Knowledge-based theory of the firm: Organizational structure

The above assumptions about knowledge and the conceptualization of the firm as a knowledge- integrating institution have two main implications for the internal structure of the firm: first, the role of hierarchy; second, the location of decision making.

1. Implications for hierarchy

The fundamental organizational problem is achieving purposeful, coordinated action from organizations comprising many individuals. As noted above, there are two dimensions to this problem: first, the pure coordination problem;

second, the cooperation problem. Even if the technical problem of coordination can be solved, how are the divergent goals of individuals resolved? Hierarchy has emerged as an efficient solution to both. Aoki (1990) observes that one of the differences between U.S. and Japanese corporations is that, while the hierarchies of Western firms combine the roles of cooperation and coordination, Japanese hierarchies exist primarily to provide the incentive structures to support cooperation, but coordination occurs outside the formal hierarchy.

As observed earlier, within organization theory, analysis of hierarchy has concentrated upon the problem of cooperation. The preoccupation with organizations as hierarchies of authority reflects the organizational antecedents of business corporations: churches existed to impose the authority of God, government departments to impose the authority of the monarch or (in democracies) the people, while the effectiveness of armies and navies required the authority to send men to their deaths.

The analysis of hierarchy as a coordination mechanism has been associated with cybernetics and systems theory. Simon (1981) argues that hierarchy is a general feature of complex systems emerging because of its evolutionary and problem-solving advantages. Hierarchy is an efficient mechanism for coordinating a complex system comprising multiple specialized units. Business firms are examples of hierarchies since they are ‘composed of interrelated sub-systems, each of the latter being in turn hierarchic in structure until we reach some lowest level of elementary subsystem’ (Simon, 1981: 196). Using simple models of information processing, Radner (1992) derives principles and algorithms for the optimal design of hierarchies.

Simon (1981) identifies intensity of interaction as the basis for organizing hierarchy: at every level, interaction within the substructure is more intense than between the substructures. This property permits near decomposability—for most aspects of their functioning each unit may be viewed as operating autonomously. Thompson (1967: 57-61) uses this principle of grouping by intensity of interaction to propose that organizations should structure their hierarchies by group in, first, those individuals who are reciprocally interdependent, and subsequently individuals subject to sequential and pooled interdependence.

These approaches to hierarchical coordination involve assumptions about the forms of knowledge being utilized within organization: typically that hierarchies are involved in the processing of information. Once firms are viewed as institutions for integrating knowledge, a major part of which is tacit and can be exercised only by those who possess it, then hierarchical coordination fails. Consider the design of a new range of cosmetics. Within the marketing department different market researchers, brand managers, advertising executives, and sales representatives each have valuable insights into the market opportunity for a new cosmetic range, the desirable characteristics of such a range, the profiles of potential purchasers, and the appropriate marketing of such a range. Within R&D expertise about the technical opportunities for using new materials and developing innovative characteristics in cosmetics is distributed among specialists in botany, fatty acids, emulsification, perfumes, and polymer science. If new product design requires integrating marketing know- how and technical know-how, how can meetings between the marketing VP and technology VP achieve this if the required knowledge is distributed among their subordinates? When managers know only a fraction of what their subordinates know and tacit knowledge cannot be transferred upwards, then coordination by hierarchy is inefficient.

Only one of the integration mechanisms identified in the previous section is compatible with hierarchy: integration through rules and directives. Indeed, the bureaucratic systems typically associated with organizational hierarchies rely heavily upon rules and directives. However, their basis is different in the knowledge-based model from the traditional bureaucratic model. In a bureaucracy rules and directives are vehicles for the exercise of authority. They emanate from the source of authority in the organization and apply top down. In the knowledge- based firm, rules and directives exist to facilitate knowledge integration; their source is specialist expertise which is distributed throughout the organization.

Many current trends in organizational design can be interpreted as attempts to access and integrate the tacit knowledge of organizational members while recognizing the barriers to the transfer of such knowledge. While analysis of delayering has concentrated upon cost reduction and increasing the speed of decision making, the knowledge-based view suggests that, to the extent that ‘higher-level decisions’ are dependent upon immobile ‘lower-level’ knowledge, hierarchy impoverishes the quality of higher-level decisions. The dilemma is this: if production (and decisions about production) require many types of knowledge, if that knowledge is resident in many individuals, and if integration mechanisms can involve only relatively small numbers of individuals—what organizational structures are possible?

The recent vogue for team-based structures where team membership is fluid, depending upon the knowledge requirements of the task at hand, is one response to the deficiencies of hierarchy. The essence of a team-based organization is recognition that coordination is best achieved through the direct involvement of individual specialists and that specialist coordinators ( ‘managers’ ) cannot effectively coordinate if they cannot access the requisite specialist knowledge. The spread of team organization throughout production activities recognizes that critical knowhow is located among individual operatives— specialists. The displacement of scientific management by various forms of participative, employee-empowering management approaches partly reflects the motivational benefits of these systems, but is also a result of the greater efficiency of these systems in accessing and inte- grating the relevant knowledge. Wrack and Jensen (1994) identify total quality management as a nonhierarchical, team-based organizing technology that permits an organization to access and utilize individuals’ knowledge located at low levels of the organization.

In ‘higher-level’ integration—cross-functional coordination for example—barriers to vertical knowledge transfer imply that integration requires the direct participation of specialists. Hence, the trend in new product development has been away from sequential processes coordinated by the heads of functional departments towards crossfunctional teams. The key problem with such teams is, given coordination restricts their size, teams are unable to directly access the full range of specialist knowledge relevant to their activities. This can be partially addressed by making their membership fluid so that relevant expertise can be tapped when needed.

More generally, if movement of knowledge within the organization requires the movement of the specialists who possess it, then effective knowledge utilization will tend to require that individuals occupy multiple organizational roles involving membership of multiple teams.

2. Implications for the distribution of decision- making authority in the firm

Implications for the allocation of decision-making authority in the firm follow directly from the above discussion of the problems of hierarchical structures in integrating knowledge. The conventional basis for the analysis of decision making is delegation. Decision- making rights reside in the owners of the firm. As representatives of owners, the board of directors confers decisionmaking powers on senior management, which in turn delegates authority down the hierarchy. Agency theory provides a rigorous analysis of the problems of divergent individual goals and the creation of incentive structures to achieve goal alignment (Jensen and Meckling, 1976).

The knowledge-based view of the firm has two principal implications for the distribution of decision making. The first issue concerns the linkage between decision rights and ownership. If the primary productive resource of the firm is knowledge, and if knowledge resides in individual employees, then it is employees who own the bulk of the firm’s resources. The firm contracts with employees for the use of these knowledge resources. However, unlike physical and financial assets, employment contracts confer upon the firm only partial and ill-defined ownership rights over employees’ knowledge assets. Moreover, the decision rights of the firm in relation to employees’ knowledge are severely constrained. Knowledge assets remain resident within individual employees and cannot be readily transferred. If decision rights are conferred by ownership and if the firm’s resources are jointly owned by stockholders and employees—then management’s decision rights are delegated downwards by the stockholders and board of directors, and upwards by employees. Thus, the knowledge- based firm corresponds more closely to Aoki’s (1990) analysis of the Japanese corporation as a system of dual control jointly exercised by stockholders and employees, than it does to the conventional share- holder-owned and controlled corporation which dominates the Anglo-Saxon capitalist tradition.

The second issue concerns co-location of decision making and knowledge. The quality of decisions depends upon their being based upon relevant knowledge. If the knowledge relevant to a particular decision can be concentrated at a single point in the organization, then centralized decision making is feasible. But the ability to transfer and aggregate knowledge varies between different types of knowledge. Explicit knowledge is transferable, but cannot necessarily be aggregated at a single point. Jensen and Meckling’s specific knowledge is knowledge which is costly to transfer; this would comprise both tacit knowledge and explicit knowledge which cannot be aggregated and analyzed in statistical form. The principle of co-location requires that decisions based upon such tacit and idiosyncratic knowledge are decentralized, while decisions requiring statistical knowledge are centralized.

Recent organizational changes in the oil and gas industry illustrate these tendencies (Grant and Cibin, 1996). Decisions which require accessing and processing quantifiable information have become increasingly centralized—treasury and financial risk management functions for example. Decisions requiring tacit and idiosyncratic knowledge—strategic planning, investment appraisal, and operational decisions concerning individual oil and gas fields— have become increasingly decentralized.

Source: Grant Robert M. (1996), “Toward a Knowledge-Based Theory of the Firm”, Strategic Management Journal,

Vol. 17, Special Issue: Knowledge and the Firm (Winter, 1996), pp. 109-122.

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