Although the model of economically efficient markets is flexible enough to predict decision outcomes in alternative organizational forms under the restrictive conditions stated above, it is clearly limited in a number of significant ways. First, as formulated, the model cannot distinguish between the market and specific organizations that operate within the exchange market. The model’s prediction of the outcome in any specific type of organization does not require organizational struc- ture and in fact is independent of any organizational structure. It there- fore cannot capture the effects of organization that are not present in markets, or which do not replicate the exchange process between par- ties that embody the characteristics of the market process.
The model of economically efficient markets is one where the relative price, reflecting true opportunity costs, serves as the central signaling device in a system of voluntary exchanges. Where price is fully informed this model provides useful predictions of decision behavior. When price (or opportunity cost) is not fully informed, this role as a signal is muddied. Although an equilibrium position can be demon- strated, it is not clear in the framework of this model how the signal of relative opportunity cost that brings the organization to its equilibrium is articulated. The implicit assumption is that this is accomplished through some type of exchange mechanism within the particular organization that aligns the preferences of the actors. The design and operation of the alignment process is not revealed; it is apparently exogenous to the organization. The underlying mechanism for the transferability of the efficient market model to an organizational deci- sion problem is therefore unclear. While a market may be constructed as an organization, an organization may not necessarily be constructed as a market.
Second, the model as formulated cannot distinguish across organiza- tional types. The objective of maximizing total net benefits is applied in each case, but the interesting and essential features of interorganiza- tional variations are missing. In this model it is not possible to consider the peculiarities of what constitutes benefits and costs in the context of any specific organizational form, the effects of variable objective func- tions and constraints across organizational forms, and the alternative decision environments associated with the variations in organizational forms. These are not captured by the model. Rather, the peculiarities and variations are assumed away by structuring the decision process in each case along the lines of a competitive exchange market.
The literature on the theory of the firm has shown that organizations arise as a response to market failures. In this case, the assumptions of the competitive model do not hold. Market failures take a variety of forms. There may be economies of scale or scope in production so that production efficiencies can only be captured through an organi- zational structure that replaces simple exchanges. There may be positive transactions costs so that efficiencies in contracting can be captured best through a specific organizational design. For example, costs of negotiating or enforcing contracts may be minimized by vertical integration of two firms creating a new hierarchical structure. There may be information problems and incentive issues that can be solved through a particular hierarchical system developed according to a spe- cific organizational type, such as the unitary form (U-form) or multidi- visional form (M-form) as alternative ways to organize a for-profit corporation.
Thus, the model of efficient decision making in a competitive market economy essentially illustrates a macro-level outcome for efficient orga- nizational structures. To do this, however, it must rely on the highly specified assumptions of that model and assign these assumptions to the organizational structure. It cannot, nor is it designed to, provide either insight into the micro-level decision process or a rationale for the existence of any particular organizational form. Demsetz (1993) describes the limits of the neoclassical model in its applications to the firm as organization:
Its appropriate name is perfect decentralization. Perfect decentraliza- tion is realized theoretically through assumptions guaranteeing that authority, or command, plays no role in coordinating resources … The model contributes little to our understanding of the workings of a command economy or of political processes that might be struc- tured around authority … These abstractions are defensible because the real objective of the model is to study allocation in the absence of authority. (p. 160, italics in the original)
The efficiency shown by the model remains the standard against which alternatives are measured, however. I return to this point later.
Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.