The economic theory of organizations: what it is

The economic theory of organizations as a field of study includes (1) the theory and policy of industrial organization; (2) the theory of the firm; (3) the theory of contracts; and (4) extension of these to theories of markets, governments, and nonprofit organizations. I briefly review the first three of these on the way to an examination of (4).

First, theories of industrial organization originated with Mason (1939) and Bain (1958). These initially focused on defining industry structure through specific characteristics such as size and number of firms in an industry, product type (that is, whether of a homogeneous nature or dif- ferentiated), and conditions of entry and exit. The basic premise of the original theory is that these structural characteristics describe an eco- nomic environment which dictates firm behavior. A firm’s behavior, or conduct, in the market includes the pricing strategies that it  adopts, output adjustments it may make in response to variations in demand, advertising or marketing strategies it may use, and research and devel- opment activities it may engage in, among other  things.  The  resulting firm conduct determines performance: Evaluation of performance  is based on the level of efficiency in the allocation of resources through the market and on the level of efficiency achieved in production. Efficiency of allocation is most simply measured by how close market price is to the marginal cost of production: as price falls and approaches marginal cost, allocative efficiency increases. Efficiency in production occurs when output is produced at the lowest per unit cost.

This theory is termed the Structure-Conduct-Performance (SCP) model of industrial organization because it proposed a specific direction of causation from structural characteristics to firm behavior that affect how well (that is, how efficiently) the overall industry performs. The theory predicts a spectrum of outcomes ranging from most efficient in least structured industries (that is, industries that are most competitive, with more and smaller firms), to least efficient in highly structured industries (that is, industries that are more monopolistic, with fewer, larger firms). The smaller number of larger firms that characterize a highly structured industry presumably face less competitive pressure. These firms are therefore in a position to use their market position and power to raise price above marginal cost while operating at excess capacity at a higher than minimum per unit cost. The major implications of these predictions therefore are that larger firms are less efficient than smaller firms, and that having many firms is more efficient than having fewer firms. The theoretical framework of the SCP model has provided a basis for antitrust policy to correct limited or absent competition and regulatory policy to correct competitive market failures in the US and in Europe.1

The simple association of bigness and inefficiency derived from the SCP theory of industrial organization has given rise to considerable con- troversy and alternative theories of industrial organization. Some of these theories question the basic assumption of the model, that is, the direction of causation that structure, exogenously determined, affects firm behav-ior and therefore efficiency in the market. Koch (1980) summarized some of the difficulties with the SCP model, indicating that the direction of causation may be reversed. He suggested that structure may be endoge- nously determined by firms in response to their profit performance. That is, firms may engage in specific conduct (that is, strategies) as a way to create or increase the structure of the industry rather than as a response to some exogenously determined structure already in place. Thus alter- native theories are designed to explain industry structure as well as firm behavior. In these theories the motivation for the firm’s conduct is to gain market power and greater profit. Although the direction of causa- tion is reversed the theory leaves in place the implications of the origi- nal SCP model, however, that larger firms are less efficient than smaller firms and that having more firms is better than having fewer firms in an industry.

Other   theories   question   the   basic   assumptions   and   implications of both sets of these structural theories. In particular, new theories proposed that increasing industry structure may be a means to greater efficiency (see, for example, Demsetz, 1968 and Williamson, 1971). This research questioned other assumptions of these structural models upon which their predictions were based. These assumptions included limited or no economies of scale or scope, full information  to  all  parties,  and zero transactions costs. Reconsidering these assumptions resulted in alternative theories that yield quite different results. Larger firms that are able to capture scale economies are able to produce at a lower per unit cost than smaller firms can, for example. Also, a firm may become larger by merging vertically with a distributor by reducing transactions costs or capturing scope economies, producing more efficiently. One of the implications of these alternative theories therefore is that an indus- try comprised of larger and fewer firms may be more efficient than one with many small firms.

Most of these alternative theories of industrial organization retain the pure neoclassical approach where the firm is a monolithic entity. Thus the firm is a simple unit of production that responds to changes in its environment (represented by relative prices) while subject to different assumptions about the characteristics of its production process. These may be associated with characteristic of alternative structures, such as scale economies, product variation, or research and development require- ments, to determine the level of efficiency.

Other theories of industrial organization, however, break away from the view of the firm as a simple monolithic production unit. These theories examine the way that the internal structure of the firm affects or may be affected by information transfers or transactions costs under alternative industrial structures (Coase, 1937). These alternative theories give rise to different policies designed to increase efficiency. For example, efficiency effects of a merger will vary and may depend on factors that are exogenous and endogenous to the firm.  Endogenous  factors  that affect the efficiency of a merger may include the requirement for highly specific assets that may give rise to significant transactions costs or risk in dealing with suppliers (Klein, Crawford, and Alchian, 1978; Williamson, 1985 and Joskow, 1988). Alternatively, endogenous factors may include internal transactions costs, such as in the process of trans- fer pricing, or the costs of merging administrative functions, personnel benefit packages, compensation plans, and managerial–staff  relation- ships (Hart and Holmstrom, 2002). These more recent theories of indus- trial organization thus propose that structure and performance may be either unrelated or may be related in the opposite way  that  the  SCP model predicts.

The second area of the economic theory of organizations, the theory of the firm, includes a more fully developed theory of the firm itself as an organization and is less focused on industry structure. This area of research explores the origins and rationale for the firm as an organiza- tion. This research was given impetus by Coase (1937) and considers that the firm operates by edict or authority as opposed to actions of strictly voluntary exchange. The research explores why production is organized in authoritative firms in an economy characterized by free voluntary exchanges. The focus of this research is the neoclassical firm as a con- struct of efficient production versus the use of multiple market transac- tions to achieve the same outcome. These theories essentially view the neoclassical firm as a device to minimize transactions costs. The firm can be thought of as a set of contracts that reduces transactions costs by organizing and internalizing supplier contracts rather than engaging in the more costly process of multiple individual external contracts through markets. The firm as organization, then, becomes a nonmarket hierarchical form that substitutes authority for exchange.

In this framework the internal hierarchical structure of the firm becomes important. This discussion extends to developing theories of firm structure and decision making. I examine details of these theories in later chapters. Here I present an overview of the different approaches to the issue of firm structure. Machlup (1967) proposed a classification of theories of the firm into marginalist (that is, neoclassical), behavioral, and managerial. Cyert and Hedrick (1972) elucidated and more fully developed Machlup’s classification of these theories as neoclassical (and modified neoclassical), managerial, and behavioral.2 Machlup (1967) also noted that there are many concepts of a firm, depending on the context of its use. Although he suggested that there were at least 21 such concepts, he outlined ten. Of these ten, five would be classified as neoclassical, two would be managerial or behavioral, and the remaining three, which were definitional, would for analytical purposes be classi- fied also under neoclassical concepts of the firm.

Neoclassical and modified neoclassical theories treat the firm as a monolithic entity, or ‘black box,’ which as a whole maximizes a clearly defined organizational objective subject to externally imposed con- straints. In the pure neoclassical theory of the firm, the firm’s objective is to maximize profit; in the modified neoclassical firm, the firm’s objective is to maximize sales, revenue, market share, or growth, for example. The constraints on the firm are imposed by competitive input markets (factor prices) and competitive output markets (goods prices). An additional constraint imposed on modified neoclassical models is a minimum profit constraint. The theory generates predictions for levels of output, prices, profits, and efficiency under alternative industrial structures.

Both managerial theories and behavioral theories of the firm depart from the neoclassical tradition in that they look inside the firm as a complex organization. These theories explicitly examine the way that organizational structure affects decision behavior within the firm to determine how resources may be allocated within the firm itself rather than simply in the markets in which the firm operates. Milgrom and Roberts (1988) note that organizational structure yields at least some control to a central authority, or manager, with power of intervention to increase organizational efficiency. The problem they point out is that ‘the very existence of a central authority affects how that system oper- ates’ (p. 447). Managerial and behavioral theories therefore develop implications for the way that decision behavior of the manager within the firm may alter predictions for output, cost, and price that are derived from the neoclassical or modified neoclassical model. Managerial and behavioral theories of the firm differ in that managerial theories assume optimizing behavior (that is, unbounded rationality) on the part of decision makers whereas behavioral theories do not. Behavioral theories assume bounded rational decision behavior.

Managerial theories of the firm follow along the lines of Williamson (1963). These theories focus on the corporate form of the firm where the owners are shareholders who are widely disbursed and separated from the day-to-day operation of the firm. The manager in these theories takes on the function of decision maker whose role ostensibly is to allocate resources so as to maximize owners’ profit. The corporate manager therefore is in control as the decision maker who is responsible for the allocation of firm resources. Managerial theories assume that the deci- sion maker has his or her own objective, which is managerial utility maximization rather than profit maximization for the shareholders. Firm profit is included in managerial theories as either only one of a number of arguments in the managerial utility function or a constraint imposed on the decision maker. Managerial theories explore the way managerial utility maximization affects the way resources are allocated internally, and how this affects owners’ profitability and the efficiency of firm performance in the market.

Alchian and Demsetz (1972) developed a theory of the firm as a system of team production. This theory incorporates both neoclassical and managerial elements. They cast the manager as a team member who has a residual claim. That is, the manager is in the position of the firm owner who earns the profit generated by the team. In this sense the model is neoclassical, for there is no separation of ownership from con- trol. The model considers the internal operation of the firm as an organ- ization of production, however. In this sense it is a managerial model. The manager is a distinct individual from the productive team of work- ers who generate the profit. It is a principal–agent relationship in which the manager/owner is the principal and the team of workers is the col- lective agent. In this model profit is the only source of the manager’s utility. Because individual marginal product cannot be observed in a situation of team production, the team members have an incentive to shirk, thereby reducing output and profitability of the team. Thus the manager as principal faces a situation of imperfect agency. The manager as principal therefore takes on the role of monitor of the team’s productive activities. His or her incentive to monitor is derived from the greater return obtained by the principal from more productive teamwork.3

Managerial models permit the exploration of alternative internal struc-tural designs of a firm. For example, Williamson (1983) examines different internal structures of a corporation. These include the unitary structure, or U-form, and the multidivisional structure, or M-form, where the latter has the firm organized as a set of individual profit centers. He proposes that the efficient internal structure of a firm will be the one that minimizes transactions costs of the organization as a whole. Jantsch (1971) pro- poses an alternative organizational form to either the U-form or the M-form that promotes efficient use of information in the managerial decision process. His organization is a planning form that separates operations (current activities) from corporate planning (future activities). This model focuses on managerial authority and efficiency.

Also consistent with managerial models is the alternative interpre- tation that the optimal organizational form may be chosen because it maximizes managerial utility subject to a shareholder profit constraint. The choice of organizational form that maximizes managerial utility will incorporate the manager’s preferences for such things as authority, prestige, and the ability to create and access discretionary profit, as well as generate profit for the firm as a whole, that is, for the firm’s shareholders.

Behavioral theories follow from Simon’s (1957) proposal that individ- ual decision makers, that is, managers, are not in a position to know either what the optimum outcome is (for example, the maximum profit) or how to obtain it even if they did know. That is, behavioral models assume that decision makers are subject to bounded rationality, or nonoptimizing behavior. The concept of bounded rationality explicitly recognizes that decision makers have specific objectives. However, bounded rationality also recognizes both the difficulties associated with the information processing requirements inherent in optimization and the need for and practice of logical, consistent reasoning to achieve their stated objectives.

Behavioralists therefore subscribe to rational decision making. Their rationality is bounded by the lack of information and information processing ability to which all decision makers are subject. The decision maker cannot know or obtain an optimal outcome (such as the largest possible profit or the smallest possible cost). However,  the  decision maker can achieve an outcome that is adequate and acceptable. The out- come is one that is satisfying to the decision maker. The outcome need not be optimal in the sense of a unique maximum (for example, profit) or a unique minimum (for example, transactions costs). Simon referred to this decision behavior as ‘satsificing’ as opposed to optimizing.

Bounded rationality is concerned with the process of decision mak- ing. It therefore incorporates the notion that ‘decisions are made in real time which has a direction or flow. Thus decision processes are sequen- tial and not simultaneous …’ (Jackson, 1983, p. 80). The focus on the process and timing of decisions as well as targeting outcomes, or satis- ficing, rather than maximizing set behavior models apart from mana- gerial models of decision making in organizations.

The behavioral approach has been controversial in the economic theory of organizations, in large part due to the uniqueness problem that arises in the mathematical modeling of decision making. Recognition of the issue of bounded rationality  has  increased  with  the  development of contingent contract theory. I return to this point in my discussion of efficiency in Chapter 3.

A third area in the economic theory of organizations is a more fully developed theory of contracts. In contract theory, one view of the firm is as a nexus of contracts. This set of contracts at once defines the firm and sets it apart from the market. Defining an organization as a nexus of contracts necessarily develops further the important issues of transactions costs, the principal–agent relationship, information require- ments, and property rights.

Transactions costs are the costs incurred in the process of negotiating a contract, monitoring its application, and enforcing the terms of the contract. Firm contracts include employment contracts, supplier contracts, insurance contracts, and shareholder contracts, for example, as well as consumer contracts. In many cases these contracting costs may be significant. A firm’s contract with suppliers may be negotiated between two individuals or between teams of attorneys, for example. Monitoring the terms of the contract may be as simple as observing delivery of an input or delivery of a product. Monitoring of delivery of supplies may involve determination of input quality as well as timing, however, and may be more difficult to detect without testing by the firm receiving the inputs. Contract enforcement may require invoking terms of a warranty or may require a lengthy legal process.

Fundamental to a contract is   the   principal–agent   relationship. As there are multiple levels of contracts in a single firm, there are multiple levels of principal–agent relationships. A manager may take on the role of principal in one employment contract, for example, in hiring production workers, and have the role of agent in her own employment contract with respect to shareholders. Contracts cannot cover every possible contingency. It is for this reason that imperfect or asymmetric information becomes an important contractual issue.

Information problems may be minor and  impose  few  transactions costs on the firm. In this case contracts are easily negotiable and enforce- able. On  the  other  hand,  information  problems  may  be  so  significant as to preclude contracting even when a resource is valued by both par- ties (Milgrom and Roberts, 1992). This could occur when neither party is willing to provide enough information about his or her value of the resource that there is no area for negotiation. Transactions costs effec- tively become infinitely high.

Finally, in connection with contract theory are property rights. Property rights are required for any contract or exchange to take place, and therefore, for the existence of a firm or other organization. The concept of property rights and its significance are explored more fully in Chapter 4.

Fourth, the economic theory of organizations includes extensions of theories of the firm and industry and theories of contracts to markets and governments (the state) as organizations, and to private not- for-profit organizations (nonprofits). In his Nobel lecture, Coase (1991) pointed out the importance of understanding the relationship between the economic and legal systems in this regard. The analysis of a market as an organization has become increasingly significant in the area of transition economies, as in Eastern Europe and more recently, in Middle Eastern countries. The concept of a market as an organization also is applicable to industries that are moving from a regulated to a deregulated environment, such as in the generation and distribution of electricity in the US and Canada. This field of research  recognizes  the  importance of economic infrastructure and institutions, such as a banking system or mechanisms for exchange in transition economies, and the operation of network or grid systems in electricity distribution.

Governments, or the state, as an economic organization is one that operates in a political marketplace, characterized by contracts that have both political and economic characteristics. Nonprofit organizations have unique contracting  issues  associated  with  the  particular  form of property rights in this organizational form. I delay the full discussion of these extensions until Part III.

Thus far, the economic theory of organizations appears to be a collection of disparate theories. These include theories of industrial organization, theories of the firm and decision making, theories of contracts, and theories of markets, governments, and nonprofit organi- zations. These are related in a number of ways, however. Theories of contracts may define the boundaries of a firm, distinguishing firms from markets but also defining how markets work. Contracts may also define economic and legal relationships between firms, between firms and governments, or between firms and nonprofit organizations.

The role of industry structure may depend on the nature and compo- sition of the industry. For example, one industry may comprise only for- profit firms as competitors or as competitors and suppliers. For example, manufacturing industries such as automobiles have only for-profit firms as competitors and as suppliers. Another industry may be mixed. That is, it may comprise for-profit firms, government organizations, and nonprofit organizations as competitors. For example, some service industries such as health care provision or insurance include for-profit firms, nonprofit organizations, and in some cases government organi- zations as alternative sources of supply.

One common thread through the fabric of the economic theory of organizations is the thread of property rights. As stated earlier, property rights are essential to the concept of a contract and to the concept of an organization. In a contract, when an exchange is made, it is a property right that is exchanged. In addition, property rights determine the terms of trade and therefore the efficiency of the contractual exchange (Demsetz, 1964). Property rights do this by establishing and affecting incentives in contracts and in organizations.

The role of property rights is relevant to all the various economic theories of the firm and organizations, whether neoclassical  (or  modi- fied neoclassical), managerial, or behavioral. Property rights systems incorporate legal and institutional as well as economic characteristics. Property rights therefore are relevant to all types of organizations: for- profit firms, public organizations, and nonprofits, and their internal structure and design. For these reasons the structure of property rights in alternative organizations provides the framework for my comparative analysis of managerial decision making in alternative  organizational forms.

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.

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