Employee‐friendly practices, product market competition and firm value

• Date: 01 January 2019
• Author: Saeyoung Chang,Hoje Jo
• DOI: http://doi.org/10.1111/jbfa.12353
• Published date: 01 January 2019

DOI: 10.1111/jbfa.12353

Employee-friendly practices, product market

competition and firm value

Saeyoung Chang1Hoje Jo2

1LeeBusiness School, University of Nevada, Las

Vegas,Nevada, United States

2Departmentof Finance, Leavey School of Busi-

nessat Santa Clara University, California, United

States

Correspondence

SaeyoungChang, Department of Finance, Uni-

versityof Nevada, Las Vegas, 4505 S. Maryland

Parkway,Las Vegas,NV 89154, United States.

Email:saeyoung.chang@unlv.edu

Fundinginformation

LeeBusiness School Summer Research

Grants,University of Nevada,

LeaveyResearch Grant,

SantaClara University.

Abstract

In this paper, we examine whether employee-friendly practicesare

associated with product marketcompetition, and whether firm value

is related to employee-friendlypractices and product market compe-

tition. Using a large sample of US firms, we find positive and signifi-

cant associations between employee friendliness and product mar-

ket competition, and between firm value and employee friendliness

when product market competition is high, consistent with the value

creation theory. Both positive relations hold when we account for

corporate governance. In addition, using the list of Fortune's ‘100

BestCompanies to Work For’ as an alternative measure of employee-

friendly policies, we find firms in more competitive industries are

more likely to treat their workers favourably. Furthermore, we find

that the market reaction is more positive when firms in more com-

petitive industries are selected for the Fortunelist.

KEYWORDS

agency theory, employee-friendly practices, firm value, product

market competition, value creation theory

1INTRODUCTION

It is well established in economic theory that product market competition is the most powerful force driving of

economic efficiency (e.g., Alchian, 1950; Friedman, 1953; Shleifer & Vishny, 1997; and Stigler, 1958). Shleifer and

Vishny (1997) suggest that product marketcompetition is perhaps the strongest governance mechanism forcing firms

to improve efficiency to survive. Managers in non-competitive industries, however,tend to enjoy a ‘quiet life’ because

they do not haveto undertake challenging activities for the survival of the firms and the security of their jobs (Bertrand

& Mullainathan, 2003). Such firms are thus expectedto operate sub-optimally and generate significant inefficiency.

In this paper, we investigate the effect of product marketcompetition on employee-friendly practices. Employees

are considered important latent stakeholders who significantly contribute to production and thereby play a key role

in a firm's success (Agle, Mitchell, & Sonnenfeld, 1999). Pfeffer (1994) further argues that human capital is one of

the most important factors affecting a firm's competitiveness through innovation. Firms operating in more compet-

itive industries are more innovative because productivity and efficiency are critical for these firms (Aghion, Bloom,

Blundell, Griffith, & Howitt, 2005; and Zingales, 2000). Hence, our premise is that the governance role of product mar-

ket competition increases the level of employee-friendly policies to create additional value for a competitive edge.

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2018 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2019;46:200–224.

CHANG ANDJO 201

Prior studies investigate the association of product market competition with stock returns, firm value, operatingper-

formance and acquisition profitability (e.g., Giroud & Mueller, 2010, 2011; Masulis, Wang, & Xie,2007; and Nickell,

1996). However,little is known about the governance effect of product market competition on employee-friendlyprac-

tices in conjunction with the influence of competition on firm value. Thus, we ask the following research questions: are

employee-friendlypolicies driven by the intensity of competition in the product market, and do these policies influence

firm value? We believethese issues are distinct and understudied in financial economics, and our study attempts to fill

the void. We further consider these questions important because industry competition motivates firms to adopt poli-

cies that enable them to perform at the highest level. Employee-friendly policies, therefore, providea means for firms

to retain their best talent, which is necessary for optimal performance.

In recent years, researchers have paid much attention to the importance of human capital, specifically,the role of

employees in firm performance and corporate decisionmaking. One of the most debated issues is whether employee-

friendly practices are beneficial for financial performance. There are two competing explanations, value creation the-

ory and agency theory,for the wealth effect of treating employees well. Under the value creation theory, human capital

is a key organizational asset, and employees are one of the most important stakeholders in a firm's competitiveness

and success (Pfeffer, 1994; Wright & McMahan, 1992; and Zingales, 2000).1It is argued that higher product mar-

ket competition forces managers to create additional value through good employee-friendly policies, and therefore

enhancing employee friendliness is important for improving firm productivity.Proponents of this theory believe that

employee-friendlyprograms improve a firm's ability to recruit, retain and motivate its employees. These programs also

attract socially responsible consumers and improvea firm's overall reputation. The value creation theory thus predicts

that employee-friendly practices positively affect future financial performance and lead to an increase in shareholder

wealth. In support of this theory,several studies document evidence of a relationship between employee-friendly com-

pany initiatives and favourable financial performance (e.g., Bae,Kang, & Wang, 2011; Edmans, 2011; Ertugrul, 2013;

Faleye and Trahan,2011; and Kang & Kim, 2015).

In contrast, Friedman(1970) states that the goal of a corporation should be to generate profits and that employee-

friendly programs take away value from shareholders and havenegative long-term effects on firms’ financial perfor-

mance. Similarly, the principal-agent theory of Jensen and Meckling (1976) posits that managers have an interest in

overinvestingin employees for the private benefit of reputation building as model managers, at a cost to shareholders.

In support of the agency theory,Cronqvist, Heyman, Nilsson, Svaleryd, and Vlachos (2009) document that entrenched

managers pay their workers more to enjoy private benefits such as lower effort wage bargaining and improvedsocial

relations with employees. Faleye, Mehrotra, and Morck (2006) also find that employee ownership may not always

improve employee alignment with shareholders, and demonstrate that relative to other firms, labor-controlled firms

deviate more from value maximization and exhibit lower labour and overall productivity.Atanassov and Kim (2009)

further show that firms with stronger management-worker alliances are less likely to engage in employee layoffsand

management turnover even when firm performance is poor.Thus, the agency theory predicts that employee-friendly

policies lead to poor firm performance and reduce shareholder wealth.

Empirical evidence on these two competing theories is mixed. Furthermore,there can be a reverse causality prob-

lem between employee treatment and firm performance. Previously documented claims that employee-friendlyprac-

tices lead to improved productivity and firm value can be misleading. It is plausible that better performing firms have

more resources to invest in employee-friendlypolicies, in which case the direction of causation goes from firm perfor-

mance to employee-friendlypractices rather than the other way around. It is also plausible that underperforming man-

agers treat workers more generously to earn their support (e.g., through labour union) in anticipation of a disciplinary

takeover.2Thus, poor firm performance can be the cause rather than the result of excessiveinvestments in employee-

friendly practices. In this study, we overcome the causality problem by incorporating product market competition

1Pfeffer (1994) contends that creating a high-performance work force is crucial in competitive industries because traditionalsources of competitive ad van-

tagesuch as production technology, access to capital and economies of scale have become increasingly available to all firms.

2Paganoand Volpin (2005) develop a theoretical model that supports this argument. Also, Cronqvist, Heyman, Nilsson, Svaleryd, and Vlachos (2009) provide

empiricalevidence that more entrenched managers pay more to workers associated with conflict-inclined labour unions.