innovative enterprise and sustainable prosperity* · innovative enterprise and sustainable...

InnovativeEnterpriseandSustainableProsperity*

WilliamLazonickUniversityofMassachusettsLowell

[email protected]

October10,2017

*ThisessayformsthebasisforapresentationthatIwillmakeattheannualconferenceoftheInstituteforNewEconomicThinkinginEdinburgh,Scotland,October23,2017.ItalsoprovidesthesubstanceofmyFreemanLectureatthe15thGlobelicsConferenceattheNationalTechnicalUniversityofAthensinAthens,Greece,onOctober11,2017aswellasmycontributiontotheConferenceontheManyFuturesofWork,runbytheInstituteforWorkandtheEconomyinChicago,Illinois,October5,2017.

TheresearchthatunderpinsthisessayhasbeenfundedbytheInstituteforNewEconomicThinking(seehttps://www.ineteconomics.org/research/experts/wlazonick); Ford Foundation (project on FinancialInstitutions for Innovation and Development: www.fiid.org); European Commission Horizon 2020Research and Innovation Programme under grant agreement No. 649186 (ISIGrowth: Innovation-Fuelled Sustainable and Inclusive Growth: http://www.isigrowth.eu/); and the Gatsby Foundation(project on Governing Financialisation, Innovation and Productivity in UK manufacturing:https://www.soas.ac.uk/news/newsitem121890.html). I thank Ken Jacobson and Jang-Sup Shin forcommentsonthematerialinthisessay.

Nick Alpha

Lazonick:InnovativeEnterpriseandSustainableProsperity

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Abstract

Wewantaneconomythatgeneratesstableandequitablegrowth—orwhatIcall“sustainableprosperity.”Wewantproductivitygrowth thatmakes itpossibleforthepopulationtohavehigher livingstandardsovertime.Wewantanequitablesharingofthegainsfromproductivitygrowthamongthosewhoseworkeffortsandfinancialresourcescontributetothatgrowth.Andwewantsufficientjobstabilitytoenableworkerstoremaininproductiveemploymentforsomefourdecadesatworkwhileprovidingthemwithenoughsavingstoprovidethemwithadequateincomesoversometwodecadesofretirement.Weneedinnovativeenterprisetoachievesustainableprosperity.Innovation,definedasahigher-qualityproductatalowerunitcostthanhadpreviouslybeenavailable,generatestheproductivitythatunderpinsstable and equitable growth. The innovative enterprise is the linchpin of investment in productivecapabilities through the interaction of households, governments, and businesses—orwhat I call “theinvestment triad.” In this essay, I outline The Theory of Innovative Enterprise (TIE) as a conceptualframeworkforanalyzinghowaneconomycanachievesustainableprosperity.TIEtransformsourunderstandingofhowtheeconomyfunctionsandperforms.TIEexposestheabsurdityoftheneoclassicaleconomicsconceptof“perfectcompetition,”taughttomillionsofstudentseveryyear,whichpositsthattheunproductivefirmisthefoundationofthemostefficienteconomy.IputforwardTIEasarelevantandrigorousreplacementforneoclassicaltheory.TIEcanexplainhowtheU.S.economy(asa foremost example among the rich nations of the world) displayed a tendency toward stable andequitablegrowthintheimmediatepost-WorldWarIIdecadesbutthen,fromthelasthalfofthe1970s,enteredintoaneraofunstableemployment,inequitableincome,andsaggingproductivity.Driving this epochal change was the transformation of the dominant regime of corporate resourceallocationfrom“retain-and-reinvest”to“downsize-and-distribute.”Underaretain-and-reinvestregime,companiesretaincorporaterevenuesandreinvestinproductivecapabilities,includingthoseofthelaborforce,thatcangenerateinnovativeproducts.Underadownsize-and-distributeregime,seniorcorporateexecutives—incentivizedbystock-basedpayandpressuredbyfinancialpredators—focusondownsizingthe labor force (laying off workers, cutting their pay, neglecting training) and distributing corporaterevenuestoshareholdersintheformsofcashdividendsandstockrepurchases.Thecorporateproclivitytodownsize-and-distributehasbecomesoextremeintheUnitedStatesthatitcannowbetermedthe(largelylegal)lootingofthebusinesscorporation.Itbearsprimeresponsibilityforextremeconcentrationofincomeamongtheveryrichesthouseholdsandtheongoingerosionofmiddle-classemploymentopportunities.Legitimizingthislootingofthebusinesscorporationistheneoclassicaltheoryofthemarketeconomyandits particular “agency theory” application, with its mantra that, for the sake of economic efficiency,businessenterprisesshouldberunto“maximizeshareholdervalue”(MSV).Inthisessay,Iexplainwhy,farfrombeingatheoryofvaluecreation,MSVisanideologyofpredatoryvalueextraction.IconcludebyarguingthattheeradicationofMSVideologyisanecessaryconditionforenablinganeconomy’sbusinessenterprises to contribute to, rather than undermine, the achievement of sustainable prosperity. Toprovideuswitharationalintellectualfoundationforspecificpolicyproposalstostopthelootingofthebusiness corporation—including a ban on stock buybacks, radical changes in incentives for seniorcorporateexecutives,representationofworkersandtaxpayersoncorporateboards,andreformofthetaxsystemtosupporttheinvestmenttriad—Icallforinnovationtheorytoreplaceagencytheoryinourconceptualization—andteaching—ofhowasuccessfuleconomyoperatesandperforms.


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1. Investmentinproductivecapabilities1Wewantaneconomythatgeneratesstableandequitablegrowth—orwhatIcall“sustainableprosperity.”Wewant productivity growth thatmakes it possible for the population to havehigher standards of living.Wewant stableemployment opportunities that enable people toremainproductiveforsomefourdecadesoftheirworkingliveswhileprovidingthemwithenoughsavingsforadequateincomesoversometwodecadesofretirement.Andwewantanequitablesharingof incomeamong thosewhoseworkeffortsand financial resourcescontribute to thenation’sproductivity.Sincethe1980s,theU.S.economyhasexperiencedunstableemployment,inequitableincome,andsaggingproductivity—theoppositeofsustainableprosperity.ThepurposeofthisessayistoarguethatacriticalfirststepinattainingsustainableprosperityintheUnitedStates,oranyothernationaleconomy,istochangetheintellectualunderstandingofacademics,policy-makers,andtheinformedpublicabouthowamoderneconomyoperatesandperforms.Iarguethatwecannotpursueacoherentsetofpublicpoliciestogeneratestableandequitableeconomicgrowthunlesswerejecttheneoclassicaltheoryofthemarketeconomyandreplaceitwithaneconomictheorythatfocusesonhoworganizations,includinghouseholds,governments,andbusinesses,investinproductivecapabilities,withatheoryofinnovativeenterpriseatitscore.Sustainableprosperity requires innovativeenterprise. Theessenceof innovativeenterprise isinvestmentinproductivecapabilitiesthatcangenerategoodsandservicesthatarehigherqualityand/orlowercostthanthosethathadpreviouslybeenavailable.Theinnovativeenterprisetendsto be abusiness enterprise—a unit of strategic control that over timemustmake profits tosurvive.But,inamodernsociety,businessenterprisesarenotaloneinmakinginvestmentsinthe productive capabilities required to generate innovative goods and services. Householdfamiliesandgovernmentagenciesalsomakeinvestmentsinproductivecapabilitiesuponwhichbusiness enterprises rely. Working in a harmonious fashion, I call these three types oforganizations—household families, government agencies, and business enterprises—“theinvestmenttriad.”Householdfamiliesinvestintheeducationoftheyoungwithaviewtoprovidingthemwiththeknowledgethattheywillneedtofunctionasproductiveadults,whowillthenusetheincomefromproductiveemploymenttohavefamiliesoftheirown.Criticaldeterminantsofhouseholdinvestments in productive capabilities are the relation between spouses as providers ofhouseholdcareandincome,thequalityofeducationthattheyoungareabletoreceive,andthenumber of years over which they receive their education. A productive society requires thepresenceofthesupportivefamily.Governmentagenciessupporttheinvestmentsinproductivecapabilitiesbyhouseholdfamiliesbyprovidingschoolingthathouseholds,eachactingonitsown,couldnotafford.Awell-financedprimary,secondary,andtertiaryeducationsystemisanecessaryconditionforamodernsocietytoembarkonapathofsustaineddevelopmentthroughwhichmostofthepopulationcanattain1GiventheoverarchingperspectiveoninnovativeenterpriseandsustainableprosperitythatIprovideinthisessay,mostofthebibliographicreferencesaretomyownpublications,inwhichthereadercanfindthesourcesformyarguments.


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higher standards of living.2 Government agencies can also be charged with investing in thecreation,throughbasicandappliedresearch,ofnewscientificandengineeringknowledgethatwouldotherwisenotcomeintoexistence.Asacriticalcomponentofinvestmentinproductivecapabilities, government agencies are involved in providing services for public and personalhealth.Inaddition,werelyongovernmentagenciestoinvestinphysicalinfrastructuresuchastransportationsystems,communicationsystems,energysystems,andwaterandwastesystems.Taken together, the investments in productive capabilities, both human and physical, bygovernmentagenciesmanifestthepresenceofthedevelopmentalstate.Business enterprisesmake use of the knowledge and infrastructure provided by governmentagenciesandthehumancapabilitiesprovidedbyhouseholdfamiliesasfoundationsformakingfurther in-house investments inhumanandphysicalcapabilities thatcangenerategoodsandservices that these businesses can sell on product markets. In high-tech fields, businessenterprisesmayhavetomakespecializedinvestmentsinin-housecapabilitiestoabsorbthehigh-tech knowledge that investments by government agencies have created. In many cases,government agencies make strategic investments in knowledge-creation through businessenterprises in the forms of research contracts and subsidies. Of particular importance, it istypicallythroughon-the-jobexperienceinbusinessenterprisesaswellasgovernmentagenciesthat masses of individuals, building on their formal educations, accumulate the productivecapabilities that enable them to contribute to the innovation process. The development andutilizationoftheseproductivecapabilitiesaretheessenceoftheinnovativeenterprise.Theinvestmenttriadenablesinnovativeenterprisetofunctionasafoundationforsustainableprosperity.Stableandequitablegrowthoccurswhentheinvestmentstrategiesofhouseholds,governments, and businesses interact as supportive families, developmental states, andinnovativeenterprises.Householdsandgovernmentsinteractthroughinvestmentsineducation.Governments and businesses interact in the development of the high-tech knowledge base.Businesses and households interact through the employment relation. The quality of theseinteractionsinthedevelopmentandutilizationofproductivecapabilitiesisofcriticalimportancetotheproductivityofresourcesthatareinvestedintheinnovativeenterprise.Businessenterprisesprovideadultsinhouseholdfamilieswithemploymentthat,withsufficientproductivity, should enable them to support their families. Through formal and on-the-jobtraining,businessenterprisesalsoinvestintheknowledgeofsomeorallofthepeoplewhomtheyemploy.Theseenterprises thenhavean incentive to retain thepeoplewhomtheyhavetrained.Theygenerallydosothroughpayincreasesandpromotionstojobsthatrequiresuperiorfunctional capability andgreaterhierarchical responsibility. Indeed, it is primarily through in-housepay increasesandpromotions forvaluedemployees in stableemployment relations ininnovative enterprises that households’ living standards increase over time. It is through theemploymentrelationsofproductiveenterprises,notlabor-marketsupplyanddemand,thatwegetthethrivingmiddleclassthatisthesocialsubstanceofstableandequitablegrowth.

2WilliamLazonick,SustainableProsperityintheNewEconomy?BusinessOrganizationandHigh-techEmploymentintheUnitedStates,UpjohnInstituteforEmploymentResearch,2009,ch.5.


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In short, the investment triadputs inplace theproductivecapabilities thatareessential toaprosperouseconomy. Investments in theknowledgebasebyhousehold families,governmentagencies,andbusinessenterprisesmustbefinanced.Investmentsineducatingthelaborforceare generally fundedby some combinationof after-taxhousehold incomes supplementedbyhouseholddebtandgovernmenttaxrevenuessupplementedbydebtissuesatlocal,state,andfederal levels. To some extent business enterprises finance the education of the labor forcethrough corporate taxes, philanthropic contributions based on business fortunes, and directpayments to employees for the education of themselves or their children as part of theemploymentrelation.Ultimately, however, the ability of household families and government agencies to affordinvestments inproductivecapabilitiesrequirestheutilizationoftheknowledgeandskillsthathave been developed through these investments. And in a modern society, to ensure theutilizationoftheknowledgebasethathasbeendeveloped,werelyprimarilyonitsemploymentbybusinessenterprisesthat,tosurvive,mustproduceandsellcompetitive—thatis,highquality,lowcost—products.Theinnovativeenterpriseiscentraltothetriadicsocialsystemthatenablestheattainmentofsustainableprosperity.Inthenextsectionofthisessay, Icontrasttheinvestment-triadperspective,withitsfocusonorganizations—supportive families, developmental states, and innovative enterprises—as themicrofoundationsofsustainableprosperity,withtheneoclassicaleconomicstheorythatviewstheoperationofmarketsasthemicrofoundationsofthemostefficienteconomy.Ishowthattheneoclassicalperspective,whichistaughtbytensofthousandsofeconomicsPhDstomillionsofstudentsaroundtheworldeveryyear,restsontheabsurdpropositionthatthemostunproductivefirmisthefoundationofthemostefficienteconomy—anidealofeconomicorganizationknownas “perfect competition.” Indeed, the neoclassical theory of markets as omnipotent in theallocation of economy’s resources depends on a theory of the firm that portrays the idealbusinessenterpriseasimpotent.Asweshallsee,theneoclassicaltheoryofperfectcompetitionhasasitsrootsafirmthathasthecharacteristicsofanovercrowdedsweatshopinwhichworkersareunableandunwillingtobeproductive.Economicsisinneedofatheoryofinnovativeenterprisetoreplacetheneoclassicaltheoryofthefirm,andtherebyrecognizethecentralityoforganizationstotheeconomy’soperationandperformance,whileexploding“themythofthemarketeconomy.”3Thethirdsectionofthisessayoutlines the Theory of Innovative Enterprise (TIE) as a conceptual framework for analyzingwhether, how, and underwhat conditions the investment triad supports or undermines theattainmentofstableandequitablegrowth.DrawingontheexperienceoftheU.S.economyoverthepast70years,ImakeuseofTIEtoanalyzehowduringthefirstthreedecadesofthisperiod,the United States moved toward stable and equitable growth under a “retain-and-reinvest”corporate resource-allocation regime whereas from the late 1970s, under a “downsize-and-

3WilliamLazonick,BusinessOrganizationandtheMythoftheMarketEconomy,CambridgeUniversityPress,1991;WilliamLazonick,“TheTheoryoftheMarketEconomyandtheSocialFoundationsofInnovativeEnterprise,”EconomicandIndustrialDemocracy,24,1,2003:9-44;WilliamLazonick,“InnovativeEnterpriseorSweatshopEconomics?InSearchofFoundationsofEconomicAnalysis,”Challenge,59,2,2016:65-114.


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distribute” regime, unstable employment, inequitable income, and sagging productivity havecharacterizedtheU.S.economy.4In the fourth section of this essay, I place intellectual blame for the U.S. failure to achievesustainableprosperitysincethe1970sonaparticularbrandofneoclassicaleconomicsknownasagency theory, with its ideology that the business corporation should be run to “maximizeshareholder value” (MSV). Far from being a theory of value creation, MSV has legitimizedpredatory value extraction from U.S. business corporations. Effected through massivedistributionsofcorporatecashtoshareholdersandincentivizedbythestock-basedpayofseniorcorporate executives, MSV has resulted in the (largely legal) looting of the U.S. businesscorporation.IarguethatMSVhasunderminedinnovativeenterpriseandtheoperationoftheinvestment triad, andwith it thepossibility of achieving sustainable prosperity in theUnitedStates.Inthefinalsectionofthisessay,Iarguethat,asaconceptualguidetoformulatingpoliciestogettheU.S.economyonasustainable-prosperitytrajectory,innovationtheorymustreplaceagencytheory.IcontendthattheeradicationofMSVideologyisanecessaryconditionforenablinganeconomy’s business enterprises to contribute to, rather than thwart, the achievement ofsustainableprosperity.Toprovide the intellectual rationale for specificproposals (elaboratedelsewhere5)tostopthelootingofthebusinesscorporation—includingbanningstockbuybacks,compensatingseniorexecutivesfortheircontributionstothevalue-creatingenterprise,placingrepresentativesofhouseholdsasworkersandtaxpayersoncorporateboards,andreformingthetaxsystemsothatitrecognizesandsupportstheinvestmenttriad—Icallforinnovationtheorytoreplaceagencytheoryinourconceptualizationofhowtheeconomyoperatesandperforms.2. ThetheoryofthefirmandeconomicperformanceTheinvestment-triadperspectiveviewsorganizations,notmarkets,asthemicrofoundationsofsustainableprosperity.Comparative-historicalstudyrevealsthatdevelopedmarketsinproducts,finance, labor, and land are outcomes, not causes, of economic development.6 Productcompetitionassumestheexistenceofbusinessenterprisesthathavedevelopedthecapabilitiestoproducegoodsandservicesofaqualitythatbuyerswantandneedthatcanbesoldatpricesthatbuyersarewillingorabletopay.Developedmarkets instocksandbondsdependontheexistenceofbusinessenterpriseswiththecapabilitytoissueandpayyieldsonthesesecurities.Employment opportunities that can be accessed via labor markets assume the existence ofbusiness enterprises andgovernment agencies thathavedeveloped the capability to employ

4WilliamLazonickandMaryO’Sullivan,“MaximizingShareholderValue:ANewIdeologyforCorporateGovernance,”EconomyandSociety,29,1,2000:13-35.

5WilliamLazonick,“TheValue-ExtractingCEO:HowExecutiveStock-BasedPayUnderminesInvestmentinProductiveCapabilities,”InstituteforNewEconomicThinkingWorkingPaperNo.54,December4,2016,athttps://www.ineteconomics.org/research/research-papers/the-value-extracting-ceo-how-executive-stock-based-pay-undermines-investment-in-productive-capabilities

6Lazonick,BusinessOrganizationandtheMythoftheMarketEconomy;Lazonick,“TheTheoryoftheMarketEconomyandtheSocialFoundationsofInnovativeEnterprise”;WilliamLazonick,“VarietiesofCapitalismandInnovativeEnterprise,”ComparativeSocialResearch,24,2007:21-69.


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laborproductively.Amarketforlandexistsbecausehouseholds,governments,andbusinesseshaveinvestedintheinfrastructureofaparticularlocality.For the sake of continued innovation, the organizations onwhich the economy depends forinvestments inproductivecapabilitiesneedgovernmentstoregulatethesedevelopedmarketsoncetheyhaveemerged.7AsdemonstratedrepeatedlyinthehistoryofAmericancapitalism,intheabsenceofregulation,developedmarketstendtodisruptandunderminetheorganizationalprocessesthatenableinvestmentinproductivecapabilities.HerearejustafewexamplesfromthehistoryoftheUnitedStates:• Inthe1920s,industriessuchastextiles,coalmining,andagriculture,characterizedbylarge

numbersof competitors,were“sick”becauseof cut-throat competition,even though thefirmsintheseindustrieshadaccesstothemostadvancedtechnologiesintheworld.Amajorroleof1930sNewDealgovernmentinterventionwastoimplementregulationsandprogramsthathelpedtomaketheseindustrieshealthy.

• Today, with the prices of medicines largely unregulated in the United States despitegovernment-funded research, government-granted monopoly patents, and government-subsidizeddemand,pharmaceutical companieshavebecomeprimesources forpredatoryvalueextraction,underminingtheircapabilitiestoengageindruginnovation.

• The 1982 deregulation of the practice of stock repurchases by the U.S. Securities andExchange Commission through Rule 10b-18 has resulted in more than three decades oflooting of corporate treasuries by well-positioned stock-market traders, including seniorexecutives,resultingintheconcentrationofincomeatthetopandthedestructionofmiddle-classemploymentopportunities.

• Inadequate minimum wages that result from overcrowded labor markets have lefthardworkingfamiliesinpoverty,evenwhentheheadsofhouseholdsareholdingdowntwofull-timejobs.

• The “free-market” approach to college tuitions and student loans have made highereducationunaffordabletomostworking-classhouseholds,inanationthathadoncebeenintheforefrontoffreeorlow-costpublichighereducation.

• Weneedonlylookbacktothefinancialcrisisof2008-2009forthevastdevastationvisitedonhouseholdfamiliesbygovernmentfailuretoregulatehousingmarkets.

• Devastatingdestructionoccursthrough“natural”disasterscausedbythefailuretoregulateindustrieswhoseprocessesandproductcontributetoclimatechange.

TheTIEapproachtounderstandingtheoperationandperformanceoftheeconomy,includingthe interactions of households, governments, and businesses as investors in productivecapabilities,standsinstarkcontrasttotheneoclassicalfocusonmarketcoordinationofeconomicactivity.Theneoclassicaltheoryofthemarketeconomyposesaprofoundintellectualbarriertoanalyzing and understanding the organizational foundations of economic development.Neoclassical economists assume that an advanced economy is a market economy in whichmillions of household decisions concerning the allocation of the economy’s resources are7See,forexample,WilliamLazonick,CompetitiveAdvantageontheShopFloor,HarvardUniversityPress,1990;WilliamLazonick,“TheFunctionsoftheStockMarketandtheFallaciesofShareholderValue,”InstituteforNewEconomicThinkingWorkingPaperNo.58,July20,2017,athttps://www.ineteconomics.org/research/research-papers/the-functions-of-the-stock-market-and-the-fallacies-of-shareholder-value.


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aggregatedintopricesforinputstoandoutputsfromproductionprocesses.Anyimpedimentstothis process of market aggregation are deemed to be “market imperfections,” and anyundesirablesocialoutcomesfromtheprocessaredeemedtobe“marketfailures.”Developedmarketsareofutmostimportancetooureconomyandsociety;theycanallowusasindividualstochoosetheworkwedo,forwhomwework,wherewelive,andwhatweconsume.Insofar aswehavemarket choices, however, it is because the economy iswealthy, and it iswealthybecauseofthehousehold,government,andbusinessorganizationsthatconstitutetheinvestmenttriad.Ifmarketprocessescannotexplaininvestmentinproductivecapabilities,thenthetheoryofthemarketeconomycannotexplainthewealthofnations.Ifeconomistswanttodevise public policies to shape the processes and influence the outcomes of investment inproductivecapabilities,weneedtoconstructaneconomictheoryof“organizationalsuccess.”Atitscenterisatheoryofinnovativeenterprise.Yetitisthetheoryofthemarketeconomythatdominatestheteachingofeconomicsandthe“well-trained”economist’smindsetonhowtheeconomyoperatesandperforms.Thetheoryofperfectcompetition,whichistheneoclassicaleconomist’sidealofeconomicefficiency,viewsthefirm as impotent and themarket omnipotent in allocating the economy’s resources. By theneoclassical theory’s keyassumptions, the firm inperfect competition is, as Iwill explain,anunproductive firm. Yet neoclassical theory posits the firm in perfect competition as themicrofoundation of an economy in which the allocation of resources results in the ideal ofeconomicefficiency,evenifthatidealisdifficultorimpossibletoattain.If,thusput,neoclassicallogicconcerningtherelationbetweenfirmproductivityandeconomicperformancesoundsabsurd, that isbecause it is.Seventy-fiveyearsago, JosephSchumpeter,with his focus on innovation as the fundamental phenomenon of economic development,confrontedthemythofthemarketeconomywhenhearguedthat“perfectcompetitionisnotonlyimpossiblebutinferior,andhasnotitletobeingsetupasamodelofidealefficiency.”Thereason: Large-scale enterprise is “the most powerful engine of [economic] progress and inparticularofthelong-runexpansionoftotaloutput.”8Theneoclassical theoryof the firm inperfectcompetitioncannotexplainwhy forwelloveracentury very large firms have dominated the U.S. economy.9 In 2012 (the most up-to-datestatistics that include revenues), 964 companies that had 10,000 ormore employees in theUnited States, with an average workforce of 33,542, were only 0.017 percent of all U.S.businesses. But these 964 companies had 9 percent of all establishments, 28 percent ofemployees,31percentofpayrolls,and36percentofreceipts.For1,909companieswith5,000ormoreemployees,theseshareswere11percentofestablishments,34percentofemployees,38percentofpayrolls, and44percentof receipts.10How these largecompaniesallocate the8JosephA.Schumpeter,Capitalism,Socialism,andDemocracy,Harper,1950,thirdedition,p.106;originallypublishedin1942.

9WilliamLazonick,“AlfredChandler’sManagerialRevolution:DevelopingandUtilizingProductiveResources,”inMorgenWitzel,andMalcolmWarner,eds.,OxfordHandbookofManagementTheorists,OxfordUniversityPress,2012:361-384.

10UnitedStatesCensusBureau,“StatisticsofU.S.Businesses,”Dataon“U.S.,NAICSsectors,largeremploymentsizes”athttps://www.census.gov/data/tables/time-series/econ/susb/susb-.Unlikethedatafor2012,thelatestdataonfirmsizefor2014donotincludereceipts(collectedonlyeveryfiveyears).


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resourcesundertheircontrolhasprofoundimplicationsforemploymentopportunities,incomedistribution,andproductivitygrowthintheUnitedStates.Theneoclassical answermust be that these large firms representmarket imperfections, alsoknownasmonopoliesoroligopolies.Butthatdoesnotexplaintheproductivepoweroftheselarge firms.Nordoes itexplain, intuitivelyat least,why,as theneoclassical theoryposits, aneconomydominatedbyvery largenumbersofsmallunproductivefirmswouldyieldthemostefficienteconomy.Thisintellectualpuzzleissolvedwhenwerealizethattheneoclassicaltheoryisutterlyillogical.Thetheoryoftheunproductivefirmasthefoundationofthemostefficienteconomydominatesthethinkingofeconomistsbecauseitservestomakethemarketomnipotentand the firm impotent in theallocationof theeconomy’s resources. In effect, this ideologicaltenet,which is held dear by both liberal and conservative economists, obviates the need toconsider the role of the investment triad, including the innovative enterprise, in achievingsuperioreconomicperformance—thatis,stableandequitablegrowth.Let’sgobacktobasicstoseewhy“perfectcompetition”isillogical.Asconventionallydefined,perfectcompetitionexistswhenaverylargenumberofidenticalfirmsinanindustryeachhassuch a small share of total industry output that each firm, acting on its own, can choose toproduceitsprofit-maximizingoutputwithoutinfluencingthepriceoftheindustry’sproduct.Eachoftheseidenticalfirmsisconstrainedtobeverysmallbytheassumptionthatataverylowlevelof the firm’s output relative to industry output increasing average variable costs (AVC)overwhelmdecreasingaveragefixedcosts(AFC),sothatthefirmfacesaU-shapedcostcurveindecidinghowmuchoutputtoproduce.Itfollowsmathematicallythatthefirmmaximizesprofitsattheoutputatwhichmarginalrevenueequalsmarginalcost.Thus,wehavethetheoryoftheoptimizing firm that holds center stage (and generally the only stage) in virtually everyintroductoryeconomicstextbookusedworldwide.11Themodelforthemodern“principles”textbookwascreatedbyPaulSamuelson,Economics:AnIntroductory Analysis, first published in 1948 and reissued in 18 subsequent editions (withSamuelsonasthesoleauthorthroughthe12thedition,publishedin1985).ThelargecorporationwasnotunknowntoSamuelson.Inthefirstedition,heobservedthat“alistofthe200largestnonfinancialcorporationsreadslikeanhonorrollofAmericanbusiness,almosteverynamebeinga familiar household word...In manufacturing alone, the 100 most important companiesemployedmorethanone-fifthofallmanufacturinglaborandaccountedforone-thirdofthetotalvalue of all manufactured products.”12 After commenting that “their power did not growovernight,”Samuelsonstates:“Largesizebreedssuccess,andsuccessbreedsfurthersuccess.”Howdid these large corporations attain these dominant positions, andwhy did the top 100manufacturersachievehigh laborproductivity relative toallmanufacturers?Theexistenceofverylarge,highlyproductivefirmsshouldhaveledeconomiststosearchforatheoryofinnovativeenterpriseasafoundationofeconomicanalysis.13YetSamuelson’sscientificpapers(whichare11Iwouldbepleasedtobeinformedofanymicroeconomicstextbookthatcontradictsthisstatementonthetheoryofthefirm.12PaulA.Samuelson,Economics;AnIntroductoryAnalysis,firstedition,McGrawHill,1948,p.125.13Inthe1940s,economistscouldhavebuiltonSchumpeter’sfocusoninnovationasthefundamentalphenomenonofeconomicdevelopment,apropositionthatheputforwardinJosephA.Schumpeter,TheTheoryofEconomicDevelopment,


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virtuallyallmathematical,devoidofempiricalcontent)andhisfamous“principlesofeconomics”textbookinitssuccessiveeditionspromulgatedthetheoryoftheunproductivefirminperfectcompetitionastheidealofeconomicefficiency.Perfect competition idealizes the very small firm, its growth constrained by rising AVC as itexpandsoutput.Itisassumedthatataverylowlevelofoutput(forthefirmtoremainverysmall),theincreaseinAVCoutweighsthedeclineinAFCsothataveragetotalcostsrise,givingthefirm’scostcurveitsUshape.ButwhydoAVCrisetosuchanextentthattheyoutweighdecliningAFC?Currenttextbooksdonotsupplyanexplanation.Forexample,N.GregoryMankiw,PrinciplesofMicroeconomicssimplystatesthatthecostcurveisU-shaped—representing“costcurvesforatypicalfirm”14—andillustratesthis“principle”withmade-upnumbersforahypotheticalcoffeeshopinwhichAVCincreasefrom$0.30foronecupofcoffeeto$12.00for10cups,withrisingAVCsurpassingdecliningAFCafter6cups.15Similarly,PaulKrugmanandRobinWells,EssentialsofEconomicsarguesthata“realisticmarginalcostcurvehasa’swoosh’shape,”16andgivestheexampleofasalsamakerwhoseAVCrisefrom$12.00foronecaseofsalsato$120.00fortencases, with rising AVC surpassing declining AFC after three cases.17 In both theMankiw andKrugman/Wells textbooks, the “explanation” for the U-shaped cost curve—and hence theunproductive firm that is the ideal of economic efficiency—is simply themade-up numericalexample!We can, however, find an explanation for the U-shaped cost curve in the early editions ofSamuelson’stextbook.18InthefirstthroughfiftheditionsofEconomics,SamuelsonexplainedtheU-shapedcostcurvebyassumingthat(asistypicallythecase)laboristhefirm’smainvariable-costinputandthatastheemploymentoflaborincreasesasthefirmexpandsoutput,theaverageproductivity of labor falls because of, in Samuelson’s words, “limitations of plant space andmanagement difficulties.” As the professor put it (with my emphasis) in the fifth edition ofEconomics,publishedin1961(withwordingonlyslightlydifferentfromthatinthefirstedition):“Aftertheoverheadhasbeenspreadthinovermanyunits,fixedcostscannolongerhavemuchinfluenceonaveragecosts.Variablecostsbecomeimportant,andasaveragevariablecostsbegintorisebecauseoflimitationsofplantspaceandmanagementdifficulties,averagecostsfinallybegintoturnup.”19Thereitis:Theexplanationofthemostimportant“principle”oftheneoclassicaltheoryofthefirm—andIwouldargue,ofneoclassicaleconomicsmoregenerally—buriedawayonpage524of

HarvardUniversityPress,1934(firstpublishedinGermanin1911).SeeWilliamLazonick,“WhatHappenedtotheTheoryofEconomicDevelopment?”inPatriceHiggonet,DavidS.Landes,andHenryRosovsky,eds.,FavoritesofFortune:Technology,Growth,andEconomicDevelopmentsincetheIndustrialRevolution,HarvardUniversityPress,1991:267-296.Bythe1960s,Samuelsoncouldhavefoundpowerfulexplanations,boththeoreticalandhistorical,forthegrowthofthefirminEdithT.Penrose,TheTheoryoftheGrowthoftheFirm,Blackwell,1959;andAlfredD.Chandler,Jr.,StrategyandStructure:ChaptersintheHistoryoftheAmericanIndustrialEnterprise,MITPress,1962.Initsvariouseditionsoverthedecades,Samuelson,Economics,hasneverreferencedthesescholarsorthebodyofresearchthattheirideashavespawned.

14N.GregoryMankiw,PrinciplesofMicroeconomics,CengageLearning,eighthedition,nodate,p.259.15Ibid.,p.254.16PaulKrugmanandRobinWells,EssentialsofEconomics,WorthPublishers,fourthedition,2017,p.189.17Ibid.,p.185.18IamgratefultoWynnTuckerforsearchingthroughthefirsteditionofSamuelson,Economics,tolocatetheexplanation.19PaulA.Samuelson,Economics:AnIntroductoryAnalysis,fifthedition,McGraw-Hill,1961,p.524.


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as an 853-page textbook.The theory of the firm in perfect competition in turn provided thefoundation for Samuelson’s “grand neoclassical synthesis” of microeconomics andmacroeconomics, which continues to dominate economics teaching and thinking. ButSamuelson’s twocryptic sentencesprovide farmoreofanexplanation for theU-shapedcostcurve than Mankiw and Krugman/Wells (as but two examples from the crowded field ofSamuelson-cloneintroductoryeconomicstextbooks)havetooffer.Sowhatdothosesentencesmean?WhenIusedthefiftheditionofSamuelson,Economicsinmyveryfirsteconomicscoursein1964,IwastoldthatwhatProfessorSamuelsonwasarguingwasthatasmoreworkersareaddedtotheworkplaceasvariableinputsasthefirmexpandsoutputtheir averageproductivity falls becauseof overcrowding that causes them tobump intooneanother(“limitationsofplantspace”)andbecausetheincreaseinthenumberofworkerstobesupervised makes it more difficult for the employer to prevent workers from shirking(“management difficulties”). The resultant decline in labor productivity as output increasescausesAVCtorise.Inotherwords,Samuelson’sexplanationfortheU-shapedcostcurvewasthatariseinAVCoccursbecauseworkerscan’tworkandwon’twork.Moreover,thecostcurvegetsitsUshapewhentheriseinAVCissolargethatitoverwhelmsthefall inAFC.Theriseintotalunitcosts,reflectingdecliningproductivityasthefirmexpandsitsoutput,thenconstrainsthegrowthofthefirm,andratherthanconfront“limitationsofplantspace”and“managementdifficulties,”theneoclassicalemployerjustoptimizessubjecttothese“given”constraints.Insharpcontrast,theinnovativeenterprisewouldconfront“limitationsofplant space” by investing in more spacious plant and “management difficulties” by creatingincentivesforworkerstosupplyhigherlevelsofproductivity.Theseinvestmentsandincentiveswouldaddtothefirm’scosts,butiftheinnovatingfirmcanincreaseitsproductivitysufficientlybymaking theseexpenditures, it couldpossiblyoutcompete theoptimizing firm,as shown inFigure1.Somuchfortheneoclassicalidealofeconomicefficiency!Just a minute (I can hear the well-trained neoclassical economist saying). What about theneoclassicaltheoryofmonopolythatonecanalsofindinvirtuallyeveryintroductoryeconomicstextbook, with its demonstration that, compared with perfect competition, the monopolist,maximizingprofitssubjecttoadownward-slopingdemandcurve,restrictsoutputandraisestheproduct’sprice?Isn’tthatproofofperfectcompetitionastheidealofeconomicefficiency?No,itisnot.Thereisalogicalflawintheneoclassicalmonopolymodelthatyieldsthe“results”—restrictedoutput,higherprice—thatneoclassical ideologyrequires.AsshowninFigure2, it isassumedthatthemonopolistmaximizesprofitssubjecttothesamecoststructureastheperfectcompetitors.Butthenhowdidthemonopolistbecomeamonopolist?IntheTheoryofInnovativeEnterprise,thefirmgrowslarge,andoutcompetesperfectcompetitors,bytransformingthecoststructure—by,forexample,investinginmorespaciousplanttopreventovercrowding,creatingpositiveincentivesforemployeestoexpendmoreworkeffort,orlaunchinganR&Dinitiativethatmay yield a higher quality product. Compared with perfect competitors, who follow theneoclassical directive to optimize subject to given constraints, the innovating firm increasesoutputand,bydrivingdownAFCasitexpandsoutput,canlowerpricestoconsumerswhilestill


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increasingitsprofits.Fortheprosperityoftheeconomy,that’sabigplus.Forneoclassicaltheory,however,that’sabigminus.

Figure1:Theinnovatingfirmtransformsthecoststructurethat

theoptimizingfirmtakesasa“given”constraint

Figure2:Thelogicalflawintheneoclassicalmonopolymodelthat

seekstoprovethat“perfectcompetition”istheidealofeconomicefficiency

Comparing optimizing and innovating firms

q c

pc

pminc

qmax c

innovating firm

optimizing firm

averagecostmarginal cost

marginaland averagerevenue

Technological and market conditions are given by cost and revenue functions. The “good manager” optimizes subject to technological and market constraints. Through strategy, organization, & finance, innovating firm transforms technologies and markets to generate higher quality, lower cost products. There is no “optimal” output or “optimal” price.

p = price; q = output; c = perfect competitorpmin = minimum breakeven price; qmax = maximum breakeven output

output output

price,cost

How does the innovating firm transform high fixed costs into low unit costs?

Monopoly and competition: ILLOGICALCOMPARISON

pmininnovating firm

optimizing firmmarginal

cost

marginalrevenue

averagerevenue

Innovating and optimizing firms LOGICAL COMPARISON

pc

pm

qcqmqmin

pm= monopoly price; qm = monopoly outputPc = competitive price; qc = competitive output

The innovating firm transforms technological and market conditions that the optimizing firm accepts as “given” technological and market constraints.

pmin= lowest breakeven price, optimizing firmqmin= lowest breakeven output, optimizing firm


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Note also that, in his explanation of the U-shaped cost curve, Samuelson writes (with myemphasis)thatbecauseoflimitationsofplantspaceandmanagementdifficulties,“averagecostsfinallyturnup.”Samuelsoninserted(probablyinstinctively)theword“finally”becauseifaveragecostsdonotturnup,thefirmwillgrowlargeranddestroythepossibilityof“perfectcompetition”asanidealand“constrainedoptimization”asthedecisionruleforthe“profit-maximizing”firm.Samuelson’stheoryrequiresthatthefirmthatisthe“idealofeconomicefficiency”remainsmallandunproductive.Iftheeconomyisdominatedbyfirmsinwhich,touseSamuelson’sownwords,“largesizebreedssuccess,andsuccessbreedsfurthersuccess,”thenperfectcompetitionasthe“ideal of economic efficiency” disappears and “constrained optimization” may not be themanagementpracticethatachievessuperioreconomicperformance.YetevenPaulSamuelsonwasawarethat thereal-worldeconomycanbedominatedby largefirmsthatarehighlyproductive.InChapter2(“CentralProblemsofEveryEconomicSociety”)ofthefiftheditionofEconomics,Samuelsonfirstdiscusses“IncreasingCosts”and“TheFamousLawofDiminishingReturns”(bothsubheadings)andprovidesatablewithanumericalexamplethatbearstheheading“Diminishingreturnsisafundamentallawofeconomicsandtechnology”andthecaption“Returnsofcornwhenunitsof laborareaddedtofixed land.”Onthenextpage,however,hehasthesubheading“EconomiesofScaleandMassProduction:ADigression,”withtheexplanation:“Economiesofscaleareveryimportantinexplainingwhysomanyofthegoodswebuyareproducedbylargecompanies...Theyraisequestionstowhichweshallreturnagainandagaininlaterchapters.”Samuelsonmadehis“honorroleofAmericanbusiness”remark,citedabove,100pageslater.Butitwouldbeanexaggerationtosaythattheprofessorkepthispromiseto“return[tothiscentralproblem of every economic society] again and again.” After all, for Samuelson the actualimportanceofeconomiesofscaletotheproductiveeconomywasjust“adigression”fromhisobsessionwith“thefamouslawofdiminishingreturns”asa“fundamentallawofeconomicsandtechnology.”It may be, however, that, in the course of revising Economics in the early 1960s, ProfessorSamuelsongavethisglaringcontradictionbetweenneoclassical ideologyandeconomicrealitysomedeeperthoughtandcametorealizetheabsurdityofarguingthattheunproductivefirmisthe ideal of economic efficiency. If so, he resolved the problem, not by renouncing theneoclassical theory of the firm and calling for the construction of a theory of innovativeenterprise—drawingupon,forexample,EdithPenrose’sseminalcontribution,publishedin1959,andAlfredChandler’spioneeringhistoricalresearchdocumentedinhis1962bookStrategyandStructure20—butratherbysimplyexcisingfromthesixthandsubsequenteditionsofEconomicsthesentencesquotedaboveaboutoverheadbeingspreadthin, limitationsofplantspace,andmanagement difficulties. Henceforth, Samuelson would just refer to the “famous law ofdiminishingreturns”tojustifythenonsensethattheunproductivefirmistheidealofeconomicefficiency.And,overthesubsequentgenerations,economistssuchasN.GregoryMankiwandPaul Krugman, among other PhD economists, have published textbooks that reproduce this

20Penrose,TheTheoryoftheGrowthoftheFirm;Chandler,StrategyandStructure.


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nonsense as a principle of economics, taught routinely to students and requiring neitherintrospectionnorexplanation.Theproblemwithperfectcompetitionastheidealofeconomicefficiencyisnotjustthatmillionsuponmillionsofeconomicsstudentshavebeenandcontinuetobemiseducatedabouttheroleofthebusinessenterprise intheeconomy.Thebiggerproblemisthatthe“well-trained”PhDeconomistswhoare supposed tobe theeducators (included those towhomso-calledNobelprizesineconomicshavebeenmetedout)spouttheinanitythattheunproductivefirmistheidealofeconomicefficiency,andinsodoingportraythe“ideal”firmasapowerlessentitythatdoesnot,andshouldnot,interferewiththemarketcoordinationoftheallocationofresources.In my own teaching, I call this view of the world “sweatshop economics” because theovercrowdedandunmotivatedfirmthatSamuelsondescribesasthemicrofoundationof idealefficiencyhas the characteristics of a sweatshop. Imake thepoint that if such firms actuallydominated the economy, we would, in a nation such as the United States, all be living inpoverty.21Meanwhile,the“well-trained”economistviewsthehighlyproductivefirmsthatgrowlarge,andperhapsevendominatetheindustriesinwhichtheyoperateasmassive“marketimperfections”thatimpedethepurportedefficiencyofmarketresourceallocation.Intherealeconomicworld,however,theinnovativeenterpriseisapowerfulentitythat,bytransformingthetechnological,market, and competitive conditions that it faces, succeeds in generating the higher-quality,lower-costgoodsandservicesthatraiseproductivity.Farfrombeingamarketimperfection,byconfrontingandtransformingthe“neoclassicalconstraints,”theinnovativeenterpriseprovidestheproductivefoundationsforachievingsustainableprosperity.AsIargueinthenextsectionofthisessay,throughtheveryprocessofdevelopingandutilizingproductive capabilities, the innovative enterprise tends to providemore stable employment,moreequitableincomes,andhigherproductivitythanthe“uninnovative”enterpriseswithwhichneoclassicaleconomistsareenamored.Forthesocietyasawhole,theinnovativeenterpriseisthe linchpinofthe investmenttriad,making itpossibleforhouseholdfamilies,throughstableandequitableemployment,tobesupportive,andforgovernmentagencies,throughaccesstotax revenues fromhouseholds andbusinesses andby servicing theneedsof households andbusinesses,tobedevelopmental.Forthesakeofsustainableprosperity,theacademicdisciplineknownaseconomicsneedstoriditselfofthemythofthemarketeconomy—fromtheSamuelson-cloneintroductorytextbookstotheubiquitousmathematicalmodelsthattypicallybearnorelationtoreality(andwhichoftenreflectutterignoranceofhowanactualeconomyfunctionsandperforms).ItishightimetotakeuptheSchumpeterianchallenge,andbuildausefulanalysisofeconomyandsocietyaroundatheory of innovative enterprise. We will then understand how and why the ideology thatcompaniesshouldberunto“maximizeshareholdervalue”subvertsinnovativeenterpriseand,withthatsubversion,ourquestforstableandequitableeconomicgrowth.

21Lazonick,“InnovativeEnterpriseorSweatshopEconomics?”.


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3. Fromretain-and-reinvesttodownsize-and-distributeTheTheoryofInnovativeEnterprise(TIE)thatIhaveconstructedthroughdecadesofresearchand teaching provides an analytical perspective on the microfoundations of sustainableprosperity.Thereisnowayinwhichaneconomycanattainstableandequitablegrowthunlessits major business enterprises focus on investing in productive capabilities for the sake ofgeneratinginnovativeproducts.Beginningwithacharacterizationoftheinnovationprocessasuncertain, collective, and cumulative, TIE articulates three “social conditions of innovativeenterprise”—strategiccontrol,organizationalintegration,andfinancialcommitment—thatcansupport the innovation process. Armed with TIE, we can then consider the impacts of theinnovationprocessonemploymentstability,incomeequity,andbusinessproductivity.Wecanaskwhetherthedominantcharacteristicsofthenation’smajorbusinessenterprisessupportorunderminetheattainmentofstableandequitablegrowthintheeconomyasawhole.

.TIE is an analytical framework for understanding how a business enterprise can generate aproductthatishigherqualityand/orlowercostthanproductspreviouslyavailable,andthusbea source of productivity growth. The innovation process that can generate a higher-quality,lower-costproductisuncertain,collective,andcumulative.22• Uncertain:Wheninvestmentsintransformingtechnologiesandaccessingmarketsaremade,

theproductandfinancialoutcomescannotbeknown;iftheywereitwouldnotbeinnovation.Hencetheneedforstrategy.

• Collective:Togeneratehigher-quality,lower-costproducts,theenterprisemustintegratetheskillsandeffortsoflargenumbersofpeoplewithdifferenthierarchicalresponsibilitiesandfunctionalcapabilitiesintothelearningprocessesthataretheessenceofinnovation.Hencetheneedfororganization.

• Cumulative: Collective learning today enables collective learning tomorrow, and theseorganizational learningprocessesmustbesustainedcontinuouslyovertimeuntil, throughthe sale of innovative products, financial returns can be generated. Hence the need forfinance.

TIEidentifiesthreesocialconditions—strategiccontrol,organizationalintegration,andfinancialcommitment—that can enable the firm tomanage the uncertain, collective, and cumulativecharacteroftheinnovationprocess.• Strategic control: For innovation to occur in the face of technological, market, and

competitiveuncertainties,executiveswhocontrolcorporateresourceallocationmusthavetheabilitiesandincentivestomakestrategicinvestmentsininnovation.Theirabilitiesdependon their knowledge of how strategic investments in new capabilities can enhance theenterprise’s existing capabilities. Their incentives depend on alignment of their personalinterestswiththecompany’spurposeofgeneratinginnovativeproducts.

22WilliamLazonick,“TheTheoryofInnovativeEnterprise:FoundationofEconomicAnalysis,”AIRWorkingPaper,August2015,

atwww.theAIRnet.org.


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• Organizational integration: The implementation of an innovation strategy requiresintegrationofpeopleworkinginacomplexdivisionoflaborintothecollectiveandcumulativelearning processes that are the essence of innovation. Work satisfaction, promotion,remuneration,andbenefitsareimportantinstrumentsinarewardsystemthatmotivatesandempowersemployeestoengageincollectivelearningoverasustainedperiodoftime.

• Financial commitment: For collective learning to cumulate over time, the sustainedcommitmentof“patientcapital”mustkeepthe learningorganization intact.Forastartupcompany,venturecapitalcanprovidefinancialcommitment.Foragoingconcern,retainedearnings(leveraged,ifneedbe,bydebtissues)arethefoundationoffinancialcommitment.

Theuncertaintyofaninnovativestrategyisembodiedinthefixed-costinvestmentsrequiredtodevelop the productive capabilities thatmay, if the strategy is successful, result in a higher-quality product. But an innovative strategy that can eventually enable the firm to developsuperiorproductivecapabilitiesmayplacetheinnovatingfirmatacompetitivedisadvantage(asindicatedforlowlevelsofoutputinFigure1above)becausesuchstrategiestendtoentailhigherfixed costs than the fixed costs incurred by rivals that choose to optimize subject to givenconstraints. As an essential part of the innovation process, the innovating firmmust accesssufficientmarketsforitsproductstotransformhighfixedcostsintolowunitcosts(seeFigure1),and, thereby, convert competitive disadvantage at low levels of output into competitiveadvantageathighlevelsofoutput.Thesehigherfixedcostsderivefromboththesizeandthedurationoftheinnovativeinvestmentstrategy.Theinnovatingfirmwillhavehigherfixedcoststhanthoseincurredbytheoptimizingfirmif,asistypicallythecase,theinnovationprocessrequiresthesimultaneousdevelopmentofproductive capabilities across abroader anddeeper rangeof integratedactivities than thoseundertakenbytheoptimizingfirm.Butinadditionto,andgenerallyindependentof,thesizeoftheinnovativeinvestmentstrategyatapointintime,highfixedcostswillbeincurredbecauseofthedurationoftimethat isrequiredtotransformtechnologiesandaccessmarketsuntil theyresultinproductsthataresufficientlyhighqualityand/orlowcosttogeneratereturns.Ifthesizeofinvestmentsinphysicalcapitaltendstoincreasethefixedcostsofaninnovativestrategy,sotoodoesthedurationoftheinvestmentrequiredforanorganizationofpeopletoengageinthecollective and cumulative—or organizational—learning that, to transform technologies andaccessmarkets,isthecentralcharacteristicoftheinnovationprocess.Thehighfixedcostsofaninnovativestrategycreatetheneedforthefirmtoattainahighlevelof utilization of the productive resources that it has developed—what are generally called“economiesofscale.”Giventheproductivecapabilitiesthatithasdeveloped,theinnovatingfirmmay experience increasing costs because of the problem of maintaining the productivity ofvariable inputs as it employs larger quantities of these inputs in theproductionprocess. Butratherthan,asinthecaseoftheoptimizingfirm,takeincreasingcostsasagivenconstraint,theinnovatingfirmattemptstotransformitsaccesstohigh-qualityproductivecapabilitiesathighlevels of output. To do so, it invests in the development of that productive capability, theutilizationofwhichasavariableinputhasbecomethesourceofincreasingcosts.Toovercomethe constraint on its innovative strategy posed by reliance on the market to supply it with


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inputs—whichiswhatavariablefactorofproductionentails—theinnovatingfirmintegratesthesupplyofthatfactorintoitsinternaloperations.Thedevelopmentoftheproductivecapabilityofthisnow-integratedfactorofproductionaddstothefixedcostsoftheinnovativestrategy.Previouslythisproductiveresourcewasutilizedasavariablefactorthatcouldbepurchasedincrementallyatthegoingfactorpriceonthemarketasextraunitsoftheinputwereneededtoexpandoutput.Havingaddedtoitsfixedcostsinorderto overcome the constraint on enterprise expansion posed by increasing variable costs, theinnovatingfirmisthenunderevenmorepressuretoexpanditssoldoutputinordertotransformhighfixedcostsintolowunitcosts.In effect, to restate Adam Smith’s first principle of economics enunciated in TheWealth ofNations,23economiesofscalearelimitedbytheextentofthemarket.Thefirm’shigher-qualityproductenablesittoaccessalargerextentofthemarketthanitscompetitors,althoughlearningaboutwhat potential buyerswant and convincingpotential buyers that the firm’s product isactually“higherquality”addtothefixedcostsoftheinnovationstrategy.Hencethefixedcostsoftheinnovativestrategydependoninvestmentsinnotonlytransformingtechnologybutalsoaccessingmarkets,withanincreaseinfixedcostsrequiringanevenlargerextentofthemarkettoconverthighfixedcostsintolowunitcosts.Apotentwayforaninnovatingfirmtoattainalargerextentof themarket is to share someof thegainsof this cost transformationwith itscustomersintheformoflowerprices.As, through the development and utilization of productive capabilities, the innovating firmsucceedsintheconversionofhighfixedcostsintolowunitcosts,itineffect“unbends”theU-shapedcostcurveratherthan,asinthetheoryoftheoptimizingfirm,takeinternaldiseconomiesofscaleasagivenconstraint(seeFigure1above).Byreshapingthecostcurveinthisway,theinnovatingfirmcreatesthepossibilityofsecuringcompetitiveadvantageover its“optimizing”rivalswhich,asinstructedbytheeconomicstextbooks,takeincreasingcostsasagivenconstraint.Tosumup:InmyelaborationofTIE,Iusethedistinctionbetweenfixedcostsandvariablecoststoarguethataninnovatingfirmthatexperiencesrisingvariablecostsasitseekstoexpandoutputwillrecognizetheneedtoexercisecontroloverthequalityofthevariableinput,theuseofwhichisdecreasingproductivity.Todosotheinnovatingfirmwillintegratetheproductionofthatinputintoitsinternaloperations,thusseekingtotransformvariablecostsintofixedcostsaspartofitsinnovative strategy. This strategic move will place the innovating firm at a competitivedisadvantageat lowlevelsofoutput(as inFigure1), increasingtheimperativethat itattainalarge market share to drive down unit costs. Moreover, there are often high fixed costs ofaccessingthatmarketshare(branding,advertising,distributionchannels,asalariedsalesforce,etc.),andindeedinsomeindustriesthefixedcostsofaccessingalargemarketsharearegreaterthanthefixedcostsofinvestinginthetransformationofproductiontechnologies.

23AdamSmith,AnInquiryintotheNatureandCausesoftheWealthofNations,fifthedition(editedbyEdwinCannan),Methuen,1904,ch.1(“OntheDivisionofLabour”);originallypublishedin1776.


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Alongwith investments inplant andequipment, investment inproductive capabilitiesentailstrainingandretainingemployees.Itmayalsopossiblyentailsustaininglearningrelationshipswithfirmsthatactassuppliersofinputsanddistributorsofoutputsiftheseservicesareperformedbylegallyindependententerprises.Thetheoryoftheoptimizingfirmviewslaborasavariablecost;acommoditythatisaddedtoandsubtractedfromtheproductionprocessasrequiredbythe expansion or contraction of output. In fact, however, when a company enhances theproductive capability of an employee, either through formal or on-the-job training, thatemployee’scapabilitytakestheformofafixed-costassetthatbothcanenhancethequalityoftheproductthattheinnovatingfirmhastosellandincreasetheneedtoattainalargeextentofthemarkettotransformhighfixedcostsintolowunitcosts.Whenthefirmsucceedsinboth,itgeneratesahigher-quality,lower-costproductthanwaspreviouslyavailable.Innovationandthegrowthofthefirmgohandinhand.Investmentinproductivecapabilities,includingthoseofitslaborforce,driveinnovationandthegrowthofthefirm.Toretainandmotivatetheemployeesthatthefirmhashiredandtrained,the innovating firmgenerallyoffers theseemployeeshigherpay,moreemployment security,superiorbenefits,andmoreinterestingwork,allofwhichaddtothefixedcostoftheassetthatanemployee’slaborrepresents.Theinnovatingfirmmakesitsemployeesbetteroff,butitcanafford, and indeed profit from, the increased labor expense when that labor’s productivecapabilityenablesthefirmtogainacompetitiveadvantagebygeneratinghigh-quality,low-costproducts.Theinnovatingfirmsharesthegainsofinnovationwithitsemployeesbymakinginvestmentsinwhat I have called their “collective and cumulative careers.”24 Under such circumstances,increases in labor incomesand increases in laborproductivity tend to showahighlypositivecorrelation—aninterconnectionthat,Iargue,wasprevalentinU.S.businessenterprisesinthedecadesafterWorldWarIIwhen,forwhitemalesatleast,the“careerwithonecompany”wastheemploymentnorm.25Whensuccessful,the innovatingfirmmaycometodominate its industry,but itsoutput is farlargeranditsunitcosts,andhencepotentiallyitsproductprice,farlowerthantheywouldbeifalargenumberofsmallfirmshadcontinuedtopopulatetheindustry.Indeed,onemightevenfindthistransitionfromcompetitiontodominancemanifestedbythetransformationofalargenumber of overcrowded sweatshops with alienated labor into a small number of spaciousfactories with highlymotivated labor! The overall gains from innovationwill depend on therelationbetweentheinnovatingfirm’scoststructureandtheindustry’sdemandstructure,while

24WilliamLazonick,PhilipMoss,HalSalzman,andÖnerTulum“SkillDevelopmentandSustainableProsperity:CollectiveandCumulativeCareersversusSkill-BiasedTechnicalChange,”InstituteforNewEconomicThinkingWorkingGrouponthePoliticalEconomyofDistributionWorkingPaperNo.7,December2014,athttps://ineteconomics.org/ideas-papers/research-papers/skill-development-and-sustainable-prosperity-cumulative-and-collective-careers-versus-skill-biased-technical-change;MattHopkinsandWilliamLazonick,“WhoInvestsintheHigh-TechKnowledgeBase?”InstituteforNewEconomicThinkingWorkingGrouponthePoliticalEconomyofDistributionWorkingPaperNo.6,September2014(revisedDecember2014),athttp://ineteconomics.org/ideas-papers/research-papers/who-invests-in-the-high-tech-knowledge-base.

25WilliamLazonick,“LaborintheTwenty-FirstCentury:TheTop0.1%andtheDisappearingMiddleClass,”inChristianE.Weller,ed.,Inequality,Uncertainty,andOpportunity:TheVariedandGrowingRoleofFinanceinLaborRelations,CornellUniversityPress,2015:143-192.


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the distribution of those gains among the firm’s various “stakeholders”will depend on theirrelativepowertoappropriateportionsofthesegains.26Whatisimportantinthefirstinstanceisthat,asaresultofthetransformationoftechnologicaland market “constraints,” there are gains to innovative enterprise that can be shared. Inexpanding output and lowering costs, it is theoretically possible (although by no meansinevitable) for thegains to innovativeenterprise topermit, simultaneously,higherpay,morestableemployment,andbetterworkconditionsforemployees;astrongerbalancesheetforthefirm;moresecurepaperforcreditors;higherdividendsandstockpricesforshareholders;moretax revenues for governments; and higher-quality products at lower prices for consumers.

Innovativeenterpriseprovidesafoundationforachievingsustainableprosperity.TIE explains how, in the rise of the United States to global industrial leadership during thetwentiethcentury,a“retain-and-reinvest”allocationregimeenabledarelativelysmallnumberofbusinessenterprisesinawiderangeofindustriestogrowtoemploytens,orevenhundreds,of thousands of people and attain dominant product-market shares. Companies retainedcorporateprofits and reinvested them inproductive capabilities, including first and foremostcollective and cumulative learning. Companies integrated personnel into learning processesthroughcareeremployment.Intothe1980s,thenormofacareer-with-one-companyprevailedatmajorU.S.corporations.Asteadystreamofdividendincomeandtheprospectofhigherfuturestockpricesbasedoninnovativeproductsgaveshareholdersaninterestin“retain-and-reinvest.”Intheimmediatepost-WorldWarIIdecades,thebeneficiariesofaretain-and-reinvestcorporateresource-allocationregimeweremainlywhitemales.Forminoritiesandwomen,accesstomorestableemploymentandmoreequitableincomewasbolsteredbytheCivilRightsActof1964andtheEqualEmploymentOpportunityCommissionlaunchedthefollowingyear.Asabellwetherofprogressinupwardmobility,bythe1970shundredsofthousandsofblackswithnomorethanhigh-schooldiplomaswereattainingmiddle-classstatusthroughemploymentinunionizedsemi-skilledoperativejobsinmass-productionindustriessuchasautomobiles,steel,andelectronicsmanufacturing.27 White males, however, maintained privileged access to intergenerationalupwardmobility fromblue-collar jobs towhite-collar jobs as the sons of blue-collarworkersobtainedhighereducations followedby “careerwithone company”employment inbusinesscorporations. In the 1970s, females (disproportionately white) with college educations alsogainedsignificantlyincreasedaccesstocareeremploymentinbusinesscorporations,althoughtheir upward mobility was impeded by the persistence of the ideology that, when childrenarrived,theywouldgiveuporinterrupttheircareerstoassumethetraditionalmiddle-class“stay-at-home-mother”role.Then,however, fromthe late1970s,andcontinuingtothepresent, formassesofAmericans,includingwhitemales,thequantityandqualityofemploymentopportunitythatcouldsupportupwardmobilityeroded,whilethedistributionofincomegrewincreasinglyunequal.Thatdespite26Lazonick,CompetitiveAdvantageontheShopFloor;Lazonick,“TheTheoryofInnovativeEnterprise”27WilliamLazonick,PhilipMoss,andJoshuaWeitz,“TheEqualEmploymentOpportunityOmission,”InstituteforNewEconomicThinkingWorkingPaperNo.53,December5,2016,athttps://www.ineteconomics.org/research/research-papers/the-equal-employment-opportunity-omission.


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thefactthatoverthepastfortyyearsorso,realgrossdomesticproductpercapitahasdoubledin the United States.28 By the first half of the 1980s, some acute observers of blue-collaremployment perceived that the U.S. income distribution was taking a “great U-turn.”29 Inhistoricalretrospect,wenowknowthat,sincethatchangeindirectionintheearly1980s,theUnitedStateshascontinueddownthe road toextreme income inequalityand theerosionofmiddle-class employment opportunities. TIE provides a framework for analyzing this historicchangeindirectionofU.S.economicperformance—essentiallytheendofthenationalquestforsustainableprosperity—byfocusingonthetransformationofthedominantregimeofcorporateresourceallocationfromretain-and-reinvesttodownsize-and-distribute.Underretain-and-reinvest,thecorporationretainsearningsandreinveststhemintheproductivecapabilitiesembodiedinitslaborforce.Underdownsize-and-distribute,thecorporationlaysoffexperienced, and often more expensive, workers and distributes corporate cash toshareholders.30 Since the beginning of the 1980s, employment relations in U.S. industrialcorporationshaveundergonethreemajorstructuralchanges,summarizedas“rationalization,”“marketization,” and “globalization,” that have eliminated existing middle-class jobs in theUnited States. The failure of the U.S. economy to replace these jobs with newmiddle-classemployment opportunities cannot, however, be attributed to these changes in employmentrelations alone. Exacerbating the rate of job loss and limiting investment in new careeremploymentopportunitieshasbeenthefinancializationofthebusinesscorporation,manifestedbymassivedistributionsofcorporatecashtoshareholders.From theearly 1980s, rationalization, characterizedbyplant closings, terminated the jobsofhigh-school educated blue-collarworkers,most of themwell-paid unionmembers. From theearly 1990s,marketization, characterized by the end of a career with one company as anemploymentnorm,placedthejobsecurityofmiddle-agedwhite-collarworkers,manyofthemcollege educated, in jeopardy. From the early 2000s, globalization, characterized by theacceleratedmovementofemploymentoffshoretolower-wagenations,leftallmembersoftheU.S. labor forcevulnerable todisplacement,whatever theireducational credentialsandworkexperience.Initially, thesestructuralchanges inemploymentcouldbeexplainedasbusinessresponsestochangesintechnologies,markets,andcompetition.Duringtheonsetoftherationalizationphaseintheearly1980s,theplantclosingswereareactiontothesuperiorproductivecapabilitiesofJapanesecompetitorsinconsumer-durableandrelatedcapital-goodsindustriesthatemployedsignificantnumbersofunionizedblue-collarworkers.Duringtheonsetofthemarketizationphaseintheearly1990s,theerosionoftheone-company-careernormamongwhite-collarworkerswasaresponsetothedramatictechnologicalshiftfromproprietarysystemstoopensystems,integraltothemicroelectronicsrevolution;ashiftthatfavoredyoungerworkerswiththelatestcomputerskills,acquiredinhighereducationandtransferableacrosscompanies,overolderworkerswithmanyyearsofcompany-specificexperience.Duringtheonsetoftheglobalizationphaseinthe28https://fred.stlouisfed.org/series/A939RX0Q048SBEA29BennettHarrisonandBarryBluestone,CorporateRestructuringandthePolarizingofAmerica,BasicBooks,1986;BennettHarrison,ChrisTilly,andBarryBluestone,“WageInequalityTakesaGreatU-Turn,”Challenge,29,1,1986:26-32.

30LazonickandO’Sullivan,“MaximizingShareholderValue.”


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early2000s,thesharpaccelerationintheoffshoringofjobswasaresponsetotheemergenceoflargesuppliesofhighlycapable,andlowerwage,laborindevelopingnationssuchasChinaandIndiawhich,linkedtotheUnitedStatesthroughinexpensivecommunicationandtransportationsystems,couldtakeoverU.S.employmentactivitiesthathadbecomeroutine.OnceU.S.corporationstransformedtheiremploymentrelations,however,theyoftenpursuedrationalization,marketization,andglobalization tocutcurrentcosts rather than to repositiontheirorganizationstoproduceinnovativeproducts.Definingsuperiorcorporateperformanceasever-higherquarterlyearningspershare(EPS),companiesturnedtomassivestockrepurchasesto“manage”theirowncorporations’stockprices.TrillionsofdollarsthatcouldhavebeenspentoninvestmentinproductivecapabilitiesintheU.S.economyoverthepastthreedecadeshaveinsteadbeenusedtobuybackstockforthepurposeofmanipulatingstockprices.Figure3showsnetequityissues(newstockissueslessstocktakenoffthemarketthroughstockrepurchasesandM&Aactivity)ofU.S.nonfinancialcorporationsfrom1946through2016.Overthedecade2007-2016netequityissuesofnonfinancialcorporationsaveraged-$412billionperyear. In2016netequity issueswere-$586billion.Overthepastthreedecades, inaggregate,dividendshavetendedtoincreaseasaproportionofcorporateprofits.Yetin1997buybacksfirstsurpasseddividendsintheU.S.corporateeconomyand,evenwithdividendsincreasing,havefarexceededtheminrecentstock-marketbooms.31

Figure3.Netequityissues,U.S.nonfinancialcorporations,1946-2016

Source:BoardofGovernorsoftheFederalReserveSystem,FederalReserveStatisticalRelease

Z.1,“FinancialAccountsoftheUnitedStates:FlowofFunds,BalanceSheets,andIntegratedMacroeconomicAccounts,”TableF-223:CorporateEquities,June8,2017,athttps://www.federalreserve.gov/releases/z1/current/

31WilliamLazonick,“StockBuybacks:FromRetain-and-ReinvesttoDownsize-and-Distribute,”CenterforEffectivePublicManagement,BrookingsInstitution,April2015,pp.10-11,athttp://www.brookings.edu/research/papers/2015/04/17-stock-buybacks-lazonick;Lazonick,“TheValue-ExtractingCEO.”


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UsingthedatainFigure3,thefirstdatacolumnofTable1showstheamountsofnetequityissuesbynonfinancialcorporations,decadebydecade,from1946to2015,in2015dollars.ForthefirstthreedecadesafterWorldWarII,netequityissuesweremoderatelypositiveinthecorporateeconomyasawhole.Inthefollowingdecades,however,netequityissuesbecameincreasinglynegative (even after adjusting for inflation). As a gauge of their growing importance in theeconomy,theseconddatacolumnofTable1showsnetequityissuesasaproportionofGDP.

Table1.Netequityissuesbynon-financialcorporationsintheU.S.economy,

bydecadein2015dollars,andasapercentofGDP Netequityissues,

U.S.non-financialcorporations2015$billions

Netequityissuesas%ofGDP

1946-1955 143.2 0.561956-1965 110.9 0.301966-1975 316.0 0.581976-1985 -290.9 -0.401986-1995 -1,002.5 -1.001996-2005 -1,524.4 -1.092006-2015 -4,466.6 -2.65

Sources:NetequityissuesdataisthesameasinFigure4,adjustedto2015U.S.dollars,usingtheconsumerpriceindexinCouncilofEconomicAdvisors,Economic Report of the President 2017, January 2017, Table B-10, athttp://www.presidency.ucsb.edu/economic_reports/2017.pdf.

AsshowninFigure4,sincetheearly1980s,majorU.S.businesscorporationshavebeendoingstockbuybacksontopof(andnotinsteadof)makingdividendpaymentstoshareholders.Figure4showsdividendsandbuybacksfor236companiesthatwereintheS&P500IndexinJanuary2016thatwerepubliclylistedfrom1981through2015.Atthebeginningofthe1980s,buybackswereminimal,andfrom1981through1983buybacksforthese236companiesabsorbedonly4.3percentofnetincome,withdividendsrepresenting49.5percent.Thebuybackproportionofnet income increased to 18.8 percent in 1984 and 30.8 percent in 1985,while the dividendproportionswere42.5percentand52.4percent.Thereafter,byten-yearperiods,thebuybackproportionsofnetincomeincreasedfrom25.8percentin1986-1995to42.9percentin1996-2005and49.5percentin2006-2015,whiledividendpayoutsoverthesedecadalperiodswere50.7percent,39.0percent,and39.1percent,respectively.Eventhoughdividendpayoutratioswerelowerin1996-2005and2006-2015thanin1986-1995,totalpayoutratiostoshareholdersrosefrom76.5percentto81.9percentto88.6percentoverthesethreeperiods.Mostrecently,thetotalpayoutratiosforthese236companieswere97.0percentin2014and106.2percentin2015.


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Figure4.Meancash-dividendandstock-buybackdistributionsin2015dollarsfor236companies in theS&P500 Index in January2016 thatwerepublicly listedfrom1981through2015

Source:StandardandPoor’sCompustatdatabase;calculationsbyMustafaErdemSakinçandEmreGomeçof

theAcademic-IndustryResearchNetwork.Overthepastthreedecades,U.S.stockmarkets,ofwhichtheNewYorkStockExchangeandtheNationalAssociationofSecuritiesDealersAutomatedQuotation(NASDAQ)exchangearebyfarthemostimportant,haveenabledtheextractionoftrillionsofdollarsfrombusinesscorporationsintheformofstockbuybacks.Ofcourse,somecompaniesdoraisefundsonthestockmarket,particularlywhen theyaredoing initialpublicofferings (IPOs).But theseamounts tend toberelativelysmall,swampedoverallbystockrepurchases,whichhavebeenmainlyresponsibleforthehugelynegativenetequityissuesofnonfinancialcorporationsshowninFigure1.Moreover,whenthemostsuccessfulstartupsbecomemajorenterprises,oftenemployingtensofthousandsofpeople,theytootendtobecomemajorrepurchasersoftheirownshares.Whyare companiesdoing thesemassivedistributions to shareholders? In anarticle “ProfitsWithoutProsperity”thatIpublishedinHarvardBusinessReviewin2014,32Iarguethatthestock-basedremunerationofseniorexecutiveswhoexercisestrategiccontroloverresourceallocationin these U.S. business corporations incentivizes them to manipulate their companies’ stockprices.Thatistheonlylogicalexplanationforthisbuybackactivity.Standard&Poor’sExecuCompdatabase provides the numbers needed to determine how much money the highest-paidcorporateexecutivesintheUnitedStatestakehomeintotalandtheproportionoftheirtotalcompensationwhichisstockbased.Figure5showstheaveragetotalcompensationofthe500highest-paidexecutives intheExecuCompdatabaseforeachyearfrom2006through2015. Itranges froma lowof$15.9million in2009,whenthestockmarketshadcrashed,withstock-32WilliamLazonick,“ProfitsWithoutProsperity:StockBuybacksManipulatetheMarketandLeaveMostAmericansWorseOff,”HarvardBusinessReview,September2014,46-55.


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basedpay(realizedgainsfromstockoptionsandstockawards)makingup60percentofthetotal,toahighof$32.6millionin2015,withstock-basedgainsmakingup82percentofthetotal.U.S.corporate executives are incentivized to boost their companies’ stock prices and are amplyrewardedfordoingso.InSEC-approvedstockbuybacks,theyhaveattheirdisposalaninstrumenttoenrichthemselves.Intheirmassive,widespread,andubiquitoususeofthisinstrument,theyhavebeenparticipatinginthelegalizedlootingoftheU.S.businesscorporation.

Figure 5. Mean total direct compensation, 500 highest-paid namedexecutivesintheUnitedStates,foreachyear,2006-2015

Source:Standard&Poor’sExecuCompdatabase,retrievedOctober11,2016.CalculationsbyMattHopkins

oftheAcademic-IndustryResearchNetworkNote:Thefollowingextraordinarilyhighlypaidoutliers,with$1billionormoreintotalcompensation,have

beenremoved:2012,RichardKinder,KinderMorgan,$1.1billion,andMarkZuckerberg,Facebook,$2.3billion;2013,MarkZuckerberg,$3.3billion.

Thisstock-basedpayofU.S.corporateexecutivesisamajorreasonfortheextremeconcentrationofincomethathasoccurredsincethe1980samongtherichesthouseholdsintheUnitedStates.Basedaswellondatafromhouseholdfederaltaxfilings,Figure6showstheshareofincomeinthehandsofthe0.1percentofallhouseholdswiththehighestincomes,includingcapitalgains,from1916through2011.In1975,theshareofthetop0.1percentwas2.56percentofallU.S.incomes,thelowestproportionovertheentire96-yearperiod.Thehighestproportionwas12.28percent in2007, justbefore the financialcrisis. In thecrisis, theshareof the top0.1percentdeclined,butwiththerecoverybouncedback.In2012(notincludedinFigure6),theshareofthetop0.1percentwas11.33percent,thefourth-highestproportionrecorded.33Clearly,fromthe

33TheWorldWealthandIncomeDatabase,athttp://topincomes.parisschoolofeconomics.eu/#Database:UnitedStates,P99.9incomethreshold.Forthelatestdataonthepre-taxshareofthetop0.1%notincludingcapitalgains,seehttp://wid.world/world/#sptinc_p99.9p100_z/US/last/eu/k/p/yearly/s/false/2.9295/12.5/curve/false


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late1970s,onadramaticscale,therewasareversalinthetrendtowardasomewhatfallingshareofincomeofthetop0.1percentthathadoccurredinthedecadesafterWorldWarII.

Figure6:ShareoftotalU.S.incomesofthetop0.1%ofhouseholdsintheU.S.income

distributionanditscomponents,1916-2011

Source:http://topincomes.parisschoolofeconomics.eu/#Database:UnitedStates,Top0.1%income

composition.Note:Thecategory“salaries”includescompensationfromtherealizedgainsonexercisingstock

optionsandthevestingofstockawards.NotethatinFigure6,alargepartoftheexplosionoftheshareofthetop0.1percenthasbeenintheformof“salaries.”Asindicated,these“salaries”includerealizedgainsfromstock-basedpay—stockoptionsandstockawards—thatshowupinthesummarystatisticsofanexecutive’sForm 1040 tax returns (the source of these data) as “Wages, salaries, tips, etc.” Since 1976virtuallyalloftherealizedgainsfromstock-basedpayhasbeentaxedattheordinaryincome-taxratesandhenceisnotincludedinthe“capitalgains”portionoftheincomesofthetop0.1percentasshowninFigure6.Federal tax returns include information on a filer’s occupation and, through an employeridentificationnumber(EIN)onFormW-2,thetypeofbusinesssectorthatprovidesthetaxpayerwithhisorherprimaryemploymentincome.JonBakija,AdamColeandBradleyHeimaccessedfederaltaxreturndataforselectedyearsfrom1979to2005toanalyzetheoccupationsoffederaltaxpayers at the topof theU.S. incomedistribution. They found that “executives,managers,supervisors,andfinancialprofessionalsaccountforabout60percentofthetop0.1%ofincomeearnersinrecentyears,andcanaccountfor70percentoftheincreaseintheshareofnationalincomegoingtothetop0.1%oftheincomedistributionbetween1979and2005.”3434JonBakija,AdamCole,andBradleyT.Heim,“JobsandIncomeGrowthofTopEarnersandtheCausesofChangingIncomeInequality:EvidencefromU.S.TaxReturnData,”workingpaper,April,2012,at


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For2005,theyfoundthat,oftaxpayerswhoseincomes(includingcapitalgains)placedtheminthe top0.1%,executives,managers,andsupervisors innon-financebusinessesmadeup41.3percentof the total,while financialprofessionals (includingmanagement)wereanother17.7percent.Ofthe41.3percentwhowerenon-financeexecutives,managersorsupervisors,19.8percentweresalariedandtherestwereincloselyheldbusinesses.35Besidesthe6.2percentofthetop0.1%whowere“notworkingordeceased,”thenextlargestoccupationalgroupswerelawyerswith5.8percent,realestatewith5.1percent,andmedicalwith4.1percent.WecanusetheStandard&Poor’sExecuCompdatabase,whichcompilesdataonexecutivepaythatisinSECFormDEF14A—theproxystatementthatacompanyfilespriortoitsannualgeneralmeetingofshareholders—togetanideaoftherepresentationofhigh-paidcorporateexecutivesamongthetop0.1%ofhouseholdsintheincomedistribution.In2012,forexample,thethresholdincome including capital gains for inclusion in the top 0.1% of the income distribution was$1,906,047.36FromtheExecuCompproxystatementdataon“named”topexecutives(theCEO,CFO, and three other highest-paid executives), in 2012, 4,339 executives (41 percent of theexecutives in the ExecuComp database that year) had total compensation greater than thisthreshold amount,with an average incomeof $7,524,168.Of that amount, 64 percentwererealized gains from stock-based compensation,with 32 percent derived from the exercise ofstockoptionsandtheother32percentfromthevestingofstockawards.Thenumberof corporateexecutiveswho, in2012,weremembersof the top0.1%clubwas,however,farhigherthan4,339fortworeasons.First,totalcorporatecompensationofthenamedexecutivesdoesnotincludeothernon-compensationincome(fromsecurities,property,feesforsitting on the boards of other corporations, etc.) thatwould be included in their federal taxreturns. Ifwe assume that namedexecutiveswhose corporate compensationwasbelow the$1.91million thresholdwereable toaugment that incomeby25percent (topickaplausiblenumber)fromothersources,thenthenumberofnamedexecutivesinthetop0.1%in2012wouldhavebeen5,095.Second, included inthetop0.1%oftheU.S. incomedistributionwereapotentially large,butunknown,numberofU.S.corporateexecutiveswhosepaywasabovethe$1.91millionthreshold,butwhowerenotnamedinproxystatementsbecausetheywerenottheCEO,CFOoroneofthethreeotherhighest-paidexecutives,asrequiredbySECregulations.Forexample,ofthehighest-paidIBMexecutives in2012namedinthecompany’sproxystatement,thelowestpaidhadatotalcompensationof$9,177,663.TherewerepresumablymanyotherIBMexecutiveswhosetotalcompensationwasbetweenthisamountandthe$1.91millionthresholdforinclusioninthetop0.1%.These “unnamed”executiveswouldhavebeenamong the top0.1% in the incomedistribution.

https://web.williams.edu/Economics/wp/BakijaColeHeimJobsIncomeGrowthTopEarners.pdf.Thequoteisfromthepaper’sabstract.

35Ibid.,p.38.36TheWorldWealthandIncomeDatabase,athttp://topincomes.parisschoolofeconomics.eu/#Database:UnitedStates,P99.9incomethreshold.


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Therefore,topexecutivesofU.S.businesscorporations—industrialaswellasfinancial—areverywellrepresentedamongthetop0.1%oftheU.S.incomedistribution,withmuch,andoftenmost,oftheircompensationincomecomingfromtherealizedgainsfromexercisingstockoptionsandthevestingofstockawards.WhenthismodeofcompensatingtopexecutivesiscombinedwiththefactthatWallStreethas,sincethe1980s,judgedtheperformanceofcorporationsbytheirquarterly stockprices, the importanceof stock-basedpay inexecutivecompensation is clear.Stock-basedpay gives top executives powerful personal incentives to boost, fromquarter toquarter,thestockpricesofthecompaniesthatemploythem.Instockbuybacks,theseexecutiveshavefoundapotent,andSEC-approved,instrumentforstock-marketmanipulationfromwhichtheycanpersonallybenefit,evenifthestock-priceboostsareonlytemporary.Most household income comes fromworking in paid employment, with the business sectoraccounting for about 81 percent of all U.S. civilian employment. Figure 7 shows the relationbetweenthecumulativeincreaseinhourlylaborproductivityandthecumulativeincreaseinrealhourlywagesinthebusinesssectoroftheU.S.economyfrom1948to2015.Fromthelate1940sto the mid-1970s, rates of increase in real wages kept up with rates of increase in laborproductivity—an indicator of “sharedprosperity.” Beginning in the secondhalf of the 1970s,however, theproductivitygrowth ratebegan tooutstrip thewagegrowth rate,andover theensuingdecadesthegapbetweenthetwogrewwiderandwider,asshowninFigure7.Figure7:Cumulativeannualpercentchangesinproductivityperhourandrealwagesperhour,

1948-2015

Source:U.S.BureauofLaborStatistics,CurrentPopulationSurvey(Nonfarmbusinesslabor

productivity;Medianusualweeklyearnings-inconstant(1982-84)dollars)IsubmitthatthewideninggapbetweenproductivityincreasesandwageincreasesreflectstheintensificationofthelootingoftheU.S.businesscorporation.Figure8appearedinaNewYork


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Timesarticle,“Ourbrokeneconomy,inonesimplechart.”Basedondatainhouseholdfederaltaxfilings,in1980,therewasanegativecorrelationbetweenahousehold’ssuperiorpositioninthe income distribution and its income gains since 1946. In sharp contrast, in 2014, thiscorrelation was positive, and enormously positive for the top 0.1 percent of the incomedistribution.Fromtheperspectiveof theTheoryof InnovativeEnterprise,Figure8charts thetransitionsincethe1980sfromretain-and-reinvesttodownsize-and-distributeasthedominantnorm of U.S. corporate resource allocation. And justifying this looting of the U.S. businesscorporationhasbeentheneoclassicaleconomicsideology,rootedintheoryoftheunproductivefirmasthefoundationforthemostefficienteconomy,that,forthesakeofsuperioreconomicperformance,businessenterprisesshouldberunto“maximizeshareholdervalue.”Asshown in thenextsectionof thisessay, fromthe1980sneoclassicaleconomistsknownasagencytheorists,alsomiredinthetheoryoftheunproductivefirm,arguedthatU.S.businesscorporationsshouldusestock-basedpaytoincentivizeseniorcorporateexecutivestodistributecorporate cash to shareholders for the sake of the efficient allocation of the economy’sresources.Thatiswhatagencytheoristsargued;extremeincomeinequalityiswhatAmericansgot.

Figure8:Percentchangeinincomegrowthduringtheprevious34years,1980and2014,bypercentileintheU.S.incomedistribution

Source: David Leonhardt, “Our broken economy, in one simple chart,” New York Times, August 7, 2017, at

https://www.nytimes.com/interactive/2017/08/07/opinion/leonhardt-income-inequality.html.


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4. AgencytheoryandthelootingoftheU.S.businesscorporationDistributionsof corporate cash to shareholders incentivizedby the stock-basedpayof seniorexecutivesaretheclearestmanifestationsofthefinancializationoftheU.S.businesscorporation.Legitimizingthisfinancializedmodeofcorporateresourceallocationhasbeentheideologythatabusinesscorporationshouldberunto“maximizeshareholdervalue”(MSV).Throughtheirstockoptionsandstockawards,corporateexecutiveswhomaketheresource-allocationdecisionstodistributecashtoshareholdersarethemselvesprimebeneficiariesofthefocusonrisingstockprices,earningspershare(EPS),and“totalshareholderreturn”(dividendsplusstock-pricegains)as the sole measures of corporate performance. While rationalization, marketization, andglobalization have undermined stable and remunerative employment structures, thefinancialization of the U.S. corporation has entailed the distribution of corporate cash toshareholdersthroughstockrepurchases,ofteninadditiontogenerouscashdividends.Overthepastdecade,atanacceleratingrate,hedge-fundactivistshavejoinedseniorcorporateexecutivesinthefeedingfrenzyinaprocessthatcanonlybedescribedasthelegalizedlootingoftheU.S.businesscorporation.37Thedramaticchangeintrajectoryfromretain-and-reinvesttodownsize-and-distributethathasoccurredintheUnitedStatesoverthepastfourdecadesdidnothavetohappen.Rather,itwasimposedupontheU.S.laborforcebytheadherencetoahighlydamagingandfallaciousideologyof the relation between corporate governance and economic performance. The widespreadacceptanceofMSVideologyasaguidetoU.S.corporategovernancefromthe1980sthatresultedinthefinancializationofthecorporationrepresentsaquintessentiallyneoclassicalresponsetoinnovationandcompetitioninthenewglobaleconomy—aresponserootedinadherencetothetheoryoftheunproductivefirmastheidealofeconomicefficiency.InthenameofMSV,U.S.businessexecutivesfavoredlivingoffvaluecreatedinthepastratherthaninvestinginproductivecapabilitiesthatcouldcreatevalueinthefuture.TheresultwastheU-turnoftheU.S.economyfrom a movement toward stable and equitable growth to instability, inequity, and stuntedproductivity.38We shouldnotunderestimate the roleof theneoclassical theoryof themarket economy, asespousedbyboththeneoclassicalconservativeMiltonFriedmanandtheneoclassicalliberalPaulSamuelson,aswellastheiracademicoffspring,insanctioning(evenifoutofignoranceand/ornaiveté)thepoliciesthat,inthenameofMSV,haveresultedinthelootingoftheU.S.businesscorporation.Beginninginthe1970sandwithavengeanceinthe1980s,theUnitedStatesasasociety looked to “market forces” to respond to changes in innovation and competition.Deregulationofproductmarkets,financialmarkets,andlabormarketsensued.Theneoclassicaltheoryoftheunproductivefirmasthefoundationofthemostefficienteconomyunderpinnedthese free-market policy choices—with, not surprisingly, disastrous results in terms ofemploymentopportunityandincomedistribution.Whatenabledthesefree-marketprinciplestogainpoliticaltractionandchangethesocioeconomictrajectoryoftheUnitedStateswastherise37WilliamLazonickandJang-SupShin,RebalancingValueCreationandValueExtraction:HowtoDeactivateHedgeFundsandRecreateSustainableProsperity,ReporttotheKoreaEconomicResearchInstitute,May31,2017.

38Onstuntedproductivitygrowth,seeRobertJ.Gordon,TheRiseandFallofAmericanGrowth,PrincetonUniversityPress,2016.


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ofanewideologyofcorporategovernance,rootedintheneoclassicaltheoryoftheunproductivefirmandpropoundedbyagencytheorists,whopositedthat,forthesakeofeconomicefficiency,businessesshouldberunto“maximizeshareholdervalue.”If “the firm” is inherently unproductive, then the vast amounts of cash controlled by largecorporationsshouldbe“disgorged,”asMSV’smostvocalacademiccritic,MichaelC.Jensen,socrudelybutevocativelyputit,39tofinancialmarketsforreallocationtotheirmostefficientuses.Nevermindthatagencytheory,rootedintheneoclassicaltheoryoftheunproductivefirm,hasabsolutely nothing to say about how business corporations grow large nor how “the mostefficientuses”towhichthemarketissupposedtoallocateresourcescomeintoexistence.WhiletheriseofMSVtoitsstatusasahegemonicideologyofU.S.corporategovernancebytheendofthe1980s represented the triumphof the free-marketChicago School, theEastCoast liberalSamuelsonian School shared with Friedman’s Chicago School the same underlying, andintellectuallydebilitating,viewof theunproductive firmas the idealofeconomicefficiency. IknowofnoprominentSamuelsonianneoclassicaleconomist,eventhemostprogressiveamongthem,whohasbeencriticalofMSV.Rathertheyhavecontinuedtospintheirstoriesofimperfectmarketsandmarketfailureswhilethelootingofthebusinesscorporationhasgonefrombadtoworse.Thathavingbeensaid,thepromulgationofMSVasaviewofhowtheeconomyshouldoperateandperformwas theworkofMilton Friedman’sChicagoSchoolof Economics. In September1970, theNew York Times Magazine published an article by Friedman, entitled “The socialresponsibilityofbusinessistoincreaseprofits”—anarticlewhichsubsequentlybecameviewedastheclarioncallfortheMSVversionofagencytheory.Friedmanwarns:

Inafree-enterprise,private-propertysystem,acorporateexecutiveisanemployeeofthe owners of the business. He has direct responsibility to his employers. Thatresponsibility is to conduct the business in accordance with their desires, whichgenerallywillbetomakeasmuchmoneyaspossiblewhileconformingtothebasicrules of the society, both those embodied in law and those embodied in ethicalcustom.

Friedmanconcludesthearticlebyquotinghimselffromhis1962bookCapitalismandFreedom:“Thereisoneandonlyonesocialresponsibilityofbusiness—touseitsresourcesandengageinactivitiesdesignedtoincreaseitsprofitssolongasitstayswithintherulesofthegame,whichistosay,engagesinopenandfreecompetitionwithoutdeceptionorfraud.”40To produce profits, however, the firmmust generate competitive—that is, high-quality, low-cost—products.Onhowafirmgeneratessuchproducts,Friedman’sCapitalismandFreedomhasnothing to say.41 Like Samuelson. Friedman rooted his free-market argument in the ideal of

39MichaelC.Jensen,“AgencyCostsofFreeCashFlow,CorporateFinance,andTakeovers,”AmericanEconomicReview,76,2,1986:323-329(theterm“disgorge”isusedonpages323and328).

40MiltonFriedman,“Thesocialresponsibilityofbusinessistoincreaseitsprofits”NewYorkTimesMagazine,September13,1970.

41MiltonFriedman,CapitalismandFreedom,UniversityofChicagoPress,fortiethanniversaryedition,2002.


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“perfectcompetition”withitssmallunproductivefirms.Howdoesabusinesscorporation“makeasmuchmoney as possible…in open and free competitionwithout deception or fraud”? Toanswerthatquestion,Friedmanwouldhaveneededatheoryofinnovativeenterprise.TheTheoryof InnovativeEnterpriseargues that, inaworldof innovationandcompetition, ifthosewhoexercisestrategiccontrolovertheallocationofcorporateresourcesfailtoinvestinthe productive capabilities that can generate innovative products, their firmswill experiencecompetitive decline. Indeed, Friedman’s own advice to corporate executives that they shouldavoid“socialresponsibility”provesthisrule.AtthetopofFriedman’s“socialresponsibility”articleasitappearedintheNewYorkTimesMagazinewasaphotoofGeneralMotorschairmanJamesRoche, standingat thepodiumat thecompany’sannual shareholdermeeting thathad takenplaceinMay1970,fourmonthsbeforetheTimespublishedFriedman’spiece(presumablyasaresponse to ongoing efforts to make General Motors socially responsible). The editorialdescriptionof thephotostates thatRochewas replying tomembersof“CampaignG.M.,”anorganizationthat

demandedthatG.M.namethreenewdirectorstorepresent“thepublicinterest”and setupa committee to study the company’sperformance in suchareasofpublicconcernassafetyandpollution.Thestockholdersdefeatedtheproposalsoverwhelmingly,butmanagement,apparentlyinresponsetotheseconddemand,recentlynamedfivedirectorstoa“public-policycommittee.”Theauthor[MiltonFriedman] calls such drives for social responsibility in business “pure andunadulteratedsocialism,”adding:“Businessmenwhotalkthiswayareunwittingpuppetsoftheintellectualforcesthathavebeenunderminingthebasisoffreesociety.”

MichaelOlenick,whoprovidedmewiththepdfofthearticleasitoriginallyappearedintheNewYorkTimes,with thephotoofRocheand theeditorializingon it,pointsout that, inhistoricalretrospect, the demands of Campaign G.M. for safer and less polluting cars were in effectdemandsforG.M.toengage inautomobile innovation.42 Inthe1970sandbeyond,theworldleaders in producing these “socially responsible” cars would be Japanese and Europeancompanies,leavingthe“profit-maximizing”GeneralMotorslaggingfurtherandfurtherbehind.WhatFriedman(and,quotinghim,theNewYorkTimeseditor)called“pureandunadulteratedsocialism”provedtobethefutureoftheautomobileindustry!MeanwhileFriedmanandhisMSVfollowers, themselves indoctrinatedwiththetheoryoftheunproductivefirm,instructedU.S.corporateexecutivesthattheyshoulddoeverythingpossibleto resist such innovative strategies, perhaps making them, to turn Friedman on his head,“unwittingpuppetsoftheintellectualforces”oftheabsurdFriedman-Samuelsonviewthattheunproductivefirmistheidealofeconomicefficiency.Ineffect,theneoclassicaleconomistswere

42IamgratefultoMichaelOlenick,aresearcheratINSEAD,formakingthispointconcerningFriedman’s1970NewYorkTimesarticle.SeeMichaelOlenick,“Originalshareholdervaluearticle—MiltonFriedmantoGM:Buildclunkycars,”athttps://olen.com/2017/09/15/original-shareholder-value-article-milton-friedman-to-gm-build-clunky-cars/and“Shareholdervaluetheory:History,athttps://olen.com/2017/09/15/shareholder-value-theory-history/,OlenonEconomics(nodatesofpublicationprovided).


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advisingcorporateexecutivesto,asRobertHayesandWilliamAbernathywouldputitinaclassic1980HarvardBusinessReviewarticle,managetheirwaytoeconomicdecline.43Theneoclassicaltheoryoftheunproductivefirmastheidealofeconomicefficiencyinfusedtheagency-theoryarguments inMichaelC. JensenandWilliamH.Meckling,“Theoryof theFirm:Managerial Behavior, Agency Costs, and Ownership Structure,” the academic journal articlepublishedin1976thatpioneeredinapplyingagencytheorytotheseparationofshareownershipfrommanagerialcontrol,adominantcharacteristicof theU.S.businesscorporationsince theearly twentieth century.44 On the business school faculty of the University of Rochester, anultraconservativeoutpost of theChicago School, Jensen andMeckling assumed that a publiccorporation should be run for the sake of its shareholders, as owners. They then posed theproblemofthe“optimal”ownershipstructurethatcouldgetmanagers,astheiragents,toservetheinterestsofthesupposedprincipals.Jensen andMeckling view the firm as a legal fiction that can be understood as a nexus ofcontracts.Inthiscontractualrelation,theagencyproblemforownersasprincipalsistoprovideincentivestomanagerstobehaveinawaythatmaximizesprofitsfortheowners.The“agencycosts”oftheseparationofownershipandcontrolderivefromtheinteractionofthepartiestothecontractaseachseekstomaximizehisownutility. JensenandMecklingposetheagencyproblemassusceptibletoaconstrained-optimizationsolutioninwhichan“equilibrium”(thatis,anagreed-uponcontract)isachieved.ThereisnonotioninJensenandMecklingthat,bypursuinginvestmentstrategiestotransformtechnologiesandaccessmarkets,managerscanleadfirmsthat generate gains from innovative enterprise, obviating the need for a constrained-optimizationsolution.JensenandMeckling’s“TheoryoftheFirm”lacksatheoryofinnovativeenterprise.Yet agency theorywouldhave aprofound influenceon the realworldof corporate resourceallocation.45Acriticalpointofdeparture46was thecapture in1981of theU.S.SecuritiesandExchange Commission (SEC) by free-market Chicago economists with the election of RonaldReaganasPresidentoftheUnitedStates.Reagan’sappointmentofE.F.HuttonexecutiveJohnShadaschairoftheSECputtheagencythatwassupposedtoeliminatefraudandmanipulationfromthenation’sfinancialmarketsundertheleadershipofaWallStreetbankerforthefirsttimesinceJosephKennedyhadbeentheinauguralholderofthatpositionin1934-1935.Upontakingoffice,Shadimmediatelycreatedthenewpostof“chiefeconomist”attheSEC,andpickedforthepositiona1975ChicagoeconomicsPhD,CharlesCox,who,ina1976articleintheJournalofPoliticalEconomyhadappliedthe“efficientmarketshypothesis”tofuturestrading.In1983,Shad

43RobertH.HayesandWilliamJ.Abernathy,“ManagingOurWaytoEconomicDecline,”HarvardBusinessReview,July-August

1980:67-77.ForaparallelargumentthatImadeinthe1980sconcerningthestanceofneoclassicaleconomichistoriansinthedebateonBritisheconomicdecline,seeBernardElbaumandWilliamLazonick,“TheDeclineoftheBritishEconomy:AnInstitutionalPerspective,”JournalofEconomicHistory,44,2,1984:567-583.

44MichaelC.JensenandWilliamH.Meckling,“TheoryoftheFirm:ManagerialBehavior,AgencyCosts,andOwnershipStructure,”JournalofFinancialEconomics,3,4,1976:305-360.

45SeeLazonickandO’Sullivan,“MaximizingShareholderValue”:JustinFox,TheMythoftheRationalMarket:AHistoryofRisk,Reward,andDelusiononWallStreet,Harper,2009;MarionFourcadeandRakeshKhurana,“TheSocialTrajectoryofaFinanceProfessorandtheCommonSenseofCapital,”HistoryofPoliticalEconomy,49,2,2017:347-381.

46ThefollowingsummaryisbasedonmyresearchinprogresswithKenJacobsonoftheAcademic-IndustryResearchNetwork.


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managedtoousthisnemesis,SECCommissionerJohnEvans,aNixonappointeewhobelievedthatfinancialmarketsneededtoberegulated,andputCoxinEvans’place.Shad’snewappointeeasSECchiefeconomist,GregJarrell,wasanoutspoken1978ChicagobusinesseconomicsPhDwhocametotheSECfromajuniorfacultypositionattheUniversityofRochester,homeofJensenandMeckling.OnNovember17,1982,theSECpromulgatedRule10b-18,whichgivesacompanyasafeharboragainstmanipulationchargesindoingopen-marketrepurchases.47Thesafeharborstatesthatacompanywillnotbechargedwithmanipulationif,amongotherthings,itsbuybacksonanysingleday are nomore than 25 percent of the previous fourweeks’ average daily trading volume(ADTV). Under Rule 10b-18, moreover, there is no presumption of manipulation should thecorporation’srepurchasesexceedthe25percentADTVlimit.48TheadoptionofRule10b-18in1982 was called a “regulatory about-face” from previous SEC views on the detection andpreventionofmanipulationthroughopen-marketrepurchases.49UnderRule10b-18,apubliclylisted company can do hundreds of millions of dollars per day in open-market repurchases,tradingdayaftertradingday,forthesolepurposeofgivingmanipulativebooststoitsstockprice.Asithappened,onNovember19and20,1982,withindaysoftheadoptionofSECRule10b-18,Michael Jensen and Chicago economist Eugene Fama (inventor of the “efficient markethypothesis” for stock-price determination) held a conference, “Corporations and PrivateProperty” at the Hoover Institution at Stanford University, ostensibly to commemorate thefiftieth anniversary of the publication of Adolf Berle and Gardiner Means, The ModernCorporation and Private Property.50 In fact, with two joint articles by Fama and Jensen on“OwnershipandControl”and“AgencyProblemsandResidualClaims,”51theHooverInstitutionconference agenda was to make shareholder-value ideology influential in the practice ofcorporate governance. That influence was assured when, in 1985, the president of HarvardUniversityandthedeanofHarvardBusinessSchool(HBS)convincedJensentoleaveRochestertobecomeanHBSprofessor.52Figure9,takenfromapaperthatpresentsresearchonmentionsof“shareholdervalue”intheWallStreetJournalfrom1965to2007,suggeststhatitwasonlyinthemid-1980sthatMSVbecamecentraltothepublicdiscourseoncorporategovernance.47 Securities and Exchange Commission, “Purchases of Certain Equity Securities by the Issuer andOthers; Adoption of SafeHarbor,”November17,1982,FederalRegister,RulesandRegulations,47,228,November26,1982:53333-53341.

48http://www.sec.gov/divisions/marketreg/r10b18faq0504.htm.Forthesafeharbortobeineffect,Rule10b-18alsorequiresthatthecompanyrefrainfromdoingbuybacksatthebeginningandendofthetradingday,andthatitdoallthebuybacksthroughonebrokeronly.

49LloydH.FellerandMaryChamberlin,“IssuerRepurchases,”ReviewofSecuritiesRegulation,17,1,1984:993-998.50ThomasMoore,“Introduction[totheSpecialIssuefromtheConferenceontheCorporationandPrivateProperty],”JournalofLawandEconomics,26,2,1983:235-236.

51EugeneF.FamaandMichaelC.Jensen,“SeparationofOwnershipandControl,”JournalofLawandEconomics,26,2,1983:301-325;EugeneF.FamaandMichaelC.Jensen,“AgencyProblemsandResidualClaims,“JournalofLawandEconomics,26,2,1983:327-349.

52SeeDuffMcDonald,“HarvardBusinessSchoolandthepropagationofimmoralprofitstrategies,”Newsweek,April14,2017,athttp://www.newsweek.com/2017/04/14/harvard-business-school-financial-crisis-economics-578378.html.FormyearlycritiquesofJensenandagencytheoryfromtheperspectiveofthehistoricalevolutionoftheU.S.economy,seeWilliamLazonick,“ControllingtheMarketforCorporateControl:TheHistoricalSignificanceofManagerialCapitalism,”IndustrialandCorporateChange,1,3,1992:445-488;WilliamLazonick,“CreatingandExtractingValue:CorporateInvestmentBehaviorandAmericanEconomicPerformance,”inMichaelA.BernsteinandDavidE.Adler,eds.,UnderstandingAmericanEconomicDecline,CambridgeUniversityPress,1994:79-113.


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Figure9.Mentionsof“shareholdervalue”intheWallStreetJournal,1965-2007

Source:JohanHeilbron,JochemVerheul,andSanderQuak,“TheOriginsandEarlyDiffusionof‘ShareholderValue’in

theUnitedStates,”TheoryandSociety,43,1,2014:1-22.Inanarticle,“AgencyCostsofFreeCashFlow,CorporateFinance,andTakeovers”thatJensenpublishedinAmericanEconomicReviewin1986,heargued:

Freecashflowiscashflowinexcessofthatrequiredtofundallprojectsthathavepositive net present values when discounted at the relevant cost of capital.Conflictsofinterestbetweenshareholdersandmanagersoverpayoutpoliciesareespeciallyseverewhentheorganizationgeneratessubstantialfreecashflow.Theproblemishowtomotivatemanagerstodisgorgethecashratherthaninvestingitatbelowcostorwastingitonorganizationinefficiencies.”53

In the 1980s and 1990s, Jensen advocated the use of stock-based pay to incentive seniorexecutivesto“disgorge”theso-called“freecashflow”intheformsofbuybacksanddividends.54Yet,itistheMSVargumentitselfthatdefineswhatcashflowis“free”—evenifitmeanslayingoffthousandsofemployeestodobillionsofdollarsinbuybackstomanipulatethecompany’sstockprice.Jensen’s“relevantcostofcapital”iselevatedbytheshareholders’successinclaimingthatallprofitsshouldaccruetothem,andthereinvestmentofcorporatecashisdeemedtobe“belowcost”whentaxpayersandworkerscannotbeexcludedfromsharinginthegainsofthevaluethattheyhelptocreate.FromtheMSVperspective,reinvestmentofcorporateprofitsina53Jensen,“AgencyCostsofFreeCashFlow,CorporateFinance,andTakeovers,”p.323.54MichaelC.JensenandKevinJ.Murphy,“PerformancePayandTopManagementIncentives”JournalofPoliticalEconomy,98,2,1990:225-264.


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companythatsharesthegainsofinnovationwithtaxpayersandworkerswhosecontributionsofmoney and effort help to generate innovative products represents, for Jensen, “wasting[corporatecash]onorganizationalinefficiencies.”Onewayofsolvingthe“agencyproblem”isthroughwhatagencytheoristscallthe“marketforcorporate control,” which seeks to use voting rights connected with shareholding to oustcorporate executives who ignore the interests of shareholders. In practice, “the market forcorporatecontrol”takestheformofproxyconteststhatseektoreplaceboardmembersandseniorexecutives,aprocessthat,asJang-SupShinandIrecountinaforthcomingbook,55wasfacilitatedby theSEC in the1990sby the rule that institutional investors (pension fundsandmutualfunds)mustvotetheproxiesofthecompanieswhosestockstheyholdintheirfinancialportfolios.ShinandIanalyzetheperpetratorsofwhatwecall“predatoryvalueextraction”asaconcatenationconsistingofseniorexecutivesasvalue-extractinginsiders,institutionalinvestorsasvalue-extractingenablers,andactivistshareholdersasvalue-extractingoutsiders.56Inshort,asarticulatedbyJensenandothers,MSVisatheoryofvalueextraction,posingasatheoryofvaluecreation.57MSVideologyisrootedintwomisconceptionsoftheroleofpublicshareholders in theU.S.businesscorporation.Themost fundamentalerror is theassumptionthatpublicshareholdersinvestintheproductiveassetsofthecorporation.Theydonot.58Theyallocatetheirsavingstothepurchaseofsharesthatareoutstandingonthestockmarket,andtheyarewillingtodosobecausetheliquidityofthemarketenablesthemtosellthosefinancialassets at any time they so choose. The erroneousMSV assumption that public shareholdersinvestintheproductiveassetsofthecompanyisthencompoundedbythefallacythatitisonlypublic shareholders whomake risky investments in the corporation’s productive assets, andhencethatitisonlyshareholderswhohaveaclaimonthecorporation’sprofits,ifandwhentheyoccur.The agency-theory argument raises two critical and related questions: Why are publicshareholdersdeemedtobethe“principals”inwhoseintereststhefirmshouldberun?Andwhatcontributionsdopublicshareholdersmaketothevalue-creationprocess?Theanswerstothesequestionsexposeagencytheory’slogicalandfactualflaws.Agencytheory’sanswertothefirstquestionisthatonlyshareholdersinvestinthefirm,whileallother participants in the firm provide marketable inputs for which they are paid market-determinedprices.Itsanswertothesecondquestionisthat,havinginvestedinthefirm,publicshareholderstaketherisksofwhetherthoseinvestmentswillyieldprofitsorlosses,andhence,forthesakeofeconomicefficiency,onlyshareholdershaveaclaimonthefirm’sprofitsifandwhenthereisapositive“residual”ofrevenuesovercosts.Public shareholdersdonot,asa rule, invest in the firm.They invest insharesoutstandingbysimplypurchasingthemonthestockmarket.Andinpurchasingsharesonaliquidstockmarket55LazonickandShin,RebalancingValueCreationandValueExtraction.56Ibid.57Lazonick,“CreatingandExtractingValue.”58Lazonick,“TheFunctionsoftheStockMarketandtheFallaciesofShareholderValue.”


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suchastheNewYorkStockExchangeorNASDAQ,publicshareholderstake littleriskbecausetheyenjoylimitedliabilityiftheyholdtheshareswhile,atanyinstantandataverylowcost,theycansellthesharesatthegoingmarketprice.Public shareholdersareportfolio investors,notdirect investors.Thegenerationof innovativeproducts,however,requiresdirectinvestmentinproductivecapabilities.Theseinvestmentsininnovation are uncertain, collective, and cumulative. Innovative enterprise requires strategiccontroltoconfrontuncertainty,organizationalintegrationtoengageincollectivelearning,andfinancialcommitmenttosustaincumulativelearning.Thatiswhy,tounderstandtheproductivityofthefirm,weneedatheoryofinnovativeenterprise.When,asinthecaseofastartup,financiersmakeequityinvestmentsintheabsenceofaliquidmarketforthecompany’sshares,theyaredirectinvestorswhofacetheriskthatthefirmwillnotbeabletogenerateacompetitiveproduct.Theexistenceofahighlyspeculativeandliquidstockmarketmayenablethemtoreapfinancialreturns—insomecases,evenbeforeacompetitiveproducthasbeenproduced. Itwastomakesuchaspeculativeand liquidmarketavailabletoprivate-equityinvestors,whoweretobecomeknownas“venturecapitalists,”thatin1971theNational Association of Security Dealers Automated Quotation exchange was launched byelectronicallylinkingthepreviouslyfragmented,andhencerelativelyilliquid,Over-the-Countermarkets.NASDAQbecameaninducementtodirectinvestmentinstartupspreciselybecauseitoffered the prospect of a quick IPO; one that could take placewithin a few years after thefoundingofthefirm.ItisforthatreasonthatventurecapitalistscallalistingonNASDAQan“exitstrategy.”Ineffect,theyareexitingtheir illiquid,high-riskdirect investmentsbyturningthemintoliquid, low-riskportfolio investments. If, after an IPO, the former direct investors decide to hold onto theirshares,theyareinpreciselyinthesamelow-riskportfolio-investorpositionasanyotherpublicshareholder:theycanusethestockmarkettobuyandsellshareswhenevertheysochoose.But venture capitalists are not the only economic actorswho bear the risk ofmaking directinvestments in productive capabilities. Taxpayers through government agencies andworkersthrough the firms that employ themmake risky investments in productive capabilities on aregularbasis.Fromthisperspective,householdsastaxpayersandworkersmayhave,byagencytheory’sownlogic,“residualclaimant”status:thatis,aneconomicclaimonthedistributionofprofitsifandwhentheyoccur.Through government investments and subsidies, taxpayers regularly provide productiveresourcestocompanieswithoutaguaranteedreturn.Asanimportantexample,butonlyoneofmany,the2016budgetoftheU.S.NationalInstitutesofHealth(NIH)was$32.3billion,partofatotalNIHinvestmentinlife-sciencesresearchspanning1938through2016thataddeduptojustunder$1trillionin2016dollars.59Businessesthatmakeuseoflife-sciencesresearchbenefitfrom59NationalInstitutesofHealth,“Budget,”athttp://www.nih.gov/about-nih/what-we-do/budget.SeealsoWilliamLazonick,MattHopkins,KenJacobson,MustafaErdemSakinç,andÖnerTulum,“U.S.Pharma’sFinancializedBusinessModel,”InstituteforNewEconomicThinkingWorkingPaperNo.60,revisedSeptember8,2017,athttps://www.ineteconomics.org/research/research-papers/us-pharmas-financialized-business-model.


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the public knowledge that the NIH generates. As risk bearers, taxpayers who fund suchinvestments in theknowledgebase,orphysical infrastructuresuchas roads,haveaclaimoncorporate profits if and when they are generated. Through the tax system, governments,representinghouseholdsastaxpayers,seektoextractthisreturnfromcorporationsthatreaptherewardsofgovernmentspending.Infinancinginvestmentsininfrastructureandknowledge,therefore,taxpayersmakeproductivecapabilities available to business enterprises, but with no guaranteed return on thoseinvestments. Nomatter the corporate tax rate, households as taxpayers face the risks that,becauseoftechnological,market,andcompetitiveuncertainties,theenterprisewillnotgeneratetheprofitsthatprovidebusiness-taxrevenuesasareturntohouseholdsastaxpayersontheirinvestments in infrastructure and knowledge.Moreover, tax rates are politically determined.Householdsastaxpayersfacethepoliticaluncertaintythatpredatoryvalueextractors—financialinterestswho “take” farmore than they “make”60—may convincegovernmentpolicy-makersthatunlessbusinessesaregiventaxcutsorfinancialsubsidiesthatwillpermitadequateprofits,theywillnotbeabletomakevalue-creatinginvestments.Politiciansmaybeputinpowerwhoaccedetothesedemands.Workersregularlymakeproductivecontributionstothecompaniesforwhichtheyworkthroughtheexerciseofskillandeffortbeyondthoselevelsrequiredtolayclaimtotheircurrentpay,butwithoutguaranteedreturns.61Anyemployerwhoisseekingtogenerateahigher-quality,lower-costproductknowstheprofounddifferenceintheproductivitylevelsofthoseemployeeswhojustpunchtheclocktogettheirdailypayandthosewhoengageinlearningthatallowsthemtomake productive contributions through which they can build their careers, thereby puttingthemselvesinapositiontoreapfuturereturnsinworkandinretirement.Yetthesecareersandthereturnsthattheycangeneratearenotguaranteed,andunderthedownsize-and-distributeresource-allocationregimethatMSVideology—legitimizedbyagencytheory—hashelpedputinplace,thesereturnsandcareershave,infact,beenundermined.Therefore,insupplyingtheirskillsandeffortstotheprocessofgeneratinginnovativeproductsthat, if successful, can create value in the future, workers take the risk that, because oftechnological, market, or competitive uncertainties, the application of their skills and theexpenditureoftheireffortswillbeinvain.Farfromreapingexpectedgainsintheformsofhigherpay,morejobsecurity,superiorbenefits,andbetterworkconditions,workersmayfacecutsinpayandbenefits if thefirm’s innovative investmentstrategydoesnotsucceed,andtheymayeven find themselves laid off. Workers also face the possibility that, even if the innovationprocess is successful, the institutional environment in which MSV prevails will empowercorporateexecutivestocutsomeworkers’wagesandlayoffothersinordertoextractvalueforshareholders,includingthemselves,thatthoseworkershelpedtocreate.Asriskbearers,therefore,taxpayerswhosemoneysupportsbusinessenterprisesandworkerswhoseeffortsgenerateproductivityimprovementshaveclaimsoncorporateprofitsifandwhen

60SeeRanaForoohar,MakersandTakers:TheRiseofFinanceandtheFallofAmericanBusiness,CrownBusiness,2016.61Lazonick,CompetitiveAdvantageontheShopFloor;Lazonick,“TheTheoryofInnovativeEnterprise.”


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theyoccur.MSVignorestherisk-rewardrelationforthesetwotypesofeconomicactorsintheoperation and performance of business corporations.62 Instead, based on agency theory, iterroneouslyassumesthatshareholdersaretheonly“residualclaimants.”TheironyofMSVisthatthepublicshareholderswhomagencytheoryholdsupastheonlyriskbearerstypicallyneverinvestinthevalue-creatingcapabilitiesofthecompanyatall.Rather,theypurchaseoutstandingcorporateequitieswiththeexpectationthat,whiletheyareholdingtheshares,dividendincomewillbeforthcoming,andwiththehopethat,whentheydecidetoselltheshares,thestock-marketpricewillhaverisentoyieldacapitalgain.FollowingthedirectivesofMSV,aprimewayinwhichtheexecutiveswhocontrolcorporateresourceallocationfuelthishopeisbyallocatingcorporatecashtostockbuybackstopumpuptheircompany’sstockprice.Those holding onto their shareswill receive cash dividends,while thosewishing to sell theirshareswillstandachanceofreapingenhancedcapitalgainsashigherstockpricesareachievedthrough stock repurchases—if they are able to get the timing of the stock sales right. Theassumptionisthat,viafinancialmarkets,shareholderswillthenreallocateatleastaportionoftheirgainsfromdividendsandstocksalestousesthataremoreefficientthanthosetowhichtheywouldhavebeenputhadthefundsbeenretainedbythecompany.MSVimpliesthatshareholdersderivetheirgainsbyextractingvalueasarewardfortakingtheriskofcontributingtoprocessesthatcreatevalue.Thus,whencorporationspaydividendsordobuybacks, MSV characterizes these distributions as “returning” capital to shareholders. Forexample,from2012throughthesecondquarterof2017,Applespent$151billiononbuybacksand$54billionondividendsunderits“CapitalReturnProgram.”63YettheonlytimeinitshistorythatAppleeverraisedfundsonthepublicstockmarketwasin1980,whenitcollected$97millioninIPO.64Howcanacorporationreturncapitaltopartiesthatneversupplieditwithcapital?ThevastmajorityofthosewhoholdApple’spubliclylistedshareshavesimplyboughtoutstandingsharesonthestockmarket.TheyhavecontributednothingtoApple’svalue-creatingcapabilities.ProponentsofMSVmayacceptthatacompanyneedstoretainsomecashflowtomaintainthefunctioningofitsphysicalcapital,buttheygenerallyviewlaborasaninterchangeablecommoditywhoseservicescanbehired,andfired,asneededonthelabormarket.Andtheytypicallyignorethecontributionsthathouseholdsastaxpayersmaketobusiness-valuecreation.Rootedintheneoclassical theory of the market economy, MSV assumes that markets, not organizations,allocate resources to their most efficient uses. Yet it is organizations—including not only62WilliamLazonickandMarianaMazzucato,“TheRisk-RewardNexusintheInnovation-InequalityRelationship,”IndustrialandCorporateChange,22,4,2013:1093-1128.

63RogerFingas,“Appletoincreasecapitalreturnprogramby$50B,extendedforfullyear,”AppleInsider,May2,2017,athttp://appleinsider.com/articles/17/05/02/apple-to-boost-capital-return-program-by-50b-extended-for-full-year;AppleInc.,“ReturnofCapitalandCashPosition,”PressRelease,athttp://files.shareholder.com/downloads/AAPL/4402228650x0x840254/7137D28C-2E6E-4406-8435-ADAB52BB6F4C/Return_of_Capital_Timeline_Q217.pdf

64WilliamLazonick,“NumbersshowAppleshareholdershavealreadygottenplenty,”HarvardBusinessReview,October16,2014,athttps://hbr.org/2014/10/numbers-show-apple-shareholders-have-already-gotten-plenty.SeealsoWilliamLazonick,MattHopkins,andKenJacobson,“WhatwelearnaboutinequalityfromCarlIcahn’s$2billion‘nobrainer’,”InstituteForNewEconomicThinkingPerspectives,June6,2106,athttps://www.ineteconomics.org/perspectives/blog/what-we-learn-about-inequality-from-carl-icahns-2-billion-apple-no-brainer.


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businessesenterprises,butalsogovernmentagenciesandhouseholdfamilies—thatmaketheinvestmentsinproductivecapabilitiesthatdetermineboththe“mostefficient”usesthatexistata given point in time and the extent to which those “most efficient” uses become moreproductiveovertime.65Oncewedebunkthemyththatonlyshareholderstakerisk,therefore,themassivedistributionsthathavebeenmadetoshareholderssincethemid-1980sintheformsofbuybacksanddividendsraisequestionsabouthowmuchof thecash flowthatbothshareholdersandmanagershavedeemedtobe“free”hasbeentheappropriationoffundsthatshouldhavegonetomassesofhouseholdsastaxpayersandworkersasreturnsontheinvestmentsofmoneyandeffortthattheyhavemadeintheproductivecapabilitiesthathavegeneratedcorporateprofits.66Unfortunately,forlackofatheoryofinnovativeenterprise,thevastmajorityofeconomists,betheyliberalorconservative,adheretoagencytheory’scontentionthat,forthesakeofeconomicefficiency, the purpose of the corporation is to “maximize shareholder value.” Hence, theydescribethetrillionsofdollarsincashflowingoutofcompaniestothestockmarketasa“return”of capital to shareholders,whowill then reallocate financial resources to theirmostefficientuses.MSV,however,canexplainneitherhowthese“mostefficientuses”comeintoexistencenor,inparticular,theroleoforganizationsincreatingvalueintheeconomy.67 Aswehaveseen,foraboutthreedecadesafterWorldWarII,theUnitedStatesconsolidateditspositionastheworld’sleadingeconomicpower,drivenbybusinessenterprisesthatengagedinretain-and-reinvest.Duringthesedecades,thedistributionofincomebecamesomewhatmoreequalandamiddleclassofbothhigh-school-educatedblue-collarworkersandcollege-educatedwhite-collar workers thrived. Over the past four decades, in contrast, the United States hasexperiencedextremeconcentrationofincomeamongtherichesthouseholdsandtheerosionofmiddle-class employment opportunities for the vastmajority of the population.68 These twoeconomicproblemsareintegrallyrelated,as,undertheinfluenceofthemantrathatcompaniesshould be run to “maximize shareholder value,” the resource-allocation regimes of businesscorporationshaveshiftedfromretain-and-reinvesttodownsize-and-distribute.695. EradicatingShareholderValueasanIdeologyofCorporateGovernanceWhy have agency theorists gotten it so wrong? Because, like neoclassical economists moregenerally, they lackatheoryof innovativeenterprise:a theoryofhowbusinessorganizationstransformtechnologiesandaccessmarketstogenerateproductshigherinqualityandlowerincost thanthosepreviouslyavailable.Yet these innovativeproductsare thebasisofeconomicgrowth.Moreover,basedoncomparative-historicalanalysis, Icontendthatthewaysinwhich65Lazonick,“InnovativeEnterpriseorSweatshopEconomics?”andreferencestherein.66WilliamLazonick,“InnovativeEnterpriseSolvestheAgencyProblem:TheTheoryoftheFirm,FinancialFlows,andEconomicPerformance,InstituteforNewEconomicThinkingWorkingPaperNo.62,August28,2017,athttps://www.ineteconomics.org/research/research-papers/innovative-enterprise-solves-the-agency-problem.

67Lazonick,BusinessOrganizationandtheMythoftheMarketEconomy;Lazonick,“TheTheoryoftheMarketEconomyandtheSocialFoundationsofInnovativeEnterprise”;Lazonick,“InnovativeEnterpriseorSweatshopEconomics?”.

68Ibid.69LazonickandO’Sullivan,“MaximizingShareholderValue”;Lazonick,“StockBuybacks.”


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innovative enterprises allocate resources and returns providemicrofoundations for not onlyeconomicgrowthbutalsotheemploymentstabilityandincomeequitythatareassociatedwitharobustandexpandingmiddleclass.70Ifagencytheoristshaveacoherenttheoryofthefirm,itisthenotionthatthesmall,unproductivefirm that optimizes subject to given technological and market constraints provides themicroeconomicfoundationforthemostefficienteconomy.Aswehaveseen,hypotheticalfirmsofthisdescriptionplaytheleadingrole intheabsurdtheoryknownas“perfectcompetition.”Fromsuchaneoclassicalperspective,itismarkets,notorganizations,thatallocateresourcestotheirmostefficientuses.Fromthisperspective,thelargecorporationsthathavedominatedtheU.S.economyforover100yearsaremassive“marketimperfections.”Inlinewiththisreasoning,ifwewantamoreefficienteconomy,corporateexecutivesshouldbeincentivized,asMichaelJensenandhisacolyteshavetoldus,to“disgorgethefreecashflow.”WithitsMSVideology,agencytheoryisatheoryofvalueextractionwithoutatheoryofvaluecreation. It is not surprising, therefore, that Jensen’s 1993 American Finance Associationpresidentialaddress,“TheModernIndustrialRevolution,Exit,andTheFailureofInternalControlSystems,”71 is, as the title states, all about exiting existing industrial investments, not aboutenteringnewones.JenseneveninterpretsJosephSchumpeter’snotionof“creativedestruction”asbeingabout“efficientexit”,i.e.,“destruction”,72wheninfactSchumpeter’sentiretheoreticalorientationwastowardtheconditionsfor“entry”throughentrepreneurshipandinnovation:thatis,towardthe“creative”partofthecatchphrase,thepartthatcalledformakingoldwaysofdoingthingsobsolete(towhichSchumpeter’s“destruction”refers).73Tounderstandentry,oneneedsatheoryofinnovativeenterprise,whichispreciselywhatagencytheorylacks.TheTheoryofInnovativeEnterpriserecognizesrolesofhouseholdsactingastaxpayers,workers,consumers,savers,andinvestorsinthevalue-creationprocess,andhenceprovidesaneconomicrationale for their claims on the extraction of value from that process. Through governmentagencies, households as taxpayers make investments in physical infrastructure and humanknowledgewithoutwhicheven,andperhapsespecially,thelargestbusinessenterpriseswouldnot be able to generate competitive products. Hence, through the tax system, the body oftaxpayers should get shares of corporate profits if and when they accrue. Through theemployment relation,householdsasworkers supplybusinessenterpriseswithskill andeffortthatarecentraltotheprocessesofgeneratingcompetitiveproducts.Hence,throughjobstabilityaswellashigherpayandbenefits,workersshouldalsoshareinprofitsifandwhentheyaccrue.70SeeLazonick,CompetitiveAdvantageontheShopFloor;Lazonick,BusinessOrganizationandtheMythoftheMarketEconomy;WilliamLazonick,“OrganizationalLearningandInternationalCompetition,”inJonathanMichieandJohnGrieveSmith,eds.,Globalization,Growth,andGovernance,OxfordUniversityPress,1998:204-238;Lazonick,“TheTheoryoftheMarketEconomy”;Lazonick,“VarietiesofCapitalismandInnovativeEnterprise”;Lazonick,SustainableProsperityintheNewEconomy?;WilliamLazonick,“InnovativeBusinessModelsandVarietiesofCapitalism:FinancializationoftheUSCorporation,”BusinessHistoryReview,84,4,2010:675-702;IngeLippert,TonyHuzzard,UlrichJürgens,andWilliamLazonick,CorporateGovernance,EmployeeVoice,andWorkOrganization:SustainingHighRoadJobsintheAutomotiveSupplyIndustry,OxfordUniversityPress,2014:Lazonick,“LaborintheTwenty-FirstCentury.”

71MichaelC.Jensen,“TheModernIndustrialRevolution,Exit,andtheFailureofInternalControlSystems”JournalofFinance48,3,1993:831-880.

72Ibid.,833.73JosephA.Schumpeter,Capitalism,Socialism,andDemocracy,HarperCollins,2008(originallypublishedin1942),pp.81-85.


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Through demand for goods and services, households valorize the products that businessesgenerate.Hence,householdsshouldgainfromtheinnovativecapabilitiesofcompaniesthroughthe production of higher-quality, lower-cost products, which is indeed the purpose of thebusinesscorporation.Finally, The Theory of Innovative Enterprise permits the distinction between investors, whoparticipateintheprocessofvaluecreation,andsavers,whoderiveincomesfromtheprocessofvalue extraction. Investors in value creation provide financial commitment to industrialenterprisestosustainthedevelopmentandutilizationofproductiveresources,andhenceshouldreceiveanequitableshareofprofitsfromthegenerationofcompetitiveproductsifandwhenthey accrue. In contrast, savers who, as value extractors, use their money to purchaseoutstanding corporate shares without in any way contributing to the value-creation processshouldgetanincomeintheformofdividendsafterallothervalidclaimsofvaluecreatorshavebeenpaid.Inprovidingfinancialliquidity,thestockmarketpermitsthisseparationofownershipand control,making savers as passive shareholders able andwilling to place their savings insecuritiesinthehopethattheywillbeabletoobtaindividendsor,iftheychoosetoselltheirshares,capitalgains.Innovativeenterprisesolvestheagencyproblem.Byincentivizingandrewardingtherealvaluecreators,theinnovativeenterprisecanmobilizetheskill,effort,andfinancethat,bygeneratinghigh-quality,low-costproducts,canimprovetheperformanceoftheeconomy—definedintermsof stable and equitable economic growth. The application of innovation theory to corporategovernance solves the “agency problem” by setting up governance structures that induceindividualswithvariedhierarchicalresponsibilitiesandfunctionalspecialtiestoworktogetherinbusiness organizations toward the achievement of higher levels of productivity, embodied inhigher-quality, lower-cost products. These value-creators share in the gains to innovativeenterprise,andtheycollectivelysupporttaxpaymentsasreturnsforgovernmentalcontributionstothevalue-creationprocess.AsIhavearguedelsewhere,theUnitedStatescanstartthetransitionfromthevalue-extractingeconomy to the value-creating economy by banning stock buybacks, compensating seniorexecutives for their contributions to the value-creating enterprise, placing representatives ofhouseholdsasworkersandtaxpayersoncorporateboards,andreformingthetaxsystemsothatitrecognizesandsupportstheinvestmenttriad.74Noprogresswillbemade,however,aslongasagency theorywith itsMSV ideologyholds sway.By replacingagency theorywith innovationtheory,academicscancontributetotheprocessofputtingtheUnitedStatesandothernationsonapathtoachievingstableandequitablegrowth.TheTheoryofInnovativeEnterpriseoffersarelevantandrigorousanalyticalperspectivethatcaneducateacademics,policy-makers,andtheinformedpublicabouthowaprosperouseconomyfunctionsandperforms.Wemaythenpossessthecollectiveintellectualcapabilitytoformulatepolicesthatgovernbusinessenterpriseforthesakeofsustainableprosperity.

74Lazonick,“TheValue-ExtractingCEO.”

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