Abstract:

The development of business strategy and appropriate forms of corporate governance are two of the major means to achieve competitive advantage. Depending on the type of institutional environment a firm faces, strategy can either drive or constrain performance. Business strategy is a necessary but not sufficient condition for competitive performance. Performance is also influenced by a firm’s governance arrangements, which are related to the abilities of the managers and their incentives to develop effective strategies.This chapter reviews the theoretical and empirical literature related to business strategy and corporate governance – two central issues when considering the competitiveness of firms. In this study we draw on March’s exploitation–exploration framework to distinguish different approaches to formulating business strategy. It expands the framework using insights from institutional theory, the resource-based view and transaction cost economics. The discussion of corporate governance focuses on ownership structure and the boards. In addition, our study will extend the application of agency theory to corporate governance in an appeal to institutional theory. This discussion leads to our conceptual model. It provides a basis for identifying the need for further research and deducing detailed research questions to be addressed.

Key words

institution

business strategy

corporate governance

firm performance

To engage pro-active restructuring strategies, managers need incentives and strategic advice. As a result, strategy content is influenced by the firm’s ownership structure and board characteristics. In a dynamic perspective, corporate governance factors may be affected by strategic choices.

(Igor Filatotchev and Steve Toms)

Introduction

As outlined in the introduction, there is a dual set of objectives in this study: the main empirical objective of this study is to analyse the business strategies and corporate governance adopted in Chinese firms, including those that are State-owned, collectively-owned and privately-owned. The theoretical objective is to integrate the perspectives of institutional theory, the resource-based view and transaction cost economics to explain exploitation and exploration strategy, and to explore the application of agency theory to discussing corporate governance in the Chinese context. Here we evaluate the relevant theoretical and empirical literature, of which there is a considerable body. It proposes an integrative framework that characterizes determinants for exploitation and exploration of strategic choices (institutional factors, resource and transaction cost) and corporate governance (ownership structure, board of directors and supervisory board) and the interrelationship implications within the Chinese social context.

This chapter is organized around six sections that reflect the empirical and theoretical objectives of this study. The next section critically reviews institutional factors related to business strategies and corporate governance. The third section discusses current theoretical knowledge on business strategies. Next, the theory related to corporate governance is analysed. The fifth section is an identification of the void in the literature. The final section concludes the chapter.

Institutional theory (IT)

Firms are not autonomous. They are embedded in a specific social and institutional context or institutional framework that both constrains and enables strategy and corporate governance (Morgan, 2004; Williamson, 1994). When formulating and implementing its business strategies, a firm needs to consider its external environment, including the broader institutional influences (Oliver, 1997). Institutional theory also is a lens to compare the corporate governance models (Nicita and Pagano, 2003). This is particularly important in transition economies, where firms are more susceptible to institutional influences and changes (Child, 1994; Henisz and Delios, 2002; Peng, 2003; Scott, 2002). Baron (1997) observes that since the business environment is composed of market and non-market components, any approach to strategy formulation must integrate both market and non-market considerations. The researchers who have investigated the strategy–structure–performance paradigm in the Chinese context generally conclude that performance is enhanced by the alignment of a firm’s strategy and its environment (White and Xie, 2006; Tan, 2002; Tan and Tan, 2003, 2004). Understanding the institutional dimension of a firm enables us to better understand decisions made by firms about the use of existing resources, the acquisition or development of new resources, and where resources are developed internally, whether acquired on the market or from a membership of a network of aligned firms. Many authors observe that institutional factors modify the use of agency-theory hypotheses in transition economies (Bebchuk and Roe, 2004; Chen, 2005; Clarke, 2003). Institutional theory not only helps explain the diversity of ownership and that the board characteristics will persist due to the institutional differences such as culture, ideology, politics and legal origins, but also shows that institutional reform could provide incentives for the change of corporate governance.

Different institutional environments give rise to different business strategies and corporate governance practice. Institutional theory facilitates our understanding of the underlying determinant of the longrun performance (North, 1990). The framework of institutional theory is primarily concerned with an organization’s relationship with the institutional environment (Martinez and Dacin, 1999). Institutions are the ‘rules of the game’ in a society, including formal rules (political rules, economic rules, and contracts) and informal rules (codes of conduct, norms of behaviour and conventions), which are embedded in culture and ideology (North, 1990). A social network based on interpersonal relationships is a particular type of informal institution that has long been important in China (Boisot and Child, 1996; Luo and Park, 2001; Peng, 2002, 2004). Informal institutions offer some constancy and predictability in the absence of well-developed formal institutions (Luo, 2003; Luo and Park, 2001; North, 1990). The formal and informal arrangements, after Scott (1995), possess regulative, normative, and cognitive pillars. The regulative pillar has to do with rule setting, monitoring and sanctioning activities. The normative pillar is a prescriptive, evaluative, and obligatory dimension. The cognitive pillar refers to the rules constituting the nature of reality and the frames through which meaning is conveyed (Scott, 1995). The formal institution is the regulative pillar while the informal institution combines the cognitive and normative pillars. As such, the institutional impact on a firm can be viewed from the formal and informal perspectives.

Firms as organizations are a response to the institutional contexts in a given economy (North, 1990; Oliver, 1991). The strategic choices of firms are selected within and constrained by the institutional frameworks (Peng and Heath, 1996). Different institutions can explain why the strategies of firms are not the same in different countries, regions or even at different periods in the same area (North, 1990). Differences in the country-level institutional environment may also explain the differences in corporate governance practices (Aguilera and Jackson, 2003; Gospel and Pendleton, 2003; Wittington and Mayer, 2000). When the institutional context changes we expect the strategies and corporate governance practices of the firm to adjust accordingly.

The economic reform process in transition economies has brought about huge institutional changes. The shift away from a command economy to a market-oriented economy implies that the institutions of the central planning regime have been replaced by more market-based institutions that facilitate economic exchange (Groves et al., 1994). While previous formal constraints of central planning have been weakened, the new formal institutions necessary for a market-based economy have yet to appear or are embryonic in form (Peng and Heath, 1996). Therefore, informal institutions such as networks that have been established during the past period of the planned economy continue to play a role regulating economic exchanges in these countries. Peng (2002) argues that there are three main informal institutions: interpersonal relations for managerial networking; external connections linking executives, key stakeholders, especially government officials; and the reputation of conglomerates. Informal institutional arrangements may remain operative despite official reforms because they are culturally based (North, 1990). This explains why some of the legal texts are similar between advanced countries and developing countries, but practices are so different (Gordon and Roe, 2004).

Institutional theory provides a framework enabling us to examine how institutional change facilitates and constrains a firm’s...