C E S P R ICentre for Research on Innovation and Internationalisation Processes

Università Commerciale "Luigi Bocconi"via R. Sarfatti 25 - 20136 Milan, Italytel. 02 5836.3397 - fax 02 5836.3399http://www.cespri.uni-bocconi.it/

Nicola Lacetera

CORPORATE GOVERNANCE AND

THE GOVERNANCE OF INNOVATION :

THE CASE OF PHARMACEUTICAL INDUSTRY

WP n. 122 december 2000

2

Corporate Governance and the Governance of Innovation:the Case of Pharmaceutical Industry∗∗

Nicola Lacetera†

December 2000

Abstract

The paper focuses on some organizational dynamics that have characterized pharmaceutical industry in thelast thirty years, when biotechnology and the development of life sciences have defined a new technologicalparadigm, reshaping many aspects of the industry, especially the organization of innovative activity.We suggest an original interpretation of some organizational settings, as the increased importance of skilledscientists within firms and the development of inter-organizational alliances for the division of scientificlabor. Following recent theorizing on corporate governance issues, which points out the intrinsicorganizational and relational dimensions of the resource allocation processes or strategic decision-making, wepropose a role of the organizational practices mentioned above on corporate governance, and, in turn, aninfluence of different governance arrangements on innovative activity. We recall more traditional approachesto the analysis of corporate governance, and give a broader interpretation to the relevant variables proposed.Further, relying on more recent theories and on literature on firm’s boundaries and sectoral systems ofinnovation, we propose industry-specific variables for pharmaceuticals, including internal settings as well asrelations with external actors. Preliminary empirical support is given to our hypotheses, concerning a panel oflarge US pharmaceutical companies.

Keywords: corporate governance, firm’s boundaries, innovation, pharmaceutical industry, researchagreements, research organization, technological change.

JEL classification: D23, G34, L22, L65, O32.

∗ I would like to thank Gigi Orsenigo for his support, suggestions and comments when I was working on myfinal BA thesis, on which this work is partially based, and during the preparation of this work itself. I am alsoindebted to Franco Malerba and Francesco Lissoni for encouraging me to write this paper; and to BarbaraChizzolini, Fabio Montobbio, Fabio Pammolli, Fausto Panunzi, Lorenzo Zirulia, and all the participants to aCESPRI Seminar held on November 2000, for their comments and suggestions. All errors and omissions aremy own.† Bocconi University and CESPRI. E-mail: nicola.lacetera@uni-bocconi.it .

3

CONTENTS

Introduction 4

1. The pharmaceutical industry after the biotechrevolution: scientific, institutional, and organizational changes 51.1 From scale to science: the strategic role of specialized human capital 71.2 From scale to science: collaborative arrangements andthe division of scientific labor 8

2. Organization, governance, innovation: recent theorizingand an application to pharmaceuticals 92.1 The limits of traditional approaches 102.2 Recent theorizing: from property rights allocation to organizational control 112.3 Governance structures: a tentative synthesis 152.4 An application to pharmaceutical industry 17

3. A preliminary empirical analysis 243.1 The sample and data 243.2 The dependent variable 253.3 Governance variables 253.4 Control variables 283.5 Method 293.6 Results 30

4. Concluding remarks and directions for future research 33

References 36

4

INTRODUCTION

This paper focuses on some dynamics that have characterized pharmaceutical

industry in the last thirty years, when biotechnology and the development of life sciences

have defined a new technological paradigm, reshaping many aspects of the industry,

especially the organization of innovative activity. In chapter 1, we interpret such changes as

the result of the co-evolution of scientific, institutional, and organizational dimensions.

Organizational dynamics will be the main subject of our analysis. In chapter 2, in particular,

we suggest an original interpretation of some organizational settings, as the increased

importance of skilled scientists within firms and the development of inter-organizational

alliances for the division of scientific labor. Following recent theorizing on corporate

governance issues, which points out the intrinsic organizational and relational dimension of

the resource allocation processes and strategic decision-making, we stress the role of the

organizational practices mentioned above on corporate governance, and, in turn, the

influence of different governance arrangements on innovative activity. Further, relying on

literature on firm’s boundaries and sectoral systems of innovation, we propose industry-

specific governance variables for pharmaceuticals, including internal settings as well as

relations with external actors.

Chapter 3 presents empirical evidence, concerning a panel of large US

pharmaceutical companies, that gives some support to our suggestions. The very early stage

of the theoretical approach we develop, and the difficulty to collect relevant information

both for its heterogeneity and the scarcity of data sources, makes our findings only a first

step in a rather unexplored issue. Chapter 4 concludes.

5

1. THE PHARMACEUTICAL INDUSTRY AFTER THE BIOTECHREVOLUTION: SCIENTIFIC, INSTITUTIONAL, AND ORGANIZATIONALCHANGES

The pharmaceutical industry has experienced dramatic changes in the last thirty

years. The advances in biological sciences and the emergence of biotechnology clearly

represent the first engine of this revolution. Starting from the discovery of the double helix

structure of DNA and the development of genetic engineering techniques, the ability to

understand the mechanisms of action of drugs and the biochemical and molecular roots of

many diseases increased enormously. This has created new opportunities for drug therapy

and, therefore, for firms in pharmaceutical industry.

However, the evolution of scientific knowledge does not explain all the features of

this new phase of the industry history. A simply “science driven” evolution would have

created a common industry structure all over the world (at least in the developed countries).

By contrast, different changes across different regions are occurring. This led scholars to

explore other dimensions of the dynamics of the industry; two of them have captured great

attention: the influence of the institutional environment, and the development of new

organizational capabilities1.

The structure of national institutions is considered one of the most effective forces

in configuring a particular innovation system. This is by no means true for the

pharmaceutical industry. The public support for health-related research, the intellectual

property and product approval legislation, the structure of the health care system, the

relationships between private firms and universities, the availability of capital, are only

some of the environmental conditions that shaped the national industries. In the USA, for

example, the easy access to capital markets has given new small biotech firms the necessary

resources to start their activities. These new biotechnology firms (NBFs) are often spin-offs

of academic activity, as they are usually formed through collaboration between scientists

and professional managers, supported by venture capitalists. This led to a much higher

institutional flexibility and variety than in Europe and Japan, where the phenomenon of the

biotechnology startups has been only marginal, primarily because of a lack of financial

resources provided by “specialized” investors2.

1 For a detailed understanding of such co-evolutionary processes, see Gambardella (1995), Henderson et al.(1999), and Pammolli (1996).2 Other factors, as the ones mentioned above and even a cultural climate less adverse to biotech research, havebeen highlighted as the determinant of US leadership. See Henderson et al. (1999).

6

******

The main focus of this paper is the analysis of a third dimension in the evolution of

pharmaceutical industry: the relevance of the organizational structure of firms in capturing

and exploiting the new technological opportunities. Large incumbent firms will be the main

subjects of our analysis.

In order to understand properly organizational dynamics, we should recall some

features of the new scientific and technological paradigm. Most authors have labeled the

drug discovery methodology diffused until the 70s as “random”: pharmaceutical research

was indeed conducted through large-scale experiments of thousands of chemical

compounds, in order to find effective agents. The difficulty to understand the “mechanisms

of action” of must drugs, given the state of knowledge in molecular biology, chemistry and

physiology, led to such research practices. Many scholars see the scale of experiments and

the ingenuity of medicinal chemists and “technicians” as the main determinants of research

productivity in that phase of the industry evolution.

In the 70s, as we pointed above, the advances in biological sciences and the

emergence of biotechnology made it gradually possible to rely on a clear knowledge of the

biological bases of diseases, and gave firms tools to discover new drugs and/or to produce

old ones with different and more effective techniques. This new way of drug discovery,

more “rational” or “science guided”3, has required a substantially different set of

organizational practices and skills. Many studies have highlighted two different but related

dynamics reshaping the organization of firms: the importance of hiring expert scientists in

several disciplines, and the creation of networks of alliances between different actors in the

industry.

3 See Cockburn and Henderson (1996, 1998), Gambardella (1995) and Henderson et al. (1999).

7

1.1 From scale to science: the strategic role of specialized human capital

There are several reasons for firms to hire skilled scientists and to keep them within

the organization for long periods. Firstly, as drug research has become more rational and

science based, biologists, physiologists, biotechnologists are required to conduct such

research and profit from its outcomes. Moreover, through advanced in-house research firms

become more capable to exploit the results of basic research, by improving their

“absorptive capabilities”4: this means that public knowledge requires substantial costs to be

acquired, in terms of investments in human and organizational capital. Anyway, firms still

obtain a great part of research they need from outside, especially from public founded

sources (universities and other institutions) and from relationships with other firms (we will

develop this point later on). Many studies have suggested that “star” scientists represent a

key factor in connecting these institutions, because of their links to academic life and

because they are able to discern the “best” ways to cooperate, on the basis of their

knowledge 5.

Firms have thus elaborated several incentives to attract scientists toward their

organizations and to hold them over time. The existing literature have emphasized both

“financial” and “non financial” incentives, such as allowing scientists to keep relationships

with academia (at the cost of less secrecy of in-house work), e. g. by co-authorship, or

rewarding them on the basis of their ranking in the scientific community. Some authors

have tried to test the effects of such practices on firms’ research productivity; most work is

still in progress, nonetheless the results are quite interesting. For example, Cockburn and

Henderson (1998) have found significant relations between co-authorship of scientific

papers of pharmaceutical company scientists and publicly founded researchers, and

performance in drug discovery, and have explored (1999, with Scott Stern) the

organizational determinants of pro-publication incentives. Other measures, such as granting

stock options to top scientists and giving them a role in the strategic decision process, have

been cited by some scholars6; however, their effects on innovative input and output, and on

firm strategies and performance, has not been tested yet, due to a lack of empirical data.

1.2 From scale to science: collaborative arrangements and the division of scientificlabor

4 Cohen and Levinthal (1989).5 See Brewer et al. (1995), Darby and Zucker (1995) and Gambardella (1995).

8

Firms are getting aware that the new scientific paradigm requires so many different

skills and financial resources7 that almost no firms can manage “working alone”. The

increasing consolidation of the drug industry in the last twenty years has indeed been seen

as a way to reduce average costs. However, as stated above, scale no longer represents the

main determinant of research effectiveness: human capital and scientific ingenuity have

become the critical sources of success. Relying on such resources, new small firms entered

the market, often as spin-offs of academic activity, since they were usually formed through

collaboration between scientists and professional managers, supported by venture

capitalists8. Such firms seemed “quicker” in achieving and profiting from new patterns of

search, while established firms, unless they had already revisited their organizational

structure and had a solid research tradition, showed a higher “viscosity” and seldom gained

advantage from their M&A strategies, in terms of innovative performance.

In spite of the reduction of entry barriers related to knowledge, other obstacles have

made life hard for many NBFs, especially when they tried to evolve into vertically

integrated pharmaceutical firms: this strategy required considerable financial and

managerial resources, to conduct both research and marketing activities9, and not all NBFs

coped to raise and develop such “complementary assets”. In such situations, the only way

to survive has been to be acquired by a large incumbent company, which in turn looked at

acquisitions as an easy way to catch up new specialized skills.

The substitution of market with hierarchical relationships has not been (and is still

not) the only pattern different actors of the industry followed in non-competitive

arrangements. Several types of more flexible linkages have been developed, such as

research agreements (between firms and with universities) and minority participation. In

this division of scientific labor, some scholars have noticed a specialization of NBFs and

public institutions in basic upstream research, and a focus of incumbents on clinical tests

and in the development of complementary assets. On the other side, it has been noticed that

the established firms having already invested in internal basic knowledge, and then in

absorptive capacity, were more successful in such agreements and became parts of

innovation networks. Moreover, such firms seem to perceive the different types of external

6 See, for example, Brewer et al. (1995).7 Besides investments in organizational change, regulatory requirements and time to complete researchprocesses are the main components of these costs. The average cost to produce a new molecule was around150 mil$ in the 80s. Now, it is estimated at about 500 mil$ (see Farmindustria, 1999). Such increases haveeven offset the risk reduction in research, due to improved scientific knowledge. See Gambardella (1995).8 We have already pointed out that this phenomenon is typical of the US industry, and that it can be seen asthe result of the co-evolution of scientific, institutional, and organizational changes.

9 For example to face the severity of control procedures and to organize sales forces.

9

linkages as complementary rather than alternative10. We will return on these points later on.

In this introductory notes we just want to point out that innovation process is moving from

full integration of R&D toward new and different organizational arrangements, in which

specialized complementary assets, controlled by different agents, are combined.

2. ORGANIZATION, GOVERNANCE, INNOVATION: RECENT THEORIZINGAND AN APPLICATION TO PHARMACEUTICALS

This work analyzes in detail the role of a particular aspect of organizational

dynamics, the corporate governance structure, in shaping firms’ strategies and patterns of

innovation. Our focus will be on pharmaceutical industry.

The existing literature on corporate governance and on innovation has seldom

explored the interaction between the two issues, although it seems straightforward that the

definition of who makes investment decisions, what type of investments they make, and

how returns from such investments are distributed – that is, the system of corporate

governance - affect the innovative capabilities and performance of firms. In our opinion,

this is mainly due to the kind of theoretical framework in which the debate on corporate

governance has been developed: the principal-agent approach.

2.1 The limits of traditional approaches

Starting from the seminal work of Berle and Means, economic analysis of firm has

highlighted the separation between ownership and control in corporations. Shareholders,

the owners of the firm, must rely on managers to perform certain functions; managers

however may be ill informed and/or have different objectives, conflicting with

shareholders’ ones (i. e., maximizing returns to their investments). As equity investors,

stockholders are assumed as the only economic actors who make investments, without any

contractual guarantee of return; therefore, they should exercise ultimate control over the

allocation of resources. In presence of asymmetric information and delegation of decision-

making power, managerial interests have to be realigned to shareholders’ ones by

appropriate incentive measures. Corporate governance deals with the definition of such

10 See Gambardella (1995).

10

mechanisms. Several relevant institutional dimensions have been suggested: stock-based

rewards for managers to enhance their profit-maximizing behavior, outsider-dominated

boards of directors and relevant owners or specialized investors to increase monitoring

capabilities of residual claimants, the efficiency of markets for corporate control as a

disciplining device.

The proposal of a quite simple theoretic framework and of observable variables is

an important feature of such approach. However, the cost of simplicity is a lack of attention

to specific activities and roles of the firm; in particular, the concepts of business strategy

and economic performance on which these debates rely devoid of any systematic

conception of innovation and the central role that business organizations play in that

process.

In this paper, we adopt an evolutionary approach to innovation, which sees the

innovative process as highly complex and uncertain. Firms, moreover, are considered as

complex organizations that have to deal with a much richer variety of issues than just

providing incentives and solving so-called hold-up problems11. In particular, within such

complex organizations, learning, the central dynamics of innovation processes, is seen as

collective and cumulative rather then individual and discrete: in other words, transforming a

“good idea” in economic success requires the interaction of different agents and groups,

within and outside the firm. Internal organization affects the generation of knowledge

because it influences the way people interact with each other in the performance of their

work, the relationships they establish, and thus the possibilities of collective learning. In

particular, the definition of who makes investment decision, what type of investment they

make, and how returns are distributed, gets great relevance12. In this perspective, firms are

not just a set of hierarchical relationships established to reduce transaction costs, and thus a

second best with respect to the market, but rather an original “device” to produce “low

powered” incentives13, that is at organizational rather than individual level. Moreover, like

the internal organization, the institutional environment that “surrounds” firms affects their

decision and is a key actor in innovative dynamics.

The first implication of such approach is that the ways in which these social

relations evolve strongly depends on the historical, institutional and sectoral contexts.

Giving a narrow, “contractualist” definition of corporate governance and of the related

relevant variables, the traditional principal-agent theory fails therefore to capture some

11 See Holmström and Roberts (1998) and Teece and Pisano (1994).12 See Lazonick and O’Sullivan (1996).13 See Teece and Pisano (1994).

11

central features of business organizations. This explains, in part, the scarcity and frequent

inconsistency of existing empirical research14.

2.2 Recent theorizing: from property rights allocation to organizational control

Two very different approaches, in recent years, have tried to deal with the issue of

corporate governance and innovation. Let us summarize both, and then propose a synthesis

and an application to pharmaceutical industry.

The first approach is an evolution of transaction costs theory, and it has first been

elaborated by Grossman, Hart and Moore (GHM) in the 80s15. According to the “GHM

paradigm”, firm is a collection of assets (and not just a nexus of contracts) on which

property rights are defined16. These rights, called residual rights of control, give the owner

the power to make decisions in all circumstances not stated in contracts; furthermore,

property is the strongest incentive for people to make specific and irreversible investments

in human capital and then improve the performance of firms. Corporate governance is thus

a matter of best allocation of property rights. The optimal allocation crucially depends on

individuals’ features, on the technological characteristics of assets (and then of firms and

industries), and on interdependence between individuals and physical assets.

Aghion and Tirole (1994) have proposed an interesting application of the model to

the management of innovation in firms. The key aspect of their analysis is to determine

whether financial or intellectual resources are “indispensable” in the development of a

given project: if the formers are critical, the financing part should “own” the innovation;

conversely, the research unit should be given the ownership. In terms of “real” rather than

“formal” authority17, the problem is to define, case by case, the distribution of decision-

making power between different agents. This could be extended to relations between

different organizations, as Lerner and Merges (1998) have done analyzing research

agreements in pharmaceutical and biotechnology industry (we will return on this study later

on).

The GHM paradigm, therefore, stresses the role of authority as a powerful incentive

device, and explores its best allocation in terms of individual (or collective) abilities.

14 See, for example, Agrawal and Knoeber (1996), Hansen, G. S. and Hill (1991), Hill and Snell (1988),Oswald and Jahera (1991), and Zahra (1996).15 See Grossman and Hart (1996) and Hart and Moore (1990).16 Property thus determines a social relation.

17 See Aghion and Tirole (1997).

12

Different ownership and organizational structures may be defined, as key capabilities are

different across firm and industries, and even across time and countries. Nonetheless, this

approach presents some serious limits. Individual capabilities and technological conditions

are taken as given in the models. The optimal ownership and control allocation depends on

these initial conditions and is always achievable. If we just assume exogenous changes or

frictions in the market for corporate control (as implied by the asymmetric information

hypothesis), strategies of actual optimal owners may be inefficient in the new state of the

world. Therefore, supposing that “today” decisions affect “tomorrow” performance, firms

may take sub-optimal paths; besides lowering performance, this will reduce opportunities

for potential better owners to get authority. All in all, the implicit assumption of optimality

of effective ownership allocation gives no room to any transition process and leads to “lock

in” phenomena.

******

We will now refer to a different approach to the issue of corporate governance and

innovation, developed by W. Lazonick and M. O’Sullivan18. Their “organizational control”

theory adopts an evolutionary approach to the analysis of innovative processes (as outlined

above), and defines the corporate governance as essentially an organizational issue,

regarding the distribution of decision-making power, that is, the power to determine the

allocation of resources.

According to Lazonick and O’Sullivan, the allocation of resources, or the

organization of human capital and the supply of money, has three basic features in

innovative firms: it is developmental – resources are committed to irreversible investments

with uncertain returns; organizational – returns are generated through the integration of

human ad physical resources; and strategic – resources are allocated to overcome market

and technological conditions that other firms take as given.

Corporate governance is not just a matter of defining incentive schemes to realign

managers and workers to a simple and general objective, nor is just a choice of the optimal

power structure, given technological conditions and human capabilities. Following this

point of view, governance has a much wider scope, and is a genuine organizational

problem, concerning investment strategies and the way people and assets interact. In order

to assess different corporate governance configurations, and to propose some normative

18 We will refer on Lazonick (1998), Lazonick and O’Sullivan (1996, 1997a, 1997b, 1998), and O’Sullivan(1998a, 1998b, 1999).

13

conclusions, Lazonick and O’Sullivan point out two dimensions: organizational integration

and financial commitment.

Organizational integration. In complex social organizations like firms, it is quite

straightforward to assume that people have different capabilities and objectives.

Organizational integration describes the relations that provide people with the incentives to

“use” their skills within the firm. In particular, insiders – “those whose experience and

creativity is integrated into a process of collective learning in the enterprise”19 - are

assumed to have more incentives and abilities to allocate resources to innovative

investments.

Financial commitment describes the extent to which firms have continuous access to

financial resources, as innovation requires time to produce returns and is a highly uncertain

process. In other words, financial commitment deals with the investors’ propensity to

reduce their liquidity at least in the short run.

All in all, “[…] organizational integration and financial commitment represent

social conditions that support organizational control over the critical inputs to the

innovation process: knowledge and money. But […] these inputs are not commodities.

Rather they reflect the social relations to the business organizations of people who supply

knowledge and money […]”20.

As organizational and financial requirements of innovative strategies vary across

contexts, we should expect that the institutions promoting innovation in one era and

technological regime will vary in another period and industry. For example, following

Pavitt’s taxonomy, in a science based industry people whose competencies are crucial in

the productive and innovative process are different from those in a scale intensive sector21.

Firms are thus supposed to elaborate different mechanisms to involve key people in the

strategic decision process.

In his analysis of the role of financial capital in the innovative process, Dosi (1990)

gives us a clue to interpret the variability of financial commitment requirements in different

circumstances22. According to Dosi, credit-financed firms could rely on more direct and

personal relations with investors; however, creditors may not differentiate enough their

investments, especially in those systems where relationships with few banks are privileged:

this leads creditors to prefer “traditional strategies”. Equity markets, if sufficiently “liquid”,

19 O’Sullivan (1999).20 Ibidem.21 See Lazonick (1998) and Pavitt (1984). As an example, Lazonick proposes a difference betweenpharmaceutical industry, where top managers and scientists are supposed to be the key people, andautomobile sector, where even shop-floor worker play a central role.22 See also Williamson (1988).

14

will offer diversification possibilities to investors, and then reduce the risk of new patterns

of firms’ development. But, if exit, and then selection dynamics, are too much stronger than

learning ones, innovation will be inhibited by time and budget constraints.

The organizational control perspective seems more consistent with the definition of

innovative dynamics and the conception of firm we have adopted in this work. It points out

the complexity of firms’ activity and in particular of innovation process, and stresses that

the decision-making process is a multidimensional one, and not just the definition of

appropriate incentive schemes to minimize agency costs. Moreover, this is a dynamic

approach, in that it allows different solutions for different industries, institutional

environments, and historical contexts. To date, however, this approach is still more a

research agenda (although a promising one) than a solid theoretical body on corporate

governance. A first step would be to apply the general principles of organizational

integration and financial commitment to specific sector analysis, and to provide empirical

evidence about their relevance. This in turn implies that “concrete” governance variables

are to be defined. Let’s try a first specification of some variables, and propose an

application to a particular industry.

2.3 Governance structures: a tentative synthesis

The definition of governance variables represents an opportunity to propose a

synthesis between the different theoretical approaches we have outlined. Indeed, we believe

that traditional analyses give useful suggestions about the relevant corporate governance

arrangements, even in our broader point of view. Of course, we will need to reinterpret

some of them and to integrate the analysis with other dimensions, as we assume that

traditional economics has a very limiting approach to the study of the firm. However, “it is

simply naïve to deny the real world importance of opportunism and the need for monitoring

and incentives to curb opportunistic behavior […]. Indeed, we need standard organizational

economics insights to help us explain that part of economic organization that is not best

understood in terms of capabilities…”23.

******

23 Foss (1997).

15

The composition of the principal decision-making centers, as the board of directors,

can actually affect the resource allocation process, and then organizational and learning

dynamics within the firm. In our perspective, decision-makers should have appropriate

information about firm’s operations in order to enhance innovation; insiders, or people who

are directly and continuously involved within the enterprise, seem thus best suited than

independent directors to attend this task. Moreover, granting insiders strategic decision

power is said by most studies to be a powerful incentive to share knowledge and

competencies. From a more traditional point of view, the presence of insiders in the board

may improve rather than worsen the board’s monitoring ability, as inside directors are

better informed about a firm’s operations. Similar conclusions can be drawn about insider

ownership, which is, further, often much more stable and long-term oriented than outside

shareholding. This is a broader approach to the issue, in that it does not take the board as

just a monitoring center, on behalf of shareholders, as the traditional view does, assuming

that strategies are always easily defined and similar in any context and period. The problem

is not the separation of ownership and control and the need for realigning devices, but the

definition of institutional relations that enhance knowledge flows and the integration of

different capabilities. Again, as learning processes rely on the integration of very different

skill bases, the identity of insiders (or, in GHM terminology, of key people and groups) will

differ and evolve across industries and over time.

Similarly, ownership concentration may increase the financial commitment of

shareholders: large investors tend indeed to keep their relevant participation for long

periods; this increases owners’ knowledge of firm’s activities and their monitoring

capabilities. Large creditors may provide a stable flow of financial resources as well.

Again, we do not suppose a “best” solution; the analyses of firms’ financial structure by

Williamson (1988) and Dosi (1990) mentioned above, show the relevant dimensions on this

issue.

2.4 An application to pharmaceutical industry

We will now try to interpret some organizational dynamics of the pharmaceutical

industry, outlined in previous pages, as concerning the decision-making and resource

allocation processes, or the corporate governance structures in the definition we have

adopted. On one side, this analysis is aimed to give a contribution to the debate about

corporate change in pharmaceutical industry, proposing a different perspective in the

16

analysis of the issue. On the other side, this is aimed to integrate (both theoretically and

empirically) exhisting theories on corporate governance and to apply our findings to a

particular industry in a new phase of its evolution.

We believe that both organizational dimensions we have recalled above -the

importance of hiring scientists from several disciplines, and the creation of networks of

alliances between different actors in the industry – present interesting features related to

governance dynamics. Let’s start from the role of scientists.

******

We have already outlined some reasons for firms to hire skilled scientists, for we

will not recall them again. In brief, firms try to integrate scientists within the organization,

in order to “transform” their knowledge in processes of collective learning. As we have

highlighted above, scientific knowledge is playing a crucial role in firms’ activity, and it is

emerging as the main force in shaping research organization. The organization and the

intensity of research, in turn, are more and more the key determinants of firms’ success. In

other words, the activities of R&D laboratories and people working in them affect firm’s

strategies and allocation processes, thus playing an implicit role in corporate governance.

Especially in the US, firms are acknowledging this new role of scientists, and are taking

formal arrangements to involve them directly in the decision-making process. Some studies

have outlined practices such as granting stock options and seats in the board of directors, as

means to “hold” scientists within the organization for long periods. Adopting a GHM

perspective, the indispensability of scientists makes it optimal to grant them some formal or

real authority, as an incentive to invest in their human capital. In the organizational control

framework, the participation of such key figures, or insiders, in the decision process is an

expression of organizational integration. To date, little work, most based on case studies,

has been done on this issue 24. The difficulty to collect relevant data has impaired broader

empirical analyses on the effects of such practices on firms’ innovative efforts and

performance. We will later discuss on our preliminary empirical work.

******

The other intriguing organizational practice we have outlined in previous pages is

the emergence of alliances between large incumbent firms and other institutions, especially

24 See Darby and Zucker (1995).

17

NBFs. Very different kinds of agreements have been arranged, from one-purpose research

agreements to joint ventures and minority participation. Firms are getting aware that the

new scientific paradigm requires so many different skills and financial resources that

almost no firms can manage “working alone”. On one side, established firms can obtain

very specific knowledge from NBFs. Many scholars have noticed, however, that in order to

profit from such agreements, large companies have to develop internal “absorptive

capabilities”; in other words, alliance strategies are something more complex than just

externalization and downsizing policies25. On the other side, alliances with pharmaceutical

firms have become in recent years the single largest source of financing and other

complementary assets (product control procedures, manufacturing know how, sales forces)

for biotechnology firms. Using an expression by Teece (1989), most of these relationships

are therefore “strategic alliances”, or alliances in which both parts share their

complementary assets.

Fig. 1: Research agreements arranged by US biotech firms, as filed by SECor by other control commissions

Source: Lerner and Merges (1998)

Literature on alliances is also analyzing why such linkages seem to work better than

mergers and acquisitions (even though evidence on this issue is still scattered and mostly

anecdotal). This is probably due to the flexibility and multidimensionality of such deals that

seem to replicate research activity in the scientific community. An interdisciplinary study

on this point by Brewer et al. (1995) offers evidence that inter-organizational alliances are

different from hierarchical relationships, as exchanges are external to the firms, but they are

not just market relationships. Indeed, legal contracting is only a part of such processes:

shared norms of trustworthy behavior, reciprocity, respect for individual property rights,

25 See Gambardella (1995).

0

20

40

60

80

100

120

140

160

180

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

18

and honesty in research appear to be a relevant component of these networks, enhancing

their flexibility, reducing costs, and enabling firms to gain access to unique resources.

Networks of innovation in pharmaceutical and biotech industry present thus both explicit

and implicit contractual activity (see Teece, 1989). Moreover, such alliances are seen as a

more powerful incentive for specialized firms to share their knowledge than integration

through acquisition by established companies. In this case, it is not sure that skilled

workers, the key assets of the firm, will accept the new vertical organization, and they may

leave away; if the acquiring firm has not already developed specific internal knowledge,

such acquisition strategies may thus lead to competence destruction.

However, the co-existence of formal and informal linkages in such collaborative

arrangements does not imply that an “invisible hand” drives their enforcement. Rather, as

many different dimensions are involved, and because of the complexity and strategic

relevance of the underlying scientific research, the allocation of control over such

agreements is a central step and quite a complex issue. Lerner and Merges (1998) have

identified 25 critical control rights in biotechnology alliances: they concern some key

aspects of alliance management (managing clinical trials, manufacturing…), the

determination of alliance scope, the control of intellectual property, and the governance

structures (equity in R&D firms, seats in firm’s board…). It is not our purpose to analyze in

detail all these and other potential relevant dimensions. Rather, we want to point out that

the organization of research agreements implies an influence by external agents in a central

function of firms, and that in order to gain results from such activities the allocation of

control plays a central role in increasing the incentives of different actors to co-operate.

Therefore, external agents may influence a firm’s strategy-making process and

performance, that is, in our perspective, a firm’s system of corporate governance. External

agents may indeed be considered as “insiders”, as their experience and creativity is part into

processes of collective learning in the enterprise, and then they may be involved in

processes of organizational integration.

From a more traditional principal-agent perspective, such alliances may be viewed

as agency relationships: the established firm delegates some activities to an agent, the

specialized biotech firm. The incumbent firm (the principal) should therefore provide

adequate incentives to the agent, and sharing decision-making power has emerged as a

powerful device. Further, in order to improve their monitoring capabilities, incumbents are

supposed to invest in the development of internal scientific knowledge. The research firm,

however, is not as risk adverse as traditional models assume, since advanced research is its

core activity, and it may be profitable only by the intervention of complementary assets.

19

Even the evidence proposed by Lerner and Merges (1998) is not conclusive about the

relevance of the agency problem in such alliances. In their analysis, the share of control

rights an R&D firm obtains is only in part correlated with the attempts of the incumbent to

get its commitment26. Again, we prefer an explanation in terms of the development and

sharing of specific capabilities rather than simple incentive enhancing schemes.

More generally, the extent to which decision-making power is shared even with

other organizations, or the level of “inter-firm organizational integration”, will depend on

the nature of specific agreements and contexts, and on the characteristics of the agents

involved. Anyway, in this preliminary work, we advance the hypothesis that alliance

strategies may affect internal decision processes and then shape corporate governance. Such

influence is not just one-way, i.e. on NBFs by large firms, given the stronger financial

position of the latter. As stated above, deep and multidisciplinary scientific knowledge is

considered a crucial factor in affecting a firm’s performance as well, and almost no single

organization can manage to develop internally all the relevant skills. When some key

components of relevant knowledge (scientific principles, but also routines, past experience,

organizational settings) are held by an external agent in agreements, this agent is

“indispensable”, in GHM terminology, in order to achieve results. This increases its

influence on a firm’s strategy.

All in all, opting for a more open organization of research activities in a science-

based industry implies, at least in part, the acceptance of external influence in the internal

allocation of resources. Collaborative arrangements, alliances and other inter-firm

relationships (what Holmström and Roberts (1998) call “governance contracts” or

“contractual assets”) may therefore allocate decision rights much like ownership and

internal control.

Broadly speaking, we are trying to enlarge the debate on corporate governance,

recognizing that strategic decision-making and the actors involved in such process are

complex and heterogeneous and go beyond the firm’s “legal” boundaries. Traditional and

more recent approaches to corporate governance, which focus on activities and relations

inside the firm, should therefore be integrated by models of multilateral negotiations and

influence-seeking among a number of different internal and external agents.

26 The authors, following Aghion and Tirole (1994), posit that more control rights will be granted to the R&Dfirm in the earlier stages of the project, when scientific knowledge is supposed to be more relevant. in order toavoid under-investment. This hypothesis does not have solid empirical support, and its influence on controlallocation goes in the opposite direction than the one theorized. By contrast, the relation between the numberof patents related to the project (a measure of its maturity) and control right allocation is consistent with theAghion-Tirole model. Moreover, from the Lerner and Merges analysis the financial sustainability of theresearch firm is positively correlated with the share of control right on the project it commands, since theabsence of financial constraints increases its bargaining power.

20

The evolution of pharmaceutical and biotech industries is quite emblematic in this

sense. A “constellation” 27 of heterogeneous actors is indeed playing a role in such

dynamics, and inter-firm linkages represent only a part of the process. Universities,

financial markets and investors, service providers, regulators have equally shown their

relevance (as summarized in the first chapter).

27 See Casper and Kettler (2000).

21

Fig. 2: Corporate governance and innovation in pharmaceutical industry. An application of organizational control theory

Financial commitment:firms need continuousaccess to financialresources, as innovationresearch time to producereturns and is a highlyuncertain process

The innovative firm

Rethinking of a firm’s dynamic capabilities, public and tacitknowledge, organizational structure, strategies, resourceallocation processes.

Corporate governance

Organizational integration: relationsthat provide people with theincentives to “use” their skills andshare them within the firm. Inparticular, integration of experts inscientific disciplines as a measure toensure their continuous participationin firm’s activities

Insider control: insiders –those whose experienceand creativity is integratedinto a process of collectivelearning in the enterprise -are assumed to have moreincentives and abilities toallocate resources toinnovative investments

Other films: emergence of NBFs,collaborative arrangements, researchnetworks, minority participation, M&A

Financial markets andinstitutions

Universities,research institutescollaborations,exchange of skilledscientists

Public policies:intellectual propertylegislation;control procedures;structure of nationalhealth system

The biotech revolution

New technological paradigmSciece-guided researchEmergence of biotechnology industry

The economic and institutionalenvironment

22

3. A PRELIMINARY EMPIRICAL ANALYSIS

In this section we test some of the hypotheses discussed above on a sample of

large pharmaceutical companies. In particular, we will verify the influence of some

governance structures on firms’ innovative effort. This analysis is preliminary and far

from exhaustive; we interpret it as a first step in the definition of a solid empirical basis

for the conceptual framework we have outlined above. Moreover, this is intended to be

a synthesis between different approaches, as we recognize the relevance of some

traditional models and recall their methodology and main findings.

3.1 The sample and data

We collected data on a panel of 27 US large pharmaceutical companies,

accounting for more than 75% of domestic market. Information is from 1994 to 1999

for all firms, even though we obtained earlier data in some cases. Several reasons have

led us to use such sample.

First of all, we concentrate on only one country to “control” for different

institutional and legal arrangements that may affect governance structures. US

legislation, for examples, seems less severe in terms of governance forms companies

can adopt, and the evolution of financial markets actually makes almost any

configuration achievable (for example in terms of ownership concentration). The

strongest constraints firms have to respect are disclosure duties, and that made it easier

for us to find relevant data. However, data collection has been quite a difficult and time-

consuming task, both for the heterogeneity of relevant information and difficulty to find

available sources, especially for governance data. Information about the origin of our

data is provided below, in the specification of the model. Firms included in our sample

are listed in Table 1. Some of them, as Procter & Gamble and Monsanto, are not

primarily drug companies; anyway, they play an important role in the market, especially

in the US; others, as Biogen and Genentech, are “first generation NBFs”, or former

small biotech firms, now integrated and “large enough” to be considered incumbent.

23

Table 1Sample CompaniesAbbott Lab. Bristol Myers Squibb Monsanto

Allergan Eli Lilly & co Mylan Lab.

Alpharma Forest Lab. Perrigo

Alza Genentech Pfizer

American Home Products Genzyme Pharmacia & Upjohn

Amgen ICN Pharmaceuticals Procter & Gamble

Bausch & Lomb Johnson & Johnson Schering - Plough

Biogen Mallinckrodt Warner Lambert

Boston Scientific Corp Merck & co Watson Pharm.

3.2 The dependent variable

We used R&D intensity as a proxy for the innovative effort of firms. We are

aware that this is in general a quite biased and spurious strategy measure. However,

many studies have showed a strong relationship between R&D and innovative

performance in pharmaceuticals and other science-based firms. A further step in this

analysis would be testing our hypotheses directly on output measures such as patent

activity (or patent citations). This would require, however, rather arbitrary assumptions

about time lags between the definition of strategies (and people responsible for that) and

innovative outcome, and our data set is still too “recent” to follow this way28.

3.3 Governance variables

We defined five governance variables; three of them have been already proposed

in previous work29: ownership structure, insider shareholding and insider presence in

the board of directors.

Ownership concentration, especially if relevant shareholders maintain their

participation for long periods of time, is assumed to stimulate long term investments

28 Other output measures could be patent applications or scientific publications by people working in afirm’s R&D laboratories. The “advantage” of such variables is that the time lag between decision-makingand results can be assumed as shorter. Moreover, in order to evaluate even the “quality” of bothinnovative effort and output, it is desirable to analyze the different technological classes in which firms doresearch.29 See note n. 14.

24

and then innovative strategies; in the absence of any credible control by shareholders,

manager would tend to maximize short run profits and firm market value, sacrificing

long term objectives. Adopting a broader perspective, one that does not look at

corporate governance as just a matter of agency conflicts, the presence of a large,

“stable” shareholders could be a signal for managers that relevant owners will “forgive”

even poor short-term performances, if decision-makers pursue long-term strategies.

Moreover, having a big stake in the company, blockholders will improve their

knowledge about a firm’s activities, in order to properly evaluate managers’ behavior.

Ownership concentration can thus be seen as a form of both financial commitment and

organizational integration.

We have already exposed some reasons to consider insider ownership and

decision-making power as relevant variables in the issue we are discussing, for we will

not recall them here. We will now propose a more accurate analysis of the board of

directors and of the identity of insider shareholders. As we already pointed out, in

pharmaceutical industry the activities of R&D laboratories and people working in them

affect firm’s strategies and allocation processes, thus playing an implicit role in

corporate governance. Especially in the US, firms are acknowledging this new role of

scientists, and are taking formal arrangements to involve them directly in the decision-

making process. Some studies have outlined practices such as granting stock options

and seats in the board of directors, as means to “hold” scientists within the organization

for long periods. However, their effects on innovative input and output, and on firm

strategies and performance, has not been tested yet, due to a lack of data. Indeed, getting

such information is quite a difficult and time-consuming task. Most commonly used

databases, as Global Researcher or World Scope, do not have such detailed information

and often rely only on last updated information. A richer source of information on

governance variables are companies’ Proxy Statements, “stored” in the SEC web site

(EDGAR database) since 1994. For earlier data, we directly asked companies to send us

relevant information, getting an answer from seven of them. Proxy Statements provide

CVs of directors, from which we obtained the board’s compositions and in particular

the percentage of insiders and of scientists in them. Accurate information on “more than

5%” relevant owners (in terms of voting rights) is also provided. As a proxy for

25

ownership concentration, we then used the sum of such “relevant” stocks. In this

preliminary work, we did not distinguish between different kind of owners (individuals,

financial institutions, other firms, etc…). Data on insider ownership are limited to

directors and executive officers. This restriction, however, is not very limiting in

pharmaceutical industry, where the processes of transformation are “driven by top

managers who were technically competent to evaluate the importance of the bioscience

breakthroughs […]”30. Unfortunately, data about stock ownership by scientists are not

available, and we have just some information on the issue from case studies.

Table 2 shows that the presence of at least one relevant owner is quite frequent

in our sample, especially in smaller firms but even in very large companies. Moreover

the average percentage of the principal shareholders is in general higher in drug

companies firms than the average level at NYSE31. Boards tend to be outsider-

dominated (especially the largest firms’ ones), even though insiders represent a relevant

component. Almost all firms have at least one scientist in the board. Table 3 shows a

significant correlation between the percentage of insiders and scientists in the board;

recall that scientists are insiders as well, and therefore, in order to include the former,

firms will decrease the presence of the latter, and vice-versa. In a sense, we are thus

testing the effect of two alternative practices.

******

Including research agreements, we try to broaden corporate governance issues

beyond a firm’s boundaries. Again, this is just a suggestion, and much stronger

theoretical basis must be built on this point to draw clear conclusions. However, we

believe that exploring this way is an important step, and propose a first, approximate

specification of this dimension. Information about research agreements comes from

PHID (Pharmaceutical Industry Database) jointly developed at the Sant’Anna School of

Advanced Studies, Pisa and at CUSTOM, University of Siena. From this database, we

extracted only those research projects in which the issuer was one of the firms in our

30 Darby and Zucker (1995).31 See Maher and Andersson (1999).

26

panel and the developer was different from the issuer (even subjects not included in our

database). We did not explore the peculiarities of each project, such as the

characteristics of the involved parts and the contractual aspects of the agreements, since

we do not have such accurate information. For these reasons, we preferred not to

“count” such agreements; instead, we have created a dummy variable, that gets value

“1” if the firms have signed agreements for more than half the period we have

information on it, starting from one of the first two years, and “0” otherwise. We

capture, therefore, a propension to deal with other firms to organize research activity,

and, in our perspective, a propension to accept the influence of external agents in the

definition of innovative patterns and strategies. We have already noticed that in order to

profit from such agreements, large companies have to develop internal “absorptive

capabilities”; in other words, alliance strategies are something more complex than just

externalization and downsizing policies. Therefore, we assume that firm’s openness in

research organization has a positive impact on internal innovative effort.

3.4 Control Variables

We introduced other variables to control for commonly recognized determinants

of research intensity, as firm’s size and financial stability. We used assets value as a

proxy for size. It should be noticed that, despite its frequent consideration, the effect of

size is not clear and empirical evidence is scattered. Let’s recall that in our sample

“smaller” companies are former NBFs, and then we can assume a higher innovative

effort by such firms. We will also test a hypothesis proposed by Grabowski and Vernon

(1994) about a U-shaped relation between firm’s size and innovative effort, typical of

hi-tech industries. Financial stability is represented by cash flow as a percentage of

sales, and by debt-to-equity ratio. Following Williamson (1988) and Dosi (1990), we

assume that creditors are more “conservative” and therefore highly indebted firms will

27

be less innovative in a science-based sector32. We derived financial data from Global

Researcher database.

We have also tested the effect of another control variables, accounting for the

role of “scientific background” in a firm’s strategic orientation. As a proxy for such

“knowledge stock”, we used the number of citations that a firm’s patents received from

1978 till the beginning of our period of observation for the other variables. More

precisely, we elaborated a weighed measure, dividing citations by average sales in the

period considered. We thus have a sort of dummy variable accounting for firm specific

“knowledge intensity”. Data on patent citations have been obtained from the EPO-

CESPRI database on patenting activity.

Table 2Descriptives

Variables Obs Mean Std. Dev. Min Max

Sales Total value of sales (000$) 180 6698039 8452153 87057 3.81E+07

RD Total value of RD expenditures (000$) 180 645774.8 664562.2 6233 2775999

Rdsales RD/Sales 180 13.94949 11.94575 0.9 64.9

Conc % of voting rights in >5% stocks 180 16.42914 18.1815 0 73

Insid % of voting rights held by directors andexecutive officers

180 25.59428 10.14233 7.142857 57

Scien % of scientists in the board 180 15.58149 10.73878 0 42.9

Inshold % of insiders in the board 180 3.759278 5.731158 0 41.55

Agree 1 = propension to get into researchagreements ; 0 = otherwise

180 0.4777778 0.5008993 0 1

Assets Total value of assets (000000$) 180 7679.473 8486.275 130.271 35634.9

Assets2 Assets^2 180 1.31E+14 2.31E+14 1.70E+10 1.27E+15

Cash CashFlow/Sales 180 19.40939 10.08235 -42.2 58.3

Lev Debt-to-Equity ratio 180 50.23215 54.01595 0 308.6

Knowstock (Patent Citations (1978-1994) /averagesales (1994-1999)) * 1000000

180 74.2393 171.6777 0 754.0284

3.5 Method

We adopted a cross-sectional time-series FGLS method, assuming panel specific

autocorrelation and heteroscedasticity. The autocorrelation hypothesis takes into

account inertial (and firm specific) aspects in the determination of R&D budget, and

32 Notice that in Williamson (1988) corporate finance settings are considered as part of corporategovernance structure.

28

heteroscedastcity hypothesis implies differences between firms even though our sample

is quite homogeneous.

3.6 Results

Table 4 gives details about the econometric exercises we have conducted. We

first tested the effects of only governance variables, excluding even agreement dummy,

as we acknowledge that it represents a peculiar organizational arrangement and its

interpretation as a governance variable is controversial. Ownership concentration and

the percentage of scientists in the board have a significant positive effect on research

intensity, while insider ownership and presence in the board (two more traditional

governance variables) are not significant. Regarding the board composition, it seems

that enhancing the role of specific skills is more effective that traditional incentive

realigning, at least in pharmaceutical industry. These results seem quite robust to

different specifications.

Table 3Correlations

Rdsales Scien Conc Insid Inshold Agree Assets Assets2 Lev Cash KnowStockRdsales 1

Scien 0.3626* 1

Conc 0.3669* -0.1292 1

Insid 0.1359 -0.1750* 0.2353* 1

Inshold -0.0956 -0.2295* 0.2954* 0.3513* 1

Agree 0.3364* 0.1984* -0.1629* -0.0173 -0.3680* 1

Assets -0.2468* 0.0708 -0.4851* -0.3236* -0.3990* 0.2060* 1

Assets2 -0.2282* 0.0783 -0.4014* -0.2640* -0.3047* 0.1003 0.9431* 1

Lev -0.1444 -0.1218 0.0974 -0.0781 0.0076 -0.0441 0.0214 0.0183 1

Cash 0.0954 0.1921* -0.3109* 0.0821 -0.1278 0.2812* 0.0179 -0.0054 -0.2551* 1

KnowStock 0.7880* 0.2945* 0.6209* 0.1295 -0.0353 0.2416* -0.2412* -0.1945* -0.1659* -0.0305 1

* Significant at.05 level

We have then added the agreement variable, and then the other control variables.

Firm’s openness in research organization increases internal innovative effort, and it

strengthens the idea that collaboration is something different from externalization and

29

risk reducing policies. Size effects go in the direction we have assumed, and even the

"U-shaped relation” hypothesis gets some empirical support. Financial variables are not

relevant: none of the companies in our samples is in financial troubles in the period

considered, so we can suppose a weaker pressure by creditors. A similar explanation

can be given for the reduced significance of ownership concentration in some

regressions, as the presence of a “long-sighted” stockholder is less relevant33. In

general, governance variables indicating organizational practices, as the integration of

relevant competencies in strategic centers and of different actors in research activity

seem more robust.

Knowledge stock measure adds much significance to the model, and is the most

robust regressor together with agreement variable. Again, scientific and organizational

dimensions 34 show a crucial role in explaining firms’ strategies. This also explains the

relevance of scientists in the board (such variable does not lose significantly its

explanatory power even adding size, financial and knowledge variables). Notice,

moreover, that “Scien” is the only governance variables not significantly correlated to

the size measure. It is clearly more likely that smaller companies are directed and

owned by a larger percentage of insiders. Hiring and integrating scientists within the

organization, however, seems an independent practice with respect to other firm’s

dimensions.

To conclude, we noticed a high degree of stability of strategy (i.e., R&D

intensity) and governance variables in each firm, as well as financial and size ones.

Even though we have not explored in detail the issue, we can imply that the “between”

or cross-sectional effects are more relevant than the “within” dimension. However, an

accurate analysis of the issue would require a larger amount of historical information,

which is extremely difficult to obtain.

33 Anyway, the presence of at least one relevant shareholder in most US pharmaceutical companiessuggests that blockholding cannot be explained only in terms of a substitute for legal protection, asproposed in recent literature. See Shleifer e Vishny (1997).34 Since we analyze firms of only one country, we “neutralize” the effect of institutional factors.

30

Table 4Empirical resultsDependent variable: RD/Sales

1 2 3 4 5 6 7

Const 7.33356 3.523 4.91075 4.95059 5.10076 5.238962 4.654808

(6.967)*** (3.260)*** (2.886)*** (3.240)*** (3.541)*** (3.514)*** (4.371)***

Scien .09708 .116615 .093188 .084388 .084140 .083120 .057519

(3.179)*** (3.542)*** (3.146)*** (3.170)*** (3.141)*** (3.088)*** (3.616)***

Conc .11904 .119095 .105162 .106560 .107297 .106187 .030938

(3.189)*** (4.538)*** (3.993)*** (4.247)*** (3.947)*** (3.867)*** (1.801)*

Insid .019973 .014681 .013289 .026604 .022767 .023450 -.001904

( 0.507) (0.569) (0.561) (1.208) (0.997) (1.012) (-0.130)

Inshold .029888 .110867 .131216 .150912 .065095 .066670 .060282

(0.778 ) (1.489) (1.420) (1.524) (0.812) (0.818) (1.887)*

Agree 6.51942 7.643712 9.035387 9.29737 9.313051 5.400798

(6.225)*** (4.603)*** (6.117)*** (6.863)*** (6.889)*** (5.663)***

Assets -0.000152 -.000545 -.000529 -.000157 -.000199

(-2.679)*** (-3.690)*** (-3.377)*** (-3.437)*** (-2.279)**

Assets2 1.46e-08 1.40e-08 1.44e-08 4.20e-09

(3.320)*** (2.927)*** (2.975)*** (1.852)*

Lev .000933 .001015 .003499

(0.211) (0.225) (1.353)

Cash .004865 .002211

(-0.203) (0.108)

KnowStock .075719

(7.192)***

Wald chi2 18.66*** 67.05*** 39.47*** 46.70*** 46.54*** 64.12*** 174.98***

Num. Of Firms 27 27 27 27 27 27 27

Num. of Obs. 180 180 180 180 180 180 180

Method: FGLS regression, heteroscedastic, panel specific AR(1)

z-levels in parentheses* Significant at .1 level** Significant at .05 level

*** Significant at .01 level

31

4. Concluding remarks and directions for future research

In this paper we focused on some determinants of firms’ strategy and

performance in the pharmaceutical industry, following the so-called biotechnology

revolution. We pointed out that various dimensions are involved in this evolution, and

highlighted the emergence of new organizational practices to deal with different

research methods. Following recent theorizing on corporate governance issues, that

adopts a more appropriate definition of firm and innovative activities than traditional

approaches, and sees governance first as a set of social relations defining who makes

investment decisions, what type of investments they make, and how returns from such

investments are distributed, we interpreted some organizational arrangements as

affecting investment decision and firms’ strategies.

In particular, the integration of skilled scientists within the organization, given

their key role in the new technological paradigm, often required their involvement in

strategic processes, both by their participation in decision-making centers and by stock

ownership. These practices can be seen as incentive measures, but also as the awareness

of the crucial role of science and research organization for a firm’s profitability.

Moreover, we have tried to broaden our analysis beyond a firm’s boundaries. In

pharmaceuticals, strategic alliances, especially between large companies and new

biotechnology firms, are a peculiar feature in the industry organization; they concern the

division of scientific work and the development of complementary, strategic assets as

sales and manufacturing forces. External subjects can thus be called to participate in the

organization of central activities of a firm, and may thus affect its strategy and

performance. Counterparts in research agreements are just an element of complex

constellations of actors that interact with pharmaceutical companies, and, inevitably,

shape their conduct and performance. Among such relevant actors, we should at least

recall national institutions and public policy-makers.

We have tried to support our hypotheses with an empirical analysis on US

pharmaceutical industry, in which we explore the effect of traditional and “new”

governance variables on firms’ innovative effort, and control for other dimensions

commonly considered as relevant. The results seem quite consistent with our approach;

32

in particular, the integration of particular actors in a firm’s decision-making process,

both internal and external, is associated with a greater innovative activity, as expressed

by research intensity.

This is, however, a very early stage of research; what we found are just

significant (and rather interesting) correlations, and we do not infer any clear causal

relationship. Broadly speaking, our theoretical and empirical findings are far from

conclusive. The organizational control theory is a promising framework to analyze

corporate governance issues, as it adopts a broader approach to firm’s analysis than

traditional theories, one that allows us to explore the effect of governance on particular

firm’s activities, as innovation processes. To date, however, organizational control

principles lack a solid theoretical basis as well as a “concrete” specification; these will

be necessary steps to define relevant institutional and organizational practices.

Traditional theory offers a first, general set of variables that can be interpreted even as

organizational arrangements that affect resources allocation processes. However, we

believe that the inclusion of such organizational approach to the issue should lead to

industry-specific analyses, in order to define more in detail what institutional and

organizational arrangements are relevant in each sector. Further, we recognize that firms

interact with other actors that may even influence internal decision processes. Current

approaches to corporate governance should therefore be generalized to models of

multilateral negotiations and influence-seeking among a number of different agents.

Literature on national and sectoral systems of innovation, and recent theorizing on

firm’s boundaries may thus offer great help 35, in order to develop such analysis and

define national and sectoral systems of corporate governance.

Our study of pharmaceutical industry goes in such directions, as it explores some

peculiar aspects of industry evolution, concerning firms and their relevant environment,

and give them a preliminary interpretation as dynamics concerning even corporate

governance. Much work has still to be done.

First, the issue should be given a more solid theoretical background, in order to

define a clear and consistent set of relevant institutional and organizational

35 See Holmström and Roberts (1998).

33

arrangements. Again, we believe that the convergence of traditional and more recent

theorizing on corporate governance, and the adoption of theoretical tools from other

field of industrial economics, is the appropriate pattern.

Second, variables included in our empirical tests need a more detailed

specification. For example, it is desirable to have more precise information about the

role of scientists-directors within a firm’s R&D laboratories, in order to assess the

consistence between their influence on strategic decision-making and on research

activity. The analysis of the relation between scientist participation in the board and the

links with universities and other basic research institutions could be another interesting

development. Information about the identity of relevant shareholders and on the

duration of their investments, and details about each research agreement are, as already

stated, relevant dimensions to explore as well. Other developments of the analysis have

been proposed in previous pages. It is worth noting that collection of data would be a

very time-consuming task though, as such information is not easily available.

Moreover, it is desirable to extend the analysis to other industries and countries.

The relevance of different institutional settings at sectoral and national level, and

consequent different patterns of evolution, will require a further effort in the definition

of sector and country-specific relevant variables36. Regarding the sectoral dimension, a

preliminary, “easier” exercise could be to compare the impact in other industries of the

variables we have used for pharmaceuticals. A complete analysis of national

differences, finally, should explore not just strictly economic dimensions. Recent

studies, as Hamilton and Feenstra (1995), have indeed examined the influence of some

social and cultural habits on national firm- and industry-level organization. Once we

interpret corporate governance as a set of complex social relations, therefore, the

convergence of different disciplines in the analysis would certainly provide a better

understanding of the issue.

36 A research agenda on the issue has been proposed by Berglöf and von Thadden (1999). The authorsstress only the country-specific dimension of corporate governance, while we try to show the relevance ofsectoral considerations as well.

34

REFERENCES

AA.VV., Il Mercato della Proprietà in Italia: Aspetti Teorici e Istituzionali, Banca d’Italia, Roma, 1994a.

AA.VV., Assetti Proprietari e Mercato delle Imprese, voll. I e II, Il Mulino, Bologna, 1994b.

Aghion, P. and Tirole, J., “The Management of Innovation”, Quarterly Journal of Economics, vol. 109,pp. 1185-1209, 1994.

Aghion, P. and Tirole, J., “Formal and Real Authority in Organizations”, Journal of Political Economy ,vol. 105, n. 1, pp. 1-29, 1997.

Agrawal, A. and Knoeber, C. R., “Firm Performance and Mechanisms to Control Agency Problemsbetween Managers and Shareholders”, Journal of Financial and Quantitative Analysis, vol. 31, n. 3, pp.377-397, 1996.

Barca, F., Imprese in Cerca di Padrone: Proprietà e Controllo nel Capitalismo Italiano, Laterza, Bari,1994.

Barzel, Y., Economic Analysis of Property Rights, Cambridge University Press, II ed., 1997.

Baysinger, B. D. and Hoskisson, R. E., “The Composition of Board of Directors and Strategic Control:Effects on Corporate Strategy”, Academy of Management Review, vol. 15, n. 1, pp.72-87, 1990.

Baysinger, B. D., Kosnik, R. D. and Turk, T. A., “Effects of Board and Ownership Structure on CorporateR&D Strategy”, Academy of Management Journal, n. 1, pp. 205-214, 1991.

Berglöf, E. and von Thadden, E. L., The Changing Corporate Governance Paradigm: Implications forTransition and Developing Countries, mimeo, 1999.

Berle, A. A. and Means, G. C., The Modern Corporation and Private Property, Macmillan, New York,1932.

Blair, M. M., Ownership and Control. Rethinking Corporate Governance for the Twenty-First Century,The Brookings Institution, 1995.

Brewer, B. B., Liebeskind, J., Oliver, A. and Zucker, L. G., Social Networks, Learning, and Flexibility:Sourcing Scientific Knowledge in New Biotechnology Firms, NBER Working Paper n. 5320, 1995.

Burkart, M., Gromb, D. and Panunzi, F., “Large Shareholders, Monitoring, and the Value of the Firm”,Quarterly Journal of Economics, n. 112, pp. 693-728, 1997.

Bussolati, C., Malerba, F. and Torrisi, S. (eds.), L’Evoluzione delle Industrie ad Alta Tecnologia in Italia ,Il Mulino, Bologna, 1996.

Casper, S. and Kettler, H. E., The Road to Sustainability in the UK and German Biotechnology Industries,Paper prepared for the ESSY conference, Berlin, June 1-3 2000.

Chandler, A. D., Scale and Scope: The Dynamics of Modern Capitalism, The Belknap Press of HarvardUniversity Press, Cambridge, Mass., 1990.

35

Chandler, A. D., Paths of Learning. The Evolution of High Technology Industries (forthcoming),manuscript, 1999.

Coase, R., “The Nature of the Firm”, Economica, vol. 4, pp.386-405, 1937.

Cockburn, I. and Henderson, R., “Scale, Scope and Spillovers: the Determinants of Research Productivityin Drug Discovery”, RAND Journal of Economics, vol. 27, n. 1, pp. 32-59, 1996.

Cockburn, I. and Henderson, R., “Absorptive Capacity, Coauthoring Behavior, and the Organization ofResearch in Drug Discovery”, The Journal of Industrial Economics, vol. 46, n.2, pp. 157-182, 1998.

Cockburn, I., Henderson, R. and Stern, S., Exploring the Diffusion of Science Driven Drug Discovery inPharmaceutical Research, Tuck/CCC Conference: Evolution of Firm Capabilities, 24-25 September1999.

Cohen, W. M. and Levinthal, D. A., “Innovation and Learning: the Two Faces of R&D”, The EconomicJournal , n. 99, pp. 569-596, 1989.

Colli, A., Corporate Governance and Economic Performance: the Italian Case, 1st CGEP Workshop,Fontainebleu, January 1999.

Daily, C. M. and Dalton, D. R., “The Relationship Between Governance Structure and CorporatePerformance in Entrepreneurial Firms”, Journal of Business Venturing, n. 7, pp. 375-386, 1992.

Dalton, D. R., Kesner, I. F. and Rechner, P. L., “Corporate Governance and Board of Directors: anInternational, Comparative Perspective”, Advances in International Comparative Management, vol. 3, pp.95-105, 1988.

Darby, M. R. and Zucker, L. G., Present at the Revolution: Transformation of Technical Identity for aLarge Incumbent Pharmaceutical Firm after the Biotechnological Breakthrough, NBER Working Papern. 5243, 1995.

Demsetz, H. “The Structure of Ownership and the Theory of the Firm”, The Journal of Law andEconomics, vol. 26, pp. 375-390, 1983.

Donaldson, T. and Preston, L. E., “The Stakeholder Theory of the Corporation: Concepts, Theory andImplication”, in Clarkson, M. B. E. (eds.), The Corporation and its Stakeholders. Classics andContemporary Readings, University of Toronto Press, pp. 205-242, 1995.

Dosi, G., “The Nature of the Innovative Process”, in Dosi et al. (eds., 1988), pp. 221-238.

Dosi, G., “Finance, Innovation and Industrial Change”, Journal of Economic Behavior and Organization ,n. 13, pp. 299-319, 1990.

Dosi, G., Freeman, C., Nelson, R., Silverberg, G. and Soete, L. (eds.), Technical Change and EconomicTheory, MERIT, 1988.

Dosi, G. and Orsenigo, L., “Coordination and Transformation: an Overview of Structures, Behaviours andChange in Evolutionary Environments”, in Dosi et al. (eds., 1988), pp. 13-37.

Fairtlough, G., “Innovation and Organization”, in Dodgson, M. and Rothwell, R. (eds.), The Handbook ofIndustrial Innovation, Edward Elgar, Cheltenham, pp. 325-336, 1994.

Fama, E. F. and Jensen, M. C., “Separation of Ownership and Control”, The Journal of Law andEconomics, vol. 26, pp. 301-325, 1983.

36

Farmindustria, Fatti e Cifre, 1999.

Foss, N. J., Toward a Strategic Theory of the Firm: Governance, Capabilities, or Both?, CopenhagenBusiness School, 1997.

Gambardella, A., Science and Innovation – The US Pharmaceutical Industry During the 1980s,Cambridge University Press, 1995.

Gambardella, A. and Orsenigo, L., “Le Biotecnologie in Italia: una Opportunità Perduta?”, in Bussolati,Malerba and Torrisi ( eds., 1996), pp. 251-283.

Grabowski, H. and Vernon, J., “Innovation and Structural Change in Pharmaceuticals andBiotechnology”, Industrial and Corporate Change, vol. 3, n. 2, pp. 435-449, 1994.

Greene, W., Econometric Analysis, Prentice Hall International, 2000.

Grossman, S. and Hart, O., “The Costs and Benefits of Ownership: a Theory of Vertical and LateralIntegration”, Journal of Political Economy , vol. 94, pp. 691-719, 1986.

Hamilton, G. G. and Feenstra, R. C., “Varieties of Hierarchies and Markets: an Introduction”, Industrialand Corporate Change, vol.4, pp. 51-89, 1995.

Hansen, G. S. and Hill, C. W. L., “Are Institutional Investors Myopic? A Time-Series Study of FourTechnology-Driven Industries”, Strategic Management Journal, vol. 12, pp. 1-16, 1991.

Hart, O., “Corporate Governance: Some Theory and Implications”, Economic Journal, n.105, pp. 678-689, 1995.

Hart, O., Imprese, Contratti e Struttura Finanziaria, Giuffrè, Milano, 1998.

Hart, O. and Moore, J., “Property Rights and the Nature of the Firm”, Journal of Political Economy , vol.98, pp. 1119-1158, 1990.

Hart, O., Shleifer, A. and Vishny, R. W.: The Proper Scope of Government: Theory and an Application toPrisons, NBER Working Paper n. 5744, 1996.

Henderson, R., Orsenigo, L. and Pisano, G. P., The Pharmaceutical Industry and the Revolution inMolecular Biology: Exploring the Interaction between Scientific, Institutional and OrganizatonalChange , in Mowery and Nelson (eds., 1999).

Herzel, L., “Board of Directors Versus Institutional Investors”, in Baums, T., Buxbaum, R. M. and Hopt,K. J. (eds.), Institutional Investors and Corporate Governance, Walter de Gruyter, Berlino, pp. 161-180,1994.

Hill, C. W. L., and Snell, S. A., “External Control, Corporate Strategy, and Firm Performance inResearch-Intensive Industries”, Strategic Management Journal, vol. 9, pp. 577-590, 1988.

Holmström, B. and Roberts, J., “The Boundaries of the Firm Revisited”, Journal of EconomicPerspectives, vol. 12, n. 4, pp. 73-94, 1998.

Jensen M. C. and Meckling, W. H., “Theory of the Firm: Managerial Behavior, Agency Costs andOwnership Structure”, Journal of Financial Economics, vol. 3, pp. 305-360, 1976.

37

Kelly, G., Kelly, D. and Gamble, A. (eds.), Stakeholder Capitalism, Houndmills, Basingstoke,Macmillan, 1997.

La Porta, R. Lopez-De-Silanes, F. and Shleifer, A., “Corporate Ownership Around the World”, TheJournal of Finance, vol. 44, n.2, pp. 471-517, 1999.

Lazonick, W., “Organizational Learning and International Competition: the Skill-Base Hypothesis”, inMichie, J. and Smith, J. G. (eds.), Globalization, Growh and Governance: Creating an InnovativeEconomy , Oxford University Press, 1998.

Lazonick, W. and O’Sullivan, M., “Organization, Finance and International Competition”, Industrial andCorporate Change, vol. 5, n. 1, pp. 1-49, 1996.

Lazonick, W. and O’Sullivan, M., “Finance and Industrial Development. Part I: the United States and theUnited Kingdom”, Financial History Review, vol. 4, n. 1, pp. 7-29, 1997a.

Lazonick, W. and O’Sullivan, M., “Finance and Industrial Development. Part II: Japan and Germany”,Financial History Review, vol. 4, n. 2, pp. 117-138, 1997b.

Lerner, J. and Merges, R. P., “The Control of Technology Alliances: an Empirical Analysis of theBiotechnology Industry”, The Journal of Industrial Economics, vol. 46, pp.125-155, 1998.

Maher, M. and Andersson, T., Corporate Governance: Effects on Firm Performance and EconomicGrowth, OECD, 1999.

Malerba, F. and Orsenigo, L., “The Dynamics and Evolution of Industries”, Industrial and CorporateChange , vol. 5, n. 1, pp. 51-87, 1996.

McConnell, J. J. and Servaes, H., “Additional Evidence on Equity Ownership and Corporate Value”,Journal of Financial Economics, vol. 27, pp. 595-612, 1990.

Morck, R., Shleifer, A. and Vishny, R. W., “Management Ownership and Market Valuation”, Journal ofFinancial Economics, vol. 20, pp. 293-315, 1988.

Morck, R., Shleifer, A. and Vishny, R. W., “Alternative Mechanisms for Corporate Control”, TheAmerican Economic Review, vol. 79, n. 4, pp. 843-852, 1989.

Mowery, D. C. and Nelson, R. R. (eds.), The Sources of Industrial Leadership: Studies of SevenIndustries, Cambridge University Press, 1999.

Nelson, R. R. (ed.), National Innovation Systems, Oxford University Press, Oxford, 1993.

Nelson, R. R., “Recent Evolutionary Theorizing About Economic Change”, Journal of EconomicLiterature, vol. 33, pp. 48-90, 1995a.

Nelson, R. R., Il Progresso Tecnico come Processo Evolutivo, Giuffrè, Milano, 1995b.

OECD, The OECD Principles of Corporate Governance, OECD, 1999.

O’Sullivan, M., “Sustainable Prosperity, Corporate Governance, and Innovation in Europe”, in Michie, J.and Smith, J. G. (eds.), Globalization, Growth and Governance, Oxford University Press, 1998a.

O’Sullivan, M., “The Innovative Enterprise and Corporate Governance”, Cambridge Journal ofEconomics, December 1998b.

38

O’Sullivan, M., Contests for Corporate Control: Corporate Governance and Economic Performance inthe United States and Germany, Oxford University Press, 1999.

Oswald, S. L., and Jahera, J. S., “The Influence of Ownership on Performance: an Empirical Study”,Strategic Management Journal, vol. 12, pp. 321-326, 1991.

Pagano, U., “Authority, Co-ordination and Disequilibrium: an Explanation of the Co-existence of Marketand Firms”, Structural Change and Economic Dynamics, vol. 3, n. 1, pp. 53-77, 1992.

Pammolli, F., Innovazione, Concorrenza e Strategie di Sviluppo nell’Industria Farmaceutica, GueriniScientifica, Milano, 1996.

Pavitt, K., “Sectoral Patterns of Technological Change: Towards a Taxonomy and a Theory”, ResearchPolicy, vol. 13, pp.343-374, 1984.

Pavitt, K., “Key Characteristics of Large Innovating Firm”, in Dodgson, M. and Rothwell, R. ( eds.), TheHandbook of Industrial Innovation , Edward Elgar, Cheltenham, pp. 357-366, 1994.

Pisano, G. P., “The Governance of Innovation: Vertical Integration and Collaborative Arrangements inthe Biotechnology Industry”, Research Policy, vol. 20, pp. 237-249, 1991.

Porter, M. E., “Capital Disadvantage: America’s Failing Capital System”, Harvard Business Review, pp.65-82, Settembre – Ottobre 1992.

Rajan, R. G. and Zingales, L., Power in a Theory of the Firm, Quarterly Journal of Economics, May1998.

Romano, R., “Public Pension Fund Activism in Corporate Governance Reconsidered”, in Baums, T.,Buxbaum, R.M. and Hopt, K.J. (eds.), Institutional Investors and Corporate Governance, Walter deGruyter, Berlino, pp. 105-159, 1994.

Rubinstein, M., Corporate Governance and Innovation: an Initial Survey, manuscript, 1999.

Schmidt, K.M., “The Cost and Benefits of Privatization: an Incomplete Contracts Approach”, TheJournal of Law, Economics and Organization, vol. 12, n. 1, pp.1-24, 1996.

Scott, K. E. and Kleidon, A. W., “CEO Performance, Board Types and Board Performance: a First Cut”,Baums, T., Buxbaum, R.M. and Hopt, K.J. (eds.), Institutional Investors and Corporate Governance,Walter de Gruyter, Berlino, pp. 181-199, 1994.

Shleifer, A. and Vishny, R. W., “A Survey of Corporate Governance”, The Journal of Finance, vol. 52, n.2, pp. 737-783, 1997.

Stigler, G. J. Friedland, C., “The Literature of Economics: the Case of Berle and Means” The Journal ofLaw and Economics, vol. 26, pp. 237-261, 1983.

Teece, D. J., “Technological Change and the Nature of the Firm”, in Dosi et al. (eds., 1988), pp. 256-282.

Teece, D. J., “Concorrenza e Cooperazione nelle Strategie di Sviluppo Tecnologico”, Economia ePolitica Industriale, n. 64, pp. 17-45, 1989.

Teece, D. J. and Pisano, G. P., “The Dynamic Capabilities of Firms: an Introduction”, Industrial andCorporate Change, vol. 3, pp. 537-555, 1994.

39

Vaccà, S. and Zanfei, A., “L’Impresa Globale Come “Sistema Aperto” a Rapporti di Cooperazione”,Economia e Politica Industriale, n. 64, pp. 47-89, 1989.

Williamson, O. E., “Organization Form, Residual Claimants, and Corporate Control”, The Journal of Lawand Economics, vol. 26, pp. 351-366, 1983.

Williamson, O. E., “Corporate Finance and Corporate Governance”, The Journal of Finance, vol. 43, n. 3,pp. 567-591, 1988.

Zahra, S.A., “Governance, Ownership, and Corporate Entrepreneurship: the Moderating Impact ofTechnological Opportunities”, Academy of Management Journal, n. 6, pp. 1713-1735, 1996.

Zingales, L., “Corporate Governance”, The New Palgrave Dictionary of Economic and the Law, Volume1998.

Zysman, J., “Institutions and Economic Development in the Advanced Countries”, in Dosi, G. andMalerba, F. (eds.), Organization and Strategy in the Evolution of the Enterprise, Macmillan Press, 1996.