Vertical Integration

INFORMATION TO USERS
This manuscript has been reproduced from the microfilm master. UMI films
the text directly from the original or copy submitted. Thus, som e thesis and
dissertation copies are in typewriter face, while others may be from any type of
computer printer.
The quality of this reproduction is dependent upon the quality of the

copy subm itted. Broken or indistinct print, colored or poor quality illustrations
and photographs, print bleedthrough, substandard margins, and improper
alignment can adversely affect reproduction.
In the unlikely event that the author did not send UMI a complete manuscript
and there are missing pages, these will be noted. Also, if unauthorized
copyright material had to be removed, a note will indicate the deletion.
Oversize materials (e.g., maps, drawings, charts) are reproduced by

sectioning the original, beginning at the upper left-hand comer and continuing
from left to right in equal sections with small overlaps.
Photographs included in the original manuscript have been reproduced

xerographically in this copy. Higher quality 6" x 9" black and white
photographic prints are available for any photographs or illustrations appearing
in this copy for an additional charge. Contact UMI directly to order.
ProQuest Information and Learning

300 North Zeeb Road, Ann Arbor. Ml 48106-1346 USA
800-521-0600
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
NOTE TO USERS
Page(s) not included in the original manuscript and are

unavailable from the author or university. The manuscript
w as microfilmed as received.
136-139
This reproduction is the best copy available.
UMI'
DISSERTATION
Dong Kwan Kang
The Graduate School
University of Kentucky
2002
OWNERSHIP CONCENTRATION, VERTICAL INTEGRATION. AND ITS
DETERMINANTS IN THE KOREAN CORPORATION:
HOW DOES CHAEBOLS ORGANIZATION AFFECT OWNERSHIP
CONCENTRATION AND VERTICAL INTEGRATION
DISSERTATION
A dissertation submitted in partial fulfillment of the

requirements for the degree of Doctor of Philosophy in the
Collage of Business and Economics
at the University of Kentucky
By
Dong Kwan Kang
Lexington, Kentucky
Co-Directors: Dr. John Garen, Professor of Gatton School

and Dr. Frank Scott, Professor of Gatton School
Lexington, Kentucky
2002
UMI Number: 3047784
___ _
UMI
UMI Microform 3047784
Copyright 2002 by ProQuest Information and Learning Company.
All rights reserved. This microform edition is protected against
unauthorized copying under Title 17, United States Code.
ProQuest Information and Learning Company

300 North Zeeb Road
P.O. Box 1346
Ann Arbor, Ml 48106-1346
By
Dong Kwan Kang
Lexington, Kentucky
Co-Director of Dissertation
d .
. Co-Cffrec
irector o f Dissertation
/ Director of Graduate Studies
S ' /*-3> ( 01 .
Data
ACKNOWLEDGEMENTS
The following dissertation benefited from the assistance and direction of several
people. First, I really appreciate my Dissertation Chair, Dr. John Garen and Co Director
Dr. Frank Scott, who provided sensible, constructive, and informative advices and
appraisal at every stage of the dissertation process, allowing me to complete this
dissertation finally. Next, I wish to thank all Dissertation Committee, Dr. Mark Berger,
Dr. Christopher Bollinger, and Dr Walter Ferrier of Gatton School
Also, I desire to thank Dr. Young Yong Kim, professor of Chun-Nam National
University who had encouraged me continually and supplied the data and comments. I
would like to thank Dr. Seung Chul Ahn, Professor of Young-Nam University, Dr.
Yunbai Kim, professor of Gatton School, and Dr, Seung Hahn Koh who encouraged me
with love and friendship to finish this work. In addition, I wish to thank all members of
Kentucky-Korean Tennis Club Association, who have been sharing friendship with
respect.
Lastly, I wish to thank my family for providing me with endless love and
support. My father, Sung Suk Kang, and my mother, Soon Chun Ahn, inspired me to
achieve Ph.D and had supported me until I finished it. This dissertation is absolutely for
them. I would like to thank to my brother, Iel Kwan Kang, who has been taking care of
our parent instead of me. My sister, Joo Sil Kang, and her husband, Jae Geun Lee,
reminded me of the kindness and love of brotherhood. I wish to thank my pretty
daughters, Davina (So-Dahm) and Jenella (So- Lin), who are sound and healthy and
always make me cheerful and happy. My wife, Jung Hee Suh, provided on-going support
in
with lovely smile. She was always there for me with love. It is really hard to express
myself to her for many thanks, but if I have to do, I would say, Go-Mah-Wa, Sah-
Lahng- Hae!
iv
TABLE OF CONTENTS
Acknowledgement....................................................................................................... in
List of Table................................................................................................................ vii
List of Figures............................................................................................................... viii
Chapter One: Introduction

1.1 Purpose............................................................................................... 1
1.2 Over view of Theories and Estimated Results...................................... 4
1.3 Organization of Dissertation.............................................................. 8
Chapter Two: Literature Review

2.1 Introduction.......................................................................................... 9
2.2 Ownership, Its Determinants, and Performance................................... 11
2.2.1 Ownership and Agency Problem.............................................. 11
2.2.2 Empirical Relationship between Ownership and Performance... 14
2.2.3 The Determinants of Ownership Concentration....................... 19
2.3 Vertical Integration, Its Determinants, and Performance..................... 22
2.3.1 The Nature of the Firm and Transaction Cost........................... 22
2.3.2 Determinants of Vertical Integration.......................................... 30
Asset Specificity...................................................................... 31
Uncertainty.............................................................................. 32
Evidence.................................................................................. 33
2.3.3 Vertical Integration and Performance........................................ 37
2.4 Conclusion............................................................................................. 41
Chapter Three: Methodology

3.1 Introduction.......................................................................................... 44
3.2 Empirical Model.................................................................................. 44
3.2 Data Collection................................................................................... 46
3.4 Descriptions of Data........................................................................... 49
Chaebol and Its Affiliated Firms.............................................. 49
Ownership Concentration........................................................ 54
Degree of Vertical Integration................................................. 55
Determinants of Ownership Concentration.............................. 56
Determinants of Vertical Integration........................................ 56
Uncertainty............................................................................. 57
Performance and Economic Variables...................................... 58
3.5 Mean Values of Variables.................................................................. 58
Chapter Four: Ownership Concentration and Its Determinants

4.1 Introduction......................................................................................... 63
4.2 Ownership Structure In Korean Private Companies............................. 65
4.3 Determinants of Ownership Concentration.......................................... 74
Capital Resources.................................................................... 76
Control Potential...................................................................... 77
The Finns Age........................................................................ 77
Organizational Form................................................................. 79
4.4 Empirical Modeling and Results.......................................................... 81
Modeling.................................................................................. 81
Regression Results.................................................................... 88
4.5 Conclusion............................................................................................ 93
Chapter Five: Vertical Integration and Determinants

5.1 Introduction.......................................................................................... 96
5.2 Organizational Structure In Korean Corporations................................ 98
5.3 Determinants of Vertical Integration...................................................... 106
Asset-Specificity.........................................................................106
Uncertainty............................................................................... 106
Organizational Form................................................................. 107
Modeling................................................................................... 108
Regression Results................................................................... 114
5.5 Conclusion........................................................................................... 119
Chapter 6: Performance with Ownership concentration and Vertical Integration

6.1 Introduction.......................................................................................... 121
Modeling.................................................................................... 122
Regression Results................................................................... 125
6.3 Conclusion............................................................................................ 132
Chapter 7: Conclusion................................................................................................. 136
References................................................................................................................... 140
Vita.............................................................................................................................. 145
vi
LISTOF TABLES
Table 2-1: Empirics in Vertical Integration and Its Determinants................................ 34

Table 3-1 :Total Sales in All Industry, the Listed Firms, and Sample Data of 1995.... 47
Table-3-2: Value Added by Total Industries and Top-30 Chaebols in 1994 of Korea.... 50
Table 3-3: Vertical Relationship Among Affiliated firms of Doosan Chaebol 52
Table 3-4: Variables and Their Descriptions................................................................. 59
Table 3-5: Means and Standard Deviation.................................................................... 60
Table 4-1: Ownership in Top-30 Chaebols.................................................................. 70
Table 4-2: Percentage of Outstanding Corporate Equity Held by Various Sectors
in Korea, U.S., and Japan in 1984................................................................ 71
Table 4-3: Ownership Concentration in Korea of 1995................................................ 73
Table 4-4: Mean Values of Ownership, Assets, and Equity in Top-30, 100 Chaebols,
and Non-Chaebols in the Listed Corporations of 1995................................................ 80
Table 4-5: Variables and Their Descriptions............................................................... 84
Table 4-6: Mean and Standard Deviation Values.......................................................... 86
Table 4-7: Correlations Matrix................................................................................... 87
Table 4-8: Determinants of Ownership Concentration with LNOl............................. 89
Table 4-9: Determinants of Ownership Concentration with LN02................................ 92
Table 5-1: Index of Diversification in Big 30 Chaebols (1994)...................................... 104
Table 5-2: Diversification of 135 Chaebols in 1994..................................................... 105
Table 5-4: Means and Standard Deviations of Chaebols and Non-chaebols firms
in the listed firms of 1995............................................................................ 113
Table 5-5: Correlation Matrix..................................................................................... 115
Table 5-6: Determinants of Vertical Integration in All Listed Firms With Vis. 116
Table 5-7: Determinants of Vertical Integration In All Listed Firm VIa...................... 118
Table 6-2: Means and the Standard Deviation.............................................................. 126
Table 6-3: Correlation Matrix..................................................................................... 127
Table 6-4: Ownership Concentration and Performance with LA.................................. 129
Table 6-5: Performance (IA) with Ownership Concentration and Vertical
Integration.................................................................................................. 131
Table 6-6: Performance (IE) with Ownership Concentration and Vertical
Integration................................................................................................... 133
LIST OF FIGURES
Figure 2-1: Market Failure Framework....................................................................... 25

Figure 4-1: Ownership Structure of Hyundai Chaebol................................................ 75
Figure 5-1: Organizational Structure (Hyundai Group).................................................. 99
Figure 5-2: Vertical Integration and Diversification (Hyundai Group)........................ 101
viii
ABSTRACT OF DISSERTATION
Dong Kwan Kang
The Graduate School
University of Kentucky
2002
A dissertation submitted in partial fulfillment of the

requirements for the degree of Doctor of Philosophy in the
Collage of Business and Economics
at the University of Kentucky
By
Dong Kwan Kang
Lexington, Kentucky
Co-Directors: Dr. John Garen, Professor of Gatton School

And Dr. Frank Scott, Professor of Gatton School
Lexington, Kentucky
2002

Two distinguishable features of chaebols, non-separation of ownership from
management and vertical integration at the group level, are of crucial importance in
industrial organization theory because of their strategic significances. These features are
related to agency cost theory and transaction cost theory, respectively. Using these two
theories, this study investigates the determinants of ownership structure (ownership
concentration) and organizational form (degree of vertical integration), how the chaebols
structure affects the determinants of ownership concentration and vertical integration, and
how ownership concentration and vertical integration affect a firms performance in the
Korean private corporations.
In the case of the determinants of ownership concentration, my results suggest
that among determinants, firm size and the firms age are significantly and negatively
while instability and debt-equity ratio are significantly and positively related with inside
ownership concentration. However, firm size and instability are positively and
significantly related with outside ownership concentration. Therefore, the distinguishing
inside and outside ownership concentration is necessary. In addition, the role of
ownership concentration to performance demonstrates that ownership concentration is a
positive and important determinant of a firms performance.
In the case of the determinants of vertical integration, my results demonstrate that
asset-specificity and uncertainty affect vertical integration and, therefore, play an
important role in the decision to adopt vertical integration. In addition, the chaebol firms,
which are vertically integrated at the group level, are found less integrated at the firm or
plant level integration than non-chaebol firms. Interestingly, the estimate reveals that
vertical integration at the firm level is significantly but negatively related to the firms
performance: the more integration at the firm level, the worse the performance. However,
integration at the group level is not related to performance at all.
KEYWORRDS: Vertical Integration, Ownership Concentration, Transaction Cost theory,

Agency Theory
Chapter One: Introduction
1.1 Purpose
Over four decades after the Korean War, Korea has achieved a truly remarkable
economic growth, from one of the poorest countries to one of the leading developing
countries.1 The Korean business groups, the chaebols, have served not only the most
important role of achievement in the development and growth of the Korean economy but
also have been leading the Korean economy. Consequently, the chaebol is one of the most
prominent structures of the Korean economic area. However, it is not easy to define
chaebol exactly. It may be defined as a business group that consists of many formally
independent firms, but under single administrative and controlled by main shareholders,
such as owners, their family members or relatives in many diversified business area.2 There
were 32 chaebols composed of 509 affiliated firms named first as a big business group
by the Anti Trust & Fair Trade Law in 1987.3 According to the Anti Trust & Fair
Committee, total assets of big-30 chaebols composed of 616 affiliated firms in 1994 were
250 U.S. billion dollars and total asset of big-5 chaebols was 138.6 billion dollars, which is
69.5 % of total assets of big-30 chaebols. Total sales of big-30 chaebols were 169.3 billion
1 Korean economy growth of GNP per capita is remarkable: the GNP per capita was
changed from $100 to $2000 in two decades between 1965 to 1985 same as Japan
achieved in two decades between 1950 to 1970. Korea was accepted as a member of
OECD in 1996.
2 According to Yoo and Lee (1987), to be a chaebol, two conditions should be
satisfied: it should be owned by family members or relatives: and it should have diversified
into several business operation. Most Korean Chaebols satisfy these two conditions.
3 The decision of a chaebol (or a big business group) by The Fair Trade Committee
had depended on its total assets (over 400 billion Won) until the law was changed in 1993.
According to the new law, only 30 chaebols are appointed as a big business group by the
dollars and those of big-5 chaebols were 112.3 billion dollars, which is 66.3% of total
amount of big-30 chaebols. The value added amounts by big-30 chaebols were 13.15% of
total value added by all industries.
In contrast to other countries business groups such as the keiretzu in Japan or a
Western conglomerate, the chaebol has some distinguishable features in ownership and
organizational structure; non-separation of ownership from management and vertical
integration at a group level. The inspiration of this dissertation stems from these
distinguishable ownership and organizational structure in Korean private businesses,
especially the Korean big business group, the chaebol. These two distinguishable features
are of crucial importance in industrial organization theory because of their strategic;
significance; non-separation of ownership from management is related to agency cost,
which stems from a principal-agent problem while vertical integration is related to
transaction cost, which stems from opportunistic behavior and bounded rationality.
On one hand, the chaebols affiliated firms maintain relatively higher ownership
concentration though they are much larger, so ownership is not separated from
management. Non-separation of ownership and management is called an owner-
management system. Ownership is retained as the right of dividends and appreciation in
the Western enterprise; consequently, the owner is a non-active decision maker. However,
the owner in the Korean corporation is an active decision maker as the largest shareholder.
In the case of the chaebols affiliated firms, they are bounded by ties of fractional
ownership (e.g., cross subsidy). In the economic point of view, the owner-management
system is associated with managers shirking problems. That is, monitoring by the owners
ranking of its assets.

2
(the insider shareholders) seems to be more efficient than that by the main bank (Japan) or
than that by the market and the border (American and Western). This ownership structure
may be also a safeguard from the hostile takeover and less affected by the fluctuation of
business circumstance. This ownership structure in the Korean private corporations raise
several questions; what factors determine this ownership structure, how ownership
concentration is related to performance, and whether the chaebols ownership structure are
effective to the fluctuation of business circumstance. Seeking the answer to these questions
is one of my purposes of this paper.
On the other hand, the chaebols affiliated firms are integrated at a group level
rather than at a firm or plant level, and diversified into many industries. This chaebols
organization form has been resulted by intermediate market failure after the Korean War
(1950-53), capital market failure by the government intervention in financial markets, and
industrial policies. Though each affiliated firm is formally independent (Korean Commerce
Law prohibits holding companies), it is a subsidiary in reality and one of the divisions in
multi-market structure at the group level. Upward integration at the group level in the
chaebol is adopted as a market strategy to reduce the increased transaction costs by the
uncertainties of market transaction or to generate quasi-rent value from asset-specificity
while downward integration, such as a general trading company and department stores in
the chaebols, can be interpreted as efforts to seek economies of scale as well as transaction
cost economies from certainty and asset specificity. Under this transaction cost theory, my
paper aims to investigate what the determinants of organizational form (degree of vertical
integration) are, how the chaebols organizational form affect vertical integration at the
firm or plant level, and how vertical integration affect the firms performance in the
Korean private corporations.
In sum, the objective of this study is to inveterate the determinants of ownership
concentration and vertical integration in theory, which will reflect Korean business
characteristics, and evidence using Korea listed companies of 1995.
1.2 Overview of Theories and Estimated Results
From corporation revolution in the 1930s in U.S., Berle and Means (1932) draw
attention to separation of ownership from control. They suggest that small professional
managers who may not even have ownership of the assets increasingly centralize owners
nominal property rights of large corporations. That is, the actual power of decision-making
in open corporations has been transferred into the hands of the manager. Thus, the goal of
the owner may deviate from the goal of the manager. Agency costs stem from this
deviation between the owner and the manager. From this phenomenon, the agency cost
was formalized (i.e., Jensen and Meclding, 1976). The incongruence of goals between the
owner (the principal) and the manager (the agent) was an important motif of this theory,
increasing insiders ownership was presented as one solution for eliminating agency costs
and, in turn, achieving better performance.
However, Demsetz and Lehn (1985) insisted that firms for which ownership
matters select their optimal structure and, therefore, there is no significant and positive
relationship between ownership concentration and performance. In addition, they treated
ownership concentration as an endogenous variable rather than an exogenous variable and
proposed a number of potential determinants of ownership concentration, such as capital
resources and control potential in their study. To reflect Korean business environments,
Arm age, debt, and organizational structure are considered as the determinants of
ownership concentration in my study. In addition, ownership concentration is categorized
into two parts, inside and outside ownership concentration. Furthermore, the chaebols
organization is considered as one of the determinants in order to capture the possibility that
it alters the effect on stability: a dummy variable is adopted to measure the effect of
organizational form. The top-30 chaebols firms actually have less ownership
concentration than other firms in inside ownership, but have relatively higher inside
ownership in comparison to their assets or equities. Part of this is assumed to be due to
chaebol membership reducing the positive effect of instability on ownership concentration.
An interaction dummy is used for the measurement of this effect.
The findings from the empirical estimates are that: 1) firm size and uncertainty are
important determinants of inside ownership concentration, which is consistent with
Demsetz and Lehns (1985) view, whereas firm size is significantly and positively related
with outside ownership concentration and uncertainty is insignificantly but negatively
related with outside ownership concentration, 2) the firms age is significantly and
negatively related with inside ownership concentration while the firms age is significantly
but positively related with outside ownership concentration, 3) debt ratio does not show
any relationship with ownership concentration, and 4) the dummy variable reports that
chaebols actually have less inside ownership concentration than other firms, and the
interaction dummy shows that relatively higher inside ownership concentration in
comparison to their assets or equities stems partly from chaebol membership reducing the
positive effect of instability on ownership concentration.
Transaction occurs when a good or service is transferred across a technologically
separable interface. However, there is a cost of using the price mechanism.1 Thus, firms
or inter-organizational exchange exists. That is, by integrating vertically two or more
stages of homogeneous production process in a firm, the firm can eliminate or at least
reduce transaction costs from the separating process in many firms. Therefore, the
theoretical point of departure in vertical integration is transaction cost economies; this
theory started with Coase (1937) and was further developed by Williamson (1975, 1985).
Coase distinguished ex-ante transaction costs such searching, bargaining, and contracting
costs from the costs of production and the costs of organization. In addition to ex-ante
transaction costs, Williamson considered possible ex-post costs of contractual hazards such
as costs of monitoring, settling disputes, renegotiating, arbitration, and litigation. He
developed Coases insights by taking into account two concepts from human nature,
bounded rationality and opportunism. Williamson suggests hierarchy (or hybrid
form) that provides a safeguard from bounded rationality and opportunism because of
better possibilities for control with organizations relative to the market. This governance
form is determined by the level of specialized assets and uncertainty. Thus, asset specificity
and uncertainty are treated as main determinants of vertical integration in theory (e.g.,
Coase, 1937, Williamson, 1975, 1985, Klein, Crawford, and Alchian, 1978) and empirics
(e.g., Monteverde and Teece, 1982, Masten, 1984, Joskow, 1987, Liberman, 1991). To
reflect the Korean business circumstance, the role of an organizational form is considered
as a determinant of vertical integration using a dummy variable; the chaebols firms are
vertically integrated at the group level rather than the him or plant level, so that the firm
that is vertically related with its affiliated firms would be less likely integrated at the firm
or plant level. The empirical measurement shows that 1) the role of asset-specificity and
uncertainty to vertical integration is important and 2) the role of the organizational form is
also significant on the decision to vertical integration.
Whenever a principal (an owner) delegates authority to an agent (a manager) with
the expectation that the delegated authority will act in the principals behalf. However,
the altruistic behavior of the manager causes agency costs, so one solution is increasing
ownership concentration for more effective monitoring of managerial performance.
Transaction costs are particularly significant when the market exchange relates to
specialized assets and uncertainty. These costs relate, for instance, the costs of searching
for the desired inputs, negotiating supply contracts, monitoring and enforcing these
contracts, and the risk associated with unforeseen changes in supply conditions. One
solution is vertical integration to diminish these costs by dealing more efficiently with
bounded rationality, complexity, and tendency towards opportunism faced by the
markets. Therefore, vertical integration is supposed to be a positive relationship with
performance. However, the empirics do not support strongly that an increase of
ownership concentration or/ and vertical integration do affect the firms performance
positively. Vertical integration at firm level is negatively and significant related with the
firms performance: the more integration in the firm level the worse performance. In
addition, the group level integration is not related with performance at all. On the other
hand, ownership concentration is a positive and important determinant of the firms
performance in the case of Korean private companies. The estimation shows both a
linear and a curvilinear relationship between ownership concentration and performance.
1J Organization of Dissertation
The rest of this paper is organized into five chapters in addition to an introduction
(Chapter 1) and a conclusion (Chapter 7).
Chapter 2 provides the theoretical basis for this paper. The objectives of this
chapter are to review theories and empirics about the determinants of ownership and
vertical integration. The reviews include (1) ownership, its determinants, and performance
and (2) vertical integration, its determinants, and performance.
Chapter 3 describes the methods to test the theoretical model empirically. An
adopted basic theoretical model is refined to reflect the Korean business environment. In
addition, this chapter introduces all data sources and statistic values of dependent and
independent variables.
Chapters 4, S, and 6 are about empirical estimates and results based on the
theoretical model. Chapter 4 explores ownership structure and the determinants of
ownership concentration in the Korean business corporation and tests the theoretical model
empirically whereas Chapter 5 explores what determinants of vertical integration are, how
the chaebols are organized in its structure, and how chaebols' structure (vertical integration
at group level) differently affects the determinant of vertical integration. Chapter 6
explores the effects of ownership concentration and vertical integration on the firms
performance.
Chapter Two: Literature review
2.1 Introduction
The objectives of this chapter are to review theories and empirics about ownership
and vertical integration. This review is organized into two parts in addition to an
introduction and a conclusion: (1) ownership, its determinants, and performance and (2)
vertical integration, its determinants, and performance.
The first part is the review of ownership. In the context of corporate governance,
the meaning of ownership of a corporation is different from the general meaning of
ownership. With the corporation revolution, ownership rights in modem corporations
have been changed; the symbol of ownership rights in open corporations is represented
by shareholdings, but normal property rights and the actual power of decision-making are
transferred into the hands of a management group while the shareholders position has
been changed from active decision maker to passive recipient of dividends and
appreciation because widely dispersed ownership cannot exercise any influence over the
firms activities. By extension, it is presumed that managers run the business for the
shareholders best interest. However, this perspective has not been without challengers
who argue that shareholders are not indistinguishable and that the firms performance
depends on the distribution of share ownership among manager and others (McConnell
and Servaes, 1990). The agency cost theory was formalized from this phenomenon, i.e.,
the conflict between the mangers and the shareholders. Jensen and Mecklings (1976)
study shows why insider ownership matters with the firms performance. They presume
that increasing insiders ownership is one solution for eliminating agency costs and, in
turn, predicting better performance. However, the empirics have not supported the view
that greater inside ownership improves performance; that is, the direction of casualty
between ownership concentration and a firms value are not consistent. As a result,
ownership concentration was treated as an endogenous variable instead o f an exogenous
variable, and the firm size and the control potential, for example, are introduced as main
determinants of ownership concentration by Demsetz and Lehn (1986).
The second part discusses vertical integration in terms of transaction cost
economies. Transaction cost theory provided a new approach to look inside the black box
of the firm. The existence of organizations cannot be explained in the context of classical
and neo-classical economy. Coase (1932) explains the existence of the firm with two
reasons, the costs of using the price mechanism (for instance, costs of discovering what
the relevant prices are) and higher contract costs. A more complete model for the
existence of organizations was developed and refined by later organizational theorists and
economists, such as Klein, Crawford, and Alchian (1978), Williamson (1975,1985, and
1995), and Ouchi (1979, 1980). Klein, Crawford, and Alchian (1978) described a firm as
a particular kind or set of interrelated contracts and introduced the concepts of
appropriable rent of specialized assets and opportunistic behavior. An alternative
explanation is transaction cost economies, which is Williamsons reply to why internal
organizations exist. The explanations of transaction cost theory begin under two basic
behavioral assumptions, bounded rationality and opportunism. To eliminate these two
problems, Williamson (1975) suggested a hierarchical governance mechanism, which is
an alternative instrument to the market governance mechanism. However, this theory is
criticized for negligence of the important role of the market system (Robins, 1983) and
the role of social relationships in economic transactions (Granovetter, 1987). Despite
10
these criticisms, transaction cost theory has undeniable authority to answer the
fundamental question of the firms existence. Application of transaction cost theory to
vertical integration was the most direct examination of the firms existence. Two main
aspects, transaction specific investment and uncertainty, are considered the most
important determinants of vertical integration in transaction cost theory. The empirics
also show that the relationships among them are consistently positive. In addition,
transaction cost economies is expected to provide better performance by getting rid of the
bounded rationality and the tendency towards opportunism faced by the market
mechanism. However, the empirics do not show a positive relationship between vertical
integration and performance.
2.2 Ownership, Its Determinants, and Performance
2.2.1 Ownership and Agency Problem
Blair (1995) mentions that ownership generally means the right to possess or
dispose of assets, the right to use assets in any way not specifically prohibited by law or
proscribed by prior contract, the right to claim the proceeds from the sales of asset or the
returns generated by assets, and the responsibility for bearing certain risks associated
with the right of possession and the control of assets. The right of possession and the
control of physical assets are customarily bundled together with the right to receive
benefits from assets and the responsibility for bearing risk associated with its misuse or
with a decline in its value. However, in the context of corporate governance, the meaning
of ownership is different from the general meaning of ownership because in large, in
publicly traded corporations, normal rights that constitute ownership of real property
11
have been unbundled and parceled out to numerous participants in the company9' (Blair,
1995). As consequence, owners nominal property rights and the actual power of
decision-making in open corporations have been transferred into the hands of the
executive group. In addition, the shareholders have become passive property owners
whose major concern is the size of the dividends and/or the current market price of their
shares.
This phenomenon was first described by Adolf A. Berle Jr., and Gardiner C.
Means in their classic, The Modem Corporation and Private Property, first published in
1932. Berle and Means (1932) found that the limitation of capital supply by the owners,
associated with the corporation revolution in massive products, resulted in the dispersion
of ownership and, in turn, in the separation of ownership from management. Berle and
Means historical evidence shows that individual stockholdings in 169 of the 200 largest
non-financial corporations are so widely diffused that effective decision making is
transferred into the hands of a management group from those who hold a majority of the
ownership rights (equity securities). That is, the symbol of ownership rights is transferred
into the hands of the management group such as the executive group or board of directors
who may not own equity or stock while the stockholders position has changed from an
active decision maker to passive recipient of dividends and appreciation. As a consequence,
the value of shareholdings is coming to depend on managers actions.
The agency cost theory was formalized by Jensen and Meckling (1976) from this
phenomenon. The conflict between shareholders and managers comes basically from the
separation of ownership from management in modem corporations. In brief, suppose that
there are two objectives of a principal (owners) and an agent (managers who are hired to
12
run the business for the principals interest) and that owners usually seeks profit
maximization whereas managers usually seeks profit maximization as well as non-
pecuniary benefit maximization, such as their salaries, job securities, size of office and
staff, and so on. In addition, suppose that, in contrast to the agent, the principal does not
have good information about profit possibilities that result from the agents decision.
That is, because of asymmetric information between the principal and the agent, there
may be a substantial divergence of knowledge about the profit possibility frontier.
Therefore, the principal would try to set devices, including monitoring, bonding, and ex
post readjustments in order to induce the agent to make a decision that the principal
prefers. The costs of monitoring, bonding, and the residual losses from slippage are
agency costs. Jensen and Meckling insist that these agency costs may decrease by
increasing the agents ownership because the interests between two objectives, the
principal and the agent, would converge: It is likely that the most important conflict
arises from the fact that as the managers ownership claim falls, his incentive to devote
significant effort to creative activities such as searching out new profitable ventures
falls(p.313). Therefore, they thought a relationship between ownership concentration and
performance would be positive. That is, the higher degree of ownership concentration will
decrease the problems of managers shirking and thus greater profitability will be possible.
However, this theory fails to explain why the large modem corporations are in the
hand of managers. Jensen and Meckling view the firm as a set of contracts between two
objectives of agent and principal with each objective motivated by its self-interest.
When management and risk bearing [ownership] are viewed as naturally separate factors
of production, looking at the market for risk bearing from the viewpoint of portfolio
13
theory tells us that risk bearers are likely to spread their wealth across many firms and so
not be interested in directly controlling the management of any individual firm(Fama,
1980). In addition, internal monitoring of managers by managers themselves (a natural
process of monitoring from a higher to a lower level of management) and outside
monitoring by the managerial labor market were overlooked.1
In sum, separation of ownership and management from the corporation
revolution changed ownership position from an active decision maker to a passive
recipient, so that the incongruence of interests between the principal and the agent was an
important motif of agency cost theory. Increasing insiders' ownership was presented as
one solution for eliminating agency costs and, in turn, achieving better performance.
However, the empirics have not supported this expectation. This will be described in the
next section in detail and discussed about the new views of the relationship between
ownership concentration and performance from the empirics.
2.2.2 Empirical Relationship Between Ownership and Performance
Empirical studies raise an important question about the nature of a relationship
between ownership concentration and a firms value (or a firms performance) because
1 Therefore, Fama and Jensen (1983) insisted that the problem of separation of
ownership and management could be controlled by decision systems that separate the
management (initiation and implementation) and control (ratification and monitoring) of
important decisions at all levels of the organization. They state, Devices for separation
decision management and decision control include (1) decision hierarchies in which the
decision initiatives of lower level agents are passed on to higher level agents, first from
ratification and then for monitoring, (2) boards of directors that ratify and monitoring the
organizations most important decisions and hire, fire, and compensate top-level decision
managers, and (3) incentive structures that encourage mutual monitoring among decision
agents. (p. 328)
14
simple theoretical arguments alone cannot explain clearly the relationship. Formalization
of the relationship between ownership and a firms value, therefore, has been persistently
disputed in the empirics. The relations can be explained with three hypotheses; (1) the
convergence-of-interest hypothesis (i.e., Jensen and Meckling, 1976) that predicts that the
larger inside ownership concentration should be associated with the higher market value
of the firm or higher firms performance, (2) the entrenchment hypothesis (i.e., Morck,
Shleifer, and Vishny, 1988) that predict that the market value or the performance of the
firm can be adversely affected for some ranges of high ownership concentration because
of managements entrenchment behaviors, and (3) the optimal structure hypothesis
(i.e., Demsetz, 1983 and Demsetz and Lehn, 1985) that expects that ownership does not
relate with performance (profitability) because firms for which ownership matter will
have selected their optimal structure of ownership already.
As mentioned earlier, asymmetric information of the production function as well
as profit possibilities and different interests between two objectives, i.e., the agent and the
principal, bear agency costs. These agency costs include the costs of monitoring by the
principal, and of bonding by the agent plus of the residual loss incurred by the agent.
Jensen and Meckling suggest that agency costs could be reduced (but not wholly) by
increasing the agents ownership. As a consequence, agency cost hypothesis predicts that
an increase in the agents ownership would generate higher performance; the increased
the agents ownership induces two objectives, the principal and the agent, to converge
into same interest. It is called the convergence-of-interest hypothesis.
However, Demsetz (1983) and Demsetz and Lehn (1985) insist that the ownership
structure of the firm does not relate with the firms performance (profitability). Demsetz
15
and Lehn (1985) state, A decision by shareholders to alter the ownership structure of
their firm from concentrated to diffuse should be a decision made in awareness o f its
consequences for loosening control over professional management. The higher cost and
reduced profit that would be associated with this loosening in owner control should be
offset by lower capital acquisition cost or other profit-enhancing aspects of diffuse
ownership if shareholders choose to broaden ownership. It means that firms for which
ownership matter will have selected their optimal structure of ownership already, so the
general regression of performance on equilibrium ownership structure should be yield no
significant positive result. This is called the optimal structure hypothesis. Their test,
using 511 U.S. firms from 1976 to 1980 shows what they expected: no significant
positive relationship and no support to the Berle and Means and Jensen and Mecklings
view.
In addition, Prowse (1992), Weinstein and Yafeh (1998), and Miwa and
Ramseyer (2000) discovered no relationship between performance and ownership. Using
a linear model with 734 firms from 1979 to 1984, Prowse found no significant
relationship between ownership concentration and accounting profit rates for either the
Japanese keiretzu or non-keiretzu firms; the coefficients of profit rate in both keiretzu and
non-keiretzu firms on ownership concentration are positive, but insignificant. No
evidence of any non-monotonic relationship between ownership concentration and
profitability is also found in the both cases. In addition, Weinstein and Yafeh discovered
no relationship between top-10 ownership concentration and performance (profit/sale),
using a linear model with 686 firms from 1977 to 1986. Miwa and Ramseyer also
mentioned, Because ownership was endogenous to expected performance, it seldom
16
made sense to regress profitability on ownership. They confirm the essential logic of
Demsetz and Lehn (optimal structure hypothesis) using a database of 637 large firms
from 1953 and 710 from 1958.
On the other hand, Morck, Shleifer, and Vishny (1988), McConnell and Servaes
(1990), Hermalin and Weisbach (1992), and Holdemess, Kroszner, and Sheehan (1999)
show a curvilinear relationship between ownership concentration and performance, which
supports a convergence-of-interest hypothesis in some ranges of a lower ownership level
and an entrenchment hypothesis in some ranges of a higher ownership level.
Morck, Shleifer, and Vishny (1998) suggest that the relationship between
ownership and corporate value is non-monotonic, so that Demsetz and Lehn (1985) failed
to find a relationship between ownership concentration and profitability by using a linear
specification that does not capture an important non-monotonic relation. They estimate a
piece-wise linear regression in which the dependent variable is Tobins q, defined as the
ratio of the market value of a firms securities to the replacement costs of the firms plant
and inventories, and the primary independent variable as the portion of shares of insider
owners. Using a sample of 371 Fortune 500 firms for 1980, they find that Tobins q rises
first as the insider ownership increases up to 5%, then falls as the insider ownership
increases to 25%, and lastly, rises slightly with more than 25% insider ownership. This
study implies that effective managerial control of the firm occurs at 25%, the point at
which a firms value begins to rise.
McConnell and Servaes (1990) also found a non-monotonic but curvilinear
relationship between ownership concentration and profitability. They investigated the
relationship between Tobins q and the structure of equity ownership for a sample of
17
1,173 firms for 1976 and 1,093 firms for 1986. They found a significant curvilinear
relation between Tobins q and the fraction of common stock owned by corporate
insiders. Whereas Morck, Shleifer, and Vishny found that Tobins q increased up to 5 %
level of ownership and then decreased, McConnell and Servaes found that the curve
slopes upward until insider ownership reaches approximately 40% to 50% and then
slopes slightly downward.
In addition, Hermalin and Weisbachs (1991) estimations with 142 NYSE firms
from 1971 to 1983 provide more evidence for a convergence-of-interest and an
entrenchment hypothesis. They revealed a non monotonic relationship between Tobins q
and CEO stock ownership but their results are different from those of Morck et al and
McConnell and Servaes; Tobins q and CEO stock ownership is positive between 0% and
1%, negative between 1% and 5%, positive between 5% and 20%, and negative after that.
Moreover, Holdemess, Kroszner and Sheehan (1999) found a similar result using
1,236 U.S. firms from 1935 and 3,759 from 1995; Tobins q and director stock ownership
are positive between 0 % and 5%, but negative from 5% to 25%. After that, the
coefficients are not significant at all.
On the other hand, some economists insist that the agency problem can be reduced
(but never be zero) by expected future salary of the agent (Kaplan, 1994), by dividends
(Easterbrook, 1984), by the managerial labor market (Fama, 1980), or by the threat of an
outside takeover. For instance, the compensation policy induces the manager to choose
actions close to shareholders interest (i.e., maximum profits). Kaplan (1994) found that
cash compensation for top executives in Japan and the U.S are highly related with the
firms performance. A 100 % increase in stock returns is associated with a 9.5 % increase
18
in salary and bonus, and a 100% increase in sales is associated with a 24.7 increase on cash
compensation, whereas a 100 % increase in stock returns and in sales growth are associated
with a 15.4 % and a 23.3 % increase in cash compensation, respectively. Jensen and
Murphys (1990) study, however, show that the sensitivity of managers salary to firm
performances is low (3.25 dollars increase in salary to the 1,000 dollars increase in the
value of the corporation) and the results are inconsistent with the implication of formal
agency model of optimal contracting.
In sum, the principal-agent problem raised an important question about the
direction of casualty between ownership concentration and a firms value; whereas
optimal structure hypothesis supporters insist that firms for which ownership matters
will have selected their optimal ownership structure already, while convergence-of-
interest and entrenchment hypothesis supporters insist that the firm value is a function of
the structure of equity ownership. However, the empirics do not show a consistent
relationship between ownership concentration and performance.
2.2.3 The Determinant of Ownership Concentration
On one hand, Berle and Means (1932) study gave economists notice of
separation between ownership and management, with a greater dispersion of stock
ownership, a steady reduction in the power and interest of the stockholder, and a gradual
enhancement of managerial authority. On the other hand, Jensen and Mecklings (1976)
hypothesis raised an empirically important question about the direction of relationship
between ownership concentration and a firms value. However, it was a question about
the degree of ownership concentration as an exogenous variable, which affects financial
19
policy associated with, for example, a dividend and capital structure and management
performance in private corporations, until Demsetz and Lehn (1985) consider the degree
of ownership concentration as an endogenous variable. As mentioned above, Demsetz
and Lehns understanding of the relationship between ownership and performance is that
firms for which ownership matters will have selected their optimal ownership structure
already, so that the general regression of performance on equilibrium ownership structure
should yield no significant result. Therefore, they treated ownership concentration as an
endogenous variable rather than an exogenous variable and proposed a number of
potential determinants of ownership concentration in their study.
According to Demsetz and Lehn, one determinant of ownership concentration is
the value-maximizing size of a firm because the larger is the competitively viable size,
ceteris paribus, the larger is the firms capital resources and generally, the greater market
value of a given fraction of ownership. The higher price of a given fraction of the firm
should, in itself, reduce the degree to which ownership is concentrated. Moreover, a
given degree o f control generally requires a small share of the firm the larger is the firm.
Both these effects may imply greater diffuseness of ownership the larger is a firm. This
may be termed the risk-neutral effect of size on ownership. In addition, normal risk
aversion implies that a shareholder would increase his ownership proportion of a firm
only at lower, risk compensating prices.
Empirical tests (Demsetz and Lehn, 1985 and Prowse, 1992) show a negative
relation between firm size and ownership concentration. In the Demsetz and Lehn study,
using a sample of 511 U.S. corporations in the late 1970s, the size of a firm, as measured
by the market value of equity, is negatively related to ownership concentration and the
20
estimated coefficient is statistically significant at the 5% level. In addition, Prowses
study, using a sample of Japanese firms in the mid 1980s, reveals the same result; firm
size, as measured by market value of equity, is positively and significantly related with
ownership concentration in the non-keiretzu firms and positively but not significantly in
keiretsu firms.
The second possible determinant is business environment. Demsetz and Lehn
(1985) call it control potential," which means the wealth gain achievable through more
effective monitoring of managerial performance by an owner. They assume that neither
the markets for corporate control nor the managerial labor market operate costlessly. If
these markets are perfectly operated, then control potential would play no role in
explaining the ownership structure. Firms that transact in markets characterized by
stable prices, stable technology, stable market share, and so forth are firms in which
managerial performance can be monitored at relatively low cost. In addition, they
postulate that control potential is likely correlated with environmental noise. The tighter
control will pay off to the owner if a firm faces more noise in its environment.
Accordingly, noisier environments should give rise to more concentrated ownership
structures. Empirical tests by Demsetz and Lehn (1985), Levy (1984), and Prowse
(1992) show a positive relationship with ownership concentration. Demsetz and Lehn
used three proxy variables for stability: 1) a firms specific risk, as measured by the
standard error of estimate calculated from the market model,2 2) the standard deviation
2 The capital asset pricing model (CAPM) describes the relationship between the
security and market returns. Specially, the market model holds that returns on an
individual security are linearly related to an index of market returns. This concept divides
a security's expected excess return into two parts: 1) market related and 2) non-market-
related returns. This can be expressed simply:
21
o f monthly stock market rates of returns, and 3) the standard deviation of yearly income.
They found positive relationships between ownership concentration and these proxy
variables of stability. However, this positive relationship between ownership and business
environment is contrary to the viewpoint o f portfolio theory that risk bearers are likely to
spread their wealth across many firms and so not be interested in directly controlling the
management of any individual firm; Common stock allows residual risk to be spread
across many residual claimants who individually choose the extent to which they bear
risk and who can diversify across organizations offering such claims. Other things being
equal, portfolio theory implies that such unrestricted risk sharing lowers the cost of risk-
bearing services (Fama, 1980).
2 J Vertical Integration, Its Determinants and Performance
2 3 A The Nature of The Firm and Transaction Cost
A question, why do organizations exit,3 may sound odd in classical and neo
classical economic theories, which explain that the economy is operated by the decentralized
system of prices (i.e., an invisible hand) without any planned centralized system (i.e., a
hierarchically governed system like a firm or an organization). In the context of classical
and neo-classical economics, the rise and existence of the centralized system cannot be
explained because these theories define a firm as a technological black box, which would try
Expected Return = ALPHA + BETA* Market related + error

BETA means the systematic risk coefficient that expresses the expected response of
asset or portfolio returns to excess returns on a market portfolio. See Robert Hargin
(1979) for more detail.
3 There are five major theoretical approaches to understanding organizations; the
population-ecology model, the resource-dependence model, the rational contingency
model, the transaction-cost model, and the institutional model. Of course, I focus on the
transaction cost model here. For detail, see Hall (1996).
22
to maximize its profits under the given prices of labor and capital that were set by market
conditions. In addition, these theories assume that individuals will act in their own self-
interests and that simple transactions happen on-the-spot1and are conducted freely. Over
history, however, the market environment in which transactions took place became
increasingly uncertain and more complex, so that simple trust in relationships with
respect to transactions became more problematic. As a consequence, the planed or
centralized systems instead of the decentralized systems have been required.
A new conception of a firm as a centralized governance system instead of a
market is introduced by Coases article (1937), The Nature of A Firm. It was an
attempt to connect between two assumptions, the allocation of resources in a firm and the
allocation in the market price mechanism. Coase mentioned, The purpose of this paper
is to bridge what appears to be a gap in economic theory between the assumption that
resources are allocated by means of the price mechanism and the assumption that this
allocation is dependant on the entrepreneur-coordinator.
Coase puts a distinguishable mark of a firm and tried to develop a theory of the
firm that is both realistic and tractable; Outside the firm, price movements direct
production, which is co-ordinated through a series of exchange transaction on the market.
Within a firm, these market transactions are eliminated and in place of the complicated
market structure with exchange transactions is substituted the entrepreneur-coordinator,
who directs production. It is clear that these are alternative methods of co-ordinating
production (p.388). Therefore, he assumed that distinguishing mark of the firm is the
supersession of the price mechanism because of (1) costs of using the price mechanism
(costs of discovering what the relevant prices are); the market transaction cost can be
23
eliminated and the complications of market exchange can be avoided in the firm and 2)
higher contract costs that may be saved by making a long term contract or integration for
supply of the intermediate goods or services instead of a successive short term contract.
However, by Coases (1972) own admission, The Nature of A Firm was much cited
but little used because of Coases failure to explain precisely about which transactions
will be left to the markets and which will be internalized within firms. A more complete
model of the costs using the price mechanism to manage economic exchange was
developed and refined by later organizational theorists and economists, such as
Williamson (1975,1985, 1995), Klein, Crawford, and Alchian (1978), and Ouchi (1980).
The best alternative explanation is transaction cost economies which is Oliver
Williamsons reply to why internal organizations exist. It is an alternative explanation for
the existence of the governance system and a study how trading partners protect themselves
from the hazardous activities between them.
Transaction cost theory starts from two basic behavioral assumptions: bounded
rationality and opportunism. These relationships between human factors and environmental
factor are shown in Figure2-1. Bounded rationality means the limits of cognition. Without
cognitive limits, all exchange could be conducted through planning; Bounded rationality
is the cognitive assumption on which transaction cost economies relies. This is a semi
strong form of rationality in which economic actors are assumed to be intendedly
rational, but only limitedly so (Simon. 1961) (Williamson, 1985).
Without bounded rationality, economic actors could write contracts of unlimited
complexity that would specify all possible contingencies in an economic exchange. On the
24
Figure 2-1: Market Failure Framework
Market Failure Framework
Human factors Environmental Factors
Bounded Rationality < > Uncertainty/ Complexity
Opportunism < > Small Numbers
Adopted from Williamson (1975)
25
other hand, opportunism comes from bounded rationality faced by unforeseeable future
uncertainty. Without unforeseeable uncertainty, bounded rationality is irrelevant.
For instance, bilateral monopoly between a buyer and a seller arises because benefits
from trade between them are increased by specific asset investments that are specialized to
their trade (Williamson called it asset specificity). Such specific asset investments give
rise to appropriable quasi-rents; the higher level of specific asset investment will increase
the threat of opportunism. That is, the asset specificity causes the quasi-rent value, and, in
turn, the quasi-rent creates additional incentives for opportunism. While traditional
economic theory assumes simply that economic actors behave out of self-interest,
transaction cost economies assumes the possibility of self-interest with guile. This
[opportunism] includes but is scarcely limited to more blatant forms, such as lying,
stealing, and cheating. Opportunism more often involves subtle forms of deceit. Both
active and passive forms and both ex ante (e.g., adverse selection) and ex post (e.g.,
moral hazard) types are included... More generally, opportunism refers to the incomplete
or distorted disclosure of information, especially to calculated efforts to mislead, distort,
disguise, obfuscate, or otherwise confuse (Williamson, 1975). That is, a situation in
which economic actors are in a position to exploit some vulnerability of a firm causes
opportunistic behavior or a hold up problem. Therefore, opportunism causes higher
contract costs that may be saved by making a long-term contract or integration for supply
of the intermediate goods or services instead of successive short-term contracts: vertical
control by a single ownership can substitute for successive short-term contractual
arrangements made across markets and, in turn, reduce transaction cost.
26
Vertical control, i.e., a hierarchical governance mechanism, is Williamsons answer
(198S) for these bounded rationality and opportunism problems. The hierarchical
governance mechanism is an alternative instrument for the market governance mechanism
in transaction or exchange of goods and services. In general, if there exists higher risk in the
transaction because of uncertainty and/or a higher level of specific asset investment, markets
and contracts (or other forms of a market governance system) are less likely and the
hierarchical forms of governance are more likely. Though the hierarchical form of
governance system is costly, it is acceptable if the hierarchical governance mechanism can
reduce uncertainty and complexity stemmed from bounded rationality and the tendency
towards opportunism faced by the market governance mechanism. Of course, the marginal
benefit from the hierarchical governance mechanism should be greater than or at least equal
to the marginal cost of bounded rationality and the tendency towards opportunism.
Contrary to transaction cost economies view, institutional theorists, for instance,
insist that cultural and social forces have important roles in organization (Ouchi, 1979,
1980; Wilkins and Ouchi, 1983; Smircich, 1983; DiMaggio and Powell, 1983;
Granovetter, 1985; Scott, 1987: Hall, 1996). Culture is usually defined as social or
normative glue that holds an organization together (Smircich, 1983). It expresses the
values or social ideas and the beliefs that organization members come to share. These
values or patterns of belief are manifested by symbolic devices such as myths, rituals,
stories, legends, and specialized language.4 In this point of view, transaction cost theory
4 Scott (1987) reviewed institutional theories used in organizational analysis and

categorized them into four ways: (1) as a process of instilling value, which views
organizational structure as an adaptive vehicle shaped in reaction to the characteristics
and commitments of participants as well as to influences and constraints from external
environment, (2) as a process of creating reality (legitimacy of institutional practice)
27
underestimates the role of social and cultural forces in economic activity. Granovetter
(1985) points out that transactions are embedded within networks of social relationships
and influenced by expectations that are formed by the history of relationships. Therefore,
abstract transaction dimensions such as asset specificity and uncertainty do not alone
determine the governance arrangements. Close friends, for example, may trade co
specialized assets without hierarchy, a formal contract, or other tangible credible
commitments because they trust one another.
The clan is considered an alternative mode for transaction that adopts the
concept of institutional theorists views. The clan is able to be efficient in governing
transactions under conditions of relatively high uncertainty and complexity. To do so,
however, it requires relatively high levels of goal congruence and the sharing of some
general paradigm that helps participants determine collective interest (Wilkins and
Ouchi, 1983). Ouchi (1980) extended the transaction cost framework to describe this
alternative way of coordinating activities within firms. Transaction costs arise
principally when it is difficult to determine the value of the goods or service. Such
which views organization as the social process by which individuals come to accept a
shared definition of social reality, (3) as a class of element, which views organization as
pertaining to a distinctive set of elements that can account for the existence, and (4) as
distinct societal spheres, which views organization as both symbolic-cognitive and
normative- system and behavioral system. In addition, organization is considered as a
process of isomorphism (DiMaggio and Powell, 1983): Coercive isomorphism stems
from the influence of political power and the problem of institutional legitimacy, mimetic
isomorphism results from standard response to uncertainty, and normative isomorphism
is associated with professionalization, which means the collective struggle of members of
an occupation to define the condition and methods of their work and to establish a
cognitive base and legitimating for their occupational autonomy. Organization of Korean
chaebol can be explained with DiMaggio and Powells view: the centralized capital
resource in domestic as well as foreign loan (i.e., capital market failure) after military
revolution (1959) is one of example of coercive isomorphism whereas instability of
political situation and resource market after Korean War are the examples of mimetic
isomorphism.
28
difficulties can arise from the underlying nature of the goods or service or from a lack of
trust between the parties. To solve these problems, he suggested a clan form. This
form focuses on the socialization of individuals into an organization. This form can be
efficient when the objectives of individuals are congruent but performance evaluations
are not ambiguous.s For instance, Japanese firms rely to a great extent upon hiring
inexperienced workers, socializing them to accept the companys goals as their own, and
compensating them according to length of service, number of dependents, and other non
performance criteria. It is not necessary for these organizations to measure performance
to control or direct their employees, since the employees natural (socialized) inclination
is to do what is best for the firm. It is also unnecessary to derive explicit, verifiable
measures of value added, since rewards are distributed according to non-performance-
related criteria that are relatively inexpensive to determine (Ouchi, 1980, p. 132). The
clan, then, can be efficient in governing transactions under conditions of relatively high
uncertainty as well as complexity.
Internal organizations may be an efficient governance structure. However,
hierarchical structure may cause some costs such as attenuated incentives, lower quality,
and bureaucratic distortions. Thus, The lower the appropriable specialized quasi-rents,
the more likely that transactions will rely on contractual relationships than common
ownership. And conversely integration by common or joint ownership is more likely, the
higher the appropriable specialized quasi-rents of the assets involved (Klein, Crawford,
and Alchian, 1978). The problems, bounded rationality and opportunism, can be
s Z-organizations such as Hewlett-Packard and Intel are more like clans than
bureaucracies and markets because they foster close interchange between work and social
life. (Ouchi, 1981) In addition, Korean chaebol and Japanese keiretzu are considered as
clans.
29
mitigated by various contracts. Various contractual agreements may be employed where
both spot markets and complete vertical integration are relatively costly methods for
organizing the transfer; contractual governance over opportunism or bounded rationality
may not be costly when specific asset investments are not substantial. Long-term
contracts are often designed to resolve supply or demand reliability problems. An
equivalent series of short-term contracts might represent a compromise between
reliability and flexibility to adapt the relationship to changing market conditions.
Exclusive dealing and requirements contracts also economize on search costs and at least
partially address certain externalities that arise with pure spot market exchange of
particular products. Franchising agreements represent more complex market adaptations
that are largely designed to alleviate simultaneous opportunistic inclinations on the part
of both trading parties (Blair and Kaserman, 1983).
In sum, despite criticisms6 of transaction cost theory, transaction cost theory has
undeniable authority to answer the fundamental question of why firms exist. Transaction
cost theory provides a new approach to look inside the black box of the firm for
organization theorists.
2.3.2 Determinants of Vertical Integration
Application of transaction cost theory can be found in many forms such as
vertical integration, multidivisional form, and hybrid forms of organization. Specifically,
6 Transaction cost theory (TCT) is criticized with these points: (1) TCT focuses on
cost minimization because minimizing transaction costs is relatively little benefit in case
of exist of well developed markets and no specific assets with regard to uncertainty
(Robins, 1983); and TCT neglect the role of social relationships in economic transaction
(Granovetter, 1987)
30
application of transaction cost theory to vertical integration was the most direct
examination of the question why do organizations exist? In this section, I will review
the determinants of vertical integration in association with transaction cost economies.
Asset Specificity
In transaction cost economics, the primary determinant of vertical integration is
asset specificity. Coases article (1932) explains the nature of the firm versus market in
terms of vertical integration. Work by economists (e.g., Williamson, 1975, 1985 and
Klein, Crawford, and Alchian, 1978) produced an explanation of vertical integration
based on asset specificity and avoidance of opportunism. Asset specificity means that
investments in assets between a buyer and a seller (or between a downstream firm and an
upstream firm) are specialized, so that the gains from trade between them (i.e., a bilateral
monopoly relationship) rather than the others are profitable. However, the existence of
specific assets often leads to possibilities of a hold up situation in which one party is in
a position to exploit some vulnerability of another party. Such exploitation is often an
example of opportunistic behavior and the amount, which can be exploited, is the
appropriable quasi-rent. Therefore, opportunistic behavior may occur when one party can
take advantages of its position with respect to another party, as either a buyer or seller.
Therefore, the two assets together (a hierarchical governance mechanism) are worth more
if they are owned by one party than if they are separately owned, and this is the
fundamental requirement of vertical integration. That is, though the hierarchical
governance mechanism is costly, it is acceptable if the hierarchical governance
mechanism can reduce the tendency towards opportunism faced by the market
31
governance mechanism in association with asset specific investment. Of course, the
marginal benefit from the hierarchical governance mechanism should be greater than or
equal to the marginal cost of the tendency towards opportunism.
Asset specificity takes a variety of forms such as site specificity, physical asset
specificity, human asset specificity, and dedicated specificity. (For more detail, see
Williamson, 1985, p. 95) The first is site-specificity such as cheek-by-jowl
relationship. For example, physical proximity of contracting firms in the coal market
(e.g., Joskow, 1985 and Spiller, 1985) and the average distance shipped (e.g., Levy,
1985) are used for the proxy variables of site specificity. Second is physical asset
specificity, referring to relationship-specific equipment and machinery. Empirically,
R&D (e.g., Levy, 1985 and MacDonald, 1984) and sunk cost (e.g., Joskow, 1985;
MacDonald, 1984; and Lieberman, 1991) are used as proxy variables. The third is human
asset specificity, describing transaction-specific knowledge or human capital, achieved
through specialized training or leaming-by-doing (e.g., Monteverde and Teece, 1982).
The last is dedicated specificity, referring to investments that are dedicated assets (e.g.,
Joskow, 1987) that involve expanding an existing plant on behalf of a particular buyer. In
sum, the predicted effect of asset specificity on vertical integration is positive when a
firm makes higher specified investments.
Uncertainty
Uncertainty is another determinant of vertical integration. Where there are
specific assets in two firms, as either a supplier or a consumer, changes in circumstances
may lead to change in efficient modes of cooperation and gains from cooperation may
32
increase or decrease. When there is no integration, and assets are separately owned,
owners of assets will then bargain over responses to changed market circumstances and
over the division of gains or losses from these same circumstances because all complex
contracts are incomplete. Writing a contract with enough specificity to avoid any
opportunistic behavior is impossible; it is impossible to enumerate all possible
contingencies and/or stipulate appropriate adaptations to contracts in advance to the
unpredictable change of market circumstances because of bounded rationality.
Therefore, hold up may occur in the case that one firm can take advantages of its
position with respect to another firm, as either a buyer or a seller. Such re-negotiation on
the contract over hold up is costly and time consuming. Even if a contract could be
written with sufficient specificity, enforcement would be difficult. For instance, in many
of the cases where appropriative quasi-rent is possible, time is important, so that the delay
associated with litigation over a contract breach might itself impose substantial costs on
the firm. Therefore, the best solution is ownership that is the right to control the use of
assets within a firm.
Evidence
Empirical evidence shows that these two determinants are positively and
importantly related with the degree of vertical integration. The following explanations of
empirical work are summarized in Table2-l.
Armour and Teece (1980) regressed the number of primary production stages in
the U.S. petroleum industry from 1954 to 1975 on measures of asset specificity such as
expenditure amounts of basic and applied materials and R&D costs. They found positive
33
Table 2-1: Empirics in Vertical Integration and Its Determinants
Authors Data Determinants Vertical Methodology

Integration
Liebennan 34 organic Asset specificity; number o f Zero/one Backward
(1991) chemical products upstream supplier (+), sunk cost dummy for Integration
o f U.S. in 1980 (+), cost o f a upstream input(+, each &Logit
significant) downstream analysis
Uncertainty; Demand product and
variability^-*-, significant) producer
Anderson & Electronic Asset specificity; physical and Use o f direct Survey data
Schmittlein components dedicated asset (+) sales force & Logit
(1984) industry Uncertainty; deviation between analysis
forecast and actual sales (-)
Frequency; territory density (-),
Firm size (+, significant)
MacMillan, Consumer (178), Market share (+, significant) 1- Multiple
Hambrick, & Capital (99), Uncertainty; concentration o f purchase/costs regression
Pennings &Component purchases (-, significant), sales o f goods sold
(1986) (275) firms growth (-/+), sales instability (+,
significant)
John& 87 industrial Human specific asset; sales skill LN[%sold to Survey data
Weitz (1988) goods firms (+, significant) end-users/(l- & Logit
Environmental and Behavioral [%sold to end- analysis
Uncertainty (+, significant) users )]
Masten 1,887 component Design specificity: complex or Make or buy Maximum
(1984) firms in aerospace specialized items (+, significant), likelihood
industry standardized item (-) estimates
Site specificity: co-location o f
assets or processes (+)
Monteverde 133 auto Asset specificity; transaction- Percentage of Probit
& Teece components specific skills (+, significant), in-house analysis
(1982) specific items (+. Significant), production
system effect (+, significant)
Levy(1985) 69 firms Asset specificity; distance (+/-), Value OLS
R&D (+, significant), advertise added/sales
intensity (+/-), firm size (+,
significant).
Uncertainty; sales fluctuation and
systematic risk in profit (+,
significant)
Joskow 277 observations Physical asset specificity (+, Annual Multiple
(1987) of contracts or significant) contract regression
complete Site asset specificity (+, quantities
ownership by coal significant)
burning electric Dedicated asset specificity (+,
generating plants significant)
Armour & US petroleum Asset specificity: expenditure on Number of Multiple
Teece (1980) industry basic, applied, or development primary regression
research (+, significant) production
stages
34
relationships between them with at least the 10 % significance level. Monteverde and
Teece (1982) also found that the percentage of in-house production has a positive
relationship with asset specificity such as transaction specific skills, specific items, and
system effects. The result of the probit model, using data of 133 auto components,
supported the view that transaction cost considerations surrounding the development and
deepening of human skills have important ramifications for delineating efficient
organizational boundaries.
Based on a probit model, Masten (1984) tested the dichotomous choice between
internal and external procurement of supplies. The results support the contention that
design specificity and complexity are important determinants of integration necessary in
the aerospace system; specificity and complexity of items are positively and highly
significant at the 1 % level and co-location of assets or processes and standardization of
items have the expected sign but lower statistical confidence.
Anderson and Schmittlein (1984) analyzed survey data of electric components
industry with the logit model. As expected, integration was associated with increasing
levels of asset specificity, difficulty of performance evaluation, and the combination of
these factors. Contrary to the transaction cost model, neither frequency of transactions
nor the interaction of specificity and environmental uncertainty was significantly related
to integration. The transaction cost model improves significantly upon the fit of a simple
model relating integration to company size alone.
Levy (1985) analyzed the relationship between the degree of vertical integration
(the ratio of value added amount to sales) and asset specificity and uncertainty,
respectively, using ordinary least regressions with 69 firms. He found that R&D intensity,
35
firm size, sales fluctuation, and systematic risk (P) are positively and significantly related
with the degree of vertical integration.
MacMillan, Hambrick, and Pennings (1986) examined the relationship between
backward integration and two views of uncertainty and the threat of supplier retaliation,
respectively; that is, the extent to which integration relieves the uncertainty of supply for
a firm facing a variable demand function and the threat that existing suppliers will
retaliate if such vertical integration is attempted. The multiple regression results provided
the evidence that buyers would be discouraged from backward vertical integration if both
the likelihood and the severity of retaliation were high.
Joskow (1987) examined the importance of specifically related investments in
determining the duration of coal contracts negotiated between coal suppliers and electric
utilities. Using multiple regressions with 277 observations of coal contracts by coal
burning electricity generating plants, the results provided strong support for the view of
transaction cost economies; annual contract quantities are significantly and positively
related with physical, site, and dedicated asset specificities. That is, the buyers and sellers
make longer commitments to the terms of future trade at the contract execution stage, and
rely less on repeated bargaining, when specifically related investments are more
important.
John and Weitz (1988) used survey data of 87 industrial firms with sales over $50
million. The model explained about 28 % of variation in sale volume through the direct
channel. They found that human specific asset (salesmen skill), environmental
uncertainty and behavioral uncertainty are positively related with the degree of vertical
integration with at least the 5 % significance level.
36
The study of Lieberman (1991) confirmed that transaction costs and demand
variability have both been important determinants of integration in the chemical
manufacturing sectors. Using 34 organic chemical products of the U.S. in 1980, he uses a
logit model of firms, backward integration choices; zero/one dummy for each
downstream integration as a dependent variable on sunk costs, input costs and a number
of upstream suppliers as independent variables. The results show that sunk costs, input
costs, and a number of upstream suppliers have a significantly positive relationship at the
5%, 1%, and 1% level in t-value, respectively
In sum, the transaction cost theory focuses on two aspects, transaction specific
investment and uncertainty, which are the most important determinants of vertical
integration. The relationship is theoretically as well as empirically consistent.
Theoretically, it is acceptable if the hierarchical governance mechanism can get rid of the
tendency towards opportunism faced by the market governance mechanism or as long as
the marginal benefit from the hierarchical governance mechanism is greater than or equal
to the marginal cost of the tendency towards opportunism. In addition, many empirics
support that vertical integration with regard to transaction cost economies has positively
important relationships with asset specificity and uncertainty.
2.3.3 Performance and Vertical Integration
Hierarchical structure of an internal organization may be an efficient governance
system for better performance. First of all, as mentioned above, vertical integration
generates transaction cost economies by getting rid of the tendency towards opportunism
faced by the market governance mechanism. Therefore, vertical integration associated
37
with asset specific investment and uncertainty in demands and/or supplies is expected to
provide better performance. For instance, when environment is uncertain, vertical
integration may result in cost increase through unimproved coordination of production,
R&D, and inventory scheduling between stages; improvement in coordination of production
(Alchian and Demsetz, 1972) and inventory scheduling between stages are other benefits
from vertical integration. Moreover, vertical integration generates technological economies.
The cost function is said, for instance, to be stricdy sub-additive if for any multiple of
outputs qi, q:...... qn. the summation of each cost of q, are greater than summation cost of all
qt. That is, sub-additive means that it costs less to produce the various outputs together than
to produce them separately. For example, integrated production of steel enables the metal to
remain hot from the blast furnace to carbon bum-off to rolling and drawing. Costly
reheating at each stage is eliminated. Finally, vertical integration may get benefits from
higher entry barriers, which results in market power (e.g., Stigler, 1957; Comanor, 1967;
and Williamson, 1979). If a firm wants to enter into a new industry, it needs a condition that
the firm can operate under or equal to the minimum efficient scale that the other firms do.
Therefore, vertical integration may discourage potential new entrants.
However, vertical integration may not pay off when the negative effects from
integration outweigh the positive ones; too much vertical integration may reduce
flexibility to market condition once vertical integration is set up (Harrigan, 1983). It may
cause other costs such as inefficiency in overall functioning as well as attenuated
incentives and bureaucratic distortion. As a firm gets larger, there may be decreasing
returns to the entrepreneur function, that is, the costs of organizing additional transactions
within the firm may rise Coase (1937, p. 340). Williamson (1973) also states a similar
38
explanation: spans of control can be progressively extended only by sacrificing attention
to detail. Neither transactional economies nor effective monitoring can be achieved if
capacity limits are exceeded (p. 323). Vertical integration itself also gives rise to another
opportunistic behavior by labor unions; if two firms are vertically integrated, then the
unions bargaining power in the integrated firm will be increased because of the increase of
employers (Vicker and Waterson, 1991).
Empirical studies reflect these views on the relationship between vertical
integration and performance. For instance, Buzzells study shows a curvilinear
relationship between vertical integration and performance. Data on net profit margins,
investment-to-sales ratios, and returns on investment for businesses with differing levels
of vertical integration (V/S=[Sales-Purchase]*l 00/Sales) with 1,649 firms are used to
find out the relationships. He finds that profit margins are modest up to a V/S of 60%, but
from that point, profits rise consistently with increasing integration. In addition,
investment intensity in his study increases along with vertical integration while return on
investment decreases up to level of 60% and then increases with vertical integration.
Therefore, the study demonstrates clearly how rising investment requirements offset the
higher profit margins associated with intensified vertical integration. If integration can
somehow be achieved without the penalty of a proportionally higher investment base,
then increasing vertical integration should be extremely beneficial (Buzzell, 1983).
Contrary to Buzzell, Chang and Choi (1988) found a positive relationship
between vertical integration and performance. They tried to find the relationship between
transaction cost economies and the Korean business groups, the chaebols. They considered
39
the structure of a chaebol group as a relational structure,7 showing both vertical
integration and the characteristics of conglomerates, and as a multidivisional structure that
reduces transaction costs arising from market failure.8 Therefore, they expected that the
chaebols affiliated firms would be superior in economic performance. They divided the
Korean top-30 business groups into three types. The first type includes the top 4 business
groups, Hyundai, Samsung, Lucky-Goldstar, and Daewoo, which show the characteristics of
a conglomerate and a multi-divisional structure. The second type includes the next 20
business groups that have multi-divisional structure, and the third type includes the
remaining 6 business groups that do not have multi-divisional structure. They obtained
empirical evidence that group affiliated firms show superior economic performance; the
business group with strategy and structure of the first type has superior economic
performances.
Though vertical integration may be a sensible strategy with regard to transaction
cost economies in theory, vertical integration does not show a consistent positive
relationship with performance in empirics because the relationship between governance
and performance cannot be accurately assessed without an appreciation of the factors that
lead transactors to adopt one form of organization over another (Masten, 1993). The co
existence and stability of varied governance forms are more evidence that vertical
integration cannot guarantee higher performance. Bureaucratic organizations exist
7 Many other concepts of chaebols organization are introduced. One set structure,
department style structure, octopus arms structure and fleet structure are examples.
These concepts are different relational structure basically because all these concepts
come from only chaebols appearances (diversification into many industries) whereas the
concept of relational structure came from the insight of vertical and horizontal
relationship among affiliated firms in a chaebol.
8 Williamson (1975) viewed vertical integration and conglomerate as intermediate
market and financial market failure respectively.
40
because, under certain specifiable conditions, they are the most efficient means for an
equitable meditation of transactions between two parties. In a similar manner, market and
clan organizations exist because each of them, under certain conditions, offer the lowest
transaction cost Ouchi (1980).
2.4 Conclusion
In this chapter, I reviewed theories and empirics of ownership structure and
vertical integration.
Separation of ownership from management with the corporation revolution
raised a question about property rights between a principal (ownership) and an agent
(management), which is called a principal-agent problem. This problem provoked another
problem about the direction of causality between ownership concentration and a firms
value because the empirics did not support the theoretical explanation that the firms
value is a function of equity ownership (the convergence-of-interest theory). In turn, new
explanations about ownership structure were given; whereas the optimal structure
hypothesis describes that firms for which ownership matters will have selected their
optimal structure already, the entrenchment hypothesis expresses that the firms value is a
negative function at some ranges of higher ownership concentration because of
managements entrenchment behavior.
Under the view of the optimal structure hypothesis, ownership was treated as an
endogenous variable instead an exogenous variable. Demsetz and Lehn (1985) first
treated ownership concentration as an endogenous variable and proposed a number of
potential determinants of ownership concentration in their study. One determinant of
41
ownership concentration is value-maximizing size of the firm because the larger the
competitively viable size, ceteris paribus, the larger the firms capital resources and
generally, the greater market value of a given fraction of ownership. The second possible
determinant is control potential, which means the wealth gain achievable through more
effective monitoring of managerial performance by a firms owners.
On the other hand, transaction cost theory, which answers the fundamental
question of why firms exist, has undeniable authority despite of criticisms of it. This
theory provides a new approach to look inside the black box of the firm. Transaction cost
theory starts from two basic behavioral assumptions: bounded rationality and opportunism.
Williamsons answer for these bounded rationality and opportunism problems was a
hierarchical governance mechanism, which is an alternative instrument to market
governance mechanism in transaction or exchange of goods and services. Specifically,
application of transaction cost theory to vertical integration was the most direct
examination of the question of why firms exist. Over the years, the determinants of
vertical integration associated with transaction cost economies were focused on specific
asset investment and uncertainty of business environment. In transaction cost economics,
the primary determinant of vertical integration is asset specificity, which causes the
quasi-rent value. In turn, the quasi-rent creates additional incentives for opportunism,
which may lead to the adaptation of vertical integration. Uncertainty is another
determinant of vertical integration. Uncertainty comes from bounded rationality because
without uncertainty, bounded rationality is irrelevant. The change of market environment
forces re-negotiation on the contracts because even the best contracts are not perfect,
which may subject the firm to a hold up problem. It is costly and time consuming.
42
Therefore, the gain of the right to control the use of assets within a firm (vertical
integration) is a solution for the hold up" problem. Empirical tests show evidence that
these two determinants of vertical integration have positive and important relationships
with asset specificity and uncertainty. As a consequence, vertical integration seems to be
a sensible strategy with regard to transaction cost economies, but in the empirics vertical
integration does not show a consistent relationship with performance. The co-existence
and stability of varied governance forms are evidence that vertical integration is
profitable only under certain conditions.
43
Chapter Three: Methodology
3.1 Introduction
The objectives of this chapter are to structure econometric models to incorporate
information from economic theory about the determinants of ownership concentration
and vertical integration and the firm's performance. One model is set up for estimating
the determinants of ownership concentration and vertical integration in Korean firms with
particular interest in seeing if Chaebols affiliation firms make any differences once other
factors are controlled for. In the case of the model for the determinants of ownership
concentration, a basic equation is employed from Demsetz and Lehns (1985) regression
model, which is refined to reflect the differences in the Korean business environment.
Another model is set up for investigating both ownership concentration and vertical
integration effect on the firms performance. All models will be estimated using ordinary
least squares or weighted least squares to solve the problem of heteroscedasticity arising
when using cross-sectional data. The rest of this chapter will describe data and mean
values of variables for these model.
3.2 Empirical Model
Estimation of each equation of the model for the determinants of ownership
concentration and vertical integration has the form:
Y =X fi +SC,
44
where Y stands for each dependent variable such as ownership concentration and the
degree of vertical integration, X represents economic factors as independent variables,
and C is a dummy variable indicating such as a chaebol.
From this form, the basic equation for the determinants of ownership
concentration is:
O W N=00 + fil*SIZE +02 *INSTABILITY+ 03*AGE + 8* CHAEBOL + fJ,
where OWN stands for the ownership concentration, SIZE represents a firms size,
INSTABILITY means a firms instability to the change of business environment, AGE
represents a firms age, and CHAEBOL is a dummy variable to capture the effect of
organizational structure between chaebols and non-chaebols affiliated firms; if a firm
belongs to the chaebols group, then CHAEBOL would be equal to 1 and the others
would be 0.
The basic equation for the determinants of vertical integration will be:
VI = 00 + 01* SPECIFICITY + 02*UNCERTAINTY+ 8* CHAEBOL + n
where VI means the degree of vertical integration, SPECIFICITY stands for the firms
specific assets, UNCERTAINTY represents uncertainty of business circumstances, and
CHAEBOL is a dummy variable to capture the effect of organizational structure between
chaebol and non-chaebol firms.
45
On the other hand, estimation of an equation o f the model for the firms
performance has the form:
PROFIT= al+ a2* VI + a3*OWN+ MOTHERS + p.
PROFIT means firm performance, which is measured by the ratio of a firms net
income to its total assets or total equity. As mentioned above, VI and OWN stand for the
degree of vertical integration and ownership concentration, respectively. OTHERS stands
for economic factors that affect the firms performance such as advertisement intensity,
R&D intensity, firm size, and leverage.
3.3 Data Collection
Empirical analysis will be conducted using the firm level data obtained primarily
from Annual Report o f Listed Companies published by Korean Listed Companies
Association (KJLCA) in 1996. Categorizing the top-30 or 100 chaebols and the data of
these chaebols affiliated firms and their products are collected from Annual Report o f
Korean Companies 1996 published by Korea Investors Services Inc. (KISI), Investment
Analysis o f the Listed Companies 1996 published by Kyobo Securities Inc. (KSI), and
Korea Company Yearbook 1996 published by Asia-Pacific Infoserv, Inc. (APII).
The original sample of 446 listed manufacturing firms (of 663 total listed firms)
in the Korean stock market is collected. Table 3-1 shows that sale amounts o f total
industry, all listed companies and sample companies, which covers from SIC IS to SIC37,
and their proportion of sales amount to total industry sales amount.
46
Table 3-1: Total Sales in All Industry, the Listed Firms, and Sample Data of 1995
___________ Unit: billion Korean Won
SIC A ll11 Listed Firms^ Sample FirmsJ)
15: Foods & Beverage 26,234 12,624(48%) 10,967(42%)
16: Tobacco Products 3,448 0( 0%) 0(0%)
17: Textiles 19,330 12,967(67%) 8,475(44%)
18: Wearing Apparel and Fur Articles 10,558 1,809(17%) 1,514(14%)
19: Tanning & Dressing of Leather 5,353 1,201(22%) 556(10%)
20: Wood and Products of Woods 3,069 495(16%) 495(16%)
21: Pulp, Paper, Paper Products 9,438 3,606(32%) 2,150(23%)
22: Publishing, Printing, & Recording 6,839 238(03%) 50(01%)
23: Coke, Refined Petroleum Products 16,305 12,118(74%) 12,090(74%)
24: Chemicals and Chemical Products 33,128 15,639(47%) 13,840(42%)
25: Rubber and Plastic Products 13,908 3,212(23%) 2,658(20%)
26: Non-Metallic Mineral Products 15,164 5,957(39%) 5,359(35%)
27: Basic Metals 30,546 20,340(67%) 10,459(34%)
28: Assembling Metal Products 16,686 971(06%) 620(04%)
29: Machinery and Outfits 30,107 7,355(24%) 5,963(20%)
30: For Office & Calculating 5,169 1,457(28%) 1,353(26%)
31: Electrical Machinery & Apparatus 12,316 3,726(30%) 3,495(28%)
32: TV & Communication Equipment 44,600 36,799(83%) 32,808(74%)
33: For Medical, Precision and Optical 3,767 180(05%) 73(02%)
34: Motor Cars and Trailer 34,528 24,493(71%) 16,967(49%)
35: Other Transport Equipment 10,948 3,720(34%) 1,416(13%)
36: Furniture 6,993 1,286(18%) 427(06%)
37: Recycling 451 0( 0%) 0
Total 358,888 170,195(47.4%) 131,735(36.7%)
Sources: (1) Report of Mining and Manufacturing Survey (Whole Country) of 1997
published by National Statistical Office (Republic of Korea).
(2) Annual Report of Listed Companies of 1996 published by Korea Listed Companies
Association.
Note: (%) in the third and forth column shows the percentage to total industry in sales
amount.
47
All listed companies cover 47.4% of all industries' sales amount and the sample
companies cove 36.7% of them. From all listed companies, some are excluded as
follows:
1) The companies that are owned by the government.
2) The companies that are under supervision or applying for composition.1
3) The companies that listed after 1991 in the Korean stock market, because 60-
month stock price data are needed for the data of beta index, standard errors
from the capital asset pricing model, and the standard deviation of monthly
stock rates of return.
4) The companies for which five-year annual data from 1991 to 1995 for
ownership percentage, value added amounts, assets, equities, debts, profits,
fixed costs, sales amounts, overhead costs, advertisement and R&D costs are
unavailable.
After excluding all of the above cases, the sample for estimation decreases to 341.
Included manufacturing industries are as follows: Food & Beverages (47), Textiles (44),
Wearing Apparel (13), Leather, Handbags & Luggage & Footwear (12), Wood & Wood
Products (4), Pulp & Paper Products (26), Publishing & Printing (3), Chemicals &
Chemical Products (81), Refined Petroleum Products (6), Rubber & Plastic Products (14),
Non-Metallic Mineral Products (25), Basic Metal Industries (36), Fabricated Metal
Products (13), Computer & Office Equipment (8), Image, Communication & Sound
1 Composition means an agreement between an insolvent debtor and his creditors,

whereby the creditors accept less than the full value of their claims. Considered an
expedient alternative to bankruptcy, composition plans most often agree with small,
unincorporated businesses rather than larger firms. Creditors are inclined to accept the
composition repayment in the belief that a going concern is better than one that liquidates
to pay off its creditors.
48
Equipment (54), Electric Machine & Converter (18), Automobiles & Trailers (26), Other
Transport Equipment (4), Medical, Precision & Optical Instruments (3), and Furniture
(9).
3.4 Descriptions of Data
Chaebol and Its Affiliated Firms
The Anti-Monopoly and Fair Trade Act, first promulgated in 1981, describes a
chaebol as a group of companies," owned or controlled by a single shareholder or his
family or associates. The companies in the group are affiliated firms. There are
perceptions, particularly among foreign businesspersons, that a chaebol is like a holding
company. However, Korean law strictly and explicitly bans holding companies in any
form. Thus, Samsung and Hyundai chaebol groups, as they are most commonly
perceived, do not exist legally. Categorizing top-10, top-30, top-50, or top-100 chaebols by
the rank of total assets has been done for analysis of chaebol effects on economic sectors
among economists. When the Fair Trade Committee (FTC) named a chaebol as a big
business group in 1987, there were 32 chaebols with 509 affiliated firms. The FTC had
named 53 big business groups in 1990, 61 big business groups in 1991, 78 big business
groups in 1992 according to the total assets (over 400 billion Korean Won2). Since 1993,
the FTC has named only 30 chaebols as big business groups by the rank of its total assets.
Table 3-2 shows the value-added amounts of total industries, top-30 chaebols, and
gross national product (GNP) of 1994. The gross total industry product was 90.9 percentage
of the GNP and the gross top-30 chaebols product was 14.6 percentage of the GNP in 1994.
2 It is 494.98 million US dollars. The ratio of Korean Won to US Dollar is 1 to 808.10

in 1993.
49
Table 3-2: Value Added by Total Industries and Top-30 Chaebols in 1994 of Korea (In
Billion U.S. Dollars, %)
Industries Total Industries Top-30 Share (%)

Chaebols
Agriculture, Forestry, & Fisheries 27.258 .025 .09
Mining 1.281 .051 3.96
Manufacturing 103.957 29.937 28.82
Electricity &Water 8.964 .890 .99
Construction 52.027 6.622 12.73
Whole & Retail 45.145 2.518 5.59
Transport & Communication 28.688 3.266 11.39
Finance 66.060 3.347 5.07
Social Service 15.580
Others 14.104
Gross Total Industry Product (A) 348.977 45.894 13.15
GNP (B) 384.000
Am 90.9%
Sources: Management Efficiency Research Institution: the data covers 41 companies of
the 30-business group and financial industry is excluded.
50
The value-added amount of top-30 chaebols is 45.894 billion dollars (except the security
and finance industry), which is 13.15% of the total value-added amounts of all industries. In
addition, this table shows the top-30 chaebols dominate in the principle economic sectors,
such as manufacturing (28.82%); construction and civil engineering (12.73); wholesale,
retail, and hotels (11.38); and transportation and communication (11.38).
The data o f top-30 chaebols and their affiliated firms are collected from Annual
Report o f Korean Companies 1996 published by KJSI and the data of top-100 chaebols
and their affiliated firms are collected from Investment Analysis o f the Listed Companies
1996 published by KSI, and Korea Company Yearbook 1996 published by APII. These
data are used for two dummy variables as follows:
1) If a firm belongs to top-30 chaebols, then DUM30= 1, otherwise DUM30=Q.
2) If a firm belongs to top-100 chaebols, then DUM100= 1, otherwise DUM100=Q.
In addition, the other dummy variables are considered in association with vertical
relationships among affiliated firms. For instance (see Table 3-3), on one hand, Doosan
Corp. does foreign exporting and domestic distribution of Doosan chaebols productions.
Thus, it has a backward vertical relationship with the other affiliated firms, such as
Oriental Brewery Co. that produces beer and wines. On the other hand, Oriental Brewery
Co. has a backward relationship with Doosan Glass Co. (bottles), Sam-Hwa Crown &
Closure Inc. (bottle lids), Doosan Farm Co. (hops and grapes), while it has a forward
relationship with Doosan Corporation. Doosan Glass, Sam-Hwa Crown & Closure, and
51
Table 3-3:Vertical Relationship Among Affiliated firms of Doosan Chaebol
Sales Products Supply of Input

D oosan Corp.: O riental Brewery Doosan Glass: Bottles
Exporting and Co.: Sam Hwa Crown A Closure: Bottle Lid
Domestic sale Beer and Wine Doosan Farm: Hops and Grapes
Doosan Continental Can M fg. : Metal Wrap
52
Doosan Continental Can Mfg. have a forward vertical relationship with Oriental Brewery
Co. Therefore, these companies would be less willing to integrate vertically at the plant
or firm level because they are vertically related at the group-level.
The data of top-100 chaebols, their affiliated firms, and their products are
collected from Investment Analysis o f the Listed Companies 1996 by KSI, Annual Report
o f Korean Companies o f 1996 by KISI, and Korea Company Yearbook 1996 by APII.
These data are used for the following dummy variables:
1) If a part or all of the outputs of its affiliated firms processes is employed as a
part or all of the inputs of a firms processes (forward vertical relationship) and a
part or all o f the outputs of a firms processes is employed as the input of its
affiliated firms processes (backward vertical relationship), then the dummy
variable, indicating back and forward integration (BF), is equal to one, and zero
otherwise.
part or all of the inputs of a firms processes (forward vertical relationship), but a
part or all of the outputs of a firms processes is not employed as the input of its
variable, indicating forward integration (FfVD), is equal to one, and zero
otherwise.
3) If a part or all of the outputs of a firms processes is employed as the input of
its affiliated firms processes, but a part or all of the outputs of its affiliated firms
processes is not employed as a part or all the inputs of a firms processes, then the
53
dummy variable, indicating back integration (BACK), is equal to one, and zero
otherwise.
Ownership Concentration
Because of non-separation of management and ownership in Korean private
companies (chaebols as well as non-chaebols) the percentages of owners shareholding
are collected instead of, for instance, the percentage of top 3 or 5 shareholders.
Ownership concentration (OWN1) is calculated as the percentage of an owners
shareholdings that totals the percentage shareholdings of an owner, his family, especially
related persons3, and the percentage shareholdings by affiliated firms of 1995. In
addition, the percentage shareholdings of institutions (OWN2) are collected to test the
relationship between the institutions investment behavior and the ownership
determinants, such as firm size and business stabilities. All data are collected from
Annual Report o f Listed Companies published by KLCA (1996).
All these data are transformed into a log form because this transformation is
made to convert an otherwise bounded dependent variable into an unbounded one
(Demsetz and Lehn, 1985).
LNOj = Log [Percentage of Shareholdings^ 100-Percentage of Shareholdings)]
Where j is 1 and 2 which stands for inside ownership concentration (LNOl) and outside
ownership concentration (LN02).
3 The especially related persons mean persons who became a new family member by
marriage. A son-in-law and a daughter-in-law are examples.
54
Degree of Vertical Integration
The ratio of value-added to sales amount, as a measure of the degree of vertical
integration, is used widely in empirical literature and mainly for cross sectional data (e.g.,
Adelman, 1955; Tucker & Wilder, 1977; Buzzell, 1984; and Levy, 1985). A value-added
method explains that the more stages of production and distribution combined within a
firm, the higher the ratio of value-added to the sales. The value-added method is
problematic in measuring the degree of vertical integration because profit is included in
the items of value-added. This method is corrected by subtracting net profit from value-
added (the adjusted value-added measurement). Another problem is that the degree of
vertical integration by the value-added method would be biased because of different
successive stages of each firms production flows, and different market circumstances in
supply and demand faced by each firm. For instance, if a material-supply market for a
firm is competitive, and in turn transaction costs are very low, the firm will be less likely
to integrate upward. Therefore, the data is required to be standardized (the standardized
value-added measurement). An adjusted {VIa) and a standardized-degree of vertical
integration (VFS) are calculated as follows:
VIa -(V a lu e added - N et Incom e-Incom e Tax)/(Sale - Net Incom e-Incom e Tax)
VIS= (VIr Ave. V I / STD. V I/
Ave.VIj and STD.VIj represent the average and the standard deviation of the
degree of vertical integration in the j-th industry, respectively. The data of value-added
55
amounts, net incomes, taxes, and sales are collected from the Annual Report o f Listed
Companies by KLCA (1996).
Determinants of Ownership Concentration
Firm Size: The average of five-year annual data for assets (ASSET), equities (EQ), and
debt (DEBT) are collected for proxy variables for firm size. All these data from 1991 to
1995 are collected from the Annual Report o f Listed Companies by KLCA (1996).
Uncertainty: The data of stock prices, profits, and overhead costs are collected from the
Annual Report o f Listed Companies by KLCA (1996) to measure the stability of business
environments. The 60-month data of month-end-prices of stock from 1991 to 1995 are
collected to create the standard deviation of monthly rates of returns (STD) and standard
errors (SE) from the capital asset pricing model. In addition, yearly data of profits from
1991 to 1995 are collected for the standard deviation of the annual ratios of profit to
assets (STDINC).
Firm Age: The data of firm ages are collected from the Annual Report o f Listed
Companies published by KLCA (1996) and calculated as follows:
YR = 1995 - The Listed Year in Korean Stock Market
Determinants of Vertical Integration
Asset Specificity: Sunk cost (SUNK) is adopted for physical asset specificity, referring to
relationship-specific equipment and machinery. In addition, R&D (RDT) and advertising
intensity (ADI) are employed as the proxy variables for asset specificity, referring
56
specific intangible assets and product differentiation. The data are collected from the
Annual Report o f Listed Companies published by KLCA (1996). The annual costs of
advertising and R&D are divided by the sales amount to figure out the intensity of
advertising (A D I) and R&D (RDT). Then the five-year annual data of advertising and
R&D are averaged. The depreciating assets in the fixed assets are divided by total assets
to create sunk costs (SUN K) each year from 1991 to 1995 and the five-year annual data
of sunk costs are averaged. All these variables are represented by the unit of percentage.
R D I (%) = R& D C ost/Sales
A D ! (% )- Advertisem ent C ost/Sales
S U N K (%) = F ixed C ost/ Total Assets
D IV (%) = Sales A m ount o f M ain Product/ Total Sales
Uncertainty: From the Annual Report o f Listed Companies by KLCA (1996), the five-
year annual data of overhead costs and sales amounts and the 60-month data of month-
end-prices of stock from 1991 to 1995 are collected to capture uncertainty due to a
volatile supply, demand market conditions, and stock prices. From these data, the
following variables are created: the beta (BETA=fi) of the capital asset pricing model and
the standard deviation of a monthly return on a stock (STD) for 60 months from 1991 to
1995.
57
Performance and Economic Variables
Profit is calculated into two ways to test the firms performance: the ratios of the
average annual rate o f net incomes after taxes from 1991 to 1995 both to assets (IA) and
to equities (IE). The data of advertising intensity (ADI), R&D intensity (RDI), assets
(LNASSET), and the ratio of debt to assets (LEVER) are collected for the performance
test from the Annual Report o f Listed Companies by K.LC.
All variables and their descriptions are summarized in Table 3-4
3.5 Mean Values of Variables
The means, the standard deviations, maximum, and minimum values of dependent
and independent variables are computed by using 341 listed companies; data are
categorized into four parts, top-30 chaebols, top-100 chaebols, non-chaebols, and other
listed firms (see Table 3-5).
Ownership Concentration: Table 3-5 shows that the ownership concentration of non
chaebol firms is higher than that of chaebols affiliated firms: the percentage of non
chaebols ownership is 4.51% and .53 % higher than that of top-30 chaebols and top-100
chaebols in OWN1, respectively. The higher percentage may reflect the matter of firm
size. OtVNl seems to have a negative relationship with firm size (ASSET or EQUITY).
However, the percentage of non-chaebols ownership in OWN2 is 6.32% and 5.05%
lower than that of top-30 chaebols and top-100 chaebols.
Degree of Vertical Integration: The degree of vertical integration in chaebols affiliated
firms shows a slightly lower level than that in non-chaebols; this lower level gives an
expectation that a group level integration may decrease a willingness to organize either a
58
Table 3-4: Variables and Their Descriptions
Variables Descriptions
Via (Value Added-Profit - Taxes)/(Sales-Profit- Taxes) of 1995
VIS Standardized Degree of vertical integration; VI = (Vljj-Ave.VIj/ Std. VIj)
IA(%) Average annual rate of net income after tax to asset from 1991 to 1995
IE (%) Average annual rate of gross income to stockholders' equity from 1991 to
1995
OWN1 (%) Shares (%) of owner & owners family and affiliated firms of 1995
OWN2 (%) Shares (%) of institutions of 1995
LNOl Log [OWN 1/(100-0WN1)]
LN02 Log [OWN2/( 100-OWN20]
ASSET Asset is 5-year annual average (million Won) (1991-95).

LNASSET Log (Assets)
EQ Equity, Equity is 5-year annual average (million Won) (1991-95).
DEBT Debt; Debt is 5-year annual average (million Won) (1991-95).
LEVER(%) Debt/Asset of 1995
ADI (%) Advertising intensity, annual average of advertising cost to total sales (1991-
95)
RDI(%) R&D intensity, 5-year annual (1991-95) average of advertising cost to total
sales
SUNK (%) Fixed Cost/ Total Assets; 5-year annual average (%) (1991-95)
DIV(%) The ratio of sales amount of main product to total sales of 1995
YR Period of years as a listed firm =1995- the listed year
BETA Systematical risk on investment from CAPM for 60 months (1991 -1995)
SE (=p) Standard error of estimate from CAPM for 60 months (1991 -1995)
STDINC Standard deviation of annual ratio of net profit to asset from 1991 to 1995
STD Standard deviation of monthly rate of return on the stocks of 60 months
(1991-95)
DUM30 If a firm belongs to the top-30 chaebols, then DUM30=1, otherwise

DUM100 DUM30=0.
BF If a firm belongs to the top-100 chaebols, then DUM100=1, otherwise
DUM 100=0.
BACK If a firms production has backward and forward vertical relationship with
its affiliated firms production, then BF=1, otherwise BF=0.
FWD If a firms production has backward vertical relationship with its affiliated
firms production, then BACK=1, otherwise BACK=0.
If a firms production has forward vertical relationship with its affiliated
firms production, then FWD= 1, otherwise FWD=0.
59
Table3-5: Means, Standard Deviations, maximum, and Minimum Values of All Variables
Variables Top-30 Chaebol Top-100 Chaebol Non-Chaebol All Data

Mean Maximum Mean Maximum Mean Maximum Mean Maximum
(S.D) Minimum (S.D) Minimum (S.D) Minimum Minimum
Via 22.217 43.552 24.027 44.488 24.152 47.187 24.084 47.187
(9.946) .6831 (8.425) .6831 (9.504) 1.312 (9.030) .6831
Vis -.3934 1.737 -.1618 3.447 -.0713 2.601 -.1206 3.447
(.968) -3.001 (.986) -3.001 (1.092) -3.292 (1.035) -3.292
IA(%) 1.357 6.714 1.816 7.841 2.485 8.417 2.106 8.417
(1.663) -3.826 (1.917) -3.826 (2.078) -1.823 (2.005) -3.826
IE (%) 4.007 25.023 4.888 25.023 5.357 17.685 5.101 25.0237
(7.521) -16.122 (6.322) -16.122 (4.870) -12.856 (5.705) -16.122
OWN1 21.133 51.80 25.111 51.80 25.645 62.80 25.354 62.8
(%) (12.653) 4.30 (12.565) 2.40 (11.888) 4.3 (12.247) 2.4
OWN2 14.325 59.80 13.055 68.50 8.005 68.2 10.759 68.5
<%) (13.000) 0 (12.129) 0 (9.654) 0 (11.448) 0
LNOl -1.487 .072 -1.231 .072 -1.174 .523 -1.205 .524
(797) -3.102 (.766) -3.705 (691) -3.102 (.732) -3.705
LN02 -2.221 .389 -2.294 .760 -2.875 .746 -2.558 .760
(1.330) -4.615 (1.256) -4.615 (1.244) -4.615 (1.282) -4.615
YR 15.211 29 14.732 39 10.245 33 12.698 39
(7.218) 5 (7.759) 4 (6.101) 5 (7.299) 4
ASSET 1.097.72 8.238.32 523.28 8.238.32 88,93 1,128.80 326.425 8,238.32
(1547.3) 35.85 (1020.81) 19.77 (142.98) 5.19 (790.26) 5.19
LNASSET 13.153 15.924 12.328 15.924 10.955 13.936 11.7038 15.924
(1.296) 10.487 (1.218) 9.892 (822) 8.554 (1.258) 8.554
EQUITY 301.42 2.444.6 150.81 2.444.6 31.45 283.35 96.719 2,444.64
(444.28) 6.29 (289.83) 4.16 (38.11) 3.06 (223.64) 3.06
DEBT 796.29 5.793.6 372.45 5.793.6 57.48 845.27 229.705 5,793.67
(1121.8) 24.79 (742.78) 7.12 (108.61) 2.13 (575.401 2.13
LEVER 349.31 1.257.7 276.04 1257.75 189.448 1421.88 236.682 1421.88
(226.54) 74.56 (181.83) 30.27 (156.03) 23.64 (175.73) 23.64
SE .06495 .07614 .0629 .0761 .0603 .07648 .0617 .07647
(.0070) .04724 (.0070) .0451 (007) .04402 (.007) .04402
BETA .87746 1.6049 1.0087 1.892 1.1635 2.209 1.072 2.2090
(.3167) .1244 (.3134) .1244 (343) .0034 (.340) .0034
STD 3.5041 4.358 3.5835 4.613 3.761 5.155 3.664 5.155
(.332) 2.796 (.368) 2.796 (.403) 2.877 (.391) 2.796
STDINC 26775.0 1048523 11328.0 1048523 1688.1 53589.6 6946.26 1048523
(12488) 224.47 (77059) 107.36 (49615) 40.599 (57132) 40.599
ADI 1.189 8.520 1.53 14.573 1.989 14.996 1.739 14.996
(1.791) 0 (2.519) 0 (3.649) 0 (3.089) 0
RDl 7.093 52.122 4.819 52.122 3.209 37.862 4.087 52.122
(11.519) 0 (8.911) 0 (6.050) 0 (7.773) 0
SUNK 41.272 77.436 36.944 77.436 32.086 65.292 34.736 77.437
(12.409) 15.823 (13.67) 5.706 (12.23) 7.398 (13.244) 5.706
DIV 50.5215 100 53.655 100 54.556 100 54.046 100
(24.412) 0 (24.59) 0 (24.22) 0 (24.39) 4.50
DUM30 I .3548 0 .194 1
(.479) (.396) 0
DUM100 1 1 0 .545 1
(498) 0
Obs. 66 186 152 I 341
firm or a plant level integration.
Asset Specificity: R&D intensity (RDl) and sunk cost (SUNK) in chaebols affiliated firms
are much higher than those in non-chaebol firms; RDI is twice as high in top-30 chaebols
affiliated firms (7.09%) than in non-chaebol firms (3.21%) and SUNK is 8.51% higher in
top-30 chaebols affiliated firms (40.85%) than in non-chaebols firms (32.34%). On the
other hand, advertisement intensity (ADI) is lower in top-30 (1.19%) and top-100 chaebols
(1.53%) affiliated firms than in non-chaebols firms (1.99%). This lower percentage may
be explained by recognition of firms; for instance, chaebols firms are broadly recognized
by the public, so that they may not have to advertise as much as non-chaebols do.
Uncertainty: Mean values of stability variables do not show a consistent standard
comparison between chaebols affiliated firms and non-chaebols firms. Both the
standard deviation of 5-year net profits (STDINC) and the standard error (SE) from the
capital asset pricing model for 60 months in chaebols affiliated firms are higher than those
in non-chaebols firms; however, the standard deviation of overhead costs (STDCS), the
standard deviation of monthly rate of return on stock, and the systematic risk on investment
(BETA) in the chaebols affiliated firms are lower than those of non-chaebols firms.
Firm Size: Assets vary from 35.85 to 8,238.32 in top-30 chaebols, from 19.77 to 8,238.32
in top-100 chaebols, and from 5.19 to 1,128.80 billion Korean Won in non-chaebols.
However, top-30 chaebols affiliated firms are 12.3, 9.6, and 13.8 times higher in assets,
equity, and debt, respectively than are non-chaebols firms, but the difference of ownership
concentration between chaebols affiliated firms and non-chaebols firms is only 4.51%.
That is, chaebols affiliated firms have relatively higher ownership concentration though
they are generally larger.
61
Performance: This table shows that the performance of non-chaebols firms is higher
than that of top-30 and top 100 chaebols affiliated firms: non-chaebols are 1.10% and
.64 % higher in IA than top-30 chaebols and top-100 chaebols, respectively and 1.35%
and .47% higher in IE than top-30 chaebols and top-100 chaebols, respectively. Non
chaebols are better in performance than chaebols.
62
Chapter Four: Ownership Concentration and Its Determinants
4.1 Introduction
This chapter investigates ownership structure and its determinants in Korean
private corporations, using a sample o f the listed firms in the Korean stock market o f the
early 1990s. Many questions arise with regard to the ownership structure of Korean
private companies. Who are the main shareholders and how is ownership concentrated?
Are the main shareholders active decision makers or passive recipients of dividends and
appreciation? What are the determinants of ownership concentration? How is the
ownership structure of chaebols affiliated firms different from that of the others that do
not belong to such chaebol groups? In addition, do the effects of determinants on
ownership concentration between chaebols and non-chaebols differ? These questions are
answered by examining the ownership structure in Korean corporations.
Ownership generally means the legal right of possession, control, use, and
disposition of physical assets. Thus, the owner has the right to receive benefits from
assets and the responsibility for bearing risks associated with decision-making in their
use. However, this general meaning of ownership is different from ownership in the
context of corporate governance because ownership in the publicly traded corporation is
the concept of stock, which is distributed among numerous shareholders. As a
consequence, the owners nominal property rights and actual power of decision-making
in the corporation have been replaced by the executive group. While retaining ownership,
the role of shareholders has changed from active decision makers to passive recipients of
dividends and appreciation. However, the position of ownership in Korean chaebols is
different from that in Japanese keiretzu or Western corporations; the owner is an active
63
decision maker as well as a large shareholder in Korea. In addition, the owner or the
members of his family hold the most important positions. In an economic point of view,
these positions are very important with respect to problems of managers shirking. That is,
monitoring by the owner (insider shareholder) seems to be more efficient than that by the
main bank as is common in Japan or than that by the market and the board, which is the
common practice in the U.S. This separation of ownership and control in the modem
corporation is a part of the ongoing debate concerning the firms performance. This
debate will be joined later in Chapter 6. My primary concern in this chapter, however, is
to explore some factors that affect the structure of corporate ownership.
The main determinants of ownership concentration in the literature are the market
value of a firm and uncertainty of business circumstance. In addition, to reflect Korean
business circumstances, a firms age, debt, and organizational form are considered
determinants of ownership concentration. In the corporation development point of view,
it is taken for granted that ownership concentration diffuses with the lapse of time.
Though the firms age may not be a determinant in countries where corporations have
experienced corporation revolution, it may be one determinant of ownership
concentration in countries such as Korea, where financial markets are undeveloped and
corporations are at the threshold of corporation revolution. Debt is considered one of
the determinants, also. The shortage of capital resources for new investment can be
solved not only by issuing new shares but also issuing bonds or borrowing. Loans or
bonds' usually do not affect ownership concentration directly, so that chaebols as well as
1. Bonds may affect ownership concentration because convertible debentures, for

instance, are exchangeable for a set number of other forms (usually common shares) at a
pre-stated price.
64
the other firms preferred using them to issuing new shares. Moreover, organizational
structure is considered a determinant of ownership concentration. Since the chaebol's
organizational structure, which is the multi-market form2 at a group level, is
advantageous in inter-firm contracting, reciprocal financing, sharing market information,
and so on, owners ownership is expected to fluctuate less against the uncertainty of
business circumstances.
First, I will map out the ownership structure of Korean private corporations. Next,
the determinants of ownership concentration will be outlined in terms of Korean business
circumstances, such as non-separation of ownership and management, undeveloped
financial markets, and the organizational form in the chaebol. Then, the empirical tests
follow.
4.2 Ownership Structure in Korean Private Companies
Ownership in most Korean corporations is not separated from management. The
largest shareholder, an owner, is an active decision maker, such as a CEO or a manager.
It is quite different from the typical ownership structure in U.S. or Japanese corporations,
where ownership is separated from management. In large U.S or Japanese corporations,
the actual power of decision-making has come to rest on management members such as
the executive group or board of directors who may not own equity or stocks, whereas the
stockholders remain in the position of residual income claims. However, ownership is not
separated from management in most Korean corporations and is concentrated in an owner
2.1 define a multi-market form as an organizational form that is expanded and diversified
by participating from raw materials to the final product market, so the product processes
are related among a group's companies. Thus, it is different from a conglomerate form
that is organized by merging and/or acquiring.
65
and his family. Therefore, the owner, as a large shareholder, is still the active decision
maker while common shareholders are simply the recipients of dividends and
appreciation.3 In addition, the owners family or relatives are widely positioned in the firms
not only as managers but also as main shareholders. This tendency is common in small and
middle sized firms as well as in chaebols. According to the research by the Korean stock
exchange (1997), 422 firms in 485 listed manufacturing firms are run by owners, relatives,
or specially related persons.
Non-separation of ownership and management in Korean private corporations
may stem from the capital structure that is an adaptive vehicle shaped in reaction to
influences and constraints from internal and external economic factors. In addition to
economic influences, various institutional factors affect ownership concentration.
First, non-separation is related with culture; it is associated with amenity potential or
social standing of a top manager. Instead o f remaining like those who own only the largest
fraction of shareholdings, an owner wants to run the business directly. That is, not only
pecuniary benefits but also the social respectability from leadership or the opportunity to
deploy resources to suit his personal preferences are associated with non-separation. This
may come from the cultural background o f Confucianism, which focuses on ones social
standing and fame rather than wealth. In addition, it is very important with regard to
inheritance of the family business and to monitoring management. According to Kim
(1997, p. 64), 44 percent of upper-level managers who worked in chaebols responded that
inheritance of the family business was the most important reason for hiring family
3 Hereafter, I use the owner as a person who is a main inside shareholder as well as an
active decision maker, whereas the shareholders is defined as the outside shareholders
and passive recipient.
66
members. Twenty-one percent responded that an easy way of controlling management was
the reason.
Second, the legal and regulatory environment of Korean business is different from
those of the U.S. and Japan. It can be explained with a view of DiMaggio and Powells
(1983) coercive isomorphism, which stems from the influence of political power. After
the Korean military revolution in 1959, the roles of both commercial and specialized
banks became a means of political financial distribution. Approvals of the annual budget
and appointments of top executives in commercial as well as specialized banks were
controlled by the hands of a new military regime. Furthermore, the new regime governed
foreign loan capital as well as foreign investment. In addition, the commercial law
prohibited the corporation from holding up to 4% of voting stock of any bank. As a
result, the financial markets were fully under the control of the government; the banks
were not closely associated with the corporations as the long-term shareholders by the
market system but as the financial distributors in lieu of the government. Banks had only
a creditor-debtor relationship with the corporation through the medium of the
government. Therefore, Korean banks are unlike Japanese banks, which are closely
related to Japanese corporations as the steady and long-term shareholders, monitors, and
financial supporters because the Japanese government permits them to be active
investors to a greater extent in a corporation. In the case of the U.S., commercial banks
have been prevented by law from holding any corporate stock in their accounts (Prowse,
1992).
After centralizing capital resources of domestic and foreign loans, the new
military regime, as an active government, pursued economic development to overcome
67
the lack of legitimacy of military revolution. For economic development, the larger
businesses such as chaebols were selected as the new regimes partners because the new
regime believed that the larger businesses had an advantage in economies of scale.
Therefore, loans were made predominantly to chaebols at low rates. In addition, the
government preferred an owner management-system to a manager-management
system because the government believed that to move ahead swiftly with the
government economic plans, the owner-management system was superior to the
manager-management system in decision procedure; consensus was not achieved through
bottom-up decision-making processes and ultimate authority on the decision lay with
the owner-managers, so that if the decision were made by them everyone would march in
that direction.4 Furthermore, Article 200 of the Security Exchange Law of Korea, which
states that outside shareholders could not hold more than 10 % of voting stock, protected
ownership from a hostile takeover.5
Third, there exists a unique business group, chaebol. in the Korean private
business world, which is characterized by a group of firms that are diversified vertically
or laterally and bounded by ties of fractional ownership and reciprocal or joint
investments. Therefore, the ownership structure of the chaebols affiliated firms is
different from that of the other firms that do not belong to such chaebol groups.
Generally, the larger shareholders in a chaebol are the owners (including his family,
relatives and specially related persons) and its affiliated firms.
4 Therefore, chaebol may be called a clan form because chaebols shows relatively high
level of goal congruence though consensus is not achieved through a bottom up
decision process.
s It was revised in 1997 and a new article allowed for the outsiders to hold shares without
limitation.
68
According to the Fair Trade Committee (FTC), the average percentage of
ownership in the top-30 chaebols with 652 firms in 1995 is 43.8%. This ownership
divides into two parts, direct ownership (10.5%) that belongs to the owner and his
family and indirect ownership that belongs to the affiliated firms (32.8 %). (See Table
4-1).
Table 4-2 shows how the ownership of all listed Korean companies breaks down
among various sectors from 1980 to 1995. During this period, the number of listed
companies increased 2.0 times (352 to 721 firms) but the capital stock of them increased
19.9 times (1.96 trillion to 38.05 trillion Won). This table shows that the percentage of
ownership by financial institutions in Korea has increased (from 8.2 % in 1980 to 25.5 %
in 1995) while the percentage of that by non-financial institutions and households has
decreased (from 30.0% to 18.7% and from 56.7% to 37.4% respectively) during this
period. Increased foreign ownership in 1995 stems from opening domestic financial
markets to foreigners after 1992.
These data, constituting the percentage of shares in the various sectors of the U.S.
and Japan in Table 4-2, are adopted from Prowse (1992) in a standard of comparison in
the same table. They are categorized into four parts: all corporations, households,
foreigners, and others of the U.S., Japan, and Korea of 1984. Then, all corporations are
divided into two parts, financial and non-financial institutions, and financial institutions
are classified into three parts, commercial banks, insurance companies, and other
financial companies.
The percentage of shareholdings by financial institutions of all corporations in
Korea (12.7%) is lower than those in the U.S. (26.6%) and Japan (43.3%).
69
Table 4-1: Ownership in Top-30 Chaebol
Year Owner (%)=A Affiliated firm (%)=B A+B
1990 13.7 31.7 45.4
1991 13.9 33.0 46.9
1992 12.6 33.5 49.1
1993 10.3 33.1 43.4
1994 9.7 33.1 42.8
1995 10.5 32.8 43.8
Fair Trade Committee (1996)
70
Table 4-2: Percentage o f Outstanding Corporate Equity Held by Various Sectors in Korea,
U.S., and Japan in 1984
Sector o f Ownership 1980 1985 1990 1995 1984
Korea U.S.A* Japan*
All corporation 27.6 45.1 40.8 44.2 43.8 37.7 67.3
Financial Institutions 8.2 15.1 25.2 25.5 12.7 26.6 43.3
Commercial Banks 5.9 7.1 7.3 11.2 6.6 .2 20.5
Insurance Na 0 5.5 5.7 0 4.6 17.7
Others Na 8.0 12.4 8.6 6.1 21.8 5.1
Non Financial Inst. 19.4 30.0 17.8 18.7 31.1 11.1 24.0
Foreigners 2.0 2.0 1.7 10.1 2.2 4.2 5.0
Households 56.9 52.5 46.0 37.4 53.7 58.1 26.7
Others 14.5 .4 10.3 8.3 .2 .0 1.0
Note: Source from Choosik (Stock), 1996 and * is adopted from Prowse (1992)
71
The percentage of shareholdings by commercial banks (6.6%) shows much higher
than that of the U.S. (.2%) but lower than that of Japan (20.5%) because, as mentioned
above, commercial banks are not allowed to hold more than 5% of voting stock of a
corporation in the U.S., while the legal and regular environment of Japanese financial
institutions permits them to be active investors to a much greater extent in corporations
(Prowse, 1992). The higher percentage of non-financial institutions shareholdings in
Korea may reflect the inter-investment or interlocked ownership structure among the
multi-market firms such as chaebols. For example, in the 30 big chaebols in Korea, the
average of inter-investment among the affiliated firms is 26.8% of total assets in 1995.
Households in Korea and the U.S. hold a higher portion of shares but there exists a major
difference between them; the percentage of households in Korea includes a high
percentage of owners shareholdings.
Table 4-3 shows how ownership is concentrated in the various shareholders of the
Korean corporations: it reports who is the largest shareholder in the corporation. Data
includes all manufacturing and non-manufacturing (except financing) sectors in the 578
listed companies from the Annual Report o f Listed Companies in 1995. It is categorized
into four parts: Owner, Institutions, Individuals, and Others. Owner stands for the
average percentage of owners and their families total possessions of stocks: ownership is
highly concentrated to Owner, which is 19.22% in the top-30 chaebols and 25.04 % in all
listed Korean corporations. Institutions that include financial and non-financial
corporations with more than or equal to 1% of total shares show 10.83%. Individuals who
are the households (but not as an insider shareholder) and have more than or equal to 1%
of total shares shows 7.72%.
72
Table 4-3: Ownership Concentration in Korea of 1995
Types Chaebols All Listed firms
Owner 19.22 25.04
Institution 15.91 10.83
Individuals 4.60 7.72
Other 60.26 56.40
Note: Data are collectedfrom Annual Report o 'Listed Companies in 1995.
73
The accumulation of total percentage in the large shareholders of Owner, Institutions, and
Individuals is 43.60%. Others indicate small shareholders who have less than 1% of total
stocks in all sectors and shows 56.40%.
Figure 4-1 explains how ownership in chaebols is concentrated. For instance, the
owner of the Hyundai chaebol is Chungs family (Joo-young Chung is a founder as well
as chairman of Hyundai chaebol) who are the largest shareholders of Hyundai Heavy Ind.
(69.2%), Hyundai Auto Corp. (6.3% by the owner and 10.3% by Hyundai Heavy Ind.),
and Hyundai Industry Development Corp. (40.5%). These three firms are the biggest
shareholders of Hyundai Corporation Ltd. (15.5%, 7.3%, and 5.2% respectively).
Hyundai Corp. Ltd., Hyundai Engineering, and Hyundai Development Corp. are three big
shareholders of Korean Aluminum Industry. They have 21%, 5.3% and 4.8% of total
common stocks, respectively. Korea Aluminum Ind. has 50% of shares of Hyundai
Electrical Engineering Ltd. In reality, the Chung family has only 1.12% of total
shareholdings (direct ownership), while his affiliated firms possess 48.88% of total shares
(indirect ownership) in Electric Engineering Limited. This is a way to keep a relatively
higher percentage of ownership in the affiliated firms.
4.3 Determinants of Ownership Concentration
There may be many visible and invisible factors that affect the ownership structure.
Generally, capital resources and control potential (stability of business circumstances) are
described as the main determinants of ownership concentration. In addition, a firms age,
debt, and organizational structure are considered the determinants of ownership
74
Figure 4-1: Ownership Structure o f Hyundai Chaebol
Hyundai
Engineering
Ltd.
5.3
Chung & Hyundai Hyundai Korean Hyundai

69.2 Heavy
15.5 Corp.
21.0
Aluminum
50.0 Electric
Chungs
Family Industry Ltd. Industry Engineering
Ltd.
10.3
Hyundai
Auto
6.3 Corp.
7.3
Hyundai 5.2
Industry
40.5 Development 4.8
Corporation
75
concentration to reflect Korean business environments. However, the effects of the
determinants on ownership concentration will be different from inside shareholders to
outside shareholders in the case of non-separation of ownership and management. Non
separation of ownership and management in Korean corporations is one feature that
distinguishes them from Western corporations. Therefore, I categorized big shareholders
into two parts: inside shareholders (Ownl) and the big outside shareholdings by
institutions (Own2) instead of top-five or ten shareholders. Ownl includes the total
possessions (%) of stock by an owner and his family plus the affiliated firms; Own2
includes the total possessions (%) of stock by financial and non-financial corporations
that have more than or equal to 1% of total shares. In addition, Own 12 is used as a
dependent variable, which is inside and outside ownership concentration together.
Capital Resources
There is a constraint for inside shareholders to supply capital resources for a new
investment or the expansion of business lines. That is, if an owner as the inside
shareholder cannot increase the share of ownership prorata, ownership concentration will
fall. Additional capital can be raised with newly issued shares, but a reduction of insiders'
ownership concentration is inevitable. Therefore, if a firm is getting larger, the insiders
ownership (e.g., Ownl) will be reduced, ceteris paribus. However, outside shareholders
ownership (e.g., Own2) may be increased if the decreased ownership of Ownl is
transferred into Own2.
Debt may be one of the determinants of ownership concentration. An increase in
capital resources for new investment can be obtained not only by issuing new shares but
76
also by issuing bonds or borrowing. Whereas the reduction of insider ownership
concentration occurs with issuing new shares unless inside shareholders increase the
share of ownership prorata, debt does not affect ownership concentration directly. That is
to say, if the inside shareholder does not wish to reduce his ownership, he will prefer debt
rather than issuing new shares.6 The high debt ratio under non-separation of ownership
and management in Korean corporations may be explained with this reason. Most big
debt-holders are financial institutions in Korea, which are under control of the government
and are used as a window of political financial distribution. A good relationship with the
government, therefore, is most important because it guarantees favored loan status
continually with lower interest rates. However, the higher the ratio of debt to equity is,
the higher the required interest payment on the debt, the higher bankruptcy cost, and, in
turn, the less stability in running the business is expected. Therefore, these side effects of
debt decrease the owners willingness to increase the ratio of debt to equity. Overall, the
effect of debt on insiders ownership concentration is ambiguous because of the side
effects of debt such as higher interest payments and bankruptcy costs though debt does
not affect ownership concentration.
6 However, this explanation may not be adopted in the case the place o f ownership and
management are separated or that the financial market is well operated by a market
system because debt is more related to financial stability rather than ownership
concentration. Theoretically, the greater the ratio of debt to equity is, the higher the
required interest payment on the debt, and the higher bankruptcy cost is expected to be.
Therefore, the optimal debt ratio should be lower as long as the marginal benefit from
using debt is less than marginal cost of debt and bankruptcy.
77
Control Potential
According to Demsetz and Lehn (1985), control potential is defined as the wealth
gain achievable through more effective monitoring of managerial performance by an
owner. They assume that neither the markets for corporate control nor the managerial
labor market operate costlessly. If these markets were perfectly operated, then control
potential would play no role in explaining the ownership structure. Firms that transact in
markets characterized by stable prices, stable technology, stable market shares, and so
forth are firms in which managerial performance can be monitored at relatively low cost.
In addition, they postulate that control potential is likely correlated with environmental
noise. The tighter control will pay off to the insider owner if a firm faces higher noise in
its environment. Accordingly, instability of the firms environment affects insiders
ownership concentration positively: inside ownership will be more likely to be
concentrated if the business environment is not stable. However, portfolio theory explains
that risk bearers such as big outside shareholders are likely to spread their wealth across
many firms if they are not members of the board and do not engage in monitoring as well.
Therefore, the effects of unstable business surroundings on ownership concentration in
the inside as well as outside shareholders such as Ownl and Own2 are expected to be
ambiguous.
The Firms Age
The age of the firm may be one of the possible determinants in the case of the
early stage of business history, like Korean private business. In the view of the firm
development, the diffusion of ownership concentration is thought to be inevitable with
78
the lapse of time. A firm needs to develop new technology, expand its business, or enter
into new business lines in order to survive changing business environment as time goes
by. Therefore, issuing new stock is needed for these businesses unless the owner can
supply the required capital. Eventually, it leads to the diffusion of ownership
concentration. Berle and Means (1968) show how the ownership concentration had been
dispersed and ownership was separated from management with the firm development in
the early 1900s of U.S. business. However, the age of a firm does not seem to be a
meaningful determinant in the countries that have already experienced corporation
revolution, i.e., the diffusion in ownership and the separation of ownership and
management. Korean firms are on the threshold of corporation revolution, because of
short business history: the average of the established year in the listed firms is 1966.8 and
the average year listed is 1983.4. Therefore, I control for the firms age and expect a
negative relationship with insider ownership concentration.
Organization Form
Organizational form may affect ownership concentration in the case of the Korean
corporations because the ownership structure of chaebols affiliated firms is different
from that of the other firms. Table 4-4 shows that the affiliated firms in the chaebol show
lower owner concentration but they are much larger; percentage of ownership in top-30,
top-100, and non-chaebol firms are 21.13%, 25.11%, and 25.65%, respectively whereas
the assets of top-30, top-100, and non-chaebol firms are 1,097.72, 523.28,, and 88.93
billion Korean won, respectively and the equities of top-30, top-100, and non-chaebol
firms are 301.42, 150.81, and 31.45 billion Korean Won, respectively.
79
Table 4-4: Mean Values of Ownership, Assets, and Equity in Top-30, 100 Chaebols, and
Non-Chaebols in the Listed Corporadons of 1995
Chaebols Stockholdings Stockholdings Assets Equity
by Owner by Institutions (Billion S) (Billion $)
Top-30 21.133 14.323 1,097.72 301.42
Top-100 25.111 13.055 523.28 150.81
Non 25.645 8.005 88.93 31.45
Average 25.354 10.759 326.43 96.72
80
However, chaebols have relatively high ownership concentration in comparison to their
assets or equities. Top-30 chaebols are about 12 and 10 times larger than non-chaebols in
assets and equities, respectively while there is only less than 4.51 percent difference
between top-30 and non- chaebols in ownership concentration. In sum, chaebols are
expected to have lower ownership concentration because they are much larger than non
chaebols are.
On the other hand, a relatively higher ownership concentration in chaebols stems
from its stable ownership structure; they have advantages in credit, capital flow,
reciprocal pledges, and higher quality of information on the market. Though each
affiliated firm is legally independent, it is operated as a part of a chaebol and under single
common administrative and financial control. That is, the affiliated firms of chaebols are
bound by ties of fractional ownership and reciprocal or joint investments among them
(see Figure 4-1). Therefore, ownership concentration in the affiliated firms is more stable
to the fluctuation of business circumstances than that in the others if other things are
equal.
4.4 Empirical Modeling and Results
Modeling
From the theoretical view of the determinants of ownership concentration, I set up
the following model.
4-1) O w nershipj= + f i * Firm S ize + fi2 * L isted Year + B usiness S ta b ility + Sf
* O rganizational Form + e ,
81
This model explains ownership concentration by firm size, listed years in Korean
stock market, business stability, and organizational form. I categorize ownership
concentration into three parts: (1) inside ownership concentration (%) including an
owner, his family, and affiliated firms {OWNI), (2) outside ownership concentration (%)
including only ownership that is greater or equal to 1% of the total shares (OWN2) by
institutions, and (3) inside and outside ownership concentration together
{OWNI2=OWNl +OWN2). LNOl, LN02, and LN012 are the transformed log forms of
OWNl, OWN2, and OWN12, respectively.
ASSET, EQUITY and DEBT are proxy variables for firm size. They stand for the
average of total assets, equity, and debt from 1991 to 1995, respectively. These variables
are expected to have negative relationships with inside ownership concentrations (LNOl).
However, the decreased amount of inside ownership may increase outside ownership
(LN02). Thus, LNOl2 is ambiguous.
YR stands for a time period as a listed company (J7?=1995 - the listed year). The inside
ownership (LNOl) is likely to decline with time, so that YR is expected to have negative
coefficients in the LNOl equation, but not necessarily in the LN02 equation.
SE, STD, and STDINC are employed as proxy variables for environmental
stability. They stand for the standard error of the regression of the firm's monthly returns
on stock regressed on the market portfolio returns for 60 months, the standard deviation
of monthly stock market rates of return, and the standard deviation of annual firm income
from 1991 to 1995, respectively. The effects of unstable business surroundings on
ownership concentration of inside and outside shareholders are expected to be
ambiguous; control potential theory by Demsetz and Lehn(1985) explains that these
82
variables will show a positive relationship with inside ownership while portfolio theory
explains that risk bearers are likely to spread their wealth across many firms if they are
not members of the board and do not engage in monitoring as well. With considering the
circumstances that outside owners usually do not influence management in most Korean
companies, the effects of unstable business surroundings on outside ownership
concentration, LN02, are expected to be negative.
LEVER, which is the average of debt-equity ratios from 1991 to 1995, is
employed to capture debt effect on ownership concentration,. Normally, the coefficient
sign of LEVER is thought to be ambiguous. However, if the coefficients of LEVER are
negative and significant, it can be interpreted that owners prefer debt rather than issuing
new shares in order to protect their ownership concentration from diffusing. For the
organizational form effect on ownership concentration, dummy variables are adopted.
Dummy variables such as DUM30 and DUM100 for top-30 chaebols and top-100
chaebols, respectively will capture the difference of ownership concentration between
chaebols and non-chaebols. DUM30 and DUM100 are expected to have negative signs
because chaebols are much larger than non-chaebols. In addition, interaction dummy
variables are considered in order to capture the possibility that chaebols alter the effect on
stability; SE30 is SE*D(JM30 and SE100 is SE*DUM100. Affiliated firms are operated
as a part of a chaebol and under single common administrative and financial control and
are bound by ties of fractional ownership and reciprocal or joint investments among
them. This gives advantages in capital flow and reciprocal pledges, so that chaebols can
maintain relatively stable with fluctuation of business circumstance than in the others if
other things are equal. Hence, the coefficients of interaction dummy variables are
83
OWNl (%) Shares (%) of owner & owners family and affiliated firms of 1995
OWN12(%) OWN1+OWN2
LNOl Log (OWNl/lOO-OWNl)

LN02 Log (OWN2/100-OWN2)
LN012 Log (OWN12/100-OWN12)
ASSET Asset of 5-year annual average (Billion Won) from 1991 to 95

EQUITY Equity of 5-year annual average (Billion Won) from 1991 to95
DEBT Debt of 5-year annual average (million Won) from 1991 to 95
LEVER Average of debt-equity ratios from 1991-1995
SE Standard error of estimates from market model in which firms monthly

returns (60 months of 1991-1995) are regressed on the market portfolio
for the same period
STDINC Standard deviation of annual ratio of net profit to asset from 1991 to 1995
STD Standard deviation of monthly rate of return on the stocks of 60 months
(1991- 1995)
YR Period of years as a listed firm =1995- the listed year
DUM30 Top-30 chaebol firm=l, The Others =0.

DUM100 Top-100 chaebol firm= 1, The Others=0.
SE30 SE* DUM30

SE100 SE* DUM100
84
expected to have negative signs if SE has a positive sign, vice versa. Descriptions of all
independent and dependent variables are summarized in Table 4-5.
Table 4-6 shows means and standard deviations o f all variables in top-30, top-
100, non-chaebols, and all firms. Firm size in top 30 and top-100 as well as non-chaebols
is variable. Table shows that the ranges o f assets in top 30 chaebol, top-100 chaebols, and
non-chaebols are from 35.8 to 8,238.3, from 19.8 to 8,238.3, and from 5.2 to 1,128.8
billion Won and the range of equities of top-30 chaebols, top-100 chaebols, and non
chaebols are from 6.3 to 2,444.6, from 4.2 to 2,444.6, and from 2.1 to 845.3 billion Won,
respectively. However, the average of asset and equity are quietly different among them.
That is, top-30 and top-100 chaebols are 12 and 6 times higher, respectively than non
chaebol firms are. Though there are big differences in asset and equity among top-30,
top-100, and non-chaebols, the difference of inside ownership concentration (OWNl)
between chaebols affiliated firms and non-chaebol firms is only 4.51% and .51%,
respectively while. OWN2 of non-chaebols is 6.32% and 5.05% lower than that of top-30
chaebols and top-100 chaebols. Mean values of the stability variables do not show
consistent difference between chaebols affiliated firms and non-chaebol firms; non
chaebols show lower values in the standard deviation of 5-year net profits (STDINQ and
the standard error (SE) from the capital asset pricing model for 60 months, but a higher
standard deviation of returns on stock (STD) than chaebols.
Table 4-7 shows the correlation matrix among variables. The statistical
significance test revealed that the true correlations among variables are very significant;
the null hypothesis that there is no linear relationship between each pair of random
variables is rejected against the alternatives that the true correlation is a positive
85
Table 4-6: Mean and Standard Deviation Values
Variables Top-30 Chaebol Top-100 Chaebol Non-Chaebol All Data
Mean Maximum Mean Maximum Mean Maximum Mean Maximum
(S.D) Minimum (S.D) Minimum (S.D) Minimum Minimum
OWNl 21.133 51.80 25.111 51.80 25.645 62.80 25.354 62.8
(%) (12.653) 4.30 (12.565) 2.40 (11.888) 4.3 (12.247) 2.4
OWN2 14.325 59.80 13.055 68.50 8.005 68.2 10.759 68.5
<%) (13.000) 0 (12.129) 0 (9.654) 0 (11.448) 0
LNOl -1.487 .072 -1.231 .072 -1.174 .523 -1.205 .524
(.797) -3.102 (.766) -3.705 (691) -3.102 (732) -3.705
LN02 -2.221 .389 -2.294 .760 -2.875 .746 -2.558 .760
(1.330) -4.615 (1.256) -4.615 (1.244) -4.615 (1.282) -4.615
YR 15.211 29 14.732 39 10.245 33 12.698 39
(7.218) 5 (7.759) 4 (6.101) 5 (7.299) 4
ASSET 1,097.72 8,238.32 523.28 8,238.32 88,93 1,128.80 326.425 8,238.32
(1547.3) 35.85 (1020.81) 19.77 (142.98) 5.19 (790.26) 5.19
EQUITY 301.42 2,444.6 150.81 2,444.6 31.45 283.35 96.719 2,444.64
(444.28) 6.29 (289.83) 4.16 (38.11) 3.06 (223.64) 3.06
DEBT 796.29 5,793.6 372.45 5,793.6 57.48 845.27 229.705 5,793.67
(1121.8) 24.79 (742.78) 7.12 (108.61) 2.13 (575.401 2.13
LEVER 349.31 1,257.7 276.04 1257.75 189.448 1421.88 236.682 1421.88
(226.54) 74.56 (181.83) 30.27 (156.03) 23.64 (175.73) 23.64
SE .06495 .07614 .0629 .0761 .0603 .07648 .0617 .07647
(.0070) .04724 (.0070) .0451 (007) .04402 (.007) .04402
STD 3.5041 4.358 3.5835 4.613 3.761 5.155 3.664 5.155
(.332) 2.796 (.368) 2.796 (.403) 2.877 (.391) 2.796
STDINC 26775.0 1048523 11328.0 1048523 1688.1 53589.6 6946.26 1048523
(12488) 224.47 (77059) 107.36 (49615) 40.599 (57132) 40.599
DUM30 1 .3548 0 .194 1
(.479) (396) 0
DUM100 1 1 0 .545 1
(498) 0
Obs. 66 186 152 341
86
Table 4-7: Correlation Matrix
LNOl LN02 LNOl 2 ASSET EQ DEBT

LN02 -.199
LN012 .653 .467
ASSET -.237 .109 -.101
EQ -.221 .107 -.088 .972
DEBT -.239

.105 .995 .945
i*
LEVER -.017 .045 .004 .145 -.037 .184
YR -.148 .289 .049 .231 .228 .228
SE .017 .087 .073 .330 .329 .325
STD .075 -.078 .000 -.248 -.248 -.244
STDINC .037 -.040 -.003 -.055 -.067 -.049
DUM30 -.189 .128 -.026 .477 .448 .482
DUM100 -.037 .226 .129 .274 .266 .293
LEVER YR SE STD STDINC DUM30

YR .209
SE .061 .269
STD .057 -.095 .004
STDINC .193 -.049 -.071 .168
DUM30 .314 .168 .222 -.197 -.024
DUM100 .244 .306 .189 -.230 .056 .445
87
(or negative) linear association at a .5% significance level for all pairs. This table shows
that inside ownership concentration (LNOl) and the other independent variables move as
expected but do not show higher correlation coefficients at all. In addition, institutions
ownership concentration (LN02) and the other independent variables show the expected
movement but lower correlation coefficients.
Regression Results
Table 4-8 reports the estimates of inside ownership concentration (LNOl) based
on the model. Due to a heteroskedasticity problem, the equations are weighted by asset.
Equation 1 reports the estimate results: the p-values of two-tail significance test are .00%
for ASSET, 1.54% for YR, 44.66% of LEVER, and 1.89% of SE. All signs are as
predicted and are significant except LEVER. The sign and significance of ASSET and SE
are consistent with the views of Demsetz and Lehn (1985) that inside ownership will be
diffused, as a firm is getting larger and that the tighter control will pay off to the inside
owners if the firm face higher noise in its environment. Equations 2 and 3 report the
estimates with entering different proxies of stability such as STD and STDINC. They are
positive as predicted, but not significant at all. Equations 4 and 5 reveal the estimates
with entering different variables of firm size such as equity (EQUIYT) and debt (DEBT).
The results are similar to Equation 1. All signs are as predicted. The significant and
positive signs of ASSET and SE are also consistent with the views of Demsetz and Lehn
(1985). Equations 6 and 7 show the estimates added with dummy variables to capture the
differences in inside ownership concentration between chaebols and non-chaebols.
88
Table 4-8:Determinants o f Ownership concentration (LN Ol)
Variables 1 2 3 4 5 6 7 8 9
Concept -1.8572 -1.1253 -1.0387 -1.7942 -1.869 -1.8619 -1.7910 -1.9532 -24615
(5.196)* (2.900)*(1100)* (5.02)* (5.23)* (5.21)* (-5.01)* (5.03)"* (4.78)*"
ASSET -2.361*10* -1.977*10*
-1.985*10*
(-4.53) * (3.80)* (3.07)*
EQ -7.604*10* -5.795*10* -7.887*10* -5.212*10* 7.083*10*
(4.13)"* (2.87)*" (4.19) * (232) (3.69)*
DEBT -3.314*10*
(4.62)_*
YR -.0137 -.0108 -.0109 -.0135 -.0138 -.0135 -.0144 -.0141 -.0146
(2.43) (1.91)* (1.97) (2.38)" (2.48) (2.41)" (2.49) (2.47) (2.53)
LEVER 1.707*10* 1.522 10* 1.573*10* -.529*10* 2187*10* 2171*10* 1.719*10* 2180*10* .029*10*
(.762) (.670) (.696) (.236) (.972) (.921) (.034) (.924) (.001)
SE 13.9586 13.2925 14.0019 14.2655 13.0293 15.8249 24.2023
(2.36)* (2.236)" (2.37)" (2.41)" (2.19)" (2.44) (2.83)*"
STD .0235
(.229)
STDINC 4.721 *107
(.054)
SE3Q -9.3684
(60)
SE100 -20.9282
(181)*
DUM30 -.2463 .3429
(2.14)" (.345)
DUM100 .0656 1.3468
(.774) (1.88)*
Adj. R-sq. .0713 .056 .056 .062 .073 .072 .061 .070 .067
F-statistic 7.525* 6.047* 6.035* 6.645*" 7.734 * 6.288* 5.429"* 5.289* 5.100*"
Note: () shows absolute value of t- statistics and*, **, and *** for the significance level
at a 10%, 5%, and 1%, respectively.
89
Equation 6 shows that the signs o f all variables are as predicted and significant at least at
a 10% level: 0.42% for EQUITY, 1.81% for YR, 36.59% for LEVER, and 1.51% for SE.
In addition, DUM30 shows a negative sign as expected and is significant at a 5% level. It
explains that there is a difference in inside ownership concentration between chaebols
and non-chaebols. In Equation 7, all signs are as predicted except DUM100. EQUITY,
YR, and SE are significant at least at a 5% level while DUM100 and LEVER are
insignificant. Equations 8 and 9 report the estimates of the interaction variables such as
SE30 and SE100 to capture the possibility that chaebols alter the effect on instability.
Equations 8 and 9 report that the interaction variables such as SE30 in Equation 8 have
negative signs, but are not significant at all. In addition, the coefficient of DUM30 in
Equation 8 has a high standard error and a low significance level in spite of that fact that
DUM30 is highly significant in Equation 7. Equation 9 shows that both coefficients of
SE100 and DUM100 are significant at the 10% significance level, but DumlOO reveals
not an expected sign. These symptoms stem from higher correlation between interaction
dummies and dummy variable and lower variation in SE; SE30 and DUM30 or SE100
and DUM100 are highly correlated (rSE3o, dum 3o = -993 and T s e io o , d u m io o = -986) and
variation of SE is very low (SE=.0617 and s.d. of SE=.007). That is, these indicate that
interaction dummies are not very meaningful.
In short, Table 4-8 reveals that the results are consistent with Demsetz and Lehns
outcomes, which explain that firm size and business environment are two main
determinants of ownership concentration. In addition, the firms age is found as a
significant determinant that affects inside ownership concentration.
90
On the other hand, the estimates with outside ownership concentration (LN02)
are reported in Table 4-9. It shows the opposite signs to inside ownership concentration
(LNOl). Equations 1, 2, and 3 reveal that only YR is negative and significant at a 1%
level and the others coefficients are opposite signs to LNOl but are insignificant.
Equations 1, 2, and 3 reveal that SE, STD, and STDINC are positive coefficient signs. It
seems to support the portfolio theory that risk bearers such as outside big shareholders are
likely to spread their wealth across many firms, but the coefficients of those variables are
not significant at all. As EQUITY or DEBT is entered into the regression in place of
ASSET in Equations 4 and S, the results show the same signs as ASSET is entered, but
all variables except YR are not significant at all. YR reveals positive signs and is
significant at a 1% level in all equations of Table 4-9. Thus, it is consistent with the view
of firm development; the increased dispersion of inside ownership by transferring to
outsiders is inevitable with the lapse of time. . Equations 6 and 7 show the estimates
added with dummy variables to capture the differences in outside ownership
concentration between chaebols and non-chaebols. Equation 6 shows that all coefficients
are not significant, except YR; the coefficient of DUM30 shows a positive sign, but are
not significant. However, the coefficient of DUM100 in Equation 7 shows a positive sign
and is significant at a 1% level; there is a difference in outside ownership concentration
between chaebols and non-chaebols. Equations 8 and 9 report the estimates of the
interaction dummies such as SE30 and SE100 to capture the possibility that chaebols
alter the effect on instability. Equation 8 shows that both interaction dummies and
DUM30 are significant at the 5% level, but SE30 is positive while DUM30 is negative. In
Equation9, SE 100 are positive and significant at the 10% level whereas DUM100 is
91
Table 4-9: Determinants o f Ownership Concentration with LN02 (n=341)
(Independent Variable=LNQ2, n=341)
Variable 1 2 3 4 5 6 7 8 9
Concept -3.1373 -2.6898 -3.1752 -3.1520 -3.1355 -3.0672 -3.1314 -2.4031 -2.0550
(5.02)*** (4.00)**8 (21.69)* (5.07)* (5.02)*" (4.92)*" (-5.08) * (3.57)* (2.32)"
ASSET .744*104 -.566M04 -8.743*104
(.806) (.627) (.780)
EQUIT -2.493*10-7 -2.275*107 -7.195*10-7 4.017*10-7 -5.714*10-7
(.778) (.058) (.214) (1.04) (181)
DEBT -1.029*1O4
(.818)*"
YR .0496 -.0491 -.0494 -.0495 -.0497 -.0496 -.0438 -.0537 -.0442
(5.06)*** (5.14) * (5.14)* (5.03)* (5.08)* (5.06)*" (4.40)* (5.45)* (4.46)*
LEVER -1.479*1(h* - . I ^ I O 4 -1.500*10 4 -n o e v o 4 -.1.613*104 -3.162*104 -3.342*10 4 -3.226-104 -3.061'104
(.377) (.296) (.383) (.283) (412) (.769) (.849 (.791) (779)
SE -.6428 -.5231 -.6215 -1.7419 -2.1702 -13.0885 -20.1068
(.062) (.051) (.060) (1.68) (212) (1.167) (1.36)
STD .1315
(761)
STDINC -3.153*10-7
(.390)
SE30 68.1672
(2.31)
SE100 33.5791
(1.69)*
DUM30 .3085 -3.9785
(1.54) (2.31)
DUM100 .4107 -1.6460
(.2.81)* (1.34)
Adj. R- .074 .076 .074 .074 .074 .078 .093 .093 .098
sq.
F-stat 7.815* 7.964* 7.826 * 7.798* 7.816"* 6.736*" 7.951 * 6.754"* 7.137*
Note: () shows t-statistics and *, **, and *** stand for the significance level at a 10%,
5%, and 1%, respectively.
92
negative, but not significant. In addition, the coefficients of DUM30 and DUM100 in
Equations 8 and 9 reveal big changes with an opposite sign. These symptoms also stem
from multicollinearity ( r s E 3 o . d u m jo = 993 and ts e io o , d u m io o = 986) and low variation in
SE. That is, these indicate that interaction dummies are not very meaningful.
4.5. Conclusion
In this chapter, my research investigated ownership structure and its determinants
in the Korean private business sector. First, I divided ownership concentration into inside
and outside ownership concentration because of non-separation of ownership from
management in Korean private businesses. In most empirics, top-5 or top-10
shareholders' ownership percentages were used for dependent variables. It may cause a
problem because the standpoints between outside and inside shareholders may be
different. Demsetz and Lehn (1985) insisted that business environment would affect
inside ownership concentration negatively. However, in the standpoint of outside
shareholders who do not participate in management, they would spread out their
shareholdings in accordance with the portfolio theory if they expect that the business
environment is unstable; that is, outside ownership concentration would have a negative
relationship with instability. Therefore, the empirics without differentiating from inside to
outside shareholdings may result in unsuitable outcomes. Furthermore, considering
Korean business circumstances, three other variables were added in two main
determinants of ownership concentration. One is debt because debt does not cause
diffusion of insider ownership directly but bears capital cost, i.e., interest, which is
considered one of the production costs. The second one is the firm's age. According to
93
the corporation revolution theory, inside ownership is likely to decrease with time.
Modem business history of Korean private corporations is very short in comparison to
that of the developed countries corporations. Most corporations in Korea had been
established since World War II and Korean stock market was opened in 1956 (the
average o f the listed period is only 12.8 years). Thus, inside ownership is predicted to be
likely to decrease with time. Lastly, in order to estimate the difference of stability effect
between chaebols and non-chaebols, an interaction dummy was adopted. Each of the
affiliated firms is operated as a part of a chaebol and under single common administrative
and financial control and is bounded by ties of fractional ownership and reciprocal or
joint investments in the chaebol. Hence, it is assumed that change in business
environment will less affect ownership concentration in chaebols than in non-chaebols if
other things are equal.
The findings from the estimates are the followings:
1) Firm size affects inside as well as outside ownership concentration. In the case
of Korea, the results show a negative relationship between inside ownership
concentration and firm size. This is consistent with Demsetz and Lehns (1985) and
Prowses (1992) findings in the U.S. and Japan, respectively. In addition, outside
ownership concentration shows a positive relationship with firm size, but not
significantly. Therefore, distinguishing inside from outside ownership concentration is
necessary.
2) Stability of business environments demonstrates positive relationships with
inside ownership concentration. This result is consistent with Demsetz and Lehns view
that inside ownership concentration increases as business environments are expected to
94
be unstable. On the other hand, instability variables reveal negative relationships with
outside ownership concentration but the coefficients were not significant at all. That is,
the portfolio theory failed in explaining that risk bearers such as outside shareholders are
likely to spread their wealth across many firms.
3) The firms age shows a negatively significant determinant in the Korean case.
This result, a negative relationship between the firms age and insiders ownership
concentration, is consistent with Berle and Means view, i.e., corporation revolution
theory. On the other hand, the firms age reveals a positively significant determinant of
outside ownership concentration. It reflects that the decreased ownership concentration
from inside ownership is transferred to outsiders.
4) For inside ownership concentration, top-30 chaebols actually have less
ownership concentration than other firms, but have relatively higher inside ownership
concentration in comparison to their assets or equities. Part of this is thought that chaebol
membership would reduce the positive effect of instability on ownership concentration.
However, the estimates shows unexpected way because of high correlations ( r s E 3 o , d u m 3 0 =
.993 and ts e io o . d u m io o = .986) and low variation in SE (SE=0.0617 and s.d. of
SE=0.007). That is, these indicate that interaction dummies are not very meaningful.
95
Chapter Five: Vertical Integration and Determinants
5.1 Introduction
There are different organizational structures from country to country. A chaebol
in Korea is defined as a big business group that consists of many formally independent
companies and is governed by a single family. It has a unique structure, which is
vertically integrated at a group level rather than at a firm level or a plant level1 and
diversified into related businesses. Though each affiliated firm is formally independent
(Korean Commerce Law prohibits holding companies), it is a subsidiary in reality and
one of the divisions in a multi-market structure at the group level.
Three important economic factors may affect the present chaebols multi-market
structure. The first one is market imperfection, which may be a common phenomenon in
undeveloped or developing countries. After liberalization in 1945, the Korean economy
fully depended on foreign aid and agricultural products. Moreover, the Korean War
(1950-53) destroyed for the most part infrastructure. Thus, domestic markets, especially
raw and intermediate input markets, were unstable as well as imperfect; there were the
incomplete or distorted disclosures of information in markets as well as contracts.
Increased transaction costs2 from these problems led chaebols to participate in various
business lines; the chaebol coordinated a variety of resources and tried to become much
more self-sufficient. That is, vertical integration might be an inevitable strategy in order to
eliminate higher transaction costs and uncertainty caused by unstable and imperfect
1 Group-level integration is integration that occurs among different firms in different

geographic sites but under a single administration. Firm-level integration occurs in the
same firm in a different geographic site, while plant-level integration occurs in the same
firm at the same geographic site.
2 Vertical integration and diversification are considered evidence of intermediate market
failure and capital market failure, respectively (Williamson, 1987).
96
markets.
The second factor is related to the industrial policy of the Korean government.
After the military coup detat of 1959, an active government insisted on an export
promotion and nurturing policy for economic development and rearranged faltering
businesses. The export promotion policy led chaebols to participate in various light
industries. The government provided various kinds of supports such as subsidies, bounties
on export, and low rate domestic loans to exporting business groups. In addition, the
nurturing policy for heavy and chemistry industries in the 1970s led them to join those
industries. This policy gave full benefits to the established corporations, such as chaebols,
because the government thought they had economies of scale and experience in business.
Furthermore, the government rearranged faltering businesses in the 1970s and readjusted the
heavy industries with over-capacity in the 1980s. It also offered an opportunity for chaebols
to become more diversified and vertically integrated.
The final economic factor is government intervention in domestic financial
markets after the military coup detat in 1959. Commercial banks were nationalized;3
therefore, the approval of annual budgets and the appointment of top managements came
under the control of the government. Of course, the government tightly controlled the
allocation of credit, which is related to chaebols diversification. A conglomerate or a
group firm enables the circulation of funds in a group to maintain stable capital flows and
the smooth shift of funds to those showing higher profits; the conglomerate contains a
miniature capital market substituting the capital allocation function of the market. The
3 Until the 1960s, the intermediary role of commercial banks was of little significance
because of negligible savings of the nation. The primary purpose of financial institutions
was to channel aid funds to rehabilitation projects and fanners (Nam and Lee, 1995).
97
multidivisional organization forms a pool of funds from affiliated firms and reallocates
them in order of profitability of investment (Chang and Choi, 1987).
The chaebols organizational structure, which is the multi-market form at the
group level, stems from these three economic factors and may affect differently the
determinants of vertical integration between chaebols affiliated firms and the other
independent firms. Therefore, my purpose of this chapter is to research how chaebols
organizational structure affects firm-level integration in addition to what the vertical
integration determinants are. In the first section, the structure of Korean business groups
will be described. This section will explain why the chaebol has the multi-market form at
the group level and why the effects of determinants on vertical integration may be
different between the chaebols affiliated firms and the other independent firms (non
chaebols). Then, the determinants of vertical integration are to be investigated and
possible proxy variables of determinants will be introduced in terms of the chaebols
organizational structure. Lastly, the empirical test will follow.
5.2 Organizational Structure in Korean Corporations
On one hand, upward integration at the group level in chaebols is adopted as a
market strategy to reduce the increased transaction costs by the uncertainties of market
transaction or to generate quasi-rent value from asset-specificity. On the other hand,
downward integration, such as a general trading company and department stores in
chaebols, can be interpreted as efforts to seek economies of scale and scope as well as
transaction cost economies from certainty and asset-specificity.
Figure 5-1 shows a general organizational structure of a chaebol, Hyundai, which
98
Figure 5-1: Organizational Structure (Hyundai Group)
Chairman
Planning Office President

Or Secretarial Office Meeting
Audit and Inspection The General Board

Office
Affiliated Firms
Sales/Export
Finance Manufactures R&D

(Integration
among affiliated
Transportation firms and Advertisement
Diversification)
Development or Import of Law Materials
99
is organized centering on the chairman of the chaebol group. The chaebol operates an
office of planning and coordination, a president meeting, a self-audit inspection team, and
a general board of directors. The office of planning and coordination (sometimes called
the secretarial office) operates to determine all decisions, to take care of problems faced
by all affiliated firms, and to advise the chairman of all possible information. It is a think
tank.
The regular president meeting is a path of communication for the initiation of new
investment, implementation, ramifications of proposals, and reports or briefings of
performance on implementation. The self-audit inspection team operates for monitoring
all employees. The general board members usually consist of inside members of the
group, and the chairman is the president of the board. All these systems are centralized on
and governed by the chairman; therefore, all authority is concentrated toward the
chairman.
Figure 5-2 shows another view of organization. It shows how chaebols are
vertically integrated at the group level. The Hyundai chaebol group, for instance, entered
almost all industries from the supply of raw materials to sales of final goods and services:
47 affiliated firms of the Hyundai group participate in the 10 out of 15 industries (by two-
digit standard industrial classification: SIC). Hyundai shows a multi-market form that
includes characteristics of vertical integration (that is, operating several stages of the
production process at the group level) and of conglomerate (that is, diversifying all
industries). For instance, in the case of a manufacturing sector in the Hyundai chaebol,
Hyundai Engineering & Construction Co., Ltd. is vertically related with Inchun Iron &
Steel Co. Ltd. (e.g., reinforcing bar), Hyundai Construction Equipment Services Co., Ltd.
100
Fieure 5-2: Vertical Integration and Diversification (Hyundai Group)
Inchun Iron & Steel Co., Ltd.

Construction Equipment Services Co.
Engineering &
Koryeo Industrial Development Co.,
Construction
Hyundai Aluminum Industry Co., Ltd.
Hyundai Hosing Co.
Hyundai Elevator Co., Ltd.
Hyundai Pipe Co., Ltd.
Hyundai
Resource Hyundai Heavy Industry
Development Co. Hyundai Mipo Dockyard
Hyundai Woods Industries Co., Ltd Hyundai Corporation
Hanmoo Shopping
Keum-Kang Development
Alaska Hyundai Department
Development Hyundai Petrochemical
o Hyundai Oil Co.,

I.id Hyundai Electronics
Hyundai Production
Diamond Advertise
Kepico
Hyundai Auto Service
Hvundai Motor America
Hyundai Auto Co.
Hyundai Precision Co. Ltd
Resource Supply Intermediate & Final products Sales &Export

(e.g., construction equipment), Hyundai Woods Industries Co., Ltd. (e.g., construction
woods, fliers, logs), Koryeo Industrial Development, Co. Ltd. (e.g., cements), Hyundai
Aluminum Industry Co., Ltd. (e.g., window sashes), Hyundai Elevator Co., Ltd. (e.g.,
elevators and escalators), Hyundai Pipe Co., Ltd. (e.g., plumbing pipes) and so
on. Hyundai Auto is integrated forward to Hyundai Corporation (e.g., sales and export of
cars) and Hyundai Auto Service (e.g., auto repair and parts sale), and is integrated
backward to Kepico (e.g., auto parts), Hyundai Precision Co. Ltd. (e.g., auto frame),
Hyundai Electronic Co. Ltd. (e.g., auto electric parts), and so on. On one hand, Hyundai
Corp. (an exporting window), Hanmoo Shopping and Keum-Kang Development
(department and retails) are integrated forward to the affiliated firms that produce
consumer goods. Alaska Development (e.g., development of oil and wood in Alaska),
Hyundai Resource Development (e.g., development wood in Russia), Hyundai Oil (e.g.,
oil importing and refining) and Hyundai Aluminum (e.g., aluminum, metal, and non-
metal importing) are integrated backward to the affiliated firms that use the raw material
goods. On the other hand, transportation firms (e.g., Suneel Shipping and Hyundai
Merchandise for transportation, shipping and resource development), finance institutions
(e.g., Hyundai Marine & Fire Insurance for fire insurance and retirement allowances,
Kangwon Bank, Hyundai Security, and Hyundai Auto Finance), R&D institutions (e.g.,
Hyundai Economic Research, John-Brown Engineering, Hyundai Information
Technology and Hyundai Technology System) and advertisement companies (e.g.,
Diamond Advertise and Seoul Production) are universally related with all Hyundai
chaebol's affiliated firms. Therefore, the affiliated firms have more advantage supplying
102
upstream product goods, receiving information of downstream firms, improving capital
flows, and incorporating R&D and advertisement.
Table 5-1 shows how the top-30 chaebols are diversified by industry. The degrees
of diversification are calculated based on the Berry Index, the Entropy Index, and the
2
Diversification Index. The Berry Index defines 1- S . , where S is Xi/X, Xi is sales
amounts of i-th industry of a chaebol and X is total amounts of the sales of the chaebol. If
2 2
a chaebol specializes in a certain industry, then S. will be 1. Therefore, the closer S. is to
1, the closer the Berry Index will be to 0, which means that the chaebol is less diversified.
If the chaebol is more diversified the Berry Index will be close to 1. The Entropy Index
defines -ISi* In (S), where In (S) is a log form of S . If the chaebol specializes in a
certain industry, the Entropy Index will be 0 because In (S) is 0. The Diversification
Index defines 1-XL/X, where XL is the largest sales amount of an industry in the chaebol.
If the chaebol is less diversified, the closer the Diversification Index will be to 0, and if
the chaebol is more diversified, the closer Diversification Index will be to 1. Among
chaebols, Kia (automobiles), Dong Ah (construction), Dongkuk (steel), and Kukdong
(construction) show a less diversified index while Hyundai, Samsung, LG, Ssangyong,
Doosan, and the Kolon show a highly diversified index.
Table 5-2 shows diversification index as for subgroups of 135 chaebols.4 They are
calculated according to sale and asset amounts. Diversification I is 1- XL/X, where XLis
the largest sales or assets of a firm and X is the total sales or assets of a chaebol.
4 Data of 132 chaebols are collected from the Annual Report o f Korea Companies,
1995, published by Korea Investors Services Inc.
103
Table5-1: Index o f Diversification in Big 30 Chaebols (1994)
Berry (a) Entropy (b) Diversification (c) Number (d)

Hyundai .7521 1.1633 .6305 10(47)
Samsung .6782 1.1449 .6260 10(58)
Daewoo .5210 .8080 .4754 5 (24)
LG .7639 1.6612 .6400 10 (49)
Sunkyung .6658 1.3362 .4971 7(32)
Hanjin .3829 .7348 .2326 6 (34)

Ssangyong .7958 1.8123 .6613 11 (22)
Kia .1176 .2754 .0618 3(15)
Hanwha .4974 1.0186 .3128 7(33)
Lotte .7372 1.5948 .6400 10(27)
Kumho .6516 1.0079 .5667 3 (15)

Daelim .4013 .8253 .2396 5(17)
Doosan .7490 1.5775 .6121 7(27)
Dong Ah .3479 .5642 .2202 3 (14)
Hyosung .5863 1.0181 .4655 6(16)
Halla .4680 1.0219 .3467 4(15)

Hanil .5909 1.0719 .4891 5 (9)
Dongkuk .2556 .6909 .1424 4(16)
Sammi .4625 .7405 .3385 5 (8)
Tong Yang .5571 .9844 .4434 5 (20)
Kolon .7169 1.5248 .5711 8(20)

Jinro .5684 1.0508 .4065 5(11)
Kohap .4664 .8168 .3147 4(10)
Woosung .3574 .6641 .2128 3 (8)
Dongbu .7443 1.4632 .6362 5 (23)
Haitai .6856 1.3084 .5205 5(13)

Kukdong .0675 .1507 .0339 3(10)
Hanbo .5135 .8733 .3838 4(21)
Miwon .6971 1.3602 .5457 5(14)
Byucksan .6321 1.2310 .4632 6(18)
Note: 1) (a) Berry Index = I-(Xi/X) = 1-Si , where X* is i-th industrys sale amounts and X is total sale
amounts o f a group, (b) Entropy Index = ISi*ln S (c) Diversification Index = 1-XL/X, where XL is the largest
industrys sale amounts o f a group, and (d) Number means the number o f industries in which a group
participates; ( ) in Number shows the number o f affiliated firms.
2) Industries are divided into 15 groups: Fishing, Mining, Foods & Beverages, Textile & Wearing
Apparel, Wood & Paper, Chemical & Petroleum (Rubber & Plastic), Non Metallic products, Basic &
Fabricated Metal, Machinery & Equipment, Electric & Gas, Construction, Sale (whole & Retail) & Hotel,
Transportation & Storage, Real Estate, and Trade. (Financial Industry is excluded.)
104
Table5-2: Diversification o f 135 Chaebols in 1994
Diversification I Diversification II
Sales Assets Sales Assets
Big 30 Chaebols .606 .702 9.789 11.497
Big 50 Chaebols .542 .629 7.319 8.503
Big 3 0 - 135 Chaebols 391 .429 2.073 2.284
Big 135 Chaebols .447 .502 4.016 4.588
Notice: Diversification II=(l-X[/X)*#of firms and Diversification 1=1- XL/X.
105
Diversification II is another index that is multiplied by the number of affiliated
companies in a chaebol to Diversification I. Both indexes show that the bigger the
chaebol (both in sales and assets), the more diversified.
5.3. Determinants of Vertical Integration
Asset-specificity
The transaction cost theory is based on two basic assumptions: bounded
rationality and opportunism. In most of the literature, determinants of vertical integration
associated with transaction cost economies were tested based on this conception. In
transaction cost economics, the primary determinant of vertical integration is asset-
specificity (Coase, 1937; Williamson, 1975, 1985; Klein, Crawford, and Alchian, 1978;
and Alchian and Demsetz, 1972). Asset-specificity generates quasi-rent value that is
more easily captured through vertical integration. Therefore, the predicted effect of asset-
specificity is positive; it can be hypothesized that a firm is more likely to integrate when
the firm makes higher specific investments.
Empirically, R&D, advertisement intensity, (e.g., Levy, 1985 and MacDonald,
1984) and sunk cost (e.g., Monteverde and Teece, 1987; Joskow, 1985; MacDonald,
1984; and Lieberman, 1991) are used for proxy variables.
Uncertainty
Uncertainty is one of the determinants of vertical integration. Uncertainty stems
from bounded rationality (Williamson, 1975 and 1985). Without bounded rationality,
economic actors could write contracts of unlimited complexity that would specify all
106
possible contingencies in an economic exchange; this complicates writing and enforcing
contingent claim contracts since the environment shifts in unforeseen ways (Anderson
and Schmittlein, 1984). The change of market environment forces contract re-negotiation
(even the best contracts are not perfect), which may lead to the adaptation o f vertical
integration to eliminate either the revising costs for formal agreements or the contracts
between two parties. In addition, if uncertainty is higher in the present and future
markets, vertical integration is expected to increase for improving supply reliability
(Carlton, 1979 and Helfat and Teece, 1987).
Organizational Form
As mentioned above, chaebols are vertically integrated at the group level; each of
the affiliated firms, which are legally independent, is operated as a part of a chaebol and
these affiliated firms are universally integrated at the group level under a single common
administration and financial control. Therefore, the affiliated firms have more advantage
supplying upstream product goods and services, improving capital flow, and coordinating
R&D and advertisement. These are not a firms but rather a groups specific assets,
making the affiliated firms substitute group-level integration for firm or plant-level
integration. As a result, the affiliated firms are expected to be less likely to integrate at
the firm or plant level; the affiliated firms tend to integrate at the group level rather than
at the firm or plant level. Therefore, a firm would be less likely to integrate at the firm or
plant level if the firm were vertically related with its group.
107
Modeling
Estimation of each equation o f the model has a following form.
5-1) VI=PQ+ f^*Asset-specificity + P2*Uncertainty + 8* Organization + e
VI is the degree of vertical integration. Asset-specificity and Uncertainty
represent the variables for asset-specificity and uncertainty in business circumstances
whereas Organization is a dummy variable to capture the effect of the chaebols
organization.
The value-added method, which is a way to measure the degree of vertical
integration, is used widely for the cross sectional data (Adelman, 1955; Tucker & Wilder,
1977; Buzzell, 1984; and Levy, 1985). The value-added method explains that the more
stages of production and distribution are combined within a firm, the higher the ratio of
value-added to sales amount is.
Though it is easy to the data of value-added, using a value-added method is
problematic in measuring the degree of vertical integration. One problem is that profit is
included in the items of value-added, which are net profit, income taxes, depreciation,
rents, labor expense, pension and retirement expense and interests. This method is
corrected by subtracting net profit from the value-added, using the adjusted value-added
measurement. Another problem is that the degree of vertical integration by the value-
added method may be biased because of different successive stages in production flows
and different market circumstances in supply and demand faced by each industry.
108
Therefore, the data is required to be standardized. An adjusted ( VIa) and a standardized-
degree of vertical integration (VIS) are calculated as follows:
VIa =(Value added - Net Income-lncome Tax)/(Sale - Net Income-Income Tax)
VI, = (VIr Ave. VI/STD. VI)
Ave.VIj and STD.VIj represent the average and the standard deviation of the
degree of vertical integration in thej-th industry, respectively.
R&D, advertising intensity (e.g., Levy, 1985 and MacDonald, 1984), and sunk
costs (e.g., Monteverde and Teece, 1987; Joskow, 1985; MacDonald, 1984; and
Lieberman, 1991) are employed as the proxy variables for asset-specificity. R&D (RDI)
and advertising expenses (ADI) are used primarily in a firms producing differentiated
goods that require asset specific investment. Therefore, the firm that spends the
significant amount of R&D and advertising will have more specific investment assets.
Other specific investments are measured by sunk costs (SUNK) and a percentage
of main production (DIV). The higher the specialized investment, the more likely those
transactors will rely on common ownership rather than a contractual relationship because
supplier-switching costs are often high (Lieberman, 1991).
If uncertainty is higher in the present and future markets, then vertical integration
is expected to increase. Empirical studies treat this uncertainty as an independent
variable, using a proxy variable, such as beta (BETA) from the capital asset pricing
model (e.g., Levy, 1984) and the standard deviations of monthly returns on the stock
(STD) for 60 months, from 1991 to 1995. These variables capture uncertainty due to
109
systematical risk on investment and stock price, respectively.
Vertical integration at the group level rather than the firm or plant level in
chaebols is considered a strategy to economize on transaction costs; that is, an affiliated
firm that is vertically integrated at the group level is predicted to be less likely to
integrate at the plant or firm level because of nearly non-opportunistic behavior and non
contractual problems among the affiliated firms. Dummy variables are used to capture
different effects on vertical integration. Descriptions are as follows:
1) If a firm belongs to top-30 chaebols, then DUM30= 1, and DUM30=0 otherwise
2) If a firm belongs to top-100 chaebols, then DVM100= 1, and DUM100=0
otherwise
part or all of the inputs of a firms processes (forward vertical relationship) and a
part or all of the outputs of a firms processes is employed as the input of its
variable for the firm, indicating back and forward integration (BF), is equal to
one, and zero otherwise.
part or all of the inputs of a firms processes (forward vertical relationship), but a
part or all of the outputs of a firms processes is not employed as the input of its
variable for the firm, indicating forward integration (FWD), is equal to one, and
zero otherwise.
110
S) If a part or all of the outputs of a firms processes is employed as the input of
its affiliated firms processes, but a part or all of the outputs of its affiliated firms
processes is not employed as a part or all the inputs of a firms processes, then the
dummy variable for the firm, indicating back integration (BACK), is equal to one,
and zero otherwise.
All these variables are described at Table 5-3 while Table 5-4 summarizes the
standard deviations, means, maximum, and minimum values of variables. The degree of
vertical integration in chaebols shows a slightly lower level than that in non-chaebols;
this gives an expectation that group-level integration may decrease willingness to
organizing firm or plant-level integration. Among asset-specificity variables, R&D
intensity (RDI) and sunk cost (SUNK) in chaebols are much higher than those in non
chaebol firms; RDI is twice as high in top-30 chaebols (6.396%) than in non-chaebols
(3.247%) and SUNK is 8.51 % higher in top-30 chaebols (40.849%) than in non-chaebols
(32.338%). On the other hand, advertisement intensity (ADI) is lower in top-30 (1.198%)
and top-100 chaebols (1.502%) than in non-chaebols (2.202%). This may be explained by
recognition of firms; chaebol firms are broadly recognized to the public, so that they may
not have to advertise as much as non-chaebols do. In addition, the percentage of main
product (DIV) is lower in top-30 (50.56%) and top-100 chaebols (53.76%) than in non
chaebol (54.55%). In the case of uncertainty variables, the standard deviation of monthly
rate of returns on stock (STD), and the systematical risk on investment (BETA) in
chaebols are lower that those of non-chaebols are. In addition, this table shows that
chaebols are highly integrated at the group level; 96.9% (BF+BACK+FWD) of top-30
chaebols are vertically related whereas only 28.4% of non-100 chaebols are vertically
111
VIa Adjusted degree of vertical integration; (Value-added - Net profit)/(Sales-Net
profit) of 1995
Vis Standardized degree of vertical integration; (VIj-Ave.VIj)/ STD.VIj of 1995
ADI (%) Advertising intensity; 5-year (1991-95) annual average of advertising costs to
total sales
RDI (%) R&D intensity, 5-year annual (1991-95) average of advertising cost to total
sales
SUNK(%) Sunk costs; Fixed Costs/ Total Assets; 5-year (1991-95) annual average
DIV(%) Diversification; Sales amounts of main product/ Total Sales of 1995
BETA The systematical risk on investment from CAPM for 60 months (1991-95)
STD The standard deviation of monthly rate of returns on the stock of 60 months
(1991-95)

DUM30=0.
DUM 100=0.
BF If a firm's production has backward and forward vertical relationship with

its affiliated firms productions, then BF=1, otherwise BF=0.
BACK If a firms production has only backward vertical relationship with its
affiliated firms productions, then BACK=1, otherwise BACK=0.
FWD If a firms production has only forward vertical relationship with its
affiliated firms productions, then FWD=1, otherwise FWD=0.
112
TableS-4: Means and Standard Deviations o f Chaebols and Non-chaebols firms in the
listed firms of 1995
Variab Big 30 Big 100 Non All Manufacturing Firms
les Chaebol Chaebol Chaebol Mean Max Min
Via 23.419 24.814 25.104 24.084 47.188 .683
(8.828) (8.425) (8.962) (9.030)
VIS .76715 .81999 .85848 -.121 3.447 -3.292
(.241) (.257) (279) (267)
ADI 1.198 1.502 2.022 1.739 14.994 0
(1.798) (2.504) (3.6780 (3.088)
RDI 6.396 4.489 3.247 4.087 52.122 0
(1.086) (8.151) (6.102) (7.774)
SUNK 40.8492 36.7026 32.338 34.736 77.437 5.706
(11.644) (13.666) (21.342) (13.244)
DIV 50.5593 53.7602 54.5546 24.389 100.00 4.50
(24.600) (24.647) (24.148) (13.244)
BETA .87746 1.0087 1.1551 1.072 2.209 .003
(.3167) (.3134) (.3487) (340)
STD 3.5041 3.5835 3.7262 3.664 5.156 2.796
(.332) (.368) (398) (391)
DUM30 .194 1 0
(396)
DUMIO .545 1 0
0 (498)
BF .43076 .17460 .00658 .0997 I 0
(.4990) (.3806) (.300)
BACK .32307 .35978 .16447 .273 1 0
(.4712) (.4812) (.3719) (.446)
FWD .21538 .25396 .11842 .194 1 0
(.4143) (.4364) (.2791) (.396)
Obs. 66 189 152 341
113
related to one another. This implies that bigger chaebol groups are more highly integrated
at the group level.
Correlations among variables are reported in Table 5-5. The statistical
significance tests revealed that the true correlations among variables are very significant;
the null hypothesis of no linear relationship between each pair of random variables is
rejected against the alternatives; the true correlations are positive (or negative) linear
associations at a .5% significant level for all pairs. Generally, this table shows that
correlations among all variables are low, except among DUM30, DUM100, and BF.
Regression Results
Regression results with the standardized degree of vertical integration {Vis) are
represented in Table 5-6. Among asset-specificity variables, ADI, SUNK, and D IV show
important determinants of vertical integration but RDI does not; both advertisement
intensity {ADI) and sunk costs {SUNK) show the significant level at 1% in all equations
with the predicted positive signs; sales of main production {DIV) shows generally
significant at a 5% level with the predicted sign; and research and development intensity
{RDI) is not significant at all with a negative sign in Equation 1.
An uncertainty variable, BETA, seems to be an important determinant of vertical
integration. The coefficients of BETA show the predicted positive signs and are
significant at the level of 5% and 10% in Equations 2 and 4, respectively. The
coefficients of STD also show the predicted positive signs and are significant at least at a
5% and 10% level in equations 1 and 3, respectively. Both coefficients of chaebol
dummies, DUM30 and DUM100, show the expected signs, and DUM30 is significant at
114
Via Vis ADI RDI SUNK DIV BETA STD D3& D10& BF BACK
Vis .888
ADI .317 .245
RDI -.026 -.056 .034
SUNK .182 .124 -.271 -.025
DIV -.001 .089 -.198 -.250 .066
BETA .102 .081 .124 -.202 -.235 .045
STD .085 .108 .059 -.167 -.156 .050 .590
D30 -.104 -.129 -.087 .190 .242 -.071 -.282 -.198
DI00 -.007 -.044 -.074 .103 .183 -.018 -.246 -.228 .447
BF -.082 -.112 -.048 .164 .150 -.144 -.295 -219 .531 .304
BACK -.036 -.073 -.089 .046 .134 .003 -.047 .008 .067 .215 -.204
FWD -.040 -.047 -.009 .017 -.061 -.049 -.014 -.097 .023 .149 -.163 -.283
Note: D30J=DUM30, and D100J=DUM100
115
Table 5-6: Determinants o f Vertical Integration in All Listed Firms with Ms
Independent Variable=Standardized degree of Vertical Integration ( VI,), n=341

IM W tM U lk V f^ i W M W 1 I
Variables 1 2 3 4 5
Concept -2.3193 -.5034 -2.1213 -2.2557 -1.8926
(4.057)*** (5.357)*** (3.826)*** (3.949)*** (3.276)***
ADI .1087 .1077 .1071 .1085 .1037
(6.024)*** (5.937)*** (5.988)*** (6.013)*** (5.771)***
RDI -.0014
(.197)
SUNK .0172 .0174 .0195 .0177 .0193
(4.124)*** (4.099)*** (4.609)*** (4.185)*** (4.584)***
DIV .0055 .0057 .0052 .0056 .0045
(2.443)** (2.571)** (2.351)** (2.542)** (2.019)**
STD .3049 .2527 .2300
(2.202)** (1.842)* (.1.648)
BETA .2653 .2914
(1.655)* (2.089)**
DUM30 -.3508
(-2.533)**
DUM100 -.0693
(-.631)
BF -.4734
(-2.436)**
BACK -.2961
(-2.288)**
FWD -.1932
(-1.340)
Adj. R-sq. .1186 .11.50 .1352 .1325 .1357
F-statistic 10.158*** 12.043*** 11.617*** 10.241*** 8.625***
5%,
116
a 1% while D UM 100 is insignificant. The coefficient of D U M 30 in equation 3 is lower
than that of DUM 30. The negative sign in D UM 30 means that a group level integration
is likely to decrease the willingness of a firm or plant-level integration. The other dummy
variables, BF, BACK, and FWD, disclose the expected negative signs, and B F and
B A C K are significant at least at a 5% level. These coefficients suggest that backward and
forwardly integrated firms (BF) among the affiliated firms are less willing to integrate at
the firm or plant level, and back ward integrated firms (BA C K ) also are less willing to
integrate at the firm or plant level.5
The regression results with the adjusted degree of vertical integration (Via)
instead Vis are reported in Table 5-7. The results with Via are very similar to them with
Vis, except the variables of D IV and BACK. This table shows that A D I and SU N K are
important determinants of vertical integration but the others such as R D I and D IV are
not. That is, both advertisement intensity (ADI) and sunk costs (SUNK) show a 1%
significant level with the predicted coefficient signs in all equations whereas research and
development intensity (RDI) and sales of main production (DIV) are of the expected
positive signs but not significant at all.
Two uncertainty variables, BETA and STD seem to be important determinants of
vertical integration with Via. The coefficients of BETA show the predicted positive signs
and are significant at a 1% and 10% level in equations 1 and 5, respectively. The
coefficients of STD also show the predicted positive signs and are significant at least at
10% level in equations 2, 3,and 4. DUM 30 shows the expected sign and is significant at a
5 To avoid correlation problems among DUM30, DUM100, and BF, these variables
are not used together. The estimates with together also revealed that DUM30 is negative
and insignificant, and DUM100 is positive and insignificant.
117
Table5-7: Determinants o f Vertical Integration In All Listed Firm with Via
Independent Variable=Adjusted degree of Vertical Integration (VI.), n=341

Variables I 2 3 4 5
Concept 9.9045 4.7374 6.6072 4.9323 11.9242
(3.954)*** (1.026) (1.415) (1.025) (4.716)***
ADI 1.1619 1.1814 1.1676 1.1807 1.1371
(7.649)*** (7.790)*** (7.753)*** (7.772)*** (7.447)***
RDI .0088
(.147)
SUNK .2154 .2077 .2261 .2086 .2252
(6.057)*** (5.919)*** (6.034)*** (5.820)*** (6.279)***
DIV .0198 .0160
(1.039) (.869)
BETA 3.3257 2.4939
(2.423)*** (1.783)*
STD 2.4544 .1.9876 2.4167
(2.138)** (1.721)* (2.058)**
DUM30 -2.8887
(-2.478)**
DUM100 -.1459
(-.158)
BF -3.1539
(-1.887)*
BACK -1.1874
(-.981)
FWD -1.5506
(-1.413)
Adj. R-sq. .1841 .1830 .15858 .1807 .1897
F-statistic 16.345*** 20.051*** 15.831*** 15.999*** 12.378***
5%, and 1%, respectively.
118
5 % level. However, DUM100 does not show statistical significance in equation 4. The
other dummy variables, BF, BACK, and FWD, report the expected negative signs; only
BF is significant within a 10 % level, which suggests that backward and forwardly
integrated firms (BF) at the group level are less willing to integrate at the firm or plant
level.
5.5 Conclusion
The purpose of this chapter is to investigate how chaebols organizational structure
affects firm-level integration and what the vertical integration determinants are as well.
First section described the structure of Korean business groups; chaebols have a
multi-market form at the group level, which would affect a firm or plant level vertical
integration. In addition, two determinants of vertical integration, asset-specificity (Coase,
1937; Williamson, 1975, 1985; Klein, Crawford, and Alchian, 1978; and Alchian and
Demsetz, 1972) and uncertainty in business circumstance, are introduced as primary
determinants of vertical integration.
The followings are the findings from the estimates:
1) Asset-specificity affects the degree of vertical integration. The estimates provide
further evidence of the role of asset-specificity on vertical integration: asset-
specificity proxies, such as advertisement intensity, sunk costs, and main
production ratio, are positive and significant determinants of vertical integration.
It is consistent with earlier findings by, for instance, Levy (1984). However, a
very weak effect of research and development (R&D) intensity to vertical
integration is found while Tucker and Wilder (1977) and Levy (1984) find a
119
significant relationship.
2) The role of uncertainty to vertical integration is important. In order to estimate the
role of uncertainty on the decision to vertical integration, systematic risk in profit
and the standard deviation of stock prices are used as the proxy variables. The
estimates display that uncertainty is a positive and significant determinant of
vertical integration.
3) The role of organization form also is significant on the decision to vertical
integration. The estimates show that top-30 chaebols affiliated firms are less
vertically integrated than non-chaebols. It stems from chaebols organizational
form, which has a multi-market form with group-level integration and is operated
under the single common administration and finance control. Therefore, group-
level integration substitutes for the firm-level integration (the degree of vertical
integration: VI). In addition, the estimates shows that backward and/or forward
integrated firms at the group level are less willing to integrate at the firm or plant
level.
120
Chapter Six: Performance with Ownership Concentration and Vertical
Integration
6.1 Introduction
Separation of ownership from management raises an important question about
property rights between a principal and an agent, which is called the principal-agent
problem. This problem, in turn, raises another question about the direction of casualty
between ownership concentration and the firms value. Namely, the higher ownership
concentration generates the higher performance by reducing agency costs (the
convergence-of-interest hypothesis). However, the empirics have not supported this
relationship vigorously. For instance, the entrenchment hypothesis (i.e., Morck, Shleifer,
and Vishny, 1988) states that the market value or the performance of the firm is adversely
affected for some ranges of high ownership concentration because of managements
entrenchment behavior. In addition, Demsetz (1983) and Demsetz and Lehn (198S) argue
that the ownership structure of the firm does not relate with the firms performance
(profitability) because the firm for which ownership matters will have selected its optimal
structure of ownership already.
On the other hand, the application of the transaction cost theory to vertical
integration was the most direct examination for better performance because vertical
integration generates transaction cost economies by dealing more efficiently with
bounded rationality, complexity, and a tendency towards opportunism faced by the
market governance mechanism. That is, vertical integration is associated with asset-
specific investment and certainty in the markets, which may provide better performance.
However, empirical research into the effects of vertical integration on the firms
121
performance does not show a vigorous positive relationship because of the negative
effects from vertical integration. For instance, vertical integration reduces flexibility.
Once vertical integration is set up, it is difficult to adjust to variable markets or economic
circumstances. Therefore, too much integration harms strategic flexibility (e.g., Harrigan,
1983). In addition, it may cause other costs, such as inefficiency in functioning all
varying scales of operations as well as attenuated incentives and bureaucratic distortion.
As a firm gets larger, there may be decreasing returns to the entrepreneur function, that
is, the costs of organizing additional transactions within the firm may rise (Coase, 1937,
p. 340). Moreover, the co-existence of various governance forms is further evidence that
vertical integration may not guarantee higher performance; the firm may have selected its
optimal vertical integration already (e.g., Demsetz, 1983, Demsetz and Lehn, 1985).
Therefore, the aim of my research in this chapter is to investigate both ownership
concentration and the vertical integration effect on the firms performance in the Korean
private corporation, and to compare my research to other studies in the literature, which
show no clear predictions. In addition, the influence of chaebols on performance is to be
tested.
Modeling
The empirical model has the following forms.
6-1) P R O F IT = P0 + * Ownership + e
6-2) P R O F IT = p + p * Ownership + P2 Ownership2 + e
122
6-3) PROFIT = P0+P, * Ownership +p* Vi +6*CHAEBOL + e
Equation (6-1) will test a simple linear relationship between ownership
concentration and performance, whereas Equation (6-2) will test whether or not the
ownership concentration has a curvilinear relationship with performance. Equation (6-3)
will examine the effects of ownership concentration and vertical integration on
performance. This estimate will include the other economic factors as well as chaebol
dummies.
The economic factors and dependent variables, such as ownership concentration
and the degree of vertical integration, are summarized in Table 6-1. Performance as a
dependent variable is calculated as the ratio of net income to assets (IA) and to equity
(IE), which is the average annual rate of net income after tax to assets and equity from
1991 to 1995, respectively. Research and development intensity (RDI = R&D/Sales) and
advertising intensity (ADI = Advertisement/Sales) are used for proxies for intangible
capital (e.g., Harris and Raviv, 1991 and Levy, 1985). Also, the advantages of R&D and
advertisement are primarily differentiating goods and services and may generate entry
barriers. Their effects on the firms performance are usually expected to be positive. The
firms size (LNASSET=\o% [assets]) usually reflects two important roles: economies or
diseconomies of scale and entry barriers. The economies of scale comes from simply
massive production, while the diseconomies of scale comes from inefficiency in
management. The entry barrier by the firm size stems from setup costs that must be
incurred at a minimum efficient scale by all entrants. A ratio of debt to equity (LEVER)
represents a proxy of instability and is predicted as a negative relationship with
performance.
123
IA(%) Average annual rate of net income after tax to asset from 1991 to 199S
IE (%) Average annual rate of net income after tax to stockholders' equity from
1991 to 1995.
Via (Value Added - Profit After Taxes)/(Sales - Profit After Taxes) of 1995
Vis Standardized Degree of vertical integration; VI =( Via - Ave. Vial Std. Via)
OWN1 (%) Shares (%) of owner & owners family and affiliated firms of 1995
OWNISQ OWNl*OWNl
OWN2SQ OWN2*OWN2
OWN12 OWN1+OWN2
OWN12SQ OWN12*OWN12
LNOl LogfOWN1/(1OO-OWN1)]
LN02 Log[OWN 2/(100-OWN2)]
LN012 Log[(OWN 1+OWN 2)/( 1OO-OWN1-OWN2)]
LNASSET A Log form of Assets; a 5-year annual average (million Won) of assets from
1991-95.
ADI (%) Advertising intensity, a 5-year (1991-95) annual average of advertising costs
to total sales
RDI (%) R& d intensity, a 5-year (1991-95) annual average of R&D costs to total
sales
LEVER(%) The Ratio of Debt to Asset of 1995
DUM30 If a firm belongs to top-30 chaebols, then DUM30=1, otherwise DUM30=0.

DUM100 If a firm belongs to top-100 chaebols, then DUM 100=1, otherwise
DUM 100=0.
BF If a firms production has backward and forward vertical relationship with

its affiliated firms productions, then BF=1, otherwise BF=0.
BACK If a firms production has only backward vertical relationship with its
affiliated firms productions, then BACK=1, otherwise BACK=0.
FWD If a firms production has only forward vertical relationship with its
affiliated firms productions, then FWD=1, otherwise FWD=0.
124
Table 6-2 shows the statistics of the means, the standard deviations, and
maximum and minimum values. The performance of non-chaebol firms is much better
than those of chaebols; the performance of non-chaebol firms is greater by 1% in both
cases of IA and IE. Also, this table displays that chaebols affiliated firms are lower in
both inside ownership concentration (OW NI and L N O I) and the degree of vertical
integration {VI a and VIJ, but have a higher outside ownership concentration {OW N2 and
L N 0 2 ) and higher vertical integration at the group level {BF, BACK, and FWD) than in
non-chaebols.
Table 6-3 sums up the correlation matrix among independent and dependent
variables. This table reports lower correlations among variables except for a correlation
between IA and LEVER, which is -.439. Both I A and IE show positive correlations with
ownership concentration {LN O I, L N 0 2 , OWNI, and OW N2), but are negatively
correlated with the degrees of vertical integration {V ia and Vis). The statistical
significance tests report that the true correlations among variables are significant; the null
hypothesis of no linear relationship between each pair o f random variables is rejected
against the alternatives with a 1% significant level for all pairs.
Regression Results
Table 6-4 displays the estimates of ownership concentration and vertical
integration on performance with LA, excluding other economic factors. Equations from 1
to 4 report that inside ownership {O W N I) has a positive relationship with performance.
Equation 1 in Table 6-4 shows that insider ownership (O W N I) is linearly related with IA.
The coefficient of O W N I shows a positive sign, and is significant at a 1 % level, the
125
Table6-2: Means and the Standard Deviations
Variables Top-30 Top-100 Non All Manufacturing 'inns

Chaebol Chaebol Chaebol Mean Max Min
IA(%) 1.357 1.816 2.485 2.106 8.417 -3.826
(1.663) (1.917) (2.078) (2.005)
IE (%) 4.007 4.888 5.357 5.101 25.0237 -16.12
(7.521) (6.322) (4.870) (5.705)
LNASSET 13.153 12.328 10.955 11.7038 15.924 8.5538
(1.296) (1.218) (.822) (1.258)
OWNI 21.133 25.111 25.645 25.354 62.8 2.4
(%) (12.653) (12.565) (11.888) (12.247)
OWN2 14.325 13.055 8.005 10.759 68.5 0
(%) (13.000) (12.129) (9.654) (11.448)
LNOI -1.487 -1.231 -1.174 -1.205 .524 -3.7051
(.797) (.766) (.691) (.732)
LN02 -2.221 -2.294 -2.875 -2.558 .760 -4.6151
(1.330) (1.256) (1.244) (1.282)
ADI (%) 1.189 1.531 1.989 1.739 14.9959 0
(1.791) (2.519) (3.649) (3.089)
RDI (%) 7.093 4.819 3.209 4.087 52.122 0
(11.519) (8.911) (6.050) (7.773)
LEVER 349.309 276.043 189.448 236.682 1421.8830 23.642
(%) (226.54) (181.83) (156.03) (175.73)
V ia 22.217 24.027 24.152 24.084 47.187 .6838
(9.946) (8.425) (9.504) (9.030)
-.3934 -.1618 -.0713 -.1206 3.447 -3.291
V is (.968) (.986) (1.092) (1.035)
DUM30 1 .3548 0 .194 1 0
(.479) (.396)
DUM100 1 1 0 .545 1 0
(498)
BF .4242 .1829 0 .099 1 0
(.498) (.388) (.300)
BACK .333 .360 .1677 .273 1 0
(-475) (.481) (.375) (.446)
FWD .2121 .247 .1290 .194 1 0
(.412) (.433) (.336) (.396)
Obs. 66 186 155 341
126
IA IE ADI RDI ASSET LEVER LNOI LN02

IE .825
ADI .108 .192
RDI .029 .045 .034
00

LNASSET .066 -.013 .256
LEVER
-.439 1 -.288 .085 -.061 .304
LNOI .152 .052 .035 -.288 -.185 -.016
k>
LN02 .023 .099 -.005 .200
1
-.008 .046
o
OWNI .142 .044 .023 -.255 -.163 -.023 .974 -.239
OWN2 .037 .111 -.013 -.004 .159 .033 -.179 .874
VI, -.188 -.112 .317 -.026 -.054 .159 .064 .012
Vis -.132 -.083 .245 -.057 -.082 .122 .058 -.008
DUM30 -.185 -.094 -.087 .189 .566 .314 -.189 .129
DUM100 -.166 -.041 -.074 .103 .544 .246 -.039 .226
BF -.080 -.021 -.048 .046 .453 .149 -.202 .108
BACK -.035 -.009 -.090 .017 .201 .080 .053 -.062
FWD .019 .048 -.009 .017 .025 .008 .015 .128
Correlation Matrix continued

OWNI OWN2 Via Vis DUM30 DUM1 BF BACK
00
OWN2 -.210
VI, .055 -.010
VIS .050 -.029 .887
DUM30 -.169 .154 -.101 -.129
DUM100 -.022 .222 -.007 -.044 .447
BF -.184 .111 -.082 -.112 .531 .304
BACK .090 -.065 -.036 -.073 .067 .215 -.204
FWD .013 .113 -.040 -.047 .023 .149 -.163 -.283
127
convergence-of-interest hypothesis. In Equation 2, OWNI also has a curvilinear
relationship, which seems to support the management entrenchment hypothesis.
In equation 2, the coefficients of OWNI and the square of OWNI (OWN1SQ) are
significant at a 1% level with a positive sign and a 5% level with a negative sign,
respectively, which means that profit is an increasing and then decreasing function of
ownership; performance increases in some lower ownership ranges and decreases in
some higher ownership ranges. The turning point of profit to ownership concentration
occurs at 38.29%; 34 out of 341 samples are under this range. Therefore, the estimates
explain that performance and ownership concentration have a positive relationship at
some lower ranges and a negative relationship at some higher ranges. Equation 3 reports
that outsiders ownership concentration (OWN2) is positively but not significantly related
with performance. OWN2 and OWN2SQ in Equation 4 show a negative and a positive
sign, respectively, and both are not significant. Also, F-statistic is very low (1.066).
Equations S and 6 report that ownership concentration (OWN12) has a positive
relationship with performance: OWNI2 is significant at a 1% and a 10% level in
Equation S and Equation 6, respectively. Equation 7 shows that the coefficient of inside
ownership concentration (LNOI) is positive and significant at a 1% in Equation 7. It also
suggests that ownership concentration has curvilinear relationship with performance. In
addition, Equation 7 similar to Equation 3 shows that outside ownership concentration
(LNOI) is positively but not significantly related with performance. Equations 8 and 9
show a different performance between chaebols and non-chaebols. Both DUM30 and
DUM100 show negative signs and are significant at a 1 % level, which means that the
chaebols affiliated firms are worse performance than non-chaebols.
128
Table 6-4:Own^rship Concentration and Performance with IA
Independent Variable, LAprofit/asset (n341).
U lU V pV l 1UVI1I
Var. 1 2 3 4 5 6 7 8 9
Concept 15263 .7680 1.3299 1177 1.3950 1.0056 1889 1.5689 1.6408
(6.12)"* (1.68) (4.54)- (1104)- (4.94)'" (1048)" (8.721) (5.28) (5.44)
0WN1 .023* .0919 .0259 .0217 .0267
(165)"* (156)- (186)"' (141)" (199)
0WN1SQ -.0012
(-1.979)"
OWN2 .0125 -.0182 .01641 .0201
(1.280) (-.845) (1 W (104)"
0WN2SQ .0006
(1.29)
0WN12 .0202 .0436
(178) (1.72)'
0WN12S -.0003
Q (-.962)
LN01 .4497
(198)-
LN02 .0882
(1.02)
DUM30 -.90541
(3.28)
DUM100 -.7567
(-3.45)
R-sq .0173 .025 .0191 .0038 .0193 .0191 .0203 .0467 .0498
F-stat. 6995* 5.463'" 4.323" 1.066 7.704 4.314" 4.534" 6.552 6941
0 shows t-statistics and *, **, and *** stand for the significance level at
' tote:
a 10%, 5%, and 1%, respectively.
129
Table 6-5 reports the estimates of ownership concentration on performance, IA,
including other economic variables. This table displays that both advertisement intensity
(ADI) and debt ratio {LEVER) are the expected signs and significant at a 1% level in all
equations. However, firm size (LNASSET) and R&D intensity {RDI) are positive, but
statistically insignificant in all equations. The coefficients of inside ownership
concentration such as O W N I and LNOI are positive and significant at least at a 1% level
in Equations 1,2,3, and 4 while OWN2 and LN O I are not significant at all. OW N12, and
LN O I2 show that their coefficients are positive and significant at 1% level in Equations 5
and 6. Vertical integration such as Via and 17s are also significant at a 1% and 5% level,
respectively, but show negative signs in all equations, which means that the higher
integration the worse performance. The coefficient of top-30 chaebols dummy {DUM30)
in Equations 7 shows a negative sign and is insignificant whereas the coefficient of top-
100 chaebols dummy {DUM I00) in Equation 8 shows a negative sign and is significant
at a 5%. The coefficients of BF, BACK, and FWD in Equation 9 do not show a constant
sign and are insignificant, which indicates that the group level integration does not affect
the firms performance. In sum, Table 6-5 reports that ownership concentration is
positively and significantly related with the firms performance {IA) and vertical
integration is negatively and significantly related with the firms performance {IA). In
addition, the chaebols affiliated firms, which are related vertically at the group level,
show worse performance than non-chaebols do. Among other economic variables, only
advertisement intensity and debt-equity ratio are significantly related with the firms
performance, respectively: though research and development (R&D) and firm sizes
display that they are positively related with the firms performance, but not significantly.
130
Table 6-5: Performance (IA) with Ownership Concentration and Vertical Integration
Independent Variable = IA (profit/assets), n=341
1 2 3 4 5 6 7 8 9
c 2.7928 1.7491 4.5497 3.4142 4.1358 3.0784 2.1231 1.8391 2.5914
(2.74) (1.77)' (4.29) (3.45) (4.19) (3.09) (1.90)' (1.64) (Z29)
ADI .1314 .1126 .1299 .1110 .1308 .1318 .1272 .1250 -.1301
(4.07) (3.52) (4.03) (3.47) (4.06) (4.09) (3.93) (3.87) (3.98)
RDI .0074 .0063 .0099 .0096 .0060 .0055 .0090 .0077 .0079
(571) (473) (7 54) (643) (463) (.424) (.689) (594) (.591)
LNASSE .0345 .0428 .0372 .0461 .01522 .0171 .0992 .1275 .0553
T (.411) (502) (.441) (539) (.184) (.206) (1.05) (1.33) (561)
LEVER -.0049 -.0051 -.0049 -.0051 -.0049 -.0049 -.0047 -.0048 -.0049
(8.50) (8.73) (8.54) (8.77) (8.426 (8.47) (7.99) (8.29) (8.74)
OWN1 .0273 .0266 .0267 .0293 .0273
(3.35) (3.21) (3.26) (3.58) (3.28)
0W N 2 .0149 .0143 .0158 .0181 .0148
(1.73)' (164) (1.83)' (2.07)" (1.70)'
LN01 .4999 .4840
(3.62) (3.47)
LN 02 .1243 .1160
(1.62) (1.50)
0W N 12 .0215
(3.31)
L N 012 .4277
(3.44)
Via -.0425 -.0432 -.0418 -.0422 -.0440 -.0417
(3.80) (3.87) (3.74) (3.77) (3.92) (3.75)
Vis -.2392 -.2441
(2.48r (-2.54)"
DUM30 -.4407
(1.47)
DUM100 -.4639
(2.00)"
BF -.1662
(.411)
BACK -.0576
(-.227)
FWD .0021
(.007)
R-sq .2565 .2384 .2602 .2415 .2576 .2557 .2591 .2805 .2502
F-stat 17.76 16.20 28.08 16.47 20.66 20.47 15.87 16.18 11.35
Note: () shows absolute t-statistics and *, **, and *** stand for the significance level at a
10%, 5%, and 1%, respectively.
131
Table 6-6 summarizes the estimates of ownership concentration and vertical
integration on performance using IE. These estimates are very similar to Table 6-5 in some
cases; (1) the coefficients of ADI and LEVER show the expected positive signs and
significant at a 1% level in all equations; (2) the coefficients of RDI show a negative sign
and are insignificant in all equations; (3) the group level integration (BF, BACK, and
FWD) does not affect the firms performance; (4) inside (OWN1 and LNOI) as well as
outside ownership concentration (OWN2 and LN02) have positive coefficients that are
significant at least at a 10% level; and (4) the coefficients of 17a and Vis report negative
signs and are significant at a 1% and 10% level, respectively in all equations.
In contrast to the coefficients of LNASSET using IA, the coefficients of
LNASSET using IE show a positive relationship with performance and are significant at
least at 1% level in all equations. In addition, top-30 chaebols dummy (.DUM30) shows a
negative sign in Equation 7 and is significant at a 10% level whereas top-100 chaebols
dummy (DUMI00) shows negative sign, but is insignificant in Equation 9.
Overall, Table 6-6 reports that inside and outside ownership concentration is
positively and significantly related with the firms performance (IE), whereas vertical
integration is negatively and significantly related with the firms performance (IE). In
addition, top-30 chaebols affiliated firms, which are related vertically at the group level,
show a lower level of performance than non-chaebols do.
6.3 Conclusions
The purpose of this chapter is to investigate how ownership concentration and
vertical integration affect performance from the empirical estimates.
132
Table 6-6: Performance (IE) with Ownership Concentration and Vertical Integration
Independent Variable = IE (profit/equity), n=341

t 2 3 4 5 6 7 8 9
c -1.3478 -3.4736 2.4795 .1505 -1.5104 -1.4421 -1.8721 -5.2637 -2.2040
(.443) (.1.19) (.781) (.050) (.524) (.533) (.585) (1.64) (659)
ADI .4921 .4541 .4898 .4513 .4904 .4501 .4742 .4413 .4886
(5.11) ( 4 .7 9 ) - ( 5 .0 9 ) - (4.76) (5 .1 1 ) - ( 4 .7 7 ) - ( 4 .9 4 ) - (4.66) (5.04)
RDI -.0055 -.0080 -.0012 -.0040
(.141) (.203) (.031) (.101)
LNASSE .7399 .7565 .7385 .7564 .7536 .7644 .9972 .9287 .8282
T (2.96) ( 3 .0 0 ) - ( 2 .9 2 ) - ( 2 .9 7 ) - (3.19) (3.22)** ( 3 .6 4 ) - (3.33) (2.85)
LEVER -.0111 -.0114 -.0111 -.0114 -.0110 -.0113 -.0104 -.0111 -.0110
(6.39) ( 6 .5 9 ) - (6 .4 0 ) - ( 6 .5 9 ) - (6.45) ( 6 .6 3 ) - ( 5 .9 7 ) - (6.46) (6.41)
0WN1 .0405 .0389 .0437 .0391
(1-64)* (158) (1.83)' (1-63)
0W N 2 .0588 .0575 .0644 .0581
(2.29) (2.27r (2.47)" (2.25)"
LN01 .7558 .7233
(1.83)' (175)'
LN02 .4687 .4519
(2.05)' (1.% )'
0W N 12 .0463
(2.45)"
LN012 .8723 .8754
(Z 4 0 )" (2.43)"
Via -.0886 -.0887 -.0868 -.0913 -.0874
(2.60) (2 .6 6 ) - (2.61) (2.74) (2.62)
Vis -.4983 -.5061 -.4856 -.4857
(1.71)' (1.77)' (1.70)' (1.71)
DUM30 -1.5433
(1.75)'
DUM1Q0 -.9275
(1.33)
BF -.8567
(.715)
BACK -.0270
(.036)
FWD .3299
(.415)
R-sq .1749 .1655 .1740 .1643 .1770 .1679 .1822 .1699 .1724
F-stat 11.29 10.63 1 1 .2 3 - 1 0 .5 5 - 15.63 14.72 13.62 10.94 8 .8 7 -
Note: () shows absolute t-statistics and *, **, and *** stand for the significance level at a
10%, 5%, and 1%, respectively.
133
Whenever a principal (an owner) delegates authority to an agent (a manager) with the
expectation that the delegated authority will act in the principals behalf, it is called a
principal-agent relationship. Such a principal-agent relationship runs into a number of
potential problems because the interests of the agent may be different from those of the
principal whom the agent is supposed to represent. One solution is increasing ownership
concentration for more effective monitoring of managerial performance.
Transaction costs are particularly significant when the market exchange relates to
specialized assets and uncertainty. These costs relate, for instance, the costs of searching for
the desired inputs, negotiating supply contracts, monitoring and enforcing these contracts,
and the risk associated with unforeseen changes in supply conditions. One solution is
vertical integration to diminish these costs by dealing more efficiently with bounded
rationality, complexity, and tendency towards opportunism faced by the markets. Therefore,
vertical integration is supposed to have a positive relationship with performance.
However, the empirics do not support strongly that an increase of ownership
concentration or/ and vertical integration do affect the firms performance positively.
The findings from the estimates are the followings:
1) Vertical integration at firm level is negatively and significant related with the
firms performance: the more integration in the firm level the worse performance.1 In
1Some factors may explain why the higher vertical integration at the plant or group-level
does not have an advantage in performance in the Korean case. The poor quality intra
firm trade may be one example: reciprocal support may take place even under a
circumstance where a supplier company is not able to compete with the rivals in price
and quality. The accounting problem is another example: the accounting data may not be
correct by omitting some profits or by transferring profits on purpose to the other
affiliated firms in the group company. In addition, the co-existence of various governance
forms is further evidence that the vertically integrated firm may not guarantee higher
performance; the firm will have selected its optimal vertical integration already. Lastly,
134
addition, the group level integration (BF, BACK, and FWD) is not related with
performance at all.
2) Ownership concentration is a positive and important determinant of the firms
performance in the case of Korean private companies. The estimation shows both a linear
and a curvilinear relationship between ownership concentration and performance.
they may misuse the theory of transaction cost economies as the market strategy. As
mentioned earlier, too much vertical integration may cause problems, such as inefficiency
in functioning all varying scales of operations as well as attenuated incentives and
bureaucratic distortion.
135
NOTE TO USERS
Page(s) not included in the original manuscript and are

unavailable from the author or university. The manuscript
was microfilmed as received.
13 6 -1 3 9
This reproduction is the best copy available.
UMI*
References
Adelman, M. A., Concept and Statistical Measurement of Vertical Integration, in Business

Concentration and Price Policy, Princeton University Press. Princeton, 1955
Alchian, Armen A. and Harold Demsetz, Production, Information Costs, and Economic
Organization, American Economic Review. 1972,62, p. 777-795
Anderson, Erin and Schmittlein, David, Integration of the Sales Force: An Empirical
Examination." The Rand Journal of Economics. Autumn 1984, 15:3, p. 385-395.
Armour, H.O. and Teece, D. J. Organizational Structure and Economic Performance,

Bell Journal of Economics. 1980,9, p. 106-122.
Arrow Kenneth J., Vertical Integration and Communication, Bell Journal of Economics.
1975,6, p. 173-183
Comanor, William S., Vertical Mergers, Market Power, and Antitrust Laws, America
Economic Review. May 1968,81, p. 254-265.
Berle, Adolf A. and Means, Gardiner C., The Modem Corporation and Private Property,
Harcourt. Brace & World Inc. NY., Revised Edition, 1934.
Blair, Margaret, Ownership and Control, The Brooking Institution. 1995
Blair, Roger D. and Kaserman, David L., Law and Economics of Vertical Integration and
Control." Academic Press, Inc. 1983
______________________________ , Vertical Integration, Tying, and Antitrust Policy,
American Economic Review. June 1978,68:3, p.397-401
Buzzell, Robert D., Is Vertical Integration profitable? Harvard Business Review. January-
February, 1983, p.93-102.
Carlton, Dennis W., Vertical Integration in Competitive Market under Uncertainty,

Journal of Industrial Economics. March 1979,27:3, p. 189-209.
Chandler, Jr. Alfred D., The Visible Hand: Managerial Revolution in American Business,
The Belknap Press of Harvard University Press. 1977.
Chang, Seajin and Choi, Unghwan, Strategy, Structure and Performance of Korean
Business Groups: A Transactions Cost Approach, Journal of Industrial Economics.
December 1988,37:2, p. 141-158
Coase, R. The Nature of A Firm Economica. November, 1937,4, p.386-405
140
Comanor, William S., Vertical Mergers, Market Power, and Antitrust Laws, American
Economic Review. May 1968,81, p. 254-265.
Demsetz, Harold, The Structure of Corporate Ownership and the Theory of the Firm,
Journal of Law and Economics. 1983,26, p. 375-390.
Demsetz, Harold and Lehn, Kenneth, The Structure of Corporate Ownership: Causes and
Consequences. Journal of Political Economics. December 1985,93:6, p. 1155-1176.
DiMaggio, Paul J. and Walter W. Powell, The Iron Cage Revisited: Institutional
Isomorphism and Collective Rationality in Organization Fields, American Sociological
Review. April 1983,48, p. 147-160
Easterbrook, Frank H., Two Agency-Cost Explanations of Dividends, America Economic

Review. September 1984,74:4.
Fama, Eugene F., Agency Problems and the Theory of the Firm, Journal of Political
Economics. 1980, 88:2, p. 288-307.
Fama, Eugene F. and Jensen, Michael C., Agency Problem and Residual Claims," Journal
of Law & Economics. June 1983,26, p. 301-325.
______________ , Separation of Ownership and Control, Journal of Law & Economics.

June 1983,26, p. 327-349.
Granovetter, Marie, Economic Action and Social Structure: The Problem of Embedded
ness, American Journal of Sociology. November 19985,91:3, p. 481-510
Grossman, Sanford and Oliver D. Hart, The Cost and Benefit of Ownership: A Theory of
Vertical and lateral Integration, Journal of Political Economies. 1989,94:4, p. 691-718.
Hall, Richard H., Organizations: Structure, Processes, and Outcome: Chapter 14,
Organizational Theory, Prentice Hall. Inc. 1996.
Harrigan, Kathryn R., Matching Vertical Integration Strategies to Competitive Condition,

Strategic Management Journal. 1986-7
Helfat, C.E. and Teece, D.J., Vertical Integration and Risk Reduction, Journal of Law.
Economics, and Organization. Spring 1987,3:1, p. 47-67.
Hermalin, Benjamin E., and Michael S. Weisbach, 'The Effect of Board Composition
and Direct Incentives in Firm Performance, Financial Management. Winter 1991,
20, p. 101-112.
141
Holdemess, Clifford G., Randall S. Kroszner, and Dennis P. Sheehan, Were the Good
Old Days That Good? Changes in Managerial Stock Ownership Since the Great
Depression, Journal of Finance. 1999,54, p. 435-469.
Jensen Michael C. and Meckling, William H., Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure, Journal of Financial Economics. 1976, 3,
p.305-360.
John, George and Weitz, Barton A., Forward Integration into Distribution: An Empirical
Test of Transaction Cost Analysis, Journal of Law. Economics, and Organization. Fall
1988,4:2, p. 337-355.
Joskow, Paul L., Vertical Integration and Long Term Contracts: The case of coal Burning
Electric Generating Plants, Journal of Law. Economics. & Organization. 1978
_____________ , Contract Duration and Relationship-Specific Investments: Empirical

Evidence from Coal Markets. American Economic review. March 1987, 77:1,168-185.
_____________ , The Performance of Long Term Contracts: Further Evidence From the
Coal Markets. Rand Journal of Economics. 1990,21
Jones, Gareth, Transaction Costs, Property Rights, and Organizational Culture: An

Exchange Perspective. Administrative Science Quarterly. 1983,28, p.454-467.
Kaplan Steven N., Top Executive Rewards and Firm Performance: A Comparison of
Japan and the United States, Journal of Political Economics. 1994, 102: 3.
Klein, B., Crawford, R. G. and Alchian, A. A, Vertical Integration, Appropriable rents,

and the Competitive Contracting Process, Journal of Law and Economics. 1978, 21,
p.297-326.
Leffler, Keith B., and Rucker, Randal R., Transaction Costs and the Efficient Organization
of Production: A Study of Timber-Harvesting Contracts, Journal of Political
Economics, October 1991,99:5, p.1060-1087.
Levy, Davis, The Transaction Costs Approach to Vertical Integration: An Empirical

Examination, Review of Economics and Statistics. 1985,67, p.438-445.
Lieberman, Marvin B., Determinant of Vertical Integration: An empirical Test, Journal of

Industrial Economies. September 1991,39:5, p. 451-466.
MacDonald, James M., Market Exchange or Vertical Integration: An Empirical Analysis,

Review of Economics and Statistics. April 1984, p. 327-331.
142
Maddigan, Ruth., The Measurement of Vertical Integration," Review of Economics and
Statistics. June 1980, p.328-335.Martin, Stephen T., Cause and Effect of Vertical
Integration. Applied Economics. 1986, vol. 18, p737-55
Masten, Scott E., The Organization of Production: Evidence From the Aerospace
Industry, Journal of Law & Economics. October 1984,37, p.403-417.
Monteverde, K. and Teece, D.J., Supplier Switching Costs and Vertical Integration in
the Automobile Industry, Bell Journal of Economics. 1982, 25, p. 321-328.
Morck, Randal, Andrei Shleifer, and Robert W. Vishiny, Alternative Mechanisms for
Corporate Control. American Economic Review. September 1989, 79:4, p.842-852
____________ , Management Ownership and Market Valuation: Empirical Analysis,

Journal of Financial Economics. 1988,20, p. 293-315.
McConnell and Servaes, Additional Evidence on Equity Ownership and corporate

Value. Journal o f Financial Economics. 1990,27, p. 595-612
Miwa, Yosihiro and Ramseyer, J. Made, Does Ownership Matter?: Evidence from the
Zaibatsu Dissolution Program. Discussion Paper No.314. Harvard Law School.
February 2001.
________________ , The Fable of the Keiretsu Discussion Paper No.316. Harvard Law
School. February 2001
Ouchi, Williams G., A Conceptual Framework for the Design o f Organizational Control
Mechanism. Management Science. 1979,25, p. 838-848.
_______________ , Market, Bureaucracies, and Clan, Administrative Science Quarterly.

1980,25, p. 129-141
_______________ , Theory Z: How American Business Can Meet the Japanese
Challenge. Addison -Weslev Publishing Company Inc.. 1981.
Prowse, Stephen D. The Structure of Corporate Ownership in Japan, Journal of Finance.

July 1992, 157:3, p. 11221-1140.
Robert Hargins, Modem Portfolio Theory, Dow Jones- Irwin Press. 1979.
Robins, James, Organizational Economics: Notes on the use of Transaction Cost Theory in
the Study of Organization, Administrative Science Quarterly. 1987,32, p.68-86.
Scott, W. Richard, The Adolescence of Institutional Theory, Administrative Science

Quarterly. December 1987,32, p.493-511.
143
Smircich, Linda, Concepts of Culture and Organizational Analysis, Administrative
Science Quarterly. September 1983, p339-357.
Spiller, Pablo T., On Vertical Merger, Journal of Law. Economics, and Organization.
Fall 1985,1:2, p.285-312.
Sdgler, George J., The Division of Labor is Limited by the Extended Market, Journal of
Political Economics. June 1951,59, p. 281-312.
Vickers, John and Michael Waterson, Vertical Relationships: An Introduction, Journal

of Industrial Economics. September 1991, 39:5, p. 445-450.
Weinstein, David E. and Yishay Yafeh, On the cost of a Bank-Centered Financial

System: Evidence from the Changing Main Bank Relations in Japan, Journal of
Finance. 1999, 53, p. 635-672.
Wilkins, Alan L. and Ouchi, William G., Efficient Cultures: Exploring the Relationship
Between Culture and Organizational Performance, Administrative Science Quarterly.
September 1983, p. 468-471.
Williamson, O. E, The Vertical Integration of Production: Market Failure Considerations,

American Economic Review. 1971,61, p. 112-123.
, Markets and Hierarchies: Analysis and Antitrust implications, New

York: Free Press. 1975.
___________, Transaction Cost Economics: The Governance of Contractual

Relations, Journal of Law and Economics. 1979,22, p. 233-261.
___________, The Modem Corporation: Origin Evolution, Attributes, Journal of

Economic Literature. December 1981,19, p. 1537-1568.
___________, Corporate Finance and Corporate Governance, The Journal of Finance.

July 1988, 153:3, p.567-591
The Economic Institutions of Capitalism: Firms, Markets, Relational

Contracting. New York. Free Press. 1985
, Mechanism of Governance, New York, Oxford University Press.

1995.
144
Vita
Bom on June I?"1, 1960 at Kyung-Ju city in Korea

B.S. in Economics at Sung Kyun Kwan University in Seoul (1987)
Signature
145

Vertical Integration

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Vertical Integration

Uploaded by

Copyright:

Available Formats

INFORMATION TO USERS

The quality of this reproduction is dependent upon the quality of the

Oversize materials (e.g., maps, drawings, charts) are reproduced by

Photographs included in the original manuscript have been reproduced

ProQuest Information and Learning

Page(s) not included in the original manuscript and are

This reproduction is the best copy available.

Dong Kwan Kang

The Graduate School

A dissertation submitted in partial fulfillment of the

Co-Directors: Dr. John Garen, Professor of Gatton School

ProQuest Information and Learning Company

Dong Kwan Kang

/ Director of Graduate Studies

appraisal at every stage of the dissertation process, allowing me to complete this

Dr. Christopher Bollinger, and Dr Walter Ferrier of Gatton School

reminded me of the kindness and love of brotherhood. I wish to thank my pretty

List of Table................................................................................................................ vii

List of Figures............................................................................................................... viii

Chapter One: Introduction

Chapter Two: Literature Review

Chapter Three: Methodology

Chapter Four: Ownership Concentration and Its Determinants

Chapter Five: Vertical Integration and Determinants

Chapter 6: Performance with Ownership concentration and Vertical Integration

Chapter 7: Conclusion................................................................................................. 136

Table 2-1: Empirics in Vertical Integration and Its Determinants................................ 34

Figure 2-1: Market Failure Framework....................................................................... 25

Dong Kwan Kang

The Graduate School

A dissertation submitted in partial fulfillment of the

Co-Directors: Dr. John Garen, Professor of Gatton School

OWNERSHIP CONCENTRATION, VERTICAL INTEGRATION. AND ITS

Two distinguishable features of chaebols, non-separation of ownership from

theories, this study investigates the determinants of ownership structure (ownership

Korean private corporations.

In the case of the determinants of ownership concentration, my results suggest

significantly related with outside ownership concentration. Therefore, the distinguishing

inside and outside ownership concentration is necessary. In addition, the role of

positive and important determinant of a firms performance.

In the case of the determinants of vertical integration, my results demonstrate that

asset-specificity and uncertainty affect vertical integration and, therefore, play an

integration at the group level is not related to performance at all.

KEYWORRDS: Vertical Integration, Ownership Concentration, Transaction Cost theory,

total value added by all industries.

In contrast to other countries business groups such as the keiretzu in Japan or a

organizational structure; non-separation of ownership from management and vertical

distinguishable ownership and organizational structure in Korean private businesses,

are of crucial importance in industrial organization theory because of their strategic;

significance; non-separation of ownership from management is related to agency cost,

which stems from a principal-agent problem while vertical integration is related to

management. Non-separation of ownership and management is called an owner-

management system. Ownership is retained as the right of dividends and appreciation in

ranking of its assets.

is one of my purposes of this paper.

uncertainties of market transaction or to generate quasi-rent value from asset-specificity

Korean private corporations.

In sum, the objective of this study is to inveterate the determinants of ownership

characteristics, and evidence using Korea listed companies of 1995.

1.2 Overview of Theories and Estimated Results

and, in turn, achieving better performance.

relationship between ownership concentration and performance. In addition, they treated

ownership concentration as an endogenous variable rather than an exogenous variable and