Insights Volume 15 April 2014 by The Faculty of Business and Economics, The University of Melbourne

insights Melbourne business and Economics volume 15 april 2014

Inequality in OECD countries: the facts and policies to curb it

By John Martin and Michael Fรถrster Do we all want permanent full-time jobs?

By Sue Richardson Can employee voice and participation unlock employee engagement?

By John Purcell Performance management: poison, panacea or plain hard work?

By Michelle Brown and Martin Nally The time of our lives

By Daniel S. Hamermesh Emerging dragons: the rise of the Chinese multinational

By Dean Xu Governing the ungovernable: the market, technology and you

By Stephen King The accounting profession and independence: the scrutiny intensifies

By Warren McGregor and Greg Pound Audit quality and regulation

By W. Robert Knechel Occasional address

By Keith Hancock

Insights: Melbourne Business and Economics ISSN:1834-6154 Editor: Associate-Professor Geoff Burrows Associate Editor: Ms Fiona Lawry Sub-editor: Ms Rebecca Gleeson

Advisory Board: Professor Kevin Davis Professor Colin Ferguson Professor Emeritus Ian McDonald Design: Ms Sophie Campbell Illustration: Mr Gregory Baldwin

insights vol 15 Table of contents 03 Welcome

39 The time of our lives

By Geoff Burrows, Editor

05 Inequality in OECD countries: the facts and policies to curb it

By John Martin and Michael Fรถrster Rising income inequality risks leaving more people behind in an ever-changing world economy.

15 Do we all want permanent full-time jobs?

By Sue Richardson The standard offering of full-time permanent work is no longer the best fit for many people in the workforce today.

47 Emerging dragons: the rise of the Chinese multinational

By John Purcell Active line-management combined with effective top-level consultative arrangements involving senior managers is needed to boost employee engagement.

By Michelle Brown and Martin Nally Performance management systems can create both positive intended and negative unintended consequences for employees and organisations. Constant attention is needed for these systems to be effective.

By Stephen King Rapid changes in technology have created new opportunities and challenges for competition laws and the regulators and courts that enforce them.

62 The accounting profession and independence: the scrutiny intensifies

31 Performance management: poison, panacea or plain hard work?

By Dean Xu Western companies can perhaps learn from their once students.

55 Governing the ungovernable: the market, technology and you

23 Can employee voice and participation unlock employee engagement?

By Daniel S. Hamermesh Why do people worry so much about their incomes and so little about how they spend their time?

By Warren McGregor and Greg Pound The credibility of and trust in the accounting profession lies in its preparedness to take a strong stance on self-regulation in the public interest.

66 Audit quality and regulation

By W. Robert Knechel Regulating audit quality will inevitably have unintended consequences.

Occasional Address 74 Keith Hancock

Insights Melbourne Business and Economics

Welcome Insights publishes condensed and edited versions of important public lectures connected with the Faculty of Business and Economics. Its objective is to share these lectures with the wider public, especially Alumni. The issues presented and developed generally relate to research findings on public economic and social policy. Insights also constitutes an archival source of an important part of Faculty life. Suggestions and comments from readers on any feature of the journal are welcome. For more than a decade, the Corden lecture has been an important date in the Faculty’s calendar. In the 2013 lecture, John Martin and Michael Förster examined patterns of inequality in OECD countries and possible policy prescriptions to lessen inequality. The next three articles deal with various aspects of labour markets and workplace culture. Sue Richardson used her Foenander lecture to question whether the standard offering of fulltime work is still the best fit for many in today’s workforce. Within the workplace, John Purcell, addressing the 2013 Joe Isaac Industrial Relations Symposium, argued that labour productivity can be enhanced if line- and top-managers develop policies that enhance employee engagement and voice, while Michelle Brown and Martin Nally in the former’s inaugural master-class provided a critical examination of the concept of ‘performance management’. Employment and the workplace are but one element of life. In his Downing lecture, Daniel Hamermesh questioned why, given that time is the ultimate human constraint, people worry so much about their incomes and so little about how they spend their time. In what has become a regular series in Insights about the economic consequences of China’s rise as an economic power, Dean Xu used his inaugural lecture to outline the lessons Western corporations can draw from the rise of Chinese multinational enterprises.

The Faculty’s proliferating public programs are represented by two articles. Inaugurating a series initiated by the Department of Economics honouring John Freebairn’s contributions to public policy, Stephen King examined the challenges to competition laws created by the rise of digital technologies and transactions. The Accounting Department’s counterpart development has been the Australian Accounting Hall of Fame, in conjunction with the Institute of Chartered Accountants in Australia and CPA Australia. Warren McGregor and Greg Pound used an address to the 2013 induction ceremony to raise concerns about how political pressures on standard-setting for financial reporting are potentially compromising the professional independence of accountants. Continuing the theme of pressures on accounting and the accounting profession, Robert Knechel, in the 74th lecture in the University’s longest-running annual public lecture series – the CPA Australia/ University of Melbourne Annual Research Lecture – examined the possible unintended consequences of moves to regulate improvements in audit quality. Finally, in his Occasional Address to new graduands, Keith Hancock offered some thoughts on the links between economics and happiness. Thanks must go to Gregory Baldwin, whose illustrations give each article added character. Geoff Burrows Editor ghb@unimelb.edu.au

Insights Melbourne Business and Economics

Article heading here

inequality in oecd countries: the facts and policies to curb it Rising income inequality risks leaving more people behind in an ever-changing world economy. by john p. martin and michael fĂśrster*

A condensed version of the Corden Lecture given at the University of Melbourne on 9 October 2013.

Why should we care about high and growing inequality?

returns by investors with rapidly-growing incomes might have contributed to asset-price bubbles.

The gap between rich and poor in OECD countries has reached its highest level in 30 years. Rising income inequality creates economic, social and political challenges and risks leaving more people behind in an ever-changing world economy. It can jeopardise social mobility: intergenerational earnings mobility is low in countries with high inequality and higher in countries where income is distributed more evenly. The resulting inequality of opportunities can negatively impact on economic performance and wellbeing. Inequality can also fuel protectionist sentiments. People will no longer support open trade and free markets if they feel that they are losing out while a small group of winners is getting richer. High inequality also raises political challenges because it breeds social resentment and generates political instability.

How unequal are OECD societies?

High and increasing inequality may also fuel economic instability. Aggregate demand can be reduced when resources are redistributed from poorer credit-constrained households to richer households with a higher propensity to save. The period of the Great Moderation prompted low interest-rate policies which helped trigger increases in household and sovereign debt beyond sustainable levels. In parallel, the search for high

There are large differences in income inequality levels across countries.1 Today in the OECD countries, the average income of the richest 10 per cent of the population is close to ten times that of the poorest 10 per cent. In Australia and New Zealand, the income gaps between the richest and poorest deciles are in line with the OECD average. In some European countries, the gap is much smaller, with the incomes of the richest decile being five times those of the poorest. In the US, the ratio raises to around 14:1, and in Chile and Mexico to a high of 27:1. In Japan, the rich have incomes more than 10 times those of the poorest. The Gini coefficient, a standard summary measure of inequality that ranges from 0 (when everybody has identical incomes) to 1 (when all income goes to only one person), stood at an average of 0.31 in OECD countries in 2010, ranging from a low of 0.25 in Iceland and Slovenia to a high of 0.50 in Chile. As Figure 1 shows, there are large differences in income inequality levels across OECD countries. How widespread is income poverty? For crosscountry comparisons, the standard practice is to treat â&#x20AC;&#x2DC;povertyâ&#x20AC;&#x2122; as a relative concept in developed economies. The comparison of absolute incomes Insights Melbourne Business and Economics

between countries shows, for example, that the poorest 10 per cent in Japan have more money (in terms of purchasing power parities) than the average Mexican person. But what matters is the standard of living relative to other people in the country. Here, poverty is measured as half of the national median household income. This benchmark, of course, also varies over time. Around 11 per cent of the population across the 34 OECD countries fell below this poverty threshold (see the orange diamonds in Figure 1). Again, this differs hugely between countries: from 6 per cent in Denmark and the Czech Republic to 20 per cent and more in Israel and Mexico. Poor people, on this relative definition, make up 14.4 per cent of the population in Australia. Countries with wider distributions of income tend to have more widespread income poverty â&#x20AC;&#x201C;

though measures of inequality and poverty do not necessarily go hand-in-hand. In New Zealand and the UK, for instance, inequality is higher than in Japan and Korea, but poverty is higher in the latter two countries.

Has the gap between rich and poor widened? Over a longer period of 25 years, the gap between rich and poor has widened in over three-quarters of OECD countries for which data series back to the 1980s are available. For the more recent period since the mid-1990s (Figure 2), it climbed by more than 3 percentage points in Canada, Denmark, Finland, Israel and Sweden. Only Mexico and Turkey recorded sizeable declines in their Gini coefficients. As Figure 2 shows,

Figure 1: Gini coefficients of disposable income and relative poverty rates, 2010 28%

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Gini coefficient of inequality

Gini coefficient of income inequality (left-hand scale)

Relative poverty rate (right-hand scale)

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d ia ay rk lic d lic m ria n rg ry ny s d ce d d a d ly ia a lia n ce in m al el es ey o ile 9 lan ven rw ma ub lan ub lgiu st ede ou ga a land rlan an lan lan ore lan Ita ston nad tra apa ree Spa gdo rtug Isra tat urk exic Ch D-2 S T M C n o Ice Slo No en Rep Fin Rep Be Au Sw mb Hun ermher itze Fr Po Ire K Zea E Ca us J G e Ki P D h G et w A ed OE ux ew ak c nit N S ed L v t e N i U o Cz Sl Un

Note: 2009 for Hungary, New Zealand, Japan and Turkey; 2011 for Chile. Data refer to household equivalised disposable income. Poverty rates refer to the percentage of persons living in households with less than half the median income, in each country. Information on data for Israel: http://dx.doi.org/10.1787/888932315602. Source: OECD Income Distribution Database (www.oecd.org/social/income-distribution-database.htm), accessed in December 2013.

Inequality in OECD countries: the facts and policies to curb it

Figure 2: Gini coefficients of disposable income, mid-1990s to 2010 0.55

Increasing inequality mid 1990s

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Little change in inequality

2010s

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k d d rg den el pan ralia ada nce any ar an ite s ra t ou a n Ja inl nm rm mb Swe Fr us Un tate Is F e e Ca A D G S xe Lu

s h y in ita land zecblic rwa C u No er p h a t e e Re Gr N

r tB

ile o ey d aly ary Ch exic urk alan It ng M T Ze Hu w Ne

Source: OECD Income Distribution Database (www.oecd.org/social/income-distribution-database.htm), accessed in December 2013.

income inequality (Gini coefficients) increased in a majority of OECD countries during this period. Income inequality followed different patterns across OECD countries over time. It first started to increase in the 1980s in some English-speaking countries, notably the UK and the US, but also in Israel. The trends in the 2000s showed a widening gap between rich and poor not only in some of the already high-inequality countries like Israel and the US, but also – for the first time – in traditionally low-inequality countries, such as Germany and the Nordic countries, where inequality grew more than anywhere else in the 2000s. At the same time, Chile, Mexico, Greece, Turkey and Hungary reduced income inequality considerably – often from very high levels. There are thus signs of a possible convergence of inequality levels towards a higher average level across OECD countries. In most countries, increasing inequality was due to rich households faring much better than both low- and middle-income families. There has been a marked increase in the share of top incomes, especially the top 1 per cent of earners. This has often been attributable to higher shares of labour, not capital, income – partly due to the development of stock options which are reported as part of wages and salaries. Figure 3 shows how the share of very high incomes increased in many

countries from 1980 to 2010. The rise at the top was most marked in the US where the share of the richest 1 per cent in all pre-tax income reached 18 per cent. However, it was also large in a number of other English-speaking countries (Australia, Canada, Ireland and the UK). Elsewhere, increases tended to be greater in the Scandinavian and Mediterranean countries than in Continental Europe. Even within the group of top-income earners, incomes became more concentrated. In the US, for instance, the share of the top 0.1 per cent in total pre-tax income quadrupled in the 30 years to 2010 from 2 per cent to over 8 per cent of total pre-tax incomes. The top 0.1 per cent accounted for some 4 to 5 per cent of total pre-tax incomes in Canada, the UK and Switzerland, and close to 3 per cent in Australia, New Zealand, and France.

The links between high inequality and social mobility The trends highlighted so far are based on crosssectional income-distribution data over time. While these are very informative, they do not tell us anything about the dynamics of inequality over time, that is, the extent of equality of opportunities across generations. We now turn briefly to this important intergenerational dimension of inequality. Insights Melbourne Business and Economics

Figure 3: Shares of top 1 per cent incomes in total pre-tax income, 1980 – 2010 (or closest) 24

% of total pre-tax income

2010

1980

15 12 9 6 3 0

a y in d d d al an an ad ite s rita ug Jap lan lan m an er Un tate at B Ire Port er C z t i G S re Sw G

Ita

ali

str

ain

lan

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ala

lan

h et

Source: OECD calculations derived from the World Top Incomes Database.

When measures of the intergenerational earnings elasticity are plotted against measures of income inequality, this generates what Alan Krueger has called the ‘Great Gatsby Curve’.3 Figure 4 plots such a relationship for a sample of OECD countries for which we have comparable estimates of the two variables, and shows how high inequality can hinder social mobility (the inequality measure is the Gini coefficient). This shows that the ‘Gatsby Effect’ is alive and well: intergenerational earnings mobility is lower in high-inequality countries. At one extreme, we have countries such as the US, UK and Italy with relatively low intergenerational earnings mobility and high inequality while the Nordics are clustered at the other end, with relatively high intergenerational earnings mobility and low inequality. Both Australia and New Zealand are in mid-way positions, as is Canada; this may partly reflect the greater shares 08

Inequality in OECD countries: the facts and policies to curb it

of immigrants in their populations as well as their greater selectivity in choosing immigrants who tend to exhibit greater earnings mobility than their native-born peers. While there is some disagreement in the literature about the interpretation of the negative correlation in Figure 4 and the mechanisms underpinning intergenerational mobility, there is no doubt that Figure 4: Income inequality and intergenerational earnings mobility, mid-2000s 40 38

United States

36 34

Gini coefficient

At OECD we have been studying the phenomenon of social mobility and how it is associated with income inequality across countries by focussing on the concept of intergenerational earnings mobility: in the literature this is proxied by the degree to which sons’ earnings are correlated with those of their fathers.2 The key empirical measure here is the intergenerational earnings elasticity: the higher the value of this elasticity, the lower the degree of earnings mobility between generations.

Italy New Zealand

Great Britain

Spain

30 28

France

Canada Japan Australia South Germany Korea Norway

Switzerland 26

Finland

Sweden

Denmark

20 45 50 55 60 65 70 75 80 85 90

Intergenerational earnings mobility Source: OECD (2008) and d’Addio (2007).

it focuses policy debate on a very important topic: the degree to which high and rising inequality may hinder or help achieve equality of opportunity across countries.

Possible culprits for the growing divide Globalisation is often blamed for growing inequality. Over the past decades, OECD countries underwent significant structural changes, driven by their closer integration into the global economy and to rapid technological progress. Trade integration doubled in many OECD countries and outward stocks of foreign direct investment (FDI) increased steeply – from an average of less than 5 per cent of GDP in 1980 to nearly 50 per cent in the late 2000s. The increased productivity and opportunities for trade and FDI have contributed to raising the growth potential but these changes often brought highly skilled workers greater rewards than low-skilled ones and thus affected the way earnings from work were distributed. Further, technological progress shifted production technologies in both industries and services in favour of skilled labour and away from unskilled and middle-skilled workers. These structural changes got underway in the early 1980s and accelerated from the mid-1990s. But changes in policy choices, regulations and institutions have also often been cited as a culprit for increasing inequality. These changes can shape how globalisation and technological changes affect the product markets, wage-setting mechanisms and workers’ bargaining power. Most OECD countries carried out regulatory reforms to strengthen competition in the markets for goods and services, and to make labour markets more adaptable. All countries significantly relaxed anticompetitive product-market regulations and many also loosened employment protection legislation for workers with temporary contracts. Minimum wages also declined relatively to median wages in a number of countries. Wage-setting mechanisms also changed: the share of union members among workers fell across most countries, although

the coverage of collective bargaining generally remained rather stable over time. A number of countries cut unemployment benefit replacement rates and, in an attempt to promote employment among low-skilled workers, some also reduced taxes on labour for low-income workers. Apart from economic globalisation and regulatory change, other societal changes may also have had a direct impact on increasing inequality. In particular, changing family structures made household incomes more diverse and reduced economies of scale. Populations are ageing and there are more single-headed households with and without children today than ever before: in the mid-2000s, they accounted for 20 per cent of all working-age households, on average, in OECD countries. In couple households, employment rates of the wives of top earners increased the most. And in all countries, marriage behaviour has changed. People are now much more likely to choose partners in the same earnings bracket: so rather than marrying nurses, doctors are now increasingly marrying other doctors.

What OECD evidence tells us about the main culprits The OECD’s 2011 report Divided We Stand: Why Inequality Keeps Rising took a fresh look at the drivers and remedies for increasing inequality and reveals a number of surprising findings. It finds that neither rising trade integration nor financial openness has a significant impact on either wage inequality or employment trends within the OECD countries. The wage-inequality effect of trade appears neutral even when only the effects of increased import penetration from emerging economies, such as China and India, are considered – a finding that runs counter to the expectation that trade flows from such countries should drive down wages of workers in manufacturing and/or services in OECD countries.5 At the same time, technological progress – for example, in information and communications – has exhibited a bias in favour of high-skill workers and this has been reflected in widening gaps in earnings between high-skilled, middle-skilled and low-skilled workers. Insights Melbourne Business and Economics

On the other hand, regulatory reforms and institutional changes increased employment opportunities but, at the same time, contributed to wider wage disparities as more low-paid people were brought into employment. Thus, the increase in part-time employment in atypical labour contracts and a decline in the coverage of collectivebargaining arrangements in many countries also contributed to disparities in earnings. However, the rise in the supply of skilled workers helped offset the increase in wage inequality resulting from technological progress, regulatory reforms and institutional changes. The upskilling of the labour force also had a significant positive impact on employment growth. The growth in average educational attainment among the working-age population thus appears to have been the single most important contributor not only to reducing wage dispersion among workers but also to increased employment rates. On the basis of these results, the evolution of wage inequality across OECD countries over the past few decades can be best viewed mainly as the difference between the demand for and supply of skills, or as neatly summarised by the Dutch economist Jan Tinbergen almost 40 years ago, the outcome of a ‘race between education and technology’. This explanation, however, does not satisfactorily cover the rapid rise in top-income shares. For the latter, other factors need to be taken into account too – such as the growth of the financial sector, the spread of a ‘winner-takes all’ culture, cuts in marginal tax rates on high incomes, and lobbying of the political elites by high earners in order to preserve their rents.

The importance of tax/benefit systems Public cash transfers, as well as income taxes and social security contributions, played a major role in all OECD countries in reducing market-income inequality. Together, they were estimated to reduce inequality among the working-age population by an average of about one-quarter across OECD countries. This redistributive effect was larger in the Nordic countries, Belgium and Germany, but well below average in Chile, Iceland, Korea, Switzerland 10

Inequality in OECD countries: the facts and policies to curb it

and the US (Figure 5). In Australia and New Zealand, the redistributive impact of the tax/social transfer system is just below the OECD average. As the Figure shows, market incomes are distributed much more unequally than net incomes. In most countries, tax-benefit policies traditionally offset some of the large increases in marketincome inequality, although they became less effective at doing so from the mid-1990s. Until the mid-1990s, tax-benefit systems in many OECD countries offset more than half of the rise in market-income inequality. However, while market-income inequality continued to rise after the mid-1990s, the offsetting effect of taxes and benefits on household income inequality declined. Only a few countries bucked this trend. In Japan, for instance, the extent of redistribution continued to increase slightly though its level is still lower than in most other OECD countries. The main reason for the decline in redistribution lies on the benefits side: the real value of many social benefits fell, eligibility rules were tightened to contain spending on social protection, and transfers to the poorest failed to keep pace with earnings growth in many countries. In addition, spending on out-of-work benefits shifted towards ‘inactive’ benefits, which resulted in reduced activity rates and thus exacerbated the trend towards higher market-income inequality. At the same time – and despite the substantial gains of high-income earners in some countries – income taxes played a relatively minor role in moderating trends towards higher inequality. The reason is that trends towards lower income taxes, on the one hand, and more progressive taxation, on the other, had opposite effects on redistribution and partly cancelled each other out.

What was the impact of the recent Great Recession? 6 The significant increase of inequality was occurring before the Great Recession when many countries were undergoing a period of fairly steady economic expansion. What will happen now that the ILO estimates that 200 million people are out of work worldwide? The jobs crisis is affecting the

most vulnerable groups particularly hard, amid growing long-term unemployment and mounting youth unemployment, and this has put additional pressures on the distribution of incomes. And let us not forget that many governments are embarking on a path of fiscal consolidation to rein back publicsector deficits and rising public-debt/GDP ratios. Unfortunately, comparable income distribution data are only available with a lag and the latest data refer to 2010. This means that we are only able to chart the initial effects of the Great Recession on income inequality. These data suggest that the initial short-term impact of the crisis on inequality may have been smaller than commonly suggested in most OECD countries, with some notable exceptions like Ireland and Spain (Figure 6).

This apparently small effect was due to a number of causes. First, to stimulus packages and additional public support through the tax and benefit system in 2008 and 2009, which cushioned falls in household income levels at the bottom end. Second, households adopted coping strategies â&#x20AC;&#x201C; for example, young people returned to live with their parents, or second earners increased working hours. Third, at the top end of the distribution, income shares fell due to declines in stock prices and interest rates, and a big drop in capital gains. This fall in top incomes was temporary, however, and has not reversed the preceding increase in topincome shares. Further, previous recessions have increased inequality in the mid-term because of an increasing employment divide between rich and poor. Finally, there is a risk of increasing inequality

Figure 5: Inequality (Gini coefficient) of market income and disposable (net) income in the OECD area, late 2000s 0.55

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l e 9 l y ) e y y c a s n s a c n a k a n a re and and bli de ni ar wa bli ni nd pa and and ai tri ium ad alia an ary nc and urg te om ga Ital srae hil -2 C D I Ko zerl Icel epu we love enm Nor epu Esto erla Ja eal Finl Sp Aus elg an str erm ung Fra Pol bo Sta ingd ortu m C t Z B S u i d P S EC h R R D G (H A xe nite d K O w et h u Sw e ak c N e L v t e N U ni o z l C S U Note: Data refer to working-age persons (18-65 years old). Source: OECD.

Insights Melbourne Business and Economics

and, particularly, poverty if fiscal consolidation and austerity policies are not well balanced today.

What can policies do to reduce toohigh inequality? The most promising way of reducing too-high inequality is by boosting employment and career prospects. Hence, the focus for policy-makers should be on fostering more and better jobs, enabling people to escape poverty and offering real career prospects. Within current budgets, policies to address growing inequality could be made more efficient, for example, by making more use of inwork benefits which encourage people to take up paid work and give additional income support to low-income households. Such benefits are in place in about half of all OECD countries. Another important policy challenge is to improve access to,

and the quality of, education and training which will enable workers to take up better-paid jobs and thus reduce inequality. Investing in human capital is key. This must include the vital early childhood period and be sustained through compulsory education. This will ensure equality of opportunity for children from disadvantaged backgrounds. Once the transition from school to work has been accomplished successfully, there must be sufficient incentives for workers and employers to invest in skills throughout the working life. Reforming tax and benefit policies is the third key to promote a better distribution of income â&#x20AC;&#x201C; taxes and benefits are the most direct instruments to redistribute income. As top earners now have a greater capacity to pay taxes than before, governments may consider re-examining their

Figure 6: Trends in income inequality (Gini coefficients) in selected countries, 1975 â&#x20AC;&#x201C; 2010 0.40

USA

0.38 0.36

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Germany France

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1975 1980 1985 1990 1995 2000 2005 2010 Note: Break in series for Spain in 2000. Source: OECD.

Inequality in OECD countries: the facts and policies to curb it

tax systems to ensure that wealthier individuals contribute their fair share of the tax burden. This aim can be achieved in several different ways – not only via raising marginal tax rates on the rich but also improving tax compliance, eliminating tax deductions, and reassessing the role of taxes on all forms of property and wealth, including the transfer of assets.

1 Throughout this article we focus on income inequality. Arguably, wealth inequality is more important. However, comparable cross-country wealth data are much harder to collect than data on income. Where data exist they show that wealth is much more unequally distributed than income. See OECD (2008, Chapter 10) for a discussion.

Redistribution is not only about cash. Governments spend as much on public social services, such as education, health and care services, as they do on all cash benefits taken together – Australia spends as much on such services as a proportion of GDP as the OECD average while New Zealand spends more than the average. While the prime objective of such services is not redistribution, they reduce income inequality by a fifth. Public services such as high-quality education furthermore constitute a longer-term social investment to foster upward mobility and create greater equality of opportunities in the long run.

3 For a comprehensive review of the burgeoning literature on the topic, see Corak (2013).

The new OECD work shows that there is nothing inevitable about growing inequalities. Globalisation and technological changes offer opportunities but also raise challenges that can be tackled with effective and well targeted policies. Any policy strategy to reduce the growing divide between rich and poor should rest on three main pillars: inclusive employment promotion; a more intensive human capital investment; and welldesigned tax/transfer redistribution policies. John P. Martin is a Former Director, and Michael Förster a Senior Economist, in the Directorate for Employment, Labour and Social Affairs in the Organisation for Economic Cooperation and Development (OECD). * This article is a revised and updated version of ‘Balancing economic efficiency and social equity’ which was published in the November/December 2012 issue of Japan SPOTLIGHT. The authors are extremely grateful to the editors of Japan SPOTLIGHT for giving permission to reproduce this material. The views expressed are our own and cannot be held to represent those of the OECD or its member governments.

2 Daughters’ earnings are excluded because of the great changes in women’s labour force participation rates across generations linked to rising educational attainments and different choices about work and unpaid activities made by women across different generations.

4 For more details on these estimates, see OECD (2008, Chapter 8). 5 This relatively benign conclusion about the impact of globalisation on earnings inequality needs to be nuanced, however, as it may vary depending on the institutions and policies of the countries in question. Evidence from OECD (2011) suggests that growing import competition from low-income developing countries such as China and India tended to widen wage dispersion though only in countries with less-strict employment protection legislation. Autor et al. (2012) argue that the rapid growth in China-US trade accounted for about 15 to 20 per cent of jobs lost in the US though they find no significant effect on wage dispersion. 6 This part draws heavily on OECD (2013).

References Autor, DH, Dorn, D and Hanson, GH 2013, ‘The China Syndrome: Local Labour Market Effects of Import Competition in the United States’, IZA Discussion Paper No. 7150, January. Corak, M 2013, ‘Income Inequality, Equality of Opportunity, and Intergenerational Mobility’, IZA Discussion Paper, No. 7520, July. D’Addio, AC 2007, ‘Intergenerational Transmission of Disadvantage: Mobility or Immobility across Generations’, OECD Social, Employment and Migration Working Papers No. 52, OECD Publishing. OECD (2008), Growing Unequal?, OECD Publishing. OECD 2011, Divided We Stand: Why Inequality Keeps Rising, OECD Publishing. OECD (2013), Crisis Squeezes Income and Puts Pressure on Inequality and Poverty, See www.oecd.org/social/inequality.htm

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Article heading here

do we all want permanent full-time jobs? The standard offering of full-time permanent work is no longer the best fit for many people in the workforce today. by sue richardson

A condensed version of the Foenander Lecture given at the University of Melbourne on 11 September 2013.

The norm of permanent full-time terms of employment is under serious challenge. In Australia today more than one-third of employed people work on more variable terms â&#x20AC;&#x201C; in particular, as casuals (19 per cent), independent contractors (9 per cent), other self-employed (9 per cent) and agency workers (about 3 per cent). In total, 30 per cent of people work part-time.1 While this shift to more varied terms of employment is an experience shared among many developed economies, in Australia it occurred mainly during the turbulent period from the early 1980s to the mid-1990s. During this period, casual employment rose from 15 per cent of all employees to 26 per cent and it has grown only slightly since then. Contract employment also rose, although agency employment has barely changed. The causes of these changes are not well understood. In addition to the policy-induced structural change in the economy, technological change and a shift to a service economy are some of the causes. These explanations imply that the shift away from permanent and full-time forms of employment is driven by changing employer needs (the demand side of the labour market), rather than by changing worker preferences. Whatever the causes, the growth in flexible ways of working is a major development and there is a serious concern that precarious, or flexible, types of employment are inferior and workers would not

choose them if they had reasonable alternatives. The inferior dimensions of flexible work terms are argued to include job insecurity, variability in earnings, reduced on-the-job training, increased exposure to sexual harassment and workplace bullying, and a reduced capacity to exercise autonomy in how the work is done, which is damaging to health. This view was neatly summarised by former Deputy Prime Minister, Brian Howe, in a speech to the National Press Club in 2012 in which he said: If there is one story that cuts right across our economy and its changes in the last 20-30 years, it is the story of the growth of insecure work. Increasing numbers of workers are engaged in work that is unpredictable, uncertain and that undermines what ordinary Australians need to feel secure in their lives and communities. The rise in insecure work flows from the shift from standard full-time contracts to increasingly non-standard arrangements: whether casual work, irregular hours, short-term contracts or the use of labour hire companies.2 Here I examine the presumption that most people want full-time and permanent work, and are forced by the lack of such jobs into less-preferred and harmful alternatives. I do so by taking a life course perspective on the ways in which people engage with paid work and how this has changed. Insights Melbourne Business and Economics

I also draw on direct evidence on the conditions and consequences of work on flexible terms as compared with permanent and full-time.

The changing character of the workforce In a generation, the male breadwinner model of the Australian labour market has been replaced by something much more complex. In the old model paid work is central to the lives of most adult men: men went to school, then sought full-time paid work until retirement or prior death/disablement. Marriage and children were an accompaniment to this path but did not disturb it. For women, there was more complexity. As with men, school was followed by full-time paid work. But on marriage, and especially, motherhood, women largely withdrew from paid work. Widowhood or divorce would send them back into the workforce, and single women never left. It was uncommon for older women to be in paid employment and they could access the old age pension five years earlier than men. As reflected in the justification given for lower award wages for women, women in the workforce were mainly single, and they too wanted full-time work. This is the world that generated the norm that â&#x20AC;&#x2DC;good jobsâ&#x20AC;&#x2122; were full-time and, preferably, reasonably secure.

increased their levels of formal education, and combine later years of study with employment; marriage no longer reduces the paid work effort of women; motherhood causes reduced paid work but usually not complete withdrawal from the labour force; as children become less dependent, women increase their commitment to the workforce, but not necessarily full-time. Both men and women have poorer health and substantially more disability (such as diabetes, asthma, mental illness, hypertension, obesity)3 in their 50s and 60s than did the previous generation. This development sits alongside a substantial extension of life expectancy at these ages, which in part explains the rising rates of employment (of both sexes) at older ages. These two developments mean more people with some form of health limitation are seeking employment. The combination of extended full-time study with part-time employment, the sustained and substantial increase in womenâ&#x20AC;&#x2122;s employment, the

Figure 1 (a): Employment to Population Ratio, male, by age, selected years

1978 1992 2013

100

The current reality is much more complex. 90

The male life course has not changed much, except that (i) young men have more years of formal education and many combine later years of study with employment, (ii) many fathers, through preference or encouragement, seek greater time with their children, and (iii) the real earnings of men are higher and they use this, inter alia, to reduce work effort in later life, including in response to ill health. In contrast, the female life course has changed a great deal. It is no longer safe for a woman to assume that the (same) man will provide the income she needs over her adult life. For this and other reasons, women today are in the paid workforce at all ages and marital states, with and without children. Young women have greatly 16

Do we all want permanent full-time jobs?

80 70 60 50 40 30 20 10 0 20- 25- 30- 35- 40- 45- 50- 55- 60- 65- 7015and 19 24 29 34 39 44 49 54 59 64 69 over

We can see the shifts over time in the relationship of men and women to paid work over their working life course in Figures 1 (a) and 1 (b) below. These show the proportion of each age group that was employed, in the years between 1978 and 2013.

In contrast with men, the employment life course has changed substantially for women, once they reach their mid-20s. They are now much more likely to remain in employment through the years of bearing and caring for children â&#x20AC;&#x201C; indeed their profile in 2013 looks quite similar to that of men, although their absolute rates of employment are lower at most ages. The other major change for women has been the rise in employment for older women â&#x20AC;&#x201C; those over age 50.

The employment life course for men has not changed very much over the 35 years that are encompassed in the graph. Men still enter employment on completion of their education (or while still studying), work throughout their prime working years, then start to reduce their engagement with work once they reach their late 50s. The two main changes for men are that today, 10-15 per cent of men in the prime working ages from 30-50 are not employed and that employment rates for men in their 60s have risen.

The evidence so far suggests that women of all ages, and both young (student) and older men would welcome opportunities for employment that did not require unrelenting full-time engagement, and that were compatible with study, caring for family members, and declining health and energy. These options could be provided by secure part-time work, and this has indeed been on the increase. But so have casual employment and other forms of more tenuous engagement. Figure 2 shows the changes in employment on casual terms that have

Figure 1 (b): Employment to Population Ratio, female, by age, selected years

Figure 2: The proportion of each age group that worked on casual terms, 1992 and 2011, by sex

extended lifespan combined with poorer health while still of working age, all combine to suggest that the standard offering of full-time permanent work is no longer the best fit for many people in the workforce today.

1978 1992

Female 2011

2013 80

Female 1992 Male 2011 Male 1992

0 20- 25- 30- 35- 40- 45- 50- 55- 60- 65- 7015and 19 24 29 34 39 44 49 54 59 64 69 over

Source: ABS, Labour Force Status (ST LM2) by Detailed Age, Capital City/Balance, Sex â&#x20AC;&#x201C; from February 1978, 2013

20- 25- 30- 35- 40- 45- 50- 55- 60- 65- 7015and 19 24 29 34 39 44 49 54 59 64 69 over

Source: derived from ABS Labour Force Surveys 1992 and 2011.

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occurred over the past 20 years, by age group and separately for each sex. The figure shows that more men at every age are working on casual terms: this growth is not just confined to either end of the working life. At every age, almost half of male casuals are working full-time, and this is a growing category of employment. It is hard to argue that men aged 25-54 would choose to work on casual terms if a reasonable permanent option was available, especially since 37 per cent of them are married with dependent children. I note that casual employment for this group is concentrated among labourers and elementary sales persons, groups who are not likely to have a large set of job options. The concerns about insecurity of hours, employment and earnings arising from casual employment are especially pertinent for these men. Again, the picture for women is different. Women have seen the same growth as men in casual employment among people under age 25 and over

Do we all want permanent full-time jobs?

age 55. Many of both sexes are likely to be happy to work as casuals, as they study4, manage health limitations or transition to retirement. But in contrast to men, women aged 30-50 are less likely to be working on casual terms in 2011 than they were in 1992.

Are flexible jobs worse jobs? The first point to make in answering this question is that Australia is quite unusual in the extent of protections it offers to people who are employed on flexible terms. The most notable of these is that wage setting rules require that if a job is done on casual terms, then there must be a loading of between 20-25 per cent on top of the permanent hourly rate. This loading compensates for the absence of paid leave (annual, sick, family) and, to an extent, for the insecurity. This casual loading is valued particularly by those who do not expect to get sick, or have family responsibilities, such as students. Casual workers

also have the same protection as other workers against unfair dismissal, discrimination, access to penalty rates and compulsory superannuation and (unpaid) compassionate and carerâ&#x20AC;&#x2122;s leave. In addition, unlike the United States and many European countries, access to health care and to unemployment benefits is not tied to current or prior work history. In Australia, therefore, it is very likely some workers will prefer to work on casual terms, even should a similar permanent job be available, if only for the higher hourly pay. A valuable overview of whether casual employment causes hardship is to see whether it is concentrated among households that have the least options â&#x20AC;&#x201C; those with the lower levels of socioeconomic advantage. If people who are employed on casual terms are located in high socioeconomic advantage households, we may conclude it is not because they have been forced by serious economic need to accept that form of employment. Figure 3 shows how men and women who are employed as casuals are distributed among households ranked by socioeconomic advantage. The sample is confined

to those aged 25-54, in order to focus on those who have the fewest reasons to value casual terms. We see from Figure 3 that there is some concentration of casual employment for men in the bottom four deciles of household socioeconomic advantage: if there was no association, the casual (and permanent) columns would all be equal to 10 per cent. But the concentration is not large: 33 per cent of male casuals are in the bottom 30 per cent of households and 25 per cent are in the top 30 per cent of households. For women the association is very weak, with the bottom and top 30 per cent of households providing 27 and 32 per cent of casual workers respectively. That is, more women casuals are in advantaged households than are in disadvantaged ones. The distributions shown in Figure 3 do not support the idea that people typically are forced to take casual jobs from a position of disadvantage. To this point the analysis has relied on the presentation of selected national statistics. While this is quite insightful, there is a more analytical literature that uses advanced econometric

Figure 3: Distribution of casual and permanent employment by socioeconomic advantage of the employees: 2009 Females

Males 16

Permanent

Casual

Permanent

0 bottom 2nd 3rd 4th 5th 6th- 7th 8th 9th top

Casual

0 bottom 2nd 3rd 4th 5th 6th- 7th 8th 9th top

Source: ABS Survey of Education and Training, 2009

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methods and panel data to, inter alia, see if employment on casual or part-time terms is disadvantageous. The question immediately arises: compared to what? One comparison is with similar people who are employed on permanent terms. The other comparison is with people who are unemployed. The former comparison implies that if opportunities to employ people on casual terms were restricted, then an equivalent number of permanent jobs would replace them. The latter implies that if people were prevented from working on casual terms, they would most likely not be able to find work at all. The findings of this analytical literature are as follows:5 – Both men and women have higher wages than otherwise if employed part-time (10 per cent) or on casual terms (5 per cent), once proper account is taken of individual productivity characteristics. • For women: the wages of part-time casuals exceed those of part-time permanent workers which in turn exceed those of full-time workers. • For men: the wages of part-time permanent workers exceed those of part-time casual workers which in turn exceed those of fulltime workers. – These findings for Australia are at odds with the findings for other like countries. – Casual employment in the previous period greatly increases the probability of permanent employment in the current period for men, compared with being unemployed, but this is not true for women. – Partnered Australian women have higher life satisfaction if they work part-time rather than full-time. – Employment on casual or contract terms, compared with being employed in a permanent full-time job, does not harm mental health. A more cautionary view is provided by Watson (2013, p.23), who concludes that: ‘It seems reasonable to conclude that casual 20

Do we all want permanent full-time jobs?

jobs do indeed operate as labour market traps, and they are actually crafted to do so’. If the alternative to casual and part-time employment is permanent and full-time, then we need to look more closely at how satisfied permanent full-time workers are. The main drawback of such jobs is the heightened risk of pressure to work long hours. Today, men in permanent full-time jobs work an average of 44 hours per week, a quarter work 50 hours or more and 30 per cent of men and 25 per cent of women say they would like to work fewer hours than they do (taking account of the effect on their pay). This is a much larger group than the numbers of parttime workers who say they want more hours of work. Econometric estimates find that working longer hours than is desired is both much more common and much more harmful to mental health and to job satisfaction than is under-employment.6 Drago et al (2009, p.593) conclude that ‘long hours, at least in Australia, may often represent a badge of masculinity.’

Conclusion There is a time in the lives of many people when they want full-time permanent employment. This is especially true for men in their main earning years and women too, if they do not have young children. But there are also times in the lives of many people when they want less ‘consuming’ forms of employment, to accommodate study, family needs, health limitations and phased retirement. With a focus on family needs, the Sex Discrimination Commissioner, Elizabeth Broderick (2012, p.207) concluded that ‘It is now 2012 and in terms of the workplace, there is still a fundamental mismatch between unpaid caring work and workplace structures and cultures … significant cultural change will not occur unless, and until, men start working differently – more flexibly‘. The much greater diversity of the modern workforce is better suited by a variety of terms of employment, than by full-time (and long hours) permanent terms as the only option. Furthermore, workers who are employed on flexible terms on average receive higher hourly wages as a result.

There is no doubt many people who work on flexible terms do find the insecurity, lack of paid leave and other features of this type of work to be troublesome. Full-time permanent workers also have legitimate discontents. We should apply our wit to identifying how to improve the working experience for all types of workers, while retaining the essential degrees of freedom that are most valued by employers. Professor Sue Richardson AM is Matthew Flinders Distinguished Professor at the National Institute of Labour Studies (NILS), Flinders University, and a former Director of NILS. She has also held an extensive array of advisory and policy positions in the public sector. 1 ABS, Forms of Employment, 2012. 2 Brian Howe led the Independent Inquiry into Insecure Work on behalf of the ACTU. They produced a substantial report entitled Lives on Hold in 2012. 3 See http://www.adelaide.edu.au/news/print56441.html (accessed 10-01-2014) for a summary of recent findings for Australia by Graeme Hugo, and http://archinte. jamanetwork.com/data/Journals/INTEMED/926555/ ilt130001_385_386.pdf.gif (accessed 10-01-14) for similar results for the US. 4 48 per cent of higher education students aged 15-24 study full-time and work part-time; 80 per cent as casuals. Of all casuals, 29 per cent are full-time students. Data are derived from the ABS Labour Force Surveys. 5 Full citations to the articles on which I draw are provided in the bibliography. 6 Richardson et al, 2012; A Dockery, 2006, ‘Mental health and labour force status: panel estimates with four waves of HILDA’, Centre for Labour Market Research Discussion Paper 06/1, Curtin Business School, Curtin University of Technology.

References Abhayaratna, J, Andrews, L, Nuch, H and Podbury, T 2008, ‘Part-time employment: the Australian experience’, Productivity Commission Staff Working Paper, Canberra.

Broderick, E 2012, ‘Women in the workforce’, The Australian Economic Review, 45(2): 207. Buddelmeyer, H and Wooden, M 2011, ‘Transitions out of casual employment: the Australian experience’, Industrial Relations, 50 (1): 109-130. Buddelmeyer, H, Wooden, M and Ghantous, S 2006, ‘Transitions from Casual employment in Australia’, Melbourne Institute of Applied Economic and Social Research. Cai, L and Waddoups, J 2012, ‘Unobserved heterogeneity, job training and the employer size-wage effect in Australia’, Australian Economic Review, 45 (2): 158-75. Dockery, A 2006, ‘Mental health and labour force status: panel estimates with four waves of HILDA’, Centre for Labour Market Research Discussion Paper 06/1, Curtin Business School, Curtin University of Technology. Drago, R, Wooden, M and Black, D 2009, ‘Long work hours: volunteers and conscripts’, British Journal of Industrial Relations, 4 (3): 571-600. Gilfillan, G and Andrews, L 2010, ‘Labour force participation of women over 45’, Productivity Commission Staff Working Paper, Canberra. Wooden, M, Warren, D and Drago, R 2009, ‘Working Time Mismatch and Subjective Wellbeing’, British Journal of Industrial Relations, vol. 47 (1): 147–179. 2009, p.157. Richardson, S, Lester, L and Zhang, G 2012, ‘Are casual and contract terms of employment hazardous for mental health in Australia?’, Journal of Industrial Relations, 54 (5): 557-578. Watson, I 2013, ‘Bridges or Traps? Casualisation and labour market transitions in Australia, Journal of Industrial Relations, 55 (1): 6-25.

Booth, A and Wood, M 2008, ‘Back-tofront down under? Part-time/full-time wage differentials in Australia, Industrial Relations, 47 (1): 114-135. Insights Melbourne Business and Economics

Article heading here

can employee voice and participation unlock employee engagement? Active line-management combined with effective top-level consultative arrangements involving senior managers is needed to boost employee engagement. by john purcell

An edited version of an address to the University of Melbourne – Monash University Joe Isaac AO Industrial Relations Symposium at Monash University on 21 October 2013.

Employee engagement is a hot topic in managerial circles fixated on finding cost-effective means of boosting labour productivity by tapping dedication and commitment. Psychologists focus on individual attributes to discover the characteristics of the fully-engaged worker – someone who lives for their job. Their descriptions can sometimes seem unreal, coming from a managerial dreamland. For example, Rich, Lepine and Crawford (2010, p.272, emphasis in the original) describe how: In engagement, organisation members harness their full selves in active, complete work role performances by driving personal energy into physical, cognitive and emotional labours. Engaged individuals are described as being psychologically present, fully there, attentive, feeling, connected, integrated, and focussed in their role performances. They are open to themselves and others, connected to work, and focussed in their role performance. Not surprisingly, reference is often made to ‘depletion theories’ (Macey and Schneider, 2008) and the ‘dark side’ of engagement where employees who try to discharge all work and team roles, as well as being conscientious organisational

citizens, ‘experience burnout, health problems and disengagement’ (Welbourne 2011, p.97). Described in this way ‘engagement’ must always be a minority attribute, found perhaps among one-third of employees while another one-third are partially or periodically engaged and the remainder are neither engaged nor disengaged (Truss and Soane, 2010, p.24). Australian Gallup-poll data, cited by Gardiner (2013), show that around two-thirds of employees ‘consider themselves emotionally detached from their employer... One in five Australians have admitted to being actively disengaged, openly disliking their workplace, performing poorly and taking unnecessary sick days’. This negativity, matched with unrealistic expectations about the characteristics of fully-engaged employees, can detract from the positive features of engagement once the focus changes from individual workers to the wider organisation. Human-resource (HR) professionals and employment specialists tend to focus on behavioural engagement linked to the employing organisation. Truss et al (2014), in their compendium of essays on engagement, take the view that ‘engagement with the organisation rather than the job may be more meaningful Insights Melbourne Business and Economics

in theory than in practice’. It is here we find a close association with long-established notions and theories of organisational commitment and job satisfaction. In Britain, and most probably in Australia, the debate has tended to focus on the organisational attributes associated with higher levels of engagement, and on the search for conclusive evidence of positive links to productivity and performance in, for example, customer service. The highly influential, UK government-sponsored report on engagement by David MacLeod and Nita Clarke (2009) synthesised the evidence, collected case studies and suggested four pillars supporting or enabling employee engagement: – Leadership; – Organisational integrity; – Employee voice; and – Engaging managers. Consultants and business leaders embraced the report and efforts have been made to turn the pursuit of employee engagement into a social movement. Most attention has been devoted to defining and pursuing ‘leadership’ styles that resonate with employees together with renewed emphasis on ‘mission’ and ‘values’. Subsequently, ‘voice’ has been largely eclipsed or even ignored. My argument here is that this limits the prospects for generating engagement in the attitudes and behaviours of employees since it is the experience of being able to voice opinions, concerns and ideas – and be listened to – which triggers engagement. It does so more effectively than the more nebulous ideas of ‘leadership’ and ‘integrity’. When we look at ‘engaging managers’, the final pillar, we find that a great deal of what the good manager does is linked to employee voice through discussion and collaborative working: voice in action.

Employee voice Explanations for this neglect of voice only really emerge once we are clear what ‘voice’ is and what it is not. MacLeod and Clarke (2009, p.75) 24

Can employee voice and participation unlock employee engagement?

considered that an ‘effective and empowered employee voice’ occurred when: Employees’ views are sought out; they are listened to and see that their opinions count and make a difference. They speak out and challenge when appropriate. A strong sense of listening and of responsiveness permeates the organisation, enabling effective communication. Here, management actively seeks employee views which can make a difference to plans and decisions. Even when not asked for their views, employees are empowered to challenge and speak out. This is not just getting employee views through an engagement questionnaire, nor is it the regular briefing-group meeting, run by a front-line manager for 15 to 30 minutes or so, allowing little time for questions. It is something more profound, about building a culture of participation and involvement. More recently, Farndale et al (2011, p.114) explored the connection between employee voice and organisational commitment, closely related to the concept of organisational engagement. To them: The root of employee voice lies in influence being shared among individuals who are hierarchically unequal. In essence voice relates to employees’ ability to influence the outcome of organisational decisions by having the opportunity to advance their ideas and have them considered. This adds a slight extra twist to the MacLeod and Clarke (2009) description of the voice-rich organisation since it specifies ‘organisational decisions’ of the sort taken by senior managers and executives – often in places remote from the dayto-day work carried out by employees. This means that any effective voice system has to include senior as well as front-line managers while HR staff run the annual employee survey. This type of top-level voice comes quite close to the definition of consultation in German works councils where, according to Budd and Zagelmeyer (2010), labour law establishes ‘a right for employees to be informed of planned measures

in advance and to have an opportunity to express an opinion prior to implementation’. Employees in UK enterprises with 50 or more employees have this right to ask for business-related consultation under the Information and Consultation of Employees Regulations 2004. Few know about it, but companies can establish consultative committees – union based, non-union or mixed – under the Regulations without being requested by employees. Many don’t. My colleague Mark Hall (2006) considers the Regulations ‘a damp squib’. There are three explanations for this lack of interest in voice. First, voice, as defined by MacLeod and Clarke, is too challenging for many managers because it is an alternative to managerial unilateralism. Managers dislike being challenged and senior managers find it hard to justify their decisions and share their plans with employees, although for those that do it is often seen as a valued activity especially in managing change. Second, as Francis and Reddington (2012) complain, the active management of employee engagement tends to view employees in a passive role with engagement – something that is driven by the organisation, rather than by employees. Engagement, like discretionary behaviour, is given by employees, not something done to them. Finally, the engagement industry, including ‘engage for success’, the UK social movement promoting engagement, has a fixation with the outcomes of engagement, admirably summarised by Rayton (2012), but little is done to analyse why employees are engaged in the first place. What are the antecedents? Where does engagement come from and what destroys it? We need yet again to ‘unlock the Black Box’ as I and colleagues from Bath University did 10 years ago in looking for the connection between HR and performance (Purcell et al, 2003). In an early black-box type research study of engagement, Robinson et al (2004) identified ‘the key driver’ of engagement as ‘a sense of feeling valued and involved’. This came from involvement in decision-making; the extent to which employees feel able to voice their views, and managers value employees’ contribution; the opportunities

employees have to develop their jobs (i.e., voice in job design and development); and the extent to which the organisation is concerned for employees’ health and wellbeing (and this means listening and responding). Recent results from a huge national survey – the UK 2011 Workplace Employment Relations Study (WERS) (van Wanrooy et al, 2014) – show the connection between involvement and engagement. Only about 40 per cent of employees were satisfied with the amount of involvement they had in decision-making. Of those that were satisfied, 85 per cent felt proud to work for their organisation. This is one of the standard tests for engagement and commitment. However, of those who were dissatisfied with their level of involvement in decision-making, only around a third were proud of their organisation. These differences are not trivial. The best explanation for the link between employee attitudes and behaviour and positive contributions to the job and the organisation comes from social-exchange theory, with its identification of reciprocity as a form of social exchange. The key to this is employee perceptions of the organisational support they receive from management. One of the lead authorities on engagement in the US, Saks (2006) concluded that perceptions of organisational support were the only significant predictors of both job and organisational engagement. While we can look for policy and practice actions which generate feelings of organisational support like those identified by Robinson et al (2004), the underlying causes come from employee perceptions of fairness, justice and trust in management. Fairness is created not just by consistent, bias-free and ethical procedures but by allowing employees to express an opinion. What is really interesting is that even if employees think their opinions will not influence a decision, the fact that their opinions were sought is enough for perceptions of fairness to grow and persist (Tyler and Blader, 2003, p.351), a conclusion supported by Farndale et al (2011). This is sometimes referred to as procedural justice – ensuring that decision-making, especially in employment and job related matters, is explained and understood with an opportunity to contribute, and seen to Insights Melbourne Business and Economics

be fair. These days this is linked to interpersonal justice related to how decisions are communicated and explained by line managers in a way which treats employees with respect. This strongly shapes people’s reactions to their personal experience and those of their colleagues.

making. Ever since the Black Box research in 2003 I have argued that the key group of employees in generating commitment and engagement, and through these to performance, are line managers – what Robinson and Hayday (2009) call ‘the engaged manager’.

At Bath University, we analysed the factors most strongly associated with organisational commitment, using the 2004 WERS data (Purcell et al, 2009). The results are of interest since they can be interpreted as a list of the classic building blocks of engagement. In descending rank order the seven strongest factors were:

Second, is the problem of senior managers. Line managers can go so far but they are not responsible for high-level, strategic decisions and cannot provide convincing explanations at briefing groups if they are as much in the dark as their team members. It is evident that there is a low level of trust in senior managers in the UK at least – in the decisions they make, the way change is managed and in the opportunities provided for employees to contribute their views. This lack of trust and involvement in decision-making is consistently shown in the Chartered Institute of Personnel and Development (CIPD) time series data (2011), National Health Service employee attitude survey (2011) and Civil Service employee surveys (Bach and Kessler, 2012). The recently published fifth European Working Conditions Survey (Eurofound, 2013) showed that across the whole of the EU most of the workforce is in organisations that provide very limited opportunities for employees to participate in decision-making. Yet the evidence is clear. ‘Trust in senior management and strong employee-line manager relationships constitute key components of the ‘organisational climate’ required for engagement to flourish’ (Rees et al, 2013).

– Employee trust in management; – Satisfaction with work and the job; – Involvement in decision making at work; – Climate of relationships between management and employees; – Satisfaction with pay; – Job challenge; and – Sense of achievement from work. The most influential factor, which applied to all types of employees, was trust in management. None of the other factors were quite so universal in their link to commitment for all occupational groups.

Policy implications There are obvious policy conclusions. First, as is increasingly being recognised, line managers are the critical players in providing trustworthy leadership, encouraging employee voice and allowing for meaningful involvement in job and team decisions. It looks, too, as though these managers are getting better. Not only is there clear evidence of the use of a wide range of communication methods with over 80 per cent of workplaces using briefing groups, workforce meetings and other channels like social media, but positive employee judgements of their line managers are growing. In 2011 just under 60 per cent of employees in the WERS survey ‘agreed that their managers are sincere in attempting to understand their views’. As we have seen, far fewer were content with their involvement in decision26

Can employee voice and participation unlock employee engagement?

This is where another type of organisational justice comes into play. Informational justice, as it is called, relates to how perceptions of justice are shaped by accounts and explanations by organisational authorities about reasons why certain procedures were chosen and why outcomes were distributed in a certain way. Studies of consultation in Joint Consultative Committees (JCCs) or staff councils, which my colleague Mark Hall and I have recently completed (Hall and Purcell, 2012), show that the employee contribution to the decision-making process is most often focussed on the implementation of strategic policies rather than on the decision itself.

Once explanations are provided and knowledge shared that alternatives were considered, the debate is focussed on how to proceed, and it is here that managers often identify the key contribution made by employees. Inevitably, the involvement of employees with senior managers in contributing to decisionmaking means the creation of social institutions, most obviously through JCCs since, in all but small companies, employees will need to select representatives. It is not possible for all

employees to take part. These staff councils can be union based (and a few unions are at long last showing interest in them in both the UK and Australia), directly elected representatives in non-unionised firms, or, as is quite often the case, a mixture of union and non-union people. We have recently shown how this can best be done (Hall and Purcell, 2012) and have identified the supporting conditions required for consultation to be successful. At present, collective consultation is profoundly unfashionable. Some firms are experimenting with focus groups and other forms

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of employee representation. Recent evidence from the UK WERS 2011 shows an increasing number of firms think that emailing staff can provide an effective means of two-way communication (van Wanrooy et al, 2014). This does not get anywhere near the need to achieve dialogue with a genuine exchange of views.

Conclusion The clear evidence is that where there is both active line-manager action to promote voice and involvement combined with effective toplevel consultative arrangements involving senior managers, with good connections between the two, the outcomes in terms of commitment and engagement are better than where there is only one of these forms of employee voice (Purcell and Geogiades, 2007). Building these and making them work is the best future agenda for employee engagement. This is also where government and its agencies can make a contribution to fostering employee engagement, something that has been notably absent up to now in the UK, by legislating to require consultation between senior managers and elected employee representatives, as is quite common in continental Europe (Hall and Purcell, 2011). This can no longer rely on trade unions since their membership has collapsed in the private sector: down to 14 per cent in the UK with an even quicker and deeper fall in Australia. Increasingly, unions find they need to share membership of JCCs with non-union elected representatives if they are to gain a seat at the table. Section 205 of the Fair Work Act in Australia provides for consultation on major workplace change where there is a workplace agreement. It requires the election of employee representatives. No detail is provided on how or when the consultation is to occur, in sharp contrast to the UK statute on consultation in large scale redundancies. It is here that your Fair Work Commission can make a real contribution to developing effective means of linking consultation with employee voice, and showing how this can unlock employee engagement. 28

Can employee voice and participation unlock employee engagement?

Ultimately, however, it is up to management to build effective voice systems and participation procedures and practices. Trade unions and government need to be active supporters. With such clear evidence on the link between voice and engagement, and an understanding of the antecedents to engagement, it should not be too difficult to launch a campaign promoting this in the modern workplace. John Purcell is Visiting Professor, Bath University School of Management, UK. References Bach, S and Kessler, I 2012, The Modernisation of the Public Services and Employee Relations, Basingstoke: Palgrave Macmillan. Budd, J and Zagelmeyer, S 2010 , ‘Public policy and employee participation’ in Wilkinson, A, Golan, P, Marchington, M and Lewin, D (eds) The Oxford Handbook of Participation in Organisations, Oxford: Oxford University Press, 476-503. CIPD 2011, Employee Outlook 2011, London:CIPD. Eurofound 2013, Fifth European Working Conditions Survey, Dublin: European Foundation for the Improvement of Living and Working Conditions. Farndale, E, Van Ruiten, J, Kelliher, C, and Hope-Hailey, V 2011, ‘The influence of perceived employee voice on organisational commitment: an exchange perspective’, Human Resource Management 50(1):113-29. Francis, H and Reddington, M 2012, ‘Employer branding and organisational effectivness’ in H. Francis, L. Holbeche and M Reddington (eds) People and Organisational Development: A new Agenda for Organisational Effectiveness, London: CIPD pp 260-85. Gardiner, B 2013, ‘Employee engagement’ Business World, 23 September

Hall, M and Purcell, J 2011, Information and Consultation Practice Across Europe Five Years after the EU Directive, Dublin: European Industrial Relations Observatory. http://www.eurofound. eu/eiro/studies/tn1009029s/tn1009029s.htm Hall, M and Purcell, J 2012, Consultation at Work: Regulation and Practice, Oxford: Oxford University Press. Hall, M 2006, ‘A cool response to the ICE Regulations? Employer and trade union approaches to the new legal framework for information and consultation’, Industrial Relations Journal 37 (5): 456-472. MacLeod, D and Clarke, N 2009, Engaging for Success: Enhancing Performance through Employee Engagement. A report to Government, London: Department for Business, Innovation and Skills. Macey, W and Schneider, B 2008, ‘The meaning of employee engagement’, Industrial and Organisational Psychology 1:3-30 NHS 2011, Staff Survey (http://www.nhsstaff surveys.com/cms/) Purcell, J, Kinnie, N, Swart, J, Rayton, B and Hutchinson, S 2009, People Management and Performance, London: Routledge. Purcell, J and Geogiades, K 2007, ‘Why should employees bother with worker voice?’, in Freeman, R, Boxall, P and Hayes, P (eds) What Workers Say: Employee Voice in the Anglo-American Workplace, Ithaca, NY: ILR press, 181-97. Purcell, J, Kinnie, N, Hutchinson, S, Rayton, B and Swart, N 2003, Understanding the People and Performance Link: Unlocking the Black Box, Research Report. London: CIPD Rayton, B, Dodge, T and D’Analeze, G 2012, The Evidence, Employee Engagement Task Force, Nailing the Evidence Work Group, Engage For Success.

Rich, B, Lepine, J and Crawford, E 2010, ‘Job engagement: antecedents and effects on job performance’, Academy of Management Journal 53(2): 617-35. Robinson, D, Perryman, S. and Hayday, S 2004, The Drivers of Employee Engagement, ies Report 408, Brighton: Institute for Employment Studies. Robinson, D and Hayday, S 2009, The Engaging Manager. ies Research Report 470, Brighton: Institute for Employment Studies. Saks, A 2006, ‘Antecedents and consequences of engagement’. Journal of Managerial Psychology, 21(7): 600-19. Truss, K and Soane, E 2010, ‘Engaging the “pole vaulters” on your staff’, Harvard Business Review March p24. Truss, K, Delbridge, R, Alfes, K, Shantz, A and Soane, E 2014, Employee Engagement in Theory and Practice (eds) ‘Introduction’, London: Routledge. Tyler, T and Blader, S 2003, ‘The group engagement model: procedural justice, social identity, and cooperative behaviour’, Personality and Social Psychology Review 7 (4): 349-361 van Wanrooy, B, Bewley, H, Bryson, A, Forth, J, Freeth, L and Wood, S 2014, Employment Relations in the Shadow of Recession, Basingstoke: Palgrave. Welbourne, T 2011, ‘Engaged in what? So what? A role-based perspective for the future of employee engagement’, in Wilkinson, A and Townsend, K (eds) The Future of Employment Relations: New Paradigms, New Developments, Basingstoke: Palgrave Macmillan.

Rees, C, Alfes, K and Gatenby, M 2013, ‘Employee voice and engagement: connections and consequences’, International Journal of Human Resource Management 24 (14): 2780-98. Insights Melbourne Business and Economics

Article heading here

performance management: poison, panacea or plain hard work? Performance management systems can create both positive intended and negative unintended consequences for employees and organisations. Constant attention is needed for these systems to be effective. by michelle brown and martin nally1

A condensed version of a master-class presented at the University of Melbourne on 7 August 2013.

In this paper we outline what organisations seek to achieve from performance management (‘panacea’), then examine some empirical research to demonstrate that performance management has adverse consequences for employees and their organisations (‘poison’). Finally, we suggest that performance management is neither poison nor panacea – it is just plain hard work. Organisations need to return to the basics in order for it to be effective.

Performance management as a ‘panacea’ The Concise Macquarie Dictionary (CMD) defines a panacea as ‘a remedy for all diseases; cure all’. Academics and practitioners encourage organisations to use performance management as a cure-all for organisational performance. For organisations, it encourages employees to focus on strategic priorities, facilitate organisational change and promote employee performance through higher levels of accountability. For employees, it provides development opportunities and higher levels of remuneration (Kessler and Purcell, 1992; Shields, 2002). Nankervis and Compton (2006) provide evidence on the widespread use of performance management in Australia – 96 per cent

of organisations reported having a performance management system. An emerging body of evidence suggests that performance management is not always a panacea. There is substantial ‘churn’ in the use of performance management systems, suggesting a level of dissatisfaction. Brown and Heywood (2003) demonstrate that approximately one-quarter of firms either dropped (15 per cent) or adopted (11 per cent) their performance management system over a five year period. Studies of employees show that 30 to 50 per cent of employees think performance reviews are ineffective (Gosselin, Werner and Halle, 1997). Almost half (48 per cent) of employees refer to performance reviews as ‘second guessing sessions’ (Gosselin et al., 1997), while Brown, Kraimer and Bratton (2011) reported that 40.1 per cent of employees see the process as ‘not very useful’. Studies of managers reveal that only six per cent of CEOs believe that their organisation’s current performance management process is useful (Elicker, Levy and Hall, 2006). A study by the Australian Human Resources Institute reported that 30 per cent of HR professionals were dissatisfied with the performance management process; 20 per cent reported high or very high satisfaction with the process (Parker, 2003). Insights Melbourne Business and Economics

Performance management as a ‘poison’

when they provide help ($30,000 less) but earned $85,000 more when they received help.

One explanation for dissatisfaction with performance management systems is that they ‘poison’ the workplace. The CMD defines a poison as anything harmful ‘to character, happiness or wellbeing’. There are a number of ways in which performance management may be poisonous in the workplace – we will focus on two of these: the effect on relationships between employees and employee wellbeing.

Poisoning employee wellbeing: ‘working harder for less’

Performance management systems create a problem with ‘adverse specialisation’ (MacDonald and Marx, 2001). Adverse specialisation occurs when employees concentrate on those tasks that provide the greatest rewards, ignoring unrewarded helping behaviours (which can have a positive impact on the quality of relationships and productivity in the workplace). Two studies demonstrate adverse specialisation due to performance management systems. Encinosa, Gaynor and Rebitzer (2007) demonstrated that doctors in medical partnerships that share earnings, as opposed to receiving earnings based on their individual patients, are significantly more likely to consult with one another about cases. A study of employees in the finance industry (call centre employees, insurance administrators and financial planners) provided an opportunity to test the effect of pay on helping effort (Brown and Heywood, 2009). Respondents indicated the extent to which ‘I help make other workers more productive’ and ‘my co-workers are helpful to me in getting the job done.’ Figure 1 shows that insurance administrators were more likely to provide (73.9 per cent) and receive help (85.4 per cent). Only 49.1 per cent of the financial planners indicated that they received help from their co-workers. Part of the explanation lies in the performance management system: only six per cent of insurance administrators’ pay was based on performance, while 48 per cent of the financial planners’ pay was performance-based. Further analysis showed that financial planners earned less 32

Performance management: poison, panacea or plain hard work?

Employees also report suffering from emotional exhaustion as a consequence of performance management. Wright and Cropanzano (1998, p. 486) define emotional exhaustion as ‘a chronic state of physical and emotional depletion that results from excessive job demands and continuous Figure 1: Providing and receiving help 90

Provide help

Receive help 70

Percentage

Poisoning relationships between employees

Performance management systems are intended to promote employee performance (Aguinis, 2009). There is, however, evidence that employees experience performance management as work intensification: doing more for less (Green, 2004). Green (2001, p. 69) has shown that there has been an increase in work pressures on employees from ‘reports and appraisals’ between 1986 and 1997. Case studies of mining industry employees (Iverson and Maguire, 2000), medical scientists (Weekes, Peterson and Stanton, 2001) and public sector workers (Brown and Benson, 2005) demonstrate that performance management has been associated with increasing the workload of employees.

Call centre

Insurance administrators Type of employeee

Source: Brown and Heywood (2009)

Financial planners

hasslesâ&#x20AC;&#x2122;. A common symptom is dread at the prospect of returning to work for another day. Gabris and Ihrke (2001) suggested a positive relationship between distributive justice (the fairness of pay allocations) and emotional exhaustion. Brown and Benson (2003) found that employees with higher performance ratings were also more likely to report emotional exhaustion. Emotional exhaustion is potentially costly for organisations: it can lead to an increase in turnover (Jackson, Schwab and Schuler, 1986), deterioration in work attitudes (Wolpin, Burke and Greenglass, 1991), counterproductive work behaviour (Quattrochi-Turbin, 1983) and absenteeism (Firth and Britton, 1989).

Performance management as plain hard work Adverse outcomes are possible when an organisation does not allocate the time and resources to effectively implement a performance management system. Implementing and operating an effective performance management is plain hard work. Managers struggle with performance management as it requires constant work: planning, developing strategies, allowing people to have an understanding of the direction of the organisation and giving them an understanding of the objectives that they need to undertake. Many organisations say that the key to success lies in its people and the skills they bring to each and every activity. Unfortunately, though, this is a platitude that many companies and managers aspire to but few effectively implement.

Keys for effective performance management Successful organisations have clarity of vision for their teams, individual direction for employees, and a genuine commitment to the process. They seek regular, honest feedback on the strength of achievements as well as areas for improvement, to enable development and improve effectiveness of employees. Further, these organisations promote a dialogue about professional development to help achieve excellent performance. And this is done with business outcomes in mind.

How are we performing in Australia? In our recent multi-industry survey of employees, managers did not rate all that well in terms of managing poor performance. Managers did a poor job in matching employees to jobs and organisations were poor at providing performance feedback. Managers were not effective at recognising good performance and rewarding employees. Australian management needs to do better. Our research at hranywhere has demonstrated that a large number of employees (about half across all industries) did not have a performance review in 2013. Managers typically put forward four reasons for not conducting reviews. First, they claim to have no time to conduct reviews; they are far too busy. Second, they claim a lack of performance-management skills; they feel they do not know how to give developmental feedback. Third, they have insufficient data on which to base their feedback and identify areas for improvement. Finally, they avoid undertaking performance reviews with difficult employees, preferring to focus on the employees they like to deal with. At hranywhere, we encourage organisations to start setting objectives for employees which will deliver role clarity. This, in turn, creates a level of objectivity which has been missing, and managers start to be fair and equitable in the management of their people. Correct objective-setting will deliver good data, which in turn can provide a basis for performance feedback and can also assist managers to identify the areas for improvement. Once managers feel more confident that good data does exist and have had some input from employees, they gain a level of skill and confidence in giving developmental feedback because it is fact-based. Once managers gain a genuine understanding and confidence in providing developmental feedback, they find the time. They know it is an essential element in achieving solid business performance. We have just turned all the reasons not to undertake performance management upside down. We said it was lack of time, lack of skill, lack of good data, lack of objectivity and lack of clarity in objective-setting. Well, if we can actually reverse that, and set objectives, be objective, find data and Insights Melbourne Business and Economics

help managers feel much more confident about giving feedback, then managers find the time and more employees will have their performance management review. This is plain hard work.

Setting objectives A tried and true method of objective-setting is SMART (specific, measurable, achievable, relevant and time-bound). Where we are able to write objectives for individuals and customise those to the needs of the business, we really can make a difference. When managers adopt the SMART methodology, the key performance indicators (KPIs) will â&#x20AC;&#x2DC;drop outâ&#x20AC;&#x2122; of those objectives. These KPIs are simplified as business or performance

Performance management: poison, panacea or plain hard work?

metrics, ratios or performance indicators. They are where managers look to see that the objective is being performed; they provide the benchmark to determine if performance objectives have been achieved. We encourage managers to involve their employees in setting SMART objectives and reviewing those objectives. The KPIs, then, can become the agenda for each monthly meeting â&#x20AC;&#x201C; to assist organisations in giving feedback to their employees. One of the interesting processes is where managers set the performance processes or the standards themselves and then impose these on their employees. Ownership is dubious as they have been imposed. If managers engage their people

to write the objectives themselves – or at least have input into them – then the individuals are more likely to own the objectives, be empowered to achieve the actions and contribute to the organisation’s performance. Authorship builds ownership. If employees initially craft objectives and have them approved by managers, there is a greater likelihood that those objectives will be owned by the authors –the employees. Ownership of objectives means fewer surprises for employees when it comes to reviewing performance.

Managers and performance feedback Great managers notice performance and gather good data. We know that they learn how to be comfortable giving feedback. They have great listening skills. They know what is going on and are open to new information. They demonstrate patience, fairness, honesty and clarity. They also have regular discussions about performance and development with their employees. They provided balanced feedback, identifying employee strengths as well as areas for development. To help managers, organisations need to have a clear company vision, strategy and goals. Then managers can start to develop objectives on a departmental, business unit and then individual basis. We know managers are effective when their employees say, ‘I receive regular feedback that is actionable, appropriate and timely. I understand the performance standards that I have and that are set for me. I feel that they’re fair. I am measured on my results and how I achieve those results. I participate regularly in open and honest discussions with my managers. Great results around here are rewarded through our management, systems and how management also tackles poor performance.’ Finally, we are looking for comments like, ‘My manager supports my development and understands my needs.’ What we do know is that there are different management styles. Buckingham (2005, p.79) pointed out that: …great managers know what the most effective way to invest their time is to identify exactly how each employee is

different. We need to figure out how best to incorporate those enduring idiosyncrasies into the overall plan. It’s about constantly tweaking your environment so that the unique contribution, the unique needs and the unique style of each employee can be given a free rank. Your success as a manager would depend almost entirely on your ability to do this.

Recognising individual differences Organisations need to build upon individual employee needs and idiosyncrasies. In the performance management process, we must learn to recognise employees. In a Gallup survey in 1999 (see Harter, Schmidt and Keyes (2003) for a review), the largest of its kind ever undertaken on workplace satisfaction, recognition was regarded as being most important in the performance management process when it was sincere and spontaneous. Employees expected recognition at least every seven days. Some managers are surprised at the frequency of recognition employees prefer. If we wait until the end of the annual review or the end of the year, we are waiting too long. While recognition is important, we must acknowledge that not one size fits all. Development is a powerful tool of recognition. The least amount of recognition we can give is sending employees on training courses or education programs. The greatest level of development we can achieve is to allow employees to be mentored and coached, provided with access to experiential learning, perhaps given projects or allowing them to share some individual or expert. Finally, give them a full change of job, a stretch assignment. These are effective developmental processes that can really recognise individuals’ contribution to the business. Development is also a useful tool for both high performing as well as high potential employees. High-performers can be the lifeblood of our organisation. As our workforce is shrinking and we need to do more with less, we need to keep our quality employees as they are critical for organisational success. Insights Melbourne Business and Economics

Performance management gets results Harper and Vilkinas (2005) investigated the link between performance management and business results. Where good performance management and solid performance management existed, organisational performance improved. Employeeinvolvement and motivation were high. Employees had an increased sense of personal value and perception of empowerment. Organisations found it easier to recruit, deploy, develop and retain employees because the reputation of the organisation was strong.

Conclusion Performance management is plain hard work. It takes a great deal of time and effort to ensure that the organisation has a clear vision and strategy; that each business unit has its objectives; and that all employees have objectives and KPIs. A well-designed and implemented performance management system ensures that employees understand the direction and priorities of the organisation. Employees are able to achieve their performance objectives as they receive strong feedback from their managers and are recognised for their achievements. For organisations, this means that performance management is ongoing hard work. A ‘set and forget’ approach runs the risk of generating unintended negative consequences and undermining the potential for performance management to promote employee and organisational performance. Michelle Brown is Professor of Management (Resource Management) in the Department of Management and Marketing, University of Melbourne. Martin Nally is Managing Director of hranywhere, an Australian-based HR consulting firm. 1 The sections on performance management as a panacea and a poison are based on the first author’s research. The section on performance management as plain hard work are based on the second author’s experience as a HR consultant.

Performance management: poison, panacea or plain hard work?

References Aguinis, H 2009, Performance Management, 2nd ed. Pearson Prentice Hall, New Jersey. Brown, M and Benson, J 2003, Rated to exhaustion? Reactions to performance appraisal processes, Industrial Relations Journal, vol. 34, no. 1, pp. 65-79. Brown, M and Benson, J 2005, Managing to overload? Work overload and performance appraisal processes, Group & Organization Management, vol. 30, no. 1, p. 99. Brown, M and Heywood, J S 2003, The determinants of incentive schemes: Australian panel data, Australian Bulletin of Labour, vol. 29, no. 3, pp. 218-235. Brown, M and Heywood, J S 2009, Helpless in finance: the cost of helping effort among bank employees, Journal of Labor Research, vol. 30, pp. 176-195. Buckingham, M 2005, What great managers DO, Harvard Business Review, March, pp. 70-79. Elicker, J D, Levy, P E and Hall, R J 2006, The role of leader-member exchange in the performance appraisal process, Journal of Management, vol. 32, no. 4, pp. 531-551. Encinosa, W E, Gaynor, M and Rebitzer, J B 2007, The sociology of groups and the economics of incentives: Theory and evidence on compensation systems, Journal of Economic Behavior and Organization, vol. 62, no. 2, pp. 187-214. Firth, H and Britton, P 1989, Burnout, absence and turnover among British nursing staff, Journal of Occupational Psychology, vol. 62, pp. 55-59. Gabris, G T and Ihrke, D M 2001, Does performance appraisal contribute to hightened levels of employee burnout? The results of one study, Public Personnel Management, vol. 30, no. 2, pp. 157-172. Gosselin, A, Werner, J M and Halle, N 1997, Ratee preferences concerning performance appraisal management and appraisal, Human

Resource Development Quarterly, vol. 8, no. 4, pp. 315-333. Green, F 2001, It’s been a hard day’s night: The concentration and intensification of work in late twentieth-century Britain, British Journal of Industrial Relations, vol. 39, no. 1, pp. 53-80. Green, F 2004, Why has work effort become more intense? Industrial Relations, vol. 43, no. 4, pp. 709-741. Harper, S and Vilkinas, T 2005, Determining the impact of an organisation’s performance management system, Asia Pacific Journal of Human Resources, vol. 43, pp. 76-97. Harter, J K, Schmidt, F L and Keyes, C L M 2003, Well being in the workplace and its relationship to business outcomes: A review of the Gallop studies.

Shields, J 2002, Performance pay in Australia. In Brown, M and Heywood, J S (Ed.), Paying for Performance: an international comparison. New York: M.E. Sharpe. Weekes, K, Peterson, C L and Stanton, P 2001, Stress and the workplace: the medical scientists’ experience, Labour and Industry, vol. 11, no. 3, pp. 95-120. Wolpin, J, Burke, R J and Greenglass, E R 1991, Is job satisfaction an antecedent or a consequence of pscyhological burnout? Human Relations, vol. 44, no. 2, pp. 193-210. Wright, T A and Cropanzano, R 1998, Emotional exhaustion as a predictor of job performance and voluntary turnover, Journal of Applied Psychology, vol. 83, no. 3, pp. 486-493.

Iverson, R D and Maguire, C 2000, The relationship between job and life satisfaction: Evidence from a remote mining community, Human Relations, vol. 53, no. 6, pp. 807-839. Jackson, S E, Schwab, R L and Schuler, R S 1986, Toward an understanding of the burnout phenomenon, Journal of Applied Psychology, vol. 71, pp. 630-640. Kessler, I and Purcell, J 1992, Performance related pay: Objectives and application, Human Resource Management Journal, vol. 2, no. 3, pp. 16-33. MacDonald, G and Marx, L M 2001, Adverse specialization, Journal of Political Economy, vol. 109, no. 4, pp. 864-899. Nankervis, A R and Compton, R L 2006, Performance management: theory in practice? Asia Pacific Journal of HRM, vol. 44, no. 1, pp. 83-101. Parker, L 2003, Performance anxiety, HR Monthly, December, pp. 18-22. Quattrochi-Turbin, S, Jones, JW and Breddlove, V 1983, The burnout syndrome in geriatric counsellors and service workers, Adaptation and Aging, vol. 3, pp. 65-76. Insights Melbourne Business and Economics

Article heading here

the time of our lives Why do people worry so much about their incomes and so little about how they spend their time? by daniel s. hamermesh

A condensed version of the Downing Lecture presented at the University of Melbourne on 1 August 2013.

Most people in the wealthy industrialised world feel constrained financially and spend substantial time worrying that their incomes are insufficient to meet their ‘needs’. Since humankind’s wants are limitless, while our incomes are not, these concerns make sense. People also feel pressured for time – they have not got enough time to do all the things they ‘need’ to do. Goods are scarce, but so is time. As we become richer over our lives – as our wages rise toward the peak earnings years in our late 40s and 50s – we can buy more goods; but the time available to us remains stuck at 24 hours per day, 365 days per year.

How do we spend our time?

The same increasing relative scarcity of time compared to that of income faces countries as they become richer. Consider Table 1, which shows real GDP per capita and life expectancy at birth in Australia and the US from 1960 to 2010. In both countries real incomes tripled over this period. But even in Australia, where life expectancy rose more than in the US, the increase in longevity was only 15 per cent. So time is relatively more than twice as scarce now as it was 50 years ago. This scarcity would not be a problem if time and income were perfectly substitutable.1 Regrettably they are not; and the inability to substitute goods for time completely suggests that we need to pay much more attention in our economic decisionmaking to the growing relative scarcity of time.

– Work around the house, including child care, cooking, cleaning, gardening and even shopping, which we call household production. This category includes all activities for which you are not paid, but which you could outsource – that is, pay somebody to do for you (Reid, 1934);

Time can be spent in a huge variety of activities, which makes it difficult to discuss what people do with their 24 hours each day and to make comparisons across people within a country or across countries. As with the categorisation of the goods we buy, some accounting logic is required to facilitate these comparisons. A reasonable accounting system for this purpose would classify human activities into four main categories: – Work for pay, including time spent looking for a job or commuting;

– Personal activities, mostly biological or socially required, such as sleeping, eating, washing, sex and others, which we may enjoy but over which we have little choice; and – Leisure activities that we choose but are not compelled to do, including television-watching, exercising, attending sporting events, religious activities and many others. Insights Melbourne Business and Economics

While this categorisation is, like any accounting system, quite arbitrary, so long as it is applied consistently across people, countries and time, it will provide useful insights into how we spend our days. Consider the country-wide averages in Table 2, which in addition to data for Australia and the US, also presents statistics for recent years in Germany and Italy.2 The crucial fact to note in these data is that, except for the US, for the average adult on a typical day over the entire week, work for pay is the least important of the four categories. The average person spends somewhat more time in household (unpaid work), substantially more at leisure, and much more in personal care. This is not surprising: sleep, the major component of personal care, is the most important single activity undertaken by the average adult. Indeed, combining only three basic activities – sleep, paid work and television-watching – accounts for nearly two-thirds of the average adult’s time in rich countries. Also noteworthy is the apparently greater amount of work for pay, and lesser amount of work at home, in the US than elsewhere. The difference may point out the potential dangers of making too much out of international comparisons: the diaries that underlie these surveys are not collected in the same way across countries. Nonetheless, this finding is consistent with other data (Freeman and Schettkat, 2005). Comparisons over time are difficult because the methods of data collection change (and data are of higher quality today than they were 50 years ago). But the evidence does suggest two conclusions: – Within each country people do have more leisure time now than they did 50 years ago – mainly because they have cut back on unpaid work, perhaps due to the substitution of appliances for household time (Aguiar and Hurst, 2007); and – In most countries the time spent in paid work has decreased, surely over the last century and, in most countries, in the last 50 years. 40

The time of our lives

Table 1: Real GDP per capita and life expectancy, Australia, US, 1960-2010

Australia

GDP Life GDP Life per capita expectancy per capita expectancy (Year 2005 at birth (Year 2005 at birth Year US $$) (years) US $$) (years) 1960

$15,255

70.8

$15,398

69.8

1970

$20,713

71.0

$20,435

70.8

1980

$21,890

74.3

$24,592

73.7

1990

$26,121

77.0

$31,389

75.2

2000

$34,072

79.2

$39,669

76.6

2010

$41,114

81.7

$41,365

78.2

Source: http://www.google.com/publicdata/; Heston et al, Penn World Table Version 7.1

Table 2: Average time (hours/day), 4 rich countries, 1992-early 2000s, Ages 20-74 Time Use Category:

Germany 2001/02

Italy 2002

Australia 1992

US 2003

Work for pay

3.3

3.5

3.7

4.2

Work at home

4.1

3.9

3.5

Personal care

11.1

9.9

10.3

10.5

5.5

6.7

6.1

5.8

Leisure

Source: Burda et al 2008 and author’s calculations

Table 3: Hours per day by gender, Australia 1992, US 2003, Ages 20-74 Australia Time use category: Work for pay

Male

Female

Male

Female

5.0

2.4

5.2

3.3

Work at home

2.6

5.2

2.6

4.4

Personal care

10.2

10.3

10.7

Leisure

6.2

6.1

5.9

5.6

Source: Author’s calculations

This discussion describes the behaviour of the average person in each country. Nobody is just average; and men and women certainly behave differently, but in which ways? Consider again Australia and the US. Not surprisingly, the data from these time diaries, summarised in Table 3, show that men work for pay more hours on a typical day than do women; and women spend more hours per day in unpaid work. The crucial thing to note here is that the sum of time spent on work for pay and work at home is almost identical by gender with each country: in Australia in 1992 the average man aged 20-74 spent 7.6 hours per day in all work; so did the average woman aged 20-74. In the US in 2003 the average man spent 7.8 hours in paid and unpaid work, the average woman 7.7 hours (a difference which is both tiny and statistically insignificant). This remarkable similarity by gender underlies a more general finding (Burda et al, 2013), which I call the iso-work hypothesis: in wealthy nonCatholic countries the total amount of work performed by men equals that performed by

women. In Catholic countries women work more in total, and the same is true in poorer countries. But it does appear that something, perhaps the development of a social norm in many cultures as the economy grows, leads to gender equality in this outcome. This superficial equality does not mean that women and men are equally well-off â&#x20AC;&#x201C; that depends on how people view the time spent in these different kinds of work. All it says is that the quantitative outcomes are identical. What if we did not have to work for pay? Would we spend the freed-up time at leisure, or would we just substitute unpaid work for the paid work that we no longer perform? Some evidence on this question is provided for Japan and Korea by Lee et al (2012), who show that cutting the standard workweek from 48 to 40 hours in Japan (44 to 40 hours in Korea) led to no additional time allocated to work at home. Instead, Koreans spent substantially more time in personal care, and Japanese spent more time at leisure (predominantly television-watching). Insights Melbourne Business and Economics

hours per day between ages 25-59 and 70-74. In neither country does additional work at home replace even one of these four hours. Rather, the majority of the freed-up time goes to leisure, with the rest going to additional personal care. The clear inference is that, if we had more time, we would not just be doing things that we could pay others to do for us; instead, we would be enjoying more leisure (perhaps even having fun!).

Another perspective on this question is offered by how people spend their time when, as is typical in most economies, increasing age leads them to choose not to work for pay. Evidence on this perspective is provided by the tabulations in Table 4, which for prime-age adults (25-59 years) and older people by five-year cohorts in Australia and the US show how they allocate their time across the four major categories of activity. In both countries work for pay decreases by about four

Table 4: Time use by age (hours per day), Australia, 1992, US 2003-04 Age

25-59

60-64

65-69

70-74

Australia

Work for pay

4.2

4.8

1.8

3.0

0.4

1.4

0.8

Work at home

3.7

4.0

4.2

4.1

4.5

4.6

4.4

Personal care

10.1

10.4

10.9

10.8

10.9

11.0

11.4

Leisure

6.0

4.8

7.1

6.1

8.2

7.0

8.0

7.4

Time Use Category:

Source: Authorâ&#x20AC;&#x2122;s calculations, ATUS 2003-04, AUS Time Use Study 1992

Figure 1: Percentage of daily work time spent at each half-hour, Germany, Netherlands, US and Australia 6 USA 2003 Australia 1992

Percentage of work

Netherlands 2000 Germany 2001/02

0 Mid- 2- 4- 6- 8- 10- Noon- 2- 4- 6- 8- 10 12:30 2:30AM 4:30AM 6:30AM 8:30AM 10:30AM 12:30PM 2:30PM 4:30PM 6:30PM 8:30PM 10:30PM Source: Burda et al 2008

The time of our lives

Time of day

Does timing matter, and how stressed are we for time? What we do matters tremendously – but so does when we do it. Working for pay at unusual times of the day is not pleasant (and for that reason those who do so are more likely to be unskilled or to belong to a group that experiences wage discrimination in the labor market (Hamermesh, 1996)). But societies also differ in how their institutions and cultures generate a temporal structure of work – over the day or across the week. How does Australia look along these criteria? Figure 1 presents information on the percentage of working time spent at each half-hour of the typical day in Australia, Germany, the Netherlands and the US. Unsurprisingly, in all countries most

work is performed between 7 a.m. and 6 p.m., and relatively few workers are on the job evenings or nights. What does stand out, though, is that the fraction of work done in the evenings and nights in the US is much higher than elsewhere. Australia looks much more like the two EU countries in this regard, with relatively little work done outside ‘normal hours’. As previously noted, the Australian data are not current, and perhaps Australia looks more like the US now than it used to. But I doubt it. In addition to being an outlier in its diurnal pattern of work timing, the US is also an outlier in its hebdomadal timing of paid work. Americans are much more likely than others, both Europeans and Australians, to be working on Saturdays and/

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A striking fact in Table 5 is the apparently greater time stress expressed by women than by men. How can this be if work for pay is stressful, as so many believe, since men perform more paid work than women? The answer is that time stress arises from everything we do, and that doing more different things generates stress. Women are the managers of the household â&#x20AC;&#x201C; they juggle a greater variety of activities, and are more likely to have to switch among activities and do different things than men (Gronau and Hamermesh, 2008). This is stressful, independent of the particular activities undertaken.

or Sundays. In Australia and Europe work is much more likely to be concentrated on weekdays than in the US, where it is spread out more evenly. All of this refers to time spent on a typical day; but holiday days are not typical. While we do not know what people do on their holidays, we do know that an additional day of holiday time does not just result in people substituting longer weekly paid work hours during non-holiday weeks. Indeed, cross-country cross-time evidence (Altonji and Oldham, 2003) suggests that each additional week of mandated minimum holiday time reduces annual paid work hours by about 40 hours â&#x20AC;&#x201C; essentially a one-for-one drop. Australia, with its mandated four weeks of holiday time, looks as generous as northern European countries. The US, with no federal mandate and no uniformly collectively-bargained mandate, lacks the institutions that lead to the amount of holiday time that we see in most wealthy economies.

In all three of the countries in Table 5, those who are most pressured for time have higher earnings per hour of paid work than those who express less time pressure (Hamermesh and Lee, 2007). Indeed, average earnings become steadily lower as one looks at groups that are less pressured for time. These findings show that it takes time to spend money, and that with more money time seems scarcer to us. Indeed, women who do not work for pay but whose husbands are among the highest earners feel more time pressure than women who work for pay but have lower family incomes.

Regardless of how much or when we work for pay, few of us feel that our schedules are completely flexible and that we can be relaxed about time. Indeed, as data for the early 2000s for Australia, Germany and the US in Table 5 show, most people feel rushed at least some of the time; and one-third to one-half feel that they are rushed often or most of the time. This is not surprising â&#x20AC;&#x201C; as Table 1 showed, we face a time constraint on our activities that is increasingly relatively more important than the constraint on our ability to buy things.

The bottom line Why do people worry so much about their incomes and so little about how they spend their time? Perhaps it is because dollars are so readily visible, while time is just there; that we concentrate on the scarcity of the former and ignore the increasing

Table 5: Time pressure, couples, Australia, 2001, Germany, 2002, US, 2003, per cent distributions Australia

Male

Female

Male

Female

Male

Female

Always; almost always; often

Sometimes

Rarely; or never

Under time pressure:

Source: Hamermesh and Lee 2007

Germany

The time of our lives

scarcity of the latter (see Zauberman and Lynch, 2005). Will Rogers, 20th century American folk humorist, said, ‘Buy land – they ain’t making any more of it’. I say, ‘Think about time – you’re not getting any more of it’.

Daniel Hamermesh is Sue Killam Professor, University of Texas at Austin; Professor, Royal Holloway, University of London; and research associate, IZA and NBER. 1 This idea was initially proposed by Becker (1965); and Linder (1970) provided a variety of anecdotes to illustrate its ubiquity. 2 Sadly the Australian data are not nearly as current as those for the other countries, a result of the Australian dataprotection policies being stricter than those of most other countries.

References Aguiar, M & Hurst, E 2007, ‘Measuring trends in leisure: the allocation of time over five decades’, Quarterly Journal of Economics, vol. 122, pp. 969-1006. Altonji, J & Oldham, J 2003, ‘Vacation laws and annual work hours’, Federal Reserve Bank of Chicago Economic Perspectives, pp. 19-29.

Gronau, R & Hamermesh, D 2008, ‘The demand for variety: a household production perspective’, Review of Economics and Statistics, vol. 90, pp. 562-72. Hamermesh, D 1996, Workdays, Workhours and Work Schedules: Evidence for the United States and Germany, Kalamazoo, MI: The W.E. Upjohn Institute. Hamermesh, D & Lee, J 2007, ‘Stressed out on four continents: time crunch or yuppie kvetch?’, Review of Economics and Statistics, vol. 89, pp. 374-83. Lee, J, Kawaguchi, D & Hamermesh, D 2012, ‘Aggregate impacts of a gift of time’, American Economic Association, Papers and Proceedings, vol. 102, pp. 612-16. Linder, SB 1965, The Harried Leisure Class, New York: Columbia University Press. Reid, M 1934, Economics of Household Production, New York: Wiley. Zauberman, G & Lynch, J 2005, ‘Resource slack and propensity to discount delayed investments of time versus money’, Journal of Experimental Psychology, vol. 134, pp. 23-37.

Becker, G 1965, ‘A theory of the allocation of time’, Economic Journal, vol. 75, pp. 493-517. Burda, M, Hamermesh, D & Weil, P 2008, ‘The distribution of total work in the EU and USA’, in Boeri, T, Burda, M & Kramarz, F 2008, Working Hours and Job Sharing in the EU and USA: Are Europeans Lazy? Or Americans Crazy? Oxford University Press. Burda, M, Hamermesh, D & Weil, P 2013, ‘Total work and gender: facts and possible explanations’, Journal of Population Economics, vol. 26, pp. 239-61. Freeman, R & Schettkat, R 2005, ‘Marketization of household production and the EU-US gap in work’, Economic Policy, vol. 20, pp. 6-50. Insights Melbourne Business and Economics

Article heading here

emerging dragons: the rise of the chinese mulatinational Western companies can perhaps learn from their once students. by dean xu

A condensed version of an inaugural lecture given at the University of Melbourne on 12 November 2013.

The dragons are coming Unlike most of my colleagues at the University of Melbourne I started my academic career in a Chinese university, and spent the next 12 years in China, so I had the opportunity to observe Chinese companies rather closely. One thing that struck me was the enormous progress made by Chinese companies, both domestically and internationally. In 2001, when I finished my PhD and went to China, the country was at the eve of its World Trade Organisation (WTO) accession. At the time there was much discussion about the potentially negative consequences of WTO access on Chinese firms. Newspapers were full of headings such as ‘the wolf is coming’. Yet, such fears quickly dissipated. By 2006, the Chinese government was confident enough to launch a policy initiative

commonly referred to as ‘the going-out strategy’ which called upon Chinese companies to focus internationally and invest directly in foreign countries. Since then, Chinese outward foreign direct investment (OFDI) has increased substantially. In 2004, China’s total OFDI was roughly $US 5.5 billion. It reached $US 87.8 billion in 2012, and is predicted to be $US 150 billion by 2015. Much of this OFDI takes the form of international mergers and acquisitions (M&As). Examples of notable M&As are provided in Table 1. Further, a significant part of this OFDI came to Australia. If we exclude the three tax havens of Hong Kong, Cayman Islands and Virgin Islands, then Australia received the largest share of China’s OFDI during 2004–2010, among all countries.

Table 1: Examples of Notable Acquisitions by Chinese Firms Acquirer

Target Firm

Amount

Industry

Year

CNOOC*

Nexen

$US 15.1 billion

Energy

2013

CIC**

Morgan Stanley

$US 5.6 billion (9.9% equity)

Financial services

2007

Shuanghui

Smithfield

$US 4.72 billion

Food

2013

Wanda

AMC

$US 2.6 billion

Entertainment

2012

Geely

Volvo

$US 1.8 billion

Automobile

2010

Lenovo

IBM PC

$US 1.75 billion

Personal computing

2004

Sany

Putzmeister

€0.5 billion

Construction equipment

*China National Offshore Oil Corporation **China Investment Corporation

2012

Source: NBS China

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Emerging dragons: the rise of the Chinese multinational

Figure 1: Inward FDI in China Total Actual FDI in 100M USD 1200

1000

800

600

400

200

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1996

1995

0 1990

Through these mechanisms, Chinese firms had made steady improvements by the time China entered the WTO at the end of 2001. Consequently, the WTO accession did not bring

My own research, however, tells a very different story. Our data are from the Annual Census of Industrial Enterprises conducted by the National Bureau of Statistics (NBS) China, which covers all Chinese industrial enterprises, including SOEs, collectively-owned enterprises (COEs), shareholding enterprises (SHEs), limitedliability enterprises (LLEs), and privately-owned

1986

When the Chinese government first adopted the ‘open door’ policy in the late 1970s, modern corporations did not exist in China. All China had were bankrupt state-owned enterprises (SOEs). As FDI came into the country, four Special Economic Zones were created in coastal Southeastern China, where multinational firms established joint ventures (JVs) with local firms and, later, wholly-owned subsidiaries. These foreign firms served as showrooms for technology and managerial principles which were quickly adopted or imitated by local Chinese firms. Meanwhile, as multinationals entered the Chinese market, many of them (e.g. Volkswagen in Shanghai and Tianjin) created their local suppliernetworks. In order to be part of those networks, Chinese firms had to improve their product quality and managerial processes and comply with the standards of multinational firms. More importantly, there was knowledge spillover from the multinationals to local Chinese firms through labour turnover. Initially, it was the foreign firms that lured skilled labour away from local firms. In later years as the salary gap between foreign and local firms reduced, many experienced local managers and workers left their multinational employers to join Chinese firms.

Of course, not everyone assesses the impact of FDI in China positively. Some believe that rather than bringing anticipated technology spillovers, FDI has had a negative impact on local industries by depressing their technological advancement. One vocal critic is Professor Yasheng Huang of MIT in the US, whose book Selling China aroused strong emotions among many Chinese people. He suggests that the Chinese government’s obsession with inward FDI has adversely affected the growth of the Chinese private sector, whereas SOEs are less affected (Huang, 2003).

1985

So who made the Chinese dragons? Why were they able to make such rapid progress in a short period of time? The answer is at least partly found in a stream of research in economics and international business commonly referred to as the ‘FDI spillovers’ literature. The spillovers research examines the impact of FDI on local industries and firms in host countries. It posits that the benefits of FDI will spillover to local firms mainly through three channels: the demonstration effect, buyer-supplier relations, and employee turnovers (Caves, 1974; Spencer, 2008). In China’s case, all these mechanisms worked.

devastating consequences for Chinese firms. On the contrary, it simply fastened the spillover process, and facilitated learning by Chinese firms. As FDI continued to rise in subsequent years (see Figure 1), the effect of knowledge spillover also accumulated.

1983

Who made the dragons?

enterprises (POEs), as well as foreign invested firms (FIEs) operating in China. Each year, hundreds of thousands of firms in China, with a minimum sales volume of five million RMB ($AUD800,000), were included in this database, making it the most comprehensive database on Chinese firms. In the first study (Xu, Pan Yim, and Wu, 2006), we compared profitability, measured by return on assets (ROA), across different types of firms in China. At the time we had data only for 1998 and 2002 (Huang (2003) relied on the same data source, but his data were up to 1995). As can be seen in Figure 2, in both years, foreign firms lagged behind some classes of local Chinese firms, notably the private firms and collectives, in terms of ROA. The only Chinese firms that were clearly performing more poorly were the SOEs. In other words, the conventional perception that foreign firms are powerful predators, and local firms, especially local private firms, are weak victims of foreign predators, is untrue. In the second study (Chang and Xu, 2008), we looked at the issue more closely, using data from 1998 to 2005. We examined the exit (mortality) rate of various types of firms in China, as dependent on the presence of FDI (namely, the share of foreign firmsâ&#x20AC;&#x2122; employment in the total employment of an industry or region). There were

several major findings from this study. First, all types of Chinese firms have benefited from FDI spillovers. Second, private firms had exhibited a higher exit rate than SOEs in the presence of FDI, which is consistent with Huangâ&#x20AC;&#x2122;s (2003) study. Third, private firms were also the main force to crowd out foreign entrants. So we can now tell a more complete story: foreign entrants and local private firms are competing fiercely, and this is probably because by now the latter have learned enough from the former to fight back. If these studies are not straightforward enough, then Figure 3 presents a clearer picture. From 1998 to 2008, SOEs and collectives declined, in terms of percentage in the total population, from close to 70 per cent to about 5 per cent, while private firms increased from less than 10 per cent to about 60 per cent. The percentage of foreign firms remained largely unchanged. It is quite clear that as FDI increased (in terms of number of subsidiaries in China) throughout the years, private firms became the biggest winners in the competitive dynamics. Figure 3: Winners and Losers Foreign

Incorporated

Private

Collective

SOE

100%

90%

80%

70%

Figure 2: Comparison of Profitability Across Firms in China

60%

0.20

50%

ROA 1998

ROA 2002 40%

0.15

30%

0.10 20%

0.05

-0.05

SOE

COE

SHE

LLE

POE

FIE

# of firms

165K

162K

181K

279K

301K

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

0.00

1998

10%

412K

Source: NBS China

Insights Melbourne Business and Economics

Learning in the land of dragons While local firms learned from foreign entrants, foreign firms also learned about operating in China. There is a growing volume of research on this topic, and I draw insights only from the studies that were either conducted by myself or related to my own research. I cover four important aspects: entry mode, business strategy, relationships, and learning. The first lesson that multinational firms learned in China is that JVs may not be the optimal mode of entry for them. JVs became a popular mode of entry for Western firms because they thought they could rely on the local Chinese partners to secure the China market. That hope quickly dissipated, because China is not ‘a’ market; it consists of many regional markets separated by administrative boundaries. The local partner, often associated with the local government in a particular province or major city, typically is not able to carry business to other regions. Indeed, the local partner may become a hurdle to conducting inter-provincial operations because of the political and economic competition among Chinese

regions. Thus, multinationals today are still faced with the difficult task of building national markets in China. The second aspect is about strategy in China. The lesson is that, just because you are the firstmover doesn’t mean success is guaranteed, because once in China nothing is business as usual. The biggest mistake Western firms can make is ‘corporate imperialism’ (Prahalad and Lieberthal, 2003), that is, assuming the same product life cycles, assuming the same rules of the game, and assuming the same competitive dynamics in China as in other markets. Frequently, they bring outdated products and technologies to China, hoping to extend the life cycles of these products and technologies, and thinking they are good enough for a developing country. Yet China is a very dynamic and competitive market. Such a strategy would not confer any competitive advantage for the multinationals. One example is Kodak China. When I was teaching at Peking University around 2004, a senior executive from the company visited the university and did a

Figure 4: Kodak’s China Strategy Population

132 M

1033 M

First level: 27 leading cities with 83m population Higher: disposable income, brand sophistication, camera penetration and burn rate Per capita income: $1,050

Camera Ownership

56%

Second Level: 246 Cities with 132m population Lower: disposable income, brand sophistication, camera penetration and burn rate Per capita income: $750

Third Level: 393 Tertiary cities and all rural areas with 1,033m population Low: disposable income, brand sophistication, camera penetration and burn rate Per capita income: $330

Emerging dragons: the rise of the Chinese multinational

38%

presentation on the company’s China business. With a slide depicting China’s three-tier markets (see Figure 4), she told the audience that Kodak was a market leader in the first-tier market (major cities), had a significant presence in the secondtier market (small- and medium-sized cities), and would have ample opportunity to work on the third-tier market (rural areas) for long-term growth. The company probably had developed this three-tier-market strategy in other emerging economies and hoped to replicate their success in China. However, things in China changed quickly with digitalisation, and in just a few years, even in the poorest countryside, nobody would buy traditional Kodak films any more. Lesson number three concerns guanxi building. Guanxi, the Chinese word for relationships, is extremely important in China. However, despite the prevalence of guanxi in China, research has found that excessive relationship-building may not be cost-effective for multinationals. One study, in particular, suggests the more embedded companies are politically, the higher the degree of cost-inefficiency when the market is increasingly

liberalised (Sun, Mellahi and Thun, 2010). Taking Volkswagen China as an example, the company had huge success in earlier years, thanks to its connections to the Chinese government and local networks. At a time of increasing market liberalisation, however, the company became ‘locked’ into these relationships and could not move along with market changes, and quickly lost its market leadership to GM China. Lesson number four concerns learning by late entrants in China. While early foreign entrants had to rely on their Chinese partners for gaining local knowledge, newcomers can learn from these early entrants. However, the benefit of learning also comes at a cost. The companies you want to learn from the most are often your major competitors. My research, based on Japanese foreign subsidiaries in China during 1979–2001, indicates that if you lack China experience, it is better to stick with your peers geographically and learn from them, because this is when the benefit of learning exceeds the cost of being exposed directly to competition. Insights Melbourne Business and Economics

Waiting for the dragons My analysis suggests that in the past decades, Chinese firms have learned effectively from Western firms in China, to the extent they are now at the gate of Western markets. Among Chinese firms, private firms have benefited the most from knowledge spillovers. Indeed, SOEs are not likely to be the major contenders of Western firms. So far they have been acquirers of energy and natural resources in international markets. Their linkage to the Chinese government is their major advantage, but such an advantage cannot be easily transferred to overseas markets. Moreover, this linkage can become a constraint on SOEs in a free market, as profit maximisation may not be a top priority for the government and its officials who oversee the SOEs. The Chinese private firms, on the other hand,

Emerging dragons: the rise of the Chinese multinational

will likely become a force to be reckoned with in international markets. These firms have been treated unequally in the Chinese domestic markets (Xu, Zhou, and Phan, 2010), and so they are eager to come to the international markets with better property rights and investor protection. Their technological advancement has often been neglected or ridiculed. Nevertheless, they have shown that they have the absorptive capacity to learn from and imitate their competitors. Their major disadvantage overseas is their lack of highend brands, but such a disadvantage can be made up for by a large home market, which helps drive costs down (Xu and Meyer, 2013). If they can somehow combine the brands they acquire from Western companies with this huge home market size, theyâ&#x20AC;&#x2122;ll be able to secure a unique competitive advantage the Japanese and Korean multinationals were not able to achieve in the past.

This large home market notwithstanding, a common weakness in most Chinese firms is a poor governance structure that limits their potential. We know that the managers of many large companies in China are often government officials. Board chairmen are often the secretaries of the Chinese Communist Party. Owners of many private firms are Party members and even Party secretaries. These facts are often neglected, or pretended to be forgotten, when people analyse Chinese firms. But the truth is, regardless of their ownership form, the fate of Chinese firms is inevitably affected by political events and processes inside China.

Conclusion I believe that for the most part, inward FDI has benefited local firms in China. Such benefits are differentially distributed, favouring firms that have the willingness and capacity to learn. Some Chinese firms have learned from Western firms fast enough to have come to the international markets now. This of course doesn’t mean Western firms have failed in China. It’s a win-win situation: Western firms have learned in and profited from China, and Chinese firms also benefited. The arrival of Chinese firms internationally is not necessarily a bad thing. I chose to use the metaphor of dragons, because in Chinese mythology, dragons, while powerful, are not malicious or evil. Among other things, they bring rains for the crops. In the worst scenario, if one day Western firms find themselves in a competitive disadvantage against Chinese entrants, they just need to learn from the Chinese firms, just as the Chinese firms have once learned from them. Dean Xu is Professor of Management (International Business) at University of Melbourne. He has previously taught at Peking University, University of Hong Kong and China Europe International Business School.

References Caves, RE 1974. Multinational firms, competition, and productivity in host-country markets. Economica, 41: 176-193. Chang, SJ, and Xu, D 2008. Spillovers and competition among foreign and local firms in China. Strategic Management Journal, 29: 495-518. Huang, Y 2003. Selling China: Foreign direct investment during the reform era. Cambridge University Press: Cambridge, UK. Kim, T-Y, Delios, A, and Xu, D 2010. Organizational geography, experiential learning, and subsidiary exit: Japanese foreign expansions in China, 1979–2001. Journal of Economic Geography, 10: 579-597. Prahalad, CK and Lieberthal, K 2003. The end of corporate imperialism. Harvard Business Review, August: 109-117 Spencer, JW 2008. The impact of multinational enterprise strategy on indigenous enterprises: horizontal spillovers and crowding out in developing countries. Academy of Management Review, 33(2): 341-361. Sun, P, Mellahi, K, and Thun, E 2010. The dynamic value of MNE political embeddedness: the case of the Chinese automobile industry. Journal of International Business Studies, 41: 1161-1182. Xu, D, and Meyer, KE 2013. Linking theory and context: ‘strategy research in emerging economies’ after Wright et al. (2005). Journal of Management Studies, 50(7): 1322-1346. Xu, D, Pan, Y, Wu, C, and Yim, B 2006. Operational performance of domestic and foreign-invested enterprises in China. Journal of World Business, 41(3): 261-274. Xu, D, Zhou, C, and Phan, PH 2010. A real options perspective on sequential acquisitions in China. Journal of International Business Studies, 41: 166-174. Insights Melbourne Business and Economics

Article heading here

governing the ungovernable: the market, technology and you Rapid changes in technology have created new opportunities and challenges for competition laws and the regulators and courts that enforce them. by stephen king

The 2013 Freebairn Lecture given at the University of Melbourne on 19 September 2013.

Competition is the basis of a market economy and technology is changing the face of competition. Consumers, at the touch of a screen, can access goods and services from around the world, compare prices and product reviews, and download digital services or order physical goods. Competition and markets, however, exist within a set of institutions, laws and regulations, such as the rules of contract and laws against misleading and deceptive behaviour. In the past two decades, the rapid change in technology has created new opportunities and challenges for these laws and the regulators and courts that enforce them. Herein, I briefly discuss some of these opportunities and challenges, focussing on competition laws and business regulation. I divide my remarks into three sections. First, I consider the areas where competition laws are adapting to technological change. Then I consider the regulatory failures: where is technological change exposing regulatory gaps? Third, I consider the issue of information and consumers. In particular, can technology be harnessed to improve competition regulation?

– Second, technology has changed some business models. Simplistic approaches to analyse competition that apply to the old economy may make little, if any, sense in new markets. Regulatory shortcuts that previously have been adequate, may fail. Regulators must adapt their traditional approaches or they will make errors applying old rules to new situations. – Third, the way information moves through our economy has changed. Information technology (IT) creates opportunities for better regulation. But seizing these opportunities will require economic sophistication and a change in regulatory mindset.

Technology and traditional market regulation

I want to leave you with three conclusions:

For much anti-competitive behaviour, technological change just leads to ‘old wine in new bottles’. A cartel is still a cartel, even if the communication is by email rather than in smoke-filled rooms. An anticompetitive merger is still an anticompetitive merger, even if it involves two companies that trade in cyberspace.

– First, while new businesses may be competing with new technologies, the old rules of competition still apply. In these areas, our old rules can adapt.

Have the ‘old laws’ adapted to new technology? Let me start with an example of success. Earlier this year the High Court ruled that Google did not engage in misleading and deceptive conduct Insights Melbourne Business and Economics

when it published a number of advertisements created by its AdWords program.1 Between 2005 and 2007, Google’s AdWords was used by a number of companies to create ‘sponsored links’ that were displayed on Google’s search pages. These advertisements were misleading and deceptive. The relevant advertisers had already been dealt with for breaching Australia’s Competition and Consumer Act 2010 (CCA). However, the Australian Competition and Consumer Commission (ACCC) also brought a case against Google for misleading and deceptive conduct. Normally, a publisher is immune from such prosecution. Section 85(3) of the CCA provides a ‘publishers’ defence’. A publisher does not engage in illegal conduct if, in the normal course of business, it publishes a misleading or deceptive advertisement but had no reason to suspect that the advertisement was illegal. The publisher is a ‘mere conduit’. The publishers’ exemption makes sense. If publishers had to verify the content of every advertisement, it would bring the advertising industry to a shuddering halt. Publishers would not have the information or the ability to verify all advertisements and they would either be forced to significantly limit advertising or hope and pray that advertisers were doing the right thing. The ACCC, however, argued that Google’s AdWords technology meant that Google had a role in making or creating the sponsored links. Google did not simply ‘receive’ and ‘publish’ the advertisements. It was intimately involved in providing the program that made the misleading advertisements possible. According to this argument, Google was neither just a publisher nor an ‘innocent conduit’ but an active party to the misleading and deceptive behaviour. The Full Federal Court agreed with the ACCC.2 It stated that Google was more than a publisher because the advertisements were displayed in response to a consumer’s search request. The Court concluded, ‘Google’s conduct in response to the user’s interaction with Google’s search engine was misleading’. 56

Governing the ungovernable: the market, technology and you

Google appealed to the High Court, which reversed the Full Federal Court decision. According to the High Court, the AdWords technology ‘merely assembles information provided by others’. It ‘does not render Google the maker, author, creator or originator of the information in a sponsored link’. As such, ‘Google is not relevantly different from other intermediaries, such as newspaper publishers (whether in print or online) or broadcasters (whether radio, television or online) …’. Google simply provides ‘a means of communication between advertisers and consumers’ (judgement paragraph 69). So approximately five years after the case commenced we have clarity. Google and other internet intermediaries are publishers with the rights and obligations of publishers, but no more. Why is this decision important? – First, it makes clear that, from the perspective of competition and consumer laws, internet publishing can be handled by the same rules that hold for traditional publishing. – Second, this case and other court rulings are providing a body of law that makes the rules of the internet clear.3 – Third, the case illustrates the flexibility and adaptability of the law. Just because we have new technology does not mean we need new competition laws. This is not the only ‘old wine in new bottles’ case. The recent US decision regarding Apple and eBooks illustrates how the new-economy cases can clarify old-economy issues.4 The decision clarified the legal status of ‘most favoured nation’ clauses. These contractual conditions are used in both traditional and ‘new technology’ contracts. Similarly, recent decisions have led to a reexamination of the laws on resale price maintenance (RPM), where a wholesaler requires a retailer not to discount its product. RPM has occurred on the internet, particularly when bricksand-mortar retailers try to use wholesalers to limit competition from internet retailers. The ACCC has responded strongly to this anticompetitive

behaviour. But the re-emphasis placed on RPM has highlighted the limitations of this law.5 In summary, while new businesses may be competing in new technologies, the old rules of competition still apply. These rules can adapt to new situations. The context may differ, but anticompetitive behaviour is still anti-competitive behaviour, whether it occurs on Main Street or the internet.

Where is regulation failing? While broad competition laws have shown they can adapt to technological change, new technology is having two effects on regulation. It is exposing regulation that, while â&#x20AC;&#x2DC;good enoughâ&#x20AC;&#x2122; in the past, is unable to meet the complexities of change. It is also raising issues that are challenging competition regulators. A simple example is provided by electricity

regulation. Electricity prices have been rising. A significant part of this rise is due to rising charges for electricity networks â&#x20AC;&#x201C; the transmission and distribution wires that bring power from generators to our places of work and our dwellings. Regulators set these network charges. One source of high network charges is the regulatory approach that takes fixed network charges and turns them into per kilowatt-hour charges. The regulator works out how much money a network company needs then divides this by the expected volume of electricity to get a volume-based charge. Consumers pay this charge. The problem with this approach is that networks largely involve fixed costs. An electricity network is built to a certain size depending on the prediction of peak load. But once built, the costs of operating that network do not vary greatly with the actual load. Insights Melbourne Business and Economics

So regulators turn a fixed cost to the network business into a variable charge to be paid by consumers. This approach is fine so long as consumers cannot bypass the electricity network. Historically that has been the case. However, advances in solar technology together with government subsidies to install photo-voltaic systems mean many consumers and businesses now regularly bypass the network for at least some of their power consumption.6 Instead of predicted rises, our transmission and distribution networks are facing falling average power loads.7 So the fixed cost of the network is being divided over a smaller volume of power meaning the price per unit of power rises. Rising network charges increase the incentive for consumers to install solar power systems. And this reduces the load still further, increasing per kilowatt-hour prices and so on. This cycle has

Governing the ungovernable: the market, technology and you

been called a â&#x20AC;&#x2DC;death spiralâ&#x20AC;&#x2122; for the electricity industry. That is probably going too far. But new technology has exposed an old regulatory short cut. The first rule of economic regulation is that variable costs have variable charges and fixed costs have fixed charges. But regulators have got away with ignoring that rule for 20 years. From an economic perspective, this problem has a simple solution. Set network charges on a per customer basis that does not depend on the amount of power consumed. But this solution is more easily said than implemented. Fixed network charges create both equity and political concerns. Is it fair that low energy users pay the same network charge as high energy users? What happens to the poorest residents who cannot afford the fixed network charge? Should a household that has invested in a solar power system now have to face higher fixed network charges?

In brief, the regulations that were satisfactory for old technology are failing with new technology. The second area of concern is where technology transforms the market so the old rules of competition simply do not apply. The best example of this is with two-sided markets. [A] two-sided market is a market in which a firm sells two distinct products or services to two different groups of consumers (the two ‘sides’) and knows that selling more to one group affects the demand from the other group, and possible vice versa… A firm in a two-sided market is then said to act as a platform.8 Examples include: – Credit and debit card payments schemes. Merchants care about the number of consumers who have the relevant card and customers care about the number of merchants who will accept the card; – A classified advertising platform such as realestate.com.au or carsales.com.au. Sellers care about the number of buyers who look at the site while buyers care about the number of sellers who list on the site; and – A television network that provides entertainment/content for viewers but also provides space for advertisers to promote their products to viewers is a two-sided platform. The interactions in two-sided markets can make competition analysis difficult. Consider, for example, mergers in media where outlets provide content to attract the ‘eyeballs’ of potential customers and then sell advertising space to generate revenue. From the customers’ perspective, the content is desirable but putting up with advertising is the price they pay to get the content. More advertising is a bad thing from the customers’ perspective. Now suppose that two media platforms seek to merge. This will substantially lessen competition for advertising content but (at least in this example) consumers may still have lots of choice

of alternative media. Then the merger can lead to higher advertising prices and this will benefit customers although harm advertisers. As Jeziorski (2012) noted when looking at the merger of radio stations ‘if extra market power causes the radio station to decrease advertising, listeners benefit but advertisers are hurt’.9 Australia’s ‘black letter’ merger laws do not recognise these types of two-sided interactions. If a merger substantially lessens competition in a market then it is illegal. So if a merger of two platforms substantially lessens competition in a relevant advertising market, the fact that consumers might prefer less advertising is irrelevant. Similarly, two-sided markets can involve ‘tipping’ – where one platform dominates because of the positive benefits that flow to each side of the market when there are more participants on the other side. In 2012, when the ACCC considered the acquisition of the Trading Post, an internet platform for classified advertising, by carsales. com.au, an internet platform specialising in advertising for automobiles, a key concern was tipping.10 Given this concern, the ACCC refused to clear the acquisition and the deal did not proceed. However, tipping need not arise in two-sided markets and critically depends on the presence or absence of multi-homing – the ability of one or other side of a market to simultaneously use more than one platform. At best, the competitive effects of the carsales.com.au acquisition of the Trading Post were ambiguous. What are regulators to do in such ambiguous situations? In my opinion, when in doubt, regulators should limit interference, particularly in fast-changing areas. So regulators should ensure there are no artificial barriers being erected to competition, consumers are well informed (or at least not misinformed), and market participants have flexibility. Unfortunately, as the carsales.com.au example shows, regulators are going much further. Insights Melbourne Business and Economics

In summary, technology has changed the nature of competition in areas such as payment instruments, energy, telecommunications, advertising and media. Simplistic approaches to analyse competition that apply to the old economy may make little if any sense in new markets. Regulators must adapt their traditional approaches when dealing with these areas or they will make errors by applying old rules to new situations.

The information revolution and competition regulation Finally, let me turn to my third area. The changes in technology that are challenging competition regulators may also offer solutions. Regulators can use IT to improve regulation, in part, by helping consumers to have the knowledge or options to make better, more informed decisions. A simple example is the reforms for automatic teller machines (ATMs). In 2008 the Reserve Bank of Australia (RBA) changed the way customers were billed for withdrawals at ATMs so that banks had 60

Governing the ungovernable: the market, technology and you

to make the fees clear before customers withdrew their money. This simple reform used available ATM technology but it had a significant effect. The RBA estimated the reforms saved consumers $120m in fees in the first twelve months.11 This saving came from a mixture of changed consumer behaviour and new entry into the provision of ATMs. New ATMs have been deployed in areas that were previously not profitable so consumers have easier access to their funds. And consumers are informed and making the decisions that are best for them. This type of reform â&#x20AC;&#x201C; simply changing the way information is passed on to consumers â&#x20AC;&#x201C; can be used elsewhere. If the RBA is concerned about credit card surcharging, for example, it could change the way information is provided and the fees are paid to induce greater clarity and competition. Some of these regulatory reforms, like ATMs and credit card surcharging, depend on informing customers. In other situations the solution can

involve a change in ‘property rights’ or the ‘default option’. Australia was one of the first countries in the world to adopt mobile number portability, so when a consumer changes mobile carrier they can keep the same telephone number. Before mobile number portability the carrier owned the number, and as such, controlled a key switching cost. Simply by changing the default – so that the customer could keep the mobile number rather than the carrier keeping the number – mobile number portability reduced barriers to customers switching and increased mobile phone competition. The success of this policy is reflected in the fact that it has been copied around the world.

Technology means we can have better regulation. In some areas our old rules can adapt. In other areas, new rules need to be developed. But the big gains will come through a change in regulatory mindset. Just as technology has revolutionised our approach to business it needs to revolutionise our approach to business regulation.

Regulatory solutions may involve the creation of markets. For example, while the Victorian government adopted a one-size-fits-all approach to smart electricity meters, the AEMC has recognised a better approach to this new technology might be to allow consumers choice through a ‘market’ for electricity metering.12

2 Australian Competition and Consumer Commission v Google Inc 2012, FCAFC 49 (3 April 2012).

To exploit new technology, and design new ways to empower consumers, regulators have to change their mindset. Traditionally, regulators had a set of rules they enforced. If prices were too high, the regulators set the price. If quality was too low, the regulators set the quality. To adopt innovative solutions, however, regulators have to step back and ask a simple question: How can the regulator change the structure of market interactions to help the market function better without ongoing intervention? Or to put it another way, how can the regulator put itself out of a job? So this brings me to my third and final conclusion. The way that information moves through our economy has changed. Regulators must seize the opportunities provided by IT while considering the implication of new business models for the rules of competition. They need an increased level of economic sophistication and a change of mindset. Every regulator’s aim should be to make itself redundant.

Stephen P. King is Professor of Economics, Monash University, and Co-Director, Monash Business Policy Forum. 1 Google Inc v Australian Competition and Consumer Commission 2013, HCA 1 (6 February 2013).

3 For example see the decision of the Victorian Supreme Court in Trkulja v Google (No 5) 2012, VSC 533. 4 United States District Court, Southern District of New York, United States of America v Apple Inc, et. al. 12 Civ. 2826 (DLC). 5 For example, see Lao, M 2010, ‘Resale price maintenance: the internet phenomenon and “free rider” issues’, Antitrust Bulletin, 55: 473-512. 6 See for example Australian Energy Markets Commission 2013, Strategic priorities for energy market development 2013, EMO0025, October 23. 7 Edis, T 2013, ‘Demystifying the demand death spiral’, Climate Spectator, October 11, available at: http://www. businessspectator.com.au/article/2013/10/11/smart-energy/ demystifying-demand-death-spiral. 8 Filistrucchi,L, Gerandin, D and van Damme, E 2012, ‘Identifying two-sided markets’ TILEC Discussion Paper, Tilburg University, Holland, February 21 at p.2. 9 Jeziorski, P 2012, ‘Effects of Mergers in Two-sided Markets: Examination of the U.S. Radio Industry’, Haas School of Business, University of California at Berkeley, October 30, at p.35. 10 See Australian Competition and Consumer Commission 2012, ‘Carsales.com Ltd – proposed acquisition of assets associated with Trading Post From Telstra Corporation Ltd.’, Statement of Issues, Canberra, 19 October. 11 For details see: Filipovski,B and Flood, D 2010, ‘Reform of the ATM system – one year on’, Bulletin, Reserve Bank of Australia, June Quarter, p.37-45, and Flood, D, Hancock, J, and Smith, K 2011, ‘The ATM reforms – new evidence from survey and market data’, Bulletin, Reserve Bank of Australia, March Quarter, pp. 43-49. 12 See Australian Energy Market Commission 2012, Power of choice review – giving consumers options in the way they use electricity, Final Report, 30 November 2012, Sydney.

Insights Melbourne Business and Economics

the accounting profession and independence – the scrutiny intensifies The credibility of and trust in the accounting profession lies in its preparedness to take a strong stance on self-regulation in the public interest. by warren mcgregor and greg pound

An updated version of an address given at the annual Australian Accounting Hall of Fame induction ceremony at the University of Melbourne on 24 July 2013.

In his address at the annual Australian Accounting Hall of Fame Awards Ceremony in 2012, Rupert Myer focused on the contribution members of the accounting profession make to Australian society, including the creative arts. One of the statements he made struck a chord with us. He said: It is worth contemplating...whether we would have navigated the momentous changes that have occurred as successfully as we have without men and women with expert accounting skills and possessed of high integrity, operating within a framework of rigorous accounting standards and the oversight of their accounting profession. As members of the accounting profession, it is refreshing and indeed encouraging to hear such a glowing tribute from a highly respected person who is not, on his own admission, a part of the accounting profession. But more than that, his words shine a light on an intangible element that we believe truly underpins our profession and engenders the respect that accounting professionals have in the broader community. The framework – which we may even call a conceptual framework – for developing the highly respected accounting professionals celebrated by Rupert Myer consists of many parts. Myer referred to some of them – expertise, technical standards, 62

The accounting profession and independence – the scrutiny intensifies

monitoring and compliance. But in our view the essential element, much like the ‘asset’ element in the accounting conceptual framework, is what he referred to as ‘high integrity’ and the profession refers to as ‘professional independence’. It is both fundamental and pervasive. It is expected of our members and of the institutions that govern our behaviour, in particular those that establish our professional and technical standards. If our independence is brought into question we run the risk of losing that hard earned respect and, moreover, our pre-eminent role in business and the general community. We raise it in this short paper because we believe the point has been reached where serious questions are again being asked about professional independence and we fear the consequences for the accounting profession if bold remedial action is not taken.

Independence In the specific context of financial-report auditing, independence has for many decades been identified as the ‘cornerstone of the profession’. This concept now extends to the broader range of assurance services provided by members of the profession, as the value of these services to users lies in the belief that the assurance practitioner is unbiased, objective and has no interest in the information

other than it being prepared and presented in accordance with the required reporting framework. It is equally well established that independence comprises two elements: perceived and real independence. The profession and individual practitioners must be, and be seen to be, independent. Real independence is of little value if users do not believe that the assurance practitioner is independent. While not a new issue, it remains one that is critical to the profession, and not only at the level of individual practitioners but to the profession as a whole. When a user seeks to rely on the opinion of an assurance practitioner or firm unknown to them, it is the user’s perception of the profession that will determine whether they will derive value from that opinion. The well-documented instances of corporate failures in recent times have called into question the independence of the profession, and continue to place considerable pressure on both real and perceived independence. The resultant regulatory initiatives, both legislative and self-regulatory, in many countries are in our view appropriate. The question remains however whether they have been sufficiently comprehensive as a means of securing a robust model to ensure real and perceived independence on an ongoing basis. In an interview in December 2013 with the Belgian Instituut van de Bedrijfsrevisoren (published in their magazine Tax, Audit and Accountancy) Sir David Tweedie, world renowned authority on financial reporting and auditing, stated that: ‘The real problem is perception,’ and that: ‘… the auditor’s independence needs to be increased.’ While he indicates that he is not saying that the auditor is not independent now, he noted that: It is just that a fact is easier to change than a perception. Once the perception is there, it is very difficult to remove it and we have to do something drastic, such as with regard to the content of the audit report and to the long term ten years fixed appointments until tendering without mentioning prices. All of that could help.

In our view, one of the more significant failures of the profession to safeguard its most fundamental underlying principle is its Code of Ethics in relation to independence. The Code of Professional Ethics issued by the International Federation of Accountants and adopted in many countries as their National Code is in our view not sufficiently robust to deal with ensuring effective regulation of independence into the future. It is our view that in relation to such a fundamental principle the requirements governing it should be clear and prescriptive. While there are elements of prescription in the Code, the model also incorporates a degree of subjectivity. The Code, being a model that requires practitioners to identify threats to independence, and then apply safeguards to eliminate the threats or reduce them to an ‘acceptable level’ (based on a reasonable and informed third party test), is in our view open to differing interpretations, inconsistent application, abuse and disputes as to whether it has been appropriately applied. We find it difficult to understand how any risk to independence can be deemed to be at an ‘acceptable level’. In our view, by definition, once there is a risk to independence, there is a perceived independence issue. The best solution is to eliminate the risk in the first place. A prime example of this in the context of financialreport auditing is the controversial and ongoing debate as to whether an auditor/firm should be able to provide the auditee entity with non-audit services. While the Code does prohibit some nonaudit services being provided, it still acknowledges that an auditor can provide other services under the threats and safeguards approach. We do not believe that this is appropriate, or that an auditor or audit firm can serve both interests. At the very least there is a clear perception issue of conflict of interest. In Australia the legislative response to this has, inter alia, been to require disclosure of the nature and amount of these other services provided to the auditee entity. It is difficult to understand how this overcomes the problem. Such disclosure confirms to users that the auditor/audit firm has another financial interest in the auditee entity and a relationship with its governing body or senior Insights Melbourne Business and Economics

management. Arguably this does nothing to deal with the real independence issue and exacerbates the perception issue. In our view the overall approach to the Code, and this example, demonstrates the need to re-assess the self-regulatory approach to independence. Despite what has occurred to date, and while the initiatives taken in some countries have been more extensive than others, evidence of the continuing growing concern about professional independence is seen in the attempt by the European Union (EU) to impose further regulations on auditors. In December 2013, member states of the EU agreed to the following new audit regulations: – A 10-year maximum period during which a member state may allow an audit firm to continue auditing the same public-interest entity. If the engagement is put out for public bid, the member state may allow the engagement to continue for a maximum of 20 years. In cases of joint audits, where multiple audit firms share the engagement, the maximum period is 24 years. – A prohibition on provision of certain non-audit services by audit firms to the public-interest entities they audit. Member states will have the right to allow firms to provide some tax and valuation services to their audit clients, provided they are immaterial and have no direct effect on the audited financial statements. – A requirement that fees from permitted nonaudit services to an audit client cannot exceed 70 per cent of the audit fees. Although the new regulations will only be effective if and when they are approved by the European Parliament and the council of national governments, this development is a tangible expression by law makers that something has to change. We believe it would be folly to dismiss the growing concerns about professional independence as an overreaction to knee jerk reactions by regulators and others in the wake of the global financial crisis and to assume that order will be resumed when the world’s economies return to normal. Indeed, some 64

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leading practitioners believe the profession is on the brink of sliding into disrespect and possibly irrelevance; and that the recent actions of the EU are just the latest manifestation of a much broader and deep seated concern

So what has been happening? We believe there are two separate forces at play and the profession is caught in somewhat of a pincer movement. First, community expectations have been changing. As markets have interconnected and as more and better-informed players have participated in those markets, the bar has steadily risen. Market participants, and by extension the broader community, are demanding greater assurance that accounting professionals are independent. When they perceive potential conflicts of interest – for example, when accounting firms audit the same clients for long periods, when a significant percentage of audit fees are derived from too few clients, and when accounting firms provide other services to audit clients – they are less easily fobbed off by retorts that we have professional standards in place and we are actively managing the risk. Secondly, those with a vested interest in undermining independence have become better organised and more determined in their attempts to bend the rules or indeed to have less demanding rules in the first place. For example, the International Accounting Standards Board (IASB) has witnessed coordinated actions by banks, in the presence of ineffectual regulators, to put pressure on auditors and the IASB itself to avoid or lessen write downs on their asset portfolios. A measure of their success is the fact that in Europe today many banks continue to carry assets at amounts clearly unrepresentative of their underlying value. There have also been blatant attempts to intimidate accounting standard setters in order to achieve less-demanding accounting standards and less-transparent financial reporting outcomes. For example, when the IASB was endeavouring to introduce an accounting standard that would require the expensing of stock options, the

Financial Executives Institute in the US threatened to spend tens of millions of dollars to prevent them from doing so. President George Bush even offered the IASB accounting advice that bore a remarkable similarity to the view being expressed by hi-tech companies in Silicon Valley desperate to retain their current accounting practices. In a similar vein, President Jacques Chirac went in to bat for French banks when the IASB was endeavouring to introduce an accounting standard on financial instruments. There have also been attempts to undermine the independence of the IASB by agitating for changes to the way the Board operates, the structure within which it operates and even the composition of the Board.

So what needs to be done? First and foremost the accounting profession needs to admit that there is a problem. It then needs to engage in constructive debate both internally and externally. Within the profession there is a need to reassess educational requirements, professional standards, and the systems and procedures that give effect to those standards.

financial reporting’, that advocated such a move for the IPSASB. The credibility of and trust in the accounting profession lies in its preparedness to take a strong stance on self-regulation in the public interest. Failure to do so will increase the risk of further legislative intervention. Courageous decisions will be required and there will be some short-term pain. However, we are confident the leaders of the accounting profession both here in Australia and internationally can rise to the challenge. The long-term gain will be retaining the pre-eminent position of professional accountants in business and the general community. Warren McGregor was director of the Australian Accounting Research Foundation (AARF) from 1989 to 1999 and an inaugural member of the International Accounting Standards Board from 2001 to 2011. After holding senior positions in AARF and the Office of the Victorian AuditorGeneral, Greg Pound was chief accountant of the Australian Securities and Investments Commission during 2002–2005.

Externally, the profession needs to engage in constructive debate with policy makers to better understand the reasonable expectations of market participants and the broader community. And there needs to be a preparedness to support significant change. An example of a change we believe the profession should consider is to move the International Auditing and Assurance Standards Board, the International Public Sector Accounting Standards Board (IPSASB) and the International Ethics Standards Board away from the profession – and either set them up as independent boards or relocate them within a presently existing independent standard setting structure such as the IFRS Foundation. In this particular context, it was encouraging to see the Institute of Chartered Accountants in Australia recently publish a thought leadership paper, titled ‘It’s time...for global, high quality public sector Insights Melbourne Business and Economics

audit quality and regulation The credibility of and trust in the accounting profession lies in its preparedness to take a strong stance on self-regulation in the public interest. by w. robert knechel

A condensed version of the 74th CPA Australia/University of Melbourne Annual Research Lecture presented on 10 October 2013.

The past decade has seen tremendous changes in the regulation of the auditing profession. Auditing has gone from an essentially self-regulated profession prior to 2002 to one that is now highly supervised by government regulators. The story of these changes tells us much about what regulation may, or may not, be able to accomplish in regards to audit quality, and also suggests that we can expect to observe many unintended consequences of the current regulatory climate. What those unintended consequences will be are not known, but economic theory suggests that some of the consequences may run counter to the espoused regulatory objective to push auditors to higher levels of audit quality. As a result of the regulatory attention it now receives, the auditing profession faces an interesting and awkward conundrum. The two most common complaints about auditors are that (i) fees are too high (or the complementary statement that the Big 4 have too much pricing power) and (ii) audit quality is too low. The former problem is captured by a quote by Annette Nazareth (2007), then a member of the US Securities and Exchange Commission (SEC): ‘[The SEC has] heard complaints about auditors overauditing in part because they fear that PCAOB inspectors would otherwise find their audits insufficient.’ The latter problem is reflected in a 66

Audit quality and regulation

quote by Pierre Delsaux (2009) who was a member of the European Commission: ‘[There was] not enough control on what the banks were doing. We need good external control, specifically, auditing.’ The reason why these two viewpoints constitute a conundrum is because economic theory tells us that it is difficult to reconcile these problems in a competitive market. For example, efforts to reduce prices (fees) may lead to a loss of quality unless significant effectiveness improvements can be realised. On the other hand, efforts to increase quality may lead to higher prices unless significant efficiency improvements can be realised. Failure to achieve the mentioned improvements in efficiency and effectiveness can, in extremis, lead to a death spiral for an industry – as prices (fees) are beaten down via competitive pressures, quality may deteriorate, which puts further pressure on prices. This potential problem is compounded in an industry with flat (or declining) demand, and presents two questions. Does the auditing profession fit this model? Can the audit quality conundrum be solved via regulatory intervention? Fortunately, I do not think we are headed into a death spiral, but we may find that regulation both helps and harms the profession. The extent to which each occurs depends on the nature of auditing, the form of regulation, and the inevitable unintended

consequences of changing the fundamental regulatory regime of an entire profession.

The regulatory hydra There is little doubt that the regulatory infrastructure has expanded dramatically in the past decade. Prior to 2002 and the twin audit fiascos of Enron and Worldcom, the auditing profession was mostly self-regulated with standards being issued by US or international bodies such as the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), the Auditing Principles Board, and the International Auditing and Assurance Standards Board (IAASB, previously known as the International Auditing Practices Committee). These bodies shared a common trait: they were more or less self-regulatory, meaning the auditing profession had a great deal of influence over the standards issued by these bodies. This structure changed radically with the passage of the Sarbanes-Oxley Act of 2002 which, among other things, established the Public Company Accounting Oversight Board (PCAOB) to set regulations for the auditing profession in the US. No longer would the profession control its own operations or even its own destiny. Among notable changes ushered in with the PCAOB were restrictions on the nature of nonaudit services that accounting firms could offer their audit clients and, potentially most importantly, the introduction of inspections of audit work by government inspectors. In Australia, some of the same changes, albeit less draconian, were embedded in the Corporate Law Economic Reform Program (CLERP 9) in 2004, which came on the heels of the HIH Insurance audit scandal. Following these legal mandates, which have been mirrored in many countries, a new international organisation of audit regulators was formed, the International Forum of Independent Audit Regulators (IFIAR), to facilitate audit regulation on a global basis. By October 2013, 46 countries had formed national audit regulatory bodies and joined IFIAR. Whether all these regulatory changes have (or will) improve audit quality on a systematic basis depends on how the new

rules, standards and regulation interface with the fundamental economics of a professional service. In the remainder of this article, I will discuss how the economics of the auditing profession may influence the impact of increased regulation on audit quality.

Defining audit quality The most common definition of audit quality, from DeAngelo (1981) is that it is ‘the marketassessed joint probability that a given auditor will both (a) discover a breach in the client’s accounting system and (b) report the breach.’ This definition has two distinct elements that can be considered separately: – auditor knowledge or expertise which influences the likelihood that an auditor discovers errors in a client’s financial statements, and – auditor objectivity or independence which relates to the likelihood that an auditor will correct (via an adjusting entry) or reveal (via the auditor’s report) a client’s error when it is discovered. These two dimensions suggest two desirable aspects of the audit – independence and competence – that are essentially ‘traits’ that a consumer may be willing to pay for. That is, they are valuable aspects of an economic good in much the same way that good petrol consumption and engine power are desirable attributes of a car. Both traits are considered positive – more auditor independence improves audit quality as does more auditor expertise. However, it is important to note that the DeAngelo definition treats the two ‘traits’ as orthogonal – the level of one does not influence the level of the other. This relationship is illustrated in Figure 1 where the ray emanating from the origin of the graph indicates increasing levels of audit quality. Depicting audit quality in this manner reveals that there could be four extreme conditions that might occur, at least in an unregulated or lightlyregulated market. First, a specific engagement might entail low independence and low expertise. Such an engagement may not be desirable from Insights Melbourne Business and Economics

a societal point of view and, to the extent that auditing is an economic good, such a condition may have no economic value and generate no buyers. At the opposite extreme, we may see no suppliers because extremely high independence and expertise may not be technically feasible. This theoretical limit on audit quality is implicitly recognised in the audit-risk model which assumes that zero risk is not a feasible outcome and every audit has a non-zero level of residual risk.1 The other two extremes are potentially more interesting because they reflect a condition where the auditor is highly independent but possesses little expertise or knowledge (‘uninformed independence’) or has tremendous expertise but little independence (‘conflicted expertise’). Since none of the four ‘corner’ conditions may be desirable or attainable, this diagram illustrates the potential existence of an ‘assurance opportunity set’ away from the extremes (Figure 2).

Figure 2: The Assurance Opportunity Set

High

Low

Uninformed independence Improving audit quality No economic value

Not feasible

Conflicted expertise Auditor knowledge base

Audit quality and regulation

High

Auditor independence

Figure 1: Defining Audit Quality

Auditor independence

If an assurance opportunity set exists, at least in an unregulated market, the next step is to assess the viable combinations of independence and expertise that might be demanded by the market. Figure 3 illustrates how the trade-off between independence and expertise might be depicted using indifference curves. First, we need to reconsider the assumption that independence and expertise are truly orthogonal constructs. While

this may be the case when considered outside any specific engagement, within an engagement an auditor can only gain expertise with regards to that client by interacting with the system and personnel that are the subject of the audit. This interaction – whether due to economic, psychological or personality reasons – is likely to cause a curvilinear relationship between the two traits. That is, both traits are desirable (complementary), meaning that clients would like both traits, but there is an implicit trade-off between them in the context of a single client. Any given combination of a unique level of independence with a unique level of expertise implies a given level of audit quality. Higher levels of audit quality can be depicted with an ascending set of curves moving away from the origin. For example, the curve A1A2 would reflect a relatively ‘low’ level of audit quality, which might be described as ‘moderate assurance’ using the terminology of auditing standards. This level of audit quality might be demanded by a client that simply needs an audit to qualify for a bank loan. B1 is on an indifference curve that would reflect ‘reasonable assurance’ under the auditing standards (which actually means ‘high’ assurance) and might be appropriate for a publicly traded client. Finally, C1 falls on an indifference curve where assurance is very high and potentially exceeds what is required by auditing standards.

Low

Assurance opportunity set

Auditor knowledge base

High

Figure 3 illustrates that a consumer might contract on (demand) any given combination of assurance, independence and expertise that falls within the assurance opportunity set. Further, the shape of the curves implies that for any given level of audit quality, there is an implicit tradeoff between independence and expertise.2 The slope of the curve (as measured by a tangent to the curve at any point) reflects the marginal rate of technical substitution between independence and expertise. The curves are drawn to suggest that independence and expertise are not perfect complements but that there is a diminishing marginal benefit of substituting more expertise for less independence. An auditor can be too close to a client. In many regulatory or standardsetting situations, it is the failure to recognise this implicit trade-off (i.e. treating independence and expertise as unrelated) that could lead to negative unintended consequences. This is explained in more detail in the next section.

the profession and reduce the value of audits.4 Consequently, the profession (or regulators) may desire to impose a minimum level of assurance. For example, they might conclude that the engagement implied by A2 is not socially desirable because of the low level of independence. To avoid the occurrence of such audits, the profession (or regulators) might impose minimum requirements for independence as illustrated with the horizontal line in Figure 4. Note, this line is meant to illustrate the existence of a constraint and is not intended to indicate the â&#x20AC;&#x2DC;optimalâ&#x20AC;&#x2122; level of independence. The impact of the independence constraint is to make A2 an unacceptable engagement, as well as some of the engagements associated with the lower end of the curve with B1. It is interesting to note that the auditing profession had independence rules, typically embedded in a code of professional conduct or ethics, long before there were regulatory rules for independence.5

Figure 3: Tradeoff of Independence and Expertise

Figure 4: Constraining Independence

High

Auditor independence Low

C1 Client indifference curves

B1 A2

Auditor knowledge base

High

Auditor independence

Figure 3 might be used to describe the demand for auditing in an unregulated market. However, the profession, potential clients and regulators would probably all agree that allowing auditors and clients to contract on any level of assurance or any combination of independence and expertise might eventually undermine the credibility of

A closer examination of Figure 4 suggests that an audit high on independence but low on expertise (A1) may also not be a good idea since it is not clear if the auditor would have any basis for actually issuing an informed audit opinion. This observation suggests that a minimum level of competence (i.e. knowledge, expertise) is also desirable, which can be depicted by imposing a vertical constraint as illustrated in Figure 5 to reflect the impact on

Regulating audit quality

Low

Independence Rules

Auditor knowledge base

High

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audit practice of standards such as those issued by the IAASB or PCAOB. Now we can observe that A1 is also not an acceptable engagement. The net effect of the two regulatory/standard constraints is to essentially preclude any audits with the assurance level associated with A1 or A2 and most (but not all) of the engagements on the B assurance curve. Whether socially desirable or not, B1 would still be an acceptable audit under these ‘rules’. This simple series of illustrations reveals how regulation and standard setting can influence audit quality, at least in theory. Whether the constraints illustrated in Figure 5 are, on balance, good or bad is not the question for this article – but it is important to keep three key points in mind. First, regulation prohibits consumers from purchasing some economically viable options (e.g. A1 or A2). This may be good if the consumer is uninformed or otherwise might be misled by the seller into purchasing too little ‘assurance’. For example, this problem could occur if management contracts with the auditor but emphasises its own purpose over the objectives of the other stakeholders in an organisation (i.e. shareholders), which is one reason why many jurisdictions now lodge the power to hire or fire an auditor with the Board of Directors or a subcommittee of the Board. Second, by construction, the costs of audits will need to increase to compensate for higher levels of independence and expertise, that is, more assurance costs for some clients. However, remember that this decision is being made by regulators rather than the parties

directly involved in the contract (e.g. shareholders). A third consideration is that the nature of the constraints must be ‘interpreted’ by various parties or stakeholders to the audit contract. This may be particularly important in an environment where there is ex post inspection of audit work by a regulator. In that case, the ex ante interpretation of auditing standards – even by regulators – may differ from the ex post interpretation used during an inspection, making the location of the vertical constraint even less clear. Ultimately, the question of audit quality comes down to whether the intended benefits of regulation exceed the increased costs. Figure 5 suggests that more regulation is better than less, only when an audit fits the assumptions that underlie the indifference curves as drawn. Further, the analysis does not admit that there could be a maximum level of regulation. If an audit does not fit into a neo-classical micro-economic perspective, it is quite possible that not only will regulation have unintended consequences but that those consequences could be quite severe. In the end, the same exact curves could be used to illustrate the trade-off of bagels (x-axis) and toasters (y-axis) since possession of a toaster is likely to increase the enjoyment one obtains from a bagel. However, to state the obvious, an audit is not a toaster, so the question then remains: does audit quality behave as expected in the presence of increased regulation? The answer depends on what we mean when we talk about an audit as an economic good or activity.

What is an audit? Figure 5: Constraining Expertise

Auditor independence

High

Low

GAAS Rules C1

Independence Rules

Auditor knowledge base

Audit quality and regulation

High

Defining an audit would seem to be a simple task. Merriam-Webster (2014) has a no-frills definition: ‘a complete and careful examination of the financial records of a business or person.’ He then generalises the definition slightly by adding: ‘a careful check or review of something.’ While those definitions would probably suffice for most purposes, a deeper understanding of the attributes of an audit is necessary in order to begin to assess whether regulation will have its intended effect or result in serious unintended consequences. To do this, it is important to realise that an audit has four critical attributes that influence how

economic theory might relate to auditing: – The value of an audit derives from the economic needs of stakeholders (independent of regulation). This means that mandating an audit does not create its value, at least not all – or even a significant portion – of its value. The value of the audit derives from its use as a riskmanagement tool by various stakeholders in an organisation. – The outcome of an audit is inherently uncertain and ultimately unobservable. Zero risk is not possible either practically or economically. This is especially true during the conduct of the audit but is also true when an audit is examined after its completion (i.e. inspection). – The audit process is idiosyncratic to the client. While firms may use standardised approaches, the audit must be individually tailored to the risks, controls, transactions, systems and conditions of a specific client. – Expertise, or judgment, is the ultimate source of value in any professional service, including auditing. It is what a professional knows, how they analyse a situation, and how they reach a conclusion that drives the value of their expertise. Being ‘in compliance’ may help improve auditor judgment but cannot replace auditor judgment. Now consider how these key attributes might interact with a regulatory view of auditing. First, a regulatory view might overemphasise the compliance view of an audit – the perception that being in compliance with regulations and standards drives the value of the audit. While compliance is certainly a desirable (and necessary) attribute, it is unlikely that stakeholders will purchase an audit simply because it ‘meets standards’. Thus, mere compliance is probably not sufficient condition for creating economic value via an audit – meeting standards without reducing risk will have little economic value because the assumption that compliance equates to risk reduction may not hold in all circumstances. Second, treating the audit as if the outcome can be observable after the audit is completed can

lead to auditors being more concerned about being second-guessed by inspectors than actually finding the right answers during the course of the audit. Demonstrable defence of the audit process used in an engagement may supplant defence of an auditor’s conclusions. Further, both the auditors conducting the engagement and the inspectors examining an engagement may be essentially correct in the conclusions they reach since the actual residual risk of the audit is unobservable.7 However, the conclusions of an inspector will trump the conclusions of the auditor in most situations whether or not they are ‘more’ correct. Third, the focus on process may cause an auditor to overly standardise the process rather than tailoring it to the circumstances of the client. Variations from a standardised audit process may need to be defended to inspectors, and may become the breach through which inspectors question the entire audit. As a result, auditors may find it easier to downplay the idiosyncrasies of the client when planning and conducting an audit, or at least follow the standardised processes more rigorously than may be appropriate. Finally, the pre-eminent role of professional judgment provides the basis for economic value, and allows an auditor to function in an uncertain environment and adapt to the unique aspects of each client. The combined effects of these four key attributes are the foundation of any professional service, and are especially relevant in the auditing profession. Failure to adequately reflect their reality in the regulatory or standard-setting process is likely to lead to significant unintended consequences.

Conclusion The evolution of auditing from a self-regulated to a government-regulated profession has created significant challenges for auditors, clients and regulators. This shift has certainly had a positive and important effect on audit quality in general. However, regulation will always lead to unintended consequences. Failure to match the reality of the economics of auditing to the regulatory approaches adopted could lead to Insights Melbourne Business and Economics

results contrary to the objective of improving audit quality. Further, the manner in which regulation is imposed and managed can have far-reaching consequences for the audit profession. Causing auditors to continually defend their judgments, to answer for alleged failures in audit documentation that do not translate into broader audit failure, and to be belittled in front of the public and clients is unlikely to improve their professional standing, attitude or satisfaction in providing professional services. Such a negative environment runs the risk of undermining the trust the public holds in auditors in spite of increasing regulation; reducing the economic benefits and rewards of the profession; and eventually leading to a drain of professional talent that could harm the long-term prospects of a profession built on trust. Failure to match regulatory actions to the true economics of the audit profession runs the risk that all these negative, but unintended, consequences may eventually arise. In fact, if regulators are not careful, they could end up exacerbating the opening conundrum, resulting in more expensive audits that, simultaneously, are heavily criticised by inspectors as being less effective. W. Robert Knechel is Director, International Center for Research in Accounting and Auditing, Frederick E. Fisher Eminent Scholar in Accounting, Fisher School of Accounting, University of Florida and Professor of Auditing, Auckland Business School, University of Auckland.

5 Of course, as we have seen in the US with SOX, independence rules arising from regulation are likely to be more stringent than those that are self-imposed by the profession. 6 The potential difference between ex ante interpretation of audit standards for conducting the audit and ex post interpretation of standards by regulatory inspectors suggests the possibility of ‘shadow’ standards that differ from the formal standards. For example, the speed limit on a motorway may officially be 100 k/h. However, many drivers believe that as long as they do not exceed 110 k/h, traffic police will not bother them. In this case, the shadow standard is perceived to be more lenient than the official standard. For auditing, the opposite case is probably more important – the shadow standard used by inspectors is more stringent than the official standard. 7 Due to regulation, the view of the inspectors has more authority (by fiat) than the view of the engagement team, but that does not make the inspector ‘more right’.

References Causholli, M, and Knechel, WR 2012, ‘An examination of the credence attributes of an audit’, Accounting Horizons, December 2012, pp. 631-655. Causholli, M, Knechel WR, Lin, H and Sappington, D 2013, ‘Competitive procurement of auditing services with limited information’, European Accounting Review, September 2013, pp. 573-605. DeAngelo, L 1981, ‘Auditor size and audit quality’, Journal of Accounting and Economics, vol. 3, pp. 183-199.

1 This observation also reflects one of the limitations of the DeAngelo (1981) model of audit quality because she does not assume an upper limit to achievable audit quality. At best, audit quality can asymptotically approach a theoretical maximum.

Delsaux, P 2007, Public remarks to International Symposium on Audit Research, Maastricht University, Netherlands, June 2009.

2 Regulators implicitly acknowledge this trade-off when they express concerns about economic bonds (auditors being paid by the client) or social bonds (getting to know a client too well) undermining audit quality.

Merriam-Webster, http://www.merriam-webster. com/dictionary/audit (accessed 2 February 2014)

3 When two goods or traits are perfect complements, the indifference curves form a right angle which suggests a singular rate of substitution between the two traits. For example, for a person with two feet, left and right shoes are perfectly complementary and the marginal rate of substitution is by definition one-to-one.

Nazareth, AL 2007, Remarks before the Council of Institutional Investors.

4 This phenomenon is a variation of the well-known adverse

selection problem – where consumers cannot evaluate or trust the quality of an economic good, demand for that good will drop, as will its value in exchange. In the extreme, adverse selection could cause a market to collapse completely. This potential problem is exacerbated if the audit manifests significant attributes of a credence good (Causholli and Knechel 2012, Causholli et al. 2013).

Audit quality and regulation

occasional address

economics and happiness The evidence suggests that a general increase in real income, once the most rudimentary needs are satisfied, does disappointingly little for people’s sense of wellbeing. by keith hancock

An edited version of an Occasional Address given at Wilson Hall, University of Melbourne, on 13 December 2013.

The University has done me a great honour by awarding me an honorary Doctorate of Commerce – the more so, perhaps, because I don’t hold an ordinary degree in Commerce. I took my Bachelor’s degree at this University in 1956, but it was a BA rather than a BCom. This was because I wanted to combine Economics with History – a rewarding combination that I have always been glad I chose. The University of Melbourne, when I was a student and a tutor, had around 7,000 to 8,000 students. In today’s world, that would make it one of the smallest universities in the country. It really did end at Grattan Street. Indeed, the first 200 metres north of Grattan Street were lawn. But the University’s small size did not prevent it from being an exciting place. There was much lively debate, in which I involved myself as an activist in one of the political clubs. I was lucky enough to make the University debating team. My contemporaries – give or take a year or two – included John Button, Max Corden, Daryl Dawson, Frank Vincent, Geoff Harcourt, Clyde Holding, Inga Jewell (later Clendinnen), Barry Jones, Philip Lynch, Don Rawson and Michael Roe.

In the Commerce faculty, the people who contributed most to my education were Joe Isaac, Jean Polglaze, Jim Cairns, Don Cochrane, Frank Davidson, David Rowan, Alan Boxer, John LaNauze, Wilfred Prest, Ken Rivett and Dick Downing. I owe much to those people. Joe Isaac – my dear friend, who is here today – was the reason why I chose the London School of Economics to do my PhD. I credit Wilfred Prest, along with Max Crawford, with my getting a travelling scholarship from the University. It was Dick Downing who introduced me to the ACTU, where I helped them prepare for a basic wage case and gained an ongoing interest in wage fixation. When I left Melbourne to go to London, I had an expectation of returning here as a lecturer in economic history once I finished my PhD, but at the crucial time there was no such lectureship. The University of Adelaide offered me a lectureship in economics, and I worked under the inspiring leadership of Peter Karmel, a Melbourne graduate of the 1940s. I have spent the rest of my life in Adelaide. I congratulate all of today’s graduates. Yours is a significant achievement. Economics is now much more difficult than it was in my day. If the Insights Melbourne Business and Economics

same is true of the other disciplines which you have studied, you have ploughed a hard row. My congratulations and good wishes also go to your partners and families for the support which they have provided to you.

Comparisons with the late 1950s I want to avoid pontificating, but I would like to reflect on the kinds of worlds and societies into which graduates emerge. The distinctive features of my time – the later 1950s – included full employment and an age structure of the population which was as favourable to people of my generation as it could possibly have been. With the large generation of babyboomers coming along behind us, we had both the abundance of job opportunities which their demands afforded us and also the assurance that these babyboomers would be called upon, in one way or another, to support us as we aged. The economy and productivity were growing at decent rates. Older people such as my parents still talked about the depression of the 1930s, but my colleagues and I thought that Keynes had made their fears obsolete. On the negative side, there were the ever-present threats and effects of the Cold War, which poisoned political debate and outcomes. A side-effect of full employment seemed to be continuous inflation. The gender divide remained evident in many ways – the break-through which seemed to occur during the war had all but been obliterated. You face a different set of realities. As new graduates, you enter a more fiercely competitive world of work. You do not have a babyboomer generation coming along behind you to create an excess demand for your services; and you, with the rest of your cohort, face the burden of supporting – in one way or another – the babyboomers in their old age. The Cold War is history, but instead we have the consequences of racial divisions and hatreds, including terror, which are no less a source of foreboding and are equally destructive of constructive policy. There is also the contentious issue of climate change. If mainstream science is right, it may not have much effect in my lifetime but will be an everincreasing problem in yours. Full employment 74

Economics and happiness

is now a goal rather than a reality. Inflation is no longer much of an issue. Productivity in Australia has risen by a factor of three since the time of my graduation. Material living standards have risen, too, though the benefits have been diluted by widening disparities of income and wealth. Standards of health are, despite the widespread and no doubt justified worries about obesity, much higher than they were a half-century ago; and this is evident in a remarkable rise in life expectancy. The gender divide has not vanished, but it is gradually succumbing to continuous assault. Not least among the signs of change is today’s predominance of women in the population of recent graduates. The off-the-cuff comparisons that I have been making amount, then, to a good news-bad news story. But when all is said and done, I envy you for the future that you have ahead of you. If I could take a half-century off my age, I’d gladly do it. But all things considered, it is as well that people do not have that option.

Incomes and wellbeing Real incomes in this country, on average, are higher than they have ever been. The same is true of many other countries, but not all. Does this mean that people are happier than ever before? When I was an undergraduate, the language of happiness was not acceptable among economists. Over the past 10-20 years, this inhibition has been jettisoned by a significant proportion of the profession. Exploration of the relation between material resources and happiness is an inter-disciplinary pursuit, involving economists, psychologists, sociologists and neuroscientists. The fracturing of disciplinary borders is a welcome development, for the arbitrary partitioning of knowledge and inquiry means that the total is less than the sum of the parts. But the evidence seems to suggest that a general increase in real income, once the most rudimentary needs are satisfied, does disappointingly little for people’s sense of wellbeing. The explanation for this which commands the most acceptance is that people are more strongly influenced by their relative than by their absolute incomes and consumption

standards. If this is right, it militates against the doctrine that the rising tide lifts all boats – a doctrine which is invoked to tell us that issues of distribution are of secondary importance. Are we, then, destined to endure a perpetual rat race in which people such as yourselves strive continuously to get ahead but end up, on average, little happier than you would have been if there had never been a rat race? I don’t know the answer, but the possibility is high enough for me to doubt the wisdom of treating social goals of more equal distribution and greater security as secondary to the pursuit of ever-rising income and wealth. But for yourselves, there is the question of how fast you want to run the rat race. As I said, I don’t want to preach. You may find satisfaction in competitive success. I hope, however, you will not ignore the potential satisfactions of leisure, culture, family and public service. You are not going to be poor, and you can afford to contemplate the benefits and satisfactions of a balanced life. Whatever your choice, I wish you well. Emeritus Professor Keith Hancock AO, was Vice-Chancellor of Flinders University during 1980–87 prior to becoming a Presidential Member of the Australian Conciliation and Arbitration Commission (later the Australian Industrial Relations Commission).

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Mailing Address: The Faculty of Business and Economics The University of Melbourne Victoria 3010 Australia Telephone: +61 3 8344 0006 Email: flawry@unimelb.edu.au Internet: http://insights.unimelb.edu.au Published by the Faculty of Business and Economics, April 2014 ÂŠ The University of Melbourne Disclaimer Insights is published by the University of Melbourne for the Faculty of Business and Economics. Opinions published are not necessarily those of the publisher, printers or editors. The University of Melbourne does not accept responsibility for the accuracy of information contained in this journal. No part of this journal may be reproduced without the permission of the editors.