Academic journal article IUP Journal of Corporate Governance

Product Market Competition and Corporate Governance

Academic journal article IUP Journal of Corporate Governance

Product Market Competition and Corporate Governance

Article excerpt

Introduction

The need for corporate governance arises in business organizations primarily because of the presence of what is called agency problem or conflict of interest, involving members of the organization like owners, managers, workers or consumers. Another reason for the issue of corporate governance is the conflict of interest between the controlling shareholders and the minority shareholders. Such conflicts are present in family owned business entities. Problems arising out of conflicting interests can be solved through perfect contracts, because of the existence of transaction costs. These transaction costs are such that agency problems cannot be dealt with through contracts (Hart, 1995).

Market forces can supplement incomplete contracts. The impact of the capital market in improving corporate governance practices are well proven in the existing literature. But, the product and labor markets also have some influence on corporate governance practices of firms. A study by Verrechia in 1983, highlighted that product market competition, as an important factor in determining the level of disclosure by the management, was an important corporate governance tool. Globalization of product and labor markets also influences and improves the corporate governance practices of firms in the Indian software industry, as was proved by Khanna and Palepu in 2004.

There are various issues in corporate governance like board independence, disclosures, etc., that are effected by the prevailing product market competition. The current study limits itself to the impact of product market competition on board practices.

Various aspects of corporate governance, which are influenced by product market competition, have been studied. One such study was conducted in Sweden concerning board independence and product market among the Swedish firms (Randoy and Jenssen, 2004). In this study, we try to understand the impact of product market competition on corporate governance practices of Indian firms. For this purpose, we use the same model as that of Randoy and Jenssen (2004).

Research in corporate governance generally deals with understanding the mechanisms that can mitigate agency problems (Bushman and Smith, 2003). However, there are a few pure market forces that can mitigate agency problems, one of them being product market competition. Karuna (2008) defines product market competition as the extent to which firms attempt to win businesses from their rivals in the industry. One of the key drivers of productivity growth in a nation is the product market competition prevailing in the country (Januszewski et al., 2002). Product market competition is very important in ensuring corporate governance because it affects the incentives of managers, and thereby, the efficiency of the firm (Klaus, 1997).

Competition can act as an alternate governance mechanism because it compels managers to act in a manner that maximizes the wealth of the shareholders. This is because, when the competition is high in the industry, it would automatically reduce managerial slack (Jagannathan and Srinivasan, 1999). One of the reasons behind this phenomenon is the 'threat of liquidation' effect (Schmidt, 1997). Increased competition often forces low performing firms to declare bankruptcy, thereby forcing managers to reduce slack and work harder in order to escape liquidation. Every researcher agrees with this view. Scharfstein (1988) gave a contrary view and showed that when managers' marginal utility from income is strictly positive, competition may increase managerial slack.

However, one should consider the fact that success of competition can also be a governing tool. Some studies have shown that competition gives out higher performance evaluation information (Holmstrom, 1982). Besides, one should also consider the fact that the impact of the product market itself depends on the ownership structure of the firms in the industry, as demonstrated by Grossfell and Tressel (2001). …

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