corporate governance, investment bandwagons and overcapacity: an analysis of the worldwide...

Strategic Management JournalStrat. Mgmt. J., 24: 349–373 (2003)

Published online 6 February 2003 in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.302

CORPORATE GOVERNANCE, INVESTMENTBANDWAGONS AND OVERCAPACITY: AN ANALYSISOF THE WORLDWIDE PETROCHEMICAL INDUSTRY,1975–95

JAMES HENDERSON1* and KAREL COOL2

1 Babson College, Babson Park, Massachusetts, U.S.A.2 INSEAD, Fontainebleau, France

Previous research has provided conflicting arguments and evidence on which corporate gover-nance system—bank based or market based—is better in preventing managers from investingin value-destroying projects. This paper attempts to further the debate by comparing the effectof these different corporate governance systems on preventing capacity expansion bandwagonbehavior in the worldwide petrochemical industry in the period 1975–95. Our study shows, first,that neither system is particularly effective in curbing overinvestment; however, the market-basedsystem seems to be less ineffective than the bank-based system. Second, free cash flow appearsto drive greater bandwagon behavior in the market-based system than in the bank-based system.Finally, within the bank-based system, companies that rely on one bank–shareholder are morelikely to join the bandwagon than those with more than one. Copyright 2003 John Wiley &Sons, Ltd.

In many industries, firms tend to poorly timetheir capacity expansions by investing when theirrivals are investing, often leading to excess capac-ity and poor returns. There appear to be sev-eral reasons for this herd or bandwagon behavior:expanding firms may not be able to credibly deterother firms from following (Lieberman, 1987a);firms may follow leading firms due to asymmet-ric information (e.g., Banerjee, 1992), to mimeticisomorphism (e.g., DiMaggio and Powell, 1983),or career considerations (e.g., Lieberman, 1987b);managers may also use biased heuristics in mak-ing investment decisions (Zajac and Bazerman,1991); or firms may learn only very slowly ornot at all from past investments (Henderson andCool, 1999).

One potential influence on investment bandwag-ons, which has not received much research atten-tion, is the governance system in which firms

Key words: corporate governance; capacity expansion;overinvestment*Correspondence to: James Henderson, Babson College, BabsonPark, MA 02457, U.S.A.

operate. Corporate governance concerns the mech-anisms which suppliers of financial resources useto obtain an appropriate return on their investment(Shleifer and Vishny, 1997). Hence, investmentbandwagon behavior and its potential overcapac-ity consequences would be of serious concern. Yet,two corporate governance systems have evolvedin the developed world: the ‘market-based’ sys-tem of the United States and the United Kingdom,and the ‘bank-based’ system often associated withJapan and Germany (e.g., Charkham, 1994) sug-gesting that they may have a differential impacton investment decisions.

In the market-based systems of the UnitedStates and United Kingdom, corporations primar-ily raise their external funds through the rela-tively liquid capital markets. Investors keep arm’s-length relationships with management and shifttheir investments if realized or expected returnsare insufficient. Investors in this system are fre-quently believed to be quite short-term oriented,shunning investments with pay-offs only in thelong term. Company ownership tends to be less

Copyright 2003 John Wiley & Sons, Ltd. Received 29 January 2002Final revision received 23 September 2002

350 J. Henderson and K. Cool

concentrated and managers are supposedly moni-tored and indirectly influenced by an external mar-ket for corporate control.

In the bank-based systems of Japan and Ger-many, companies typically raise their externalfunds through banks, which have a close, long-term relationship with their corporate clients. Own-ership tends to be concentrated around these banksand the capital markets are relatively illiquid(Kaplan, 1997). By virtue of this relationship,banks can have more information on their clientand may be prepared to take a more knowledge-able view in judging investments than arm’s-lengthinvestors. Furthermore, banks’ returns from theseinvestments are more guaranteed than the returnsfor shareholders, who are residual claimants, andtherefore may be more willing to fund theirclients’ investments. Given the striking differencesbetween the two governance systems regarding thehorizon of investors and the way they can assurea return on their investments, it is indeed plausi-ble that the two systems are not neutral regardingcompanies’ investments in projects with a long-term horizon, such as investments in capacity. Tothe extent that one system is more lenient than theother in funding capacity investments, overcapac-ity may be a much more frequent phenomenon inone than in the other.

The objective of this paper is to examine ifand how different corporate governance systemsprevent capacity expansion bandwagon behavior.The setting for the empirical analysis is the petro-chemical industry in the United States, the UnitedKingdom, Germany, and Japan during the period1975–95. Petrochemicals is an industry in whichfirms frequently have to make big capacity addi-tions and often struggle to get the timing decisionright (Lieberman, 1987b). While investing in largerplants can result in significant scale economies,getting the timing wrong such as investing simul-taneously with a number of rivals can result insignificant overcapacity and poor returns. Thus, aneffective corporate governance system could actas a brake on firms attempting to add too muchcapacity simultaneously.

The paper first briefly reviews the literature oncapacity expansion, bandwagons, and overcapac-ity. Thereafter, we explore how the market-basedor bank-based systems of corporate governancemight operate to reduce a firm’s tendency to ‘hopon an investment bandwagon,’ thus leading toovercapacity. The third section then describes the

sample, variables, and econometric methods usedto compare the effect of different corporate gover-nance systems on capacity expansion bandwagonbehavior. The final section discusses the results,provides implications for research and manage-ment, and highlights the limitations of the study.

LITERATURE REVIEW ON CAPACITYEXPANSION

When industry capacity utilization is tight and cashflows are healthy, industry-wide optimism oftendevelops, prompting investment in new capacity(Achi et al., 1996). Yet, firms face a dilemma:investing in a plant can promise significant revenuepotential but too many firms investing simulta-neously would lead to overcapacity, negating theintended value creation. This is a dilemma that isall too familiar in industries such as semiconduc-tors, shipping, petrochemicals, steel, hotels, andmany other capital-intensive sectors. To addressthis problem, the literature on credible commit-ments has argued that a preemption strategy, inwhich a firm builds enough capacity to sup-ply all expected demand, would discourage rivalsfrom investing (Porter and Spence, 1982; Ghem-awat, 1984; Reynolds, 1986; Lieberman, 1987a)and would deter potential competitors from enter-ing (Wenders, 1971; Spence, 1977; Salop, 1979;Eaton and Lipsey, 1979; Spulber, 1981; Lyons,1986). However, it has been shown empiricallythat successful preemption is rare (e.g., Lieber-man, 1987a; Smiley, 1988). Lieberman (1987c)found in his study of the U.S. chemical indus-try that both entrants and incumbents exhibitedsimilar investment behavior. In a later study,Gilbert and Lieberman (1987) discovered thatfirms appeared to hop on an investment bandwagonwhen other firms invested. Rather than deterringother firms from following, capacity expansionannouncements tended to induce more announce-ments, leading to a situation of excess capacity.

Several explanations have been given as to whythis herd behavior occurs. First, believing theyare unable to deter other firms from following,firms may be relying on some other mechanismto regulate capacity expansion, for example main-taining approximately constant market shares (e.g.,Gilbert and Lieberman, 1987). In this case, firmswould decide to expand when their historical mar-ket shares decrease.

Copyright 2003 John Wiley & Sons, Ltd. Strat. Mgmt. J., 24: 349–373 (2003)

Corporate Governance, Investment Bandwagons and Overcapacity 351

Second, firms may invest because they believethere is information asymmetry in the industry(Banerjee, 1992). The mere announcement of onefirm expanding capacity sends a signal to com-peting firms on expected demand. Rather thanrely solely on their private information, firms mayeconomize on search costs either by using theinformation through the public announcements ofothers (e.g., Cyert and March, 1963) or throughnetworks of directors within the industry (e.g.,Galaskiewicz and Wasserman, 1989). Indeed, Gil-bert and Lieberman (1987) observed that, com-pared to larger firms, smaller firms were morelikely to expand when their rivals invested. Theauthors attributed this behavior to differences inthe ability of large and small firms in gatheringand interpreting information.

Third, managers are biased toward investingrather than not investing because of potentialcareer consequences were they not to invest. Man-agers are rarely fired for investing resulting inindustry excess capacity but are likely to be dis-missed for missing the opportunity when it arises(Lieberman, 1987b).

Fourth, managers’ decision making may alsobe affected by biases, which could lead to toomany firms investing simultaneously. For exam-ple, research has shown that managers tend tobe systematically overconfident in their judgmentsand decisions. This typically occurs when theyreceive confirmatory evidence (Einhorn and Ho-garth, 1978) or are in competitive situations (Far-ber, 1981). Thus, managers’ confidence in decidingto expand capacity would likely rise as more sup-porting evidence of demand growth is receivedeven though the accuracy of demand forecastsmay not have improved (Makridakis and Wheel-wright, 1989). Firms may also believe they willbe the first and only movers. They may there-fore fail to sufficiently consider that their rivalsmay attempt preemption or respond by maintainingtheir own market share positions (Zajac and Baz-erman, 1991). If several firms were to behave ina similar manner, collectively the outcome wouldbe too many capacity additions and unintentionalexcess capacity.

In sum, there is plenty of evidence that rivalsbunch their capacity investments, potentially resul-ting in industry overcapacity. However, not allfirms may be equally swayed. First, large firmsmay have an advantage in gathering and process-ing information over smaller firms (Gilbert and

Lieberman, 1987). Secondly, firms also tend tolearn, albeit slowly, from their previous movesand outcomes. Hence, more experienced firms maybe able to take advantage of less experiencedfirms by investing counter-cyclically (Hendersonand Cool, 1999). Third, more diversified firms mayhave more stable cash flows than smaller pure-playfirms and thus have better access to the capitalmarkets during troughs in the cycle (Amit andLivnat, 1988). Finally, firms embedded in moreconcentrated industries may be able to better coor-dinate their investments due to the fewer numberof players.

However, the studies referred to have mostlybeen carried out within the U.S. setting. To theextent that multi-country samples were used, theeffects of the different governance systems inwhich the firms operated were not explicitly stud-ied. Yet, corporate governance systems are verydifferent. In the next section, we describe someof these differences and explore how these couldinfluence investment in new capacity.

CORPORATE GOVERNANCE SYSTEMSAND HYPOTHESIS DEVELOPMENT

The most common perspective on corporate gov-ernance comes from the contractual view of firmsexamined by Coase (1937), Jensen and Meckling(1976), and Fama and Jensen (1983a, 1983b). Anissue stems from the uncertainty financiers faceonce they provide their funds to companies. Willthey will get anything in return for their sunkinvestment? In the absence of complete contracts,incentives, or monitoring activities, it would bein the manager’s best interest to maximize hisown welfare than that of the firm. The costs asso-ciated with this relationship are then the mon-itoring and bonding of management as well asany residual loss due to management investing invalue-destroying projects (Mann and Sicherman,1991). In the developed economies, different polit-ical and legal histories primarily with respect tothe financial system have led two distinct corpo-rate governance systems or mechanisms to dealwith these agency costs: the ‘bank-based’ systemtypically associated with Japan and Germany, andthe ‘market-based’ system of the United Statesand the United Kingdom (e.g., Roe, 1993). Whilethere are countries with hybrid systems, it is use-ful to look at the polar settings to identify system



characteristics and their possible consequences forcapacity investments. We first provide some high-lights of each system and then sketch some of theirlimitations regarding the impact on capacity invest-ments. More complete descriptions can be foundin Charkham (1994).

Characteristics of the ‘bank’-based and the‘market’-based systems

The bank-based system

The ‘bank-based’ corporate governance systems ofGermany and Japan emerged primarily due to thecountries’ political attitudes towards and regula-tions regarding equity financing during the periodof heavy industrialization, the Great Depressionand after World War II (Roe, 1993). For exam-ple, in Germany, during this period, tax policiesfavored debt over equity financing. In Japan, thegovernment regulations were skewed towards thebanks such that industrial targeting could be bet-ter controlled. As a result, the financial system andsubsequently the corporate governance system coa-lesced around the banks.

In Germany, bank loans have historically playeda larger role than securities in financing invest-ment. Firms would maintain a close relationshipwith one or a couple of banks, referred to as‘Hausbanken,’ where they were respected for theirunderstanding of the economy and the companyitself. These banks, which include Deutsche Bank,Commerzbank, and Dresdner Bank, would be prin-cipal lenders and typically equity holders as well.While they are not necessarily the largest share-holders, as depositories for stock owned by theircustomers, they control virtually half of Germanshares in stock corporations through the proxyvoting system. Furthermore, they actively partic-ipate on the Supervisory Board, where externalshareholders control half of the seats. While bankfinancing has decreased significantly over the years(Corbett and Jenkinson, 1996), banks in Germanyare still considered to be at the ‘epicenter’ oftheir corporate governance systems (Macey andMiller, 1997).

The capital markets in the German system havebeen relatively unimportant and illiquid comparedto the U.S. and U.K. markets. By the mid-1990s,approximately 650 companies were publicly listed,representing only 23.3 percent of the country’sGDP (Franks and Mayer, 1997). Furthermore, lim-ited information is available on these publicly

traded companies and the accounting standardsmake external monitoring a more difficult task thanin the United States and United Kingdom. As aresult of the monitoring and control of the banksand the weak capital markets, an external marketfor corporate control, until recently, has been vir-tually nonexistent.

In Japan, the ownership of large firms isin many ways analogous to that in Germany.The Japanese system has been characterized bycomplex networks of intercorporate equity cross-holdings known as keiretsu. Each member ofthe keiretsu typically owns about 2 percent inevery other firm in the group. Thus, a largepercentage (usually between 30% and 90%) of thestock of every firm in the keiretsu is owned byother members of the group. At the center of akeiretsu, a main bank, such as Sanwa, IndustrialBank of Japan, Fuji Bank, Sumitomo, Mitsui,or Mitsubishi, owns around 5 percent of thestock of the group’s industrial firms.1 In general,four other banks and/or insurance companies alsoown blocks of stock in the firms, thus creatinga five-holder coalition with 20 percent of theoutstanding stock (Macey and Miller, 1997). Thebanks, however, are not represented on the boardof directors as in Germany’s Supervisory Board.Rather, Japanese boards (similar to Germany’smanagement board) are largely comprised ofmanagement insiders, formally elected by thestockholders but usually appointed by the CEO.Instead, the President’s Council, consisting ofrepresentatives of the company’s banks, suppliers,and customers (all members of the keiretsu)is analogous to Germany’s Supervisory Board.Despite these differences in the structure of boardsin Japan and Germany, the role of the banks issimilar; they vote a significant block of shares,still play an important role in lending, and thushave an incentive to monitor and directly influencemanagement on their investment decisions.

Unlike in Germany, the capital markets in Japanhave taken on a greater role, as Tokyo has becomea major international financial center. This greaterrole can be seen in the increasing use of equityfinancing, from less than 10 percent in 1975to approximately 20 percent in 1990 (Frankel

1 American banking law was instituted in Japan after World WarII such that banks could only hold up to 5 percent of a company’sshares. However, this law was not fully adhered to, as shown inthe sample under study.



and Montgomery, 1991). However, despite thisincrease, publicly available information is still lim-ited, making external monitoring difficult. Further-more, difficulty in breaking into the keiretsu struc-ture has resulted in a virtually nonexistent externalmarket for corporate control.

The market-based system

While the German and Japanese systems of corpo-rate governance have some differences, the U.S.and U.K. systems of corporate governance arevery similar. Banks and insurance companies inthe United States and United Kingdom have rarelytaken significant minority stakes in publicly tradedcompanies. In the United States, they have beenlegally restricted, through the Glass Steagal andBank Holding Acts, from investing in and exercis-ing control over companies. In the United King-dom, while it is possible for banks to take stakesin companies, historically they have maintained anarm’s-length relationship (Charkham, 1994). Inter-estingly, in both countries, bank lending is not amajor source of external funds as it is in Ger-many and Japan. While in both countries, insti-tutional shareholders, such as pension funds ormutual funds, have increased corporate ownershipover the last 25 years, they rarely exert pressureon management. In sum, corporate ownership inthe market-based system is more dispersed thanin the bank-based system. Furthermore, the boardof directors, typically composed of some outsiders(often a majority in the United States but stilla minority in the United Kingdom), is supposedto act in the best interests of the shareholders.However, they are often psychologically depen-dent on the management and the CEO and lackan economic incentive to discipline managementexcept in extreme circumstances (Jensen, 1993).The CEO, who is often the Chairman of the Board,has typically been the source of ideas for newdirectors and has often exerted influence on theelection process as well as on the ongoing opera-tions of the board.

While banks, significant shareholders or boardsof directors have had little direct control over man-agement, enterprising individuals in certain caseshave exerted significant indirect influence. Exten-sive accounting and other information have his-torically been provided to investors. The liquid,fragmented and transparent capital market systemhas allowed risk-seeking entrepreneurs to monitor

and exert significant indirect influence on manage-ment through the threat and use of proxy contests,hostile takeovers and leveraged buyouts (Pound,1988).2

Generalizing, Germany and Japan may be char-acterized as an insider system of ‘dedicated cap-ital’ controlled by the banks whereas the UnitedStates and United Kingdom may be termed anoutsider system of ‘fluid capital’ dominated byentrepreneur-monitors (Porter, 1992). See Table 1for a summary of the two systems.3 While bothsystems have been considered equally effectivein punishing firms that are performing poorly(Kaplan, 1997), the question as to which one isbetter in preventing poor investments is coveredin the next section.

Hypothesis development

Weaknesses of the market-based system/strengthsof the bank-based system

Critics have argued that the market-based systemis ineffective in curbing financially unattractiveinvestments due to the lack of active investors.As Berle and Means (1932) stated, diverse ownershave few incentives to actively pressure manage-ment prior to an investment announcement becausethey would privately bear the monitoring and influ-ence costs for public benefit. While in theoryshareholders elect a board of directors to repre-sent their interests, they are more often capturedby management (Jensen, 1993). This leaves man-agement with substantial discretion to invest inprojects more for their own benefit than for thecorporation as a whole. Better information dis-closure, which we see in the United States andUnited Kingdom, may improve the knowledge gapbetween investors and management (e.g., Froot,Perold, and Stein, 1992). However, shareholders

2 The market for corporate control did, however, slow downsignificantly in the early 1990s because of opposition from cor-porate management, charges of fraud, increase in LBO defaultsand bankruptcies, insider trading convictions, and antitakeoverlegislation (Jensen, 1993).3 Note that in each system there are counterexamples. For exam-ple, in Japan, not all companies are under the control of a mainbank (such as the non-keiretsu companies.) Furthermore, not allU.S. public companies have dispersed shareholders. For exam-ple, the Hewlett and Packard families own significant stakes inHP, which certainly is having an effect on the monitoring ofthe company’s actions (such as its recent bid to merge withCompaq).



Table 1. Comparison of systems of corporate governance

Attributes Market-based systems Bank-based systems

Leverage Low but moving higher High but going lowerExternal funding Primarily through securities Primarily through bank loans,

although declining in GermanyShare ownership Dispersed ConcentratedTypes of owners Institutional investors, individuals Banks, companiesGoals Measurable investment returns Long-term appreciation of shares

Short-term performance orientedInformation Open, investment community Closed to investment community,

insider informationStrict disclosure rules Less strict disclosure rules

Direct influence Little to none Considerable direct influenceIndirect influence (market for

corporate control)Major Minor

Board of directors Primarily outsiders Codetermination in GermanyInsiders in Japan

Ability to return excess cash High. Share repurchase Low. Share repurchase generallyillegal

Source: Adapted from Porter (1992); Kaplan (1997).

will still only know about an investment deci-sion after a public announcement has already beenmade. Investors could sell their shares to voicetheir opinion regarding, for example, the com-pany deciding to invest when its competitors havealready announced their intention to invest. Yet,rarely have companies reversed their decisionsbased on the market’s reaction. Ultimately, thecompany may be subject to a hostile takeover orproxy contest but, as critics have noted, this isoften too costly and too slow (Porter, 1992).

Evidence of this weakness of the market-basedsystem has been illustrated by negative share-holder reaction to companies making acquisitionannouncements (e.g., Roll, 1986). Furthermore,investors also reacted pessimistically to announce-ments of negative NPV exploration projects inthe oil industry, at a time when the industry wasenjoying high profits but experiencing significantexcess capacity (Jensen, 1986; McConnell andMuscarella, 1986). However, none of these reac-tions led to changes in management behavior.

This is where a large active shareholder canexercise influence and potentially stop manage-ment in investing in value-destroying projects.As a substantial minority shareholder and debtprovider, a main bank in Japan or Germany hasthe incentive to monitor and influence managementon a regular basis (Shleifer and Vishny, 1997).Unlike in the market-based system, these banksconduct ongoing, detailed confidential information

gathering on the investment projects while they arestill in their formation (Macey and Miller, 1997).Since they have access to early inside informationincluding competitor activity, they can monitornew investment programs and their potential out-comes prior to any public announcements. Thus,as ‘active investors,’ banks in the bank-based sys-tem have incentives to ‘buck the system to correctproblems early rather than late’ (Jensen, 1993).Due to this inside information, they can potentiallystop or delay financially unattractive investmentprojects, such as poorly timed investment, beforethey are publicly announced. As a result of thesearguments, we can state the following hypotheses:

Hypothesis 1a: Ceteris paribus, a firm embed-ded in the bank-based system of Germany orJapan is less likely to poorly time its capacityexpansion or to hop on an investment band-wagon than one embedded in the market-basedsystem of the United States or United Kingdom.

Furthermore, Jensen (1986) argues that agencycosts, especially the residual loss associated withvalue-destroying projects, are greatest when firmsearn significant free cash flow and have few sig-nificant investment opportunities. As a result, man-agers may reduce their employment risk by diver-sifying the firm. Without the monitoring of a sig-nificant minority shareholder, such as a bank, theymay have incentives to increase the size of the



firm, regardless if it increases shareholder wealth,because executive compensation is typically relatedto firm size (Donaldson, 1984; Jensen and Mur-phy, 1990; Murphy, 1985). For example, theymay join the herd simply to maintain the size oftheir firm relative to their competitors. Followingthis line of thinking and the arguments againstthe market-based system, we can add the follow-ing hypothesis:

Hypothesis 1b: Ceteris paribus, a firm embed-ded in the bank-based system of Germany orJapan is less likely to poorly time its capacityexpansion or to hop on an investment band-wagon than one embedded in the market-basedsystem of the United States or United Kingdomeven when it is earning greater free cash flow.

Weaknesses of the bank-based system/strengths ofthe market-based system

There are however, weaknesses of the bank-basedsystem. First, large shareholders may be too softrather than too hard in influencing management.Bank managers may be more interested in theirrelationships, reputations, and implicit contractsbuilt up over time with company managementrather than the financial attractiveness of the project(Shleifer and Vishny, 1997). Thus, rather than actas a devil’s advocate, they may encourage a firmto proceed with investment projects especially iftheir compensation is related to the bank’s size(e.g., Murphy, 1985).

Second, not only may large shareholders, suchas the banks in Germany and Japan, be too soft, butalso their interests may not coincide with the inter-ests of other investors in the firm or with those ofmanagers and employees. In the process of usingtheir control rights to maximize their own welfare,large investors may appropriate wealth from others(Shleifer and Vishny, 1997). This argument wouldsuggest that banks in Germany and Japan use theirequity positions either to encourage companies toinvest through debt financing (as long as the com-panies are far from default) and/or to hold thesecompanies hostage to higher rates of interest thanthey could otherwise get in the capital markets.

Empirically, for the 1977–82 period, Hoshi,Kashyap, and Scharfstein (1991) found that invest-ment by Japanese companies with a main bankwas unaffected by fluctuations in financial liquid-ity, suggesting that investment was encouraged by

banks despite their companies’ financial liquidity.Furthermore, controlling for other factors, Wein-stein and Yafeh (1994) observed that Japanesefirms with main banks paid higher average inter-est rates on their liabilities than did unaffiliatedfirms. When regulatory changes enabled Japanesefirms to borrow in public capital markets, manyfirms jumped at the opportunity, suggesting thatthe cost of bank financing was greater than that inthe capital markets (Hoshi et al., 1991).

While hostile takeovers in the market-based sys-tem have been criticized for being costly and tooslow, their mere threat may deter managementfrom pursuing financially unattractive projects.Indeed, Gibbs (1993) showed that companies weremore likely to invest in fewer value-destroyingprojects and initiate financial restructuring whenfaced with the threat of a hostile takeover. Conse-quently, we can make the following hypothesis:

Hypothesis 2a: Ceteris paribus, a firm embed-ded in the market-based system of the UnitedStates or United Kingdom is less likely to poorlytime its capacity expansion or to hop on aninvestment bandwagon than one embedded inthe bank-based system of Germany or Japan.

Furthermore, it has been illegal until recently inboth Germany and Japan for companies to repur-chase stock. Also, in Japan, dividend paymentsare problematic because so many other companieswithin the keiretsu hold shares in the company,meaning that only a fraction of the cash actu-ally leaves the group (Kaplan, 1997). In contrast,companies in the market-based systems can returnexcess cash to shareholders through share repur-chases or dividends, potentially solving the agencycosts of free cash flow. While the ability to returnexcess cash to shareholders does not guarantee thatit happens, at least it does give companies in themarket-based system another option but to spendit on investments within the firm. Consequently,we can make the following hypothesis:

Hypothesis 2b: Ceteris paribus, a firm embed-ded in the market-based system of the UnitedStates or United Kingdom is less likely to poorlytime its capacity expansion or to hop on aninvestment bandwagon than one embedded inthe bank-based system of Germany or Japaneven when it is earning greater free cash flow.



In summary, we have conflicting and contra-dictory hypotheses regarding the merits of eithercorporate governance system to curb bandwagonbehavior in new capacity. The weakness of themarket-based system led to the conclusion that thissystem to a large extent lacks the monitoring andenforcing power of dominant investors. Thus, thebank-based systems of Germany and Japan shouldbe better placed than the market-based systemsof the United States and the United Kingdom toprevent poor investment timing. Yet, the disadvan-tages of the bank-based system raised the concernthat dominant investors may be too soft ratherthan too hard, especially in low-powered incen-tive countries such as Japan and Germany. Sincecorporations in Germany and Japan have also beenseverely limited in how they could return excesscash flow to shareholders, banks may be too easyin approving projects especially if their compensa-tion is tied to corporate size (e.g., Murphy, 1985).Indeed it may be in the banks’ interest to push theirclients to invest to take on more debt. In the fol-lowing section, we first describe the design of theempirical analysis, providing information on thesample, the variables and the estimation methods.The results of the analysis are provided thereafter.

RESEARCH DESIGN

Sample

To empirically examine possible effects of corpo-rate governance on investment bandwagon behav-ior, we analyzed capacity investments in the world-wide petrochemical industry during the period1975–95. We can cite several reasons for choos-ing this industry. First, the petrochemical industryoffers an appropriate setting to examine the inci-dence and drivers of overinvestment in new capac-ity. During this period, the industries in Germany,the United Kingdom, Japan, and the United Statesexperienced four periods where capacity utiliza-tion was tight and cash flows were high, leading toindustry-wide optimism and the desire to expand.Indeed, as shown in Figure 1, capacity utilizationrates for ethylene production and the profitabilityratios for each of the major players in each countryare highly correlated.4 Furthermore, simultaneous

4 The Pearson correlation capacity utilization and profitability(for where we have detailed petrochemical division profitability

expansions and excess capacity tend are correlatedas well.5

Secondly, the structure of the petrochemicalindustries in the United States, United Kingdom,Germany, and Japan broadly reflect the two dif-ferent corporate governance systems. Ownershipis dispersed in such U.S. and U.K. petrochemi-cal corporations as ICI, Exxon, Dow Chemicals,and Mobil. In contrast, Japanese and Germanpetrochemical companies have significant minor-ity shareholders. For example, Mitsubishi Chem-ical, Mitsui Toatsu, Asahi Chemicals, and Sumit-omo Chemicals are members of one of the majorkeiretsu, with banks either being the largest or oneof the largest shareholders. While bank sharehold-ings in German petrochemical companies such asBASF, Bayer, Hoechst, Veba, and RWE are small,their influence is still great through their mem-bership on the supervisory board and their signifi-cant voting rights (Bohm, 1992). Refer to Table 2,which shows a list of the companies in the datasetand their ownership structure.

Finally, significant data are available on thisindustry. With the help of the two major consultingfirms in the petrochemical industry, Tecnon andChemsystems, we constructed a database track-ing the following product markets: ethylene, vinylchloride monomer (VCM), styrene, low-densitypolyethylene (LDPE), high-density polyethylene(HDPE), polypropylene (PP), polyvinyl chloride(PVC), and polystyrene (PS) across Europe, theUnited States, and Japan. The database at thefirm level contains data on product-market capac-ities, petrochemical division sales and profitability(where available), corporate sales, and corporateprofitability. At the product-market level, there aredata on production, consumption, imports, exports,prices, and profitability. From that database, adataset of 2832 product-market observations wasselected, spanning 53 firms in the United States,the United Kingdom, Germany, and Japan. A total

information) is approximately 0.71 and is significant at the 1percent level.5 The Pearson correlations for the number of simultaneousexpansions and excess capacity is approximately 0.15 and issignificant at the 1 percent level. This relationship holds in aregression analysis with the introduction of control variablessuch as demand growth, uncertainty, supply lumpiness, importcompetition, industry concentration, and degree of vertical inte-gration in the product-market. Based on our sample 10 firmsexpanding at the same time would lead, on average, to a 5 per-cent increase in excess capacity. However, it does decrease overcycles, suggesting some experience effects. The results are avail-able from the authors upon request.



Capacity Utilization Capacity Utilization

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Market-based Systems

Profitability (ROS) Capacity Utilization

Bank-based Systems

Figure 1. Capacity utilization (ethylene) and average profitability in bank-based and market-based systems of corporategovernance, 1975–95

of 41 companies were not included in the samplebecause they were either private (18 cases), publicbut data were not available for all of the variables(20 cases), or had significant minority sharehold-ers even though they were in the market-basedsystem (3 cases).6 Table 3 shows the number ofobservations for each product in each market.

Dependent variable

To study the incidence and drivers of capacityexpansion bandwagon behavior, we need to define

6 Those three cases refer to Pantasote, Vista Chemicals, and Ster-ling Chemicals, who had large minority shareholders. Severalyears of observations for companies including DuPont, BP, andVeba were dropped as well because they either had a signifi-cant minority shareholder (in the case of DuPont) or minoritygovernment ownership (in the case of BP and Veba).

the variable ‘capacity expansion.’ Petrochemicalfirms can expand capacity through three meth-ods: adding a greenfield plant, de-bottleneckingan existing plant or adding an incremental unitto existing plants. De-bottlenecking stems fromimprovements in a plant’s process flow. Since de-bottlenecking is carried out on an ongoing basisand does not represent a major, discrete invest-ment, it was excluded from the total set of capacityexpansions. Thus limiting capacity expansion todiscrete additions of capacity, we operationalizedthe dependent variable, the incidence of capacityexpansion, as a binary choice measure. For a givenobservation year, this was set equal to 1 for allobservations where firm i expanded in a particularproduct-market either by adding a new greenfieldplant or by expanding one or more of its plant’s



Table 2(a). U.S. and U.K. companies represented in the market-based corporate governance system

Company Country Shareholder ownership

Allied Chemicals/Allied Signal U.S. DispersedAmoco U.S. DispersedAtlantic Richfield/Arco Chemicals U.S. DispersedUSX–Marathon–Aristech U.S. Part of U.S. Steel (dispersed) until 1986;

then went private in 1989Chevron U.S. DispersedConoco U.S. Dispersed; taken over by DuPont in 1981Dow U.S. DispersedDuPont U.S. Dispersed until 1984 when Seagrams took

23% stakeExxon U.S. DispersedB. F. Goodrich–Geon U.S. Dispersed; Geon was divested in 1993Georgia Pacific–Georgia Gulf U.S. DispersedGulf U.S. Dispersed; purchased by Chevron in 1984Hercules U.S. DispersedLyondell U.S. Spin-off from Atlantic Richfield (retained a

50% stake) in 1988Mobil U.S. DispersedMonsanto U.S. DispersedOccidental Petroleum U.S. DispersedPhillips Petroleum U.S. Dispersed; targeted by Icahn and Pickens in

1986Quantum Chemicals U.S. Dispersed; taken over by Hanson Trust in

1993El Paso–Rexene U.S. Part of El Paso (dispersed) until 1983,

private until 1987 then dispersedStauffer U.S. DispersedTenneco U.S. DispersedTexaco U.S. Dispersed; targeted by Carl Icahn in

1987–88Union Carbide U.S. Dispersed until 1985; targeted by Bass

Brothers, dispersed 1992 onwardsICI U.K. Dispersed; targeted by Hanson Group in

1991British Petroleum U.K. British government 39% stake until 1987,

then dispersedShell U.K. DispersedBritish Celanese U.K. DispersedStavely U.K. Dispersed

production capacity by more than 5 percent,7 or:

y =

1 if firm i expands by adding agreenfield plant or by increasingany one of its existing plants’ capacity> 5 percent in a particularproduct-market in a particular year

0 otherwise

7 Using the 5 percent cut-off, de-bottlenecking represented 24percent of all expansions. Using a 10 percent cut-off, de-bottlenecking represented 37 percent of all expansions. Withthe 10 percent cut-off, there were no significant changes to theresults. These estimations are available from the authors uponrequest.

Explanatory variables

The explanatory variables concern the variables ofdirect interest, i.e., the bandwagon behavior andthe corporate governance systems. Since we wantto explore how different corporate governance sys-tems affect capacity expansion bandwagon behav-ior, we need measures of the degree to which rivalsinvest simultaneously.

Two measures were defined to estimate rivals’expansion. The first, RIVAL1, was constructedas the percentage of the number of rivals thatinvested simultaneously in a product-market dur-ing an observation year. A second indicator of



Table 2(b). German and Japanese companies represented in the bank-based corporate governance system

Company Country Shareholder ownership

BASF Germany Deutsche Bank (23.9%, 1 board seat), Dresdner (15.5%),Commerzbank (7.2%)

Bayer Germany Deutsche Bank (27.9%, 1 board seat), Dresdner (12.8%),Commerzbank (5.6%, 1 board seat)

Hoechst Germany Deutsche Bank (11.9%), Dresdner (11.9%, 1 board seat),Commerzbank (8.9%, 1 board seat)

Veba Germany Minority government ownership until 1986; Deutsche Bank(11.9%, 1 board seat), Dresdner Bank (22.7%, 1 board seat)

RWE–DEA Germany Deutsche Bank (11.5%, 2 board seats), Dresdner Bank (9%, 1board seat)

Asahi Chemicals Japan Daiichi Kangyo Group: Daiichi Kangyo Bank (3.6%) andSumitomo Bank (4.5%)

Denki Kagaku Japan Mitsui Group: Mitsui-Sakura Bank (3.1%), Daiichi KangyoBank (4.4%), Long Term Credit Bank (3.5%), NorinchukinBank (3.1%)

Kaneka Japan Mitsui Group: Mitsui-Sakura Bank (5.5%), Daiwa Bank(5.0%), Taiyo Kobe Bank (4.0%), Tokai Bank (3.6%)

Kureha Chemicals Japan Fuyo Group: Fuji Bank (6.3%), Daiwa Bank (5.5%), IndustrialBank of Japan (3.5%)

Mitsubishi Chemicals Japan Mitsubishi Group: Mitsubishi Bank (4.8%), Industrial Bank ofJapan (3.0%)

Mitsubishi Petrochemicals Japan Mitsubishi Group: Mitsubishi Bank (5.4%)Mitsui Petrochemicals Japan Mitsui Group: Mitsui-Sakura Bank (7.3%)Mitsui Toatsu Japan Mitsui Group: Mitsui-Sakura Bank (3.7), Industrial Bank of

Japan (2.4%), Norinchukin Bank (2.3%)Nippon Zeon Japan Daiichi Kangyo Group: Daiichi Kangyo Bank (6.1%),

Industrial Bank of Japan (5.2%)Nissan Chemical Industries Japan IBJ Group: Industrial Bank of Japan (4.6%), and Fuji Bank

(2.8%)Sekisui Japan Sanwa Group: Sanwa Bank (4.8%) and Daiwa Bank (4.4%)Shin-Etsu Japan Related to Mitsubishi Group: Mitsubishi Bank (4.5%), Daiichi

Kangyo Bank (4.2%), Long Term Credit Bank (4.0%)Showa Denko Japan Fuyo Group: Fuji Bank (5.3%)Sumitomo Chemicals Japan Sumitomo Group: Sumitomo Bank (4.5%), Long Term Credit

Bank (2.3%), and Industrial Bank of Japan (2.4%)Toagosei Japan Related to IBJ and Mitsui Groups: Tokai Bank (3.6%),

Industrial Bank of Japan (3.3%) and Mitsui-Sakura Bank(3.7%)

Tokuyama Soda Japan Sanwa Group: Sanwa Bank (4.7%) and Industrial Bank ofJapan (2.5%)

Tosoh Japan IBJ Group: Industrial Bank of Japan (5.6%)Tonen Japan Fuyo Group: Fuji Bank (4.0%) and Industrial Bank of Japan

(4.0%)

rivals’ expansion, RIVAL2, measures the percent-age of total capacity that was added simultane-ously by rivals. There are advantages and disad-vantages to either measure. The first allows us totest whether firms are more likely to invest whenthey see more of their rivals’ investing, regardlessof how much capacity these are adding. This mea-sure has the disadvantage that it does not focuson preemption effects through the size of rivals’investments. This is where the second variable has

an advantage since it directly measures the amountof capacity added by rivals. Given the pros andcons of either measure, both were used separatelyin the estimations.

To compare the two corporate governance sys-tems regarding capacity expansion, two sets ofdummy variables were constructed. In the first set,one dummy was set to 0 when firms had headquar-ters in Japan or Germany (i.e., bank-based system)and to 1 if companies were headquartered in the



Table 3. Countries, products included in the data sample

Productname

Market Number ofobservations

Percentage of observations which have HQ in Number ofexpansions

U.S. U.K. Germany Japan

Ethylene Europe 182 36 27 36 0 40HDPE Europe 65 45 12 43 0 20LDPE Europe 137 39 27 34 0 17PP Europe 110 24 34 43 0 44PS Europe 66 12 45 42 0 13PVC Europe 92 30 29 40 0 24Styrene Europe 93 41 29 30 0 12VCM Europe 78 10 29 60 0 8Ethylene U.S. 222 90 9 2 0 41HDPE U.S. 161 81 11 8 0 41LDPE U.S. 120 100 0 0 0 13PP U.S. 123 85 15 0 0 28PS U.S. 86 78 0 0 22 23PVC U.S. 140 71 5 24 0 28Styrene U.S. 90 100 0 0 0 9VCM U.S. 60 82 18 0 0 6Ethylene Japan 125 0 0 0 100 18HDPE Japan 93 8 0 0 92 12LDPE Japan 119 6 0 0 94 11PP Japan 131 0 0 0 100 25PS Japan 180 0 0 0 100 23PVC Japan 122 6 1 0 93 13Styrene Japan 86 8 0 0 92 12VCM Japan 151 0 0 0 100 10

Total 2832 491

United States or the United Kingdom (i.e., market-based system). The second set consists of threedummy variables indicating whether the sampledfirm was headquartered in Japan, Germany, theUnited Kingdom, or the United States. (Japan wasused as the base for comparisons.) The purposeof this set of dummy variables was to analyzegovernance effects by country rather than byeach system.

Control variables

Eight control variables were included in the esti-mations: historical demand growth, lagged capac-ity utilization, supply lumpiness, market share,free cash flow, commitment to the industry, andindustry concentration. First, demand growth hasbeen shown in previous studies to have a positiveeffect on the probability of expansion (Lieberman,1987a; Gilbert and Lieberman, 1987) and is there-fore included in the estimations as a control vari-able. While firm-level growth in production maybe more indicative of the firms’ demand, such dataare not available. Similar to other studies, a 4-year

compound annual growth rate for the product-market was employed (Gilbert and Lieberman,1987; Lieberman, 1987a). The growth measure iscalled GR.8

Second, capacity utilization has been shown inprevious studies to have a positive and signifi-cant effect on the likelihood of expansion (Lieber-man, 1987a). As capacity utilization increases incommodity-like industries, significant returns areearned, prompting firms to consider expanding.Ideally, a capacity utilization measure should bedefined at the firm level. However, such detaileddata are not available. Thus, a product-market

8 We used the national market (or regional market in the case ofEurope) rather than global market as the basis of determiningthe growth, capacity utilization, market share, and Herfindahlmeasures. Many of the products, such as ethylene and VCM, arevery costly to transport long distances because of their gaseousor hazardous nature. The range of exports as a percentage oftotal production was from 0 (unsurprisingly) for ethylene to 38.4in 1975 for HDPE in Japan. Given that, on average, exportsrepresented around 5 percent for Europe, and 11 percent for theUnited States and Japan of total production, the control variableswere calculated on a regional basis (i.e., United States, Japan,Europe) rather than on a global basis.



level measure of capacity utilization was utilized,called CU. It was calculated as in previous stud-ies (Gilbert and Lieberman, 1987; Lieberman,1987a) as an average of two measures of capacityutilization, one lagged 1 year, the other lagged2 years. This was done to take into considerationboth incremental and greenfield expansions whichhave a different lead time before they comeon stream.

Third, in previous studies, lumpiness was shownto have a strong negative effect on the probabilityof expansion (Lieberman, 1987a). Lumpiness, intheory, should be measured as the fraction of themarket that a new minimum efficient scale plantwould cover. However, such data again are notavailable. Instead, we resorted to the typical proxy,which has been used in other studies: average plantsize divided by total product-market production(Lieberman, 1987a). The measure of lumpiness iscalled LUMP.

Fourth, since larger firms (in terms of marketshare) are more likely to have more plants thansmaller firms, they are also more likely to investmore. Furthermore, large firms may have an advan-tage in gathering and processing information oversmaller firms. Moreover, larger firms may havemore experience in making capacity expansiondecisions and are, thus, more cautious in their sub-sequent capacity expansion decisions (e.g., Hen-derson and Cool, 1999). It has indeed been shownin previous studies that firms with higher marketshares are more likely to expand, all else equal,but are less likely to hop on an investment band-wagon (Lieberman, 1987a; Henderson and Cool,1999). Market share (MS) was constructed as thefirm’s share of the total product-market capacitylagged by 1 year. Similar to other studies, we cal-culated market share based on capacity rather thanoutput data.

Fifth, free cash flow (FCF) is included as indi-cator of a firm’s propensity to expand. Addi-tional cash flow from operations typically promptsfirms into searching for investment opportunities,which has been strongly supported empirically(e.g., Worthington, 1995). Expanding capacity canbe one outlet. Ideally, for diversified corporations,business unit performance would be the most rel-evant measure; however, reporting standards varygreatly across countries. For example, for corpora-tions listed in the United States, reporting divi-sional performance is compulsory. However, inEurope and Japan, it is optional. At the corporate

level, a measure of cash flow would be most suit-able. However, even for this measure, data werescarce from the various financial databases used.We thus resorted to a proxy, the average of thelog of net corporate profits in the 2 years prior tothe observation year (taking into account the lead-time in capacity expansion as argued above for thevariable CU).

Sixth, we stated that more diversified firms mayhave more stable cash flows than smaller pure-play firms and, therefore, have better access to thecapital markets during troughs in the cycle. Thesecorporations would, thus, be better able to investcounter-cyclically or against the bandwagon. Totest this relationship, we included a measure, com-mitment (COMM) as the percentage of revenuesof the firm in the petrochemical industry (or itsdivisional revenues) as a percentage of its totalrevenues lagged by 1 year.

Finally, we also test for the effect of industryconcentration on investment behavior. Differencesin investment behavior could indeed be attributedto a consolidating industry (easier coordination ofcapacity expansion decisions) rather than to thecorporate governance system. Indeed, the concen-tration ratios of the three different regions do dif-fer. Thus, while dummy variables for each productwere already included in the estimations, we alsoadded a Herfindahl index of producer concentra-tion (HERF) to control for its effect.

Estimation method and expected effects

The relationship between a firm’s expansion deci-sion (a binary decision) and its determinants isanalyzed through probit regression analysis. Thegeneral form of the estimated equation is:

Prob(y = 1|X, ε) = �(α + β1GR + β2CU

+ β3LUMP + β4MS + β5FCF +4∑

i=1

∂iXi

∗ RIVAL +1or3∑j=0

λjDj ∗ RIVAL +1or3∑j=0

δjDj

∗ FCF ∗ RIVAL + ε)

where Xi represents the control variables inter-acted with RIVAL including market share, commit-ment, and the Herfindahl, and where Dj represents



the dummy variable, first, for the corporate gover-nance systems and, secondly, for those firms head-quartered in Japan, Germany, the United Kingdom,or United States. For the models incorporating thecorporate governance systems, the bank-based sys-tem was used as the basis for comparison. For themodels incorporating the country dummies, Japanwas used as the basis for comparison.

We argued above that either governance sys-tem has characteristics that may encourage or slowinvestments in new capacity, resulting in compet-ing hypotheses. First, before ascertaining whichsystem contributes more to preventing poor expan-sion timing, we can examine both systems pooledtogether. In this case, a finding of a negative effectof the rivals’ expansion variable, RIVAL, on afirm’s expansion probability would be consistentwith a beneficial effect of both governance systemson investment timing. If, on the other hand, bothsystems were ineffective in preventing overcapac-ity, then RIVAL may be expected to have a positiveeffect on a firm’s expansion probability. Givenprevious empirical research on the topic, RIVALwas anticipated to have a positive effect on theprobability of a firm expanding its capacity (e.g.,Henderson and Cool, 1999; Lieberman, 1987a).

Secondly, we examined the effect of rivals’expansion on a firm’s expansion probability acrosseach corporate governance system. We thereforeinteracted the terms measuring rivals’ expansion(RIVAL1 and RIVAL2) with the dummy vari-able representing the corporate governance sys-tem. Thus, if the bank-based system were moreeffective than the market-based system, the pre-dicted effect of RIVALBANK on the probability of

a firm expanding its production capacity would beless than RIVALMARKET. If the market-based sys-tem were ineffective, then the coefficient of rivals’expansion on a firm’s expansion probability wouldbe positive and significant, providing support forHypothesis 1a. If, on the other hand, the market-based system were effective, then we would expectthe interaction term for the market-based system tobe negative and significant, supporting Hypothesis2a. Refer to Table 4 for a summary of the inter-pretations of all of the possible results.

Third, we examined the effect of free cash flow(FCF) on investment timing. We interacted therivals’ expansion terms (RIVAL1 and RIVAL2)with the variable measuring FCF within each cor-porate governance system. Since most investmentsare funded internally, we would expect that com-panies with higher cash flows in either corporategovernance system to be more likely to jump onan investment bandwagon. However, it may notbe as big a problem in one system vs. another. Forexample, we argued that in Germany and Japan thebanks with their significant inside information maystill prevent their clients from investing, suggestingthat the coefficient for FCF * RIVAL for the bank-based system may be less than the correspondingcoefficient for the market-based system, providingsupport for Hypothesis 1b. However, the lack ofoptions to part with the excess cash in the bank-based system may lead to the opposite effect, thussupporting Hypothesis 2b. For the interpretation ofall possible results, refer to Table 5.

Fourth, we examined the effects of rivals’ expan-sion on a firm’s expansion probability across eachnation: Japan, Germany, the United Kingdom, and

Table 4. Interpretation of the possible results for corporate governance systems

Bank-based system (λ0)

Positive(and significant)

Negative(and significant)

Positive (andsignificant)

Both systems areineffective and themarket-based system isworse

The bank-based systemis effective. Themarket-based system isworse. If λ1 > |λ0| thenit is also ineffective.Market-

basedsystem (λ1) Negative (and

significant)The bank-based systemis ineffective. Themarket-based is systemis better. If |λ1| > λ0

then it is also effective

Both systems areeffective and themarket-based system isbetter



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the United States. We could then assess, first,which countries were more effective at prevent-ing investment bandwagon behavior and, secondly,whether there were significant differences acrosscountries within the two corporate governance sys-tems. We thus interacted the rivals’ expansion vari-ables with the categorical variables indicating thecountries of origin rather than the corporate gover-nance systems. On the one hand, if the bank-basedsystem were more effective than the market-basedsystem, the predicted effect of RIVAL on a firm’sexpansion probability would be less for Japan andGermany than for the United States and UnitedKingdom. If, on the other hand, these governancesystems of the United States and United King-dom were more effective, then we would expectthe interaction terms to be negative and signifi-cant. Furthermore, regardless of the effectivenessof the systems, given that Japan and Germany wereconsidered part of the same bank-based corporategovernance system, we would anticipate no sig-nificant differences in the investment patterns ofcompanies headquartered in Japan and Germany.Similarly, we would not expect any significant dif-ference between the coefficients for the UnitedStates and the United Kingdom.

Finally, to assess the effect of free cash flow onbandwagon behavior within each corporate gover-nance system, we also interacted RIVAL with thevariable measuring FCF and the categorical vari-able representing the different nations. We wouldanticipate that the results would be similar to themodels incorporating the broad corporate gover-nance systems. For example, if the market-basedsystem were more effective than the bank-basedsystem but still suffered more from agency costs

of free cash flow, we would tend to see a nega-tive interaction effect with RIVAL for the UnitedKingdom and United States. Yet, we would alsofind a positive effect for the two countries inter-acted with FCF and RIVAL. Furthermore, weought to observe no significant differences on theeffect of free cash flow on bandwagon behavioracross Japan and Germany or the United Statesand United Kingdom.

EMPIRICAL RESULTS

Descriptive statistics

Table 6 shows summary statistics for the variablesused in the estimations. All key variables showsubstantial variation (the Pearson correlation coef-ficients are given in the Appendix). On average,the capacity added by firms amounted to approx-imately 83,000 tons per year, with the maximumbeing 910,000 tons per year, the size of a newethylene cracker. The average percentage of rivalsexpanding in 1 year was approximately 15 percentbut reached a maximum of 71 percent (or 11 out of14 firms in that year). The 4-year demand growthrate was on average slightly above 2.9 percent peryear but had a low of −11 percent and a high of 18percent, reflecting demand volatility in the indus-try. The demand cycles are also reflected in thecapacity utilization rates, which range from a lowof 47 percent to a high of 116 percent.9

9 Capacity utilization rates sometimes exceeded 100 percentwhen plants in the industry were run without planned stoppagesfor maintenance.

Table 6. Descriptive statistics, selected variables

Number of observations = 2832

Variable Mean S.D. Minimum Maximum

Decision to Add Capacity 0.18 0.38 0.00 1.00Total Capacity Added 83.60 113.73 1.00 910.00Historical Demand Growth 2.75 4.28 −11.00 17.78Capacity Utilization 82.48 11.80 47.59 113.12Supply Lumpiness 6.37 2.94 2.33 19.54Percentage of Rivals’ Expansion 15.33 14.22 0.00 71.42Percentage of Capacity Expanded by Rivals 4.63 5.20 0.00 30.50Log of Net Profits 12.32 2.18 −3.99 15.62Commitment 47.09 36.94 1.31 100.00Market Share 8.07 5.52 0.00 35.37Herfindahl Index 1016.00 280.00 505.00 1927.00



Estimation results

The probit regression results can be seen inTables 7 and 8. The equation was first estimatedwith the intercept term α restricted to bethe same across firms, countries, and products.To determine the joint significance of allpossible fixed effects (i.e., company, products,and countries), a likelihood ratio test wasperformed on the restricted vs. unrestricted probitregressions (e.g., Judge et al., 1982). The countrydummies (χ 2(2) = 4.31) were insignificant. Theindividual firm dummies (χ 2(53) = 62.21) werealso insignificant, suggesting that individualfirm effects were appropriately captured in thevariables themselves. However, the χ 2 statistic

was significant for the product dummies (χ 2(7) =22.24).10 Hence, the product-specific dummieswere included in the estimations.

The first column of Tables 7 and 8 lists theindependent variables and their values at the sam-ple mean. The other columns represent the var-ious models that were tested. Model 1 has esti-mates for the control variables only. Models 2and 3 in Table 7 have estimates for the corpo-rate governance dummies measured as either thebank-based system or the market-based system.

10 These chi-squared figures are for the second definition ofrivals’ expansion. There was little difference in the chi-squaredstatistics using the alternative definition.

Table 7. Probit analysis of expansion probability: corporate governance systems (yi,t = 1 if firm i is expanded bymore than 5% in the observation year t)

Variable(mean values)

Model 1a Model 1b Model 2a Model 2b Model 3a Model 3b

Constant −0.59∗∗∗ −0.53∗∗∗ −0.51∗∗∗ −0.54∗∗∗ −0.69∗∗∗ −0.65∗∗∗

(1.00) (0.08) (0.08) (0.08) (0.08) (0.11) (0.10)GR 0.55∗∗∗ 0.64∗∗∗ 0.55∗∗∗ 0.64∗∗∗ 0.54∗∗∗ 0.68∗∗∗

(0.031) (0.19) (0.20) (0.20) (0.20) (0.20) (0.20)CU 0.04 0.10∗ 0.02 0.07 0.07 0.12∗

(0.83) (0.06) (0.06) (0.07) (0.07) (0.07) (0.06)LUMP −1.19∗∗ −1.54∗∗∗ −1.25∗∗∗ −1.57∗∗∗ −1.17∗∗∗ −1.52∗∗∗

(0.06) (0.42) (0.41) (0.42) (0.41) (0.42) (0.41)MS 0.45∗∗ 0.66∗∗∗ 0.46∗∗ 0.65∗∗∗ 0.46∗∗ 0.63∗∗∗

(0.08) (0.21) (0.19) (0.21) (0.19) (0.21) (0.19)FCF (*10−2) 1.60∗∗∗ 1.64∗∗∗ 1.87∗∗∗ 1.95∗∗∗ 3.07∗∗∗ 2.57∗∗∗

(11.15) (0.50) (0.50) (0.53) (0.52) (0.76) (0.67)RIVAL 0.42∗∗∗ 1.98∗∗∗ 0.47∗∗∗† 2.24∗∗∗† 1.88∗∗∗† 6.28∗∗∗†

(0.15 for a) (0.10) (0.57) (0.16) (0.59) (0.45) (1.48)(0.04 for b) −0.12∗∗‡ −0.54∗∗‡ −1.46∗∗‡ −6.31∗∗∗‡

(0.06) (0.24) (0.58) (2.11)

InteractionsMS 0.34 −2.13 0.27 −2.07 0.10 −2.13(0.08) (0.89) (2.61) (0.88) (2.61) (0.91) (2.61)COMM 0.14∗ 0.52∗ 0.11 0.25 −0.02 0.20(0.47) (0.08) (0.32) (0.09) (0.34) (0.10) (0.37)HERF −0.42 12.00∗∗ −0.32 −10.40∗∗ −0.24 −10.10∗

(0.1016) (1.49) (5.43) (1.49) (5.45) (1.58) (5.43)FCF −0.13∗∗∗† −0.36∗∗∗†

(11.15) (0.04) (0.12)0.12∗∗‡ 0.51∗∗∗

(0.05) (0.18)

Number of obs. 2832 2832 2832 2832 2832 2832Log likelihood −1190.98 −1216.16 −1189.71 −1213.67 −1183.29 −1207.99χ 2 for model 238.11∗∗∗ 187.73∗∗∗ 240.64∗∗∗ 192.72∗∗∗ 253.49∗∗∗ 204.07∗∗∗

χ 2 for products significant significant significant significant significant significant

Significant at the ∗0.10, ∗∗0.05, and ∗∗∗0.01 level. †bank-based; ‡market-based.



Table 8. Probit analysis of expansion probability: countries (yi,t = 1 if firm i is expanded bymore than 5% in the observation year t)


Model 4a Model 4b Model 5a Model 5b

Constant −0.48∗∗∗ −0.52∗∗∗ −0.65∗∗∗ −0.66∗∗∗

(1.00) (0.08) (0.08) (0.11) (0.10)GR 0.52∗∗∗ 0.64∗∗∗ 0.53∗∗∗ 0.67∗∗∗

(0.032) (0.20) (0.20) (0.20) (0.20)CU 0.04 0.07 0.05 0.13∗

(0.83) (0.06) (0.07) (0.05) (0.06)LUMP −1.54∗∗ −1.66∗∗∗ −1.37∗∗ −1.52∗∗∗

(0.06) (0.45) (0.43) (0.45) (0.44)MS 0.50∗∗∗ 0.66∗∗∗ 0.48∗∗ 0.65∗∗∗

(1.21) (0.21) (0.19) (0.21) (0.19)FCF(*10−2) 1.82∗∗∗ 1.90∗∗∗ 2.97∗∗∗ 2.66∗∗∗

(11.15) (0.53) (0.53) (0.77) (0.51)RIVAL 0.62∗∗∗† 2.41∗∗∗† 1.94∗∗∗† 6.24∗∗∗†

(0.15 for Model a) −0.23∗∗†† −0.35†† −0.66†† 2.52††

(0.04 for Model b) −0.12‡ −0.35‡ −0.24‡ −1.69‡

−0.26∗∗∗‡‡ −0.78∗∗∗‡‡ −2.00∗∗∗‡‡ −6.61∗∗∗‡‡

InteractionsMS 0.15 −2.16 0.03 −2.38

(0.85) (2.61) (0.91) (2.62)COMM 0.01 0.11 −0.09 0.28

(0.11) (0.39) (0.11) (0.41)HERF −0.43 −10.30∗ −0.19 9.84∗

(1.51) (5.47) 1.51 5.45FCF −0.12∗∗∗† −0.35∗∗∗†

0.04†† −0.24††

0.02‡ 0.15∗‡

0.15∗∗‡‡ 0.52∗∗‡‡

Number of obs. 2832 2832 2832 2832Log likelihood −1186.33 −1212.48 −1179.57 −1206.78χ 2 for model 247.40∗∗∗ 195.09∗∗∗ 260.93∗∗∗ 206.51∗∗∗

χ 2 for products sign. sign. sign. sign.

Significant at the ∗0.10, ∗∗0.05, and ∗∗∗0.01 level. †Japan; ††Germany; ‡U.K; ‡‡US.

Model 2 refers to the corporate governance dum-mies interacted with the rivals’ expansion terms.Model 3 adds the free cash flow interaction withthe rivals’ expansion terms. In Table 8, Models4 and 5 report estimates when corporate gover-nance is measured at the country rather than thesystem level. The columns for each model reportthe parameter estimates and their t-statistics. Theestimates are calculated as the partial derivativesof the probability of expansion with respect tothe independent variable, calculated at the sam-ple mean. For each of the three models, twocolumns are reported reflecting the two measuresfor the variable, rivals’ expansion. The ‘a’ col-umn provides the results for the interactions with

rivals’ expansion defined in terms of the percent-age of the total number of competitors, whichadded capacity (RIVAL1). The ‘b’ column givesthe outcomes for rivals’ expansion defined in termsof percentage of capacity added by the firm’s com-petitors (RIVAL2).

As mentioned in the previous section, researchhas led to the following predictions concerningthe main effect variables, RIVAL1 and RIVAL2,the eight control variables, and their interactionson a firm’s expansion probability. A positive signwas expected for MS, for GR, for CU, for FCF,the rival expansion terms, RIVAL1 and RIVAL2,and the commitment interaction term with RIVAL1and RIVAL2. On the other hand, a negative sign



was projected for LUMP and for the market share,and industry concentration interaction terms withRIVAL1 and RIVAL2.

We see from Models 1a and 1b that most ofthe control variables are significant and in theexpected direction, as has been reported in otherstudies (e.g., Henderson and Cool, 1999; Gilbertand Lieberman, 1987a). The coefficients for Model1b for GR (0.64), CU (0.10), LUMP (−1.54), MS(0.66), and FCF (1.64) show that larger firms aremore likely to expand than smaller firms; growth,capacity utilization, and liquidity are often triggersfor expanding capacity, whereas higher lumpinesslowers a firm’s expansion probability. In addition,the size and significance of the rivals’ expan-sion term pooled across the two corporate gover-nance systems strongly support bandwagon behav-ior (RIVAL1 = 0.42, RIVAL2 = 1.98). In otherwords, neither of the two corporate governancesystems slows simultaneous investments. How-ever, the estimates from Model 1 indicate thatsome of the firm-level factors such as diversifica-tion (COMM * RIVAL2 = 0.52) do act as a brake,albeit weakly, on them ‘hopping on the investmentbandwagon.’ This is illustrated by the followingexample from Model 1b: a 1 percent increase inthe capacity of rivals’ expanding (i.e., from 0.04 to0.05) would lead to a 1.98 percent + 0.52 percent= 2.50 percent increase above the average likeli-hood of expansion if a firm were fully committedto the industry. However, it would drop to 2.03percent for a petrochemical business unit, whichrepresented only 10 percent of the corporation’stotal revenue.

In Models 2a and 2b, the governance systemdummy is added to the estimation and inter-acted with the RIVAL variables. The coefficientsfor RIVAL under the bank-based systems arepositive and significant (RIVAL1BANK = 0.47 andRIVAL2BANK = 2.24). Furthermore, the coeffici-ents for RIVAL under the market-based system arenegative and significant (RIVAL1MARKET = −0.12and RIVAL2MARKET = −0.54) but their absolutevalues are less than the coefficients for RIVALunder the bank-based system. These results sug-gest that since the market-based system acts as agreater brake than the bank-based system in deter-ring investment bandwagon behavior, the banks inthe bank-based system may be too soft rather thantoo hard on their clients, thus supporting Hypoth-esis 2a. However, we must reiterate that neither

system is particularly effective in preventing aninvestment bandwagon.

Models 3a and 3b allow us to examine theeffect of the agency costs of free cash flow ineach corporate governance system on bandwagonbehavior. As mentioned earlier, in order to testfor the effect of free cash flow in each cor-porate governance system, FCF was interactedwith RIVAL. Compared to Models 2a and 2b,the coefficients for RIVAL under the bank-basedsystem are greater and remain positive and sig-nificant. Similarly, the coefficients for RIVALunder the market-based system are also greater,and remain negative and significantly differentthan zero. This time, however, in Model 3bthe absolute value for RIVAL2MARKET is greaterthan for RIVAL2BANK (|RIVAL2MARKET| = 6.31 >

6.28 = RIVAL2BANK). Thus, while controlling forone source of poor timing—free cash flow—themarket-based system is actually effective. How-ever, the signs of the coefficients for the variablesinteracting FCF and RIVAL under the two sys-tems are also different (e.g., FCF * RIVAL2BANK =−0.36 and FCF * RIVAL2MARKET = 0.51). Thus, ifa business unit were to earn $100 million in eachsystem, a 1 percent increase in RIVAL2 (i.e., from0.05 to 0.06) would result in an increase in theaverage likelihood of expansion by 2.14 percent(ln(100,000) * (−0.36) +6.28) in the bank-basedsystem and 1.70 percent (2.14%—(ln(100,000) *(0.51) + (−6.31)) in the market-based system.These results suggest that free cash flow, as arguedby Jensen (1986) and others, is a major cause ofthe ineffectiveness of the market-based system. Inother words, management does seem to have sig-nificant discretion over the use of these funds,despite the option to repurchase shares. Alterna-tively, free cash flow does not seem to pose aproblem for investment bandwagon behavior inthe bank-based system. These results suggest thatbanks in Germany and Japan may have encour-aged investment regardless of the firms’ cash flowsituation, in order to grow their revenues andprofits from increased business with their clientcompanies. Indeed, we find that the average debtequity ratios over the period as follows: Japan10.88; Germany 2.16; United Kingdom 1.40; andUnited States 1.26—providing additional evidencefor this argument. These results are summarized inthe shaded box in Table 9.

In Models 4a and 4b in Table 8, we intro-duce three dummy variables to represent the four



Tabl

e9.

Sum

mar

yof

the

resu

ltsco

rpor

ate

gove

rnan

cesy

stem

sin

clud

ing

free

cash

flow

.



Table 10. Probit analysis of expansion probabilities: Japan ownership structure (yi,t = 1 if firm i isexpanded by more than 5% in the observation year t)


Model 6a Model 6b Model 7a Model 7b

Constant −0.29∗∗ −0.46∗∗∗ −0.42∗∗∗ −0.56∗∗∗

(1.00) (0.10) (0.11) (0.13) (0.13)GR 0.74∗∗ 1.28∗∗∗ 0.79∗∗ 1.33∗∗∗

(0.034) (0.31) (0.32) (0.32) (0.33)CU −0.03 0.10 0.01 0.12(0.85) (0.09) (0.09) (0.09) (0.10)LUMP −1.17∗∗ −0.49 −1.14∗∗ −0.47(0.08) (0.59) (0.62) (0.56) (0.61)MS 0.28 0.40 0.28 0.44∗

(0.09) (0.29) (0.27) (0.29) (0.27)FCF (*10−2) 0.65 0.64 1.67∗ 1.53∗

(10.06) (0.73) (0.72) (0.95) (0.90)RIVAL 0.55∗∗1 2.82∗∗∗1 1.07∗1 5.51∗∗1

(0.12) for Model a −0.23∗2 −0.71∗2 0.422 −1.222

(0.04) for Model b −0.34∗∗3 −1.01∗∗3 −0.073 −1.333

−0.85∗∗4 −1.87∗4 −4.784 −12.624

InteractionsMS −1.41 −4.62 1.37 −5.33

(1.28) (4.13) (1.29) (4.15)COMM −0.05 0.29 −0.12 0.07

(0.15) (0.54) (0.16) (0.57)HERF −3.47 −10.10 −3.36 10.4

(2.27) (8.04) (2.02) 8.05FCF −0.051 −0.251

−0.062 0.062

−0.023 0.053

0.374 1.014

Number of obs. 829 829 829 829Log likelihood −272.77 −295.07 −270.38 −293.72χ 2 for model 122.04∗∗∗ 77.42∗∗∗ 126.81∗∗∗ 80.13∗∗∗

χ 2 for products not significant not significant not significant not significant

Significant at the ∗0.10, ∗∗0.05, and ∗∗∗0.01 level. 1one main bank; 2two banks; 3three banks; 4four banks.

countries—Japan, Germany, the United Kingdom,and the United States—to determine whether thesource of the differences stems more from thecountries rather than governance systems. Japanwas used as the basis for comparisons. Severalobservations can be made from this table. First, asin Table 7, the coefficients for RIVALJAPAN are pos-itive (0.62 and 2.41) and greater than the absolutevalues of the coefficients for RIVALGERMANY

(−0.23 and −0.35), RIVALUK (−0.12 and −0.35),or RIVALUS (−0.26 and −0.78). But one of thecoefficient values for RIVALGERMANY was signifi-cant whereas coefficient values for RIVALUK werenot significant. These results, thus, indicate that theineffectiveness of the bank-based system observedin Table 7 was primarily due to the investment

behavior of the Japanese firms in the sample.Moreover, since the investment bandwagon behav-ior of German firms is significantly different fromthat of the Japanese firms and since investmentbandwagon behavior of U.K. firms is not signifi-cantly different from that of Japanese firms, we canimply that grouping countries based on the corpo-rate governance systems alone may not be fullyjustified.11

11 When we reran Models 4 and 5 using the United States orthe United Kingdom as the basis for comparison we coulddetermine if there were significant differences within the market-based system. The results (available from the authors uponrequest) show that there are no significant differences betweenthe investment behavior within the market-based system.



Models 5a and 5b in Table 8 show estimatesof the interaction between free cash flow andrivals’ expansion within each country. As above,we note that the separate effects of the market-based countries—the United Kingdom and theUnited States—are not consistent with the aggre-gate findings of Table 7. The absolute values of thecoefficients for RIVALUK (-0.24 and -1.69) are notsignificantly different than those for RIVALJAPAN

(1.94 and 6.24). Rather, the aggregate results fromTable 7 seem to be coming from the behaviorof U.S.-based firms, as the coefficient values forRIVALUS (−2.00 and −6.61) are greater than thosefor RIVALJAPAN. Furthermore, the absolute val-ues of the coefficients for FCF * RIVALUK, whilepositive (0.02 and 0.15), are still less than thosefor FCF * RIVALJAPAN (-0.12 and -0.35), sug-gesting that agency costs of free cash flow atleast in this industry do not pose a problem inthe United Kingdom. Rather the agency cost offree cash flow seems to stem from the UnitedStates, where the coefficient values for FCF *RIVALUS (0.15 and 0.52) are greater than thosefor FCF * RIVALJAPAN. In summary, these obser-vations once again suggest that grouping countriesbased on corporate governance systems may notbe fully warranted.

Given that the source of poor investment timingprimarily in the U.S. corporate governance sys-tem comes from free cash flow, we explored howbank ownership structure may have an influencein poor investment timing in Japan.12 Bank own-ership in Japanese petrochemical companies comesin varying forms. For example, several companies(four cases) relied on one main bank–shareholderwhereas other companies had up to four mainbank–shareholders. We used this variance to deter-mine whether it indeed had an effect on invest-ment timing. Table 10 thus shows the interac-tion of the number of bank shareholders withrival’s expansion (Models 6a and 6b) and withthe free cash flow interaction (Models 7a and7b.) Models 6a and 6b illustrate some interestingresults. The Japanese investment bandwagon prob-lem seems to stem from an overreliance on onemain bank–shareholder. A sole bank–shareholdermay have a greater ability to encourage its com-pany to invest more, as long as it were far from

12 Ideally, we wanted to explore the effect of bank ownership inGermany and Japan; however, data are less readily available forGerman companies and their ownership structures.

default, regardless of the competitive dynamics.However, those Japanese companies with morethan one bank–shareholder may receive differ-ences in opinion regarding when they shouldinvest, leading them to be slightly more cautious.Upon closer examination, the debt–equity ratioswere significantly greater for those companiesreliant on one bank–shareholder.13 While we canonly speculate, German companies likely exhibitless investment bandwagon behavior because theyhave several bank–shareholders.

DISCUSSION AND CONCLUSIONS

While several empirical studies have examinedthe question of how effective corporate gover-nance systems are in punishing firms once perfor-mance declines (e.g., Kaplan, 1997), the questionof how well different corporate governance sys-tems do in preventing poor investments has notbeen addressed. The present paper is a first stepin empirical research on this topic. In this paper,we examined the impact of two broad systemsof corporate governance: the bank-based systemof Germany and Japan and the market-based sys-tem of the United States and the United King-dom on firm’s investment decisions. In partic-ular, we tested which system better prevented,if at all, investment bandwagon behavior, or thetendency to invest in capacity when rivals areinvesting. Since the theory did not provide unam-biguous explanations, we arrived at two compet-ing hypotheses. The empirical analysis drew ona detailed database developed on 53 petrochem-ical companies in Japan, Germany, the UnitedKingdom, and the United States during the period1975–95. This period was characterized by severalinstances of simultaneous investments and industryovercapacity.

The empirical analyses provided several results,which advance our knowledge on the effect of cor-porate governance systems on investment behav-ior. First, we could observe a strong and sig-nificant bandwagon effect on investment in newcapacity across the entire sample, suggesting that

13 For companies with one bank–shareholder the debt–equityratio was 1.07 times larger than for companies with twobank–shareholders; 2.15 times greater for those with three and5 times for those with four.



neither corporate governance system was partic-ularly effective in curbing overinvestment. Sec-ond, we found that the market-based governancesystem, while ineffective, did act as a strongerdeterrent than the bank-based corporate gover-nance system in curbing investment bandwagonbehavior, suggesting that banks as monitors maybe too soft rather than too hard. Third, we sawthat the source of overinvestment in the bank-based system was not from agency costs of freecash flow. It appeared that banks in the bank-based system may have encouraged investment,perhaps regardless of the firms’ cash flow situa-tion, to gain from increased business with theirclient companies. Fourth, we found further evi-dence of this potential investment encouragementby examining the structure of bank ownership inthe Japanese subsample. As the number of bankshareholders decreased in Japanese companies,investment bandwagon behavior and debt–equityratios increased, suggesting that overreliance onone large bank rather than several was a poorcorporate governance choice. Fifth, we showed asignificant link between overinvestment and thepresence of free cash flow with firms in themarket-based systems. Apparently, managementhas enough discretion in this system invested inprojects for their own benefit but which are poten-tially not in the shareholders’ best interest. Indeed,this observation is also very consistent with eventsin the petrochemicals industry during the 1980s. Ofthe 29 companies operating in the market-basedsystem, eight were subject to hostile takeovers.Sixth, we observed that there were differencesacross countries within the same governance sys-tems that limit easy generalizations. While thedisaggregated analysis of the market-based systemconfirmed the aggregate results, the findings fromthe individual countries of the bank-based sys-tem showed that the aggregate effect was drivento a large extent by the Japanese firms in thesample. German firms, while considered part ofthe same bank-based corporate governance sys-tem, did not exhibit the same degree of invest-ment bandwagon behavior as the Japanese firms.One possible explanation could be that none ofthe German companies were overly reliant on onebank–shareholder.

In addition to the academic contributions, sev-eral implications for management can be takenfrom this study, especially for those competing

in an industry with players from different corpo-rate governance systems. First, managers shouldbe aware that they may be facing competitors thatmay be more likely to join an investment band-wagon because they are embedded in a differ-ent corporate governance system. This highlightsthe importance of better timing (e.g., investingcounter-cyclically or against the herd) to gain anadvantage on their rivals. Indeed, in one studyon timing, Achi et al. (1996) found that returnon investment increased by 5 percent for bet-ter timers of capacity expansion. Secondly, whilemanagers have to be cognizant of the investmentbehavior of their foreign rivals, they cannot relyon the effectiveness of their own corporate gov-ernance system to curb investment bandwagonbehavior. Rather, they would need to look to alter-native mechanisms to manage capacity in addi-tion to better timing: new process technologiesto decrease the minimum efficient scale, and/orbetter industry coordination through debottleneck-ing, small incremental investments, and scrap andbuild policies.

Several limitations of the study need to benoted which could lead to future research. First,overinvestment in capacity expansion is only onepossible manifestation of a weak corporate gov-ernance system. There are other investments wedid not consider such as unrelated acquisitionsand organizational inefficiencies. It may indeedbe possible that, while the market-based systemis less ineffective in curbing investment band-wagon behavior, it may be more ineffective incurbing other value-destroying projects. Second,we took a broad view of both the market-basedand bank-based corporate governance systems byexamining an industry whereby the participantsfairly represent the characteristics of each. How-ever, there may indeed be differences within thesystems other than ownership concentration thatlead to differential investment bandwagon behav-ior. Thirdly, we examined primarily the effectof one main corporate governance mechanism:ownership concentration. In future research, theeffects of other mechanisms such as the make-upof the board of directors or management com-pensation could also be examined across corpo-rate governance systems. We hope, however, thatin spite of these limitations, new light has beenshed on the determinants of investment band-wagon behavior and the link with corporate gov-ernance systems.



ACKNOWLEDGEMENTS

The authors gratefully acknowledge the data col-lection support from Dr John Wyatt of TECNONand Dr David Glass of Chemsystems. The authorswould also like to thank two anonymous reviewersand Professor Jennifer Bethel for their constructivecomments on earlier versions of the paper.

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APPENDIX: PEARSON CORRELATION COEFFICIENTS OF THE INDEPENDENTVARIABLES

1. 2. 3. 4. 5. 6. 7. 8. 9.

1. Demand growth 1.002. Capacity utilization 0.16∗ 1.003. Lumpiness −0.16∗ −0.08∗ 1.004. Market share 0.01 0.03 0.28∗ 1.005. Free cash flow 0.07 0.23∗ −0.30∗ 0.02 1.006. Rivals’ expansion (1st definition) 0.27∗ 0.20∗ −0.26∗ −0.06∗ 0.12∗ 1.007. Rivals’ expansion (2nd definition) 0.31∗ 0.19∗ −0.08 −0.03 0.05∗ 0.61∗ 1.008. Commitment −0.05∗ 0.02 0.31∗ 0.08∗ −0.45∗ −0.15∗ −0.07∗ 1.009. Herfindahl 0.01 0.09∗ 0.59∗ 0.35∗ −0.02 −0.08 −0.00 0.10∗ 1.00

∗ Significant at the 5% level).


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