Term Paper

The opportunity cost of using a resource is the value of the resource in its best alternative use. For example, the cost of having a manager use five hours to work on a project is the value of the manager's time in working on the next best alternative project. Economic decision making requires careful consideration of the relevant opportunity costs.

Marginal costs and benefits are the incremental costs and benefits that are associated with a decision. In calculating marginal costs, it is important to use the opportunity costs of the incremental resources. For example, in deciding whether to purchase a new laptop computer, the marginal cost is its price and the marginal benefit is the value that the person places on the new computer. It is the marginal costs and benefits that are important in economic decision making. Action should be taken when the marginal benefits are greater than the marginal costs. Sunk costs that are not affected by the decision (for example, unrecoverable funds previously spent on computers) are not relevant.

A utility function is a mathematical function that relates total utility to the amounts that an individual has of whatever items the individual cares about (goods). Preferences implied by a utility function are pictured graphically by indifference curves. Indifference curves picture all combinations of goods that yield the same level of utility. Individual choice involves maximizing utility given resource constraints. Graphically, the constraint depicts all combinations of goods that are feasible to acquire; it defines the feasible consumption opportunities. The optimal choice is where the indifference curve is tangent to the constraint. At this point, the individual is at the highest level of utility possible given the feasible opportunities.

Changes in opportunities result in changes in the optimal choice. An important implication is that managers can affect behavior by affecting constraints and opportunities. Managers, however, have to be careful. Individuals are clever at maximizing their utility, and establishing dysfunctional incentives can have perverse consequences.

We contrast the economic model with other models of human behavior that managers often use. We argue that the economic model is often more useful than alternative models in managerial decision making.

The analysis in this chapter can be extended to the case where the decision maker faces uncertainty about the items of choice. An example of decision making under uncertainty is choosing among risky investment alternatives. One concept that we will rely on later in this book is risk aversion. When confronted with both a risky and a certain alternative having the same expected (or average) payoffs, a risk-averse person always will choose the certain outcome. A risk premium must be offered to entice the person to choose the risky alternative.

Throughout this chapter, we focus primarily on how managers might use the economic view to analyze and influence the behavior of employees. As we will see, the economic view is quite powerful and is useful in explaining behavior in a variety of different contexts.

Chapter 3

Markets, Organizations, and the Role of Knowledge There are many different ways of organizing economic activities. Economists focus on Pareto efficiency in evaluating the effectiveness of alternative economic systems. An allocation is Pareto-efficient if there is no alternative that keeps all individuals at least as well off but makes at least one person better off. Pareto-improving changes in a resource allocation are viewed as welfare-increasing.

An important feature of a market economy is the use of private property rights. A property right is a legally enforced right to select the uses of an economic good. A property right is private when it is assigned to a specific person. Private property rights are alienable in that they can be transferred (sold or gifted) to other individuals.

In free markets, property rights frequently are exchanged. Trade occurs because it is mutually advantageous. The buyer values the good more than the seller, and there are gains from trade. Trade is an important form of value creation. Trading produces value that makes individuals better off. Gains from trade also motivate the movement of resources to more productive users. Total output and standards of living often increase when individuals specialize in production activities for which they have a comparative advantage (lower opportunity costs).

Prices coordinate the individual actions in a market economy. If too little of a good is being produced, inventories will shrink, prices will rise, and producers will have incentives to increase output to exploit the profit opportunity. If too much of a good is being produced, prices will fall, inventories will build, and producers will have incentives to cut production. The market is in equilibrium when the quantity supplied of a product equals the quantity demanded. There are strong pressures in competitive economies that move the market toward equilibrium. In equilibrium, there are no shortages or surpluses and inventories are stable at their desired levels. Equilibrium prices and quantities change with changes in the supply and demand for products.

Consumer surplus and producer surplus are measures of the gains from trade to consumers and producers from participating in a market. Government-imposed price caps or floors result in market imbalances and lost surplus (in an otherwise well-functioning market).

Externalities exist when the actions of one party affect the consumption or production possibilities of another party outside an exchange relationship. Externalities can cause markets to fail to produce an efficient resource allocation. Competitive markets will produce a Pareto-efficient allocation of resources if the costs of making mutually advantageous trades are sufficiently low. The Coase Theorem indicates that the ultimate resource allocation will be efficient, regardless of the initial assignment of property rights, as long as contracting costs are sufficiently low and property rights are clearly assigned, well enforced, and readily exchangeable.

General knowledge is inexpensive to transfer, whereas specific knowledge is expensive to transfer. Specific knowledge is quite important in economic decisions. Central planning often fails because important specific knowledge is not incorporated in the planning process. Within market systems, economic decisions are decentralized to individuals with the relevant specific knowledge. Prices convey general knowledge that coordinates the decisions of individuals. Private property rights provide important incentives to individuals to act productively, since they bear the wealth effects of their decisions.

In principle, all economic activity could be conducted through market transactions. However, even in market economies, much economic activity occurs within firms, where administrative decisions rather than market prices are used to allocate resources. Firms exist because of the contracting costs of using markets. However, organizing transactions within firms also involves costs. Individuals have incentives to organize transactions in the most efficient manner—to increase the gains from trade. Economic activities tend to be organized within firms when the cost is lower than that of using markets, and vice versa.

This chapter provides important background information on both markets and organizations. In Part 2, we shall extend the analysis of markets and study important managerial decisions such as output, inputs, pricing, and strategy. In these next six chapters, we assume that managers strive to maximize firm profits. In the remainder of the book, we shall extend the analysis of organizations and cover a variety of important topics about organizational design. A reader interested primarily in organizational design can move directly to Chapter 10 without loss of continuity.

Chapter 4

Demand Understanding product demand is critical for many managerial decisions such as pricing, setting production levels, undertaking capital investment, and establishing an advertising budget. This chapter provides a basic analysis of demand.

A demand function is a mathematical representation of the relations among the quantity demanded of a product over a specified time period and the various factors that influence this quantity. We focus on three independent variables in the demand function: the price of the product, the prices of related products, and customers' incomes.

A demand curve for a product displays how many units will be purchased over a given period at each price holding all other factors fixed. Movements along a demand curve reflect changes in price and are called changes in the quantity demanded. Movements of the entire demand curve are caused by other factors, such as changes in income, and are referred to as changes in demand.

Demand curves generally slope downward to the right: Quantity demanded varies inversely with price. This relation often is referred to as the law of demand. Demand curves vary in their sensitivities of the quantity demanded to price. Price elasticity is defined as the percentage change in quantity demanded from a percentage change in price (expressed as a positive number). The price elasticity tends to be high when there are close substitutes for the product and when the good represents a significant expenditure for the consumer. Demand tends to be more elastic over the long run than over the short run. How total revenue from a product changes with price depends on the price elasticity. A small price increase results in an increase in expenditures when demand is inelastic and a decrease in expenditures when demand is elastic. Total expenditures remain unchanged when the demand elasticity is unitary.

An important concept in economics is marginal revenue, which is defined as the change in total revenue given a one-unit change in quantity. Marginal revenue for a linear demand curve is given by the line with the same intercept as the demand curve but with twice the negative slope. Total revenue increases with quantity when marginal revenue is positive and decreases with quantity when marginal revenue is negative.

The price of related products can affect the demand for a product. Goods that compete with each other are referred to as substitutes. Products that tend to be consumed together are complements. One frequently used measure of substitution between two products is the cross elasticity of demand. The cross elasticity is positive for substitutes and negative for complements.

Another factor that can affect the demand for a product is the income of potential buyers. The sensitivity of demand to income is measured by the income elasticity. The income elasticity is positive for normal goods, and negative for inferior goods.

Demand curves can be defined for individual firms or entire industries. The price elasticities for individual firms within an industry are generally higher than for the industry as a whole. Cross elasticities can be helpful in defining the appropriate industry.

For some products, demand increases with the number of users. For example, fax machines and telephones are not very useful unless there is a network of users. Products where these network concerns are important often have relatively elastic demands. When price is lowered, there is both a standard price effect and a network effect.

The standard economic analysis of demand takes the attributes of the product as given. Information about consumer demand, however, is also important in the initial design of products. Parts 3 and 4 of this book provide important insights into how to design the firm's organizational architecture to help ensure that this type of information is incorporated in the decision-making process.

Managers use three basic approaches to estimate demand: interviews, price experimentation, and statistical analysis. All three approaches can suffer from potentially serious problems. Managers have to do the best they can given imperfect information and limited resources. Knowledge of the potential pitfalls can make managers more intelligent producers and users of demand estimates.

Chapter 5

Production and Cost A production function is a descriptive relation that connects inputs with outputs. It specifies the maximum possible output that can be produced for given amounts of inputs. Returns to scale refers to the relation between output and a proportional variation in all inputs taken together. A production function displays constant returns to scale when a 1 percent change in all inputs results in a 1 percent change in output. With increasing returns to scale, a 1 percent change in all inputs results in a greater than 1 percent change in output. Finally, with decreasing returns to scale, a 1 percent change in all inputs results in a less than 1 percent change in output. Returns to a factor refers to the relation between output and the variation in only one input, holding other inputs fixed. Returns to a factor can be expressed as total, marginal, or average quantities. The law of diminishing returns states that the marginal product of a variable factor will eventually decline as the use of the input is increased.

Most production functions allow some substitution of inputs. An isoquant displays all combinations of inputs that produce the same quantity of output. The optimal input mix to produce any given output depends on the costs of the inputs. An isocost line displays all combinations of inputs that cost the same. Cost minimization for a given output occurs where the isoquant is tangent to the isocost line. Changes in input prices change the slope of the isocost line and the point of tangency. When the price of an input increases, the firm will reduce its use of this input and increase its use of other inputs (substitution effect).

Cost curves can be derived from the isoquant/isocost analysis. The total cost curve depicts the relation between total costs and output. Marginal cost is the change in total cost associated with a one-unit change in output. Average cost is total cost divided by total output. Average cost falls when marginal cost is below average cost; average cost rises when marginal cost is above average cost. Average and marginal costs are equal when average cost is at a minimum. There is a direct link between the production function and cost curves. Holding input prices constant, the slopes of cost curves are determined by the underlying production technology.

Opportunity cost is the value of a resource in its next best alternative use. Current market prices more closely reflect the opportunity costs of inputs than historical costs. The relevant costs for managerial decision making are the opportunity costs.

Cost curves can be depicted for both the short run and the long run. The short run is the operating period during which at least one input (typically capital) is fixed in supply. During this period, fixed costs can be incurred even if the firm produces no output. In the long run, there are no fixed costs—all inputs and costs are variable. Short-run cost curves are sometimes called operating curves because they are used in making near-term production and pricing decisions. Fixed costs are irrelevant for these decisions. Long run cost curves are referred to as planning curves, since they play a key role in longer-run planning decisions relating to plant size and equipment acquisitions.

The minimum efficient scale is defined as that plant size at which long-run average cost is first minimized. The minimum efficient scale affects both the optimal plant size and the level of potential competition. Industries where the average cost declines over a broad range of output are characterized as having economies of scale.

A learning curve displays the relation between average cost and the cumulative volume of production. For some firms, the long-run average cost for producing a given level of output declines as the firm gains experience from producing the output (that is, there are significant learning effects).

Economies of scope exist when the cost of producing a joint set of products in one firm is less than the cost of producing the products separately across independent firms. Economies of scope help explain why firms often produce multiple products.

The profit-maximizing output level occurs at the point where marginal revenue equals marginal cost. At this point, the marginal benefits of increasing output are offset exactly by the marginal costs.

The marginal revenue product of input i (MRPi) equals the marginal product of the input times marginal revenue. Profit-maximizing firms use an input up to the point where the MRP of the input equals the input price. At this point, the marginal benefit of employing more of the input is offset exactly by its marginal cost.

Managers often use estimates of cost curves in decision making. A common statistical tool for estimating these curves is regression analysis. One common problem in statistical estimation is the difficulty of obtaining good information on the opportunity costs of resources. Another problem with estimating cost curves involves allocating fixed costs in a multiproduct plant. Cost accountants track the costs and estimate product costs.

Chapter 6

Market Structure A market consists of all firms and individuals who are willing and able to buy or sell a particular product. These parties include those currently engaged in buying and selling the product, as well as potential entrants. Market structure refers to the basic characteristics of the market environment, including (1) the number and size of buyers, sellers, and potential entrants; (2) the degree of product differentiation; (3) the amount and cost of information about product price and quality; and (4) the conditions for entry and exit.

Competitive markets are characterized by four basic conditions: A large number of potential buyers and sellers; product homogeneity; rapid, low-cost dissemination of information; and free entry into and exit from the market. In competitive markets, individual buyers and sellers take the market price of the product as given: They have no control over price. Firms thus view their demand curves as horizontal. The firm's short run supply curve is that portion of its short-run marginal cost curve above short-run average variable cost. The long-run supply curve is that portion of its long-run marginal cost curve above long-run average cost. In a competitive equilibrium, firms make no economic profits. Production is efficient in that firms produce at their minimum long run average cost. Firms in competitive industries must move rapidly to take advantage of transitory opportunities. They also must strive for efficient production in order to survive. Some firms in the industry can employ resources that give them a competitive advantage (for example, an extremely talented manager). Yet in such cases, any excess returns often go to the factor of production responsible for the particular advantage, rather than to the firm's owners.

Although the competitive model provides a useful description of the interaction between buyers and sellers for many industries, there are others where firms have substantial market power—prices are affected materially by the output decisions of individual firms. Market power can exist when there are substantial barriers to entry into the industry. Expectations about incumbent reactions, incumbent advantages, and exit costs all can serve as entry barriers.

The extreme case of a firm with market power is monopoly, where the industry consists of only one firm. Here, industry and firm demand curves are one and the same. In contrast to competitive markets, consumers pay more than marginal cost and the firm earns economic profits. Output is restricted from competitive levels. With a monopoly, not all the potential gains from trade are exhausted.

Monopolistic competition is a hybrid between competition and monopoly. It is like monopoly in that firms under both market structures face downward-sloping demand curves. Market power comes from differentiated products. Examples include the toothpaste, golf ball, tennis racket, and shampoo markets. The analyses of output and pricing policies are similar in the two cases. The difference between monopoly and monopolistic competition is that in monopolistic competition, economic profits invite entry that limits profits.

In oligopolistic markets, only a few firms account for most production. Products may or may not be differentiated. Firms can earn substantial profits. However, these profits can be eliminated through competition among existing firms in the industry. To analyze output and pricing decisions in oligopolistic industries, we use the concept of a Nash equilibrium: A Nash equilibrium exists when each firm is doing the best it can be given the actions of its rivals. In the Cournot model, each firm treats the output level of its competitor as fixed and then decides how much to produce. In equilibrium, firms make economic profits. However, these profits are not as large as would be made if the firms effectively colluded and posted the monopoly price. Other models of oligopoly yield different equilibria. For instance, one model based on price competition yields the competitive solution: Price equals marginal cost with no economic profits. Economic theory makes no clear-cut prediction about the behavior of firms in oligopolistic industries. Available evidence suggests that in some oligopolistic industries, firms restrict output from competitive levels and hence capture some economic profits.

It is in the economic interests of firms in oligopolistic industries to find ways to cooperate, thereby capturing higher profits. Even when firms are free to cooperate, effective cooperation is not always easy to achieve. Individual firms have incentives to deviate from agreed-on outputs and prices. This incentive is illustrated by the prisoners' dilemma. This model highlights incentives that can cause cartels to be unstable. However, firms sometimes can cooperate successfully when they can impose penalties on non-cooperative firms. Cooperation also can be sustained through the incentives provided by long-run, repeated relationships.

Chapter 7

Pricing with Market Power A firm has market power when it faces a downward-sloping demand curve. Firms with market power can raise price without losing all customers to competitors. The ultimate objective is to choose a pricing policy that maximizes the value of the firm. Consumer surplus is defined as the difference between what the consumer is willing to pay for a product and what the consumer actually pays when buying it. Managers, in maximizing profits, try to devise a pricing policy that captures as much of the gains from trade as possible. Thus, they try to capture potential consumer surplus as company profit.

In the benchmark case, the firm chooses a single per-unit price for all customers. Profits are maximized at the price and output level where marginal revenue equals marginal cost. Fixed and sunk costs are irrelevant; only incremental costs matter in the pricing decision. The optimal price markup over marginal cost depends on the elasticity of demand. The optimal markup decreases as demand becomes more elastic: It is optimal to charge high prices when customers are not very price-sensitive.

Economic theory suggests that managers should price so that marginal revenue equals marginal cost. One practical problem in applying this principle is that managers often do not have precise information about their demand curves and thus their marginal revenue (Chapter 4 discusses methods of estimating demand). The linear approximation technique can be used when the demand curve is roughly linear and the manager has basic information about current price-quantity, price sensitivity, and marginal cost. Markup pricing is a technique that managers can use when they have limited information and reason to believe that price elasticity varies little across the demand curve. One of the most common pricing methods used by firms is cost-plus pricing. Managers using this technique calculate average total cost and mark up the price to yield a desired rate of return. Cost-plus pricing appears inconsistent with profit maximization since it includes fixed and sunk costs and does not consider consumer demand explicitly. Managers, however, can consider consumer demand implicitly by choosing appropriate target returns (lower target returns are chosen when demand is more elastic). The widespread use of this pricing policy suggests that it can be a useful rule of thumb in some settings.

The benchmark policy charges the same price to all customers independent of the quantity purchased. Sometimes a firm can do better with more complicated pricing policies. With block pricing a high price is charged for the first block and declining prices for subsequent blocks. Block pricing either can be used to extract additional profits from a set of customers with similar demands or can be used to price-discriminate. With a two-part tariff, the customer pays an up-front fee for the right to buy the product and then pays additional fees for each unit of the product consumed. Two-part tariffs tend to work best when customer demand is relatively homogeneous.

Price discrimination occurs whenever a firm charges differential prices across customers that are not related to differences in production and distribution costs. With price discrimination, the markup or profit margin realized varies across customers. Two conditions are necessary for profitable price discrimination. First, different price elasticities of demand must exist in various submarkets for the product (customers must be heterogeneous). Second, the firm must be able to identify submarkets and restrict transfers among consumers across different submarkets.

Personalized pricing extracts the maximum amount each customer is willing to pay for the product. Each consumer is charged a price that makes him or her indifferent between purchasing and not purchasing the product. Group pricing results when a firm separates its customers into several groups and sets a different price for each group. A firm that can segment its market maximizes profits by setting marginal revenue equal to marginal cost in each market segment (higher prices are charged to the less price-sensitive groups). Both personalized and group pricing require relatively good information about individual customer demands.

Even if the manager does not have detailed information about individual demands, price discrimination still is possible with sufficient information about the distribution of individual demands. With menu pricing all potential customers are given the same menu of options. The classic example involves block pricing, where the price per unit depends on the quantity purchased. Customers use their private information to select the best option for them. By carefully constructing the menu of options, the firm makes more profits than if it simply offered the product at one price to all potential customers.

Coupons and rebates offer price discounts to customers. Price discrimination is one reason why firms use coupons and rebates to make price discounts rather than simply lowering the price. Price-sensitive customers are more likely to use coupons and rebates—and thus are charged lower effective prices—than customers who are less price-sensitive. Similar to menu pricing, customers self-select, depending on private information about their personal characteristics. Coupon and rebate programs are expensive to administer. These costs have to be compared to the benefits in deciding whether to adopt such a program.

Firms frequently bundle products for sale. One reason for bundling products is to extract additional profits from a customer base with heterogeneous product demands. Bundling can be more profitable than selling the products separately when the relative values that the customers place on the individual products vary.

This chapter focuses on a single-period pricing problem, in which managers face a fixed demand curve and cost structure. The prices of competing products are held constant. In some situations, concerns about future demand and costs, as well as the reactions of competitors, can motivate managers to choose pricing policies that would not be appropriate in the simple single-period analysis. Chapter 9 addresses issues of strategic interaction in greater detail.

Chapter 8

Economics of Strategy: Creating and Capturing Value Strategy refers to the general policies that managers employ to generate value. Rather than focus on operational detail, a firm's strategy addresses broad, long-term issues facing the firm. Ultimately, along with its organizational architecture (to be discussed in Part 3), strategy is a key determinant of the success or failure of the enterprise.

The ultimate objective of strategic decision making is to realize sustained profits. To achieve this objective, managers must devise ways to create and capture value. An essential first step in generating profits is discovering ways to create value. There are at least four general ways that managers can increase value: (1) They can take actions to lower production costs or producer transaction costs. (2) Managers can implement policies to reduce consumer transaction costs. (3) They can adopt strategies to increase demand. Demand might be increased by taking actions to increase perceived quality, lower the price of complements, or increase the price of substitutes. (4) They can devise new products or services. Sometimes more value is created by cooperating with firms than by competing against them. Successful firms find ways to convert ideas and knowledge in their employees' wetware into software—formulas and recipes for creating value.

The discovery of better ways to use existing resources drives much of the value that firms create. For example, the value created by improved computer technology has not come from the discovery of new raw materials or resources, but by using existing resources more efficiently. Firms face an essentially unlimited set of opportunities to create better "instructions, formulas, recipes, and methods" for making improved products at lower cost. New opportunities are likely to emerge as technology continues to evolve.

Creating value is a necessary first step in making profits. It is also necessary to capture value. A firm may have reduced its transaction/production costs or increased its consumer demand, but if other firms copy these changes quickly and enter the market, the competition will eliminate the profits. Chapter 6 indicates that the potential for firms to capture value increases with market power. Sometimes it also is possible to capture value without market power if the firm has superior factors of production that allow it to be more productive than competitors.

The existence of effective entry barriers is required for market power. Entry barriers exist when it is difficult or uneconomic for a would-be entrant to replicate the position of industry incumbents. The existence of barriers, however, is no guarantee of market power or economic profits. At least four other factors are important: The degree of rivalry within the industry, threat of substitutes, buyer power, and supplier power.

Both human as well as physical assets vary in productivity. If an asset allows the firm to make a profit because of its superior productivity, other firms will compete for this resource and bid up its price. Thus, in a well-functioning market, gains from superior productivity go to the responsible asset. For example, if a firm owns a unique piece of equipment, its price will be bid up to reflect its superior productivity. The firm itself does not always have to use such assets to realize its values. It might earn more profits by selling or leasing the assets to other firms.

Competition tends to take a differentiated asset to its highest valued use, but at a market price that reflects its second-highest valued use. Because of the interdependencies among employees and assets, the value of the inputs as a team sometimes can be greater than the sum of their values if each were employed at their next best uses across other firms. Thus, it is possible that the overall firm will be more valuable than the sum of its parts. We characterize such a firm as having team production capabilities. A firm can maintain team production advantages only when competing firms cannot assemble teams that are equally productive. Firms develop different team capabilities because they have different histories and development paths.

The business environment is constantly evolving with new technological developments, changes in consumer tastes, new business concepts, new firms, and so on. Given these changes, it is unlikely that any competitive advantage will last forever. Some firms concentrate on a single major business, but many large firms engage in multiple businesses: They are at least partially diversified. Economies of scope provide the primary reason why diversification might enhance value. In addition, combining businesses in the same firm can promote complementary products. Although diversification has potential benefits, it also has potential costs. As firms grow, they often become bureaucratic and more costly to manage. If diversification occurs through the merger of two firms (as often is the case) it also can be quite expensive to develop common personnel, communication, information, and operating systems.

Some managers diversify to reduce earnings volatility. This often is a poor reason to diversify because shareholders can diversify on their own account simply by owning the shares of multiple companies. Related diversification occurs when the businesses use related technologies or serve common markets. The net benefits are likely to be greater in related rather than in unrelated diversification. For the most part, highly diversified firms have not performed well. Diversification has been most effective in the case of related diversification where there are potential economies of scope and opportunities to promote complements. Even if diversification creates value, the owners of the diversified firm do not always capture this value. Again, it depends on whether the firm brings some special resource or team capability to the transaction. Historically, most of the gains in corporate acquisitions go to the shareholders of target firms.

Developing and implementing strategies that increase a firm's value require an understanding of both the internal resources and capabilities of the firm and the external business environment. A firm's resources and capabilities include its physical, human, and organizational capital. Important factors in the business environment include the firm’s markets (input and output), technology (production, information, and communications), and government regulation. Managers monitor the external environment to identify threats and opportunities for creating and capturing value.

Most resources and capabilities are finite—choices have to be made. To make optimal choices, managers must consider the firm's resources and capabilities jointly, as well as threats and opportunities within the external business environment. Ultimately, the firm's strategy, along with its organizational architecture, is a key determinant of a firm's value.

Strategy consultants often suggest that all firms can develop strategies that deliver systematic economic profits even if they do not begin with unique resources or team capabilities. Basic economics suggests that this claim is false. Even if a manager were good at predicting the future and seeing what resources and capabilities were important, abnormal profits would not be earned on a systematic basis so long as a sufficient number of other managers adopt the same strategies. If multiple managers adopt the same strategy, there will be competition in the output markets as well as in input markets to obtain the necessary resources and capabilities. As in any competitive market, the expected equilibrium outcome is a normal rate of return—not sustained abnormal performance. Firms whose resources and capabilities do not fit the changed environment will not expect to earn a normal rate of return; they should prepare to go out of business.

Chapter 9

Economics of Strategy: Game Theory Game theory is concerned with the general analysis of strategic interaction. It focuses on optimal decision making when all decision makers are presumed to be rational, with each attempting to anticipate the likely actions and reactions of its rivals. These techniques can be employed to study a wide variety of phenomena ranging from parlor games to politics and competitive strategy. In this chapter, we introduce the basic elements of this theory in the context of managerial decision making.

In simultaneous-move problems, firms must make decisions without knowledge of the decisions made by their rivals. Non-repeated means that the game is played only once. We diagram these interactions by showing the payoffs in strategic (normal) form.

A dominant strategy exists when it is optimal for the firm to choose a particular strategy no matter what its rival does. A firm should employ a dominant strategy if one exists.

Firms do not always have dominant strategies. When dominant strategies do not exist, we employ the concept of a Nash equilibrium to predict the outcome of the interaction. A Nash equilibrium is a set of strategies (or actions) in which each firm is doing the best it can, given the actions of its rival. A problem can have multiple Nash equilibria. Nash equilibria are not necessarily the outcomes that maximize the joint payoff of the firms. The circle technique provides a simple method to identify Nash equilibria.

The power of a Nash equilibrium to predict the outcomes of strategic interactions stems from the fact that Nash equilibria are self-enforcing—they are stable outcomes. In many cases it is reasonable to expect that a Nash equilibrium will occur. This is particularly true when the firms have experience with similar problems, when they have information about each other, or when the Nash equilibrium outcome is a natural "focal point."

Some interactions are competitive—at least one of the firms has an incentive to take actions that benefit them at the expense of their rival. Other strategic situations involve coordination rather than competition. Some interactions have elements of both.

When a firm chooses one specific strategy or action, it is called a pure strategy. Sometimes it can pay to randomize—to use a mixed strategy. The benefit of a mixed strategy comes from the element of surprise; sometimes a firm is at a disadvantage if it is too predictable.

In many business situations, managers make decisions sequentially. Sequential interactions are pictured in extensive form. The extensive form displays the sequence of actions and corresponding outcomes. A node indicates a point at which a party must choose an action, and the branches leading from a node display the possible choices at the node. We solve the extensive form by backward induction—looking forward to the final decision nodes and reasoning backward.

In some interactions it is advantageous to move first: There is a first-mover advantage. In other cases it is better to move second.

Strategic moves are taken to influence the beliefs or actions of the rival in favorable ways. Typically, strategic moves involve a firm restricting its own future actions. For strategic moves to work, they must be credible. For a strategic move to be credible, it must include a commitment sufficient to convince its rival to change its beliefs.

Chapter 10

Incentive Conflicts and Contracts

Treating a firm as if it were an individual decision maker who maximizes profits is a useful abstraction in some contexts. For example, this characterization has been used in previous chapters in analyzing output and pricing decisions. But to analyze organizational issues within the firm requires a richer definition. A particularly useful definition for our purposes is that the firm is a focal point for a set of contracts.

Since individuals are creative maximizers of their own well-being, there are likely to be incentive conflicts among the parties that contract with the firm. Examples include owner-manager, buyer-supplier, and free-rider conflicts. Contracts (explicit and implicit) specify a firm's organizational architecture (its decision right, performance evaluation, and reward systems). This architecture establishes a set of constraints and incentives that can reduce the costs of incentive conflicts. Contracts are unlikely to resolve incentive problems completely because they are costly to negotiate, administer, and enforce. Asymmetric information causes particularly important problems.

An agency relationship consists of an agreement under which one party, the principal, engages another party, the agent, to perform some service on behalf of the principal. Many agency relationships exist within firms. Agents do not act in the best interests of principals automatically—there are incentive problems.

Asymmetric information usually implies that incentive problems cannot be resolved costlessly by contracts. The principal usually can limit the divergence of interests by structuring the contract to establish appropriate incentives for the agent and by incurring monitoring costs aimed at limiting dysfunctional activities by the agent. Also, agents might incur bonding costs to help guarantee that they will not take certain actions or to ensure that the principal will be compensated if they do. Generally, it does not pay to resolve incentive conflicts completely. The dollar equivalent of the loss in the gains from trade that results due to the divergence of interests in the agency relationship is known as the residual loss. Total agency costs are the sum of the out-of-pocket costs (monitoring and bonding costs) and the opportunity cost of the residual loss.

Precontractual informational asymmetries can cause breakdowns in bargaining and adverse selection. Adverse selection refers to the tendency of individuals, with private information about something that affects a potential trading partner's costs or benefits, to make offers that are detrimental to the trading partner. Costs of adverse selection reduce the gains from trade and can cause market failures. Precontractual information problems can be mitigated by information collection, clever contract design, credible communication, and mechanisms such as warranties.

Many of the contracts within firms are implicit contracts rather than formal legal documents. Implicit contracts are difficult to enforce in a court of law and depend largely on the private incentives of individuals for enforcement. Reputational concerns can provide incentives to honor implicit contracts. These concerns are more likely to be effective when (1) the gains from cheating are smaller, (2) the likelihood of detecting cheating is higher, and (3) the expected sanctions imposed if cheating is detected are higher. It sometimes is possible to structure organizations in ways that increase the likelihood that reputational concerns will be more effective in encouraging individuals to behave with integrity.

Parties to a contract have incentives to resolve contracting problems in the least costly manner. By so doing, there are additional gains from trade to share among the parties. Viewing observed contracts as efficient responses to the particular contracting problem provides a powerful tool for explaining organizational architecture.

Chapter 11 Organizational Architecture

Organizational architecture includes three important components of organizational design that are major determinants of the success or failure of firms:

· The assignment of decision rights

· The methods of rewarding individuals

· The structure of systems to evaluate the performance of both individuals and business units

The fundamental problem facing both firms and economic systems involves trying to ensure that decision makers have the relevant information to make good decisions and that these decision makers have appropriate incentives to use their information productively. The price system provides an architecture that helps solve this problem in markets. Through market transactions, decision rights tend to be transferred to individuals with the relevant knowledge to make productive use of the resources. The market also provides a mechanism for evaluating and rewarding the performance of resource owners—owners bear the wealth effects of their actions. A valuable feature of markets is that this architecture is created spontaneously with little conscious thought or human direction.

Markets are not always the most efficient method for organizing economic activity—frequently, firms are more efficient. Within firms, there is no automatic system for either assigning decision rights to individuals with information or motivating individuals to use information to promote the firm's objectives. Organizational architecture has to be created. The appropriate architecture depends on the environment facing the firm. In some firms, senior management will have most of the relevant information for decision making, and relatively centralized decision making is more likely to be adopted. In firms where lower-level employees have the relevant information, decision rights are more likely to be decentralized. In this case, reward and performance-evaluation systems must be developed to control incentive problems and to promote better decision making.

Market conditions, technology, and government regulations interact to determine the firm's appropriate strategy and architecture. The strategy and architecture, in turn, are major determinants of the firm's value.

Changes in the external business environment can motivate changes in the firm's organizational architecture. Changing architecture, however, is costly. In addition to the direct costs of designing and implementing new procedures, there are potentially important indirect costs. Thus, changing architecture should be done only following careful analysis.

The components of organizational architecture are highly interdependent. They are like three legs of a stool. Changing one leg without careful attention to the others is usually a mistake. Organizational structure also is related to other policies and systems within a firm, including the accounting and information systems, marketing, and financial policy.

Corporate culture is a frequently used term. Corporate culture usually is meant to encompass the ways work and authority are organized and the ways people are rewarded and controlled, as well as organizational features such as customs, taboos, company slogans, heroes, and social rituals. Our focus on organizational architecture is consistent with this concept of corporate culture. Indeed, our definition of organizational architecture corresponds to key aspects of what is frequently defined as corporate culture. The advantage of our approach is that it defines the key components of corporate culture and analyzes how managers might affect culture through conscious action. It also helps explain why corporate cultures of firms vary systematically across industries—different environments motivate different architectures. Elements of corporate culture like customs, social rituals, folklore, and heroes perform at least two important roles: enhancing communication and fostering more productive expectations among employees. These elements, however, are likely to be less effective unless they are reinforced by the formal architecture of the firm.

Sometimes, managers are unable or unwilling to adopt value-maximizing architectures or strategies. In such cases, value can be created through management replacement. Management replacement occurs through firings and corporate takeovers. If a firm remains inefficient, it eventually will go out of business in a competitive marketplace.

This chapter introduces the concept of organizational architecture and provides a broad overview of the factors that are likely to be important in determining the optimal architecture for a particular organization. The next six chapters contain a more in-depth discussion of each of the three components of organizational architecture: the assignment of decision rights, the reward system, and the performance-evaluation system.

Chapter 12

Decision Rights: The Level of Empowerment

Firms transform inputs into outputs, which are sold to customers. An important element of organizations is partitioning the totality of tasks of the organization into smaller blocks and assigning them to individuals and/or groups within the firm. Through the design process, jobs are created. Jobs have at least two important dimensions: variety of tasks and decision authority. This chapter focuses on decision authority. The next chapter focuses on the bundling of tasks.

In centralized decision systems, most major decisions are made by individuals at the top of the organization. In decentralized systems, many decisions are made by lower-level employees. Decentralized decision making has both benefits and costs. Potential benefits include more effective use of local knowledge, conservation of senior management time, and training/motivation for lower-level managers. Potential costs include contracting and coordination costs and less effective use of central information. The optimal degree of decentralization depends on the incremental benefits and costs, which vary across firms and over time. There has been a recent trend toward greater decentralization, motivated in part by increased global competition and changes in technology.

Decision rights are not assigned just to a hierarchical level but to particular positions within the hierarchical level. Similar to the centralization versus decentralization problem, relevant factors in making this horizontal choice include the distribution of knowledge and the costs of coordination and control.

Sometimes, firms assign decision rights to teams of employees rather than to specific individuals. Firms assign decision rights to teams for at least three basic purposes: managing activities, recommending actions, and making products. The use of team decision making sometimes can increase productivity; but this is not always the case. Team decision making is most likely to be productive when the relevant information is dispersed and the costs of collective decision making and controlling free-rider problems are low.

Decision management refers to the initiation and implementation of decisions, whereas decision control refers to the ratification and monitoring of decisions. When individuals do not bear the major wealth effects of their decisions, it generally is important to separate decision management from decision control. This principle helps explain the presence of hierarchies in most organizations. It also can help make the concept of empowerment more precise.

Sometimes, firms adopt rules that limit the discretion of decision makers; for example, airlines assign routes to flight attendants based on seniority. One benefit of limiting discretion is that it reduces incentives of individuals to engage in excessive influencing activities. Some influencing activity is valuable in that it produces information that improves decision making. Firms are, therefore, most likely to limit discretion when the firm's profits are not very sensitive to the decisions, yet the decisions are of considerable concern to employees.

Chapter 13

Decision Rights: Bundling Tasks into Jobs and Subunits The bundling of tasks into jobs and subunits of the firm is an important policy choice that can affect a firm's productivity dramatically. The primary purpose of this chapter is to examine this bundling decision.

We distinguish between two types of jobs: those with specialized task assignment and those with broad task assignment. With specialized task assignment, the employee is assigned a narrow set of tasks concentrated within one functional specialty—for example, sales. With broad task assignment, the employee is assigned a broader variety of tasks. The benefits of specialized task assignment relative to broad assignment include exploiting comparative advantage and lower cross-training expenses. The costs of specialized task assignment include forgone complementarities from not performing multiple functions, coordination costs, functional myopia, and reduced flexibility. Incentive issues might favor either specialized or broad task assignment, depending on the production technology and information flows. The appropriate bundling of tasks depends on the magnitude of the costs and benefits of each alternative. One variable that is likely to be of particular importance is the relative degree of complementarity among tasks within, versus across, functional areas. Specialized task assignment is favored when the complementarity of tasks within a functional area is relatively high.

Firms can group jobs into subunits based on functional specialty, geography, product, or some combination of the three. Functional subunits group all jobs performing the same function within one department (for example, a sales department). Senior management plays a major role in coordinating these departments and in making operating decisions. Benefits of functional organization are the promotion of coordination and expertise within functional areas and provision of a well-defined promotion path for employees. Problems with functional organization include the high opportunity cost of employing senior management time to coordinate departments and make operating decisions, handoffs across departments that can take significant time, coordination failures across departments, and employees concentrating on their own functional specialties rather than on the customer. Functional subunits are likely to work best in smaller firms with a limited number of products operating in relatively stable environments.

Larger, more diverse firms often find it desirable to form subunits based on product or geography. In the multidivisional (M form) firm, operating decisions are decentralized to the business-unit level. Senior management of the firm is responsible for major strategic decisions, including finding the optimal organizational architecture and allocating capital among business units. A primary benefit of the M form corporation is that decision rights for operations are assigned to individuals lower in the organization where relevant specific knowledge often is located. Managers of business units are compensated based on the performance of their units so as to provide incentives to use this specific knowledge productively. Decentralizing decision rights to business-unit managers also frees senior executives to concentrate on other issues. Problems with the M form of organization arise because business-unit managers often have incentives to take actions that increase the performance of their business units at the expense of other units within the firm. These problems can be controlled through careful design of business units and by basing a component of business- unit managers' compensation on group performance—where the group consists of profit centers with interrelated costs and demands. It is usually difficult, however, to control this problem completely. Multidivisional firms also forgo potential economies that might result from combining similar functional specialists within one unit.

Some firms maintain an overlapping structure of functional and product or geographic subunits. These matrix organizations have functional departments such as finance and marketing. Members of these departments are assigned to cross-functional product teams (subunits). Team members report to both a product manager and a functional supervisor. Generally, performance evaluation is conducted by the functional supervisor. Matrix organizations are common in project-oriented industries such as defense, construction, and consulting. An advantage of a matrix organization, in contrast to a pure functional organization, is that individuals are more likely to focus on the overall business process rather than just on their own narrow functional specialty. Potential advantages over a pure product organization are that the functional departments help ensure functional excellence and provide more clearly identified opportunities for advancement and development. Potential problems with the matrix organization arise from the intersecting lines of authority. An employee is likely to have loyalties divided between the goals of the project team and the goals of the functional department. This problem can be mitigated by appropriate design of the performance-evaluation and reward systems. However, as we shall see in subsequent chapters, accomplishing this objective can be difficult.

Firms often use more than one method for organizing subunits. They also use other less standard ways of organizing subunits. One example is a network organization.

Decisions on how to group jobs must be made at many levels in the organization. Our analysis of the costs and benefits of alternative groupings of jobs focuses on the overall firm level—how to form major subunits. This same basic analysis applies to the grouping of jobs at lower levels within the firm.

Historically, many firms have created jobs that are low in decision authority and narrow in task assignment. Recently, there has been a trend toward granting employees more decision authority and broader task assignments. Many companies also have shifted away from functional subunits toward more product-oriented organizations. These trends can be explained by specific technological changes and increases in global competition, along with accompanying changes in business strategies.

Chapter 14

Attracting and Retaining Qualified Employees

Chapters 12 and 13 discussed how firms assign decision rights. A second important component of organizational architecture is the reward system: Productive firms design compensation plans that attract and retain qualified employees and motivate them to exert effort and make decisions that exploit the business opportunities faced by the firm. This chapter examines how firms attract and retain qualified employees and how the level of pay can be used to motivate employees. The next chapter focuses on incentive compensation. In our benchmark model of wages and employment—patterned after the standard competitive model—firms have no discretion over the wages paid to employees; rather, wages are determined by supply and demand in the marketplace. If a firm pays too little, it will have difficulty attracting employees to job openings and will experience high turnover. A firm that pays too much will have numerous job applicants and low turnover. In addition, the firm will have high costs and will compete poorly in the product market.

Human capital is a term that characterizes individuals as having a set of skills that can be "rented" to employers. We distinguish between general and specific human capital: General human capital consists of training and education that is equally useful to many different firms; specific human capital is more valuable to the current employer than to alternative employers. In our benchmark model, employees would be expected to pay for their own general training, and employers would pay for specific training.

Our benchmark model does not consider differences in working conditions across jobs. Yet actual jobs vary in many dimensions, such as geographic location and the level of danger. Holding other factors constant, unpleasant jobs must pay a compensating differential to attract employees. Compensating differentials attract employees to unpleasant tasks; they also provide employers with direct financial incentives to enhance the work environment whenever it is cost-effective.

In some settings, it can be difficult to tell whether a firm is paying the market wage rate to employees. Important indicators are the application and quit rates and the nature of outside job offers made to existing employees.

Our benchmark model provides a good description of some labor markets, such as the market for unskilled agricultural workers. It is less useful in describing employment and wages in many other cases. Many firms are better characterized as establishing internal labor markets, where outside hiring is done primarily for entry-level jobs; most other jobs are filled from within the firm. Internal labor markets are characterized by long-term relationships between the employee and the firm. Long-term relationships can be beneficial because they provide both employers and employees incentives to invest in specific training, offer incentives for employees to work to exploit the business opportunities facing the firm, and allow firms to take greater advantage of information about employee attributes. One cost of using internal labor markets is that it sometimes is undesirable to limit the search to the firm's current employees, especially when filling higher-level positions.

Employees accepting jobs with firms that employ internal labor markets evaluate career earnings. Thus, firms with internal labor markets have more flexibility in setting the level and career profile of pay. Firms can vary compensation over the career path, so long as the overall remaining stream of earnings is competitive at each point in time relative to the streams offered by other firms within the same labor market. Economists have identified at least three ways in which firms can use their flexibility in setting the level and sequencing of pay to enhance employee motivation. These methods include the payment of efficiency wages, upward-sloping earnings profiles, and the tying of major pay increases to promotions. However, influence costs can affect the desirability of exploiting this potential flexibility. Firms might reduce the dispersion of pay among coworkers to limit influence costs.

The typical American employee receives about 25 percent of total compensation in the form of fringe benefits such as vacation time, insurance coverage, and contributions to retirement plans. Salary and fringe benefits are not perfect substitutes for most employees. Tax benefits and the fact that the company often can purchase fringe benefits more cheaply favor fringe benefits. The desire for flexibility in making purchases can favor cash payments. Employers have incentives to heed the preferences of employees when it comes to the choice between salary and fringe benefits. By responding to their preferences, firms can design compensation packages that attract and retain qualified employees at the lowest cost. Firms sometimes can use the salary–fringe benefit mix to attract particular types of employees. For example, offering liberal insurance coverage is more likely to attract people with families than single individuals, who are more likely to prefer cash payments. Firms also have incentives to heed employee preferences when it comes to choosing the mix of fringe benefits. This incentive has motivated many firms to consider cafeteria-style benefits. Use of these plans is limited due to administrative costs and adverse-selection problems.

Chapter 15

Incentive Compensation Incentive problems exist because of conflicts of interest between employers and employees. These problems are easily resolved when actions are costlessly observable. Firms can identify the most efficient actions by employees and pay employees only if these actions are taken. In most situations employee actions are not observable at low cost. Here, firms can motivate employees through incentive compensation.

In a competitive labor market, employees must be compensated for undertaking actions they find undesirable—there are compensating differentials. Thus, it is not sensible to have employees work as hard as possible. In eliciting particular actions, there is a trade-off between the benefits of the action for the firm and the personal costs to the employees.

Incentive problems arise because most of the costs of exerting effort are borne by employees, whereas most of the gains go to their employers. Sometimes, there is a simple way to resolve this incentive problem even when the actions of employees are unobservable. The solution is to sell each employee the rights to his or her total output. By selling employees their output, both the benefits and costs of exerting effort are internalized by employees and thus employees will make more productive choices. We observe this solution being approximated in private firms as well as in franchising. There are at least three important factors that limit the use of ownership in solving incentive problems: wealth constraints, team production, and costs of inefficient risk bearing.

Risk-averse individuals do not like to bear financial risks; they prefer income flows with less volatility. Risk-averse individuals can benefit from sharing risks because it lowers the volatility of the individual cash flows. People often vary in their attitudes toward risk. For instance, some people are more willing to tolerate financial risks than others. An efficient allocation of risk takes these differences in preferences into account. If one party is risk-neutral whereas another party is risk-averse, it is better to have the risk neutral party bear all the risk and the other party to receive a fixed payment.

Stockholders of firms often hold diversified portfolios; this is a powerful method for managing firm-specific risks. Employees, in contrast, have much of their human capital invested in a single firm and hence have fewer opportunities to manage risk through diversification. Thus, from a risk-sharing standpoint, it is better to pay employees more through fixed salaries and to let the risk of random income flows be borne more by the shareholders. Yet fixed salaries provide limited incentives for employees to exert effort: Therefore, there is a trade-off between optimal risk sharing and optimal incentives.

Economic analysis of incentive compensation begins with the basic principal-agent model. This model presents a relatively simple characterization of the contracting process. However, it illustrates the trade-offs between risk sharing and incentives and provides a number of useful insights for designing better compensation plans. In particular, the model suggests that firms should pay more performance-based pay when (1) the sensitivity of the value of output to additional effort by the employee is higher, (2) the employee is less risk-averse, (3) the level of risk that is beyond the employee's control is lower, (4) the employee response to increased incentives in terms of exerting additional effort is more pronounced, and (5) employee output is more easily measured.

According to the informativeness principle, it is useful to include all indicators that provide additional information about employee effort into the compensation contract— provided that these indicators are available at low cost. Including these indicators in the contract reduces the randomness of payouts and thus the costs of inefficient risk bearing. One important source of information about an employee's effort is the output of coworkers performing similar tasks. The informativeness principle suggests that it is useful to employ relative performance evaluation. In Chapter 16, however, we discuss several factors that can limit the desirability of relative performance evaluations.

In the basic principal-agent model, employees are motivated by basing compensation on their own output. But many firms base incentive pay on group performance. Common reasons offered for group incentive pay are that group performance can be less expensive to monitor than individual performance, group performance emphasizes teamwork, and group plans motivate employees to monitor one another's performance. Standard free-rider arguments provide a strong reason to question whether group plans provide effective incentives—particularly when the group is large. At least three factors might help explain the widespread popularity of these plans, even though free-riding is a potential problem. First, it can be beneficial to increase employee awareness of stock-price performance and profitability (assuming employees can be motivated to monitor these measures by relatively modest plans that do not impose much risk on employees). Second, employees might feel guilty from shirking and imposing costs on teammates who are compensated on group performance. These feelings might motivate employees, even if the direct financial consequences are small. Third, paying employees on firm performance sends a strong signal to employees about what is valued within the company. To be most effective, however, these signals must be reinforced by other parts of the organizational architecture that provide more direct incentives.

Most jobs involve a variety of tasks. Motivating an employee to strike the appropriate balance among tasks is not easy. A complicating factor is that some tasks are more easily measured than others. Compensating the employee based on what is measurable will encourage the employee to exert more effort on the compensated tasks but shirk on other tasks. These multitasking considerations suggest that firms often want to avoid paying employees based solely on measurable outputs. Given enough time, managers are likely to obtain information about the overall performance of employees. Incentives can be provided by basing promotions, terminations, and periodic pay adjustments on this information. Often, this information is not easily quantifiable but is based on the subjective opinions of supervisors.

The term incentive pay conjures up images of piece rates, commissions, and cash bonus plans, where the employee is paid based on measurable output. Broadly speaking, however, any compensation contract (explicit or implicit) that rewards employees for good performance or punishes employees for poor performance can be considered incentive pay. Rewards do not have to be monetary. Rather, rewards consist of anything that employee’s value.

The basic principal-agent model assumes employers and employees have the same information at the time of initial contract negotiations. In many contracting situations precontractual information is asymmetric. Sometimes it is possible for the firm to induce employees to reveal their private information by clever design of the compensation contract. For such a plan to work, the payoffs to employees must be higher when they are honest than when they misrepresent information.

Throughout this chapter, we have argued that compensation plans motivate employees. Although this argument is accepted by many, it is not without controversy. Critics of incentive pay rely on two basic arguments. The first is that money does not motivate people. The second, more prominent criticism is that it is difficult (if not impossible) to design an effective incentive compensation plan. The first argument seems inconsistent with the many examples where monetary incentives have dramatically affected employee behavior. The second argument is correct: Developing an appropriate incentive plan rarely is easy. The important question is whether plans can be designed where the benefits exceed the costs. Examples such as Lincoln Electric suggest it can be done. Our intent is to provide insights into how managers might design value-maximizing contracts.

Chapter 16

Individual Performance Evaluation In the previous four chapters, we have examined the first two components of organizational architecture: the assignment of decision rights and the reward systems. In this chapter, we began to examine the third component: the performance-evaluation system.

Performance evaluation is conducted for both individuals within the firm and subunits of the firm: How did Taylor perform? How did Morgan's team perform? Such questions require individual and team performance evaluations. Also, Morgan and Taylor are in the automotive products division. How did this division perform? Answering this last question requires divisional performance measures. This chapter focuses on individual performance-evaluation systems; divisional performance evaluation is discussed in Chapter 17.

The simple principal-agent model in Chapter 15 suggests that part of the employee's compensation should be based on performance (output). But basing pay on output requires that output is observable at low cost and is difficult to manipulate by the firm or the employee. Among the costs of performance measures are the compensating differentials employees must be paid for bearing the additional risks of incentive pay. Moreover, the model assumes that the firm and employee are free to contract in an unregulated labor market. This chapter explores how individual performance evaluation is affected when these conditions are violated.

To set the optimum compensation package, management must know the employee's marginal productivity of effort. One way managers estimate these marginal productivities is to use time and motion studies or data on past performance. If past performance is used, dysfunctional incentives due to the ratchet effect can result; employees will limit output if they anticipate that the next period's target benchmark will be raised. To reduce the dysfunctional consequences of the ratchet effect, some firms set performance estimates at the beginning of the period and do not adjust them simply because employees are making high earnings.

In some cases, measuring output can be extremely costly. For example, accurately measuring the output of a teacher is likely to be quite costly. Firms will select performance evaluations based on the direct cost of the measure, the cost of employee opportunism induced by the performance measure, and the indirect cost incurred by imposing more risk on the employee.

Another assumption of the model is that the employee shirks only on effort. If output is not correlated perfectly with the firm's value, employees attempting to increase output might cause the value of the firm to decline. Such dysfunctional results can occur when employees game the system—as in the Prudential Insurance Company agents case of "churning" policies.

Often a manager has multiple signals available regarding the employee's output. The informativeness principle from Chapter 15 suggests that the manager should use all these signals (so long as they are available at low cost) because they allow the firm to reduce the risk the employee bears and hence lower the compensating differential the employee must be paid. The informativeness principle suggests that when several employees are performing similar tasks, their combined output provides information about common random shocks affecting all their outputs. Thus, the employee's compensation should be adjusted relative to peers. This is called relative performance evaluation. Relative performance evaluation requires the firm to establish a reference group of employees to use as a benchmark. But relative performance evaluations can lead employees to collude or sabotage coworkers to improve their evaluations. Moreover, establishing the appropriate reference group and measuring its performance is costly.

In some cases, the measurement costs or the costs from employees' dysfunctional attempts to maximize explicit performance measures become so great that alternative measures of performance are sought. Subjective performance evaluations are periodic reviews by supervisors that usually incorporate a comprehensive examination of all the employee's outputs. Subjective evaluations can be based on either standard rating scales for a number of different areas or goal-based systems. Standard rating scales have the appearance of objectivity but entail subjective judgments by the evaluator. Goal-based systems set performance targets at the beginning of the period that the evaluator uses at the end of the period to determine an overall, subjective evaluation.

Subjective performance measures also involve costs. It becomes easier for a manager or the firm to renege on the promise to reward good performance because it is harder to define "good." There is more latitude to exercise favoritism and introduce bias in subjective measures. Finally, subjective systems often generate greater influence costs as employees try to lobby for better ratings.

Subjective and objective performance evaluations usually complement each other. Subjective evaluations often are used to reduce the incentives of employees to engage in opportunistic behaviors that increase the costs of objective measures. For example, the Lincoln Electric secretary who typed meaningless characters during lunch could be penalized using a subjective system: The supervisor could dismiss the secretary or give the secretary a poor subjective evaluation.

Teams often are formed as a way to assemble knowledge held by individual team members. No one individual has all the knowledge necessary to perform the task. When employees work in teams, each individual's marginal contribution to the team's output depends on others' efforts. There are synergies or interdependencies among employees. Measuring individual output is difficult, and it is costly to disentangle individual shirking from others' effort. Evaluating teams of employees usually requires a measure of team performance while still recognizing individual contributions to the team. Individual performance (possibly measured using peer reviews) is rewarded to overcome free-rider problems. In some cases, each team member's bonus is based on individual performance, but the bonus is paid only if the entire team reaches its goals.

The principal-agent model assumes that the parties are free to contract, yet labor laws constrain their choices. The equal employment opportunity laws in the United States have had a pronounced effect on performance-evaluation systems. For example, defending against affirmative-action lawsuits has encouraged firms to adopt more explicit, objective appraisal systems than they otherwise might have chosen voluntarily.

Chapter 17

Divisional Performance Evaluation Chapter 16 described individual performance-evaluation systems; this chapter extended the discussion to evaluating divisional performance.

Decision rights are allocated to cost, expense, revenue, investment, and profit centers. These centers often are evaluated and rewarded based on accounting-based performance measures. Cost centers are delegated decision rights over how to produce the output, but not over price or quantity. Cost centers are evaluated on either minimizing total cost for a fixed output, or maximizing output for a fixed total cost. Expense centers such as the human resources department are like cost centers except that their output is not easily quantifiable. This difficulty in quantifying output means users often are not charged for the expense center's output; hence the demand for expense center services tends to grow faster than the firm's output.

Revenue centers also are similar to cost centers, with the difference that they are responsible for marketing the products. They have decision rights over how to sell or distribute the product, but not over the price-quantity decision. Revenue centers are evaluated on maximizing revenue for a given price or quantity and a fixed budget for operating expenses.

Profit centers have all the decision rights of cost centers plus product mix and pricing decisions. They do not have decision rights over the level of investment in their profit center. Profit centers are evaluated based on total profits. Finally, investment centers are like profit centers except that they also have decision rights over the amount of capital invested in their division. Evaluating performance of investment centers involves adjusting profits for the amount of capital invested. Two commonly used investment center measures are return on assets and residual income (or economic value added). Both measures create incentives for managers to eliminate assets that are not covering their opportunity cost of capital. However, ROA gives incentives to eliminate profitable projects with returns below the average ROA for the division. Residual income avoids this incentive problem, but as a performance measure it makes comparing divisions of different sizes more difficult.

Large companies, particularly those operating across multiple lines of business, typically are organized into multiple business units or divisions. Such an organizational architecture is intended to furnish senior managers with information about the profitability or efficiency of different businesses and to provide accountability and incentives for the operating managers charged with running those businesses.

Nonetheless, when there are significant interdependencies among different business units, often involving internal transfers, motivating individual profit centers to maximize their own profits generally will not maximize profits for the firm as a whole. Individual units focusing on their own profits often will ignore how their actions affect the sales and costs of other units.

One valuable role of a transfer-pricing method, then, is to lead managers to allocate resources internally in ways that take account of such interdependencies among divisions. But transfer pricing is a quite complicated undertaking. The likelihood of getting the wrong answer is high, and the consequences of so doing—primarily in the form of poor pricing and output decisions—can be substantial. Transfer prices not only change how total profits are divided among business units but affect total firm profits.

The opportunity cost of a transferred resource is the correct transfer price. But accurate information about opportunity cost usually is known only by local divisional managers. If either the buying or selling division can set the transfer price unilaterally, it has incentives to behave opportunistically. The selling division will set too high a price trying to capture monopoly profits, and too few units will be transferred. If the buying division is allowed to set the transfer price, a price below the true opportunity cost is likely to be chosen; in this case, too few units will be produced and transferred.

Because accurate information about opportunity costs is quite expensive to obtain (or at least to verify), managers generally rely on approximations such as market values, marginal costs, full costs, or negotiated prices. Each of these approximations works better than others in certain circumstances. Market-based transfer prices are most useful when competitive external markets exist. But if an external market is employed, why is the firm producing the good or service? If there are important synergies favoring internal production, the external market price is unlikely to capture them. For example, if there are transaction costs of using the market, such as writing and enforcing contracts, then the transfer price is the market price less these transaction costs. Marginal cost is another popular transfer-pricing method. But marginal cost is expensive to estimate and can generate influence costs as managers debate whether certain expenditures are “marginal” or not. Full-cost transfer prices are objective, simple-to-compute transfer prices. They also are used widely in practice. However, full-cost transfer prices likely suffer from setting the transfer price above opportunity cost. Negotiated transfer prices, although time-consuming to establish, give both parties to the contract the incentive first to negotiate the quantity that maximizes the firm's profits and then negotiate the transfer price that determines how the total profits will be divided.

No matter what transfer-pricing method is used, it normally is important to permit both buying and selling divisions’ access to the external market. In this case, the external market acts as a check on opportunistic managerial behavior. But again, if the external market is employed regularly, one must examine whether the firm should be producing the intermediate product at all.

Finally, most divisional performance-evaluation systems rely on internally generated accounting-based numbers. These accounting-based performance metrics are for decision control (decision ratification and decision monitoring). Besides exercising decision control rights, employees also exercise decision-management rights (decision initiation and implementation). Exercising decision-management rights requires information; often managers turn to their accounting systems for this information. But the accounting systems of most firms are designed for decision control—not necessarily for decision management. This leads to a trade-off between these two uses and to the general conclusion that most managers find their accounting systems wanting when it comes to providing information for decision management.

Chapter 18

Corporate Governance Corporations have the legal standing of an individual (distinct from its shareholders) and can enter into contracts and participate in lawsuits. Shareholders have limited liability (only their initial capital contribution is subject to risk). Some corporations are closely held, while others are publicly traded. Publicly traded companies are often listed on organized stock exchanges. The largest exchange in the world is the New York Stock Exchange (NYSE), which provides an extremely active and liquid market for trading shares.

Institutional investors (for example, mutual and pension funds) now own about 50 percent of the stock of publicly traded corporations. While the typical large firm has thousands of "small" shareholders, many have block holders that own a nontrivial fraction of the shares. The relatively high frequency of widely held corporations in the United States is partially explained by the country's well-developed stock markets and legal system that help to protect the interests of small shareholders.

Corporate governance is the popular term that is used to describe organizational architecture at the top of a corporation. Alternative governance systems are often evaluated based on three key objectives that relate to value creation and survival of corporations: (1) the motivation of value-maximizing decisions; (2) the protection of assets from unauthorized acquisition, use, or disposition; and (3) the production of proper financial statements that meet the legal requirements.

Operational control of large corporations is delegated to professional managers who are overseen by a board of directors who have limited financial interests in the firm. Concerns about separation of ownership and control have led some scholars to question the social and productive efficiency of the corporate form of organization. Nevertheless, large publicly traded corporations have accounted for most of the free world's industrial output for decades. Raising capital from diversified investors is particularly important for large firms that require significant funds to finance investment, and is the primary reason why most large firms are organized as publicly traded corporations. Public corporations also benefit from not having to restrict the supply of top managers to people who are rich enough to buy large firms.

Separation of decision control and decision management is critical when, as in the case of publicly traded companies, decision makers do not bear the full wealth effect of their actions. Top-level authority in corporations is divided among shareholders, the board of directors, and top management. Other groups that can have roles in the decision-making process include the bondholders, preferred stock stockholders, lenders, independent auditors, and stock/credit analysts. The allocation of decision rights at the top of the firm is determined by law/regulation and voluntary choices, such as signing an agreement that grants specific decision rights to the contracting parties.

While shareholders are traditionally viewed as the ultimate owners of the corporation they have only limited powers to participate in the management of the company. Controversy exists as to whether shareholders should be given additional decision rights in the United States. Shareholders can be divided into three basic types: small shareholders, institutional investors, and large block holders. All shareholders benefit from increases in share price. However, they vary in their incentives to participate in the governance process and in terms of countervailing incentives that can motivate actions that are inconsistent with maximizing the value of the shares.

While the board of directors has primary legal authority for managing the firm, the typical board delegates much of this authority to professional managers. The board's primary function is top-level decision control—general oversight of the corporation and ratification of important decisions. Board composition, structure, and processes vary significantly across firms and through time—there is no one design that is optimal for all firms. Debate exists over whether the typical board is "captured by managers." Prominent examples exist where boards have fired powerful chairmen/CEOs.

The chief executive officer (CEO) is the top executive officer of the corporation. The CEO does not have the relevant knowledge or time to make all (or even most) of the decisions within a large and complex organization. Many decisions are delegated to lower-level employees. Succession planning is an important task that is performed by the board and top management.

Top managers from throughout the world receive a reasonable fraction of their pay in the form of performance-based compensation. Nevertheless, debate continues on whether the typical firm uses optimal incentive plans and whether the typical CEO receives more than a competitive wage.

Prominent external monitors include public accounting firms, stock market analysts, commercial banks, credit rating agencies, attorneys, and regulatory authorities (Securities Exchange Commission [SEC] and state attorneys general). Many of these external monitors experienced criticism, litigation, and increased regulation following the recent business scandals.

German and Japanese governance systems are not directed at maximizing shareholder wealth. Rather their traditional focus has been on a broader set of stakeholders including employees, banks, affiliated companies, the broader community, and shareholders. The relatively strong performance of U.S. companies during the 1990s motivated many foreign countries and companies to adopt "investor reforms" based on the U.S. model. One problem with governance systems that focus on multiple stakeholders is that they do not provide clear guidance to managers when the interests of stakeholders conflict.

Corporate boards and managers face important constraints imposed by external control mechanisms. Three of the most important external control mechanisms are the market for corporate control, the managerial labor market, and product market competition. Corporate disclosures of financial information allow these external mechanisms to help control corporate insiders.

Congress responded to a flurry of business scandals by passing the Sarbanes-Oxley Act of 2002 (SOX). SOX has a wide range of provisions and touches on many of the issues that arose during the business scandals, including internal monitoring, public auditing, activities by external monitors, executive loans, and disclosure. The new demands on corporate boards and the limitations on management contracts and corporate actions increase the costs of organizing as a public corporation substantially. While many large firms have no feasible alternative to organizing as publicly traded corporations, some smaller firms have chosen to "go private" and convert to closely held companies. Others have delayed going public. While the evidence is controversial, it generally supports the notion that the costs of SOX have been significant, while the benefits have been elusive.

The debate on how to improve corporate governance continues in the aftermath of the 2001–2002 corporate scandals. This debate is useful since it could lead to new insights into how to improve corporate governance. Nevertheless, it is important to recognize that corporate governance is not as flawed as some critics contend. While improvements in governance are conceptually possible, it is critical to consider both the costs and benefits when evaluating governance changes at either the firm or regulatory level.

Chapter 19

Vertical Integration and Outsourcing

When a firm participates in more than one successive stage of the production or distribution of a product or service, it is said to be vertically integrated. Firms change their degree of integration over time. An organization that begins to produce its own inputs is engaging in backward or upstream integration, whereas an organization that begins to market its own goods or to conduct additional finishing work is engaging in forward or downstream integration. The term outsourcing frequently is used to describe a movement away from vertical integration—moving an activity outside the firm that formerly was done within the firm. The term outsourcing also is used to describe an ongoing arrangement where a firm obtains a part or service from an external firm. It is useful to think of the outsourcing decision as a choice along a continuum of possibilities, ranging from spot market transactions to vertical integration with an array of long-term contracts in between.

Well-functioning markets provide powerful incentives for efficient production and low prices; thus, firms acquire many goods and services through market transactions. Economists have identified at least three primary reasons why a firm might want to engage in nonmarket procurement: contracting costs, market power, and taxes/regulation. Four factors can make the contracting costs of nonmarket procurement lower than the costs of market exchange. These factors include firm-specific assets, costs of measuring quality, externalities, and coordination problems.

Firm-specific assets are assets that are substantially more valuable in their current use than in their next best alternative use. Investment in firm-specific assets can cause enormous problems between suppliers and buyers and is a primary reason for nonmarket transactions. Once the investment in firm-specific assets is made, there is a sunk cost—the supplier has incentives to continue the relationship as long as the variable costs are covered—even if total costs are not. This incentive subjects the supplier to a potential holdup problem. The buyer also can be held up by the supplier. One way of reducing these problems is to integrate vertically. The other method is to negotiate a detailed contract that spells out the rights and responsibilities of each party.

Due to contracting costs, most contracts are incomplete: Many contingencies are unspecified and subject to future negotiation. The prospect of future negotiations can motivate suboptimal investment in both capital and effort. Parties to the contract realize that part of the gains from their investments are likely to go to other parties: They are not protected by a complete contract.

The owner has the right to determine the residual use of an asset—any use that does not conflict with prior contract, custom, or law. Residual rights give an individual increased ability to capture the gains from an investment and thus can provide investment incentives. Vertical integration and long-term contracts differ in their assignment of ownership rights. Vertical integration keeps the ownership rights for the relevant assets within one firm, whereas long-term contracting apportions them between firms. The choice between vertical integration and long-term contracts depends, at least in part, on which ownership structure creates more productive investment decisions.

A primary prediction of the economics literature is that as an asset becomes more firm-specific, the firm is more likely to choose vertical integration over long-term contracting. The analysis suggests that firms will enter long-term contracts when the desired investment is relatively firm-specific and where the environment is relatively stable and predictable (in stable environments, the range of possible circumstances to cover is more limited and negotiating more complete contracts is less costly). Conversely, if the firm faces a more uncertain environment and large investments in firm-specific assets, vertical integration is more likely to be the preferred alternative. Finally, if the investment in firm-specific assets is relatively low (the assets are unspecialized) or the lives of the assets relatively short, the firm can either enter into short-term contracts with suppliers or rely on spot market transactions.

Independent distributors can have incentives to free-ride on a brand name. One method to reduce this problem is vertical integration. Another method is to use contracts with specific provisions that control free-rider problems. Two types of contract terms that specifically address this concern are advertising provisions and exclusive territories. Exclusive territories help internalize free-rider problems, but they create another problem—double markups. This problem (which is analogous to the transfer-pricing problem examined in Chapter 17) can be reduced through two-part pricing or quotas.

At least four factors have contributed to the recent trend in outsourcing—increased worldwide competition, the development of less firm-specific production technologies, improvements in information and communication technologies, and excess capacity from a worldwide recession. The recent trend, however, is not from vertical integration to spot market transactions. It is a movement from both ends of the spectrum toward an intermediate solution of some form of long-term contracting. Technological changes, such as just-in-time production methods, electronic data interchanges, and total quality management, require closer links between manufacturers, suppliers, and distributors. These changes reduce the desirability of spot market transactions in many cases.

Chapter 20

Leadership: Motivating Change within Organizations

This chapter uses the framework developed in Part 3 of this book to provide insights into more effective leadership. The analysis presents an important example of how this framework can be used to provide a structured discussion of this popular, but not necessarily well-understood, topic.

The leadership literature stresses two important tasks that all leaders must perform—setting goals and motivating employees. To accomplish these tasks, management must design decision-right, performance-evaluation, and reward systems that effectively link relevant specific knowledge with decision-making authority and provide appropriate incentives for decision makers to act on their information. In this sense, much of this book has focused on key components of leadership.

Academic discussions often treat the process of decision ratification as a purely intellectual exercise. In most firms, however, the decision process involves significant incentive problems. As a result, decision making in firms often resembles decision making within political settings.

Effective leadership is facilitated by careful consideration of other employees' perspectives on proposals for change. It is important to recognize that people typically are risk-averse and interested in their own well-being. An important factor to consider is the existing organizational architecture. How will a proposed change affect specific employees in terms of their decision rights and rewards from the organization?

Managers can make two general types of changes in architecture that can assist in gaining support for their proposals. First, they can identify individuals who are potential supporters of their proposals and give them increased decision rights. Second, they can change the performance-evaluation and reward systems so that it is in the self-interest of more employees to support their suggestions.

Developing proposals that can be discontinued at low cost can reduce opposition. Flexibility, however, has costs as well as benefits. Sometimes it is better for managers to demonstrate a greater commitment to a change so that employees take the change more seriously. Managers can analyze the incentives of key decision makers and design proposals that are more likely to be supported.

The sponsor often will have information that can affect other employees' assessments of a proposal. The sponsor might be able to convince other employees of the merits of the proposal through careful analysis and groundwork, relying on a reputation for good decision making, and/or emphasizing a crisis.

Some managers have more personal power than others to affect the payoffs to other employees. Power within organizations generally does not come from the ability to force others to follow commands. Rather, power comes from other people who voluntarily agree to comply with a leader's proposals. For this voluntary action to occur, it must be in the interests of these other people to cooperate with the leader. Sources of power include formal authority derived from the position in their firm, control over important physical or budgetary resources, control over information, and friends/allies. Sometimes it is possible to use the power of another employee by tying the proposal to a program backed by the powerful employee.

Employees can gain support for proposals by logrolling. A logroll consists of a coalition of individuals who are largely indifferent to one another's proposals but agree to support the various requests so that each can get what he or she wants.

Words like power and politics often conjure up negative images. Our view is that power and political skills are neither universally good nor bad. Rather, they are important attributes that can be used for either productive or unproductive purposes. Managers are naive if they think that they can be effective without such attributes.

Symbols such as role modeling, formal creeds, stories, and legends can play an important role in communicating a manager's vision to employees. However, they are unlikely to be effective in motivating employees to take particular actions unless they are reinforced by the firm's performance-evaluation and reward systems.

Chapter 21

Understanding the Business Environment: The Economics of Regulation

This chapter presented a framework for understanding how government regulation affects a firm's strategy and hence the value of a firm. Chapter 8 and Figure 11.1 emphasize that government regulation is a key environmental factor affecting a firm's value. From changing the extent and nature of the competitiveness of markets, to regulating labor and capital markets, to taxation, governments touch virtually all aspects of organizations. In this chapter we discuss the managerial importance of government regulation and the benefits and costs of this regulation, and present an economic theory of regulation. This theory helps managers to understand better how various regulations come about and how to participate in the markets for regulation more effectively.

Governments provide a system of laws and legal institutions that facilitate production and exchange; they also address various market failures. Legal institutions which define and enforce property rights lower transaction costs, thereby increasing both producer and consumer surplus. For example, the patent process increases the amount invested in research and development and ultimately the value of goods and services flowing from this R&D. Governments also seek to redress market failures such as externalities (air pollution), public goods (national defense), monopolies (antitrust laws), and informational failures (lemon laws).

It is important to realize that it is costly to enforce property rights and to resolve these market failures. To finance these beneficial functions, governments must raise revenues, usually through taxes. In the process of performing these functions and raising the revenues to finance them, governments also can redistribute wealth, which imposes costs on society. Government agencies, courts, and legislative processes must be financed out of taxes and fees. And besides the direct costs of operating governments, there are potential indirect costs imposed on society associated with the wealth transfers that undoubtedly arise from most government actions. These wealth transfers are not merely zero sum games, in the sense that what one group receives another loses. Rather, there are transaction costs and deadweight losses (reduced consumer and producer surplus). In the process of transferring some of the pie from Peter to Paula, the pie is smaller because knowing that he might lose some of the pie to Paula, Peter has less incentive to make the pie as big as possible. Income taxes are another example. Paying, say, 30 percent of my income to the government in the form of income taxes causes me to engage in less work19and consume more leisure.

The economic theory of regulation is based on those who demand regulation (special interests) and those who supply it (politicians). Special interest groups who are made better off by the regulation will lobby in its favor, whereas those harmed will lobby against it. Politicians are made better off by brokering these transactions. They generate political support in the form of campaign contributions and votes from the various coalitions formed to support or oppose the regulation. The size and political power of a coalition depend on both how well it is organized to deliver votes and political contributions as well as how poorly organized its opposition is. People must feel strongly enough about the cause for either emotional or financial reasons to overcome their incentives to free-ride on the actions of others. If consumers are unorganized, they offer regulators little political support relative to an organized industry group. The outcome of the political process depends on the relative political support a special interest group can achieve. The more organized and the larger the special interest group, the more political support it can offer the regulator.

This theory of regulation has several important managerial implications. To develop strategies that both create value and capture value—it is not enough to build a better mousetrap—you must limit entry by competitors. The most direct way to limit competition is a government regulation limiting entry (for instance, zoning laws or taxi medallions). A less direct method for limiting competition is a government regulation that imposes a cost on certain competitors and potential entrants (for instance, health codes, worker safety standards, and pollution emission laws).

Another implication of the economic theory of regulation emphasizes the importance of coalition formation. Effective coalitions supply political support to politicians (votes and campaign contributions). One way to increase political support is to expand the number of people supporting the regulation. Coalitions are like other types of organizations— they have organizational architectures. To make coalitions more effective within the political process, the coalition should be structured using the concepts of organizational architecture presented throughout this book. In particular, incentives to participate and performance measures can be used to reduce free-rider problems within the coalition.

Finally, regulation can have a material impact on a firm's value. Managers must decide whether or how to participate in the market for regulation. Remaining neutral does not guarantee that your firm's value is unaffected. Managers who avoid participating place their company's continued existence at risk and call into question their fiduciary responsibility to shareholders.

Chapter 22

Ethics and Organizational Architecture

Business ethics is the study of those behaviors that businesspeople should or should not follow. This book is also about business behaviors, in particular, about how firms are organized to motivate and control the behavior of self-interested employees to maximize a firm's value. The focus of this book has been primarily descriptive. Assuming that people are motivated by self-interest, how are they expected to behave under alternative organizational architectures? Ethics is primarily normative: It is about how people should behave. Managers often endorse the ethical philosophy espoused by Adam Smith. In Smith's view, through private ownership of property, self-interest, and competition, a society's resources are put to the best use and produce the highest quantity and quality of goods and services at the lowest prices—value maximization.

Value maximization requires that all costs and benefits be considered. If a particular business decision conflicts with an employee's or customer's own personal belief, that person is worse off. If enough people are affected, costs are imposed on the firm through compensating wage differentials, higher turnover, and forgone sales.

Moral philosophers and all religions have debated ethics since ancient times and yet we still do not have a universally accepted code of ethics. Witness the current debates over abortion or the use of animals for product testing. There is considerable confusion about the meaning of corporate ethics. It appears unlikely that a universally accepted code of business conduct will emerge. The corporate social responsibility movement has focused less on raising corporate ethical standards than on transferring shareholders' wealth to other parties such as customers, employees, local communities, charities, or cultural institutions. Although other corporate stakeholders are important, if the corporation is to survive, it must maximize its value to its owners—a goal that in turn promotes efficient use of scarce resources.

Many of the issues raised in this chapter are recurring themes in the popular press and are likely to continue to be in the future. You may be called on to resolve a sexual harassment case, an environmental issue, or a product recall dispute. There is no doubt that at least once during your career you will be faced with a key decision that some will label a major ethical dilemma. This chapter seeks to demonstrate that the same basic framework we presented in the earlier chapters can provide guidance for understanding issues involving ethics.

A number of important managerial implications are raised by the discussion in this chapter.

First, behaviors that others classify as unethical impose real costs on the firm by lowering the firm's brand-name capital, especially when they are reported in the media. These costs from reduced reputation include forgone sales or higher costs because parties outside the firm are less willing to contract with the firm. Many ethical problems are similar to other incentive problems discussed throughout the text, and much of the same analysis of incentive problems can be used to analyze ethical problems.

Second, ethics has many different meanings, ranging from making firms socially responsible (transferring wealth from the firm to other parties) to trying to make employees less self-interested. Another use of ethics means informing employees that certain behaviors impose large reputational costs on the firm, and hence the firm will impose sanctions on employees found engaging in such actions.

Third, mechanisms arise to constrain unethical behavior. Like contracting costs, costs of unethical behavior create incentives to minimize these costs. Managers should understand these mechanisms to ascertain under what conditions unethical behavior is most likely. For example, extra care should be exerted when structuring deals with firms in financial distress.

Fourth, decisions that have major ethical dimensions almost invariably involve potential adverse publicity and a decline in the firm's brand-name capital. How the firm responds to the press affects how the public perceives the issue. In dealing with the media, the following application of our framework usually is helpful:

· News reporters are pursuing their own self-interest—not yours. They are trying to maximize their value, which usually means increasing their audience in order to sell more newspapers or TV and radio advertising. Reporters know more about their job than you do.

· Having access to the media is valuable. Developing brand-name capital is quite costly to do through advertising. Use your access to the media to present the firm's position in a credible, honest way. Lying or misrepresenting the facts to the media is likely to backfire because reporters have the incentive and skills to uncover these misrepresentations—again, because such uncovered lies make juicy stories.

Fifth, ethics programs occasionally are used to try to alter people's preferences. Senior managers concerned about the ethical conduct of their employees would do better to spend less time searching, like Diogenes, for "an honest man." Rather, they should pay more attention to the incentives created by the firm's organizational architecture (the three-legged stool). As discussed in Chapter 2, it is unlikely that Merrill Lynch would have faced widely reported consumer indignation and legal sanctions from inappropriate securities recommendations had it anticipated the (quite predictable) incentives its compensation plan would give its employees. Incentives work. If the compensation plan pays employees for unethical behavior, then unethical behavior is exactly what the company will get. Our approach suggests recognizing the potential incentive problems and then redesigning organizational architecture—not people's preferences. Managers must structure their subordinates' incentives to ensure that they do not reduce the total value of the firm.

Sixth, ethical guidelines can highlight behaviors that increase, as well as behaviors that reduce, a firm's value. Codes of conduct, rather than trying to change employees' preferences, can communicate to employees those value-reducing actions that will not be tolerated and would lead to sanctions imposed on the employee, in addition to those value-increasing actions that are encouraged and would be rewarded.

Chapter 23

Organizational Architecture and the Process of Management Innovation

In reviewing the business literature over the past 30 years, we find an essentially continuous stream of articles decrying then current management fads. Here are two samples from the 1970s:

Companies have developed many special devices to meet specific needs in their executive compensation plans. But other companies, wishing to be up to date, have indiscriminately put these devices in their own plans. The results have been—to say the least—embarrassing. The fads include: see-saw options, split-dollar insurance . . . 26

Perhaps the greatest time waste of all is the casting about after fads in Organizational Development, such as constantly jumping on the bandwagons and mindlessly switching from T Group to Team Building, Transactional Analysis, Gestalt Approaches, etc.27

Or consider a more recent example:

If a manager achieves success, the world comes asking for the key to that success. Organization after organization embraces the latest management fads, of which there certainly is no shortage. . . . Total Quality Management (TQM), like so many other elixirs, did not fail for companies because the idea was bad. TQM failed because managers dealt with it superficially.28

These articles all argue in one way or another that uncritical adoption of the managerial innovation du jour is a prescription for disaster. Yet new management tools are being introduced and adopted continually. We believe it is advantageous to understand the market for management innovations in order to make reasoned decisions about whether your organization might benefit from the newest management technique.

Environmental Change Prompts Innovation Management innovations generally arise as responses to material changes in technology, competition, or regulation. Since such environmental change frequently has similar impacts on a broad array of firms, there is a potentially large market for appropriate organizational responses to those new circumstances. Thus, for all their fadlike behavior, the persistence of management innovations suggests they serve a useful purpose; the benefits of such innovations, at least on average, exceed their costs. For example, if the external environment changes— say, because of technological advances or global competition—a formerly successful, changes have made the firm's current strategy and organizational architecture obsolete. Changes are required if the firm is to survive and again prosper. And because changing corporate cultures can be quite difficult, some external change agent frequently is useful. The latest management technique often can prove a productive mechanism for suggesting facets of the organization that require adjustment as well as for focusing the organization on implementing these changes. Hence, the current innovation can provide a special opportunity to introduce major changes in strategy and architecture.

If It Ain't Broke, Don't Fix It Adopting the most recent innovation can destroy value unless the change is warranted by the actual circumstances your firm faces. Unfortunately, some firms appear to adopt changes without careful analysis of the relevant costs and benefits. Figure 11.1 describes the interrelations among a firm's external environment, business strategy, organizational architecture, and value. As discussed in Chapter 8, it is important that managers continually monitor their external business environment as well as internal strengths and weaknesses to identify potentially appropriate strategic changes. Material changes in the external environment require modification of your business strategy, and likely adjustments to your organizational architecture. But if the environment is relatively stable, a successful firm should be extremely cautious about undertaking massive changes in corporate strategy or organizational architecture.

One Size Doesn't Fit All Not all firms would benefit from outsourcing, improving quality, empowerment, or any other management innovation. Just because a particular management technique appears to have increased value for one firm in no sense implies that adoption would raise your firm's value, as well. Again, only if your firm's current strategy or architecture no longer fits should you consider major changes.

Ensure That the Stool Is Balanced At any point in time, you face an array of prominent management techniques—each touted as the key to success. Most of these techniques involve fundamental changes in organizational architecture but tend to target one aspect of business strategy or organizational architecture—decision rights, performance evaluation, or rewards—while slighting the rest. For example, advocates of reengineering recommend changing the delegation of decision rights and task assignments. Just as none of these recent management techniques provides coordinated advice for changing all three components of the firm's organizational architecture, we expect that future innovations will fail to do so, as well. Yet changes that leave one leg of the stool out of balance mean that the firm's organizational architecture no longer fits and hence requires coordinated adjustment.

Don't Bite off More Than You Can Chew If you do decide to make a change in one aspect of the organization, then you should anticipate the effects of such change on other aspects and plan the implementation of complementary adjustments necessary to accommodate such change. Arguing that it is important to consider all three legs of the stool in designing an appropriate architecture does not imply that all changes must be implemented simultaneously. Changing too many aspects of the firm at one time can be difficult to digest and productivity can suffer. You need to understand your environment, formulate strategy, and devise a plan for implementing the entire array of required changes.

Organizational Change Checklist When analyzing business problems and challenges, managers often find it useful to ask themselves the following set of questions:

· Does our existing business strategy fit the business environment—technology, market conditions, and regulation—and the capabilities of our firm?

· What are the key features of our current architecture? And does our architecture fit our business environment and strategy?

· Are the three legs of the organizational architecture stool mutually consistent? Given the decision-right system, do the control and reward systems fit and vice versa?

· If the answers to any of the previous questions suggest a problem, what changes in strategy and architecture should the firm consider?

· What problems will our firm face in implementing these changes? What can be done to increase the probability of success?

In Closing It is critical to recognize that these policy choices represent fundamentally difficult organizational decisions. Across firms, public data on these internal organizational policies are limited, in part because management considers this information proprietary and in part because this information is not easy to summarize and aggregate. Finally, the interrelations among the various dimensions of the problem imply that these policy choices are inherently complex. When making such decisions, information costs are high and errors are potentially substantial. Thus, it is useful to recall Yogi Berra's observation: "You got to be careful if you don't know where you're going, because you might not get there." We believe that the organizational architecture framework we develop in this book can help by giving you a more detailed understanding of "where you're going"—it better focuses your attention and thus helps you frame better questions. Nonetheless, answers still are quite difficult. Yet by asking better, more focused questions and structuring more complete, coherent analysis, this framework helps ensure that you will in fact "get there."