Coordination of Economic Decisions

Douma, S. and Schreuder, H. . Economic Approaches to Organizations . United Kingdodom : Pearson . 20013 . ISBN 978-0-273-73529-8

The subject of this book is the  coordination of economic decisions. The (categories of) mechanisms for that job are markets and organizations. A special class of organizations is of course the firm. And so this summary of the above book is included as a connection of a new theory of the firm under construction with existing economic theories.

Chapter 1: Markets and Organizations

Economic systems can be segmented by their property rights regime for the means of production and by their dominant resource allocation mechanism1. The coordination problem is the question how information is obtained and used in economic decision-making, namely decisions where demand and supply meet. The book contributes to the answering of the coordination problem in economics: why are economic decisions coordinated by markets and by organizations and why do these systems for that job co-exist?

An economic problem is any situation where needs are not met as a result of scarcity of resources. Knowing this, then what is the optimal allocation of the available resources over the alternative uses? If resources are allocated optimally, they are used efficiently (with efficiency).

Economic approaches to organisations can be fruitful if the allocation of scarce resources are taken into account. To this end consider this conceptual framework (figure 1.1): division of labour (1) >> specialization (2) >> coordination (3) >> markets (4) AND organization (5) << information (6) << pressure from environment and selection (7)

1) division of labour as per Adam Smith: splitting of composite tasks into their components leads to increased productivity (this is taken as a fact of life in our kind of (western) society), because:

2) specialisation (Adam Smith: greater dexterity, saving of time to switch between jobs, tools) enables to do the same work with less labour: economies of specialisation. This higher performace comes at a cost to get acquainted with a new task. Higher performance but less choice: trade-off between satisfaction of higher performance and lower satisfaction because of limited choice and boredom

3) coordination: hardly anyone is self-reliant and exchange must take place between specialists to get the products needed and not self-made. The right to use them is transferred: a transaction takes place. This need to be reciprocal. Specialisation leads to a need for coordination, namely the allocation of scarce resources. There are 2 types of coordination: transactions across markets or within organizations.

4) and 5) markets and organizations: for example the stock market: no individual finds another to discuss allocation, but the price system is the coordinating device taking care of allocation. The price is a sufficient statistic (Hayek 1945) for the transaction. Optimal allocation occurs when prices meet at their equilibrium without parties needing to meet or to exchange more information than the price alone. Why is not all exchange via markets? Because if a workperson goes from dept x to dept y then the reason is not a change of relative prices but because he is told to do it (Coase 1937). A firm is essentially a device for creating long term contracts when short term contracts are too bothersome. They do not continue to grow forever, because as they grow, firms tend to accumulate their transaction cost as well; and so over time the tyransactio cost of the firm will offset those of the market. Transactions will shift between markets and organizations as a function of the transaction cost involved in either choice of alternative. Williamson (1975) has expounded this element to be adressed in Ch8 to include the marginal cost of either alternative. The balance between markets and hierarchies is constantly ‘sought after’ and when it is struck then the entrepreneur may decide to change its transaction cost by forming firms or increasing their size up to the point that its transaction cost becomes too high. Ideal markets are characterized by ‘their’ prices being sufficient statistics for individual economic decision making. Ideal organizations are characterized if their transactions are not based on prices to communicate informatiion between parties. Many transactions in reality are governed by hybrid forms of coordination.

6) Information: the eminent form of coordination is a result of the information requirements in that specific sitution. And so information is the crucial element in the model, producing the coordination mechanism. There are many situations where the price alone cannot provide sufficient information to effect a transaction – up to the point where price alone is entirely incapable of the transaction. Organization thus arises as a solution to information problems.

7) the environment and institutions are the environment in which the trade-offs between market and organization take place and they are economic, political, social cultural, institutional, etc in nature. The environment provides the conditions for the creation of both, shapes both and selects both. Institutions are the rules that shape human interaction in a society (a subset of MEMES with a regulatory character or just the entirety of the memes or the memes that are motivators); they are an important element in the environment of organizations and markets. Douglass North (1990, 2005b?). ‘In the absence of the essential safeguards, impersonal exchange does not exist, except in cases where strong ethnic or religious ties make reputation a viable underpinning‘ [Douglass North 2005b p. 27 in Schreuder and Douma p. 18]. Not agreed: evolution of morale.

If the institutions are the rules of the game imposed by the environment, ‘the way the game is played’ is shaped by the countries’ institutional framework – all institutions composing the environment of organizations and markets. These factors detemine which organizations and markets are allowed and if they do then they shape the way they function. These factors are dynamic.

This approach is fairly new because economists viewed coordination by the market between organizations and organizational scientists viewed coordination inside organizations.

Chapter 2 Markets

Standard micro-economic theory focuses on how economic decisions are coordinated by the market mechanism. Consumers decide on how much to consume, producers decide on how much to produce, they meet on the market and there quantity and price are coordinated.

Law of demand: the lower the price the higher the demand. Law of supply: the lower the price the lower the supply. Market equilibrium occurs where demand and supply intersect.

Theory of demand: goods are combined in baskets, each person can rank the goods in a basket for preference, the preferences are assumed to be transitive, each person prefers to have more of a certain good than less of it. Indifference curves represent the preferences of the person. If two baskets are on different locations on the same indifference curve (he is indifferent), then the utility of the two baskets is said to be the same (because the person’s satisfaction is the same for either). It iss assumed that the consumer knows which basket she prefers, but not by how much. The budget line indicates the person’s budget: if this line is combined with the indifference curve, the maximum utility is located on the tangential of the indifference curve with the budget line (there can be only one).

Theory of supply: how a supplier decides on how much to produce. The firm is an objective function describing the goals of the firm (profit, share value). The objective function must be maximized given the constraints of the firm’s production function. The production function describes the relation of the inputs of a firm and the maximum outputs given those inputs. Q=Q(K, L, M) is the maximum ouput at some given input. If K and M are given at some time then the output increases if L increases. L cannot be increased indefinitely and either K or M will constrain a further increase of L and thus of Q. To increase K takes most time and can only be executed in the long run only: in the short run (and so at any time) M can be changed, in the medium and the long term term L can be changed. L = variable short and long run, K = variable long run only. The production function represents all the combinations of K (LT; Capital) and L (short term; labour) isoquants that the firm can choose from if it wants to produce quantity Qx.

Profit maximization in competitive markets: assume that a firm wants to maximise profits. Then Profit = Q.p – c.K – w.L. Constraint of the production function Q = Q(K, L). Decide How Much to produce implies to choose Q. Deciding How To produce means choosing K and L. K and L are free, Q is their function. Short run: K is fixed so only L is free to choose. Profit = p.Q(KL)-c.K-w.L; its maximum is dProfit / dL = p.dQ / dL – w = 0 or dQ / dL = w / p. If dQ / dL is the marginal productivity of labour it decreases with increasing use of Labour (yet another unit of labour will decrease the marginal productivity of Labour, dQ / dL is a decreasing function.). The firm can choose how much to produce, not how to produce. Long run: dQ / dK = p. dQ / dK – c = 0. From which follows that dQ / dK = c / p, while (see above) dQ / dL = w / p. Solving both gives optimal values foor L and K and from that follows Q. The firm chooses K so that the marginal productivity of K is c / p while choosing L so that the marginal productivity of L is w / p. The firm can choose how to produce and how much.

Market coordination. Producers maximize profit: via the amount she calculates L in the short term and K and L in the long term. This results in a supply curve for all firms and an industry supply curve. Consumers maximize utility and for any given price he decides the amount he is going to buy, resulting in a demand curve for all consumers. Supply and demand meet at one point only, the intersection of their curves, and the resulting price is a given for consumers and producers. Now every consumer knows how much he will buy and every producer how much she will produce.

The paradox of profits. Normal profit equals the opportunity cost of the equity capital. Economic profit is any profit in excess of normal profit. If profit falls below the normal profits, then the shareholders will invest their capital elsewhere. In a competitive market a firm cannot make an economic profit in the long run, because profit attracts new incumbants, supply increases, prices go down and economic profits vanish. Hence the paradox: each firm tries to make a profit, but no firm can in the long run.

Comments: 1) if competition was perfect then resource allocation was efficient and the world would be pareto optimal. This does not imply that everyone’s wants are satisfied, however, it just means that, given some configuration, an initial distribution of wealth and talents, nobody can be made better off whithout someone else being worse off. 2) assumptions underpinning the assumption of perfect markets are: 2a) large number of small firms, 2b) free entry and exit of firms, 2c) standardization of products. 3) it is assumed that firms are holistic entities in the sense that its decisions are homogeneous, taken as if by one person with profit maximization in mind, given their utility function. 4) firms are assumed to have only one objective such as profit or shareholder value. If there are other then they must be combined into one as a trade-off. 5) it is assumed that there is perfect information: everyone knows everything relevant to their decisions. In reality information is biased: the insured knows more about his risks than the insurance company, the sales person knows more about his activities when travelling then his boss. This is not a sustainable market. 6) consumers and producers are assumed to maximize their profit and utility and so it is assumed that they must be rational decision makers. The decisions may be less solid and more costly the longer the prediction horizon is. 7) markets are assumed to function in isolation, but it is clear that the environment influences the market.

Chapter 3 Organizations

Are ubiquitous. It is impossible for markets alone to coordinate people’s actions. Paradox at the heart of modern economies: it is possible to an increasing extent to work individually doing specialized work but thhis is only possible because of some form of organization and interdependency. While people appear to have more agency, they are more dependent on others’ performance. The central question the is how organizational coordination – as opposed to market coordination – is achieved.

.. the operation of a market costs something and by forming an organization and allowing some of authority (‘an entrepreneur’) to direct the resources, certain marketing costs are saved‘ [Coase 1937 in Schreuder Douma 2013 p 48].

.. the problem of what is the best way of utilizing knowledge initially dispersed among all the people is at least one of the main problems of economic policy – or of designing an efficient economic system. The answer to this question is closely connected with that other question which arises here, that of who is to do the planning. .. whether planning is to be done centrally, by one authority for the whole economic system, or is to be divided among many individuals‘ [Hayek 1945 in Schreuder and Douma 2013 pp. 48-49].

The best use of dispersed information is indeed one of the main problems in economic coordination.

Mintzberg identified these ways in which work is coordinated in organizations: mutual adjustment, direct supervision, standardization of work process, standardization of output, standardization of skills, standardization of norms. ‘These are thus also the ways in which people in organizations can communicate knowledge and expectations. Conversely, they are the ways in which people in the organization may learn from other what they need to know to carry out their tasks as well as what is expected from them‘ [Schreuder and Douma 2013 p. 51]. In large organizations is it no longer possible to coordinate via the authority mechanism and so combinations of the other mechanisms are used.

Real organizations are hybrids of the above coorinating mechanisms. Some prototypical organizations are dominated by a specific coordinating mechanism: 1) Entrepreneurial Organization – Direct Supervision, 2) Machine O – Stand. of Work Processes, 3) Professional O – Stand. of Skills, 4) Diversified O – Stand. of Outputs, 5) Innovative O – Mutual Adjustment, 6) Missionary O – Stand. of Norms. When markets are replaced by organizations then the market (price) mechanism is replaced by other coordinating mechanisms. Organizations can take many forms depending on the circumstances: it can handle different types of transactions [p 58].

Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, mysellf included, are in a state of shocked disbelief‘ [Alan Greenspan former chairman of the Federal Reserve about the lack of regulation in the financial markets to the House Committee on Oversight and Govenment Reform during a congressional hearing in 2008].

Chapter 4: Information

The information requirements in any situation determine the kind of coordination mechanisms or mix of them. If agents cannot influence the price then the market is perfect and the agents are price-takers; in that case the prices are sufficient statistics conveying all the necessary information to the market parties. Under conditions of perfect markets (namely perfect competition) agents can only decide on the quantity at some price for some homogeneous good (namely no difficulties with the specifications, quality differences). The price mechanism is a sufficient coordination mechanism where the economic entities have a limited need for information. If all the required information can be absorbed in the price can we rely on the market (price) mechanism as the sole coordinating device.

If the specifications vary then more informtion than the price only is necessary. Sugar: commodity product, price suffices. Fruit: some changes with the season, some more info is needed by selecting the individual pieces. Soup: more info is needed, tasting not practical, brand name as a label to inform client of the specifications to expect. A brand name is a solution to an information problem. Uncertainties exist for instance the quality of next year’s fruit: retailers and suppliers may agree on a contingent claims contract (prices depends on the actual quality at that time). In practical terms it is difficult to cover all contingencies.

If client and supplier have different information then information asymmetry exists. Disclosing all information to a client needed to fully understand some solution or product enables the construction of the object by the client himself and destroys its value. This situation can invite opportunistic (or strategic) behavior in agents.

Hidden information means the existing skewness of availability information between the parties, leading the one to take advantage of the other. Hidden action means introduced skewness between the availability of information between parties. Hidden information and hidden action both come from unobservability, they both imply a skewness of information and both occur in both market and organizational environments. Hidden information is an ex-ante problem, while hidden action is an ex-post problem.

If everybody knew everything then all information would be of equal value.

Chapter 5: Game Theory

Coordination game: two or more players coordinate their decisions so as to reach an outcome that is best for all. Example new technology. If both choose the same platform then the customer is not forced to choose between tech AND brands, but brands only. This is an advantage for both. If the choice is to be made simultaneously then the outcome is unpredictable, if the decisions are seqeuential then one player will follow the other player’s choice of tech. As soon as a first player chooses then the choice must be comunicated to the other so as to reap the benefits and not allow the other to deviate.

The entry (monopolist versus incumbant) game: moving from one stage to two stages. This can be solved by looking ahead and reasoning backwards in a decision tree. Commitment in this sense means that a participant altes the pay-offs irreversibly by committing to some course of action so that it it becomes in its own interest to execute a threat. Example: investing in extending a mobile network prior to a new incumbant entering allows the monopolist to execute its threat to lower prices – thereby increasing its number of customers.

Situations involving more than two players in a single stage game: auctions. In both open auctions and closed bid auctions, the observability of information plays a crucial role. At an increasing bid auction the price may not be perfect for the seller as the one-but-the-last potential buyer may drop out at a price far below the cut-off of the last potential buyer. To prevent that, the dutch auction can be used: a decreasing price auction. In this way the seller reclaims some of the difference between the highest and the one-but-the-highest bid. A problem for the seller is that there is no minimum price. To establish a minimum a seller can revert to a two-stage auction: first the increasing price competition where the winner takes some premium, followed by a dutch auction. If the second stage does not result in a price then the winner of the first stage buys the lot. In this game, only the winner’s private information remains private, the others’ are known after the intial round. During the second round the bidder with the highest private valuation is induced to reveal it and the seller is willing to pay a premium to get this information. The premium is hopefully loer than the difference between the highest and the one-but-the highest bid.

Sealed-bid auction: best performance+synergies considering first bid competitor’s prize.

The observability of auctions pertains to the differences in availability of the private information of each of the participants in the auction. The winner’s curse is the question whether the winner was lucky to win or overly optimistic in her predictions. Competitors can collude to keep the price low.

Single stage PD, Iterated PD for many players. IPD with players’ mistakes: show generosity by retaliating to a lesser extent than the defection and show contrition by not re-retaliating if the other retaliates after a mistaken defection. However, too much forgiveness invites exploitation.

In evolutionary game theory strategies evolve over time: variation, selection and retention. In a fixed environment (fixed proportions of strategies) it pays to learn which competitors are exploitable: maximize cooperation with the cooperating strategies and exploit the exploitables. In a dynamic environment the fitter strategies increase their proportions in the population. If more can evolve then they co-evolve.

Chapter 6: Behavioural theory of the firm

In micro-economics the firm is viewed holistically (as a dot with agency), in behavioral theory it is seen as the locus of the coalition of the (groups of) participants of the firm. The starting point is not full but bounded rationality: cognitive and informational limits to rationality exist. Decision processes in the firm are described as step: 1) defining the goals of it2 2) how it forms expectations on which the decision processes are based 3) describe the process of organizational choice.

Each participant receives inducements and makes contributions to the organization. These can have a wide defintion: they are a vector of inducements and contributions. What sets behavioral economics apart from standard micro-economics is that participants are not fully capable to know every alternative; it is in the information they have. For some of the elements of the vector of for instance employees these are even harder to know than regarding the pay; and so on for all participants of the coalition. In standard micro-economics the management is hired by the shareholder and works for them alone. In behavioral economics, management represents the interests of all stakeholders. The competitive environment as per micro-economics is a given, behavioral economics focuses on the decision making processes in the firm.

Step 1 organizational goals: in standard micro economics (SME) one goal is assumed of profit maximization. In behavioral economics it is assumed that every participant has her goals, that between them do not necessarily coincide. The composition and the overall goals of the coalition (the firrm) are arrived at via bargaining: the more unique the expected contribution the better her bargaining position. Each participant demands that the goals reach some individual level of aspiration; if that hurdle is not reached she will leave the coalition. Theoretically in the long term there would be no difference between the levels of achievement in the firm, the levels of achievement of other firms and the level of aspiration of the participants in these respects. The difference between total resources and total payments required to preserve the coalition is the ‘organizational slack’. So in the long run there would be no organizational slack. However, the markets for the various contributions are not perfect because information about it is difficult to obtain and the levels of aspiration change only slowly. In behavioral theory it is assumed that operational subgoals are specified per managerial area; it is however often impossible to define operational goals per area. And so aspirational levels are identified taking into account the effects of the conflicts between areas and so the conlict is quasi-solved instead of completely.

Step 2 organisational expectations: SME assumes information symmetry; in behavioral firm theory this is not the case. The production manager needs the sales manager to makes a forecast. Expectations means to infer a prediction from available information. Members have different information and different inference rules.

Step 3: organizational choice: SME assumes that behavior of firms is adequately described as maximizing behavior: all alternatives are known and they can be compared so as to maximize the objective. Behavioral theory rejects these assumptions: decisions have to be made under limitations. They make decisions on a proposal, without knowing what alternatives turn up the next day. SME assumes that firms search until the marginal cost of additional searching equals the marginal revenue of additional searching. Other firms would take advantage of this because they decide quicker. In reality this is impractical. In behavioral theory alternatives are roughly evaluated based on available information one at a time instead of maximizing their (assumed) objective function and weighted against some aspired level. This process is better described (then maximizing) as satisficing: to search for alternatives that satisfy levels of aspiration and is threfore acceptable. This process is closer to reality because alternatives often present themselves one at a time (is that so?). Also it is quite implausible that the consequences of each alternative can be calculated because people cannot handle all the relevant information: their rationality is bounded. They intend to be rational but only manage to a limited extent. The final argument why firms are rather satisficing than maximizing is that each stakeholder has her objectives and if a firm has no single objective functon, how can it maximze? Alternatives are evaluated against an aspiration level of each stakeholder and if they meet those they are then accepted.

Even the inteded rationality is rather generous when it concerns people. Kahneman and Tversky concluded that people are biased and use simple rules of thumb to decide.

Chapter 7: Agency Theory

This theory stems from the separation of ownership and control and discusses the relation between the entities the principal and the agent, who makes decisions on behalf of (or that affect) the principle (e.g. manager – shareholder). Dialects of the theory are: the positive agency theory (the firm is a nexus of contracts), that attempts to explain why organizations are as they are, and the principal and agent theory (how does the principle design the agent’s reward structure).

There is a stock market for corporate shares and a market for corporate control, entire companies. Here competition between management teams increases the pressure on management performance. Also there is a market for managerial labour: management of a large firm is typically more prestigious than a smaller one. Also there is a market for the firms products: the more competition in those marjets, the less opportunity for the manager to wing it. Lastly the pay package of the manager usually includes a profit or stock related bonus that brings the manager’s interests more in line with the shareholder’s.

Managerial behavior and ownership structure.

Monitoring and bonding.

Entrepreneurial firms (owned and managed by the same person) and team production. The entrepreneur monitors and controls the work of others and gets paid after all the contracts have been fulfilled. If a freelancer puts in n extra effort she enjoys m extra utility working alone. If in a team putting in extra n she enjoys only 1/m additional utility. This results in shirking: when in a team people tend to put in much less effort then when they work alone. Everyone is willing to put in more effort if the others do also. If this can be monitored by the other members of the team then a solution can be for all to agree not to shirk and to punish someone who does. Else it is unobservable , an informational problem. [Minkler 2004]. If shirking can be detected by an independent monitor (and not or with difficulty by the other team members) then if the monitor is paid a fixed pay then the monitor is incentivized to shirk also. If the monitor has a right to the residuals after the contracted cost are fulfilled, then she will have no incentive to shirk. If the monitor is to be effective then she must be able to make changes to the team (revise contracts, hire and fire, change individual payments) without consent of all the other members and sell her right to be the monitor (to justify actions the effect of which is delayed in time). The monitor in this sense is the entrepreneur, the firm is an entrepreneurial firm. This theory assumes the existence of team production and that monitoring reduces the amount of shirking. The latter implies that this is useful if it is more cumbersome for the members to monitor themselves and each other then for an outsider to do it; only in that case is this model viable.

In these two ways 1) consumption on the job and 2) shirking are restricted by managers.

The firm as a nexus for contracts: if 1) and 2) then how to explain the existence of large corporations not (or to a limited extent) owned by their managers. Shareholders in this sense merely have contracted to receive the residual funds: they are security owners. Shareholders are just one party bound by a contract to the firm like many others with their specific individual contracts.

[Fama and Jensen 1983 a, b] explain entrepreneurial and corporations with this ‘nexus of contracts’ model. ‘They see the organization as a nexus of contracts, written and unwritten, between owners of factors of production and customers‘ [Schreuder and Douma 2013 p151].

The residual payment is the difference between the stochastic cash inflow and the contracted cash outflow, usually fixed amounts. The residual risk is the risk of this diffrence, borne by the residual claimants or risk bearers. The most important contracts determine the nature of the residual payments and the sttructuring of the steps in the decision process of the agents: initiation (decision management), ratification (decision control), implementation (decision management), monitoring (decision control) of proposals. Fama and Jensen distinguish between non-complex and complex organizations: non-complex are the organizations where decisions are concentrated in one or a few agents, complex ini more than a few (small and large organizations respectively). If a small firm is acquired by a larger one, then the decision control transfers from the management of the smaller to the larger while decision management stays with the management of the smaller firm. As the management of the smaller firm is no longer the ultimate risk bearer nor the receiver of the residual payments, this confirms the theory.

Theory of principal and agent

In this theory risk and private information are introduced in the relation between agent and principal. Conditions concerning these issues in the previous versions of the agency theory are relaxed here. If the performance of the firm depends on the weather (random) and the performance of the agent, then: situation 1) the principal has information about the agent’s performance, 2) the agent has no information about the agent, 3) the agent has no direct information about the agent’s performance but has other signals.

These models are single-period and single-relation and therefore not realistic, because agents are usually employed for more than one period. Also if more than agent is employed often in circumstances that are not exactly the same and therefore the relation is different. Monitoring is costly and so the question remains how and how much to monitor. The model is based on monetary criteria only and that is not reality.

Chapter 8: Transaction Cost Economics

The fundamental unit of analysis is a transaction. Whether a transaction is allocated to a market or a firm is a cost minimization issue. Schreuder and Douma argue that to assume tht cost in a firm are lower than cost outside of it is a tautology, becaue: ‘If there is a firm then, apparently, the costs of internal coordination are lower than the cost of market transactions‘ [Douma and Schreuder 2013 p167]. But boundaries can emerge for other reasons than costs alone and, contary to what they claim, this can be empirically tested in a ‘make or buy comparison’. Transaction cost economics as per Williamson is based on bounded rationality and on opportunism. Bounded rationality means that the capacity of humans to formulate and solve problems is limited: it is ‘intendedly rational but only limitedly so‘ [Simon, H.A. . Administrative Behavior (2nd edition) . New York . MacMillan . 1961 and Organizations and Markets . Journal of Economic Perspectives / vol. 5 (2) pp 25-44 . 1991]. Bounded rationality will pose problems when the environment is uncertain or complex. Opportunism is defined as ‘self-interest seeking with a guile’ and as making ‘self-disbelieved statements’. Opportunistic means to try to exploit a situation to your own advantage in some cases by some people. It is difficult and costly to ex-ante find out who will do this and in which cases. Opportunistic behavior can occur ex-ante (not telling the buyer of a defect prior to the transactio) and ex-post (backing out of a purchase). This problem can occur when trading numbers are small and if the numbers are large but reputations are unimportant or information about reputations is unavailable.

Whether a transaction is governed by the market or by an organization (the mode) is governed by the sum of the production cost and the transaction cost and by the atmosphere. The atmosphere is the local environment where the transaction takes place itself giving satisfaction (for example to work as a freelancer or be an employee of some organization). This acknowledges the fact that economic exchange is embedded in an environmental and institutional context with formal and informal ‘rules of the game’ (as per chapter 1); ‘the informal rules of the game are norms of behaviour, conventions and internally imposed rules of conduct, such as those of a company culture. this can be related to the informal organization. ., he acknowledges the importance of such informal rules, but admits that both the concepts of informal organization and the economics of atmosphere remain relatively underdeveloped’ [Williamson 1998, 2007 in Douma and Schreuder 2013 p. 174].

The fundamental transformation means that lock-in occurs after a supplier has fulfilled a contract during some time and has learned how to manufacture efficiently. This lock-in is effectively a monopoly in a many supplier situation.

Critical dimension of a transactions: 1) Asset specificity (asset required for one transaction only) resulting in the availability of quasi-rent (everything above the variable cost) that the buyer will want to appropriate. Solution: merger or long-term contract includes inspection of the buyer’s business by the seller. 2) Uncertainty / complexity 3) Frequency. If 1), 2) and 3) are high then the transaction is likely to be executed within an organization in the long run. If the cost of transacting under the different modes differ then the more efficient mode will prevail. This leads to competition between organizational forrms and the one that turns out to be most efficient prevails in the long term.

A peer group is a group of people together without hierarchy. The coordinating mechanism is mutual adjustment. Advantages are: 1) economies of scale regarding specific assets 2) risk-bearing advantages 3) associational gains (atmospherical elements like higher effort, inspiration, quality). Disadvantages are shirking and so even in peer groups some form of hierarchy emerges (senior partners).

A simple hierarchy is a group of workers with a boss. The advantages are: 1) team production (monitoring according to Alchian and Demsetz (1972), separation of technical areas according to Williamson (1975), this is rare). 2) Economies of communciation and of decision making (in a simple hierchy the connections are n-1, in a peer group the number of connections is 1/2n(n-1): the cost of communicating is much higher in a peer group),re decision making takes less effort and less cost also as a consequence). 3) Monitoring (to prevent shirking in a peer group).

Multistage hierarchies: U form enterprises are functional hierarchies. They suffer from cumulative control loss and corruption of the strategic decisionmaking process. M-form enterprises are a solution for those problems: divided at top level into several semi-autonomous operating divisions along product lines. Top management is assisted by a general office (corporate staff). Advantages: 1) responsibility is assigned to division management cum staff 2) the corporate staff have auditing and advisory role so as to increase control 3) the gereal office is concerned with stratefgic decision including staffing 4) separation of general office from operations allows their executives to not absorb themselves to operational detail. A third is the H-form, a holding with divisions, the general office is reduced to the shareholder representative.

Concerning coordination mechanisms other than markets and organisations: markets coordinate via price mechanisms, organizations via the 6 mechanisms defined earlier. Namely: mutual adjustment, direct supervision, standardization of work process, standardization of output, standardization of skills, standardization of norms. Often the organizational form is a hybrid of some of the ‘pure’ configurations. In addition the markets are usually to some extent organized and organizations can have markets of all kinds inside of them.

Williamson’s transaction cost economics is also called the markets and hierarchies paradigm: markets are replaced with organizations when the price coordination breaks down3. Comments on the paradignm are that: 1) people are not that opportunistic: they can and do trust each other, 2) markets and organizations are not mutually exclusive coordination mechanisms but they should be viewed as a continuum.

Ouchi introduced clans as an intermediate form between markets and organizations as markets, bureaucracies (later hierarchies) and clans [Ouchi 1980, Ouchi and Williamson 1981]. Clans are a third way of coordinating economic transactions. The replacement of bureaucracies for hierarchies was standard form in organizational sociology [Max Weber 1925, translation by A.M. Henderson and T. Parsons . The Theory of Social and Economic Organization . New York: Free Press . 1947]: personal authority is replaced with organizational authority. Modern organizations now had the legitimacy to substitute personal rules for organizational rules, described by Weber as bureaucracies. Ouchi argues that in those bureaucracies prices are replaced with rules. And the rules contain the information required for coordination. The essence therefore of this type of coordination is not its hierarchic but its bureaucratic nature.

The third way of coordinating transactions is a clan. The clan relies on the socialization of individuals ensuring they have common values and beliefs: individuals who have been socialized in the same way have common norms for behavior. The norms can also contain the information necessary for transactions. This is clarified by an axamples of Japanese firms, where workers are socialized so as t adopt the company goals as their own and compensating them for non-performance criteria such as length of service. Their natural inclination as a result of socialization is to do what is best for the firm. Douma and Schreuder argue that Ouchi’s emphasis on rules does not cover the entire richness of observed organizations and it is subsumed by Mintzberg’s typology in 6.

The role of trust: the position of Williamson is that you cannot know ex ante whom to trust because some people cheat some of the time. If you like your business partner and you know that she trusts you, you are less likely to cheat on her, even if that would result in some gain: trust is an important issue. If the trust is mutual you can develop a long-term business relationship. Trust is important between and within organizations. If, in general, people are treated in good faith then they are more likely to act in good faith also. But as Williamson argues, you cannot always ex-ante be sure about the stranger and you might be needing to prepare for an interaction.

Chapter 9: Economic Contributions to Business/Competitive Stategy

Economic contributions to strategy planning and management are mainly related to content, not process: the focus is on the information that firms need to make their choices.

Move and counter-move: In 5.3 commitment was introduced as a way to change the pay-off in a game setting. The example concerned the investment in a network by National, the existing cellphone provider. ‘Commitments are essential to management. They are the means by which a company secures the resourcces necessary for its survival. Investors, customers and employees would likely shun any company the management of which refused to commit publicly to a strategy and back its intentions with investment. Commitments are more than just necessities, however. Used wisely (?), they can be powerful tools that help a company to beat the competition. Pre-emptive investments in production capacity or brand recognition can deter potential rivals from entering a market, while heavy investments in durable, specialized and illiquid resources can be difficult for other companies to replicate quickly. Sometimes, just the signal sent by a major commitment can freeze copetitors in their tracks. When Microsoft announces a coming product launch, for instance, would-be rivals rethink their plans‘ [Sull, D.N. . Managing by Commitments . Harvard Business Review, June 2003 pp. 82-91 in Douma and Schreuder 2013 pp. 223-4].

Memeplex > Belief + Environment > Predicting* / Planning* > Committing* > Execution = Acting as Planned, * means anticipating the future. Compare to: ‘Each single business firm and each business unit in a multibusiness firm needs to have a competitive strategy that specifies how that business intends to compete in its given industry‘ [Douma and Schreuder 2013 p. 228].

Chapter 10: Economic Contributions to Corporate Strategy

In a multibusiness firm some transactions are taken out of the market and internalized within the firm: capital market, management market, market for advise. Also some transactions between the individual businesses are taken out of the market and internalized, such as components, know-how. The question is whether this approach is more efficient than the pure market approach, namely is value created or destroyed. Parenting advantages poses 2 alternative questions: 1) decide whether corporate HQ adds value. Yes if it is cheaper than the market. 2) Can another HQ add more value to one of the business units. Yes if another parent cannot add more value to the BU. This is related to the market of corporate control earlier discussed.

Value adding activities of HQ are: 1) Attract capital and allocate to business units 2) appoint, evaluate abd reward business unit managers 3) offer advice 4) provide functions and services 5) portfolio management by making adjustments to the business units.

In a mature market economy it is harder for an organization to surpass the coordinating capacity of the market. In a less developed economy this threshold is easier to meet and organizatrional coordination is more favourable than market coordination. Organizational relatedness of business units A and B sharing the same HQ can take different shapes: 1) vertical integration (A supplying B) 2) horizontally related (A and B are in the same industry) 3) related diversification (A and B share same technology or same type of customer) 4) unrelated diversification (A and B share nothing). Portofolio management means management of the business units.

Chapter 11: Evolutionary Approaches to Organizations

The perspective is on the development of organizational forms over time: from static to dynamic. The anaysis is about populations of organizational forms, not the individual organization but the ‘species’. Organizations are human constructs: ‘.. organizations can lead a life of their own, to continue the biological analogy – but the element of purposive human behaviour and rational construction is always there‘ [Scott, W.R. . Organizations: Rational, Natural and Open Systems (5th edition) . Englewood Cliffs . NJ: Prentice Hall . 2003]. Thus the creationist view is likely to have more implications for the organizational view than for the biological view. The meaning of the term construct goes beyond the design of something, and includes a product of human mental activity. It might be said that organizations are more constructionist / constructional than giraffes. ‘Organizations are much less ‘out there’: we have first to construct them in our minds before we find them. This delicate philosophical point has important consequences. One of those consequences is that it is harder to agree on the delineation of organizations than of biological species. Another consequence is that it is much less clear what exactly is being ‘selected’, reproduced’ in the next generations and so on‘ [Schreuder and Douma 2013 p 261].

Similarities between the organizational and the biological view evolve from the assumptions that 1) organizations have environments and 2) environments play a role in the explanation of the development of organizational forms. As a result the development of organizational forms instead of individual forms can be studied and additionally the concept of environment is broadened to anything that allows for selective processes. As a reminder: selection on certain forms of organization is now replacing adaptation of individual firms to their environment. ‘So, there is no question that selection, birth and death, replacement and other such phenomena are important objects of orgnizational study as well‘ [Douma and Schreuder 2013 p. 262].

Ecologists study the behavior of populations of beings: what is the defintiion of a population in organizational science and what is the procedure for the distinction of one population of organizational forms from another. Organizational ecology distinguishes three levels of complexity: 1) demography of organizations (changes in populations of organizations such as mortality) 2) population ecology (concerning the links between vital rates between populations of organizations) 3) community ecology of organizations (how the links within and between populations affect the chances of persistence of the community (=population of firms or society?) as a whole). 1) has received the most attention, 2) and 3) not so much.

The definition of a species is interbreeding: its genotype, the genepool. According to Douma and Schreuder there is no equivalent for organizations. This can be solved using the concept of memes identifying the general rules that are adopted by participants in this kind of organization, DPB.

An organizational form is defined as the core properties that make a set of organizations ecologically similar. An organizational population is a set of organizations with some specific organizational form. [Caroll and Hannan in 1995 in Douma and Schreuder 2013 p264]. An assumption is the relative inertia of organizations: they are slow to respond to changes in their environment and they are hard-pressed to implement radical change should this be required. As a consequence organizations are inert relative to their environments. This sets the ecological view apart from many others as the latter focus on adaptability. In other approaches efficiency selects the most efficient organizations. The Carroll and Hannan approach of ecological organizations is that these have other competences: 1) reliability (compared to ad-hoc groups) 2) routines can be maintained in organizations but not in ad-hoc groups 3) organizations can be held accountable more easily 4) the organizational structures are reproducible (procedures must stay in place). Selection pressures will favor those criteria in organizations and so they will remain relatively inert: inertia is a result of selection, not a precondition.

What is the size of a population, namely how many organizations with some typology do wee expect to find in a population: 1) what is its niche 2) what is the carrying capacity. Whether an actual organization survives is detemined by 1) competition with other organizations in their niche, 2) legitimation is defined as the extent to which an organization form is accepted socially (D & S are confusing the organizational form and the actual organization here). As they perform consistently and satisfactorily then they survive.

[Nelson, R. and Winter, S. . An Evolutionary theory of economic change . 1982] Their view is routine behavior of firms and developments of economic systems. Firms are better at self-maintenenance than at change if the environment is constant and if change is required than they are better at ‘more of the same’ than at other kinds of change. They denote the functioning of organizations with: 1) routines that are learned by doing 2) the routines are largely tacit knowledge (Viz Polyani 1962). Organizational routines are equivalent to personal skills: they are automatic behavior programmes. ‘In executing those automatic behavior programmes, choice is suppressed‘ [Douma and Schreuder 2013 p272]. Routines are 1) ubiquitous in organizations, they are the 2) organizational memories and they serve as an organizational truce meaning that satisficing takes the place of maximizing in the classical sense. ‘The result may be that the routines of the organization as a whole are confined to extermely narrow channels by the dikes of vested interest … fear of breaking the truce is, in general, a powerful force tending to hold organizations on the path of relatively inflexible routine‘ [Nelson and Winter 1982 pp 111-2 in Douma and Schreuder p. 272].

Thre classes of routines: 1) operating characteristics, given its short term production factors 2) patterns in the period-by-period changes in production factors 3) routines that modify over time the firm’s operating characteristics. And so routine changing processes are themselves guided by routines. And so just as in the biological sphere, the routine make-up of firms determines the outcomes of their organizational search. (The pivot of this categorization is the presence of production factors in the firm and how that changes over time; my starting point, via Rodin, was the presence of ideas that might or might not lead to the buying or making of production factors or any other method, contract, agreement, innovation or mores DPB). Whatever change happens it is expected to remain as close as possible to the existing situation minimizing damage to the organizational truce.

‘He (Nelson) went on to point out that there are three different if strongly related features of a firm..: its strategy, its structure, and its core capabilities’. .. Some of the strategy may be formalizedand writtten down, but some may also reside in the organizational culture and the management repertoire. .. Structure involves the aay a firm is organizaed and governed and the way decisions are actually made and carried out. Thus, the organization’s structure largely detemines what it does, given the broad strategy. Strategy and structure call forth and mould organizational capabilities, but what an organization can do well also has something of a life of its own (its core capabilities DPB).

Nelson and Winter classify themselves as Lamarckian, while Hannan and Freeman classify themselves as Darwinian [Douma and Schreuder 2013 p 275]. In my opinion this classification is trivial as memetic information can recombine so as to introduce new ‘designs’ in a darwinian sense or starting from the environment, new requirements can be introduced that the organization must deal with to in the end internalize them in the rules, DPB.

Hannan and Freeman conclude that organizational change is random, because 1) organizations cannot predict the future very well 2) the effects of the orrganizational change are uncertain. Nelson and Winter conclude that some elbow room (namely learning imitation and conscious adaptation) exists, but that changes are constrained by the routines that exist at some point. From a practical point of view organizations are less adaptable than might be expected.

Differences between ecological and evolutionary approach: 1) in the ecological approach the organizational form is selected, in the volutionary approach the routines are selected 2) the ecological approach observes the organization as an empty box in an environment, whereas the evolutionary approach introduces behavioral elements and so the inside of the firmm is adressed as well.

Chapter 12: All in the Family

The model encompasses a family of economic approaches. The chapter is about their similarities and differences.

Information is pivotal in the model detemining which coordination mechanism prevails. Environmental and selection pressures on both markets and organizations. In this context the pressure on organizations results in the population power law and the pressure on the stock exchange results in the power law (or exponential ?) for the distribution of the listed firms on the grid.

Commonalities in the family of models: 1) comparison between markets and organizations 2) efficiency guides towards an optimal allocation of scarce resources and therefore in the selection of either markets or organizations as coordinating mechanism 3) information is stored in the routines, the rules, arrangements.

Process and / or content traditional dichotomy: differences in the family of models: content theories dealing with the content of strategies or process theories enabling strategies to come into being. Similarly approaches to organizations can be distinguished as process (what are the processes regardless the outcomes) and content (what is the outcome regardless the process leading up to it). From process to ascending content: behavioral theory – organizational ecology – evolutionary theory – dynamic capabilities – RBV – strategy – transaction cost economics – positive agency theory – principal agent theory.

Evolutionary theory is classified as a process based theory with increasingly more capabilities to generate outcomes.

Static and dynamic approaches: itt turns out that on a content-process and statis-dynamic grid, the middle sections are empty: there is no theory that addresses both dynamicism and content generation simultaneously. View picture 12.3 p. 302.

Level of analysis ascending from micro to macro: dyad of individual persons – small group with common interest or purpose – intergroup of groups with different interests or purposes – organization as a nexus of contracts, a coalition, administratieve unit – organizational dyad as a pair of interacting organizations – population of organizations as all organizations of a specific type – system as the entire set of all organizational populations. View picture 12.4 on p. 304.

The extension of the evolutionary theory with dynamic capabilities has provided a bridge to Resource Based View strategy theories and it implies that evolutionary theories can now allow for more purposeful adaptation than before. In addition the managerial task is recognized in the sense of build, maintain and modify the resource and capability base of organizations.

Lastly: 1) at all levels of analysis (dyads to systems) economic aspects are involved 2) the approaches address different problems because they view a different level and because of different time frames 3) even at the same level of analysis different theories see different problems (differrent lenses etc).

Paragraph about complex adaptive systems.

Chapter 13: Mergers and Acquisitions

The significance of m&a: 1) globalization 2) strong cask-flow after the 2001-2003 slump 3) cheap financing facilitates PE 4) shareholder activism and hedge funds. Success and failure: target firms’ shareholder gain 20+% while bidding firms’ shareholders break even. If this is due to more efficient management of the bidder then the market for corporate control is indeed efficient, else: the market can be elated when the deal is announced but disappointed after the deal is closed. Using event analysis (change in stock price around take over) The net overall gain seems to be positive: M&A apparently in that view is a worthwhile activity as it is creating value for the shareholder. Using outcome studies (comparison of performance of merged of taken-over firms against competitors) shows that associated firms compared to a non-merging control group in 11% of the transactions come out stronger after the event and weaker in 58%. This is consistent with event studies in the long term. Details: 1) combined sales equal or lower in spite of consumer prices tendency to rise 2) investments equal 3) combined R&D lowered 4) assets restructured 5) lay-off unclear 6) management turnover in about half the cases. Serial acquirers seem to be more successful than occasional acquirers.

Focus-increasing acquisitions tend to show the best results. Diversifying acquisitions the worst. The best approximation of the success and failutre rate of any acquisition in general is about 50/50. Target shareholders do best, buyers shareholder break-even. Management encounters changes.

Strategy, acquisitions and hidden information: buyers and sellers suffer from hidden information (risk of buying a lemon).

Auctions: the vast majority of M&A take place via an auction. Description of the process.

The winner’s curse and hubris: a majority of the M&A’s destroy shareholder wealth.

Adverse selection. Moral hazard.

Chapter 14: Hybrid forms

This is a form of coordination in between market and organization. Examples: franchise, joint venture, purchase organization, long-term buyer-supplier relation, business groups (some tie of ownership, management, financing etc), informal networks.

The basic thought was that if asset specificity rises then transaction cost rises more rapidly in a market configuration than in an organization: and in a hybrid form this is in between. As an illustration: if asset specificity is very low then the market can coordinate this, if it is medium specific then a hybrid can coordinate it, else it has to an organization to coordinate it.

Tunnelling is the transfer of value through artificial invoicing. Propping is to prop up underperforming or struggling firms to the benefit of the controlling owners.

Chapter 15: Corporate Governance

This is the system by which the business firms are directed and controlled via rules, responsibilities for decisions and their procedures. It also involves the way the company objectives are set, the means of attaining them and the monitorig of them. The focus here is on the relation between the shareholders and the management. Problems can arise for a lack of alignment and because of information asymmetry between them. This may arise because sharwholders expect the management to maximize their shareholder value, while the management expects to maximize her utility function. Porblems: 1) free cash flow issue in mature markets and hubris 2) difference in attitude towards risk: shareholders invest some portion in each firm to spread risk, a CEO invests all her time in the firm: the shareholder expects that risk be taken, the CEO tends to more risk averse 3) different time horizons: shareholder are entitled forever, CEO’s are contracted for a limite period only 4) the issue of on-the-job consumption by management. Any program in this area should focus on reducing the information gap and the existing interests: the size of the agency problem can be reduced by organizational solutions and market solutions.

[Paul Frentrop 2003] shows that the main reason for improvement of the corporate governance regulations was stock market crashes and scandals such as the South Sea Bubble in the UK 1720 and the 1873 Panic in the USA.

The evolution of different corporate governance systems in the world: 1) social and cultural values: in Anglosaxon countries in the social and political realm individual interests prevail over collective interests and this may explain why markets play a relatively large role 2) is the concept of a corporation viewed from a shareholder perspective or from a stakeholder perspective 3) the existence of large blockholdings in companies by institutional investors (yes in Germany and Japan, no in the US) implies a difference of the corporate governance 4) the institutional arrangementss have been developed over time and they incorporate the lessons of the past; in that sense the countries’ policies are path-dependent. Do these diffferences between countries’ corporate governance regulations increase over time or do they converge? This may be the case because: 1) cross-border mergers, 2) international standardization of discosure requirements 3) harmonization of securities regulations and merger of stock exchanges 4) development of corporate govenernance codes (best practices) incorporating those of other countries.

1If private ownership is combined with market allocation the system is called “market capitalism”, and economies that combine private ownership with economic planning are labelled “command capitalism” or dirigisme. Systems that mix public or cooperative ownership of the means of production with economic planning are called “socialist planned economies”, and systems that combine public or cooperative ownership with markets are called “market socialism.

2In Schreuder and Douma ‘it’ is replaced with the organization.

3In this sense Williamson’s ideas are descendant of Coase’s, who argued that organizations are primarily characterized by authority (here: direct supervision).