For-profit corporations, public bureaus, and nonprofit organizations are complex and bureaucratic organizations as defined by Thompson (1961, p. 8): ‘Organization theory attempts to account for order in behavior. A bureaucratic organization is a structure composed of authority, status, technical, and social relationships.’ An organization is not only a construct of efficiency; it is also a social construct. The nexus of contracts is also a social nexus where individuals interact in a variety of social relationships: principal–agent, superior–inferior, and lateral, or peer, relationships among colleagues. Tirole (1988) recog- nized this in his discussion of the limitations of the nexus of contracts model in organizations that exist because of the effects of group behav- ior. He noted the importance of social and group relationships on orga- nizational decision making.
Although it can be considered a beginning point, the form of optimization model illustrated in Figure 3.1 is clearly too simplified to provide insight into the decision process and its effects in an organiza- tion. The Pareto optimal point depicted at E* in Figure 3.1c illustrates economic efficiency: the maximum and most highly valued use of scarce economic resources. As such, this point shows maximum eco- nomic welfare for the members of this society, be it economy or organi- zation. But this model and equilibrium necessarily abstract from other issues that are important to society. These include issues of distribution, orientation, accommodation, and motivation (Etzioni, 1964; Jackson,1983; Pfeffer, 1990; Galambos, 1993; Fischhoff and Johnson, 1997 and Zhou, 1997).
Distribution refers to the shares each member has of society’s resources and outputs. The efficiency model cannot address the issue of distribution and is independent of it. That is, there are no wealth effects that determine resource levels or prices to affect the efficiency of the outcome. In reality, however, distribution does matter. The efficiency model assumes no specific distribution of resources. Implicit in this model is the assumption that distribution is based initially on some arbitrary endowment and thereafter, on individual productivity. That is, individuals in the market are compensated according to their marginal contribution. In fact, however, distribution results from many things. Resource endowments may derive from productivity, but they also may derive from inheritance, social connections, or simply luck (lotteries, for example), and may have no relationship to productivity at all. In addi- tion, resources are committed by organizations for the purpose of redis- tribution and this affects efficiency (Pfeffer, 1990). Indeed, this is one of the costs of market power in a market economy.
Orientation refers to individuals’ awareness of and adaptation to their environment. The economic model of efficient markets is based on mul- tiple impersonal decisions. Societies and organizations are not autonomous, however. The individuals who interact in various relation- ships have personalities and individual preferences that affect the way those relationships work and, therefore, the outcomes of decisions made in the context of these relationships. Thus, orientation can affect the form of rules that are developed and the way that they are implemented, thus altering the level of efficiency (Zhou, 1997). In addition, in complex organizations, unexpected consequences may arise from failing to recognize problems in the decision making process, or from making incomplete corrections. Fischhoff and Johnson (1997, p. 232) note that ‘[c]omplexity means that corrections made in one domain may create new problems in another.’ Thus the result of simplifying a problem in a complex decision environment in order to facilitate a decision, as the economic model of efficient markets does, can lead to outcomes that increase costs and so are inefficient.
Accommodation refers to the willingness of individuals to adapt or adjust to situations or changes. In circumstances of accommodation the outcome is one of compromise rather than optimize. The resulting deci- sions reflect a middle ground that is acceptable to all parties but which may be suboptimal for any or each individual. The presence of others’ preferences could be considered and modeled as additional constraints imposed on any one individual’s preferences. This approach, however, fails to capture the interaction of the process and requires the additional assumption that those constraining preferences are more significant (Simon, 1979). In effect, the model would be assigning explicit weights to each individual’s objective. The weights are established either by assumption (in order to determine some equilibrium) or on a predeter- mined empirical basis.2 Game-theoretic strategic models are one way to model accommodation in the context of optimization and provide some insight into this behavior (Radner, 1992 and Camerer and Knez, 1997). Game theory models, however, do not provide a unique equilib- rium solution that is generally applicable, such as is possible in the effi- ciency model of Figure 3.1.
Motivation refers to the willingness of individuals to take action that moves society or the organization toward its objective. The economic model of efficient markets is based on the motivation of individual self interest. This motivation leads profit maximizing and utility maximiz- ing individuals (who respond to market pricing signals) to the general equilibrium E* in Figure 3.1c that yields maximum efficiency in the economy, to the benefit of all. It is in this context that maximizing eco- nomic efficiency, or economic welfare, is also considered to be maxi- mizing social welfare. Shubik (1971) has noted the difficulties associated with translating economic welfare of members of society to social wel- fare. He states that a
fact of life that limits any simple view of individual rational men with freedom of choice, who wisely select actions so that their pri- vate welfare coincides with the public welfare, is that, given the pref- erences of all, market mechanisms and voting procedures will only succeed if very special conditions prevail (even assuming complete information) … The aggregation of individual wants and powers into social wants and powers is one of the central problems of political science, economics, and sociology. (pp. 360–1)
Thus the ability of self-interested motivation to lead to maximization of social welfare breaks down when any of the model’s assumptions are violated, as, for example, in the presence of any market power or infor- mation asymmetries. Such violations are inevitable in organizations understood as social constructs. In many situations in organizations, individual preferences and organizational goals diverge.3 Motivation in this context requires an organizational design that moves individuals away from self-interested behavior and toward the larger organizational goals (Etzioni, 1964 and Milgrom and Roberts, 1992). To the extent that this increases organizational efficiency it will also increase efficiency in the economy. The movement away from personal preferences in order to achieve this larger organizational goal may have adverse social effects, however (Pfeffer, 1990). In this event economic welfare and social welfare are not the same.
The circumstances of distribution, orientation, accommodation, and motivation are not independent of one another. Distribution of resources is a distribution of power and authority, and therefore, estab- lishes orientation among members of society. Those who have greater access to resources have greater leverage in bargaining, and a corre- sponding lesser requirement for accommodation. The multiple effects of these affect motivation at many levels. Redistribution, authority, and leverage can lead to greater autonomy within an organization (Meyer, 1972). This may or may not increase efficiency, depending on the moti- vation of the individual who is faced with this situation.
What is good for General Motors may not be good for society. Thus, incentives are critical to achieving economic efficiency. Incentives are also critical to increasing social welfare, that is, making all members of society as well off as possible. Increased social welfare may require effi- cient organizations, and efficient decision making, and possibly more than that.
The economic model of efficient markets and of organizations as a nexus of contracts implies voluntary exchange that is mutually bene- ficial on the part of all parties to these contracts. The other side of the issue of distribution, orientation and accommodation, however, are those without authority and leverage. When there is variability in authority and leverage, the interpretation of ‘voluntary’ is unclear. The fact that an agreement is achieved is not necessarily evidence of a satisfactory outcome, let alone an optimal one. Whether the agreement increases efficiency and also social benefits depends on whether any parties have a real choice set, that is, their motivation. Thus, incen- tives are important for achieving both economic efficiency and social welfare.
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.