Economic Organization Theory

Week 6 Economics Primer, chapter 2

Week 7 Chapter 3 & 4

Week 8 Chapter 12

Week 9 Chapter 13 and 14

Week 10 Readings

Week 11 Chapter 11

Week 12 Readings

chapter 3 – Vertical boundaries of the firm

vertical boundaries of a firm define the activities that the firm itself performs as opposed to

purchases from independent firms in the market

make-or-buy decision is a firm’s decision to perform an activity itself or to purchase it from

an independent firm

upstream: early steps in the vertical chain

downstream: later steps in the vertical chain

Arm’s-length

market

transactions

Long-term

contracts

Strategic

alliances and

joint ventures

Parent/subsidiary

relationships

Perform

activity

internally

transaction in

which the buyers

and sellers of a

product act

independently and

have no

relationship to each

other

contracts to

perform

construction related

activities that will

exceed a period of

one year

two or more firms

establish an

independent entity

that relies on

resources from

both parents

Less integrated More integrated

Benefits and costs of using the market

Benefits Costs

- Market firms can achieve economies of

scale that in-house departments producing

only for their own needs cannot

- Market firms are subject to the discipline of

the market and must be efficient and

innovative to survive. Overall corporate

success may hide the inefficiencies and lack

of innovativeness of in-house departments

- Coordination of production flows through

the vertical chain may be compromised when

an activity is purchased from an independent

market firm rather than performed in-house

- Private information may be leaked when an

activity is performed by an independent

market firm

- There may be costs of transacting with

independent market firms that can be avoided

by performing the activity in-house

Reasons to buy market firms are more efficient (economies of scale, learning economies)

Firms should focus on their strength activities, leave rest to market firms because:

1) market firms may possess proprietary information or patents that enable them to produce at

a lower cost

2) market firms might be able to aggregate the needs of many customers, thereby enjoying

economies of scale

3) market firms might exploit their experience in producing for many customers to obtain

learning economies

chapter 12 – Performance measurements and incentives in firms

principal-agent relationship occurs when one party is hired by another to take actions or make decisions that affect the payoff to the principal

difficulties in agency relationship arise when:1) the objectives of principal and agent are different e.g.: managers may wish to limit their personal risk, avoiding risky strategic initiatives

that shareholders view as reasonable2) the actions taken by the agent or the information possessed by the agent are hard to observe

improved by monitoring, but this has significant limitations: i) it is often imperfect; not all relevant information can be digestedii) hiring monitors can be costly iii) hiring a monitor often introduces another layer to the agency relationship

when principles cannot adequately monitor their agents’ actions (or find it too costly) they may prefer pay-for-performance

performance-based incentives1. The slope of the relationship between pay and performance, rather than the absolute pay level, provides incentives for effort2. The firm earns a higher profit when it offers the salary-plus-commission job than with a fixed salary job3. The firm can do even better if it sets a higher commission rate 4. Performance-based pay can help resolve hidden information problems as well

problems with performance-based incentives- if the performance measure is affected by random factors that are beyond the employee’s control and therefore subjects the employee to unwanted risk- if the measure fails to capture all aspects of desired performance employees may focus on measured aspects at the expense of other equally important aspects (e.g. high % sales versus low customer service)

certainty equivalent: the certain amount that makes the decision maker indifferent between taking the risk and taking the certain paymentrisk premium: difference between the expected value of a risk and the decision maker’s certainty equivalent

three properties of certainty equivalent and risk premiumi) different decision makers will have different certainty equivalents for the same riskii) for a given decision maker, the certainty equivalent is lower (and the risk premium higher) when the spread or variability in payments is greateriii) in choosing between two risky outcomes, a decision maker will select the one with the higher certainty equivalent

risk sharing effect: if one party is risk averse and another is risk neutral, the efficient allocation of risk places all risk with the risk-neutral party and gives a certain payoff to the risk-averse party because the risk-neutral party values the gamble at its expected value, but the risk-averse party values it at a certainty equivalent, less than the expected value

stronger incentives are called for if:- the employee is less risk averse- the variance of measured performance is lower- the employee’s marginal cost of effort is lower- the marginal return to effort is higher

3 features of good performance measure1) a performance measure that is less affected by random factors will allow the firm to tie pay closely to performance without introducing much variability into the employee’s pay

2) a measure that reflects all the activities the firm wants undertaken will allow the firm to use strong incentives without pulling the employee’s attention away from important tasks

3) a performance measure that cannot be improved by actions the firm does not want undertaken will allow the firm to offer strong incentives without also motivating counterproductive actions

In implicit incentive contracts workers expect to be rewarded for their productive efforts, even if evaluations are subjective and no explicit rewards are written down

Costs to implementing subjective performance assessmentsi) supervisors may find it personally unpleasant to reward some employees but not others may result in everyone getting an average grade: ratings compressionii) subjective assessments of performance are subject to influence activityiii) subjective measures may be noisy

promotion tournament: a set of employees competes to win a promotion; the ‘prize’ is a substantial increase in compensation

Advantages disadvantagesTournaments circumvent the problem of supervisors who are unwilling to make sharp distinctions among employees; incentive to be top performer is strong counteracts compression in subjective evaluation

The individual who is best at performing a lower-level job may not be the right choice for a higher-level job

Tournaments are a form of relative performance evaluation common random factors that affect performance are netted out

Relative performance evaluation rewards employees for taking actions that hamper the performance of other employees

efficiency wage: the wage that is high enough to motivate effort

chapter 13 – Strategy and structure

large firms require complex hierarchies: the structure of the firm involves multiple groups and multiple levels of groupings1. Departmentalization: partitioning of workers into subgroups2. Coordination of activities within and between subgroups to attain the firm’s objectives

when selecting organizing dimensions; managers should consider- economies of scale and scope- transaction costs- agency costs

coordination: the flow of information to facilitate subunit decisions that are consistent with each other and with organizational objectives

control: the location of decision-making and rule-making authority within a hierarchy

four basic structures for large organizations1) the unitary functional structure (U-form)2) the multidivisional structure (M-form)3) the matrix structure 4) the network structure

1. unitary functional structure- a single unit is responsible for each basic business function (e.g. finance, marketing, production, purchasing)- promotes performance within department- makes coordination with other departments difficult- firms with this structure tend to centralize their strategic decision making- suited to relatively stable conditions in which operational efficiency is valued- focus on operational efficiency rather than profitability

2. the multidivisional structure- a set of autonomous divisions led by a headquarters office and assisted by a corporate staff that provides information about the internal and external business environment- an interrelated group of subunits (division) as the building block- divisions can be organized by e.g. product line, geography, customer- M-form develops in response to problems of inefficiency and agency that arise in U-forms as they increase in size/complexity- improves efficiency through a division of labor between strategic and operating decisions- allows firms to coordinate production, distribution and sales within different markets- clearly measures how much the performance of each division contributes to overall success

3. the matrix structure- the firm is organized along multiple dimensions at once- individuals working at the intersections of the matrix report information to two hierarchies and have two bosses- valuable when economies of scale or scope or agency considerations provide a compelling rationale for organizing along more than one dimension simultaneously- valuable when important issues are not well addressed by the firm’s principal organizing approach- managers often struggle to meet conflicting demands within the matrix- suitable when the demands of competing dimensions are roughly equivalent and difficult to address sequentially

4. the network structure- workers can contribute to multiple organizational tasks and can be reconfigures and recombined as the tasks of the organization change- each individual’s tasks, responsibilities and obligations to other workers are negotiated in discussions between the employees involved- preferable to other structures when the substantial coordination costs of employing it are compensated for by technical efficiency, innovation or cooperation- an alliance network in which separate firms can act collectively through a combination of informal relationships, bilateral contracts, etc.- modular organization: self-contained organizational units tied together through a technology standard

structural choice considerations1. whether demand-enhancing activities (e.g. advertising, product promotion) & cost-reducing activities (e.g. downsizing, product rationalization) are profit complements or substitutes complements: when an increase in the level of one activity increases the marginal

profitability of the other substitutes: when an increase in the level of one activity reduces the marginal

profitability of the other2. Whether spillovers of know-how are positively or negatively correlated

positively: if they both primarily benefit a single dimension (e.g. if the introduction of a new product in one market helps the firm produce or sell the product in other markets)

negatively: if spillovers from some activity positively one dimension (products) but reduce benefits on another (geography)

Matrix structureNever optimal if Can be optimal ifSpillovers are positively correlated and activities are profit complements

Activities are profit complements but spillovers are negatively correlated AND if spillovers do not disproportionately favor one dimension over anotherActivities are profit substitutes and spillovers are positively correlated AND if activities are strong substitutesIf spillovers are negatively correlated and activities are profit substitutes AND if spillovers are strongly product-specific in one activity and strongly specific to geography in the other

The optimal organizational structure for a firm depends on the environmental circumstances

Example: functional structureWorks well for Works poorly forManufacturer of supercomputers

Large bank

difference Less complex business environment

More complex business environment

characteristics Customers include large technology firms, businesses in sectors requiring extensive use of data, research universities; firm and customers know each other

Complex in terms of products, customers and regulatory burdens; operate on a global scale

conditions Threats and opportunities are fairly predictable and understandable to all participants

Volatility of business is high, e.g. financial crisis is unpredictable

does functional structure suit?

yes no, need of more complex structure, e.g. matrix

Environmental factors that influence relative efficiency of structures1) technology and task interdependence2) information processing

1. technology and task interdependence- a firm employing a well-known and mature technology best off adopting a hierarchical structure conducive to more stable, standardized and higher volume production- a firm working with a rapidly evolving and less well-known technology may prefer a decentralized structure that offers flexibility and responsiveness to change - technology determines the degree of task interdependence: the extent to which two or more positions depend on each other to do their own work

reciprocal interdependence: when 2 or more workers depend on each other to do their work

sequential interdependence: with 2 or more workers/groups when one depends on the outcomes of the others, but not vice versa

pooled interdependence: when 2 or more positions are not directly dependent on each other but are associated through their independent contributions to the success of the firm

2. efficient information processing- Garicano models a knowledge hierarchy in which firms encounter problems that differ according to their difficulty and the frequency- an optimal organization divides workers into production workers and ‘problems solvers’- information retrieval: firms should be structured to facilitate the efficient retrieval of information in the varied conditions they face on a regular basis

chapter 14 – Environment, Power and Culture

social context internal: the political and cultural environment within a firm that affects how

managers and employees behave external: business environment in which the firm operates and the legal, regulatory,

political and cultural environment in which the firm acts

internal context- power: an individual’s ability to accomplish his or her goals by using resources obtained through non-contractual exchange relationships- authority: the explicit contractual decision-making and dispute-resolution rights that a firm grants to an individual- influence: the use of power in a given situation by an individual

sources of power power bases: attributes of the individual that convey resources that help an individual gain powerresource dependence view of power: individuals and firms seek to gain power by reducing their dependence on other actors, while increasing the dependence of others on them

structural holes: relationships in social networks in which one actor is the critical link between individuals or entire groups

Accumulation of powerhelpful when harmful whenThere are high agency costs in coordinating managers and lower-level workers

There are high agency costs in coordinating among levels of upper management

The firm’s environment is relatively stable The firm’s environment is relatively unstable

Culture is a set of collectively held values, beliefs and norms of behavior among members of a firm that influences individual employee preferences and behaviors on the job

chapter 11 – Sustaining Competitive Advantage

important implication from theory of perfect competition opportunities for earning profit based on favorable market conditions will quickly disappear as new entrants cause increase in supply & decrease of price to zero profit

! successful incumbents in both competitive and monopolistically competitive markets can do little to preserve profits unless they can deter entry (e.g. by the incumbents creating endogenous sunk costs through branding) BUT conditions that facilitate entry deterrence tend to be absent in perfect

competition/monopolistic competition

Threats to sustainability of competitive advantage under all market structures- luck / bad luck- firm may not be protected from powerful buyers/suppliers (bargaining leverage)

Mueller’s persistence of profitability: firms with abnormally high levels of profitability tent to decrease in profitability and vice versa; however they do not converge to a common mean market forces are a threat to profits, but only up to a point

Competitive advantage: the ability of a firm to outperform its industry; to earn a higher rate of economic profit than the industry norm sustainable when it persists despite efforts by competitors to duplicate or neutralize it sustainable when resources and capabilities are scarce and imperfectly mobile create more value through

- firm-specific assets & factors of production (e.g. patents, brand-name reputation) - distinctive capabilities (e.g. activities it does better than others)

Resource-based theory of the firm: if all firms in a market have the same stocks of resources and capabilities, no strategy for value creation is available to one firm that would not also be available to all other firms in the market

Cospecialized resources: more valuable when used together than when separated (e.g. employees in productive work teams produce a better collective output than individually)

Isolating mechanisms: the economic forces that limit the extent to which a competitive advantage can be duplicated or neutralized through the resource-creation activities of other firms

Comparison entry barriers and isolating mechanismsWhat entry barriers are to an industry.. ..are isolating mechanisms to a firmAn entry barrier impedes new entrants form coming into an industry and competing away profits from incumbent firms

Isolating mechanisms prevent other firms from competing away the extra profit that a firm earns from its competitive advantage

Isolating mechanisms1) impediments to imitation: impede existing firms and potential entrants from duplicating the resources and capabilities that form the basis of the firm’s advantage 2) early-mover advantages: once a firm acquires a competitive advantage, these isolating mechanisms increase the economic power of that advantage over time

Shock: fundamental changes that lead to major shifts of competitive positions in a market (e.g. shifts in demand or tastes, product innovation, etc.)

infrequent shocks & powerful isolating mechanisms sustainable competitive advantage

1. impediments to imitationi) legal restrictions - patents, copyrights, trademarks, etc. - once a patent or operating right is secured, its exclusivity gives it sustainable value

ii) superior access to inputs or customers - firms often get favorable access to inputs by controlling the sources of supply

through ownership or long-term contracts - superior access to inputs or customers can confer sustained competitive advantage

only if the firm can secure access at ‘below-market’ prices or if the firm has unique resources or capabilities

iii) market size and scale economies - a scale-based advantage can be sustainable only if demand does not increase too

much; otherwise the growth in demand will attract additional entry or induce smaller competitors to expand allowing them to benefit from economies of scale

iv) intangible barriers to imitating a firm’s distinctive capabilities: causal ambiguity, dependence on historical circumstances, and social complexity - causal ambiguity: the causes of a firm’s ability to create more value than its

competitors are obscure and only imperfectly understood (due to the fact that a firm’s distinctive capabilities usually involve tacit knowledge) hard to translate success

- historical dependence implies that a firm’s strategy may be viable for only a limited time

- social complexity e.g. Toyota’s competitors know that Toyota’s success depends largely on trust between it and its suppliers; but difficult to create this trust

2. early-mover advantagesi) learning curve - a firm that has sold higher volumes of output than its competitors in earlier periods

will move farther down the learning curve & achieve lower unit costs than its rivals

ii) reputation and buyer uncertainty - consumers with a positive experience will be reluctant to switch to competing brands

iii) buyer switching costs - arise when buyers develop brand-specific know-how that is not fully transferable to

substitute brands (e.g. when someone knows how to work with a Windows computer, when he switches to Apple he will have to invest time in order to learn the program)

- firms will increase switching costs (e.g. frequent customer discount cards)

iv) network effects - consumers often place higher value on a product if other consumers also use it

early-mover disadvantages - firms may fail to achieve a competitive advantage because they lack the

complementary assets needed to commercialize the product - firms may fail to achieve a competitive advantage because they bet on the wrong

technologies or products

Creative destruction occurs when something new kills something older. A great example of this is personal computers. The industry, led by Microsoft and Intel, destroyed many mainframe computer companies, but in doing so, entrepreneurs created one of the most important inventions of this century.

Are large firms doomed to be less innovative than smaller rivals?factors characteristics

Productivity effect - which firm will be more productive at research- patent racing: innovation is a winner-take-all activity rewarded by patent

Sunk cost effect - entails the asymmetry between a firm X that has already made a commitment to a particular technology or products and firm Y that is planning such a commitment - when firm X considers a new technology, the costs for the old technology must be seen as sunk otherwise it may be biased and stick to the old (bad) technology- whereas firm Y can compare all the costs and will adapt the best technology anyway

Replacement effect -through innovation an entrant can replace the monopolist, but the monopolist can only replace itself entrant has greater incentive to innovate

Efficiency effect - a monopolist usually has more to lose from another firm’s entry than that firm has to gain from entering the market (1 monopolist vs 2 duopolists) increases monopolist’s incentive to innovate