Discussion Questions on Corporate Governance

DISCUSSION QUESTIONS ON CORPORATE GOVERNANCE 1

Institution Affiliation:

Law and finance

Q1. Discuss briefly the claim “A better legal system willimprove economic growth.”

In the modern economics theory, the relationship between law andeconomic development has been a major topic. A robust and upstandinglegal system especially in democratic countries is an imperative andimplied facet for an enhanced economic growth. Authors and economistshave discussed the element of economics that make a better legalsystem a key factor to success. For instance, Jonson et al. (2000)look at the role of shareholders in firm control. According to them,an emerging market crisis in the mid-90s was characterized bylooting, which was in turn facilitated by lawlessness. This is in apractice known as tunnelling, whereby there is a transfer ofresources out of companies irregularly. According to their assertion,weak laws allow courts to make this happen. As such, the authorsconclude that having a better legal system would do away withtunnelling, which otherwise, leads to the collapse of firms, andultimately, the collapse of the economy.

Other authors have discussed detailed elements of the economy, asfar as the law is concerned. According to La Porta et al. (1998),elements such as securities and bonds are rights that are critical tomanagers of companies that act in their interest. As such, like anyother right, the law protects this one. However, many companies havesuffered from the lack of rigid legal structures to ensure that thisright is fully protected. As La Porta et al. (1998) asserts, the lawand the quality of its enforcement are therefore crucial determinantsof the rights that security holders have. To put matters inperspective, La Porta et al. (1998) differentiates the economicperformance of countries that respect the security owners’ rightsand those which do not. It is evident, from empirical evidence, thatbetter legal structures are key determinants of the performance ofthe economy.

Q2. Do we need a legal system to ensure economic efficiency andbetter distribution of resources? What can be expecting from a goodlegal system?

La Porta et al. (2008) look at the redistribution of resources insome countries. In an attempt to justify the importance of democracyin those countries, the authors assert that the existence of goodlegal systems allows for the minorities and the marginalized toprotect their wealth. At the same time, the authors explain thatstandard corporate laws, which can only be achieved through stronglegal systems, have allowed outside investors to invest alongsideinsiders in many countries. According to empirical evidence, legalrules protect the investments by foreigners and other minorities,hence allowing them to contribute to the economy of the nation. Byadopting a friendly code of social control of the economic life,countries have been able to expand their economies and competealongside the top performing nations around the world. As such, it isshown that there is a need to have good legal systems to ensureeconomic efficiency and better distribution of resources.

A good legal system aids economic efficiency in some ways. Firstly,it helps to regulate the way in which corporates are controlled(Schleifer and Vishny 1997). Fundamentally, well-protected andregulated legal institutions are major tools for guiding corporategovernance, as they keep the management in check. For instance,people who invest in major organizations are guaranteed that theirinvestments will be well managed and that there will be low amountsof risk associated with their investments. Similarly, Ellingsen andKristiansen (2011), by developing a model of financial contractingunder imperfect enforcement, demonstrate some benefits of good legalsystems. These include debt control, stock management, and capitalinvestments risk protection. To put their study in perspective, theauthors compare how American companies, who arguably have some of theworld’s best legal protection structures, perform against othercountries.

Q3. Legal and institutional environment: what is the role ofcorporate law, and its enforcement? How does this vary acrosscountries?

The corporate law helps organizations to manage their internal andexternal business (Shleifer and Vishny 1997). For instance, this isby guiding the corporate management in their relationship withsuppliers and customers. At the same time, the corporate law protectsthe interests of the shareholders. This is by setting out their rolein the running of the business, for instance, decision making whenchoosing the board members. Enforcement of the corporate law helpsorganizations to regulate the engagement of various parties in therunning of the business. Among others, Shleifer and Vishny (1997)point out that enforcement helps organizations to implementprocedural formalism, do away with corruption, regulate theleadership and expedite corporate growth. By doing this, theinterests of the shareholders and investors are well taken care of,and the organization can achieve sustainable growth in the long run.

The role of the corporate law and its enforcement vary from onecountry to another. While there are some countries with strictenforcement of the same, facilitated by government and judiciaryinvolvement, other countries have far relaxed forms of corporate lawenforcement. For instance, Johnstone et al. (2000) note that Japanhad reluctant courts, as far as dealing with corporate directors isinvolved. This was not until the involvement of the United States,which led to the countries legal business reforms that led to betterfiduciary standards. On the other hand, Western countries, such asthe United States, have for a long time have rigid corporate lawenforcement (Ellingsen and Kristiansen 2011). Many of the elements ofthe corporate law are quite complex and vary significantly betweencountries. The underlying conclusion, as advanced by La Porta et al.(2008) is that a country’s corporate laws are highly related withits range of legal rules and regulations.

4. What is legal protection? How should we measure it? Does legalprotection vary across countries and how?

In the modern business environment, businesses are operating in whatcan be termed as a ‘legal minefield’. As such, they need to havethe protection of the state and government in what is commonly termedas legal protection. In general, legal protection is a set of lawsand regulations that safeguard the rights and interests of theinvestors, shareholders and other stakeholders in a business (LaPorta et al. 1998 Ellingsen and Kristiansen 2011 and La Porta et al.2008). In doing so, risks associated with business are limited, andthe firms can do business in the market without fear of unfairtreatment of the stakeholders.

La Porta et al. (2008) say that legal law measurement can be achievedby using national commercial laws. This includes corporate andbankruptcy laws. Over time, there has been the introduction of LLSVmeasure of anti-director rights, which has however been substitutedwith a measure of shareholder protection. The latter takes placethrough security laws and the offering of new issues. Alsoimportantly, there is the measure of human capital, whichspecifically addresses the interests of the investors and employeeshired by organizations.

La Porta et al. (1998) assert that common-law countries offer thebest protection for the shareholders. This is because their judicialsystems allow the shareholders to participate equally in making lawsaffecting their organizations. For instance, common law countrieshave the highest average anti-director right scores and havecomprehensive share protection regulations. Among the worstperforming countries are the French civil-law countries. Forinstance, they have poor voting systems, low shareholder protectionregulations, and minority oppression. However, the German-civil-lawand Scandinavian-civil-law countries have a lukewarm performance.While they have relaxed laws for shareholder protection, about of thecountries using, these systems have minority oppression incidences.

Q. 5 How will markets outcomes depend on the legal system? Is itthe legal system or cultural variables: trust, creativity, andindividuality?

The legal system is a style of social control of economic life (LaPorta et al. 2008). This also includes other aspects of life, such asculture and traditions. The legal system, therefore, influences theway that the state allocates resources, and how those resources areutilized for the good for the economy. As such, the legal system canbe viewed as the platform for constructing social policies, whichapply to the same capacity as economic policies. Through the same,the government can regulate business practises, address economicchallenges such as corruption, set up an economic system that servesthe nation purposefully, and influence the labour market outcomes,among many other activities. In a given economy, the laws of the landregulate the conduct of firms. Countries with strict codes of conductcan limit excesses, hence help the economy grow better than countrieswithout strict codes. Countries with weak legal structures, on theother hand, may suffer economically due to the lack of propercontrols to regulate businesses.

Both the legal system and cultural variables play a key role ininfluencing the market outcomes of a given economy. As earlierdiscussed, the legal system helps to regulate the conduct ofbusinesses within a certain economic jurisdiction. When investigatedcritically, it can be observed that cultural variables are key in theformation and implementation of laws within a country. For instance,religious norms can influence a country to adapt certain economicpolicies, which a country of differing religious customs will not. Assuch, it is established that cultural variables have an indirectinfluence on the economic outcomes of a country. Other importantcultural variables include the people’s creativity, personality andtrust amongst themselves.

6. List main forms of tunnelling and give examples. How can wederive implications from weak property rights (starting points forthe model)?

Johnson et al. (2000) establish tunnelling as the diversion ofcorporate resources from the corporation, or from the lesserstakeholders, to the controlling shareholder. While much of thetunnelling is legal, there are some illegal aspects of it. Legaltunnelling takes a variety of forms. The first form is theexpropriation of corporate opportunities from a firm by thecontrolling shareholder. The second one is transfer pricing, which inmost cases favours the controlling shareholder. There is also thetransfer of assets from a firm to the shareholder controller,however, at non-market prices. The fourth king of tunnelling is loanguarantees, which the firm’s assets are used as collateral.Finally, tunnelling can also take the form of financial, however, asopposed to real transactions and dilution of the minorities.Regardless of the existence of a number of other forms of tunnelling,these are the main ones, which are practised in modern business.

Weak property rightsare detrimental to economic progress, especially when they mean thatthe rights of the minority are not sufficiently protected. Onebusiness model that shows the importance of a strong protection ofthe rights of the minority shareholders are the pyramidal groupsstructures mainly practised in the United Kingdom and the UnitedStates of America. Through this, the minorities have the capacity tochallenge in the court of law. At the same time, common-law countriesoffer better models than civil-law countries. Similarly, weakproperty rights often give allowance for illegal tunnelling to takeplace, hence allowing theft and fraud. The result is a failure topromote financial and economic development. Finally, in cases wherethe legal structures are not rigid enough, the major shareholders incorporations harass the minor shareholders.

Q7. Can we find a positive relationship between investorprotection and economic growth? How important is investor protectionfor economic growth? How can the effect be measured?

Ellingsen and Kristiansen (2011) conduct an experiment, where theyset up financial contracting under imperfect enforcement. While doingthis, the economists attempt to demonstrate that indeed there ispositive correlation between investor protection and economic growth.Particularly, they show that when the law protects investors, thereis asset growth and decrease of project risk, meaning that thereturns from the investment will shoot. Accordingly, the model showsthat assets are protected adequately, and financing new projectsbecomes bearable, hence, growth in the economy.

One way that investor protection helps the economy to grow is byconcentrating ownership in the firms. To explain this, La Porta etal. (1998) use the case of poor investor protection, which isobserved in French civil-law countries. In these countries, poorinvestor protection is associated with extremely concentratedownership, which is detrimental to economic growth. At the same time,by protecting business owners and their shareholders, investorprotection provides fair grounds for further investment, which ispositive for economic growth.

Investor protection can be measured by quantifying the strength ofthe legal systems, and how they favour the minority shareholdersagainst the majority shareholders (La Porta et al. 1998). At the sametime, the level of investor protection can be measured by consideringthe percentage of share capital that is needed by the extraordinaryshareholders to make corporate decisions. Regarding enforcement,there are five measures that can be used. These are the efficiency ofthe judicial system, the rule of law, corruption, chances ofconfiscation contracts and risk of expropriation (La Porta et al.,1998). While some of these measures pertain to the judiciary, othersare pertinent to the relationship between businesses and thegovernment.

Q. 8. Explain how a firm`s capital structure depends on the legalsystem (investor`s legal protection). Use model to explain theeffects of a legal system on firm`s capital structure. Explainassumptions and predictions.

Legal enforcement plays a key role in determining the management ofcorporate’s capital structure. Firstly, an existing debt and commonstock influence the sales and use of collateral, all which areclosely associated with a firm’s capital. It is also assumed thatentrepreneurs are likely to divert project returns if there is notenough legal protection of their investor rights. An example can betaken of an entrepreneur who wants to leave a certain firm, which hasvaluable resources (Ellingsen and Kristiansen 2011). In this case,the legal structure can influence the entrepreneur to be punished forwrongdoing. At the same time, legal structures influence the mannerin which investors engage in business. This means that strong legalstructures influence upright investment tendencies amongshareholders. This is a show of how a firm’s capital structuredepends on the legal system of a given jurisdiction.

A good model that can explain a legal system’s effect on thecapital investments is financial contracting under imperfectenforcement (Ellingsen and Kristiansen 2011). This model is designedto bar the entrepreneurs from diverting their respective projectreturns. However, the penalties are minimized, and enforcement is notkept strict. This model will demonstrate that the prevalence ofstraight debt and common stock will result in capital structureregularities. This model contains ten propositions, which can beverified by calculating various variables and the choice ofenforcement quality. Nonetheless, one drawback of this model is thatattention is confined to entrepreneurial firms only. This does notadequately address the conflict that is experienced between outsiderinvestors and managers. The main assumption is that capital cannot bediverted, all external investors are completely uninformed, and thatthe entrepreneurs cannot be punished for crimes they did not commit.The main predictions are that financial leveraging decreasesentrepreneurs’ wealth. Empirically, the model supports implicationsby economic theories. This is supported in literature from somescholars in economic matters

Summary

The law plays a key role in the running of the economy. In thissection, it has been proven that a better legal system is set toimprove a country’s economic growth. This, among other reasons, isthrough the protection of the various players in the economic cocoon,such as the investors and shareholders. Literature shows thatcountries with friendly legal structures are most likely to benefiteconomically. In this regard, these countries allow for theprotection of their investors and minority shareholders, whichpromotes economic efficiency. One of the expectation of an efficienteconomic system is one that promotes equality in the distribution ofresources, and minority groups’ protection.

The corporate law plays a fundamental role in regulating the legaland institutional environment. For instance, it helps companies tostructure their management and guide decision-making process in theorganization. While the corporate law is necessary for the thrivingof the economy, it varies from one country to another. The foremostpurpose for this difference is the existence of varying judicialsystems, such as the Common Law and the Civil Law. However, thebottom line is that market outcomes will always depend on the legalsystem of a country. This is because different laws in differentcountries provide for different ways of dealing with the economy andfinance within that jurisdiction.

CEO incentives and corporate governance

Q. 1. Why are contracts and incentives important? Empiricalregularities.

A contract is an agreement between the firm and an employee. Itprovides legal documents that outline the expectations of each partyin an engagement. In most cases, contracts are viewed as tools forcompanies to protect their resources. For instance, Ellingsen andKristianesen (2011) outline the importance of managerial contracts.It helps the company to retain its managers, who are part of thehuman resources, as they may leave to work for other companies. Aswell, contracts help the employees to safeguard their interests asthey work for a certain company. Empirically, contracts have beenobserved not to be optimal when considering standard assumptionsabout the managers’ preferences and the behaviour of stock prices.In this case, the companies can keep their businesses profitable,while the managers are recognized and rewarded for their input. Whenconsidering empirical regularities, contracts help in corporategovernance, for instance, portability of assets across businesses.

Incentives are promises of further action. In business, they areimportance as they act as a stimulus for greater action (Oyer andSchaefer 2010). Companies may use incentives to rewardwell-performing employees, and in doing so, motivate them to performeven better. Besides setting the ground for better productivity,incentives enhance the performance of the employees, andpsychologically help them to settle into better job satisfaction.Empirically, it has been confirmed that incentive models helpcompanies to have better motivated, and better-performing employees.For instance, financial incentives change the behaviour oforganizations, and that pay-for-performance are associated withimprovement in the general organizational behaviour. Finally, throughempirical evidence, it has been shown that promotions, as incentives,are determinants of wage changes in an organization.

Q 2.A board is recruiting a new CEO. The board wants to design acompensation contract, which addresses three key questions:

  1. How can it attract a talented manager?

  2. How can it provide optimal incentives for managing the firm?

  3. How can it retain managers?

The first step towards attracting talented managers is identifyingthe right people and offering them better contracts than they havehad before (Oyer and Schaefer 2010). In a more technical approach, afirm can raise the wage offers, hence, encouraging only the bestmanager to apply for the job. Oyer and Schaefer (2010) also say thatfirms can reach out to managers who are optimistic about the firm’sprospects, and those whose visions agree with those of the firm. In amore advanced approach, firms can use employee data sets to recognizethe best talent and hire for management.

While creating an optimal inventive plan for the manager, the firmhas to balance the benefit of increased managerial effort, togetherwith the loss that is associated with risk sharing Edmans and Gabaix(2009). At the same time, there has to be a categorisation ofthe incentive compensation scheme, which may be problematic as far asmanagerial contracts are involved. As such, the best strategy to comeup with a working optimal incentive plan is to provide the same linkbetween the manager’s performance and the outcome as seen by thefirm.

Retaining managers largely has to do with keeping them satisfied. Oneway of doing this is to offer them better contracts than othercompanies. However, the best contracts are those that offer thehighest pay for their managers. Fernandes et al. (2009) use the caseof the U.S top executives, who stay with their companies longer thanin any other countries, mainly because they are paid well. Similarly,given that talented managers are likely to be attracted off to othercompanies, Elingsen and Kristiansen (2011) assert that paying thembetter wages is the best way of retaining them.

Q.3 The tenuous trade-off between risk and incentives

A negative trade off exists between risk and incentives. However,there is a strong suggestion from empirical data that a positiverelationship exists between incentives and uncertainty (Pendergast2002). For instance, when considering marginal returns, it isobserved that the delegation is most likely to record higher in anuncertain environment. This is because there is the presence of theright kinds of efforts in table environments. In such an environment,the agents have a good idea of what they are supposed to do, and assuch, come up with better strategies to induce the right behaviour.These are used as the measures upon which the firms can makedecisions to increase the pay or not to. Given this, Pendergast(2002) asserts that incentives and uncertainty can be positivelyrelated.

While considering Pendergast’s literature, observation can be madebetween the measure of risk and incentive pay. Firstly, risk and payare intrinsically poor reflections of the real environment that theemployees face in an organization. At the same time, the contractsthat the employees receive are likely to influence the relevant risksthat are taken by the firms. Empirical evidence from therelationships between employees and contractors also demonstratesthat there is negative balance between risk and incentives in abusiness’ contract. At the same time, while quantifying theexisting risk between incentives and risk, there has to be a carefulexamination of the firm from the start-up. This offers options forthe firm to manage the high salaries while at the same time, takingcare of liquidity constraints. Regardless, the bottom line is thatthe characteristics of the risks are related to the attitude towardsthe risk of the principal and the agent.

Q 4. Executive compensation as an agency problem.

For a long time, executive compensation has been a major topic ofdiscussion among economists. The main focus of the study is themanner in which executive compensation can help the publicly tradedcompanies to alleviate the agency problem. According to Bebchuk andFried (2003), understanding this needs one to comprehend thelandscape of executive compensation, as part of the agency problem incorporates. By doing this, is established that there are enoughtheoretical and empirical suggestions pointing to the fact that thepower of management has a big influence on the design of thecompensation. This is because the management affects the ownershipand control of the companies. At the same time, executivecompensation proves to be positive, not only for addressing agencyproblems occasioned by ownership and control of the firm but theagency in itself.

Rent extraction, same as managerial power, plays a role in theexecutive compensation. The same have significant implications forthe performance of the corporate governance structures. However,there are factors that play a critical influencing role in thedetermination of the matter. Perhaps the most crucial one is aninstitutional investment. This influences the outcome of compensationarrangements within an organization. Using such an observation,economists can conclude that current practices are quite differentfrom the models that are suggested by optimal contractors. Anothercritical conclusion is that compensation arrangements provide forweaker incentives for reducing managerial risk. These conclusions aremade upon the consideration of the role that is played by non-equityand equity components of manager compensation. Finally, as Bebchukand Fried (2003) point out, current practices do not give space forcost-effective incentives, which are supposed to reduce slack inmanagerial performance. They also create tenacious incentives, whichare not quite justifiable.

Q 5.The provision of incentives in firms (briefly).

Despite arguments about the supposed importance of incentives, theyhave been approved to be important to firms empirically. They areprovided to the employees so that they can help them to feel betterjob satisfaction, and hence, give more regarding productivity. Whileoffering incentives, some of the factors that are taken intoconsideration include monitoring, evaluation and contracting. Thisguides the firms in making right decisions about offering the rightincentives to the right employees. Incentives have been used bycompanies to boost the employees performance, and to help themcontribute better to the firm’s objectives. However, given thatthere is a challenge in specifying the incentive packages for eachworker independently, most firms use subjective performanceevaluation. The most typical characteristics of this is the revisionof salaries, adding bonuses to the employees’ perquisites andpromotions (Pendergast 1999). However, it has been argued that themost common form of regarding employees ‘ efforts is promoting themto higher positions, where they can get the rest of the incentives.

Economists have advanced some theories that firms have used inincentive provision. For instance, the relative performanceevaluation theory suggests that performances should be used as thebaseline in deciding on incentives. The selections effects ofcontracts theory use the initial contract agreements in giving theemployees incentives. There is also the shape of compensationcontracts theory, which gives specifications for the preferences andmeasurement of errors, which firms use to measure the employees’performance. While considering firms incentives, Pendergast (1999)asserts that contracts reflect agency concerns, which, however, donot alter the measure of performance. In modern companies, thisestablishes the relationship between the firms and the employees, asmuch as incentives are concerned.

Summary

Contracts and incentives play an important managerial role to anorganization. Most importantly, contracts outline the relationshipbetween the firm and the employee. As such, both parties’ interestsare taken care of, as the law is used to address any issues that mayarise. At the same time, incentives are used to keep the employeessatisfied and to achieve job satisfaction at a firm. Incentives maycome in the form of payments, special recognition or promotions.However, promotions have been identified as the most importantincentive for a firm, as they allow the employees to be in a positionto receive the rest of the incentives, and keep the organizationsatisfied with its workers. For companies looking to employperforming managers, they use incentives to attract and retain them,and contracts to set out the relationship between them.

However, there is a fragile balance between risk and incentive. Thisis experienced, for instance, when the law comes into play. This isthe reason there have been issues with executive compensation inorganizations, which is viewed as an agency problem. With issues likerent extraction and managerial power, firms have to maintain adelicate balance to avoid legal problems from the same.

Political economy of finance

Q 1. Why is investor protection different across countries? Whobenefits from better investor protection (large pie versus a largerslice of a smaller pie)? How can we design a reform?

One of the major differences in the levels of investor protectionacross countries is the type of judiciary that is in implementation.In this regard, countries with Common Law have better investorprotection than those with civil law (Rajan and Zingales 2003).Moreover, the legal origin of a country greatly influences itsfinancial market. The reason behind legal protection, as far as thelegal structures are involved, is the centralization of thegovernance system, which is crucial to the protection of investors inbusinesses. Other matters that affect investor protection in a givencountry include culture, religion, and politics.

Perhaps the biggest benefactors of investor protection are minorityshareholders and foreigners (Rajan and Zingales 2003 and Rajan andZingales 2001). This is because their interests are covered fromexploitation, and other internal matters that may harm theirinvestments. By enjoying a fair equity market, these groups canchannel their investments into profitable ventures, and avoidunnecessary risks. Investor protection also offers these groupsfinancial transparency and provides for systematic risk reduction inthe market.

One of the ways of designing reforms in investor protection isensuring that transparency is upheld in the legal system (Tirole 2015and Rajan and Zingales 2004). While doing this, the government canensure that the economic policies that are in place protect theinterests of all shareholders and investors operating in all sectors.At the same time, the government can pass legislative acts thataddress accountability and asset utilization, which are some of thekey elements of investment economics in modern business. At the sametime, all shareholders, while participating in the reform, should beencouraged to comply with government regulations and judicialprinciples addressing investor protection.

Q2. The long-term commitment of governments. Will the governmenthave time-consistent plans?

Financial markets benefit greatly from long-term plans, which areimplemented by the governments. There are many measures of financialdevelopment that are dependent on some economic variables, whichaffect many economic matters, for instance, the sum of equity andlong-term private debts (Rajan and Zingales 2003). However, animportant factor in formulating long term plans is time consistency.One important determiner of the ability of the government to have atime-consistent plan is the kind of competition in the financialmarket that its legal structures allow. In this regard, thegovernment can be committed to long-term plans to allowing faircompetition in the financial market, hence doing away with risks thatmay push other investors away. Similarly, a time-consistent plan isone that takes care of the domestic financial sector and institutionsand allows younger and upcoming industrial firms to establishthemselves financially. This, as far as a government’s legalstructures are concerned, can only be established in fulfillment oftime.

Substantially, time consistency takes place in the unstableallocation of scarce resources. Therefore, a government’s optimalplan for continuous action for the future can be establishedeconomically by the time in which those particular actions are taken.This is regardless of the fact that they may not seem to be optimalat present. Therefore, this is a problem that a government has tosolve for firms operating in the economic sector. To tell whether agovernment can make time-consistent plans, it is crucial to determineutility and profit maximization. This is because they go hand in handwith its general commitments to the economic sector. As such, if agovernment policy does not shift away from addressing the strategiceconomic actions, then it can be assumed to be in a position to havetime-consistent plans within its jurisdiction.

3.What does it mean the political economy of finance? What does itdo and why it is necessary?

The political economy of finance is a framework for viewing financefrom a political perspective (Tirole, 2005). It is also a way ofhaving unique insight into the financial crisis that is facilitatedby agents of politics that play within an economy. At the same time,the political economy of finance establishes the global perspectivebetween investors and other players in an economy. It is a way ofsettling the conflict, enhancing corporation, and addressing issuesthat exist in global business. The political economy of finance can,therefore, be regarded as social science that addresses politicalscience and finance economics within a singular framework. Throughthis, economists can establish the connection between politics andglobal finance.

The political economy of finance is beneficial to the economic andfinancial development of firms. It enables incumbents into afinancial market to avoid being impaired by financial development(Rajan and Zingales 2003). This is by allowing them to participate inthe market decision-making and gives them an opportunity to expandtheir finances. By doing this, it is established that politicaleconomy of finance helps to eliminate risks that associated withdominance and monopolization of the financial market. Additionally,the political economy of finances balances the acts by a financialinstitution, hence providing a healthy competitive ground for doingbusiness. Similarly, political economy means that the relationshipbetween firms and countries that are attempting to attract moreinvestors and companies can be solidified. The same also means thatthe economic theory can be applied to solve the problems that thesociety faces. Finally, the political economy of finance helpseconomists to establish distinct economic models that identify andsatisfy the interests of various groups or classes that are withincertain economic landscape.

Summary

Politics plays a key role in a country’s finance. This isparticularly in protecting the right of the investors and preparing afair and just ground for business engagement. However, differentcountries have different ways and level of protecting theirinvestors. This depends on the legal and political structures thatare in practice within that country. This is the reason there aredifferent level so investor protection in different countries. For acountry with good political influence on finance, the biggest winnersare the minority groups and foreigners, who are provided for with afair ground for business engagement.

The government, as a political institution, plays a key role ininfluencing the economy of a country. One way in which the governmentdoes this is through long-term commitment, which is seen intime-consistent plans. This involves unstable allocation of scarceresources. To establish whether the government can commit to thelong-term, economists have to consider, among others, utility andprofit maximization, as they go hand in hand with a generalcommitment to the economic sector.

Bibliography

Bebchuck L, A, Og J, M, Fried, (2003) ‘Executive compensation as anagency problem,’ Journal of Economic Perspectives, s. 71–92.

Edmans, A, and Gabaix, X, (2009), ‘Is the CEOpay really inefficient? A survey of new optimal contractingtheories,’ European FinancialManagement, pp 486-496.

Ellingsen T, and Kristiansen, G, E, (2011),‘Paying for staying,’ Working paper.

Ellingsen, T, and Kristiansen, G, E, (2011),‘Imperfect enforcement of financial contracts, QuarterlyJournal of Economics pp. 323-371.

Fernandes, N, Ferreira, M, Matos, P, and Murphy, K, (2010), ‘ThePay Divide: (Why) Are US top executives Paid More ?,’ WorkingPaper.

Johnson, S, R, La Porta, Lopez-de-Silanes, F, andShleifer, A, (2000), ‘Tunneling,American Economic ReviewPapers and Proceedings, May, 2000.

La Porta, R, Lopez-de-Silanes, F, Shleifer, A, (2008) ‘The economicconsequences of legal origins,’ Journal of Economic Literature,s. 285-332.

La Porta, R,&nbspLopez-de-Silanes, F, Shleifer,A, and Vishny, W, R, (1998), ‘Law and Finance,’Journal of Political Economy, 106(6),1113-1155.

Murph, K, J, (2000), ExecutiveCompensation, Handbook of LaborEconomics, del III, II, og I.

Oyer, P, and Schaefer, S, (2010), ‘Personnel Economics: Hiring andIncentives,’ NBER Working Paper 15977.

Prendergast, C, (1999) ‘The Provision of Incentives in Firms,’Journal of Economic Literature, pp. 7-63.

Prendergast, C, (2002), ‘The tenuous trade-off between risk andincentives,’ Journal of Political Economy, pp 1071-1102.

Rajan, R, G, and Zingales, L, (2003), ‘The greatreversal: the politics of financial development in the twentiethcentury,’ Journal of FinancialEconomics, pp. 5- 50.

Rajan, R, G, and Zingales, L, (2004), ‘Savingthe capitalism from the capitalists: Unleashing the power offinancial markets to create wealth and spread opportunity,’Princeton University Press. (Chapter 1 – 5).

Rajan, R,G, and Zingales, L, (2001), ‘Theinfluence of the financial revolution on the nature of firms,’American Economic Review Papers andproceedings, pp 206 – 211.

Shleifer, A, and Vishny, W, R, (1997) ‘A Surveyof Corporate Governance,’ Journal ofFinance, 52, 737-83.