3578.09 0.00 58596.00 Net PPE 537 19.48 1622.00 0.25 15011.00 ROA 537 -1.78 20.15 -111.91 27.24 Total Assets 537 1495.72 3415.61 17.11 28498.00 Debt to Equity 537 45.52 98.4 -423.92 1218.31 Market to Book 537 3.30 3.81 -14.09 34.13 Discretionary Accruals, using Modified Jones Model, are the residual in model (2) run with no intercept, Current Assets are year-end current assets (COMPUSTAT item A4 ), current liabilities are the year-end current liabilities (COMPUSTAT item A5 ), cash is cash and cash equivalent (COMPUSTAT item A1), Long Term Debt is



The results in Table 8 show positive and significant coefficient of the DA, which indicates that DA are higher for companies receiving unqualified internal control reports, and low for companies receiving a qualified internal control report. These results are consistent with our hypothesis H4.

TABLE 8 INTERNAL CONTROL AND DISCRETIONARY ACCRUALS

IC it = α + β1 DA it + β2 ln_TA it + β3 ROA it + β4 DTEQ it + β5 MKBK it + β6 IND it + β7 BIG4 it + ε it Parameter Variable Estimate t-statistic p-value Intercept 0.309 4.66 <0.000 DA 0.294 2.87 0.004 ln_TA -0.003 -0.27 0.789 ROA -0.001 -0.18 0.860 DTEQ -0.001 -1.91 0.057 MKBK 0.012 3.37 0.001 BIG4 0.029 0.92 0.359 SIC 0.000 0.53 0.599 Adj-R2 = 0.011 F-test = 3.41 p = 0.0013 Where IC is a dummy variable that equals 0 in case of finding internal control weaknesses, and 1 otherwise, ln_TA is the natural log of total assets, ROA is return on assets, DTEQ is debt to equity, MKBK is the ratio of market to book value, Big4 is a dummy variable that equals 1 if the audit firm is one of the Big 4, and zero otherwise, and SIC is the 4-digit SIC code. Industry Specialization

Our Analysis here is similar to that followed by Jensen and Payne (2005), Deis and Giroux (1992), and O’Keefe et al. (1994); industry expertise is measured using the number of clients in the same industry audited by a particular auditor. An audit firm will be considered a leader if it is associated with the largest number of audits in a particular industry.

Data are collected from COMPUSTAT over the period 1998 to 2001. Total number of observations is 134,400. Observations with missing variables, observations with auditors other than Big 4, observations from the banking and financial services, and observations at the upper and lower 1% are deleted. Only 31,688 observations remain. Results in Panels B and C of Table 9 show that there is no difference on average between the two groups of companies whether audited by industry leader or not in terms of their DA. DA in both Panels are at -0.01 level.


TABLE 9 DESCRIPTIVE STATISTICS FOR THE INDUSTRY SPECIALIZATION DATA

Panel A - All companies audited Variable N Mean SD Min Max Discretionary Accruals 31688 -0.01 0.15 -2.28 2.15 Current Assets 31688 1118.17 2756.95 0.00 42778.03 Current Liabilities 31688 793.02 2100.38 0.00 31538.00 Cash 31688 333.67 1075.98 -0.16 31600.00 Short Term Debt 31688 153.86 577.02 -882.00 11251.27 Depreciation 31688 153.60 417.60 0.00 7951.61 Sales 31688 2879.24 7361.85 -0.87 137634.00 Net PPE 31688 1288.51 3625.10 0.00 51444.79 ROA 31688 -6.02 48.90 -1706.42 35.73 Total Assets 31688 3375.06 7686.45 0.07 61097.44 Debt to Equity 31688 58.66 114.51 -644.64 940.98 Market to book 31688 3.08 4.94 -43.98 61.78 Panel B – Companies audited by a leader Variable N Mean SD Min Max Discretionary Accruals 10263 -0.01 0.16 -2.28 2.10 Current Assets 10263 1137.22 2786.95 0.00 42778.03 Current Liabilities 10263 791.94 2039.03 0.00 28332.12 Cash 10263 345.44 1123.19 0.00 26235.00 Short Term Debt 10263 153.12 553.51 -882.00 10600.00 Depreciation 10263 151.07 375.94 0.00 5177.00 Sales 10263 2896.10 7173.12 -0.87 99512.40 Net PPE 10263 1396.05 3829.27 0.00 48043.24 ROA 10263 -7.42 53.04 -1706.42 35.54 Total Assets 10263 3506.34 7706.22 0.21 60966.00 Debt to equity 10263 59.60 115.00 -620.07 938.05 Market to book 10263 3.05 4.94 -43.98 61.63 Panel C – Companies audited by a non-leader Variable N Mean SD Min Max Discretionary Accruals 21425 -0.01 0.14 -1.91 2.15 Current Assets 21425 1109.04 2742.48 0.00 39637.00 Current Liabilities 21425 793.55 2129.19 0.00 31538.00 Cash 21425 328.04 1052.60 -0.16 31600.00 Short Term Debt 21425 154.20 587.96 0.00 11251.27 Depreciation 21425 154.81 436.14 0.00 7951.61 Sales 21425 2871.17 7450.72 -0.23 137634.00 Net PPE 21425 1237.00 3522.04 0.00 51444.79 ROA 21425 -5.35 46.78 -1561.29 35.73 Total Assets 21425 3312.18 7676.35 0.072 61097.44 Debt to equity 21425 58.22 114.28 -644.63 940.98 Market to book 21425 3.09 4.94 -43.83 61.78 Discretionary Accruals, using Modified Jones Model, are the residual in model (2) run with no intercept, Current Assets are year-end current assets (COMPUSTAT item A4 ), current liabilities are the year-end current liabilities (COMPUSTAT item A5 ), cash is cash and cash equivalent (COMPUSTAT item A1), Long Term Debt is



TABLE 10 INDUSTRY SPECIALIZATION AND DISCRETIONARY ACCRUALS

Lead it = α + β1 DA it + β2 ln_TA it + β3 ROA it + β4 DTEQ it + β5 MKBK it + ε it Parameter Variable Estimate t-statistic p-value Intercept 0.278 30.73 <0.0001 DA 0.037 2.07 0.039 ln_TA 0.007 5.30 <0.000 ROA -0.001 -5.46 <0.000 DTEQ 0.0001 0.02 0.984 MKBK -0.0001 -0.23 0.817 Adj-R2 = 0.13% F-test = 9.38 p <.0001 LEAD equals 1 if the auditor is a leader in the industry, 0 otherwise, ln_TA is the natural log of total assets, ROA is return on assets, DTEQ is debt to equity, MKBK is the ratio of market to book value, Big4 is a dummy variable that equals 1 if the firms is one of the Big 4, and zero otherwise, and SIC is the 4-digit SIC code.

The positive and significant coefficient on the DA shows that DA are higher in audit performed by industry specialist or leader, which does not support to our hypothesis H5. CONCLUSIONS

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Managing Tourism: A Municipal Enterprise and Unfulfilled Financial Hopes

António Martins

University of Coimbra, Portugal

The municipality of Coimbra, located in Portugal, commissioned, in 2004, a study about tourism promotion in its area of influence. The report recommended that activities related to tourism promotion should be taken out of the structure of the council and a municipal enterprise should be set up. The purpose of this paper is to present how the enterprise was justified at its inception, hopes expressed in the action plan were too optimistic, and reasons for the unfulfilling of expectations. The analysis will focus on problems arising in the setting up and implementation phases, and will draw lessons for public entities engaged in tourism promotion with strategies of setting up autonomous businesses. INTRODUCTION

Tourism and its related economic activities are a strong factor in the development of national and local economies (World Tourism Organization, 2011). Thus, strategies to implement effective policies that promote tourism growth and have a positive impact on development are increasingly common. Public and private sector bodies are usually called into action, because of a shared belief that, by combining their capabilities, stronger policies can emerge (Presenza and Cipollina, 2010).

The municipality of Coimbra – a town located in the Portuguese Central Region – commissioned, in 2004, a report on the state of the tourism promotion in its area of influence. The report recommended that activities related to tourism promotion should be taken out of the organizational structure of the council, and a municipal enterprise should be set up. The main purpose of this paper is to present how the enterprise was justified at its inception, how hopes expressed in the action plan were, in our view, too optimistic, and the reasons for the unfulfilling of such optimistic expectations. The analysis will focus on problems arising in the setting up and implementation phases, and will draw some lessons for the local public sector bodies when engaging in tourism promotion using a strategy of setting up autonomous enterprises.

The paper discusses, firstly, if at local government level, when tourism is an economic activity with a significant role in a certain council, the public sector (mainly the municipality) should assume the leading role in implementing a successful tourism plan and analyses the pros and cons of such a strategy. A case study is then used to present expectations created by setting up a separate municipal enterprise and what factors were critical in the unfulfilling of stated goals.

Given the heavy competition in the tourism sector on a worldwide basis, Portuguese regions need to have tourism strategies and action plans that can succeed (Ladeiras et al, 2010). These strategies usually work better if they are based on the cooperation between the public sector and private actors. At the local level, the setting up of municipal enterprises to deal with tourism promotion has to be based on detailed analysis, and special attention need to be addressed to the sustainability and consistency of financial


projections. When municipalities and tourism enterprise managers have difficulties in attracting business from private economic agents and are not able to diversify risk by wooing private shareholders, the probability of an unsuccessful experience increases, as shown by the case.

Municipalities, when discussing the implementation of tourism strategies, should be particularly aware of two factors: the consistency of operating and financial forecasts, and the critical point of bringing together public and private actors to increase the probability of a successful venture.The paper can be useful for local government officials when deciding about tourism promoting strategies and the best ways to implement them. Particular pitfalls are highlighted in the paper, contributing to a better understanding of developing tourism promotion programs when the public sector is involved.

The paper contributes to the literature by, based on a case study, drawing a more general lesson to public sector decision makers when dealing with the frequent situation on how to implement local strategies for tourism development. We believe that most of the complexities highlighted in the paper, and the reasons for the failure of the strategy, can be a useful warning sign for public decision makers.

To address the topic under analysis the paper is organized as follows: section 2 presents a review of relevant literature; section 3 deals with tourism as a central economic activity and the role of the public and private sectors in defining and implementing promotion strategies; section 4 focuses on the research process and method; section 5 presents the case study that is at the core of the paper - the setting up of a municipal enterprise to promote tourism, its evolution and complexities regarding the relation between public and private actors; section 6 presents a discussion and broader implications of the issue; section 7 concludes.

LITERATURE REVIEW

Tourism is a key economic sector in the world economy. Tourism activities around the globe and the economic sectors that are connected with them are at the forefront of growth and development strategies of many regions and countries (World Tourism Organization, 2011).

At a macroeconomic level, the touristic sector produces growth, income and development. Cities and regions can be saved from decline by well-conceived strategies for tourism development.

In the European Union, the tourism and economic growth relationship was researched, among others, by Mello-Sampayo F. and Sousa-Vale S. (2010) for a panel of 31 European countries over the period 1988–2010. The authors concluded that there is robust evidence of a relation between tourism and GDP in European countries. Their results also show that tourism development has a higher impact on GDP in the South than in North.

Balaguer and Cantavella-Jordá (2002) analyzed the role of tourism in the Spanish economic development. They found empirical evidence of growth originated by the touristic sector, with a strong economic multiplier. Also, the income level of regions where tourism had a greater role benefited from such position.

For the Latin American case, Eugenio-Martín et al (2004) studied the impact of the tourism sector in income and employment. They present evidence that production and income related to tourism activities are important components of increasing living standards. Additionally, they found support for the hypothesis that employment rates are positively affected by the development of the touristic sector in particular regions.

In the case of Portugal, international tourism receipts represented, in 2010, 6% of GDP and 7.5% of employment (World Tourism Organization, 2011; Banco de Portugal, 2011; Varum et al, 2011).

Tourism has many sides as an economic and social activity. Its contribution to GDP and employment can be high. Its impact on particular regions or communities can be very important in terms of raising living standards. And it can also have a huge impact on the heritage of many places, not always for good. Such a wide economic and social influence attracts the attention of governments, be it a national, regional or local levels (Fazenda et al, 2010; Ladeiras et al, 2010; Font and Ahjem, 1999).

Given the growing importance of tourism, its relevance as a management topic is regularly highlighted. Authors and organizations whose focus is on the interplay between tourism and the public


sector (Varum et al, 2011; Tourism Insights, 2011; Presenza and Cipollina, 2010; OECD, 2008) usually stress the fact that it is quite difficult for the myriad of small or micro entities engaged in the tourism business to have the critical dimension to develop a wide array of activities, essential to successful strategies.

Examples of such activities are plenty. The identification of national or regional strategies in terms of branding or market segmentation; the promotion of particular destinations at the national or international level; the access to funding in order to sustain such activities; and the setting up publ ic bodies that regulate tourism activities to deal with the environmental, historical or cultural impact of touristic flows and ensure that it develops as sustainable activity (Font et Ahjem, 1999; Turismo de Portugal, 2011).

At the local government level, when tourism is an economic activity with a recognized importance in a certain council, a t horny question usually arises: should the public sector (mainly the municipality) assume the leading role in all the mentioned activities to implement a successful tourism strategy? Or, given the usual features attributed to enterprises that fall outside the municipalities´ umbrella (more flexible, less encumbered by financial rules and other legislation) should municipalities, in cooperation with the private sector, set up separate entities to develop such strategies? (Palmer, 1996; Dredge, 2006).

Besides of the direct the role of the public sector, a growing interest in the involvement of private economic agents has been gaining ground. Some forms of partnerships have been fashioned in several countries, as a sway to maximize the impact of strategies based on tourism to develop regions or countries (Weiermair et al (2010).

This trend has not been without dangers. Aspects such risk allocation between public and private bodies, the alignment of strategic aims of different entities, performance criteria to be established and regularly appraised, and the financial commitments of involved partners, are fields where pitfalls have happened.

In Portugal, in the last decade, after an earlier period when tourism development was seen a typical public sector duty, the trend was clearly one that favored the setting up of separate entities, aiming at building partnerships between municipalities and the private sector. The main objective was t he promotion mutual advantageous ways of capturing the potential benefits of tourism as a vector for sustainable development (Fazenda et al, 2010; Ladeiras et al, 2010). Coimbra was no exception, and in 2005 a municipal enterprise was set up with this objective.

TOURISM AS A CENTRAL ECONOMIC ACTIVITY AND THE ROLE OF THE PUBLIC AND PRIVATE SECTORS

In this section the importance of tourism as a key economic activity, at the world level and to the Portuguese economy, will be highlighted, in order to justify its growing status as a topic of interest to studies focusing on the public sector. Tourism in the World: Some Trends

According to the World Tourism Organization (2011), tourism’s contribution to the world GDP is estimated at around 5%. On employment terms, its direct and indirect jobs represent between 6% and 7% of total worldwide jobs. In many economies, such as s mall islands and some developing countries, tourism is the biggest economic activity.

In spite of occasional setbacks, international tourism has shown a strong growth: 25 million tourists in 1950; 277 million in 1980 and 940 million in 2010. (World Tourism Organization, 2011).

In 2010, and reflecting the state of the world economy, recovery of arrivals was stronger in emerging economies (+8%) than in advanced ones (+5%). What is remarkable is the fact that, even in more fragile economies, tourism flows do not show signs of abating, giving it a resilient nature, quite important in terms jobs and income, in times of economic hardship.

Tourism can play an important role in creating jobs for unskilled or semi-skilled workers, as well as having a multiplier effect in other economic sectors that are closely related to it (e.g., construction, travel,


leisure). For many countries tourism is a key export and a precious source of foreign exchange (OECD, 2008).

On a macro level, the recent rise of China as a t ourism destination is the most relevant significant change. According to the World Tourism Organization, (2011, p.5), “the most significant change among the top ten by international arrivals in 2010 was the rise of China to third position, ousting Spain, having overtaken both the UK and Italy during the past few years”.

The OECD (2008) reports a growing movement of retirees from high income to lower income countries, not just for holidays but for longer residence periods. Some positive effects of this trend in travel infrastructure, employment for locals and engagement in civic activities are mentioned. On the other hand, prices of real estate and the cost of living can increase with the influx of such groups.

What is certainly foreseeable is that tourism in poised for even stronger growth, and every country is trying to ride this trend to get economic and social gains from a worldwide phenomenon. This is also true for Portugal.

Tourism in Portugal: A Short Brief

Activities directly related with tourism represented, in 2010, circa 6% of GDP and 7,5% of jobs in Portugal. By 2020 tourism, and its direct and connected activities, is expected to contribute 17% of GDP and 23% of total jobs (Varum et al, 2011).

The UK, France, Spain and Germany are the main countries originating tourist flows to Portugal. New destinations in both sides of the Mediterranean, Latin America and the Caribbean, and Africa, are putting a significant pressure on the Portuguese touristic sector. However, the attractive factors usually associated with Portugal are still holding reasonably well in face of strong competition. (Eusébio, 2006).

According to Turismo de Portugal (2011, p. 16), the cumulative annual growth rate (CAGR) of tourists visiting Portugal between 2006 and 2010 was 2,3%. The strategic plan for 2011-2015 conceived for the Portuguese tourism development centers on moving from a “sun and beach” country to a renewed emphasis on he ritage, gastronomy, wine and nature. An international effort to attract higher income visitors is highlighted, with the central government playing a key important role in partnership with the most important private players (e.g., hotel associations, travel agencies, regional development agencies).

Table 1 shows some economic indicators related to the Portuguese tourism sector.

TABLE 1 SOME INDICATORS RELATED TO THE PORTUGUESE TOURISM SECTOR

2008 2009 2010

International tourism receipts

(USD million) 10.943 9.635 10.090

Tourism contribution to the

external balance (€ million) 4.501 4.196 4.658

Tourism contribution to the

external balance (% of GDP) 2,6 2,5 2,7

Sources: Own elaboration based on World Tourism Organization (2011) and Banco de Portugal (2011) This short brief on the Portuguese tourism sector clearly shows its economic importance in terms of

GDP, jobs and external balance. At the same time, the comparative advantages the country offered in the past – a relatively cheap sort of seaside vacation - are under severe threat. New ways of promoting


Portugal as a destination and attract new segments of visitors are moving to the core of tourism development.

The Role of Public Sector in the Tourism Activity and the Involvement of Private Entities

This section will, firstly, present a v ery short view of the general worldwide trends related to the influence of the public sector in the tourism activity, the cooperation with private sector agents, and then focus on the recent Portuguese experience. The Worldwide Situation

Font and Ahjem (1999) offer a rationale for the involvement of the public sector in tourism activities, stating that a purely free market based structure will not be optimal. The reasons for departing from a free market system in the tourism activity are several. First, many of the tourism players are small businesses that have not the scale to gather and process information regarding demand trends and tourists´ preferences. Second, private profit maximization does not take account of environmental and social impacts of tourism. Additionally, the public sector owns and manages many of the tourism infrastructures (e.g., historical sites, natural parks) and can take into consideration potential conflicting views on the use of such infrastructures.

The authors argue that tourism plans should consider these questions and be implemented by a public body. However, they also underline that results can be improved with the participation of private actors engaged in providing the products and experiences demanded by tourists.

Presenza and Cipollina (2010) and Pforr (2006) provide a characterization of the public sector role in tourism activity. Planning and marketing activities derived from this role require the involvement of public and private actors. This collaboration has important potential benefits:

- It enhances and legitimates the decision making process - It can solve potential conflicts in a more efficient way - It is a way for a better coordination of the activities of the stakeholders involved The vital engagement of public sector in tourism planning and marketing is also stressed by Tourism

Insights (2011), stressing the following roles: creating networks of businesses that are at the core of implementing wide strategies, providing support to the diversified types of actors that operate in the sector, and promoting and leading marketing initiatives, especially the ones that require scale and international clout.

Concerning tourism planning at national, regional or local level, there is a strong literature consensus about the need for coordination between public sector and private actors. (OECD, 2008; Ladeiras et al, 2010).

Only a supportive public sector combined with collaborative and aligned private interests can produce a combination of stakeholders that is a necessary condition to produce successful tourism strategies. The strategic planning process should be strongly participated in order to identify the involved stakeholders with the guidelines and action plans that emerge from such strategies.

The Involvement of the Portuguese Public Sector in Tourism Activity and the Engagement of Private Actors

The general consensus found in the international literature is also present in the research into tourism activity done in Portugal.

Turismo de Portugal (2011), in its strategic plan for 2011-2015, stresses that one of the key purposes of a public agency in the area of tourism is to function as a facilitator between public bodies and private companies, mainly in the planning and promotion phases.

Varum el al (2011) point that the need to control pressures towards the environment caused by some tourism related activities call for a strong public sector regulating involvement. Also, the qualification of the workforce employed in the tourism sector can be a priority that public entities can help to enhance.


On a more local scale, the regulation of real estate and construction industry are tasks where the intervention of public bodies is generally required.

On a more practically oriented research, Ladeiras et al (2010), focusing on the case o f the Open Academy of Tourism, and Fazenda et al (2010), analyzing the case of the Douro Valley Tourism Plan, are both quite supportive of the partnership approach. The latter present a model of public intervention in the Douro Valley Tourism plan where, form the national to the local levels, instruments and policies are aimed at improving governance, provide strategic objectives and priorities and seeking funding for crucial initiatives.

Ladeiras et al also conclude that public entities working in the tourism area should promote partnerships between public and private organizations. But they also conclude with a note of caution, by stressing one important factor that created instability in the sector. This is related to the fact that, many times, elected or nominated public bodies design strategies and plans that, for lack of previous coordination with key private players, and absence of day to day involvement with the private sector, fail to achieve the desired results.

RESEARCH PROCESS AND METHOD

This paper describes and discusses the application of the case st udy methodology to a m unicipal enterprise that was deemed to foster tourism development in a Portuguese town and its surrounding region.

Case studies are an established research tool for management research (Yin, 2010). In the tourism area, case studies have been often used as a research method to highlight and discuss general trends in the sector (Ladeiras et al 2010; Weiermair et al 2010; Palmer 1996) .

This methodology has the advantage of using detailed information about motives and concrete actions of parties involved. It places a high emphasis on the actual workings of a specific process, as it cannot produce generalized results based on statistical models. It analyses real life situations and aims at establishing some critical points that can be used as lessons for involved stakeholders, be they shareholders, managers, workers, and others.

In this research, the author acted as consultant-researcher, doing practice-oriented work in an organizational context (Ter Bogt and Van Helden, 2011). Our intervention was that of an expert called in the process of appraising the possible strategic decisions that local councilors had to take regarding the future evolution of the municipal enterprise. That is, presenting an outside view with potential solutions for a strategically and financially complex situation that the municipal enterprise was facing in 2011.

Our work can be categorized as ‘clinical research’, a branch of interventionist research which follows a problem-solving process, even if, in this case, we focused essentially at the problem identification, diagnosis and presenting a report that helped political decision makers to identify possible courses of action.

Advantages of case studies include lessons learned from field observations (Yin, 2010). To achieve such advantages, we have carefully analyzed the plan initially conceived to launch the municipal enterprise, worked with councilors, navigating the political spectrum and sensing different priorities for the enterprise, extensively analyzed the operating and financial information available, and worked with the enterprise’s staff to gauge the economic rationale behind financial numbers. A detailed knowledge of the enterprise business purposes and the constraints it faced because of its strong links with a political body, was also crucial to form an opinion about the potential outcomes of the process.

In line with what usually happens within qualitative research, we have additionally examined other forms of evidence in order to collect relevant information for researching the issue. We used the financial reports of the firm for the years called into analysis, the auditors´ opinions, and the management report was also useful to convey detailed information about the firm´s operations.

In the end, a report could be presented to the councilors, regarding possible courses of action that, in our view, were open and stating the causes for a not to promising start for the municipal enterprise. (Later we will address the issue of suggested actions).


The field work started in May 2011, and interviewing with interested parties happened during June-July. Our report was presented in September 2011. THE CASE: A MUNICIPAL ENTERPRISE TO PROMOTE TOURISM, ITS EVOLUTION AND LESSONS LEARNED IN PUBLIC MANAGEMENT Tourism in the Coimbra Region and Reasons for Setting Up the Municipal Enterprise

In 2004 the municipality of Coimbra commissioned a report on the state of the tourism sector in Coimbra and its area of influence, which is the Portuguese central region. Coimbra has a significant heritage, hosting a university created in the XIII century, several roman and gothic churches, is close to the seaside and also very close to two wine regions (Dão and Bairrada). Health care services are also a significant source of people flows to the town. All around the year, academic and religious festivities are also a source of attraction.

The mentioned report was very straightforward, by stating that all the factors justifying the attractiveness of Coimbra as a touristic destination were not being capitalized by the existing structure. One of its main recommendations was to set up an autonomous entity, with an important role for the municipality, but open to other actors.

According to the report, the new entity should have two overriding aims: - Enhancing the “Coimbra” trade mark in the internal and external markets for tourism; - Seeking diversified financing sources to sustain projected investments without increasing the

financial contribution of the municipality relatively to previous levels, that is, when tourism promotion was under the municipality organizational structure.

As shown in tables 2 a nd 3, the financial projections shown: a profitable operation – with the

exception of 2006 – a sustainable increase in equity, and a positive cash flow. The report ended with the following words: “Nonetheless some foreseeable financial difficulties, we

are confident that with private sector involvement, the new enterprise has all the conditions to be a successful one, increasing the tourism activity in Coimbra and its region, creating wealth for all the tourism agents in the area”.

TABLE 2 SELECTED PROJECTED ECONOMIC AND FINANCIAL DATA

REGARDING THE NEW ENTERPRISE

2006 2007 2008

Revenues not dependent on the municipality 257.115,98 293.365,98 340.740,99

Total operating revenues 624.115,98 659.115,98 686.740,99 Net profit -4.947,83 7.577,80 18.744,97 Total assets 1.664.058 2.381.289 2.379.815 Equity 70.052 77.630 96.375 Source: Own elaboration based on the “Report for the creation of the municipal enterprise”


TABLE 3 SOME ITEMS OF THE PROJECTED CASH FLOWS (€)

2006 2007 2008

Annual inflow from the municipality 1.250.000,00 1.250.000,00 1.250.000,00 Subsidies from EU funds 1.324.500,00 1.326.375,00 1.356.000,00 Private clients´ payments 305.968,01 349.105,51 405.481,78 Other inflows 512.672,49 497.233,79 432.884,42 Marketing promotion and other costs - 2.853.654,62 -2.860.772,52 -2.923.029,90 Personel costs -404.381,52 -415.593,35 -427.141,54 Investments -134.856,83 -23.800 0 Other outflows 0 -122.265,80 -93.855,30

Net cash flow 247,61 282,64 339,46 Source: Own elaboration based on the “Report for the creation of the municipal enterprise”

With such a confident report and these economic and financial projections, councilors approved the

creation on the municipal enterprise. But, in our view, the fact that the municipality was the sole equity owner, and no private sector agents were involved in the planning and financing of the new venture, and committed to its strategy, was not a promising sign.

Thus, at its inception, the new entity was seen just as another municipal initiative, disconnected from the tourism actors in the region (e.g., hotels, wine and food associations; university; festivities). Given what we have concluded in previous sections regarding the principles that should be observed regarding public and private sector cooperation in tourism strategies at regional and local level, it was not a very auspicious start.

Moreover, for any decision maker with a financial background, the projections of profits, and especially, cash flows are very worrying. With expected total cash inflows of the magnitude seen in table 3, the net expected cash flow for every year is worryingly low. Any small deviation from expected values would immediately create a deficit. And, if we look to the amount of revenues to be obtained from outside clients – that is, private sector entities using the services of the new enterprise - (table 2) and cash flows from such clients (table 3), this is an area where the fulfillment of such projections would not be easy.

Moreover, table 3, shows the importance of European funds to the cash flow position of the new entity. As securing (and receiving) such funds is always subject to delays and complex audits, this was also a recipe for possible significant deviations in cash flow projections.

Thus, in our view, the financial projections shown a very fragile entity, where minor deviations could jeopardize the whole project in terms of its sustainability. The municipality was bankrolling a new entity without a proper risk sharing strategy.

The Reality Check: The Economic and Financial Evolution of the Enterprise and Political Implications in the Council

Table 4 presents selected data on the economic and financial performance of the new entity from 2007 to 2010.


TABLE 4 THE ACTUAL ECONOMIC AND FINANCIAL PERFORMANCE

OF THE MUNICIPAL ENTERPRISE (SELECTED DATA)

Source: Own elaboration based on the “Annual financial reports of the municipal enterprise”

Data presented in table 4 confirm an economic and financial evolution that was far from encouraging.

It is of particular relevance the fact that revenues from private clients (which would be one important way that private entities could engage in valuable collaboration with the new entity, by buying its services in marketing and promotion activities) were well below expectations and were declining over time. In 2010 they represent practically nothing when compared with subsidies.

Operating income and net income are heavily negative in 2008 and 2010, and in 2009 an operating loss also arises. These losses dented the enterprise equity. Thus, the municipality, being the sole shareholder, was constantly called to cover losses. Again, the lack of private shareholders meant that the financial risk was concentrated in the municipality.

Up to that time no effective effort was put in place to attract private capital to finance the enterprise. This put is capital structure dependent on the council funds – at a t ime of stringent public finances for Portugal – and diminished its financial standing with creditors (e.g. banks).

The same worrying picture is observed regarding cash flow. At the operating level or at the total cash flow level, deficits amounted in some years, placing pressure in the municipality.

The Political Process in the Council: What to Do Next and Lessons from the Case

From the actual evolution from 2007 to 2010, a growing disenchantment was seen in the Coimbra local council. Reasons for this lack of enthusiasm were:

- The successive financial deficits that the municipality was called to cover, and the inability to woo private clients or private shareholders to strengthen the financial base of the enterprise;

- The growing tension between the councilors and the managers of the enterprise, the latter being under the focus of the politicians for not being able to turn up the enterprise into a sustainable entity;

2007 2008 2009 2010 Income

Revenue not dependent on the municipality 4.510,74 63.943,29 122.262,29 29.076,48 Subsidies from EU funds 356.500,00 942.833,80 917.487,24 1.294.790,18 External services ( marketing and other) 309.402,92 1.127.836,55 863.916,44 1.199.521,92 Personnel costs 48.207,99 144.405,45 151.923,16 166.798,52 Operating income 2.296,53 -283.544,20 -11.683,05 -120.917,81 Net income 1.290,82 -278.265,65 13.112,12 -124.921,81

Balance sheet Total Assets 193.929,67 108.000,28 291.929,10 633.002,54

Equity 76.290,82 -202.560,58 96.514,20 22.588,54

Cash flow Operating cash flow 110.210,75 -255.492,81 178.533,97 -223.281,00

Total cash flow 109.446,49 -158.639,08 -22.499,97 3.069,98


- The inability of the enterprise in tackling one of the perceived weaknesses of Coimbra tourism activity; that is, contrarily to Lisbon area, where the number of foreign visitors outnumber the share of nationals, Coimbra was dependent on 65% of internal flows.

- On a more general political level, and as is know, Portugal asked, in April 2011, for an EU-IMF led financial rescue. The memorandum signed with these entities called for severe cuts in public spending. It explicitly expressed that a detailed analysis of every enterprise where the national or local government was a shareholder should be submitted to a deep scrutiny, and a decision of restructuring or closing such entities should be taken soon.

It can be seen that the municipal enterprise was not a successful venture and was turning itself into a

vehicle of political bickering among parties represented in the council. A period of evaluation was called by the municipal assembly. The question in every mind was if bringing back the tourism promotional activities to the municipal structure would not be a way of saving resources without significant loss of promotional activities.

Our report stated that simply moving along as if the municipality would cover every deficit that would rise was not an option. National and local political and public finance reasons would prevent this course of action.

A restructuring plan was needed, if saving the enterprise was the general purpose of councilors. The council should give a deadline to the enterprise managers for presenting a restructuring plan covering three core issues: strategic reorientation, raising capital from private sources, and adapting the cost structure.

If, given a reasonable amount of time, no convincing plan would come forward, the tourism promotion activities could be taken again into the municipality structure and the enterprise activity would be terminated.

In times of stringent financial difficulties for most Portuguese private sector operators, the council concluded that wooing private shareholders would be hard. And banks, generally cutting credit to the economy, simply refused to back an enterprise that regularly presented losses. Thus, the management was given some months to present effective results of stronger involvement with private tourism operators and increase revenues and to adapt the cost structure.

The final of 2012 was seen an important date to evaluate the effectiveness of this new approach and, if needed, the activities would move again into the municipality fold.

A certain degree of voluntarism and excessive hopes at the beginning of the process was now having unpleasant consequences. The report of 2004 showed a d etailed analysis, produced rosy financial projections, and highlighted the need of private sector involvement. But, in practice, what this case really shows is that when these intentions do not materialize, there is a severe risk of the whole project going wrong, because of lack of economic and financial muscle. Also, the municipality could have done more to attract partners into the project, therefore sharing risks with tourism operators.

Disregarding sound principles of cooperation, well established in best practice literature, meant a high price for the municipality. DISCUSSION AND IMPLICATIONS

The setting up, in context of public bodies, like a municipality, of a separate entity to promote tourism development has a solid ground in the conceptual framework for implementing touristic strategies affecting local economies (Presenza and Cipollina, 2010). After a careful diagnosis, the setting up of those bodies can enhance the positive impact of tourism activities in growth and employment that are strongly needed in some regions (Palmer, 1996).

The smooth implementation of such a partnership is, in my view, depend on three pillars which are discussed in this section: a clear and firm commitment of private and public partners to establish goals; a separation of stakeholders form day to day management of tourism promotion entities but a firm


accountability of managers to public and private organizations that support the them; and the setting up of contingency plans to solve problems emerging from underachievement at operating and financial levels.

Regarding the first topic, if, at its inception, a new entity that aims at bringing together public and private funds and expertise suffers from an initial lack of integration between public and private strategic goals, such disconnection can hinder the whole project and be the seed for failure (Pforr, 2006).

In the case a nalyzed in this paper, the absence of private stakeholders in the equity funds of the municipal enterprise, a nd the lack of operational integration between tourism promotion strategies and the private actors (e.g., hotels and restaurants associations, wine regions, heritage sites, privately promoted festivals and other festivities) meant that the newly formed enterprise was seen as just another public entity, disconnected from the real needs of the broad touristic sector.

As such, and given some mistrust between public and private bodies, political actors in the municipality could have done a stronger push for integrating relevant private agents. This would have strengthened the financial muscle of the entity and, also, enhanced the marketing power of the enterprise.

Secondly, and given the politically charged environment of a municipality, the management of such a new entity should not be under the vagaries of the political process. This means that competence, effectiveness of management and performance evaluation should prevail over political connectedness.

If the new enterprise is seen as an extension of political power and its staff is not seen as proficient in its core activities and has the patronage of councilors, the enterprise loses some of its status when dealing with outside parties. This is a r eal danger and calls for a st eady political leadership from the highest placed people in a municipality.

Finally, the setting up of contingency plans to solve problems emerging from underachievement at operating and financial levels is central to any well managed entity.

In many cases, municipal enterprises tend to be set up on the assumption that councils will cover any economic and financial shortfall that its activity originates. However, and given the dire public finance situation of Portugal, such an assumption is not true. Pressure from the central government on local public organizations to be financially sound is paramount. Thus, before entering such experiences of setting up municipal enterprises careful planning must be done and alternative courses of action must be ready to be implemented. CONCLUSION

The municipality of Coimbra – a town of 145 000 inhabitants located in the Portuguese Central Region - commissioned a report on the state of the tourism promotion in its area of influence. The report, after a SWOT analysis, recommended that activities related to tourism promotion should be taken out the organizational structure of the council, and a municipal enterprise should be set up.

The expected engagement of private entities with the new enterprise, a higher degree of freedom in management decisions, and financial projections that shown positive income and cash flow, convinced local councilors to approve to the initiative. However, after 5 years of operations, no private investors could be wooed, losses amounted, and the council was, in practice, the sole provider of contracts and cash to the enterprise.

After some acrimony among political parties represented in the council, regarding the merits and problems of the firm, in 2011 everything was back to square one. The municipal enterprise was facing liquidation, and a reactivation of the tourism division of the council was under consideration.

From what has been presented in this paper the following conclusions can be drawn. Tourism represents a central economic sector in Portugal, and its importance is going to rise. Given the heavy competition on a worldwide basis, Portuguese regions need to have tourism strategies and action plans that can successfully face its competitors.

These tourism strategies usually work better if they are based on the cooperation between the public sector and private actors, involving them in the initial financing of ventures and, also, as potential revenue generators. At the local level, the setting up of municipal enterprises to deal with tourism promotion has to be preceded by sound analysis, and a special attention need to be addressed to the sustainability and


consistency of financial projections. When municipalities and tourism enterprise managers are not able to attract businesses from private clients, and are not able to diversify risk by wooing private shareholders, the probability of an unsuccessful experience increases, as shown by the case.

Naturally that, being based on a case study, this paper has the usual limitations of research based on specific cases. However, we presume that some of its lessons are valuable for every political actor or manager that is dealing with tourism promotion and, even more generally, that is involved in ventures where public and private cooperation is deemed important. REFERENCES Balaguer J. and Cantavella-Jordá M. (2002). Tourism as a long-run economic growth factor: the Spanish

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countries: a panel data approach”, Nota di Lavoro 26.2004, available at: www.feem.it/userfiles/attach/Publication/NDL2004/NDL2004-026.pdf

Eusébio M. (2006). Avaliação dos impactes económicos do turismo a nível regional: o caso da região centro de Portugal, PhD Dissertation, University of Aveiro, Aveiro.

Fazenda N., Silva F. and Costa C. (2010). “Douro Valey Tourism Plan”, Worldwide Hospitality and Tourism Themes , 2, 4, 428-440.

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Ladeiras A., Mota A. and Costa J. ( 2010). “Strategic tourism planning in practice: the case of the Open Academy of Tourism”, Worldwide Hospitality and Tourism Themes, 2, 4, 357-363.

Mello-Sampayo F. and Sousa-Vale S., (2010). “Tourism and Growth in European Countries: An Application of Likelihood-Based Panel Cointegration” Working Paper - 05/10, ISCTE- Lisbon University Institute, Lisbon.

OECD (2008). Opening up trade in services: key for tourism growth, Policy Brief, Paris. Palmer A. (1996). “Linking external and internal relationship building in networks of public and private

sector organizations: a case study”, International Journal of Public Sector Management, 9, 3, 51-60.

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Turismo de Portugal, (2011). Plano Estratégico Nacional do Turismo, Ministério da Economia, Lisboa. Varum C., Melo C., Alvarenga A. and Carvalho P. (2011). “Scenarios and possible futures for hospitality

and tourism”, Foresight, 13, 1, 19-35. Weiermair K., Peters M. and Frehse J. (2008). “Success factors for public private partnership: cases in

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http://www.insights.org.uk/�

Organizational Opportunities Endemic in Crisis Leadership

James E. Prewitt Saint Leo University

Richard Weil

Saint Leo University

Reactive leadership and crisis management have been synonymous for years. This flows from the belief that crisis is unpredictable and unexpected, which is simply not true. Crisis has its genesis in the values, beliefs, culture, or behavior of an organization which become incongruent with the milieu in which the organization operates. A leader, who is able to read the signals of looming crisis and understands how to harness the exigency brought on by the situation, can diminish the potential dangers and take full advantage of the resulting opportunities.

This paper addresses the challenges that leaders face before, during, and after crisis by using a generic crisis lifecycle model. Effectively dealing with a crisis is a competitive advantage, while ineffective crisis response can place the existence of an enterprise in jeopardy. Unfortunately many leaders that have garnered credit for leadership tools such as vision, strategic focus, and discipline preside over undisciplined crisis responses, often at great risk to the leader’s career and the enterprise’s future. We collectively recognize the immense significance inherent in understanding crisis theory and the leadership strategies that can be employed in these situations. Our hope is that this paper will improve the reader’s theoretic and practical understanding of crisis and be of value as t hey prepare, lead, and adapt their organizations to face challenges and crisis, but also grow from those same challenges and crisis.

Crisis, for the scope of this paper, is defined as an unexpected, dramatic, and unprecedented event that forces and organization into chaos and may destroy the organization without urgent and decisive action.

The study of crisis leadership is important today due to the unpredictability, intensity, duration, and cost. Leaders throughout the world struggle with the challenges of crisis from the corporate boardroom to the nonprofit board, the small businessman to the city hall. Decisive action is demanded immediately from organizational leaders due to globalization, organizational transparency, and technological advances. As a co nsequence, leaders are required to endure intense public examination while weathering the disrupting forces of catastrophe. Leaders must get ready for the inevitable, unforeseen, and unprecedented.

Organizational leaders at all levels will be able to exploit this paper for the benefit of their organizations. It provides a structure to better comprehend the crisis lifecycle and institute strategies for leaders to use as they plot a co urse through the crisis. The research presented herein provides organizations and leaders with an opening point to study and refine their leadership knowledge, skills, and abilities in preparation for the imminent crisis their organization will inevitably face.


CRISIS LIFECYCLE

Crisis is a worldwide reality. Crisis is simply an ineffaceable part of the human condition (Mitroff, 2004). Thomas Kuhn (1996) described how crisis begins in his book o n the scientific revolution, The Structure of Scientific Revolution. In it Kuhn states that “existing (organizations) have ceased to adequately meet the problems posed by an environment that they (in part) have created…the sense of malfunction that can lead to crisis” (p. 92). The failure to take note of the preliminary signals or tremors and recognize that our connection with the surroundings has changed is what leads us headlong into crisis.

FIGURE 1

Our research indicates that crisis can be defined by a generic model of a crisis lifecycle, as represented in Figure 1 (Heifetz & Linsky, 2002). This crisis lifecycle model represents a single event. It also needs to be understood that organizations face a repeated bombardment of overlapping conflicts or small crises. Likewise, most crises can’t be defined by one event and the fundamental challenge may rematerialize numerous times, overlapping its beginning and ending phases (Pinsdorf, 2004). For the purposes of this paper and clarity, our discussion will revolve around a single, cataclysmic crisis event that threatens an organization’s very existence.

The crisis lifecycle is defined over time and disequilibrium. The vertical axis represents disequilibrium and it illustrates the amount of stress felt by organizational members. This axis can further be divided into the comfort, learning, and danger zones. The comfort zone is the status quo, where organizations and bureaucracies prefer to remain. The comfort zone is a state of equilibrium or stagnation. Most organizations endeavor to dissipate conflict or stress in order to preserve the status quo. Ronald Heifetz (1994) notes “there is nothing ideal or good about a state of equilibrium…achieving adaptive change probably requires sustained periods of disequilibrium” (p. 35). Regrettably, organization that remain locked in the comfort zone keep their values, culture, or operating archetype static in relation to the ever-shifting environment.


Above the comfort zone is the learning zone. The learning zone is a cr itical area flanked by equilibrium and danger. This zone is where a minimum amount of stress is desirable for an organization to elicit change and it causes anxiety and conflict within the organization. It is the conflict linked with change that facilitates an organizations growth and the size of an organizations learning zone is directly correlated to its capacity to handle stress. Responsive and flexible organizations have larger learning zones and are better able to handle organizational chaos and conflict. Organizations that are large and bureaucratic are less able to handle change; therefore they have much smaller learning zones.

Above the learning zone is the danger zone. The line separating the learning zone and the danger zone is represented by the amount of stress that may cause an organization to implode and disintegrate. Crisis characteristically causes the stress level in an organization to hurdle into the danger zone. Perhaps the most complicated and illusive key to effective leadership is creating sufficient stress within the organization to transform it into a learning organization but not enough stress to rocket it into the danger zone.

Leaders can change organizational stress using technical or adaptive techniques. Technical responses provide quick solutions and harness a set of procedures toward well-understood problems. When a leader applies technical responses to problems, organizational stress typically abates (Heifetz, 1994). However, an adaptive solution is used when a predicament is not well understood or there is no adequate response, expertise, or procedure. Adaptive solutions address the fundamental issues that are creating the conflict. Heifetz explains, “adaptive solutions tend to demand a more participative mode of operating and shift responsibility to the primary stakeholders (and) problem solving takes place in their hearts and minds” (Heifetz, 1994, p. 121). Adaptive challenges compel people within the organization to face “dysfunctional habits, values, and attitudes;” thus escalating organizational stress. In essence, crisis leadership is recognizing that technical solutions may be essential to diminish immediate danger, but are insufficient for long-term organizational growth; which requires innovative and adaptive approaches (Goethals, 2004, p. 291).

The horizontal axis of the crisis lifecycle model is composed of three phases: preparation, emergency, and adaptive. Prior to any crisis, an organization is in the preparation phase. During this time, leaders should be cognizant of tremors or signals of misplaced values and behaviors. Complacent organizations are ripe for crisis.

The transition point from the preparation phase to the emergency phase begins when an eruption is followed by institutional awareness of the crisis (point A on Figure 1). Stress and disequilibrium become unendurable and the survival of the organization is at stake. The transition point from the emergency to adaptive phase (point B on Figure 1) is difficult to distinguish and occurs when the pressing danger is controlled. Sadly, leaders and followers don’t want to face these hard challenges, particularly after overcoming the immediate crisis. They do not take into account the urgency, attention, and opportunity gained. Staying in the learning zone after the crisis is the most complicated, least understood and largest delineator of leaders who effectively navigate crisis.

The Preparation Phase

Once you understand why leaders are ineffective at adapting their organizations during the preparation phase, then you can understand crisis. Without a crisis it is extremely difficult to move an organization from a state of comfort to a state of growth. Change threatens stable relationships, balance of power, standard operating procedure, and/or the current distribution of resources (Heifetz, 1994). Even when leaders are aware of their organization’s need for change, they struggle with the paradoxical requirement to provide direction without causing pain to the organization (Heifetz & Linsky, 2002). Leaders must also continually balance the severe pressure to remove stress from their organization while fighting the tendency to return to the status quo. In order to facilitate organizational adaptation or prior to crisis, the leader must establish credibility and create an atmosphere that allows people to face change in relative safety. It requires them to lead from the front.

Another way that a l eader can prepare an organization for crisis is to recognize, prioritize, and mobilize awareness for change. The leader must understand and focus on the core purpose of the


organization. This strategy is at the crux of understanding how an organization’s values are related to a changing environment. Positive illusions, self-serving biases, and a tendency to discount the future often prevent leaders from listening to their environment and gaining much needed feedback. Sometimes leaders are unable to overcome the state of denial or the awareness of indicating tremors (Bazerman & Watkins, 2004).

Organizations need a structured dialog, systematic decision analysis, and they must conduct continuous planning in order to ensure that actions are prioritized toward the organizations long-term health. Unfortunately, leaders often tend to ignore problems and avoid making the much needed hard choices; this is why it is important to build the team within the organization. Leaders who construct effective teams are able to rapidly respond to crisis in a unified manner. It is the leader that overcomes these obstacles and mobilizes resources toward learning, who may avoid crisis altogether.

Emergency Phase

The emergency phase begins when the crisis erupts. If an organizational leader fails to examine their fundamental assumptions of the world, connect the dots to see the big picture, or think differently from everyone else, that leader risks experiencing devastating tragedy and crisis. The most important factor during the emergency phase is to mitigate the threat and reduce disequilibrium to a l evel where the organization and people within are at a safe level (Stern, 1999). A leader can leverage an organization’s high expectations for security as cap ital for autocratic and technical solutions that will reduce the immediate stress; unfortunately, without addressing the underlying misalignments, crisis will return to the organization. A timely intervention is key to mitigating the immediate threat and limiting long term danger (Stern, 1999). At this time it is perfect for a l eader to use quick, technical fixes to reduce organizational stress to levels that are tolerable. T he leader must, however, weigh the need for action against the uncertainty that surrounds the event.

First impressions of the crisis are usually accompanied with limited factual information that often misses the underlying causes. Because of this, it is advantageous to focus on t he core purpose when formulating the initial response (Mitroff, 2004). A leader must not be overcome by the urgency of the crisis; instead the leader must step back and draw from the guiding principles of the organization. The leader must weigh the quick decisions against the realization that stress reduces cognitive abilities (Goethals, 2004). Even when they do not apply perfectly, utilizing standard operating procedures may help to lower the tension due to the routine being calming and reassuring to people within the organization (Heifetz, 1994). As information becomes available that helps to clarify the situation, action and communication become even more essential so the leader can tell the story to the organization and get their backing. Leaders must explain the facts of the situation and the actions that are being taken. People begin to relax when they see a calm, poised leader relating to their loss (Heifetz). All of these responses are crucial to seizing the initiative during the emergency phase.

The Adaptive Phase

The adaptive phase begins when the organization returns to a sense of stability. The leader must take advantage of the fleeting organization mandate to address the underlying cause of the crisis so that the event will not be repeated, even though the immediate crisis and danger is under control. The leader has an opportunity during this phase to change and grow, develop new procedures, alter the organizational culture, and help the organization to profit from the crisis. Technical solutions may still be needed during this phase, but the leader must focus on reorienting the organization to face tough choices. The adaptive phase requires a balancing act between maintaining urgency for change while at the same time fostering a sense of safety and security.

Crisis provides us with the ultimate signal that we have ignored, avoided, or failed to recognize the most pressing issues of the changing environment. As situations worsen, signals and tremors foreshadow impending disaster, giving us an opportunity to prepare for or adapt to it. Sadly, most institutions resist the needed change and prefer to chimera of safety that is provided by the status quo. When disaster strikes, the leader must refocus the organizations resources and attention on survival. The leader must use


this small window of opportunity to seize the initiative. Yet when survival seems assured, leaders face a crucial choice. The leader can either harness the urgency and attention provided by the crisis to alter the organization with the environment or risk the return of crisis and danger.

CRISIS LEADERSHIP STRATEGIES

Our research has led us to uncover some essential strategies that a l eader must apply to lead their

organization out of crisis. These strategies were identified from historical crisis situations that have been written about in the existing body of research. Not every strategy is applicable to every crisis situation and the strength of the strategy varies with the crisis. Similarly, these strategies are not confined to use during a certain, prescribed phase in the crisis lifecycle model. A strategy may fit neatly into one phase of the crisis or it may span the boundaries of several or all phases of the crisis.

Each strategy should be viewed as another tool that the leader has in their tool kit for crisis leadership. The strategies show that it is not important that the leader hit the nail squarely on the head to be effective, the leader must just hit the nail head in some way to make it useful for the organization.

Lead from the Front

“During periods of crisis, people look for a strong leader. They don’t look to committees or to teams; they look for a confident, visibly engaged leader to pull them through” (Harvard business essentials: Crisis management, 2004). Unfortunately, leaders that are hit by crisis often withdraw behind the protective curtain of their peers and lawyers or blame their subordinates and the media (Pinsdorf, 2004). Analysis of crisis situations shows how common and costly this mistake is (Pinsdorf, 2004). The leader must be many things at many times and during a crisis, at an irreducible minimum, the leader must be visible, poised, courageous, committed, and attentive. If an individual’s job during a crisis is to lead, then he must assume the role and do it well (Harvard business essentials: Crisis management, 2004). The leader must understand the importance of people seeing him face the challenges head on, walking the walk and talking the talk as it were (Witt, 2002). The leader must create opportunities for visibility and use the power of his role as a leader to provide assurance, direction, and inspiration.

Visibility & Image

Peter Arfenti conducted a study of the September 11, 2001 tragedy in New York City and this study clearly validates the power of a visible leader (Harvard business essentials: Crisis management, 2004). Arfenti found that “the most effective leaders during the crisis displayed high levels of visibility” (Harvard business essentials: Crisis management, 2004, p. 87). Those leaders understood that people needed concrete evidence that their leaders were concerned about their distress and were working to make things better (Harvard business essentials: Crisis management, 2004).

However, a visible leader must present the right image. “A crisis can quickly expose a leader’s hidden strengths as well as his core weaknesses” (Klann, 2003, p. 1). Former Federal Emergency Management Agency (FEMA) director James Lee Witt wrote that leaders who handle crisis best are the ones that think of others before they think of themselves (Witt, 2002). Fortunately, “crisis frequently brings out courage, honor, selflessness, loyalty” (Klann, 2003, p. 8) and many other positive behaviors in leaders. “During a crisis, a leader’s first mechanism to contain distress must be to contain himself. If a leader remains poised and indicates through his calm demeanor that the situation is serious but that there is no cause for panic, he reduces the possibility of one” (Heifetz, 1994, p. 140).

Demonstrate Courage

Courage is not the absence of fear, but the ability to act in its presence (Collins, 2003). Whether a leader is the departmental director or a corporate CEO, if the resources are being threatened, it is imperative that he demonstrates courage and accept responsibility for dealing with the situation (Witt, 2002). John Kennedy reminded us that courage is the willingness to speak “truth to power.” “Demonstrating courage is one action that is indispensable if a leader expects to mobilize people”


(Bazerman & W atkins, 2004, p. 215) to prevent, mitigate, or learn from a crisis. Many great leaders throughout history made their reputations through their courageous actions before, during, and after crisis; often in the face of significant uncertainty and resistance (Bazerman & Watkins). A demonstration of courage is central to crisis leadership because it signals the leader’s “willingness to act against one’s own and other’s short-term interests to avoid heavy long-term costs” (Bazerman & Watkins, p. 12). Additionally, it puts members on notice of the need for action (Bazerman & Watkins).

Show Commitment

A leader must show that he is committed to see the task through to successful completion. A leader that demonstrates the ability to accept the harsh reality brought on by the crisis, yet continues to persevere, demonstrates a personal investment in the team and their mission. Perseverance sends a clear message about the leader’s commitment and creates an opportunity for the team to rally to achieve a common goal. Similarly, if a leader signals a lack of personal investment in the team and mission, “he presents an invitation to the people who are uncommitted” (Heifetz & Linsky, 2002, p. 51) to dismiss his perspectives and push his agenda aside.

Maintain Perspective

Leaders must ensure they don’t lose sight of their ultimate goal. Regardless of where a leader is in the lifecycle of a crisis, it is imperative that he maintain perspective. “Occasionally, leaders get so caught up in the action and energy that they lose their perspective, their wisdom” (Heifetz & Linsky, 2002, p. 165). Franko Bernabe, CEO that successfully transformed Italy’s large energy industrial group Eni, was very much aware of this trap (Harvard business essentials: Crisis management, 2004). He understood that executives leading their companies through crisis often don’t have time to think. They don’t have the time to tune-in to their organization and environment; they only have time to react. Consequently, he walked to work every day. He said that this gave him an extra half hour to think (Harvard business essentials: Crisis management). Bernabe believed that the ability to step away and think clearly is “one of the most critical skills a crisis leader must have (Harvard business essentials: Crisis management). Heifetz describes this stepping away or need to get perspective as “getting off the dance floor and going to the balcony” (Heifetz & Linsky, 2002, p. 51). The intended “image captures the mental activity of stepping back in the midst of action and asking, ‘What’s really going on here?’” (Heifetz & Linsky, p. 53).

Focus on the Core Purpose

When people understand and pursue their purpose, a purpose that puts meaning into their life, they can weather any storm. Victor Frankel (1987) discovered this in a Nazi concentration camp. As a trained psychologist he observed that when a person has a greater meaning for living, they lived (Frankl, 1985). Those that had lost purpose died (Frankl). The same can be said of organizations.

Know and Understand the Core Purpose

An organization that has a relevant, acknowledged purpose can survive even the worst crisis. On the contrary, an organization which has no clear purpose, or a valueless purpose such as simply raising capital – as in the Enron scandal, will eventually fail. Successful leaders know they must understand their organization’s core purpose and then ensure that their people appreciate and support it. Both the leader and the people of an organization must believe in something higher than themselves. In planning for crisis, identifying the organization’s core purpose is essential for it will provide a foundation for every action and decision.

Instill Value and Align with Reality

An organization’s purpose must align its values and its reality. If a company’s leaders or personnel are acting contrary to the business’ core purpose, values, or environmental reality; crisis, in some form, is sure to develop. The leader must define what the future should look like, align structures and processes, and inspire people to make it happen despite obstacles (Mitroff, 2004). In this case, leadership is


influencing the organization to face its problems (Heifetz, 1994). According to Heifetz (1994), “tackling tough problems – problems that often require an evolution of values – is the end of leadership; getting the work done is the essence” (p. 26). The leader must confront and close the gaps between his organization’s values, its behaviors and its realities. This may require the organization to endure a period of significant, adaptive change. In this situation, “it becomes critically important that the leader communicates, in every way possible, the reason to sacrifice” (Heifetz & Linsky, 2002, p. 94). He must justify “why they need to sustain losses and reconstruct their loyalties” (Heifetz & Linsky, p. 94). People need to be reassured that the final results are worth it (Heifetz & Linsky). Provide Vision and Embody Values

Where the purpose and values are the foundation of the organization’s vision, a leader can leverage this vision as a rallying point to provide stability to employees during a crisis. But to make this vision truly credible, the leader must embody and be seen living the organization’s purpose and values. Successful crisis leaders know that a p urpose, value, and vision system that have been effectively communicated so employees understand them, feel ownership of them, and endorse them, become a powerful influencing tool during all phases of a crisis. The vision, grounded in values, will clarify what is, and is not important to the organization. Additionally it can serve as a co mpass for action, providing direction and stability to people who become unhinged by the crisis (Klann, 2003, p. 14). A leader must also remain mindful of his organization’s purpose and vision when overseeing the crisis planning. The vision will ensure that crisis actions are in line with the mission, goals, and objectives of the organization (Klann). During the crisis, a successful leader can provide stability and security as well as reduce anxiety by consistently returning to the organization’s values and vision (Klann). Consistently Assess and Update Purpose

A leader must periodically reassess the organization’s purpose and values to ensure they remain relevant to the current and future environment. He should look at how well the purpose prepared the organization to identify or avoid a crisis and if it enabled or hindered the response. Based on the outcome of the analysis, the leader may want to realign or redefine the organization’s purpose to make it more relevant to the environment, current and future operations, and especially crisis (Klann, 2003, p. 63). Build a Team

The success of any business organization hinges upon successful organizational team building. The question is sometimes ask, why have a t eam? And the answer is rather simple; the success of any organization cannot be accomplished by managers or leaders alone. To build a successful team begins with the leader who has been placed in the position to build a bona fide, competent, and resourceful team for the development, improvement, and the eventual fulfillment of the desired mission of the organization (George & Jones, 2005).

Before an appointed leader can begin the team building process, the leader must first recognize the mission of the organization and then organize the people and resources to fulfill the mission of the organization. This idea of fulfilling a team based mission is supported upon the notion of having a vision. A leader must first develop the vision and have that vision in place before she can identify people, skills, and behavior needed to meet challenges of the organization (Heller & Hindle, 1998).

Once the leader has developed the mission vision for the team concept, the process of team building must now focus on bringing together the right people with the right skills. The selection process of team members must be focused on four critical areas:

• Intellectual integrity • Results • The ability to make decisions • The ability to think conceptually


Leaders must select team members, who are superfluous with intellectual integrity and who are willing to confront reality at all times with total honesty. Leaders want to select team members who are results based oriented, i.e., not only are they willing to talk the talk, but they are also willing to walk the talk. Results based team members are doers and they focus on finding the right solutions. Leaders want to select team members who are not afraid to make decisions. They cannot be afraid to make decisions that are based upon empirical evidence whether in whole or in part.

Furthermore, a leader should select team members who are willing to step up to the plate despite the possibility that their decision just might be wrong in spite of their best efforts. Leaders should also select team members who have the ability to just use good old plain common sense and wisdom. Finally leaders should select team members who have the uncanny ability at conceptual thinking. Teams should be superfluous with conceptual thinkers who can put the pieces of the puzzle together and figure out the right answers in timely fashion.

Once a leader has selected teams members based on the fundamental skills needed to accomplish the task at hand, the leader is now put back under the microscope and she is now the being assessed by her followers based on her own leadership style. You see, one of the key ingredients a leader must possess in their attempt to build a successful team is the element of transparency. This must be apparent from the very start of the team building process. Leadership transparency is just not only about honesty, credibility, and integrity; it is also about interacting with team members through straight talk, openness, and accountability. Leaders must understand people are not willing to follow them until that indispensable element of transparency is exhibited in her style of leadership early on the process (Klits, Mandredi, & Lorber, 2007).

Furthermore, leaders have to realize the members of the team are not willing to follow them until they are satisfied and know that she truly care about them. In this aspect of team building relationships, leaders must adhere to the principles of Abraham Maslow hierarchy of needs and these needs must be incorporated into the team building process. From an organizational perspective the hierarchy of needs reflect:

a) Physiological Needs – In bona fide organizational settings, team members want to know that they are being adequately compensated for their participation towards the mission of the organization. Fair and equitable compensation is a means to buy food, clothing, and have adequate and fair housing.

b) Safety Needs – In bon fide business organizational setting, team members desire to know they have job security, adequate medical benefits, and safe working conditions.

c) Belongingness Needs – In bon fide organizational settings, team members desire to have a good relationship with each other and their leader. They desire to be a member in good standing with a cohesive work group, and they want to be included in organizational social functions such as company picnics and holiday parties.

d) Esteem Needs – In bona fide organizations, team members desire to know that their work product may someday offer a ch ance for promotions; moreover, team members desire to be readily recognized for job performance.

e) Self-Actualization Needs – In bona fide organizational setting, team members desire to know that they will have the opportunity to use their skills and abilities to the fullest and they strive to be all that they can be in job performance (Mears & Voehl, 1997).

The next important steps in the process team building process, is the leaders’ responsibility to nurture

the relationships among team members and promote internal team building. Leadership nurturing and internal team building is supported by giving team members the required training, education and development needed so that team members can enhance their knowledge, skills, and abilities to assist the leader in accomplishing the mission of the organization. Astute leaders of authentic organization understand the future success of the team hinges on how effectively each member of the team is developed. The right training, education, and development helps the internal system thinking process whereby team members learn how their knowledge, skills, and abilities will affect the organization in


whole and part through intellectual conceptualizing and application. Undergoing this team building process allows team members to develop their natural talents and advance their careers. The nurturing and internal team building process from a team perspective must be superfluous, i.e., leaders must continually coach and motivate followers with the notion to help them find meaning in their work, and to instill in them that their efforts do in fact matter for the good of the organization.

The external process of building a team gives team members the opportunity to view how their mission task affects others and organizational systems outside the walls of their own organization. Again this manner of system thinking is but one motivational factor that encourages creative thinking among team members and generates new ways of doing things. External team building provides opportunities to build relationships outside the parent organization in an organized fashion, and it offers a way for teams from multi-variant organizations to work on critical problems that can and will have long term globalize effects on business organizations (Ponder, 2001).

Lastly, continuous successful team building still rest upon Abraham Maslow hierarchy of needs, but of one that I would like to point out that is especially important and that is “Esteem Needs”. To maintain the continuity of the team and its mission, recognition of team members go a long way with stabilizing the mission of the team, and in this 21st Century the idea of using a holistic approach in recognizing and rewarding team members will play an important part in building and maintaining an effective team. Continuous Planning

In addition to leadership vision and organizational mission statements, every thriving organization succeeds by having a clear plan that allows the organization the wherewithal to march forward towards its goals and objectives (Lewis, Goodman, & Fandt, 2004). Therefore, unambiguous planning leads to greater and sustained goal achievements. Peter Drucker once said “Long range planning does not deal with future decisions, but with the future of present decision” (Griffith, 1990, p. 254).

Organizational planning must incorporate SWOT techniques that allow the organization to sustain a clear path towards reaching its goals from year to year. SWOT is the acronym that stands for Strengths, Weaknesses, Opportunities, and Threats. Applying SWOT techniques in the business realm is but one aspect that helps business organizations conduct the kind of organizational analyses that helps to mitigate or prevent organizational crises.

From a team perspective the notion of identifying organizational strengths and weaknesses in the planning process, offers leaders and team members an opportunity to internally assess and identify those probabilities and mechanisms that will assist or hinder the organization from attaining its goals. Some examples of organizational strengths possibly include:

• Competent personnel possessing relevant knowledge, skills, and abilities; • Staff development and training programs; • Customer loyalty; and • Capital investments and strong balance sheets; and • Efficient procedures, systems, and social responsibility, etc.

Some examples of weakness:

• Personnel lack of awareness of organizational missions, objectives, and policies; • Deficiency in IT department; • Lack of new product and services; • Non-compliance with appropriate legislation; and • Inadequate leadership, etc,

Taking into consideration opportunities and threats in the planning process provides leaders and team

members the opportunity to scan the external environment related to the industrial conditions aiding in identifying and evaluating those elements that may positively or negatively impact the organization (Heal, 2000).


Some examples of opportunities include: • New customer base and new markets; • New products and service lines; • New technology; and • Personnel training opportunities, etc.

Some examples of threats include:

• New legislation; • Lack of training, education, and development; • Price competitions; and • Customer rejection, etc.

Coupled with organizational planning is the importance of continuous planning which integrates the

continuation for contingency planning. Continuous planning within the context of business organizations should be directed in such a manner in which all processes within the organization is connected, a condition which reflects system thinking. Continuous planning further incorporates the continuation of applied SWOT techniques that allow organizational leaders and team members to adjust to the sudden impact of changes that ultimately affects the organizations position locally as well as globally.

Considering the broad base of continuous as well as contingency planning, the gravity of these important tenets is principled in the following:

• Identifying Risk and Potential Crises • Establish and Sensor Monitoring • Developing a Crises Action Plan • Testing the Crises Action Plan

The idea of continuous external environmental scanning coupled with SWOT techniques; allow

leaders and team members the opportunity to obtain information about events, trends and relationship, which can be assimilated into the continuous planning process. These congruencies enhance and sustain the present and future goals of the organization, and they greatly assist with mitigating potential crises through appropriate crises management measures. The aforementioned tenets, among many other flexible elements, are essential for organizational survival. Moreover, the aforementioned tenets aid in balancing the scorecard as the process of ongoing planning continues within the organization.

The amalgamation value of applied SWOT and Environmental Scanning techniques in an organizations continuous planning process provides a systematic approach that helps to identify risk and potential areas for crises. To identify those risk and potential areas for crises, organizational leaders and team members must consistently perform organizational audits both internally and externally. Auditing must occur throughout all levels of the organization and it must take into consideration all personnel, customers, suppliers, and external competition. As part of the ongoing planning process, organizational leaders and team members must take on the role of an assassin. Taking on this role allows for the proverbial thinking out of the box concept, i.e., thinking of creative ways in which internal and external conditions can drastically bring about a negative change to the organization (Crisis management: Master the skills to prevent disaster, 2004).

Applying SWOT and external environmental scanning techniques contributes to establishing and putting in place those sensory monitoring processes that significantly aid in mitigating potential crises situations. Sensory monitoring includes, but is not limited to:

• Adherence to effective internal and external communications from all constituents of the of the organization regarding potential areas of concern;

• The development and periodic review of comprehensive business data; and • A total organizational audit from top to bottom to flesh out potential areas of crises concern

(Leading through a crisis, 2009).


Throughout the continuous planning process, organizational leaders and team members must be able to develop the foresight for crises anticipation. The progressive development of this foresight should lead to the development and preparation of action plans designed to neutralize and contain perceived potential areas of crises. The crises plan must be able to:

• Identify obstacles and fail points, i.e., what factors can and will fuel a potential area of crises; • Create a resource plan, i.e., identify those resources the organization might need on board to

aid in a crises; • Create a communication plan, i.e., create a communication plan that is designed on a need to

know basis both internally and externally; and • Distribute the resource and communication plan, i.e., all the key players who are part of the

crises action process should be issued a copy of the resource and communication plans and measures must be taken to ensure those key players understand the resource and communication plans (Leading through a crisis, 2009).

Once organizations has identified those obstacles and fail points that can have a drastic effect on the

operations of the organization, the plan for defeating those obstacles and fail points are not complete until the leaders and team members test those plans under simulated and rigorous conditions. Scenario test activities is a means by which organizations can measure the future outcome of a cr ises situation, and actual simulated scenario activities help to improve the quality of continuous organizational planning.

Creative simulated test plan activities will reveal with clarity what can actually go wrong in the environment, and testing the plan offers a chance for organizational personnel to train and prepare for the future crises events. Creative scenarios activities ensures that organizational members are focused on priorities and the plans that have been developed are aligned with changes that can take place both inside and outside the organization. Moreover, organizational creative scenario activities allow for organizations to project negative events that could possibly affect its environment 5, 10, 15, and even 20 years down the road. Continuous planning as well as the testing of those plans through scenario training ensures that each potential crises event has a developed strategy to suppress its effects and increases the survivability of the organization (Tracy, 2010).

Mitigate the Threat

“Procrastination is the archenemy of crisis management” (Witt, 2002, p. 1). Frequently, crises emerge or go from bad to worse, simply because someone failed to act (Witt). When a cr isis presents itself, leaders must take action. “Tough decisions must be made and made fast” (Harvard business essentials: Crisis management, 2004, p. 20). Successful crisis mitigation requires immediate triage – the bleeding must be stopped (Harvard business essentials: Crisis management, 2004).

A crisis event can threaten any organization at any time during the business life cycle (Hargis & Watt, 2010). Therefore, it is important to understand the actions that may be taken to mitigate any loss and facilitate a speedy recovery for the organization. For our purposes, let us define the term, crisis, as any situation or event that creates disruption to the organization’s normal operations. We would also suggest that a t ime element exists in a crisis event. This time pressure is the result of the perceptions of the business managers/leaders of “the amount of time they have to search, deliberate, and take action before losses being to occur or escalate (Ford, 1981). Therefore, mitigation of the events occurring becomes of paramount importance. With this in mind, it is critical for business leaders/managers to have an understanding on how to lead and manage crisis events. It is obvious that no organization can “totally control or prevent the occurrence of any potentially negative crisis event” (Louden, 1992). Moving forward with this theory, we suggest in order to navigate these events strategic planning and strategic leadership are of vital concern.

Rigorous strategic planning can assist your organization to clarify its goals and deploy the available resources in a manner that is consistent with the planning. It also assists in maintaining the focus of your organization on those issues. It may also assist in averting some unexpected developments and help


mitigate others. Thus, sound strategic planning can enable your organization transcend the circumstances you are encountering and avoid the panic of entering crisis management (Lettow & Mahnken, 2009). Realistically, situations, large or small, can enter our lives instantly. More recently, the economic situation we are facing is very real and has affected virtually every type of organization at some level. “The attitude of those responding to the crisis and the cohesive nature of the teams involved is critical to the success of the effort” (Van de Walle & Turoff, 2007). To mitigate any encountered situation, the organization must first recognize what is being encountered. It is this detection that influences the organization’s ability to mitigate the encountered event(s). Clearly, the scale and scope of the event can and most likely will produce complex and difficult situations that must be handled. In some instances, the initial response by organizational leaders/managers is to deny that an event has taken place that requires the organization to respond. This assumption results in the belief that no changes or reactions are needed within the organization. These leader/managers suggest that the issue is outside their realm of influence and that by “pulling together they can weather the storm” (Ford, 1981). There is a very large body of both literature and practical real-world experience that indicates that ignoring an event will not make the event disappear.

The organization’s reputation among its various stakeholders (employees, stockholders, customers, the community where the organization is located, etc) and what those stakeholders believe regarding the previous behaviors demonstrated by the organization will also affect the mitigation and recovery effort. There is evidence that suggests that an organization’s reputation is a strategic resource to be used wisely and that same reputation may assist organizational leaders/managers during the mitigation and recovery phases of a crisis.

Take Action

“When crisis strikes, a leader must initially think like an EMT. He must quickly identify the problem and determine what actions his organization can take to stabilize the situation” (Crisis management: Master the skills to prevent disaster, 2004, p. 67). These actions may only be technical solutions, but they will buy the crisis action team time to implement the appropriate actions form the crisis action plan (Crisis management: Master the skills to prevent disaster, 2004). With the crisis action team in execution mode, the leader should continue to search for new and decisive ways to facilitate damage control and move the crisis out of the danger zone (Bazerman & Watkins, 2004). At this point, information is critical to the leader but it’s also one of his biggest challenges. His problem may be that there is too little information available, or it may be that there’s far too much, with no way to sift out what is important (Crisis management: Master the skills to prevent disaster, 2004). Consequently, the requirement for the leader to bring clarity to a murky situation might well be describe the early phase of most crises (Crisis management: Master the skills to prevent disaster, 2004). Despite this information challenge, the leader must continue to shape the response through actions, even when the response may be based on inaccurate or incomplete information (Bazerman & Watkins). Decisive, identifiable action is critical at this point because it reduces individuals’ perceived level of disequilibrium. Additionally, it gives the appearance that responsibility for the problems has been shifted to the individuals taking action. People will feel that the danger is retreating when they see the leader is paying attention (Heifetz, 1994). Be On the Scene

Individual’s need to know the leader is involved. This critical point cannot be overstated. People want to see their leaders in a crisis (Harvard business essentials: Crisis management, 2004). The leader should be physically on the scene as soon as possible. His physical presence sends a loud and clear signal that he thinks this situation is extremely important (Harvard business essentials: Crisis management). Similarly, a leader’s absence sends the message that he has other priorities (Harvard business essentials: Crisis management). Physically being at the scene also gives the leader the opportunity to embrace his central leadership role, capture the initiative, seize power and take control (Bazerman & Watkins, 2004). During periods of crisis, people look for a strong, confident, and visibly engaged leader to pull them through (Harvard business essentials: Crisis management). Sadly, analysis of crisis after crisis repeatedly reveals


that leaders hit by crisis often withdraw behind the protective shell of peers and lawyers or they play the blame game with subordinates and the media (Pinsdorf, 2004). Consult the Team/Find Experts

During crisis mitigation, a leader will find himself deluged with time sensitive decisions. Information quality may be marginal at best and there is little time to consider alternative courses of action or think about unintended consequences. The organization’s crisis action team exists to address this challenge and take pressure off the leader. Never the less, a leader’s capacity to make good decisions will undoubtedly be strained, making it imperative that he seek expert advice and counsel (Harvard business essentials: Crisis management, 2004). Small group decision making can provide a backstop to help curb a leader’s impulses, encourage reflection and critical dialogue, and point out problematic assumptions and unrecognized implications of a potential course of action (Stern, 1999). Likewise, engaging subject matter experts from outside the organization as well as individuals, companies, or industries that have an interest related to the crisis can bring fresh, critical thought and ideas to the table (Mitroff, 2004). But leaders should also consider the warning to “beware of conventional wisdom – it may be wrong” (Stern). Tell the Story

Another issue that must be part of any discussion on crisis management and leadership is the issue of communication. The communication process is critical during normal business operations; however, it takes on an even more criticality during a crisis. On June 28, 1863, three days prior to the Battle of Gettysburg, General George Meade was made the commanding officer of the Army of Potomac by President Abraham Lincoln. Realizing that a major battle was close at hand, Meade needed information- accurate and complete information – in order to prepare the Army for the forthcoming task. General Meade treated his subordinates as colleagues rather than as subordinates. Meade believed that “important plans may be frustrated by subordinates, from their ignorance of how much depended on their share of the work” (Coddington, 1968). As history shows, Meade did receive accurate and complete information and passed that information on to his subordinates, which resulted in the defeat of Confederate forces under General Robert E. Lee. What was true then is true now; communications must be accurate and complete for senior leaders/managers within the organization to formulate appropriate responses to the situation and the recovery effort. It is equally important that senior leaders/managers also provide subordinates and with complete and accurate information. As Ford (1981) suggests, information distribution and distortion is likely to place the organization at an even greater disadvantage.

Effective communication is critical to leaders through all phases of the crisis. A l eader should capitalize on all forms of communication to tell the story and ensure the widest reception. If a l eader communicates effectively, he can at least help to frame, if not control the story. Failing to communicate will result in a misinformed public that may go so far as to damage or destroy the organization (Harvard business essentials: Crisis management, 2004).

In the end, how well or how poorly a crisis goes for an organization will have much to do with its communication. If an organization’s communications seem open and truthful and the leader is seen as genuine, compassionate, and confident in the future, the leader has already gone a l ong way towards successfully managing the crisis (Witt, 2002).

Be the Spokesperson

Selecting the correct spokesperson is also central to the effectiveness of an organization’s communications. It is imperative that the spokesperson have inner discipline and poise. Crisis will escalate the stress for both the spokesperson and the audience. Despite the stressful environment, a spokesperson must not show distress; he must have the emotional capacity to endure the uncertainty, frustration, and pain that is ever present in a cr isis (Heifetz & Linsky, 2002). Whenever possible, the spokesperson should be the identifiable leader, usually the CEO (Harvard business essentials: Crisis management, 2004). When the crisis involves highly technical issues that the CEO cannot effectively address, a t eam approach should be used (Harvard business essentials: Crisis management). General


Tommy Franks used this technique very effectively during the Iraq Campaign. General Franks would provide the strategic overview and key points but would hand-off detailed questions to subject matter experts (Harvard business essentials: Crisis management).

Be Honest and Timely

Rapid, honest, and transparent communication is the lifeblood of successful crisis management (Witt, 2002). The crisis leader must provide all available information as timely as possible. His message must always be forthright, accurate to the best of his ability and reinforced with understandable facts (Harvard business essentials: Crisis management, 2004). If there is ever any doubt, his guiding principle should be to err on the side of over disclosure (Harvard business essentials: Crisis management). The leader must also get his side of the story into the public’s mind early and often (Harvard business essentials: Crisis management). When he doesn’t, his organization is often convicted by the court of public opinion because a statement by the leader is too late or overcome the medias’ negative story and the perceptions that have been fostered (Mitroff, 2004). Warren Buffett’s advice is to “first state clearly that you do not know all the facts. Then promptly state the facts that you do know. One’s objective should be to get it right, get it quick, get it out, and get it o ver” (Harvard business essentials: Crisis management). An organization’s crisis management team may be great and its crisis management plan may be complete, but if a leader cannot communicate his message during the crisis, the organization will fail (Harvard business essentials: Crisis management).

Shape the Message

A leader must also determine the principle message he wants to convey in the story. For starters, it should reduce fear and contain empathy for the victims of the crisis. Many victims will sustain incredible loss; financial, emotional, and spiritual. When a leader genuinely conveys a feeling of empathy to the victims, it bolsters the confidence, will, and character they need to recover (Witt, 2002). The story should also tie into the organizations core purpose and values. A message developed from the organization’s purpose and values will be calming and reassuring because of its consistency. Organizations that know what they stand for and know where they are going before a crisis hits, inevitably mange it better (Crisis management: Master the skills to prevent disaster, 2004).

Profit from the Crisis

Time is not a leader’s friend. The longer a crisis drags on, the more likely it is that the organization will be associated with trouble and conflict in the public’s mind. Similarly, while the organization is embroiled in crisis, it is likely that it is not working at peak efficiency. Employees will become increasingly concerned with the health of the company and defections will increase. Relationships the leader has developed with suppliers, customers, investors, and stakeholders, which strengthened in the early stages of the crisis, will become increasingly strained. The leader must press on to the next move; he must resolve the crisis, quickly (Harvard business essentials: Crisis management, 2004).

At some point the crisis will end and the leader should declare the crisis is over. The leader’s declaration serves to stand-down the crisis action team, turn off the crisis mind-set, and focus on adapting the organization while searching for opportunities. To give closure, a l eader should meet with his organization. He should explain what happened and why it happened. He should describe how things have been resolved and where they stand today. Finally, he should reiterate the company’s core purpose and values and ask everyone to do his best moving forward (Harvard business essentials: Crisis management, 2004).

Keep Moving

Once a l eader has mitigated the threat, that is, moved the crisis out of danger zone, he can begin efforts to profit from it. He must keep an eye on the threat, but his primary goal should be to move forward as quickly as possible with actions to end the crisis completely. Failure to guard against the threat


and move forward gives the crisis an opportunity to mutate and break through the holding actions (Crisis management: Master the skills to prevent disaster, 2004).

Learn From the Crisis

A lessons learned session, or after action review should follow any significant event, especially a crisis. Participants should identify what went right, what went wrong, and what should be learned from the event. The leader should add the notes from the after action review, as wel l as al l relevant crisis documents, to the historical record so valuable experiences are not lost (Crisis management: Master the skills to prevent disaster, 2004).

Adapt the Organization

The leader may feel a lot of internal and external pressure to see the crisis as a t echnical problem, with straight forward, technical solutions that can quickly restore the balance (Heifetz & Linsky, 2002). But he must not squander the urgency, attention, or opportunity the crisis has given him to address the difficult adaptive task of reinvention and simply return to status quo.

CONCLUSION

During a time of uncertainty, opportunities are available for those organizations that are prepared. As

was previously stated, managers tend to be protective and hope that over time things will work out. Leaders/managers that use their imaginations, pay attention to the indicators, and listen to understand experts both inside and outside their organizations will find recovery faster than those that enter into a protective state of mind. Those leaders that understand what caused the crisis and work to create a lasting value for the organization’s customers, employees, and shareholders will be successful when compared to those that use protectiveness as a method of dealing with the crisis. A true leader understands that the world that existed prior to the crisis will not return to its original condition, therefore, we need leaders/manages that will understand how to benefit from those events that occurred during the crisis. During a crisis, true leaders are those who believe in people; create a feeling of belonging and confidence that the organization will emerge from the crisis in a stronger position than it was before the crisis. Leadership exists because of people. It is for people and with people that we get the concept of leadership. Leadership does not exist as a concept in a vacuum; it exists because it is with this concept that we, as a people, are able to achieve great things.

For years crisis management has been synonymous with reactive leadership. While this type of leadership is often an unavoidable reality, this paper introduced a model that may be used to understand the general life cycle of a crisis, but what is the utility of such a model?

Applied to specific situations, this model can serve as a lens through which leaders may view their organizations. This lens can frame the crisis and help leader’s understand the situation they are facing. Further, the model provides the leader perspective and context during the crisis. This perspective gives the leader a birds-eye view of the situation. The crisis life cycle model addresses the theory of crisis analysis, but the strength of the tool is put into practical terms when the crisis leadership strategies are applied to the model. The strategies represent the prescriptive portion of the paper. Knowing where an organization is in a crisis is not helpful unless the leader also knows how to manage this new reality.

We believe that each crisis situation is unique and therefore it is impossible to develop a checklist that can be universally applied. However, the theory and strategies addressed in this paper may serve leaders well, if used to think about where their organization may be in the life cycle of a crisis and the appropriate strategies to be employed to meet their unique challenges.

The intent of this paper is to provoke thought within leaders at every level concerning the management of crisis situations and leadership in this environment. The skills required to lead through disaster must be continually honed to prepare for, respond to, and learn from crisis.


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Kuhn, T. S. (1996). The structure of scientific revolutions. Chicago, IL: The University of Chicago Press. Leading through a crisis. (2009). Boston, MA: Harvard Business School Press. Lettow, P., & Mahnken, T. (2009). Toolbox: Getting serious about strategic planning. The American

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Industry and Firm Influences on Performance: Evidence from Polish Public Firms

Zbigniew Matyjas University of Lodz

This study examines the influence of industry and firm effects on performance of Polish listed companies. The study is based on the data on 387 companies listed on the Warsaw Stock Exchange in the period 2007-2010. Each of them has also been classified into a specific industry according to the Polish PKD classification (similar to NACE Rev.2). The results of this research show that industry effects have non-significant influence on companies' performance while one of the used models (with ROA as a dependent variable) showed significant influence of company effects. INTRODUCTION

Strategic management has been based on some basic assumptions that in a s mart way explain the scale and complexity of the problems affecting today’s companies. However, for some of these assumptions there are some difficulties with finding empirical confirmation. One of such assumptions is the importance of the industry factors for strategic decisions making, as well as companies performance. Strategy textbooks usually do not devote attention to this subject, occasionally you can see the importance of this issue in the extensions of the chapters (Grant, 2005).

Meanwhile, there has been a major discussion on the empirical confirmation of the industry impact for the last 30 years. Many research articles addressed this issue but the results are usually significantly differentiated. Most of the research was based on the results of U.S. companies, some related to the example of other mature economies (e.g. the UK, Japan). There is, in principle, lack of research confirming the importance of industrial factors on the performance of companies on the example of the emerging economies, particularly in Central and Eastern Europe.

Hence, the purpose of this study is to examine the impact of the firm and industry effects on t he performance of Polish companies (listed on t he Warsaw Stock Exchange). Given the significant differences in the development of the Polish capital market, you can also expect differences in the results of the proposed research. To the indicated differences between the markets (and companies) we can include, for example: a much greater level of concentration of ownership in the case of Polish companies in comparison to mature markets (Jeżak, 2010b), a two-tier board model as the only one in Poland to the dominant one-tier board model (Jeżak, 2010a), or the gender differences in the composition of management and supervisory boards (Bohdanowicz, 2012).


LITERATURE REVIEW

The first study to analyze the impact of firm- and industry factors on companies performance was conducted by Schmalensee (1985). The sample was the population of U.S. industrial companies, the reference year was 1975. The results strongly influenced future debate within this issue – it turned out that industry effects explained over 20% of the performance of examined companies compared to just less than 1% of firm effects. In Schmalensee’s opinion “the apparent nonexistence of firm effects is somewhat surprising. […] The absence of firm effects […] means that knowing a firm’s profitability in market A tells nothing about its likely profitability in randomly selected market B. This is consistent with the conglomerate bust of the past decade […]: wise firms do not diversify beyond their demonstrated spheres of competence” (Schmalensee, 1985, p.349).

Schmalensee’s research caused a major impact in industrial organization and strategic management research. The first response was p repared by Rumelt (1991). In his research the time frame was a bit longer (4 years), with the same sample. The results showed by Rumelt were almost completely inverse – this time firm effects were extremely important (explained almost 44% of the total performance of examined companies), with industrial effects responsible for just 4% of it.

Such a l arge discrepancy between these two articles caused an ongoing debate among researchers within industrial organization and strategic management areas. Rumelt’s research took into account a longer time horizon, which allowed to average the results - any deviation from the long-term annual average was much less important for the final result. But the question how much industry-level effects are influencing firms’ performance remained open. These early years of research were in fact summarized by McGahan and Porter (1997) – on the basis of their research they stated that both firm (32%) and industry (19%) effects are important for companies' performance. This time the time period was much longer (covered the years 1981-1994), the sample was much larger (covered all but financial industries).

The above results of early studies were just a prelude to a huge body of research within this area for the next 15 years. For over a decade there has been conducted many research articles which results are summarized in table 1.

Based on the data contained in the table we can see significantly increased interest in the problem of the industry (and firm) effects on companies performance. The samples were larger, time horizons longer than in the previous research, moreover some samples took into consideration data from SME’s (small and medium-sized companies) beside public companies. The key research results allow to draw some general conclusions:

- generally the initially assumed (both in strategic management and industrial organization) impact of industry effects on performance of companies can be confirmed in research, although it’s not as large as it was assumed;

- as in the early studies, the results of the recent ones indicate a large spread of the results. Industry effects range from 0.14% (almost complete lack of effect) to 40.6% (a very large effect). This implies the need for further research in this area;

- it should be noted that in general more important factors are firm effects – usually two to three times larger influence. However, it is also possible for most of the research to overlook the impact of intra industrial level – the level of strategic groups. The inclusion of this level in the studies could reduce the role of firm effects.


TABLE 1 SUMMARY OF THE RESULTS OF

PREVIOUS RESEARCH

Authors Method Sample/ country

Time horizon

Industry Effect

Firm Effect

Mauri and Michaels (1998)

VCA (1988-92) VCA (1978-92) 264 (USA) 1978-1992 6,2%

5,8% 36,9% 25,4%

Chang and Singh (2000)

VCA (entire sample) VCA (small firms) VCA (medium firms) VCA (large firms)

709 (USA) 1981-1989

7,3% 4,0%

40,6% 19,3%

47,2% 44,2% 8,8%

47,6%

Sakakibara (2002) Cox maximum-likelihood proportional hazard 312 (Japan) 1969-1992 - -

Ruefli and Wiggins (2003) OLS 1797 (USA) 1984-1996 0,14% 12,33%

Hawawini et al. (2003)

VCA ANOVA 562 (USA) 1987-1996 8,1%

16,0% 35,8% 16,7%

McNamara et al. (2005) VCA 2686 (USA) 1987-1996 9,1% 43,8%

Short et al. (2007) VCA ANOVA HLM

1165 1991-1997 19,3% 16,9% 19,2%

65,8% 71,8% 65,8%

Lee (2009) OLS 7158 (USA) 1987-2006 10,0% 10,0%

Bamiatzi and Hall (2009)

Entire sample (SIC4) Micro firms (SIC4) SMEs (SIC4) Large firms (SIC4)

71 750 (UK) 2002-2004

9,2% 10,2% 1,8% 1,8%

28,3% 28,2% 10,3% 21,2%

DATA AND METHODS

The primary objective of the study is to verify the impact of industry and firm effects on performance

of listed Polish companies. Data for this study were gathered from all Polish public companies whose values were listed at the end of the years 2007- 2010 on the Warsaw Stock Exchange. Each company selected for the study was also classified into a specific industry according to Polish PKD classification (analogous to NACE Rev. 2). Financial and commercial companies were excluded from the data due to preliminary assumptions of the study. Data were collected from the Amadeus database (companies listed on the Stock Exchange), a PONT-info database (industrial data), as wel l as the consolidated annual reports or reports of individual companies, if the company did not prepare consolidated reports (both of them were hand-collected).

Given the above assumptions the sample comprises 387 c ompanies and 1208 obs ervations. The composition of the companies changed from year to year depending on the availability of data. Hence the individual company may be subjected to from one to four observations. The industrial data and assignment of companies into selected industries are presented in Table 2.


TABLE 2 COMPANIES ACCORDING TO INDUSTRIES

PKD No. Industry No. of companies

10 Manufacture of food products 22 11 Manufacture of beverages 2 13 Manufacture of textiles 5 15 Manufacture of leather and related products 2 16 Manufacture of wood and of products of wood and cork, except furniture 8 17 Manufacture of paper and paper products 5 18 Printing and reproduction of recorded media 5 19 Manufacture of coke and refined petroleum products 3 20 Manufacture of chemicals and chemical products 10 21 Manufacture of basic pharmaceutical products and pharmaceutical preparations 5 22 Manufacture of rubber and plastic products 15 23 Manufacture of other non-metallic mineral products 13 24 Manufacture of basic metals 6 25 Manufacture of fabricated metal products, except machinery and equipment 21 26 Manufacture of computer, electronic and optical products 9 27 Manufacture of electrical equipment 6 28 Manufacture of machinery and equipment n.e.c. 17 29 Manufacture of motor vehicles, trailers and semi-trailers 4 31 Manufacture of furniture 3 32 Other manufacturing 3 33 Repair and installation of machinery and equipment 5 35 Electricity, gas, steam and air conditioning supply 12 36 Water collection, treatment and supply 2 38 Waste collection, treatment and disposal activities; materials recovery 4 41 Construction of buildings 35 42 Civil engineering 15 43 Specialized construction activities 16 52 Warehousing and support activities for transportation 7 55 Accommodation 2 56 Food and beverage service activities 8 58 Publishing activities 10

59 Motion picture, video and television programme production, sound recording and music publishing activities 6

60 Programming and broadcasting activities 3 61 Telecommunications 20 62 Computer programming, consultancy and related activities 44 63 Information service activities 12 68 Real estate activities 22

TOTAL 387 Variables

The analyzed variables were divided into three basic groups: characterizing the profitability of individual companies (thus representing firm effects), the profitability of the industry (industry effects),


and the control variables describing the size of the companies. List of all analyzed variables can be found in table 3.

TABLE 3

VARIABLES USED IN RESEARCH

Acronym Description of the variable ROA – firm level Return on assets – firm level ROS – firm level Return on sales – firm level ROA – industry level Return on assets – industry level ROS – industry level Return on sales – industry level Revenues (log) Overall revenues – firm level (natural logarithm) Total assets (log) Total assets – firm level (natural logarithm)

The list of the variables is similar to that used in previous studies (Bamiatzi and Hall, 2009). The

decision on the use of certain variables in the study was d ictated by the availability of these variables within the research project. Methods

The study was conducted with the use of panel data analysis. The general panel data model was specified as:

𝜋𝑖𝑡 =∝ +𝜌𝜋𝑖,𝑡−1𝛽Χit + εit (1)

for i = 1,…,N; t = 1, … , T where πit is the dependent variable for firm i’s profit rate in period t (ROA and ROS in two different panels), vector Xit includes independent and control variables such as: ROA and ROS of industry and scale of firm. The error term εit may vary across the N i ndividual firms (individual effects) as wel l as across the T time periods (time effects).

Panel data analysis enables simultaneous analysis in two dimensions (temporal and spatial), which makes possible to effectively analyze cross-sectional data. As pointed out by Lee (2009) it offers two advantages over traditional least-squares models: allows to control for unobserved factors (constant over time but differ from one firm to another), and allows to control for variables that vary through times, but not across companies. EMPIRICAL FINDINGS Descriptive statistics

Table 4 gives the mean, standard deviation, minimum and maximum values of the variables across all firm-years in the sample. There is a significant standard deviation within variables ROA and ROS at the firm level (it is particularly the case with ROS variable) – it is due to a financial performance of two small firms. All results are depicted in graph 1.


TABLE 4 DESCRIPTIVE STATISTICS

Variable Mean Std. Dev. Minimum Maximum Observations

ROA – firm level 4.35369 26.59072 -388.5294 150.6329 1208 ROS – firm level 5.19941 1619.051 -55220.00 3918.239 1208

ROA – industry level 6.118493 3.595412 -9.590000 32.34000 1208 ROS – industry level 5.783212 3.523021 -12.03000 24.13000 1208

Revenues (log) 3.997107 2.257319 0.000000 11.34236 1208 Total assets (log) 4.116757 2.288549 0.000000 10.90500 1208

Table 5 gives the correlation matrix between the variables. As you can observe there is a significant correlation between relative types of variables: ROA and ROS at firm level, ROA and ROS at industry level, and control variables (revenues and total assets).

TABLE 5 CORRELATION MATRIX

Variable ROA – firm ROS – firm ROA – industry

ROS – industry

Revenues (log)

Total assets (log)

ROA – firm 1.000000 ROS – firm 0.112221*** 1.000000

ROA – industry -0.007651 0.044352 1.000000 ROS – industry 0.003940 0.026215 0.776551*** 1.000000 Revenues (log) 0.153865*** 0.064667** -0.075285*** -0.145312*** 1.000000

Total assets (log) 0.124243*** 0.041427 -0.146717*** -0.149876*** 0.934934*** 1.000000 Notes: * significant at 10% ** significant at 5% *** significant at 1%


FIGURE 1 THE DISTRIBUTION OF DATA

Regression Analysis

Results of estimation are reported in table 6. Analyses were conducted separately for two dependent variables: ROA and ROS of the firm. These two models gave different results, particularly in terms of the significance of firm-level effects influencing firm performance. In model 1 (ROA) there is a significant influence of the lagged profit rate (ROAi,t-1) as an important factor influencing its performance. There is also a significant influence of the second firm-level effect used within this study – ROS at the level of the firm. The results of model 1 s trongly support the thesis about the advantage of firm-level effects over industry-level effects.

Results for model 2 don' t show any significant influence, both at the company, as well as on t he industry level, on firm performance. The only significant variable is a control one (revenues calculated as natural logarithm). But the adjusted R2 statistics indicate that this model accounts for less than 1% of the overall variance of the dependent variable.


The results of these study are somewhat consistent with an earlier results obtained in the research conducted by Matyjas (2011) on the sample of 85 Polish public companies for the years 2005-2007.

TABLE 6

OLS REGRESSION RESULTS

Model 1 Model 2 ROA – firm level ROS – firm level ROA – firm level (t-1) 0.299175*** - (11.90120) - ROA – firm level - 5.310779 - (1.552311) ROS – firm level (t-1) - -0.007222 - (-0.209117) ROS – firm level 0.000901** - (2.295157) - ROA – industry level -0.212950 45.96916 (-0.524315) (1.274500) ROS – industry level 0.333530 -23.34856 (0.929721) (-0.733731) Firm size – revenues (log) 1.131654 181.4452** (1.116383) (2.055591) Firm size – total assets (log) -0.280116 -139.0507 (-0.281674) (-1.599789) Constant -3.450780 -359.5576* (-1.516869) (-1.787077) Adjusted R2 0.170802 0.008046 Observations 842 839 Log likelihood -3778.579 -7521.904 F-Statistics 29.87216 2.132885 Notes: t-statistics are in parentheses. * significant at 10% ** significant at 5% *** significant at 1%

CONCLUSIONS

To sum up the above studies conducted with regard of the current state of knowledge it should be

noted that the great interest of researchers in the world taking up the issue of industry effects on companies' performance is not a coincidence. Theoretically the level of an industry has a strong influence on strategic decision-making in every company – that’s one of the key principles of strategic management.

Further research in this area seems to be appropriate, with particular emphasis on Polish (and other Central and Eastern Europe markets) specificity. The development of emerging economies often took place in a completely different way from established routines of many developed economies. And it can also affect the results of similar studies. Further studies in this area should take into account somewhat broader spectrum of the analyzed variables, particularly at the level of individual companies (for example, expenditure on R & D, capital expenditures, or advertising expenditures).

In addition, further studies should benefit from a comparison of the simultaneously conducted quantitative tools (e.g. nonparametric methods or variance components analysis). This would increase the accuracy of the conclusions based on the results of similar studies with simultaneous use of several statistical tools.


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A Synthesis of Leadership Theories and Styles

Eric A. Landis Cumberland University

Deborah Hill

Amberton University

Maurice R. Harvey St. Leo University

Discussion is often heard concerning the downward spiral of modern organizations due to inadequate, uninspired leadership; hence, it is imperative to continue to focus attention on the many various theories of leadership that have been employed throughout history. It is crucial to place exceptionally talented, knowledgeable leaders in positions of prominence in modern organizations in order to expect and ensure optimum success. “Leadership is one of the most widely talked about subjects and at the same time one of the most elusive and puzzling” (Wren, 1995, p. 27). As the notion of exemplary leadership is advanced, the challenge is to find ways to teach people how to become prestigious, creative leaders in today's challenging business society. In striving to accomplish this goal, a succinct review of the history of leadership theory will be analyzed and synthesized, providing an in-depth exploration of leaders past and present. “There are almost as many different definitions of leadership as there are persons who have attempted to define the concept” (Bass, 1990, p.11). Leadership has been described “in essence, a process: a series of actions and interactions among leaders and followers which lead to the attainment of group goals” (Wren, 1995, p. 325). In an effort to thoroughly comprehend the different theories reviewed, this article will focus on the theories of leadership and define strategies that will maintain a collaborative working relationship and respectful team environment in a group setting. HISTORICAL PERSPECTIVE OF LEADERSHIP

Bass cites that "great leaders were important in the development of civilized societies” (Bass, 1990, p.3). Attention also was focused on civilization and the emergence of leadership, with its ability to shape leaders and leaders who had the same ability to shape civilization. Throughout the centuries, attention has been called to the development of good leaders. One of the earliest recorded leadership reports describes the plight of Moses.

“Time and again, Moses demonstrated leadership traits that are highly prized today. Because we live in the information age, where ‘facts’ evolve daily and the global marketplace is constantly shifting beneath our feet, the skills Moses used to lead his people through the wilderness are extremely relevant: being flexible, thinking quickly, sustaining the confidence of your people in uncertain times, and creating rules that work for individuals from widely diverse backgrounds” (Baron, 1999, p. xiv-xv).


In addition, Chinese history states that under the leadership of Confucius, a moral example was set. Plato expressed the idea that the leader was the most important person in government. Aristotle advanced the notion that political leaders lacked meaning and virtue. Leaders such as Machiavelli cited the need that leaders should be firm and steady. One of the most profound concepts in early leadership perspectives can be found at West Point Military Academy where Hegel’s (1930/1971) Philosophy of Mind asserts that leaders must first learn how to follow before they can lead. APPLICATION OF LEADERSHIP

Leadership has been considered one of the most important components in the success of organizations. Maccoby (1979) concluded from his observations that the need of firms to survive and prosper in a world of increasing competition, of technological advances, of changing governmental regulations, of changing worker attitudes, requires “a higher level of leadership than ever before” (p. 313). When organizations experience change, it is imperative that their organizational leadership is adequate to meet the challenge.

Leadership application gradually evolved throughout history. I n the United States during the 20th century, numerous experiments assisted in the evaluation of the importance of leadership in organizations. “Between 1971 and 1981, Katzell and Guzzo (1983) concluded that supervisory methods seemed particularly effective in increasing output” (Bass, 1990, p.8). In 1974, Hansen commented that Ford Motor Company was able to close a plant without disturbing or relocating staff. The success of that move was attributed to the application of effective leadership. Military successes also have been attributed to outstanding leadership application. “Leadership has been considered a critical factor in military successes since records have been kept; that is better-led forces repeatedly have been victorious over poorly led forces” (Bass, 1990, p.9). LEADERSHIP THEORIES AND THEORISTS

“If a theory of leadership is to be used for diagnosis, training, and development, it must be theory-grounded in the concepts and assumptions that are acceptable to and used by managers, officials, and emergent leaders” (Bass, 1990, p.37). In an attempt to extract the most crucial theories and models of leadership, the major components of the theory and the implications surrounding them must be reviewed. Bass and Wren expressed leadership theories as they related to the nature of leadership and the different variables involved. William James (1880) suggested that great men brought about changes in society. “The history of the world, according to James, is the history of Great Men; they created what the masses could accomplish” (Bass, 1990, p. 37). Adherent to the Great Men theory, women leaders were virtually ignored. Credence was seldom bestowed upon women leaders such as Catherine the Great, Elizabeth I, and other great female leaders; however, male leaders, such as Martin Luther King, John F. Kennedy, and military leaders were hailed as esteemed great men. An interesting idea of early theorists advanced the point of view that leadership was directly related to inheritance. Wiggam posited that strong leaders survived and produced an aristocratic class that was biologically superior to others. Although strongly believed by some, “Dowd (1936) maintained that there is no s uch thing as leadership by the masses” (Bass, 1990, p.37).

Other theorists expressed the idea that leaders should possess qualities that are evident to those around them. This idea developed the conceptual framework for the trait theories of leadership (Kohs & Irle, 1920). L.L. Bernard (1926), Bingham (1972), Tead (1929), Page (1935), and Kilbourne (1935) all of whom explained leadership in definition of traits of character and personality (Bass, 1990, p. 38). Stodgill (1948) criticized the trait theory and asserted that the person and the situation must be considered as well.

Arguments for the significance of the situational theory suggested that situational factors had an important effect on leadership. In the United States, many researchers favored the notion that leaders were born and not made. The leaders recognized that the situation called for certain types of action; the leader did not inject leadership, but was the instrumental factor through which a solution to a problem was


achieved (Murphy, 1941). Situational theorists argued that great leaders emerged as a r esult of place, circumstance and time (Bass, 1990). “Person (1928) expressed two hypotheses in relations to leadership: (1) any particular situation plays a large part in determining leadership qualities and the leader for that situation and (2) the qualities in an individual that a particular situation may determine to be leadership qualities are themselves the product of a succession of previous leadership situations that have developed and molded that individual” (Bass, 1990, p.39).

Personal-situational theories express the belief that war and crises provide an opportunity for leaders to emerge. William James asserted that great men needed assistance with talents necessary to meet the needs of the situation. “Personal-situation leadership to be understood demands attention be paid to (1) the traits and motives of the leader as a man (2) images that selected publics hold of him and their motives for following him (3) the features of the role that he plays as a leader, and (4) the institutional context in which he and his followers may be involved” (Gerth & Mills, 1952, p. 405). Bass (1990) stated that “several reasons accounted for some of the variance in what happens is due to the situation, some is due to the individual, and some is due to a combining effects of the situation and the individual” ( p. 40).

The political theory espouses the idea that the wealthy, military, state and church should rule and lead the masses. The political leader must compete for approval from the people and recognize the wants and needs of potential followers. Another aspect of the political theory emphasizes respect for the minorities while making decisions based on the vote of the majority.

“The theories of McGregor, Argyris, Likert, Blake and Mouton, Maslow, and Hersey and Blanchard were concerned with development of the individual within an effective and cohesive organization” (Bass, 1990, p. 43). McGregor postulated two types of theories still prevalent in organizations. Theory X and Theory Y attempt to describe how people relate to some organizations today. Theory X states that people are directed and will not produce unless coerced or made to produce in an organization. Theory Y is based on an assumption that followers will fulfill the needs of the organization because they are already motivated to do s o. Argyris (1957) provided a different viewpoint between the organization and the individual. He described his maturity-immaturity theory as the individual’s nature being that of self-discipline and the organization providing the means where individuals can make a creative contribution. On the other hand, Likert (1961a, 1961b, 1967) “suggested that leadership is a relative process in that leaders must take into account the expectations, values, and interpersonal skills of those with whom they are interacting” (Bass, 1990, p. 43). He further explained that effective leaders keep the needs of followers in mind when decisions were made, helping to advance the careers of followers by using their own influence as a leader. In terms of the theory under review, Blake and Mouton (1964, 1965) expressed different viewpoints. Their concept was based on the conceptualization that concern for the organization and the individual were separated. If leaders were concerned for the individual, then their concern for the organization had to be lower than the concern for the individual. They expressed these beliefs on a managerial grid. Leaders who rated the individual and the organization high would produce followers who had a commitment to their work and the organization they represented. During the same time, Maslow’s Theory of Eupsychian Management (1965) made mention the importance of managers supporting their subordinates and contributing positively to their self-esteem. This measure was important because it “emphasized a n eed for self-actualization, so that everyone would have the opportunity to become what he or she had the capacity to become.

The introduction of the leader-role theory suggested the concept that situations and individuals combine or interact in such a way to bring about the emergence of leaders. During this course of interaction, groups become structured in terms of positions and roles (Bass, 1990). Characteristically, leaders perform the way they are expected to perform according to the way their roles are defined. Kahn & Quinn expressed the idea that “managers ordinarily must cope with conflicts among the different sources of information about their roles” (Bass, 1990, p. 44). Hunt, Osborn and Martin believed leaders in units where policies and procedures were followed had a tendency to have more leadership boundaries and discretion than leaders who were regulated in other ways.

Fiedler’s contingency theory (1967a) noted that the effectiveness of leaders who were task oriented and relations-oriented coordinated with the demands of the situation. However, a leader that is task


oriented will be effective in any given situation, whereas the relations-oriented leader will be most effective in situations between the two extremes. Fielder believed it was imperative to leaders' success to place individuals in situations that aligned with their skills. “A situation is favorable to the leader if the leader is esteemed by the group to be led; if the task to be done is structured, clear, simple, and easy to solve; and if the leader has legitimacy and power owing to his or her position” (Bass, 1990, p.47).

Exchange theories posit that leaders receive status from the group in exchange for goal accomplishment. The power of the leader becomes depleted when members discharge their obligations to the leader (Bass, 1990). T.O. Jacobs advanced the idea that a l eader is as g ood as t he group and their status and esteem correlates with the leader’s commitment to the group in assisting them in attaining their goals. According to Kaplan and Lasswell, exchange can be achieved between the leader and the follower.

W.E. Scott (1977) articulated ideas to replace the idea that leaders changed the behavior of subordinates. The behavioral theory identified the need to replace the conception that leadership is due to influence or persuasion with analysis of the observable behavior of leaders that change the behavior of followers (Scott, 1977). Bass acknowledged “the day to day behaviors of the leader may be relatively unimportant to the supervisor-subordinate relationship compared to the leader’s behavior when a subordinate experiences an intense demand or when a leader experiences a highly unexpected response” (Bass, 1990, p.49). A review of a study performed by Sims (1977) provided research that concluded if a leader evidenced positive behavior toward the subordinate, workers' performance improved.

The communication theory was based upon the use of rhetoric in small groups in regards to the emergence of a l eader (Bass, 1990). Research was conducted by Sharf (1978) and created a rhetorical framework derived from a theory developed by Burke (1969). In his research to analyze the success of leaders in small groups, he sought to reveal the importance of leaders attaining cooperation from members in the group. According to Sharf, the analyses revealed how important it was for the leader to go beyond the symbolic divisions in an evolving leader.

In review of the theories of leadership, the attribution theory will be the final theory discussed. “This theory posits that every leader and follower has his or her own implicit theory of leadership” (Bass, 1990, p.49). In order to understand the leader, the behavior of the leader must first be understood, along with their thought process in regards to the situation they are experiencing at the time (Pfeffer, 1977). CONCLUSION

The ideas expressed by Bass and Wren suggest that there is some relationship between divergent theories and leadership styles. Although some of the theories in this review were established years ago, they continue to provide an important blueprint for current leaders. As the 21st century progresses, it will be advantageous and necessary to continue to investigate and examine the importance of acquiring and applying exemplary leadership skills. REFERENCES Baron, D. (1999). Moses on management: 50 leadership lessons from the greatest manager of all time.

New York: Pocket Books. Bass, B.M. (1990). Bass & Stogdill’s handbook of leadership, 3rd edition. New York, NY: The Free

Press. Maccoby, M. (1979). Leadership needs of the 1980’s. Current issues in higher education, 2, 17-23. Murphy, A.J. (1941). A study of the leadership process. American Sociological Review, 6, 674-687. Wren, J.T. (1995). The leader’s companion: Insights on leadership through the ages. New York: The Free

Press. Yukl, G.A. (1981, 1989). Leadership in organizations. Englewood Cliffs, New Jersey: Prentice Hall.


Do Mobility Barriers Affect the Strategy-Performance Relationship? A Study

Based on Chinese Listed Pharmaceutical Companies

Xiao Duan Tsinghua University

Zhan-Ming Jin

Tsinghua University

Literature shows that mobility barriers can maintain existing performance differentials across strategic groups. We propose that mobility barriers also play a moderating role in the strategy-performance relationship. Our sample contains Chinese listed pharmaceutical companies during 2010 to 2011. One of our findings is mobility barriers do not necessarily bring performance differentials. Another finding is the strategic choice between cost leadership and differentiation has opposite effects on firms on the two sides of a mobility barrier, and sales strategy also has different effects on them. Partitioned by mobility barriers, firms ought to consider their relative positions when making strategic decisions. INTRODUCTION

A fundamental issue in strategic management and relevant fields is to find and explain the heterogeneity within industries. Many business scholars and practitioners have realized that firms in the same industry still vary in key aspects of firm strategy and in performance. But researches have not fully revealed the causes, mechanisms, and influences of the differences up to date. Resource-based view and strategic group are two typical theories aiming to describe and explain the intra-industry heterogeneity. Resource-based view explains the performance variation within industry in terms of firms’ idiosyncratic resources. It assumes that resources are distributed heterogeneously across firms and cannot be transferred without cost (Barney, 1991). Resource-based view regards firms’ key strategic resources as the source of sustained competitive advantages (Wernerfelt, 1984; Barney, 1991; Peteraf, 1993; Newbert, 2008). For instance, Barney (1991) specified that organizational resources that are valuable, rare, difficult to imitate and non-substitutable can yield sustained competitive advantage. Resource-based view succeeds in providing a structured conceptualization of how achieved competitive advantage can be sustained, but it has rather great difficulty in explaining where competitive advantage stems from (Priem and Butler, 2001). In other words, the value of a resource is exogenous to the resource-based view. Though resource-based view excels in enlightening managers to protect firms’ existing advantages, it evades the core issue of why firms in the industry get different performances.

Strategic group theory explains the intra-industry heterogeneity from a perspective different from the resource-based view. Hunt (1972) first used the term “strategic group” to describe a structurized industry where firms can be categorized into a small number of groups that differ from each other in some critical decision variables. In literature, strategic group is commonly defined as a cluster of firms carrying out


similar competitive strategies and competing with each other in an industry (Porter, 1980; Cool and Schendel, 1987). Strategic group theory attributes the intra-industry performance variation to the strategies carried out by different groups. Firms in the same strategic group would adopt similar combination of strategies, and deploy their resources in roughly the same way (Cool and Schendel, 1987); thus it is not surprising that they achieve similar profits. In contrast, firms in different strategic groups differ significantly in the combination of key strategic dimensions, such as vertical integration, operational size, scope of product or service, and special knowledge and technologies (Hunt, 1972; Newman, 1978; Thomas and Venkatraman, 1988; Mascarenhas and Aaker, 1989), and therefore their performances vary greatly. This can help to explain why firms implementing a certain pattern of strategy are more profitable than others in an industry. It is reasonable to believe that firms get high profits because they choose the correct strategies to adapt themselves to the changing environment.

Strategic group theory also gives explanation on how competitive advantages can be sustained. An intra-industry force that imposes isolation on strategic groups, namely mobility barrier, is thought to be the source of sustained advantages (Caves and Porter, 1977; Caves and Ghemawat, 1992). Mobility barriers are structural forces preventing firms in the industry from shifting from one strategic group to another (Caves and Porter, 1977; Porter, 1979). Firms from outside a strategic group have to pay much for the entry, whereas members of the group need not (McGee and Thomas, 1986). By keeping most firms staying in their current strategic groups, mobility barriers stabilize the group structure and maintain the performance differentials across strategic groups (Mehra and Floyd, 1998). Mobility barriers may originate from three broad types of factors and their interactions: characteristics of industry, e.g. the supply characteristics; firm-specific features, such as t he organizational structure, control systems, management skills, etc; and the nature of firm ownership (McGee and Thomas, 1986). And finally, mobility barriers may take the form of firm-level attributes that reflect relative competitiveness, including production capacity, amount of capital, scope of products or services, leadership in technology, and the preemption of distribution channels (Caves and Porter, 1977; McGee and Thomas, 1986; Mascarenhas and Aaker, 1989). To enter target strategic groups, firms have to accumulate resources and build up competencies to cross over the barriers. Recognizing that mobility barriers widely exist in industries, it is natural to regard the group membership not as free choices by firms but as the result of long-term competitions.

Strategic group does not bear the fundamental defects in resource-based view, such as tautology, static logic, all-inclusive definition of resource, etc (Priem and Butler, 2001). In addition, strategic group theory better suits the cognition habit of managers, for in the real work they tend to categorize competitors into several classes with distinctive characteristics (Reger and Huff, 1993). Instead of seeing each firm as a u nique individual, which is implicitly hold by the resource-based view, strategic group theory perceives firms in an industry in terms of clusters. Perceiving firms in terms of groups helps managers to save their time and attention which are scarce resources in the complex environment when making strategic decisions.

Though strategic group theory provides a clear description of the intra-industry heterogeneity, it still has some unclarities in the theoretical foundation. This research will give a thorough analysis on these questions and seek further clarification of some fundamental assertions in strategic group research. And we shall give advice to management practitioners on the basis of findings in this research. THEORETICAL BACKGROUND AND RESEARCH HYPOTHESES Performance Differences across Strategic Groups

In strategic group literature, great attention has been paid on the comparisons between strategic groups. Strategic groups are found to be different in the average firm size, vertical integration, scope of products, reputation, advertisings, R&D investment, and mobility rate of group members (hunt, 1972; Newman, 1978; Oster, 1982; Fiegenbaum and Thomas, 1993; Ferguson et al., 2000; Lee et al., 2002). Among those comparisons, the one receiving most concern is performance comparison between groups. Many empirical studies have found significant differences in financial or market performance across


strategic groups (Porter, 1979; Mascarenhas and Aaker, 1989; Fiegenbaum and Thomas, 1990; Mehra, 1996; Nair and Kotha, 2001). However, there are also studies that didn’t find such differences (Cool and Schendel, 1987; Mehra, 1996; Guedri, 1998). McNamara et al. (2003) even found that performance differences within groups are larger than between groups, suggesting that some firms developed much stronger competences than others in the same group. From those testing results, we may get an impression that the performance differences across groups appear to be accidentally and unpredictably. Whether significant differences necessarily exist between strategic groups is still unknown.

Moreover, the methodologies used in strategic group researches have some defects. While performance differences are found across strategic groups in some industries, a simple ANOVA test can not reveal the causality between group membership and firm performance, because it cannot offer a clear logic and lacks basic control variables. Perhaps for the same reason, we could not find out why previous testing results of performance comparison are so inconsistent. Actually, it is quite difficult to regard either the studies having found performance differences or those having not as erroneous, as m ost of them followed similar research designs and were rigorously conducted. Thus, an inference can be preliminarily drawn that a universally correct relationship between group membership and firm performance may not exist. On the other hand, as strategic group theory can contribute to the understanding of industry environment and firms’ decision-making, predicting performance difference is not absolutely essential in strategic group theory (Reger and Huff, 1993). The Separation Effect of Mobility Barriers

As analyzed above, previous studies have obtained inconsistent results in performance comparison between strategic groups. Having noticed that some unprotected strategic groups may be stable only in short terms and their performances are also unstable (Mehra and Floyed, 1998), we should take mobility barriers into consideration to get a clearer picture of that question. Mascarenhas and Aaker (1989) also mentioned that mobility barriers were more closely related with firm performance than some generic strategic variables.

One mobility barrier typically separates all firms in the industry into two groups with asymmetrical positions (Harrigan, 1985). The asymmetry means that firms face differing levels of difficulties when moving across groups in opposite directions. For instance, if firms’ operational size is one of the mobility barriers in an industry, moving from the group whose members have a greater size into the group whose members are averagely smaller would be much easier than moving reversely. There might be no incentives for a large firm to move into the small-sized group, as firms usually seek the opportunity of growth. But as far as the difficulty of shifting is concerned, members of the large group face much less serious impediments when shifting to the other side. In this sense, mobility barrier acts as a p rotection against entry by potential movers for firms on the advantaged side (Caves and Porter, 1977). When more than one kind of mobility barrier is considered, it is more difficult to enter a group protected by higher mobility barriers than to enter a group protected by lower barriers (Hatten and Hatten, 1987). Firms in well protected strategic groups are in dominant positions in the competition, and firms in poorly protected strategic groups are more vulnerable to external entrants.

Figure 1 shows the relative positions of strategic groups separated by a mobility barrier. In this figure, hollow points represent firms in the industry, two circles wherein firms spread stand for the boundary of two strategic groups. The line in the middle denotes any kind of mobility barriers, for instance, the firm size, technologic leadership, special sources of funds, or whatever plays a r ole of barrier to mobility. Strategic group A is on the advantaged side and its members could shift to the other side of the mobility barrier easily, though they generally lack the incentives to do so. Strategic group B is on the disadvantaged side, and its members need to make much greater effort to move to the other side.


FIGURE 1 SEPARATION EFFECT OF MOBILITY BARRIERS

Mobility Barriers and Firm Performance

As an intra-industry structural force, mobility barriers have been explicitly thought of as the factors associated with sustained profit differentials within industry (Porter, 1979; Caves and Ghemawat, 1992). Porter (1979) noted that the height of mobility barriers protecting a particular strategic group determines the potential profitability of the group. The relationship between mobility barriers and sustained performance differentials is summarized as below.

Firms in an industry may earn different levels of profits due to many reasons. For instance, a crucial reason is they implement different competitive strategies. If mobility barriers do not exist, firms in the high performing groups would be easily imitated by potential entrants, thus the performance differences within the industry cannot last for long. In fact, mobility barriers exist in most industries. Strategic groups protected by mobility barriers are shielded from entry. The higher the mobility barriers protecting a strategic group are, the more completely the entry is deterred, and the less intense the intra-group rivalry will be. Therefore, the high profits are less likely to be competed away in groups that are well protected.

Though this relationship seems quite logical, some questions about mobility barriers and firm performance remain unsettled. Strategic group theory implicitly attributes the initial performance differences to the strategies employed by firms, but it d oesn’t predict that intra-industry performance differences are certain to occur. In other words, we have not yet known whether mobility barriers play a role in deciding or influencing firm performance. The only thing that is commonly accepted about mobility barriers is they are capable of sustaining competitive advantages and above-average profits. However, sustaining existing advantages is different from producing advantages.

We plan to explore the role of mobility barriers by asking two questions:

Question 1: Do mobility barriers directly determine firm performance? In other words, do firms on advantaged and disadvantaged sides of a mobility barrier necessarily have different levels of profitability? Question 2: Do mobility barriers influence the relationship between strategies and firm performance? In other words, do the effects of carrying out certain strategies depend partly on the positions where firms stand?

Before testing empirically, we give analyses and propose hypotheses on the basis of previous studies

on strategic group.

Strategic Group A Strategic Group B

The Advantaged Side

The Disadvantaged Side


Mobility Barriers and Performance Difference For Question 1, we are inclined to think that groups partitioned by a certain mobility barrier do not

necessarily differ in performance. A high mobility barrier is able to protect group members from entry by firms from the outside (Caves and Porter, 1977; Harrigan, 1985), thus the high profits of those members are probably to last. But what if a wel l protected strategic group is enduring a low profit rate? That is possible since mobility barrier is not the guarantee of success. Many other factors could influence firm performance, such as the ability to organize and manage operations, develop creative advertisings, make technological breakthroughs, etc (Porter, 1979). We can further illustrate this in Figure 1. When the average profitability of strategic group A is higher than that of strategic group B, members of group B couldn’t easily move into group A, and therefore the high profitability of strategic group A is likely to continue. Nevertheless, when the average profitability of strategic group A is lower than or equals to that of strategic group B, members of group A would probably not move to group B for higher profits. The first reason is that the average profitability of strategic groups may experience periodic fluctuations. Most managers would not impetuously change firm strategies when facing slow growth. Secondly, some irrational factors, for instance, firm owners’ ideological persistence, will complicate the strategic decision-making and hinder the strategic transformation. Many firms in well protected strategic group would not shift rashly to other groups when suffering from low profit rates for a short period. Then we propose:

Hypothesis 1: Performance differences do not necessarily exist between the advantaged side and disadvantaged side of a mobility barrier.

Different Effects of the Same Strategy

The protection provided by mobility barriers is thought to act as the foundation of maintaining the differentials in firms’ relative positions (Porter, 1979). From the perspective of strategic group, the rivalry within an industry can be divided into intra-group and inter-group rivalries. Members of the same strategic group are similar in product scope and resource deployment, so they tend to aim at the same market segments (Caves and Porter, 1977; Cool and Schendel, 1987). But firms do not only participate in intra-group rivalry. They will judge independently where to compete according to specific industry environment. Cool and Diericks (1993) found that the inter-group rivalry played a key role in affecting firm profitability and held an increasing proportion to industrial competitions.

When members of different strategic groups compete for the same market segment, the effects of carrying out a certain strategy by firms may vary. For instance, the outcome of the choice between cost-leadership and differentiation strategies by a firm may be influenced by firms from other groups. In a market where products with high quality and distinctive features sell well, the optimal competitive strategy would be differentiation if there is only one strategic group in the industry. But in most industries, firms are partitioned by mobility barriers into strategic groups with asymmetric competitive positions. Strategic groups vary in capabilities of product design, manufacturing, advertising, and marketing. As a r esult of competition, only a f ew advantaged groups could benefit from adopting the differentiation strategy. Other strategic groups may have to choose the cost-leadership strategy, because group members who insist on di fferentiating products would be beaten in the markets by advantaged groups that adopt differentiation strategy and thus suffer great loss. We can see t hat whether a cer tain strategy brings benefit to a firm is practically determined by the strategic choices of advantaged groups. Given that most firms are rational, members of the advantaged groups, which are protected by important mobility barriers, will choose the most favorable strategy. Firms from disadvantaged groups may confront more inter-group rivalry if they also adopt that strategy. Under the partition of mobility barriers, the adoption of a certain strategy could show very dissimilar or even opposite effects on firms from different strategic groups. Hypothesis 2 is proposed based on above analyses:

Hypothesis 2: Under the partition of mobility barriers, the same strategy may show significant different effects on firm performance across strategic groups in the industry.


The relationships between mobility barriers, firm strategy and performance difference are summarized in Figure 2. The four relations mentioned in our study are represented by arrows and marked with numbers in the circle. Relation 1 denotes that the formulation and implementation of strategies cause performance differences. Relation 2 implies that mobility barriers maintain the achieved competitive advantages and hence the differences in performance. Relation 1 and 2 have been commonly recognized by studies on strategic group. Relation 3 and 4 are our research hypotheses. Relation 3 tests whether mobility barriers directly cause performance differences. Relation 4 tests whether the effects of firm strategies on performance is influenced by mobility barriers.

FIGURE 2 RELATIONSHIPS BETWEEN FIRM STRATEGY, MOBILITY

BARRIERS AND PERFORMANCE

METHOD Sample and Data

Our sample contains Chinese listed pharmaceutical companies from 2010 to 2011 (on Shenzhen Stock Exchange and Shanghai Stock Exchange). We do not use the data before 2010, because many pharmaceutical companies were listed in 2009 and they were not included in databases. Companies that focus on veterinary products, which are very different from medicines used for human in many aspects, are not our target firms and hence excluded. The data are mainly acquired from two Chinese financial databases: CSMAR Solution and WIND financial database. Other data are collected by authors from annual reports. We collect the sample from only one industry because mobility barriers might be industry-specific (Mascarenhas and Aaker, 1989; Fiegenbaum and Thomas, 1990; McGee and Thomas, 1986). Though multi-industry studies can provide larger numbers of observations, the meanings and relative importance of critical strategic variables in different industries are unlikely to be identical. Actually, almost all strategic group studies are single-industry based. Measurement

1. Cost Leadership or Differentiation (CoDStr). This independent variable is measured by the ratio of cost of sales to administrative expense. This measure is not comparable across industries, but in a single-industry context, it reflects the inclination of the firm’s choice between cost leadership and differentiation strategy. Generally, a greater value of CoDStr indicates that a f irm spends more on the material and


manufacturing rather than office management, consultation, and R&D, thus the firm is more likely to be implementing the cost leadership strategy.

2. Sales strategy (SalStr). This is another independent variable in our study. It is measured by the ratio of selling expense to sales revenue of the firm. A greater value of SalStr implies that the firm sells its products more aggressively.

3. Firm performance. We use return on equity (ROE) as the indicator of firm performance, which is the dependent variable in this study. Return on e quity is one of the most commonly used financial indicators in firm studies.

4. Mobility barriers. We refer to the literature in strategic group research to identify potential mobility barriers (e.g. Porter, 1979; Cool and Schendel, 1987; Bogner et al., 1996; Leask and Parker, 2007).

(1) Ownership barrier. Institutional environment can affect the rules of competition and the formation of strategic groups (Tywoniak et al., 2007). In China, companies’ ownership type might have particular influences (Peng et al., 2004). A dummy variable Own is set to indicate the ownership type. Own equals to 1 when the firm is ultimately controlled by Chinese government or institutions, and equals to 0 when the firm is ultimately controlled by individuals.

(2) Firm size barrier. The operating size of firms is thought to be of great importance in many strategic group studies (Porter, 1979; Cool and Schendel, 1987; Guedri, 1998; Leask and Parker, 2007). The natural logarithm of total assets is used as the indicator of firm size. We calculate the average size for each company over the two years. Then the company will be categorized into the Large_Size group if its size is larger than the median value of all companies in our sample, and into the Small_Size group if its size is smaller than the median value.

(3) R&D barrier. Technological capacity is of special importance to pharmaceutical companies. Long-term investment in R&D can improve firms’ dynamic capabilities and act as a mobility barrier in the emergence of strategic groups (Lee et al., 2002). The investment in R&D is measured by the ratio of R&D expense to sales revenue over the year. The company will be categorized into the High_R&D group if its R&D investment is larger than the median value of all companies in the sample, and into the Low_R&D group if its R&D investment is smaller than the median value.

(4) Foreign sales barrier. Chinese pharmaceutical companies are making great efforts to expand foreign sales, which reflect the ability of internationalization. But it is not easy for many of them to increase foreign sales due to disadvantages in scientific research, manufacturing technologies, marketing channels, and the number and quality of patents. The barrier of foreign sales is measured by the proportion of sales from foreign markets in total sales of the company. The company will be categorized into the High_FRS group if its foreign sales proportion is larger than the median value of all companies in the sample, and into the Low_FRS group if its foreign sales proportion is smaller than the median value.

5. Control variables. (1) Time period. The dummy variable Year2011 equals to 1 when the data is from the year of 2011, to 0 when the data is from 2010. (2) Ownership concentration. OwnCon equals to the sum of stocks shares held by ten largest shareholders of the company. A greater value of OwnCon means the company’s ownership is more concentrated. (3) Corporate diversification. The variable Diver measures the proportion of sales in industries other than pharmaceutical industry in the total sales. A greater value of Diver means the company is more diversified. The natural logarithm of Diver will be used in regressions because it is rather right-skewed in our sample. (4) Debt to assets ratio. DAR is the ratio of amount of debt to the total assets. (5) Current ratio. CR measures the ratio of current assets to current liabilities. (6) Inventory turnover. ITO is a ratio of the costs of goods sold to the average inventory of the company, showing how many times a co mpany's inventory is sold and replaced over a year. (7) Accounts receivable turnover. ARTO is the ratio of net credit sales to the average accounts receivable. (8) Assets structure. NCAP is the proportion of a firm’s noncurrent assets in its total assets. Models

To test Hypothesis 1, we will conduct two mean-comparison tests: an independent-sample t-test and a nonparametric test. Return on equity (ROE) is the indicator of firm performance. To test Hypothesis 2, we choose the fixed-effect model regression because the sample contains two-year panel data where the


individual-specific effects among firms ought not to be ignored. The F-test also rejects the null hypothesis that all individual-specific effects are insignificant (P < 0.001), indicating that pooled OLS should not be used here. Variables relating to mobility barriers are constant during the two years in our research so that their coefficients won’t be estimated if they are set in the fixed-effect regressions as dummy variables. Therefore, for each kind of mobility barrier, observations will be divided into two groups and put into the regression respectively to see whether their coefficients are different. Clustered robust standard error is used to get more robust statistical inferences. Results

Descriptive statistics and correlation coefficients are shown in Table 1.

TABLE 1 DESCRIPTIVE STATISTICS AND CORRELATION COEFFICIENTS (OBS = 182)

Variables Mean SD 1 2 3 4 5 6 7 8 9 10 11

1. ROE 0.1334 0. 0801 1

2.Year2011 0.5000 0.5000 -0.1307 1

3. OwnCon 0.5795 0.1684 0.2052 -0.0644 1

4. Diver -3.4311 1.2074 0.0024 0.0410 -0.2229 1

5. DAR 0.3386 0.1971 0.0478 -0.0457 -0.3685 0.3059 1

6. CR 4.8870 7.5004 -0.0570 -0.0682 0.3530 -0.1808 -0.5223 1

7. ITO 3.6630 2.0681 0.0194 -0.0446 0.0094 0.0156 0.3176 -0.0943 1

8. ARTO 11.9490

23.2454 0.0717 -0.0377 0.0736 0.1340 -0.0414 0.0306 0.1640 1

9. NCAP 0.3915 0.1528 -0.1141 -0.0316 -0.4494 0.1802 0.2642 -0.4184 -0.0068 -0.0226 1

10. CoDStr 7.6101 6.9213 0.0284 0.0376 -0.0656 0.2814 0.5430 -0.2191 0.4935 0.0910 -0.1484 1

11. SalStr 0.1832 0.1300 -0.0061 0.0155 0.0933 -0.1900 -0.3766 0.1380 -0.1224 0.0134 -0.2148 -0.4129 1

Table 2 shows the results of performance comparisons between groups on different sides of mobility barriers. As these results indicate, only one out of four kinds of mobility barriers significantly brings performance differential. The average ROE of the Large_Size group (0.1483) is significantly higher than that of the Small_Size group (0.1183) at P < 0.05 in the t-test and at P < 0.01 in the Mann-Whitney test. No significant performance difference is found between Own = 1 and Own = 0, High_R&D and Low_R&D, High_FRS and Low_FRS groups. Thus, it can be drawn that mobility barriers do not necessarily lead to performance differentials. Hypothesis 1 is supported.


TABLE 2 PERFORMANCE COMPARISON BETWEEN GROUPS

Groups ROE Independent- sample T-test

Mann-Whitney Test

Own = 1 0.1237 — —

Own = 0 0.1407 Large_Size 0.1483

P < 0.05 P < 0.01 Small_Size 0.1183 High_R&D 0.1313

— — Low_R&D 0.1357 High_FRS 0.1395

— — Low_FRS 0.1272 Note: “—” indicates that no significant result is found.

Regression results of Hypothesis 2 are listed in Table 3. Competitive strategies show different effects

on performance across strategic groups that are partitioned by four mobility barriers. For companies ultimately controlled by government or institution (Own = 1), CoDStr has a significant negative impact on firm performance (-0.0105), significant at P < 0.05. For individual-owned companies (Own = 0), CoDStr has a significant positive impact (0.0052), significant at P < 0.05. The opposite results suggest that companies must consider their ownership types when making strategic decisions. Cost leadership strategy is more beneficial to individual-owned companies, whereas the differentiation strategy is more suitable for government or institution owned companies. For companies controlled by government or institution (Own = 1), SalStr does not have any significant effect. For individual-owned companies (Own = 0), SalStr has a n egative effect (-0.3751), significant at P < 0.1. This indicates that in general individual-owned companies could increase their profitability by cutting down selling expense. But there is no significant effect when government or institution owned companies do so.

For companies in the large-sized group (Large_Size), CoDStr has a n egative effect (-0.0062), significant at P < 0.1. For relatively small companies (Small_Size), CoDStr has a positive effect (0.0067), also significant at P < 0.1. The opposite results reveal how firm-size barrier influence the effect of competitive strategies. Firms protected by size barrier should choose differentiation strategy for better performance, while those without this protection had better choose cost leadership strategy. It is clear that firms must consider the positions where they stand when formulating strategies. For companies protected by size barrier (Large_Size), SalStr has a negative effect (-1.1240), significant at P < 0.01. For companies without this protection, the regression coefficient of SalStr has a much smaller absolute value (-0.1814) and is insignificant. We can see that companies in the Large_Size group could reduce the investment in promotion or advertisings to increase their profitability, whereas companies in the Small_Size group cannot improve performance by doing that.


TABLE 3 REGRESSION RESULTS (ROE AS THE INDICATOR OF DEPENDENT VARIABLE)

Groups Own = 1 Own = 0 Large Size

Small Size

High R&D

Low R&D

High FRS

Low FRS All

Intercepts 0.5296﹡ (0.2423)

0.1145 (0.1642)

0.6553﹡ (0.3081)

-0.2320﹡﹡ (0.0848)

-0.0036 (0.1039)

1.0072﹡﹡ (0.3341)

0.6549﹡ (0.2813)

0.0092 (0.1035)

0.0958 (0.0627)

Year2011 -0.0143 (0.0111)

-0.0096 (0.0080)

-0.0367﹡﹡ (0.0132)

0.0117﹡ (0.0048)

-0.0105 (0.0070)

-0.0428﹡ (0.0175)

-0.0296﹡ (0.0123)

0.0007 (0.0082)

-0.0071† (0.0038)

OwnCon -0.2003 (0.1248)

-0.0360 (0.1980)

-0.3586† (0.1880)

0.4019﹡﹡ (0.1412)

0.0269 (0.0972)

-0.5903﹡ (0.2922)

-0.6400† (0.3218)

0.1105 (0.0969)

0.0181 (0.0535)

Diver 0.0142 (0.0140)

0.0136 (0.0111)

0.0270 (0.0181)

0.0054 (0.0115)

0.0090 (0.0139)

0.0059 (0.0150)

0.0263 (0.0173)

0.0009 (0.0096)

0.0030 (0.0053)

DAR 0.0708 (0.1925)

0.0156 (0.1075)

0.2101 (0.1639)

0.1659﹡ (0.0793)

0.1196 (0.0986)

-0.0801 (0.1898)

0.0266 (0.1406)

0.1621 (0.1325)

-0.0048 (0.0424)

CR 0.0010 (0.0034)

-0.0014 (0.0010)

0.0038 (0.0057)

0.0012 (0.0009)

0.0018 (0.0020)

-0.0003 (0.0008)

0.0016 (0.0034)

0.0003 (0.0013)

0.0006 (0.0009)

ITO -0.0149 (0.0173)

0.0213﹡ (0.0098)

0.0070 (0.0181)

-0.0055 (0.0051)

-0.0034 (0.0091)

0.0043 (0.0108)

0.0043 (0.0122)

-0.0107 (0.0086)

0.0007 (0.0033)

ARTO 0.0009† (0.0005)

0.0045﹡ (0.0021)

0.0012﹡ (0.0004)

0.0052﹡﹡﹡ (0.0014)

0.0022 (0.0027)

0.0016﹡﹡﹡ (0.0004)

0.0022 (0.0030)

0.0014﹡﹡﹡ (0.0002)

0.0007﹡ (0.0003)

NCAP -0.2001 (0.3339)

0.1008 (0.1075)

-0.2798 (0.2691)

0.1343 (0.0916)

0.1501 (0.1029)

-0.6334﹡ (0.2375)

0.0233 (0.1937)

0.1171 (0.1301)

0.1171﹡ (0.0529)

CoDStr -0.0105﹡ (0.0048)

0.0052﹡ (0.0025)

-0.0062† (0.0035)

0.0067† (0.0035)

0.0102† (0.0058)

-0.0052 (0.0034)

-0.0055† (0.0029)

0.0098﹡﹡﹡ (0.0018)

-0.0005 (0.0012)

SalStr -0.3721 (0.4802)

-0.3751† (0.2150)

-1.1240﹡﹡ (0.4237)

-0.1814 (0.1356)

-0.0277 (0.2816)

-1.0283﹡﹡ (0.3333)

-0.3657 (0.3884)

-0.3765† (0.1937)

-0.3124﹡ (0.1319)

R2 -within 0.3277 0.5443 0.4391 0.5982 0.4179 0.4157 0.4016 0.4739 0.3202

Obs 78 104 92 90 92 90 92 90 182

Note: 1. Clustered robust standard errors of coefficients are given in parentheses. 2. Significance levels: ﹡﹡﹡ p < 0.001, ﹡﹡ p < 0.01, ﹡ p < 0.05, † p < 0.1. For companies protected by the R&D barrier (High_R&D), CoDStr has a positive effect on firm

performance (0.0102), significant at P < 0.1. For companies without this protection (Low_R&D), the regression coefficient of CoDStr is negative (-0.0052) and insignificant. Results suggest that the choice between cost leadership and differentiation strategies should be based on the companies’ relative R&D competencies. For companies protected by the R&D barrier (High_R&D), SalStr shows a rather tiny and insignificant impact. But SalStr has a n egative effect on performance for companies in the Low_R&D group (-1.0283), and the coefficient is significant at P < 0.01. Companies that are weak in technology could improve their performance by c utting down selling expense, whereas companies with high technological ability will not gain from that action.


For companies protected by the internationalization barrier (High_FRS), CoDStr has a negative effect on firm performance (-0.0055), significant at P < 0.1. For companies without this protection (Low_FRS), CoDStr shows a p ositive effect (0.0098), significant at P < 0.001. Cost leadership and differentiation strategies show opposite effects on the two groups. Companies protected by the internationalization barrier should adopt differentiation strategy, but those with low foreign sales should provide more low-cost products in competition. For companies protected by the internationalization barrier (High_FRS), SalStr has no significant impact. For companies in the Low_FRS group, SalStr adversely affects firm performance (-0.3765, P < 0.1).

The regression result of all observations by the same model is listed in the last column of Table 3. We can see that CoDStr shows almost no influence (-0.0005) on firm performance when all companies of the industry are put in the regression. This result seems to suggest that whether choosing cost leadership or differentiation strategy is irrelevant to firm performance. Actually, the partition of mobility barrier has led to just opposite effects of independent variable CoDStr. Besides, the impact of sales strategy is also influenced by mobility barriers. In the last column of Table 3, SalStr shows a significant negative effect (-0.3124, P < 0.05). However, regressions by group indicate that SalStr is not universally effective for all companies. The coefficients of SalStr are significant only when companies are in the groups of Own = 0, Large_Size, Low_R&D, and Low_FRS. Regressions by group demonstrate that a st rategy may bring different or even opposite influences on different strategic groups separated by mobility barriers. CONCLUSIONS AND DISCUSSION Findings and Theoretical Implications

Our research provides an in-depth understanding of the functions of mobility barriers. In literature, the most fundamental and widely acknowledged function of mobility barrier is to maintain existing performance differentials between strategic groups in the industry by preventing firms from moving to other groups. But there are still some unclarities about the effects of mobility barrier in the research on strategic group. This study examined whether mobility barriers necessarily cause performance differences, and whether mobility barriers play a moderating role in the relationship between firm strategies and performance instead of acting only as a stabilizer of performance differentials.

One of our findings is mobility barriers do not necessarily bring performance differences across strategic groups. In the testing results, only one out of four kinds of mobility barriers led to performance difference. Other mobility barriers do not lead to significant differences of firm profitability on the two sides, though they indeed result in asymmetric competitive positions. The average profitability of a strategic group is affected by many factors, such as the market growth rate, the collaboration among group members, and some historical and cultural factors. Recognizing that these factors are largely exogenous to mobility barriers, it is unreasonable to say strategic groups protected by higher barriers are sure to gain better performance. The disadvantage of not being well protected by mobility barriers is the high profits are more likely to be competed away. But that doesn’t mean members of these groups will never achieve high profits.

Another finding is mobility barriers play a key moderating role in the relationship between firm strategies and performance. Though mobility barriers do not directly determine firm performance, they significantly influence the outcomes that firms could get when carrying out strategies in the competition. Our study demonstrates that firm performance is determined neither sorely by competitive strategies implemented by firms nor by mobility barriers existing in the industry, but by the interaction of strategies and firms’ relative competitive positions. Firms in an industry should be viewed as clusters with distinctive characteristics rather than as homogenous units. Strategies that significantly improve the performance of members of a strategic group might be harmful to firms in another strategic group. And a strategy that seems to be universally effective may actually be worthless for a certain category of firms. The four mobility barriers in our empirical tests, namely ownership barrier, firm-size barrier, R&D barrier, and foreign sales barrier, all exert significant influences on the firm strategy-performance


relationship. Future studies on strategic group could take mobility barrier as a moderating variable in the research model.

Practical Implications

Firms in the real business can also learn from our study. Facing fierce intra-industry competition, firms need to understand the key dimensions of the industry environment, and figure out to which strategic groups they belong by searching and identifying possible mobility barriers. They should understand there might be no strategic actions that could benefit all firms in the industry, and conduct detailed and specific analyses when formulating competitive strategies. A strategy that is proved to be helpful to one type of firms might be detrimental to another type. Many management solutions that are claimed to suit all companies, which are usually produced by consulting companies or other professional service institutions, may not be trustworthy. Managers should refuse to blindly follow the so-called best practices without in-depth analysis, thereby avoiding to be misled by inapplicable strategies. When making benchmarking, firms might as well learn from the competitors that are both successful and comparable to themselves rather than simply from the firm with the highest market share or profitability. REFERENCES Barney, J. B. (1991). Firm resources and sustained competitive advantage. Journal of Management, 17(1),

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