Organization Theory: Managerial Economics and Organizational Architecture, Dispense di Organizzazione Aziendale

Scarica Organization Theory: Managerial Economics and Organizational Architecture e più Dispense in PDF di Organizzazione Aziendale solo su Docsity! 1 Organization Theory Book Summary: Managerial Economics & Organizational Architecture Basic Concepts Chapter 2 – Economists’ View of Behavior In the economic model, individuals are seen as having unlimited wants but limited resources. They rank alternative uses of those limited resources in terms of preference and choose the most preferred alternative. The opportunity cost of using a resource is the value of the resource in its best alternative use. Marginal costs and benefits are the incremental costs and benefits that are associated with a decision. In calculating marginal costs, it is important to incorporate the opportunity costs of the incremental resources. Action should be taken when the marginal benefits are greater than the marginal costs. Sunk costs that are not affected by the decision 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). The utility function provides an ordinal ranking of consumption bundles—not a cardinal ranking where “absolute” comparisons can be made. Marginal utility measures the additional utility that is obtained by consuming one additional unit of a good, while holding all other goods constant. Preferences implied by a utility function can be pictured graphically by indifference curves, which depict all combinations of goods that yield the same level of utility, and their slope indicates how much good X a person would be willing to give up for a small increase in good Y. Individual choice involves maximizing utility given resource constraints (budget constraint à I ≥ Px*X + Py*Y). The optimal choice is where the indifference curve is tangent to the constraint. We contrast the economic model with other models of human behavior that managers often use, such as: • Only-Money-Matters Model à a better paid employee is more productive • Happy-Is-Productive Model à a happier employee is more productive • Good-Citizen Model à individuals are interested intrinsically in doing a good job • Product-of-the-Environment Model However, the economic model is often more useful than alternative models in managerial decision making. The analysis can be extended to the case where the decision maker faces uncertainty about the items of choice. 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. Chapter 3 – Exchange and Markets 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. In free markets, property rights frequently are exchanged. 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 to other individuals. 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. 2 Vertical supply and demand curves are perfectly inelastic, while horizontal supply and demand curves are perfectly elastic. Both demand and supply tend to be more elastic in the longer run than the short run because consumers and producers have more time to adjust in quantities when price changes. In case of a cost increase, when the two elasticities are not the same, the side of the market with the less elastic curve bears the larger share of the cost increase. • If demand is perfectly inelastic, consumers bear all the costs. • If demand is perfectly elastic, producers bear all the costs. • If supply is perfectly inelastic, producers bear all the costs • If supply is perfectly elastic, consumers bear all the costs. 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. The Coase theorem indicates that the ultimate resource allocation will be efficient, regardless of the initial assignment of property rights, if 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. The cost of transferring knowledge depends on: • Characteristics of the sender and receiver à language, culture • Technology available for communication • Nature of the knowledge à some knowledge is difficult to summarize, comprehend, or transfer Depending on the exact setting, we have three types of knowledge: • Idiosyncratic knowledge of particular circumstances • Scientific knowledge • Assembled knowledge Usually, market economies incorporate specific knowledge in economic decision making, while central planning often fails to do so. Moreover, if individuals own something, they have incentives to use it productively because they keep the profits. In contrast, decision makers in centrally planned economies have limited incentives to make productive use of information (even if they have it) since they do not own the resources under their control. Why, then, is so much activity conducted within firms, where resource allocation decisions are made by managers in a manner that is similar to central planning? • Fewer transactions à If there are N customers and M factors of production, a firm can hire the M factors and sell to the N customers. The total transactions are N + M. In contrast, if each customer contracts separately with each factor of production, there are N × M transactions. • Informational specialization à Individuals cannot be specialized in everything Given these advantages, why isn’t the economy just one big firm? Allocation by firms also involves contracting costs. • Not efficient and timely decisions • Important decisions must be delegated to employees who are not owners of the firm, thus generating costs to motivate these nonowners to work in the interests of the owners Managerial Economics Chapter 8 – Economics of Strategy: Creating and Capturing 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. To modify the firm’s strategy, managers should have a good understanding of their firm’s internal resources and capabilities, which include its physical, human, and organizational capital. They also should understand their external business environment, which includes the firm’s markets (input and output), technology (production, information, and communications), and government regulation. The objective of strategic decision making is to realize sustained profits. To achieve this objective, managers must devise ways to create and capture value. 5 Buyer-supplier conflicts à Owners of firms would like to acquire high-quality inputs at low prices, whereas owners of supplying firms would like to provide inexpensive inputs at high prices Free rider conflicts à Each partner hopes the other partners will work diligently to keep the firm profitable. However, each partner has an incentive to shirk because individual partners gain the full benefit of their shirking but bear only part of the costs. Can we solve conflicts through contracts? CONTRACT ADVANTAGES Sometimes contracts can resolve incentive problems at low cost. For example, suppose that the owners of the firm do not want the CEO to reduce the firm’s value by consuming excessive perquisites. In this case the owners can pay the CEO more if he doesn’t consume excessive perquisites. S = salary P = perquisites C = compensation à C = S – P ΠM = maximum potential profit of the firm ΠR = realized profits of the firm à ΠR = ΠM – P à P = ΠM – ΠR à C = S − (ΠM – ΠR) This contract, which reduces the CEO’s salary by the difference between realized and maximum profits, is equivalent to charging the CEO the full cost of his perquisites. Nonetheless, the CEO might prefer a combination of salary and perquisites to a pure salary because bonuses are frequently untaxed. CONTRACT DISADVANTAGES However, contracts are unlikely to resolve incentive problems completely because they are costly to negotiate, administer, and enforce. 1. Postcontractual Information Problems a. Agency problems à After the contract is set, agents have incentives to take actions that increase their well- being at the expense of the principals. Since the principal cannot observe the actions of the agent costlessly, the agent generally can engage in activities such as shirking and perk consumption. à Postcontractual information problems can be limited through (1) monitoring costs incurred by owners to monitor CEOS, and (2) bonding costs incurred by CEOs to help guarantee that they will not take certain actions or to ensure that the principal will be compensated if they do. The residual loss is the loss in gains from trade that results from this divergence of interests within the agency relationship. Total agency costs = out-of-pocket costs (monitoring and bonding costs) + residual loss Generally, it does not pay to resolve incentive conflicts completely (only up to the point where the marginal cost MC equals the marginal benefit MB from reducing the residual loss). Assuming no incentive problems (left panel) the optimal number of hours is 50 and the total gains from trade (S) are $2500 = (200-100)*50/2 If there are contracting costs (right panel), the two firms spend $400 each for monitoring and bonding costs, so in total O = $800 = 40h*20$. Since it does not pay to resolve this incentive problem completely, we assume that the firm ends up providing only 40 hours of legal services (instead of 50). We have R = residual loss = $100 = (50-40)*20/2. The resulting surplus (Sʹ) is $1,600 = $2500 - $800 - $100. Note! If the parties decide not to contract at all, the contracting cost = R 6 2. Precontractual Informational Problems b. Bargaining failures à Suppose that an employee is willing to accept a job for as little as $2,500 per month and the employer is willing to pay as much as $3,000 per month. A mutually advantageous contract could be negotiated at any price between $2,500 and $3,000. Neither side, however, is likely to know the other side’s reservation price. To get the best price possible, both parties might overreach, resulting in a bargaining failure. c. Adverse selection à It refers to the tendency of an individual with private information about something that affects a potential trading partner’s costs or benefits to extend an offer that would be detrimental to the trading partner. à Precontractual information problems can be limited by (1) information collection, (2) clever contract design, (3) credible communication, (4) signaling, and (5) mechanisms such as warranties. Implicit Contracts and Reputational Concerns Many of the contracts within firms are implicit contracts rather than formal legal documents, so they are difficult to enforce in a court of law. 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 3. the expected sanctions imposed if cheating is detected are higher Designing Organizational Architecture Chapter 12 – Decision Rights: Centralization and Decentralization 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. Therefore, jobs have at least two important dimensions: variety of tasks (next chapter) and decision authority (this chapter). Centralized vs Decentralized Decision Systems ASSIGN DECISION RIGHTS TO INDIVIDUALS Decentralization benefits Decentralization costs Benefits = B × D Costs = (A × D) + (C × D2) AD = contracting costs from resolving the incentive problems CD = coordination/central information costs that increase at an increasing rate with decentralization Effective use of local knowledge • Reduce the cost of information transfer • More rapid decision making when market conditions change Incentive problems • Local managers don’t necessarily have incentives to maximize the firm’s value • Developing an effective control system is costly • Local managers may voluntarily hire weaker subordinates to enhance the manager’s career because managers sometimes view their subordinates as threatening Conservation of management time • Managers can focus on strategic decisions rather than operating decisions Coordination costs and failures • If two local managers act independently, they might ignore important interaction effects Training and motivation for local managers • Attract talented employees • Train local managers as eventual replacements for central managers • Stronger incentives to exert effort Less effective use of central information • Local managers generally have less experience and obtain direct information from only one location Economies of scale • Centralized decision may be more cost-effective 7 Optimal degree of decentralization The optimal degree of decentralization is D* = (B − A)/2C where the marginal benefits and the marginal costs of decentralization are equal (the slopes of the total benefit and cost curves are the same). The optimal level of decentralization changes across firms depending on the environment (technology, market condition and regulation). In general, within unregulated industries where market conditions and production technologies frequently change a decentralized systems is better. Moreover, as the firm becomes larger, either through vertical integration or through geographic expansion, the appropriate level of decentralization will increase. Trend toward decentralization There has been a recent trend toward greater decentralization, motivated by: 1. Increased global competition Competition has placed pressures on firms to cut costs, produce higher-quality products, and meet the demands of customers faster. The information for doing this is located lower in the organization. Thus, these competitive pressures have increased the benefits of decentralization. 2. Improvement in technology a. Firms must respond quickly to the resulting changes in technologies or lose profits. b. New technologies lowered the costs of transferring information: this promote decentralization because communication between local and central managers is easier; but it also promotes centralization because information has become less expensive to transfer to central headquarters. ASSIGN DECISION RIGHTS TO TEAMS 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 à composed of individuals from different functional areas (e.g., marketing and finance). • Recommending actions à focus on specific projects and normally disband when the task is complete. • Making products à generally are located at the plant level. Team benefits Team costs Improved use of dispersed specific knowledge • The relevant knowledge is held by a variety of employees, not just one • Encourage members to communicate and to brainstorm Collective action problem • Teams are slower • Teams are not always efficient and rational • Teams are subject to manipulation Employee Buy-In • Employees who take part in a decision process are more likely to support the final decision and be more active in its implementation • A group of employees has less to fear if they make the decision themselves or if the decision is made by employees with similar interests • Stronger incentives to invest in implementing decisions that they recommend because their reputations depend on the ultimate outcomes of the decisions Free riding • Teams encourage members to free ride on the efforts of others • Controlling free riders is costly DECISION MANAGEMENT AND CONTROL 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 is important to separate decision management from decision control. This principle helps explain the presence of hierarchies in most organizations. INFLUENCE COSTS Sometimes, firms adopt rules that limit the discretion of decision makers. 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. 10 Recent trends Historically, many firms have created jobs that are low in decision authority and narrow in task assignment. • Recently, with respect to bundling tasks into job, there has been a trend toward granting employees more decision authority and broader task assignments. • With respect to bundling jobs into subunits, many companies also have shifted away from functional subunits toward more product-oriented organizations. à Large firms are getting “flatter” and division managers are closer to the top, so that flattened firms appears more centralized. These trends can be explained by advanced information technology (better access to data, easier coordination, faster communication within firms) and increased global competition (more complex, competitive, faster environment). Chapter 14 – Level of Pay: Attracting and Retaining Qualified Employees Apart from the assignment of decision rights, another 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. Individuals will not participate in an employment relationship unless they expect to receive at least their opportunity cost and their reservation utilities (the level of satisfaction they could obtain in their next best alternative). The level of compensation is a key factor in attracting and retaining qualified employees. Benchmark Model We develop benchmark model of wages and employment. Assumptions: 1. Competitive labor market: wages are determined by supply and demand in the marketplace, not by firms. 2. Market wage rates are costlessly observable 3. Identical individuals 4. Identical jobs 5. No long-term contracts 6. No fringe benefits In this model, if a firm pays too little, it will have difficulty attracting employees 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. However, this benchmark model is different from reality. Differences with respect to the benchmark model UNOBSERVABLE MARKET WAGE RATE (2) In some settings, it can be difficult to tell whether a firm is paying the market wage rate to employees. Two important indicators of whether a firm is paying the market wage rate are: • The number of applications it receives for job openings • The quit rate among existing employees If a firm have a lot of qualified applicants when it advertises a job opening and its quit rate is low, the firm probably is paying above the market wage rate. In contrast, if the applicant rate is low and turnover is high, the firm probably is paying below the market. HUMAN CAPITAL: individuals are not identical (3) Employees vary in their abilities, skills, and training. We distinguish between: • General human capital à consists of training and education equally useful to many different firms • Specific human capital à 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. 11 COMPENSATING DIFFERENTIAL: jobs are not identical (4) Working conditions are different across jobs: they have different work environment, geographic location, or level of danger... Holding other factors constant, unpleasant jobs must pay a compensating wage differential to attract employees. Compensating differentials have two main consequences: • They attract employees to unpleasant tasks • They provide employers with financial incentives to improve the work environment as long as it is cost-effective. Note that individuals who accept unpleasant tasks tend to be the ones who bear the lowest cost for performing them. Because of this self-selection, the compensating differential is lower than if the firm attempted to hire a randomly selected person from the population. INTERNAL LABOR MARKET: there are long-term contracts (5) Many firms established internal labor markets, where outside hiring is done primarily for entry-level jobs and most other jobs are filled from within the firm. Internal labor markets are characterized by long-term relationships between the employee and the firm. Advantages Disadvantages Employers and employees have incentives to invest in specific training It limits the search to the firm’s current employees, especially when filling higher-level positions and when specific training is not essential Employees have incentives to engage in productive activities and to avoid dysfunctional activities Firms can take greater advantage of information about employee attributes, such as skills, work habits, interests, and intelligence 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. There are three ways in which firms can use their flexibility in setting the level and sequencing of pay to increase employee motivation: • Payment of efficiency wages à Individuals who are paid a wage premium are likely to reduce their shirking because they know that if they are caught and fired, they will have difficulty finding another job that offers such a premium. • Upward-sloping earnings profiles à Compensation typically increases with seniority within the firm, which is partly explained by increases in productivity that come from experience. However, an employee only accepts to be underpaid in early years because of the expectation of being overpaid in subsequent years. Note! In the short-run firms have incentives to fire older employees, since older employees are paid more than they are worth, but in the long-run this would reduce the incentive effects of the compensation plan: younger employees will not believe that hard work will lead to wage premiums when they get older. • Tying of major pay increases to promotions à usually the employee with the best relative performance is chosen for promotion. However, this can undermine employee cooperation, or it may be difficult to implement within smaller firms, firms with flatter organizational structures, and for employees with specialized skills. Influence costs Teammates frequently compare compensation levels. Employees also use information about the pay of other employees to lobby for pay increases. Firms should reduce the dispersion of pay among coworkers to limit influence costs. Such a policy, however, means that underperforming employees are likely to be paid too much, whereas more productive employees are likely to be undercompensated and leave the firm. FRINGE BENEFITS (6) The typical American employee receives about 25% 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. Advantages of fringe benefits Disadvantages of fringe benefits Certain fringe benefits are not subject to income taxes Cash gives employees more flexibility Firms often can purchase fringe benefits more cheaply 12 The employee is willing to accept any compensation package along the indifference curve, while the firm’s value is unaffected by whether it pays the employee cash or uses the same amount of cash to provide fringe benefits (à each curve is a straight line with a slope of −1). To maximize the firm’s value, choose the compensation package that meets the reservation utility of the individual at the lowest cost. Note that taxes change the slope of the curves: personal taxes are incorporated in the shape of employees’ indifference curves, whereas the firm’s taxes are incorporated in the slope of the firm’s isocost curves. Management should consider the total tax bill for the employee and the firm. Employers have incentives to follow 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. This incentive has motivated many firms to consider cafeteria-style benefits, but the use of these plans is limited due to administrative costs and adverse-selection problems. 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. Chapter 15 – Incentive Compensation THE INCENTIVE PROBLEM Incentive problems exist because of conflicts of interest between employers and employees. These problems are easily resolved when actions are costlessly observable (effort is contractible). Firms can identify the most efficient actions by employees and pay employees only if these actions are taken. In most situations, however, employee actions are not observable at low cost. Compensation contracts are useful to: 1. Motivate employees through incentives from ownership Incentive problems arise because most of the costs of exerting effort are borne by employees, whereas most of the gains go to their employers. To solve this problem even when the actions of employees are unobservable, a firm can sell each employee the rights to his or her total 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 à few employees have enough money to buy a large company • Team production à even if the firm were owned jointly by employees, it wouldn’t solve the free-riders problem • Costs of inefficient risk bearing à employees are risk averse, and employee ownership entails a risk-bearing cost 2. Share risk more efficiently 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, while employees 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. 15 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. This chapter focuses on individual performance-evaluation systems, while divisional performance evaluation is discussed in Chapter 17. SETTING PERFORMANCE BENCHMARKS To set the optimum compensation package, management must know the employee’s marginal productivity (α). Managers can estimate α using: • Time studies à they employ a wide variety of techniques for determining the duration a particular activity requires under certain standard conditions. • Motion studies à they involve the systematic analysis of work methods, considering the raw materials, the design of the product, the process, the tools, and the activity at each step. Besides focusing on how long a particular activity should take, industrial engineers often are able to redesign the product or process to reduce the time required. • Data on past performance à 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. A possible solution is to set performance estimates at the beginning of the period and do not adjust them simply because employees are making high earnings (another solution is job rotation, but it destroys job-specific human capital). ISSUES WITH PERFORMANCE EVALUATION 1. Measurement Costs Measuring output can be extremely costly and high measurement costs can lower the net benefits of tying pay to performance. 2. Opportunism Imperfect performance measures often provide incentives to employees to behave opportunistically in ways that affect their performance evaluations. a. Gaming Suppose that o Q = Action 1 + μ o Y = Action 1 + Action 2 + ϕ If the firms compensate an employee on Y, it provides incentives for the employee to take both Action 1 and Action 2, even though Action 2 does not affect the firm’s return, Q. b. Horizon Problem Short-run, objective performance measures can cause employees—especially those about to change jobs or leave the firm—to concentrate their efforts on producing results that will influence their evaluation favorably over their remaining horizon with the firm. RELATIVE PERFORMANCE EVALUATION 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 (= relative performance evaluation) and the firms should establish a reference group of employees to use as a benchmark. Within-Firm Performance The firm can establish a reference group using other employees’ output within the same firm, but: • Only in rare cases are employees’ jobs identical • The group has incentives to punish extremely productive employees who raise the average • Employees might try to get themselves classified into a reference group that has weak performance so they will appear above average 16 Across-Firm Performance Some firms employ external benchmarking to overcome the lack of an internal reference group or to avoid the destructive actions of sabotage and collusion, but: • They may be lack of data • It can be potentially illegal under antitrust laws • The two firms may not be subject to the same common shocks SUBJECTIVE PERFORMANCE EVALUATION Subjective performance evaluations are periodic reviews by supervisors that usually incorporate a comprehensive examination of all the employee’s outputs. Aspects of the job that are measured less easily can be considered along with more easily measured activities. Subjective Evaluation Methods Subjective evaluations can be based on • Standard rating scales for several different areas à scales have the appearance of objectivity but entail subjective judgments by the evaluator • Goal-based systems à set performance targets at the beginning of the period that the evaluator uses at the end of the period to determine an overall evaluation Sometimes, evaluations are not made by supervisors but through peer evaluation. This, however, gives incentives to lower everyone else’s ratings to make themselves look better, give friends high rates, collude to give everyone higher performance ratings. Problems with Subjective Performance Evaluations • Supervisor may be reluctant to give adverse ratings • Supervisor may rank employees based on personal likes and dislikes • Supervisor may assign relatively uniform performance ratings (but imposing a forced distribution where a fixed fraction of employees is assigned to each category is not more efficient) • It becomes easier for a manager or the firm to break a promise to reward good performance because it is harder to define “good” • Subjective measures may be biased • Subjective systems generate influence costs as employees try to lobby for better ratings. COMBINING OBJECTIVE AND SUBJECTIVE PERFORMANCE MEASURES 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. TEAM PERFORMANCE When employees work in teams, everyone’s marginal contribution to the team’s output depends on others’ efforts. Even if evaluating individual output is difficult, evaluating teams usually requires not only a measure of team performance, but also a measure of the individual contributions to the team to avoid free-riding problems. Peer reviews is the usual method to evaluate individual contributions to the team, especially because it is teammates who have the specific information about how each team member has performed. GOVERNMENT REGULATION OF LABOR MARKETS The principal-agent model assumes that the parties are free to contract, yet labor laws constrain their choices. The EEO 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. 17 Chapter 17 – Divisional Performance Evaluation Measuring Divisional Performance Each unit of a firm can be separated into one of five categories based on the decision rights it has been granted and the way its performance is evaluated. These centers often are evaluated and rewarded based on accounting-based performance measures. 1. Cost Centers • Cost centers have decision rights over how to produce the output (but not over price or quantity). • Cost centers are evaluated on their efficiency in applying inputs to produce output, either by: o minimizing cost for a given output o maximizing output for a given cost o minimizing average cost à however minimizing average unit cost is not the same as maximizing value because maximum profits occur where MC = MR, and this need not be where average unit costs are lowest. • Example: manufacturing department 2. Expense Centers • Expense centers 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, so the demand for expense center services tends to grow faster than the firm’s output. • Example: human resources, accounting, marketing, public relations, and R&D 3. Revenue Centers • Revenue centers also are like cost centers, with the difference that they are responsible for marketing the products. • Revenue centers are evaluated on maximizing revenue for a given price (or quantity) and a given budget for operating expenses. • They have decision rights over how to sell or distribute the product (but not over price or quantity). If the center had decision rights over product pricing or quantity and if the firm evaluated the center based on maximizing total revenue, it would be inconsistent with value maximization. To maximize revenue, the center would go to the point where MR = 0 and not to where MR = MC (MC > 0), and this would make the center sell units at P < MC. • Example: sale department 4. Profit Centers • Profit centers are most appropriate when the knowledge required to make the product mix, quantity, pricing, and quality decisions is specific to the division and this information is costly to transfer, so it’s better to create a center composed of several cost (and possibly expense and revenue) centers. • Profit centers have all the decision rights of cost centers plus product mix and pricing decisions, but they do not have decision rights over the level of investment in their profit center. • Profit centers are evaluated based on actual profits. 20 SEPARATION OF OWNERSHIP AND CONTROL 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. • ⨉ Decision makers have weak incentives to use assets productively • ✓ Corporations can raise capital from diversified investors • ✓ Corporations don’t have to restrict the supply of top managers to people who are rich enough to buy large firms. TOP-LEVEL ARCHITECTURE IN U.S. CORPORATIONS Sources of Decision Rights Separation of decision control and decision management is critical when 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. • Bondholders, preferred stock stockholders, lenders, independent auditors, and stock/credit analysts can have roles in the decision-making process. The allocation of decision rights at the top of the firm is determined by law/regulation and voluntary choices. 1. Shareholders While shareholders are ultimate owners of the corporation and the primary risk bearers, they have only limited powers to participate in the management of the company. Shareholders have the right to vote in the election of directors, but the board has primary authority for managing the firm. This is because most shareholders do not have detailed specific knowledge about the firms in their portfolios, so it is more efficient to delegate primary decision-making authority to an elected board of directors who can become appropriately informed on specific issues at lower cost. This is especially true for small shareholders, who do not have the power to influence the direction of the corporation (and even if they could take actions that increase share price, most of the gains would go to other shareholders) and that therefore prefer to free ride on the efforts of others. 2. Board of Directors • While the board of directors has primary legal authority for managing the firm, the board delegates much of this authority to professional managers. The board’s primary functions are: o General oversight o Ratification of important decisions o Compensate o Fiduciary responsibility to represent the interests of the corporation and its shareholders • The typical board has on average 11 members of which most of them are outside directors, and the CEO is almost always included. • Much of the work of the board is conducted by committees (such as the audit, compensation, nominating, and executive committees). In particular, the audit committee monitors the firm’s financial reporting, ethics, and control systems. • Outside directors typically own few stock in the firm, so their main incentives come from reputational concerns. 3. Top Management • The CEO is the top executive officer of the corporation, but many decisions are delegated to lower-level employees. The main responsibilities of the CEO are: o shaping the company’s strategic vision and direction o establishing the overall organizational architecture o recruiting and retaining key managers o succession planning o serving as the primary external spokesperson for the organization • In large firms, the top executive duties are divided between a CEO and a chief operating officer (COO): the CEO often focuses on external activities, while the COO concentrates on managing internal operations. • The CEO also relies on the CFO to direct the organization’s financial goals, objectives, and budgets. 21 • Succession planning is an important task performed by the board and top management. The two main succession patterns are: o Passing the baton à the retiring CEO stays on for a while as the chairman of the board after the COO assumes the CEO title o Horse race à several top executives compete until one is chosen as the new CEO • Usually, performance-based compensation or owning a fraction of the company’s shares help align executive and shareholder interests. However, it can also be the case that equity-based compensation increases the agency conflicts between managers and shareholders, for example if managers want to maintain temporarily high stock prices. 4. External Monitors Prominent external monitors include: • Public accounting firms à the law limits public accounting firms from providing certain consulting services to their audit clients and created the Public Company Accounting Oversight Board to monitor the auditing activities of public accounting firms. • Stock market analysts à Stock analysts often work for investment banking firms, which risk losing significant investment banking fees if their analysts produce reports that are critical of the company. • Commercial banks à well informed about a firm from depository and lending relationships. • Credit rating agencies à A conflict of interest arises from the fact that companies pay the rating agencies to rate their debt issues. This conflict, however, is small since corporate debt issuers have little choice in using the major rating agencies, and no corporate client is responsible for a large share of the rating companies’ revenues. • Attorneys • Regulatory authorities à SEC and state attorneys general INTERNATIONAL CORPORATE GOVERNANCE German and Japanese governance systems are not directed at maximizing shareholder wealth, but at a broader set of stakeholders. The 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 issue with governance systems that focus on multiple stakeholders is that they don’t provide clear guidance when the interests of stakeholders conflict. MARKET FORCES Corporate boards and managers face important constraints imposed by external control mechanisms. Three of the most important external control mechanisms are: • Market for corporate control à If a management team failed to maximize the value of the firm, it often prompted a hostile takeover offer from a competing management team who thought that it could do a better job. • Managerial labor market à Managers who perform poorly at one company are less likely to be offered management positions or board seats at other companies. • Product market competition à Inefficient firms have higher costs than more efficient firms and eventually fail in a competitive marketplace. Corporate disclosures of financial information allow these external mechanisms to help control corporate insiders. SARBANES-OXLEY ACT (SOX) OF 2002 Congress responded to a flurry of business scandals by passing the Sarbanes-Oxley Act. SOX has a wide range of provisions, 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 convert to closely held companies or have delayed going public. 22 Chapter 19 – Vertical Integration and Outsourcing Outsourcing = movement of an activity away from vertical integration and outside the firm, or an arrangement where a firm obtains a part or service from an external firm. Types of transaction in outsourcing decision • Market transactions à Spot market • Non-market transactions o Long-term contract § Standard supply and distribution contracts § Joint venture à new firm is formed that is jointly owned by two or more independent firms § Lease contract à a firm buy the right to use an asset through a lease agreement with another firm § Franchise agreement à grant the right to use another firm’s proven name, reputation, business format… § Strategic alliances à agreement between independent firms to cooperate o Vertical integration à when a firm participates in more than one successive stage of the production or distribution of a product or service. An organization that begins to produce its own inputs is engaging in backward or upstream integration, while an organization that begins to produce its own goods or to conduct additional finishing work is engaging in forward or downstream integration. REASONS FOR MARKET TRANSACTIONS 1. Competitive markets give incentives for efficient production and low prices 2. Flexibility, especially in case of uncertainty REASONS FOR NON-MARKET TRANSACTIONS The more these factors are critical, the more the firms should prefer vertical integration over long-term contracts 1. Contracting costs between buyer and supplier a. Firm-specific assets à the buyer could force the supplier to decrease prices, the supplier anticipates this and decide not to produce the asset in the first place An asset is more likely to be firm-specific if: o it is useful only if located in a particular area o it is useful to a small number of buyers o it requires specialized knowledge to be used The firm is more likely to choose vertical integration over long-term contracting as an asset becomes more firm-specific and as the environment becomes more uncertain. b. Costs of measuring quality à the supplier have incentive to deliver low-quality products once the price is set. c. Externalities à firms try to develop reputation and customer loyalty, but firms have problems motivating independent retailers to maintain their brand name. To motivate independent retailers and solve free-riding problems the firm can use: o Advertising provisions à the firm can charge its retail units an advertising fee and retain the responsibility for advertising, or the firm can share the local advertising costs with the retailer, or the firm can give the retailer the primary decision rights to decide how to spend the advertising funds. o Exclusive territories à the firm grants retailers exclusive rights to operate in a given market area, so that the retailer will internalize more of the benefits from their sales efforts, and fewer benefits will go to other units not owned by the given retailer. This helps internalize free-rider problems, but it creates a double markups problem where both the firm and the retailer have the incentive to mark up the product’s price above marginal cost. This problem (which is analogous to the transfer-pricing problem examined in Chapter 17) can be reduced through § Two-part pricing à the firm charges the retailer an up-front fee for the exclusive rights to operate in a given market area, so that the combined profits are split evenly between the two companies. § Quotas à the firm and the retailer agree on a minimum purchase requirement, which determines the split of the profits between the two companies. d. Coordination problems à independent retailers don’t set optimal systemwide prices since they only care about the profits from their own units 25 Coalitions and Logrolling 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 (i.e. Rivers and Harbors Act in the U.S.). However, in trying to form a logroll you need to: • Give credible promises • Identifying potential candidates for the logroll who are indifferent to your proposal • Give vague terms of the proposal to limit potential conflicts because specific proposals provide employees with greater opportunities to argue about details Is Organizational Power Bad? 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. THE USE OF SYMBOLS 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 22 – Ethics and Organizational Architecture ETHICS AND CHOICES Business ethics seeks to proscribe those behaviors in which businesses should not engage. If it is important for businesspeople to behave ethically in their roles as managers and employees, it is important that the organization be structured to foster ethical behavior. We may have: • External ethics policies à with customers, investors, and the local community • Internal ethics policies à with employees and managers CORPORATE MISSION: ETHICS AND POLICY SETTING Ethics and Value Maximization Managers often endorse the ethical philosophy espoused by Adam Smith, who argued that 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. Maximizing the firm’s value is the mission of most managers and, eventually, firms that deviate materially from value maximization will fail. However, there are two important cases where value maximization leads to resource misallocation. • If the firm has monopoly power, it will reduce output and set price above long-run marginal cost. • If there are externalities, the firm has incentives to produce too much or too little of an item. Thus, if appropriate regulation constrains any resource misallocation from monopolies or externalities, firms can focus on value maximization within the bounds of the regulation. Moreover, 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. Corporate Social Responsibility Nader’s view In Nader’s view, the corporation should be transformed from a means of maximizing investor wealth into a vehicle for using private wealth to redress social ills. If all firms in the marketplace face the same social requirements, then the survival of any given firm is less of an issue. 26 Economists’ view It is true that, even if companies want to maximize their value, generally it could be in their interest to devote resources to non-investor stakeholders such as employees, customers, suppliers, and local communities. For example, corporate charitable contributions could be a marketing strategy to promote the company’s products or brand identity. They can also help to avoid costs from reduced reputation, such as forgone sales or higher costs because parties outside the firm are less willing to contract with the firm. However, corporate investments that systematically fail to provide long-term returns to private investors end up reducing social as well as private wealth. This because higher corporate contributions to charities and social causes imply higher implicit taxes on corporations. If all companies are so taxed, the taxes are borne ultimately by shareholders in the form of lower returns to capital, by employees in the form of lower wages, and by customers in the form of higher prices. Corporate Policy Setting Managers should be careful to collect data for estimating the total cost and benefits of alternative actions, including costs of adverse publicity, tarnished reputation, and lost customers. Steps to help craft an appropriate policy: • Diversity of inputs à obtain input from a broad cross section of potentially affected stakeholders in the firm • Comply to legal standards • Comply to business norms à there are expectations in transactions that do not have the force of law but nonetheless represent expected behavior • Press standard à assess the public’s likely reaction Mechanisms for Encouraging Ethical Behavior Ethical lapses frequently are manifestations of conflicts of interest—incentive problems. Because reputational capital is an important determinant of future earnings, market forces provide incentives to behave ethically. But the effectiveness of market forces in controlling conflicts of interest varies among different kinds of transactions. What are the mechanisms to increase ethical behavior (and reduce the likelihood of cheating)? • Repeat sale à Firms with established market positions and valuable brand names • Seller-provided warranties • Third-party monitors à Specialized information services monitor the market, certify quality, and help ensure contract performance • Disclosure à Disclosing information reduces the potential information disparity between buyer and seller, thereby reducing the discount buyers apply to their demand prices • Ownership structure à Incentives to provide high-quality products vary across ownership structures (i.e. franchise owners or companies with large debts have incentives to cheat on quality) CONTRACTING COSTS: ETHICS AND POLICY IMPLEMENTATION But because the prompting of conscience and the desire to maintain a reputation are neither universal nor constant, it’s impossible for the principal to know the extent to which the agent is bound by such considerations. The ideal solution would be for the principal to design a perfect contract, but even if the principal were able to devise such a monitoring and reward system, it would not pay to do so due to contracting costs. Also, the expected level of opportunism is priced in the contract, so the principals do not bear the full costs of opportunistic actions by their agents. In general, higher ethical standards among agents would lead to a reduction in the level of expected opportunistic behavior and hence a reduction in contracting costs. If everyone voluntarily were to reduce opportunistic behavior, then resources devoted to monitoring and enforcing exchanges could be used in other, more productive activities. CODES OF ETHICS Many companies have written codes of conduct, and some companies also have educational programs dealing with ethics for their employees. These codes of conduct may help the firm defend itself against allegations of illegal behavior, but they are not really useful to deter unethical behavior. Indeed, it is hard that they succeed in altering people’s preferences. Mangers should pay more attention to the incentives created by the firm’s organizational architecture. If the compensation plan pays employees for unethical behavior, then unethical behavior is exactly what the company will get. Mangers should recognize potential incentive problems and then redesigning organizational architecture—not people’s preferences. 27 Chapter 23 – Organizational Architecture and the Process of Management Innovation New management tools are being introduced continually, even if they have often failed to live up to expectations. Kinds of new management tools • Total quality management (TQM) à management processes and organizational changes necessary to meet customer expectations and to achieve continual improvement • Reengineering à it focuses on accomplishing a set of major one-time changes to deal with product obsolescence and overcapacity in certain industries. • Just in time (JIT) à large corporate customers are demanding that their suppliers deliver products in continuous, small-order lot sizes, in part to reduce their own inventories and hence to improve efficiency. Why do we have demand for management innovation? Management innovations generally arise as responses to: • Changes in technology à The cost of detecting problems and monitoring production using new computerized instrumentation decreased relative to the cost of maintaining quality via manual inspection or warranty repairs. • Increasing global competition à push for higher-quality products. • Expanding deregulation Therefore, companies need to respond more effectively to their new environment, and they try to do this exactly through management innovation. But if the environment is relatively stable, a successful firm should be extremely cautious about undertaking massive changes in corporate strategy or organizational architecture. Why do these management innovations often fail? High expectations of consulting firms The demand for management solutions is met by consulting firms, academics, and management gurus that create inappropriate expectations in marketing management innovations. They do so because: • Consultants have incentives to present an optimistic view of their services • Consultants give almost the same advice to competing firms, competing away any abnormal profits Expensive quality At relatively low levels of quality, increases in quality lead to increases in firm value in two ways: by reducing production costs and by increasing consumer demand for, and the prices commanded by, the products. But, at some point, the returns to further investment in quality-increasing measures fall. Ultimately, it is the company’s customers who must pay for the cost of enhanced quality. The costs of additional improvements in quality exceed the premium customers are willing to pay—along with any further production cost savings. Unbalanced components of organizational architecture Perhaps the most important reason management innovations often fail is their failure to address all three components of organizational architecture: decision rights, performance evaluation, or rewards. For example, one important part of corporate performance/reward systems is promotions. By creating flatter organizations, reengineering reduces advancement opportunities. But most reengineering articles don’t talk about how to create new promotion systems to motivate individuals within a flatter organization. Similarly, ABC systems may not work because they don’t allow for the separation of decision management and decision control. ABC systems must be designed by operating managers because they are the people with the specific knowledge of the overhead cost drivers. Yet these are precisely the people whose performance the ABC measures are intended to evaluate. Therefore, managers were constantly arguing over the appropriate cost drivers because switching cost drivers changed product costs and thus managers’ performance measures. Changes made all at once 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. Even if it is important to consider all three legs of the stool, this does not imply that all changes must be implemented at the same time.