Relationships in the wild: how institutions affect the governance of firms

Abstract

We study how political institutions affect ownership and incentive provision in firms. In our model, firms employ managers and workers in the shadow of a “ruler,” who has the power to expropriate their output. We show that contrary to the conventional wisdom in economics, but consistent with cross-country patterns, the optimal equilibrium features state-owned firms with effective incentives under autocracy ("Haiers"), private firms with ineffective incentives under weak democracy, and private firms with effective incentives ("Toyotas") under advanced democracy. Our results motivate a new perspective on governance: a key factor in a firm’s design decision is whether the chosen ownership and incentive structure fit the underlying political institutions.