A much-debated economics puzzle is the presence of large and persistent performance differences between seemingly similar firms. For instance, within narrowly specified US manufacturing industries, establishments at the 90th percentile make almost twice as much output with the same input (Syverson 2004).
One possible explanation for this ‘dark matter’ of firm productivity is that the variation in outcomes is due to a variation in management quality (Gibbons and Henderson 2013), which can be understood both as practices (the management systems that firms put in place) and people (the CEO and other managerial talent that firms acquire).
In this column we argue that economists have tackled this important problem from three distinct perspectives. We will highlight some apparent mutual conflicts, and we will suggest one possible framework to reconcile the three approaches and make further empirical progress. We first consider the three perspectives in turn.
The contingency theory (CT) approach is a natural extension of production theory. Both managerial practices and managerial human capital are production factors, and the firm should select them optimally given the business environment it faces. Lucas (1978) is the seminal application of CT to managerial human capital. There is a market for managers where supply is given by a distribution of managers of different talent and demand is given by a distribution of firms. In equilibrium, the more talented managers are employed by the firms that need them more. CT encompasses both managerial talent and management practices, and it can take into account synergies with other productive factors – Milgrom and Roberts' (1995) theory of complementarity in organisations develops general techniques to model these synergies.
Contingency theory yields a powerful testable prediction – similar firms should adopt similar management practices, should hire similar CEOs, and should have similar productivity levels. In order to obtain firm heterogeneity, this approach must be augmented by exogenous dynamic productivity or demand shocks, so it leads to a steady state distribution of firm size and productivity (Hopenhayn 1992, Erickson and Pakes 1995).
The organisation-centric approach
While CT has a strong theoretical underpinning, the other two approaches are mainly empirical. The organisation-centric approach (OC) is concerned with the effect of management practices on firm productivity. Ichniowski et al. (1997) pioneered this approach in economics. They undertook a detailed investigation of 17 firms in a narrowly defined industry with homogeneous technology (steel finishing) and documented how lines that employed innovative human resource management practices, like performance pay, team incentives, and flexible assignments, achieved significantly higher performance than lines that did not employ such practices. Bloom and van Reenen (2007) have revolutionised the field by developing a survey tool to measure managerial practices along multiple dimensions in a cross-section of industries and countries. Their paper and subsequent work have documented both a large a variation in management practices across firms within the same industry and the ability of that variation to explain differences between firms on various performance measures, including profitability. These results are robust to the inclusion of firm-level fixed effects (Bloom et al. 2016) and they survive the inclusion of detailed employee-level information (Bender et al. 2016).
In sum, OC has shown that similar firms adopt different management practices and that this difference matters for performance. This finding is in apparent conflict with the predictions of CT – if firms choose management practices optimally given their characteristics, then performance should be predicted by firm characteristics not management practices.
Economist tend to react to this contradiction in one of two ways. What these two reactions have in common is that they have no predictive power. Some argue that existing empirical work does not measure all firm characteristics and that some omitted variables – perhaps soft factors like corporate culture – drive both performance and the adoption of certain management practices. However, what are these omitted variables that affect firms in most industries and most countries, and seem to be resistant to the inclusion of any firm-level observable? Is there any hope of ever observing them? Others react by simply saying that firms make mistakes. One firm adopts the right practices while another identical firm does not because of some flawed decision-making. But then again, why is decision making flawed in certain firms and not others? Can we ever hope to model and test the origin of these mistakes?
The leadership-centric approach
The third, and most empirical, approach is the leadership-centric approach (LC), which focuses on the role of individual managers. Some firms may perform better because they are run by better CEOs. A growing literature, employing different datasets and different methodologies, show that the identity of the CEO can account for a significant portion of firm performance (Bertrand 2009). Among others, Johnson et al. (1985) analyse the stock price reaction to sudden executive deaths; Bertrand and Schoar (2003) identify a CEO fixed effect, and Bennedsen et al. (2007) show that family CEOs have a negative causal effect on firm performance. Kaplan et al. (2012) document how CEOs differ on psychological traits and how those differences explain the performance of the firms they manage. Bandiera et al. (2016) perform a similar exercise on CEO behaviour and show that it accounts for up to 30% of performance differences between similar firms, and that the association between behaviour and performance appears only three years after the CEO is hired.
LC can be seen as the parallel of OC, applied to managerial talent rather than managerial practices, which raises the same set of questions – how do we reconcile the observed variation in CEO hiring with CT? Is it omitted variables? Is it mistakes? Or something else?
It is also natural to ask whether there exists a link between OC and LC. Are leaders and practices two orthogonal factors that influence firm performance through distinct channels, or are they somehow connected? Do we need a theory to reconcile CT and OC and a different theory to reconcile CT and LC? Occam’s Razor should lead us to prefer a story that can reconcile all three approaches.
A new theoretical framework
In a recent paper, we attempt to reconcile these three approaches in a parsimonious and falsifiable theoretical framework (Dessein and Prat 2019). Why can two seemingly similar firms end up on two different paths? The idea is simple. We assume that one production factor is highly discrete and unpredictable—leadership quality. As Steve Jobs put it, “Recruiting is hard. It's just finding the needles in the haystack. You can't know enough in a one-hour interview.” Despite all the effort that goes into executive recruitment, when a board hires a CEO they have incomplete information, both about the type of the candidates and the quality of the candidate-firm match. After the CEO is hired, it takes time to understand the quality of the match, and time to get rid of an underperforming CEO. So, the first assumption of our model is that corporate governance is imperfect, both ex ante because firms sometimes hire the wrong CEO, and ex post because it takes time for them to find out about their mistakes and fix them.
Our second assumption is that each firm has a slow-moving, hard-to-measure set of assets that we call organisational capital. This is meant to encompass important constructs such as corporate culture (Schein 2010), relational contracts (Baker et al. 2002), firm-specific human capital (Prescott and Visscher 1980) . In particular, it may capture components of the management practices analysed by Bloom et al. (2016). A key characteristic of organisational capital is that its growth is affected by the quality of the CEO. As Schein (2010) puts it, "leadership is the source of the beliefs and values of employees, and shapes the organisational culture of the firm, which ultimately determines its success or failure." A good CEO devotes her limited attention to increasing organisational capital day after day, improving the long-term performance of the firm. A bad CEO spends her time boosting short-term performance instead and lets the firm’s organisational capital slowly depreciate, hurting the firm in the long-term. Bad CEOs do get fired in our model, but it takes time and in the meantime they inflict long-lasting damage to firm performance.
If a firm is lucky, it gets a good CEO who increases organisational capital (and retires at some point). If it is unlucky, it gets a bad CEO who depletes organisational capital until the firm fires her. As a result, a firm’s organisational capital follows a stochastic process punctuated by endogenous CEO transitions. With this micro-foundation, we can characterise the steady state of an economy where all firms behave as above. In this world seemingly similar firms end up with different organisational capital – for instance, different management practices – and persistently different productivity levels. These different paths can be traced back to the type and behaviour of the CEOs who led those firms.
The paper produces a wealth of testable implications linking firm performance, CEO variables, and management practices. These implications are listed in the Table 1.
Table 1 Testable implications linking firm performance, CEO variables and management practices
The first nine implications correspond to patterns that have already been observed and predicted by one of the three existing literature streams – contingency theory, organisation-centric theory, or leadership-centric theory. The remaining four predictions are, as far as we know, untested. For instance, number 10 predicts a cross-sectional correlation between changes in management practices (or other forms of organisational capital), and the behaviour, type, and tenure of CEOs. Instead, number 12 predicts a connection between the career of a CEO and the growth in management practices and organisational capital of the firms she previously ran.
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