1.

INTRODUCTION
An organization is a blend of formal and informal relationships. The formal organization is what appears on an organization chart. It defines official relationships among its members. The informal organization has no chart, nor is one necessary. It's the sum of personal relationships and communication links among its members, regardless of official position. People seek membership in informal organizations to share information, win acceptance, advance their aims, and build friendships.

Informal interactions Besides formal interactions, people interact informally and form personal bonds that reinforce official relationships, both in and out of the work place: The CG and an NCO are close friends; they once served together in combat. Two division chiefs are members of the same fraternal lodge. Secretaries from two divisions ride in the same car pool.

Influence In these informal associations natural leaders lacking formal power can still influence others through their control of resources personal magnetism access to information institutional memory reputation, and proximity to decision makers

Examples The informal

organization

can

influence

the

formal

organization

by

transmitting valuable information through the grapevine

attacking tough jobs enthusiastically cutting red tape supporting or resisting change disciplining members who violate official or unofficial standards, or ostracizing unworthy members

The Formal Organization appears on the Organizational Chart. The Informal Organization is the system of relationships amongst the employees. The Informal Organization can Adapt quickly Help to foster group cohesiveness Aid in communications - the Grapevine

Examples of Informal Group Norms Do your job, but dont produce more than the rest of the group. Dont tell off-colour jokes or use profane language among group members. Listen to the boss and use his/her expertise, but dont trust him/her. Everyone is to be clean and organized at their work stations. Never side with managers in a dispute involving group members. Respect and help your fellow group members on the job. Criticize the organization only among group members. Never among strangers. Drinking is done off-the-job. Never at work!

2. COMPARISON OF INFORMAL AND FORMAL ORGANIZATIONS

Widespread interest in the informal organization developed as a result of the Western Electric studies in the 1930s, which concluded that it was an important part of the total work situation. These studies showed that the informal organization is a network of personal and social relations not established or required by the formal organization but arising spontaneously as people associate with one another. The emphasis within the informal organization is on people and their relationships, while the formal organization emphasizes official

positions in terms of authority and responsibility. Informal power, therefore, attaches to a person, while formal authority attaches to a position and a person has it only when occupying that position. Informal power is personal, but formal authority is institutional. Power in an informal organization is given by group members rather than delegated by managers; therefore, it does not follow the official chain of command. It is more likely to come from peers than from superiors in the formal hierarchy; and it may cut across organizational lines into other departments. It is usually more unstable than formal authority, since it is subject to the sentiments of people. Because of its subjective nature, the informal organization cannot be controlled by management in the way that the formal organization can. A manager typically holds some informal (personal) power along with formal (positional) power, but usually a manager does not have more informal power than anyone else in the group. This means that the manager and the informal leader usually are two different persons in work groups. As a result of differences between formal and informal sources of power, formal organizations may grow to immense size, but informal organizations (at least the closely knit ones) tend to remain small in order to keep within the limits of personal relationships. The result is that a large organization tends to have hundreds of informal organizations operating throughout it. Some of them are wholly within the institution; others are partially external to it. Because of their naturally small size and instability, informal organizations are not a suitable substitute for the large formal aggregates of people and resources that are needed for modern institutions.

3. HOW DOES TBE INFORMAL ORGANIZATION EMERGE?

The organization's structure is designed by management to be consistent with its environment, tel;hnology, and strategy. This structure, with its rules, procedures, and job descriptions, creates a set of prescriptions for employees to follow. Individuals and groups are expected to behave in certain ways. If they perform their tasks as prescribed, the organization is efficient. This ideal may not happen as much as managers would like, however, for several reasons.

The informal organization emerges from within the formal structure as predictably as flowers grow in the spring. The result of this combination is different from what managers may have expected in at least three ways.3 First, employees act differently than required. They may work faster or slower than predicted, or they may gradually modify a work procedure on the basis of their experience and insight. Second, employees often interact with different people, or with different frequencies, than their jobs require. Georgia may seek advice from Melissa instead of Todd, and Candy may spend more time helping Jose than Steve. Third, workers may embrace a set of attitudes, beliefs, and sentiments different from those the organization expects of them. Instead of being loyal. committed, and enthusiastic about their work, some employees may become disenchanted, while others are openly alienated. The lesson for managers is painfully obviousthey must be aware of the informal activities, interactions, and sentiments of employees in addition to the required ones. The combination of required and emergent behaviors sometimes makes it difficult to predict levels of employee performance and satisfaction.

MEMBER STATUS AND INFORMAL LEADERS

Among the members of the marketing department in one firm there were remarkable, but somewhat typical, differences. Their ages ranged from thirty to seventy-two; their seniority in the organization varied from newly hired to thirtynine years; and the highest-paid member earned about 80 percent more than the lowest-paid member. Some of the group had grown up in the local area, while others had moved across the United. States tq accept their jobs. Also, their offices differed in many dimensions, such as size, availability of natural lighting, and proximity to noise. Members of work groups like that described above have identifiable characteristics that distinguish them from one another and give rise to status dif ferences. As seen in the example, they differ in age, seniority, earnings, birthplace, and nature of their workplace. Other factors, such as technical competence, freedom to move around the work area, and personality, are also recognizable. Each of these elements can provide status to its holder, largely based on what the group members value. The causes of informal status are nearly numberless. The employee with the largest amount of status in the informal organization 4

usually becomes its informal leader. This person emerges from within the group, often acquiring considerable informal power. Informal leaders may help socialize new members into the organization, and they may be called upon by the group to perform the more complex tasks. A young neurosurgeon, for example, related how the group's senior partner would often stop by the operating room during a particularly delicate operation to assist briefly in the removal of a brain tumor, and then quietly move on when help was no longer needed. In return for their services, informal leaders usually enjoy certain rewards and privileges. Perhaps the informal leader is permitted by coworkers to choose a vacation time first, or the leader might be spared from a messy cleanup chore. A predictable reward is the high esteem in which the informal leader is held, and this is significant enough to balance the responsibilities the person shoulders. Informal groups overlap to the extent that one person may be a member of several different groups, which means that there is not just one leader but several of varying importance. The group may look to one employee on matters pertaining to wages and to another to lead recreational plans. In this way several people in a department may be informal leaders of some type. There might be an experienced person who is looked upon as the expert on job problems, a listener who serves as counselor, and a communicator who is depended upon to convey key problems to the managers.

IDENTIFYILNG INFORMAL LEADERS

Sometimes the informal leadership of a group is unclear, at least to outside observers or managers. However, informal leaders often exhibit distinct behaviors that allow them to be identified. For example, Ellen may serve as the unofficial representative to management when workers have a question or complaint. Or managers may notice that other employees gather around Willie's workstation to swap stories whenever there is a coffee break. Sarah may voluntarily train new employees when they ask for technical help. These 'examples suggest that acting as a spokesperson, being the center of social attention, and offering well-received wisdom and guidance all provide useful clues regarding informal leadership. Why are some employees, such as Ellen, Willie, and Sarah, willing to be informal 5

leaders? To some workers informal leadership is a form of job enrichment, providing them with variety in their workday and a feeling of greater significance. Others find that it helps satisfy their social needs by dramatically increasing their interpersonal contacts during the day. Many find it a source of recognition for their esteem needs-a way of being acknowledged for their skills and experience while avoiding the responsibilities of formal supervision. By recognizing these rewards for informal leadership, managers can better understand the behavior of some individuals. Although several persons in a group may be informal leaders of various types, there is usually one primary leader who has more influence than others. Each manager needs to learn who the key informal leader is in any group and to work with that leader to encourage behavior that furthers rather than hinders organizational objectives. When an informal leader is working against an employer. the leader's widespread influence can undermine motivation and job satisfaction. The informal organization is a desirable source of potential formal leaders, but it should be remembered that an informal leader does not always make the best formal manager. History is filled with examples of successful informal leaders who became arrogant bosses once they received formal authority. Sume informal leaders fail as formal ones because they fear official responsibility-something they do not have as informal leaders. They often criticize management for lacking initiative or for not daring to be different, but when they take a managerial job, they become even more conservative because they are afraid to make a mistake. Other informal leaders fail because their area of official managerial authority is broader and more complex than the tiny area in which they had informal power. The fact that Joe is the leader in departmental social activities does not mean that he will be successful as the departmental manager. The difficult transition from informal to formal leader may be partially explained by the results of a research study of emergent leaders in small groups.4 By using members' ratings of one another on the degree to which they were goal-directed and gave directions, summarized, and appeared self-assured after their first task, the researcher was able to predict eight out of nine emergent leaders. However, it was also discovered that the informal leaders typically rated quite highly as "quarrelsome," but not as "sensible." It appears that candidates for informal lead6

ership require many of the same skills as formal leaders, but their other characteristics may later impair their effectiveness as formal leaders.

4. BENEFITS OF INFORMAL ORGANIZATIONS

Although informal systems may lead to several problems, they also bring a number of benefits to both employers and employees. Most important is that they blend with formal systems to make an effective total system. Formal plans and policies cannot meet every problem in a dynamic situation because they are reestablished and partly inflexible. Some requirements can be met better by informal relations, which can be flexible and spontaneous. Another benefit of the informal organization is to lighten the workload on management. when managers know that the informal organization is working with them. They feel less compelled to check on the workers to be sure everything is shipshape. Managers are encouraged to delegate and decentralize because they are confident that employees will be cooperative. In general. informal group support of a manager probably leads to better cooperation and productivity. It helps get the work done. The informal organization also may act to fill in gaps in a manager's abil ities. If a manager is weak in planning, an employee may informally help with planning. In this way, planning is accomplished in spite of the manager's weakness. A significant benefit of the informal organization is that it gives satisfaction and stability to work groups. It is the means by which workers feel a sense of belonging and security, so satisfaction is increased and turnover reduced.

In a large office an employee named Rose McVail may feel like a mere payroll number, but her informal group gives her personal attachment and status. With the merIlbers of her group she is somebody, even though in the formal structure she is only one of a thousand clerks. She may not look forward to posting 750 accounts daily, but the informal group gives more meaning to her day. When she thinks of meeting her friends, sharing their interests, and eating with them, her day takes on a new dimension that makes easier any difficulty or tedious routine

in her work. Of course, these conditions can apply in reverse: The group may not accept her, thereby making her work more disagreeable and driving her to a transfer, to absenteeism, or to a resignation. An additional benefit is that the informal organization can be a useful channel of emPloyee communication. It provides the means for people to keep in touch, to learn more about their work, and to understand what is happening in their environment. Another benefit, often overlooked, is that the informal organization is a safety valve for employee frustrations and other emotional problems. Employees may relieve emotional pressures by discussing them with someone else in an open and friendly way, and one's associates in the informal group provide this type of environment. Consider the case of Max Schultz, who became frustrated with his supervisor, Frieda Schneider. He was so angry that he felt like striking her, but in a civilized organization th'at was not appropriate behavior. He wanted to tell her what he thought of her, using uncomplimentary words, but he might have been disciplined for that. His next alternative was to have lunch with a close friend and to share with his friend exactly how he felt. Having vented his feelings, he was able to return to work and interact with Schneider in a more relaxed and acceptable manner. A benefit of the informal organization that is seldom recognized is that its presence encourages managers to plan and act more carefully than they would otherwise. rvlanagers who understand its power know that the informal organization provides a check on their unlimited use of authority. They introduce changes into their groups only after careful planning because they know that informal groups can undermine even a worthwhile project. They want their projects to succeed because they will have to answer to formal authority if they fail. The benefits of the informal organization are more likely to appear if the group is cohesive and its members have favorable attitudes toward the firm.s Cohesiveness is indicated by how strongly the employees stick together, rely on each other, and desire to remain members of the group. Productivity among

members of cohesive groups is often quite uniform, and turnover is low. Whether productivity will be high or low, however, is directly related to the cohesive group's internal work attitudes. If they are favorable toward the organization, performance will likely be higher; if they are negative, performance will likely be diminished.

5. PROBLEMS ASSOCIATED WITH INFORMAL ORGANIZATIONS

Many of the benefits of informal systems can be reversed to show potential problems. In other words, informal systems can help and harm an activity at the same time. For example, while useful information is being spread by one part of the system, another part may be communicating a malicious rumor. An informal system also can change its mood in a positive or negative way. A work group, for example, may accept, welcome, and nurture Flew employees and thus facilitate their feelings of comfort and performance levels. By contrast, the same group may confront, harass, and reject other employees, causing dissatisfaction and resignations. Both positive and negative effects exist side by side in most informal systems. One major problem with informal organizations is resistance to change. There is a tendency for a group to become overly protective of its way of life and to stand like a rock in the face of change. What has been good is believed to be good enough for the future. If. for example, job A has always had more status than job B, it must continue to have more status and more pay, even though conditions have changed to make job A less difficult. If restriction of productivity was necessary in the past with an autocratic management, the group might believe it to be necessary now, even though management is participative. Although informal organizations are bound by no chart on the wall, they are bound by convention, custom, and culture. A related problem is that the informal organization can be a significant cause of employee conformity. The informal side of organizations is so much a part of the everyday life of workers that they hardly realize it is there, so they usually are unaware of the powerful pressures it applies to persuade them to conform to its way of life. 111e closer they are attached to it, the stronger its influence is. Conformity is encouraged by norms, which are informal group requirements for 9

the behavior of members? These norms may be strong or weak (depending on the importance of the behavior to the group), and positive or negative (depending on their impact on the organization). Groups rigidly expect their members to follow strong norms, while individuals may choose to accept or reject weak ones. Research studies show that groups have norms for both their task responsibilities and their personal relationships at work8 They also generate norms for their superior and subordinates, as well as their peers. The group whose norms a person accepts is a reference group. Employees may have more than one reference group, such as the engineering manager who identifies with the engineering profession and its standards, plus one or more management groups. A reference group often uses rewards and penalties, called sanctions, to persuade its members to conform to its norms. The combination of informal norms with their related sanctions consistently guides opinion and applies power to reduce _my behavior that tends to vary from group norms. Nonconformers may be pressured and harassed until they capitulate Or leave. Examples of harassment are interference with work (such as hiding one of the offender's tools), ridicule, interference outside the workplace (such as letting the air out of the offender's automobile tires), and isolation from the group. In Britain it is said that a person isolated from the group is being "sent to Coventry." In these instances the group refuses to talk with the offender for days or even weeks, and group members may even refuse to use any tool or machine the offender has used. Actions of this type can even drive a worker from a job. Another problem that may develop is role conflict. Workers may want to meet the requirements of both their group and their employer, but frequently those requirements are somewhat in conflict. What is good for the employees is not always good for the organization. Coffee breaks may be desirable, but if employees spend an extra fifteen minutes socializing in the morning and afternoon, productivity may be reduced to the disadvantage of both the employer and consumers. Much of this role conflict can be avoided by carefully cultivating mutual interests with informal groups. The more the interests of formal and informal groups can be integrated, the more productivity and satisfaction can be expected. However, there always will be some differences between formal and informal organizations. This is not an area where perfect harmony exists.

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A major difficulty with any informal organization is that it is not subject to management's direct control. The "authority" that it depends on is the social system rather than management. All that management can do is influence it here and there. Informal organizations also develop interpersonal and intergroup conflicts that can be damaging to their organization. When employees give more of their thoughts and energies to opposing one another, they are likely to give less to their employer. Conflicts and self-interests can become so strong in informal organizations that they reduce both motivation and satisfaction. The result is less productivity, which harms both the employer and employees. No one gains.

6. MONITORING THE INFORMAL ORGANIZATION

One way to gain a better understanding of an informal system is to prepare a visual portrait of it. These diagrams are called network charts, or informal organization charts. 10 They usually focus on either interpersonal feelings expressed (e.g., attraction, repulsion, or indifference) among individuals or actual behaviors exhibited. Identifying the feelings within a group can be useful for determining who trusts whom, or for selecting an individual to negotiate a satisfactory compromise on a sticky issue. Determining patterns of behaviors can be done either through direct observation of interactions, through collecting data on communication patterns, or by directly :asking individuals involved (e.g., "From whom do you seek advice most frequently?"). Network charts can reveal central individuals ("stars," such as Tania or Jackie), isolated persons (Carolina) who are likely to feel overlooked, and dramatic differences between what people think is happening versus what is actually occurring.

7. INFLUENCING INFORMAL ORGANIZATIONS

Management did not establish informal organizations, and it cannot abolish them. Nor would it want. to do so. But management can learn to live with them and have some measure of influence on them. Management guidelines for action include the following: 1. Accept and understand the informal organization. 2. Identify various levels of attitudes and behaviors within it. 11

3. Consider possible effects on informal systems when taking any kind of action. 4. Integrate as far as possible the interests of informal groups with those of the formal organization. 5. Keep formal activities from unnecessarily threatening informal organizations. The most desirable combination of formal and informal organizations appears to e a predominant formal system to maintain unity toward objectives, along with a well-developed informal system to maintain group cohesiveness and teamwork. In other words, the informal organization needs to be strong enough to be supportive, but not strong enough to dominate.

8. FORMAL ORGANIZATION VERSUS INFORMAL ORGANIZATION The FORMAL ORGANIZATION appears on the organization chart. The INFORMAL ORGANIZATION is the system of relationships among employees that develop outside the formal organization. The FORMAL ORGANIZATION is the structure that details lines of responsibility, authority, and position. The INFORMAL ORGANIZATION is the system of relationships that develop spontaneously as employees meet and form power centers. No organization can operate effectively without both types of organization. The FORMAL ORGANIZATION can be SLOW and BUREAUCRATIC, while the INFORMAL ORGANIZATION CAN ADAPT QUICKLY. The INFORMAL ORGANIZATION is TOO UNSTRUCTURED AND EMOTIONAL for decision-making, while the FORMAL ORGANIZATION PROVIDES GUIDELINES AND LINES OF AUTHORITY. It is wise to learn quickly who the important people are in the informal organization. The center of the informal organization is the GRAPEVINE. Successful managers learn to WORK WITH THE INFORMAL ORGANIZATION and use it to the organizations advantage.

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9. INFORMAL ORGANIZATIONAL STRUCTURE- THE HAWTHORNE STUDIES The big contribution of the late 19th century to organizations was the notion of rationality. The essence of what Weber, Fayol, Taylor and all those other classical theorists were saying was try to organize in a rational manner. Rather than make your brother vice-president of finance, put in somebody is qualified to do the job. Instead of moving pig-iron the traditional way, work out the biomechanics of it and develop a work style that maximizes output. A part of this rationalist perspective was a simple motivational theory, based ultimately on Adam Smith and utilitarianism. The idea is that people work best when they are maximizing self interest. Which was interpreted to mean money. But there is more to formal organizations than purely formal behavior, and more to human motivation than just pay. Human beings are social animals. We need to hang around with others. We like to be liked by others. We don't like to be the person that nobody likes. We also like respect and power and autonomy. So there are other needs that workers need to fill besides the ones that money buys. Whenever a set of people gets together and starts interacting on a long term basis, they start to form an informal group. An informal group is more than just a collection of people. Groups have internal social structure based on dominance and friendship relations. There are social leaders. There are hangers-on. Organizations contain lots of informal groups. Their existence -- and importance -- really came to light in the 1920's and '30s at the Hawthorne plant of the Western Electric Company in Chicago, studied by Elton Mayo, Roethlisberger and Dickson, from MIT. They started out studying ways of improving worker productivity, partly in the tradition of Taylor, and partly as a reaction to Taylor because one effect of Taylorization was tremendous morale problems among workers. Their experiments were in 3 phases, called the illumination, relay assembly, and bank wiring room studies respectively.

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Illumination: The first experiments were with illumination - lighting in the factory. It was thought that workers might work better when there was more light, but light was very expensive, so they needed to find the optimum level to satisfy both requirements. They assigned workers making induction coils to 2 groups: test and control. Both started with same amount of light. Then the Test group was given more light. Productivity went up. But, unfortunately, it also went up in the control group. So then they increased the light in the Test group again. Once again, productivity went up or stayed the same in both groups. Again they raised the light level, and again the same result. So then they reduced the lighting in the Test group way down, below the level in control group. Productivity soared in the Test group, and continued to go up in the control group. They reduced light some more: same result. They finally got down to a level of light equivalent to a moonlight night, and found that productivity was still the same or higher. This really confused the researchers. They finally took two workers and put them in a closet with no light at all -- just the crack under the door. Productivity was just fine. They had to conclude that light didn't seem to matter in the way they expected. And there was something very strange about why output kept going up relative to the rest of the factory. So they planned a more elaborate experiment. Relay Assembly Test Room: The second experiment was the relay assembly test room. Six women who assembled telephone relay switches were taken out of the main area and placed in special test room where they could be observed. All immigrants (as were most factory workers). It was a 5 year experiment. Productivity was measured the whole time by a machine that counted the number of relays that each person assembled as she dropped it down a little chute. They gauged the effects of rest pauses, shorter work days, shorter work weeks, wage incentives and different supervisory practices on output.

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The results were just like the results of the lighting experiment. No matter what change they introduced, it always seemed to either have no effect, or it improved productivity, even when the change was just returning the variable to its original state! As a result of these two studies, the Hawthorne team theorized that there was a key variable that managers had been ignoring, which had to do with workers' relationships, attitudes, feelings, and perceptions. By separating people into groups and then making lots of changes in working conditions, the researchers inadvertently did two things: 1. Made workers feel like management actually cared about them. They felt important and special. 2. They created bonds among people in the test and control groups -- in effect turning them into true groups as described above. People work better when they are part of a clear social structure. So an important conclusion was that people did not necessarily behave according to models of economic rationality. Social processes within the group that formed were much more important than purely material gains. Also, even material goods or physical events or wages or workhours etc were perceived differently by different people in different situations and so its not so much the money or the hours themselves that matter, its what meaning they hold for people, and meaning is something that is socially mediated. The group affects how the individual interprets things. An example occurs in the next phase of the experiments, the bank wiring room, where it turned out that workers conferred a lot of meaning on which chair people occupied (front or back of room). The front of the room was higher status. This was not something that management was even aware of. But it affected relationships among people in the room. To really understand employee grievances, complaints, squabbles requires understanding employee's position in the group social structure. Employee complaints are subjective: can't be treated as objective facts. Often, they are symptoms of other problems like personal or social disorders.

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For example, suppose a worker refuses to be moved to another desk, claiming that the light isn't as good and it smells there. But its really that that area is where the people of the out-group sit, and she's a member of the in-group. and she would rather die than sit with the out-group. If management isn't aware of this, they will simply think she is irrational. The meaning and value that employee assigns to his or her position depends on the degree to which position permits him to fulfill his social obligations to others in the group. A social organization provides a system of values that provide basis of action and satisfaction. Bank Wiring Room: The third phase of the experiments was designed to investigate the social structure of employees. How did it form, what did it consist of, how did it affect productivity, and so on. The room contained 9 wiremen, 3 soldermen, 2 inspectors, and the observer. Each solderman serviced 3 wiremen. wiremen attached wires to panels in a particular order, and soldermen soldered the connections closed. Then the inspectors would test them electrically with some test equipment. Also, among the 9 wiremen, 3 worked only on selectors and the other 6 worked on connectors. The connector stations were located in the front of the room. A basic question asked was, is the informal social structure based on occupations? The answer was "somewhat". For example, connector wiremen were all together at front of room. The men said they preferred connectors to selectors. Supposedly they were lighter to carry but they only had to carry two of them each day, so that sounded like an excuse). It also happened that new men were typically added to back of room. New men were slow, and had low hourly rates. People in front were old hands, more proficient, and therefore more status. So people preferred connectors cuz that's what the more prestigious people were doing. It was found that wiremen had higher prestige than soldermen. New people started as soldermen then became wiremen. Evidence for prestige was in things like who had to get lunch for everyone, some fights over the windows, and bits of conversation.

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Another job was trucker: he brought wire and raw materials into the room each day and took away finished terminals. For each terminal who took away, he had to put on an id tag and a stamp. The men called him "goofy" and "gigolo" and would annoy him constantly: spitting on the terminals right where he had to pick them up, jogging his arm just as he was putting on stamp, holding on to the handtruck, tickling him when his hands were full etc. When a new trucker came on, they behaved the same way towards him. Note that it was not exactly in the company manual that wiremen should harrass truckers. It was just something that developed. The inspectors reported through a different branch of the organization. They were better educated and wore nicer clothes. In the Bank Wiring room, they were higher status for most things, but considered outsiders. They did not have lunch with others and had no control over windows. Again, it was obviously not something management had mandated. One of main things going on in the room was games: matching coins, lagging coins, shooting craps, card games, bets on combinations of digits in the serial numbers of weekly pay checks, pools on horseracing, baseball, quality records. Also chipped in to buy candy, and they practiced binging (punching each other in the arm), and they did a special kind of arguing that was like a white version of playing the dozens: they would insult each other until somebody got mad. Whoever got mad lost. The games went on basically within two groups: a frontof-room group and a back-of-room group. Other things going on where conflicts over the windows: should they be shut or open? In-group members could control the windows. There was also job trading and helping each other out. A guy labeled w3 by the researchers was the most popular guy. He was also one of the fastest workers and didn't really need any help, but everybody wanted to help him. He didn't reciprocate much but that didn't matter. As in all groups, there were longterm friendships and antagonisms, whose effects come out practically every day. In general, the wiremen were antagonistic to the inspectors and vice-versa. But the men particularly hated I3, and eventually

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ousted him. In contrast, they liked I1. I1 would point out errors without charging them. The men also hated W5 for squealing on them. In the end, most of the relationships came down to two cliques, each with a hanger-on, and some isolates. The groups included several different professions. They seemed based more on physical closeness than anything else. These groups were recognized by the men themselves. They developed ideas about each other. In private interviews would say things like "we talk about interesting things, those guys in the back just horse around." The basic determinants of clique membership:

not a rate-buster: don't work too much not a chiseler: don't work too little not a squealer: don't let supervisor know anything that could possibly be used against operators not officious: don't act like an inspector

Clique membership/ostracism acted as a form of social control, forcing people to conform to group desires. Membership was also used to manage bosses. The men in a group would all stick together on stories, and would fudge reports so as to achieve uniform results. They also covered for each other. The groups established norms regarding output, treatment of supervisor, reciprocity and other interpersonal relations. effective controls and sanctions. But the main thing of course was to keep piece-rates from changing. By having group cohesion, they could resist change. The cliques served as a system for sense-making about organizational events. They developed their own set of beliefs, explaining things to each other like the complicated western electric payment system (which they had completely wrong). Consequently, employee logic didn't always agree with management or rational logic: eg. they restricted their output even though it cost them money. The investigators found that tests of intelligence, manual dexterity, physical health were unrelated to productivity. This means that social factors like norms of productivity overwhelmed any differences in ability among the workers.

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It should be noted that the social organization of the room had elements of the official structure (like relations between soldermen and wiremen), but also had entirely foreign elements. - Overall conclusion: formal organizations are not really formal. when human beings interact with each other over a long period of time, they develop a social structure that is only partly based on the formal organizational structure. Summary

Formal orgs develop informal groups within them. These informal groups have well-developed social structures, histories, culture etc. Group structure and processes serves specific purposes of controlling members, and of protecting group from management.

The informal social structure has as much to do with the way the organization runs as does the formal structure. The informal social structure may or may not work to the detriment of the organization. It is safe to say, thought, that it is always in mgmt's interest to understand that social structure, both so that they can predict how workers will react to things, and to manipulate them Organizations serve several functions.
o o o

provide society with products/services provide employment - money for its members provide a framework for a social system. just like shipwrecks and coral reefs create habitats for millions of fishy creatures, organizations provide social habitats for people.

10. INFORMAL ORGANIZATION ANALYSIS When men organize to accomplish specific purposes, they often begin their tasks by series of informal, "off-the-record" discussions. They may meet informally, making no definite commitments as to their positions in regard to the subject under discussion. They "want to see all angles," "shake the bugs out of a proposition." They may say, "This looks pretty good to me, but I cannot speak for

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my company (or church, or party), but I will take it up with them (formally) and you do the same with your group and we will see what can be done." Informal groupings in society represent flexible social structures in contradistinction to more rigid institutional structures. Informal group discussions are an important means by which society "makes up its mind" related to a particular direction for action. The value structures of informal groups are less rigid, less absolute than those of institutions. Their value systems tend to be pragmatic, that is, "if a thing works, it is good." Traits of informal Organization . Informal groups have no constitutions, written rules of procedures, or binding traditions to guide them. They may develop quasitraditional way of acting, but so long as they remain informal, the ways may be easily changed to meet specific circumstances. Informal power groupings are usually seeking ways to accelerate action, to expedite it, to find short-cuts around cumbersome institutionalized procedures, and to effect change with the least amount of disruption of the institutionalized groups of which they are auxiliaries. An informal group has both manifest and latent functions. That is, it has a loosely stated purpose and its actions are apparently aimed at this visible goal. This is its manifest function. In addition, it may also do things and express ideas that serve individual members in a manner quite unrelated to the expressed aim of the group. For example, a small group may decide to hold informal meetings to discuss means of increasing the community water supply. The manifest function is getting more water. But by meeting together and the group may gain increased business. And if the project is successful, the whole group may gain community prestige. None may have had these latter purposes in mind at the beginning of the meetings, but these functions of group activity were latent in the situation. Again, it may be stressed that one looks at what men do. As one sees what is being done, social structures become apparent. Informal structures are often taken for granted. They appear to be friendly gatherings. They may seem trivial in their purpose, but if looked at for their functional significance, they may give one clues to the directions taken by related larger and more formal institutional groupings.

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There can be no hard and fast line drawn between formal and informal social groups, and yet, when one sees a group operating without publicity, with no formal record of its activity with changeable membership, and with relatively few members, it is likely that the group is purely informal. Political caucuses are wellknown example of informal groups. Such groups may continue to be informal, become formal, or dissolve. Dysfunctional groups. A word may be said here concerning dysfunctional groups. Not all informal group activities are correlated to the over-all well being of the larger society or community. Some groups may function informally to subvert the larger system, or they merely may be "misguided" in their aims. Through discussion and trial-and-error activities, they may finally come to conclusions in conformity with the ongoing interests of society. Nevertheless, such groups, in operation, are dysfunctional to the system in which they act, regardless of the "rightness" or "wrongness" of their cause. Gossip cliques in a corporate structure, critical of top management, might be an example. Regardless of the merit contained in the gossip, it usually is dysfunctional to the corporation. In this case, the gossip activity may be functional to the smaller group while being dysfunctional to the whole group. Functional evaluation is, of course, subjective and related to the observer. One check is to have different observers evaluate the same phenomena. This will result in more objective conclusions. No matter how informal a group may be, it will have a leader or leaders. Such leaders are often leaders in the more formal organizations. Formal organizations operate social institutions, but the identification of elite leaders who are engaged in informal activities may throw light on formal movements within organizations. Boundaries of informal groups. The manifest function of the informal group will suggest its limitation to individuals with some relationship to the stated goal. But since latent functions also are important, they may have much to do with the delineation of informal group membership. A regular, informal gathering of public relations people, for example, might have no more manifest function than to provide a congenial gathering at luncheon time. Yet this group might serve the latent function of providing a place where politics, literature, or a variety of

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subjects could be discussed. The group could also be a social device for exclusion. It might limit its membership to certain persons considered "desirable" and keep out those who "would not fit." Such a latent function of inclusionexclusion is always a characteristic of a group. The rules of inclusion and exclusion may be vaguely defined or unstated in an informal group, in contrast to those of formal Organizations and institutions. Yet most persons recognize whether they are included or excluded from an informal group, even though there is no formal statement of membership qualifications. They know, for example, that only persons of a certain religion, racial background, economic status, social position, party affiliation, or business connection can belong to this or that informal group. Thus the operator may often discover both membership and limitations upon it of the informal group from the non-member. But the excluded person probably will have only general knowledge of the inside workings of the informal group. Such information can usually not be obtained in detail, except from members of the group itself. Using hidden informal groups as channels . Many informal groups may be unknown to the majority of persons in a culture or community. Many may be of relative unimportance, but the informal groups of the elite are important to seek out, to inquire about, because they are often channels of access to the most influential decision-makers. The operator may not find himself included in an informal elite circle, but by knowing members he may approach them individually and know that his information will eventually be carried into the informal group for discussion. The informal "grapevine" is often a powerful and swift channel of communication. Informal groups operate in and criss-cross through formal organizations. In many large scale organizations, one often hears the statement made, "the man to see on such and such a project is John Doe." Doe may not have the title of "running the show." Top decisions may be made by the chairman of the board of the corporation, but Doe is still the man to see. Why? Simply because, in all likelihood, Doe is the person who can go most quickly to the chairman and get a decision. Many men in corporate positions refuse to retire at an early enough age to allow for vigorous prosecution of their own work, or they may rely heavily on 22

technical persons in relation to certain decisions. These angles must be explored to ascertain the best channels of contact in relation to any given project. No set rule can be laid down here, but it may be emphasized that the organization chart of a corporate grouping will not reveal the informal channels that make the whole group function adequately. See Figure 3.

FORMAL AND INFORMAL ORGANIZATION* Figure 3

In studying the organization structure, the official organization chart is obtained. Sociometric ratings based on with whom most time is spent in getting work done are superimposed over the formal organization chart. In all samples, there are noticeable deviations between the formal organization and the informal

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organization as revealed by the sociometric ratings. An index of deviation to show in statistical terms the amount of deviation is in process of development. In this figure, the formal organization chart is shown in solid lines with the pattern of interpersonal relationships in checked lines. The checked lines show the first two choices; that is, the two persons within the group with whom most time is spent. The arrow points in the direction of the person named. Thus, number 51 named number 1 and number 511 and number 1 named number 2 and number 51. One can see what are sometimes called "violations" of the organization chart. The studies of various staff suggest that "violations" are a normal activity. The informal or interpersonal work structure represents day-to-day relationships. Staffs are usually fairly familiar with the organization chart, but little has been done to acquaint staff members with an understanding of the "interpersonal chart." The informal structure is one index of the dynamics of getting work done, and it appears that for efficiency it will necessarily deviate from the formal structure. Extreme deviations, however, may hamper rather than promote efficiency. *Carroll L. Shartle, "Leadership and Executive Performance," Personnel (1949), reprinted and copyrighted, 1949, by the American Management Organization. Reproduced with the permission of the American Management Organization. Discovery of informal groups . The easiest way to locate the informal elite structures of a community or a nation is to identify the formal elite structures first, and then ask oneself, "what really makes them work?" The stated purposes of an organization may be so general and highly abstract that they have little meaning in terms of action, but the Organization may accomplish a great deal. How, then, is this done? A large measure of the activity of a formal organization is carried by informal methods. "Off the record" meetings, informal luncheons overlapping club memberships of Organization members, social knowledge of members of one another, card games on the breakfast car coming into New York, civic, educational, and project committees of many sorts may all be points at which influentials meet to come to a like-mindedness on social, political, moral, and economic questions. Places in which men eat, sleep, play, are all likely spots for developing groups that may have profound bearing on formal decisions.

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In every formal organization the process of delegating responsibilities for the execution of projects is a continuing task of the organization leadership. The process does not end with naming a formal chairman of a committee, for example, but continues with further delegation by the man named. To know the persons called upon to act, time and again, on behalf of a formal organization, is to make a beginning at understanding the operations of it, but to go a step further and see whether these persons habitually use an informal group to stimulate their ideas, and to carry out details of operations is to begin to trace out informal patterns of behavior. Access to top elite information via informal groups . It may well be that in some instances, access to the top elite of both the formal and informal organizations will be denied the operator. In such cases, the whole patterning of action, from its formal to its informal aspects is highly important and highly relevant work for the operator, for it will lead him to persons who can contact those higher on the hierarchical line and transmit the information he wishes to disseminate to the target persons. For a power structure is of one piece, operating up and down gradations of influence, with messages and information going up and down the line. The further from the source of decision one finds oneself, the less formalized may be the modes of operating in relation to a given policy, and the greater the number of informal actors who in various ways have access to others higher in the power gradient than they.

11. INFORMAL ORGANIZATION IN NEW INSTITUTIONAL ECONOMICS

Exchanges are governed by a set of formal institutions (contracts, incentives, and authority) and informal institutions (norms, routines, political processes) which are deeply intertwined. However, for the most part, informal institutions are treated as exogenous forces changing the benefits to use alternative formal structures, and formal institutions are treated as mere functional substitutes of informal elements governing exchanges. As a result, scholars have not sufficiently explored the interactions between formal and informal institutions. We contend that the failure to integrate these concepts into a common theory has led to faulty reasoning and incomplete theories of economic organizations. In this paper, we highlight three potential areas of research exploring the interplay

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between formal and informal institutions: first, whether formal institutions support (complement) or undermine (substitute for) the contributions of informal institutions; second, how vacillation in formal organizational modes allows managers to efficiently alter the trajectory of informal institutions; and third, how certain informal institutions can lead to hierarchical failure, thereby requiring managers to constrain the boundaries of the firm. 1 THE INTERPLAY BETWEEN FORMAL AND INFORMAL INSTITUTIONS We argue that the managers implicit task is to shape informal and formal institutions influencing the operation of an organizational form in such a way as to increase the functionality that they collectively deliver. By functionality, we mean a variety of dimensions such as capacity to coordinate tasks, to achieve levels of cooperation, or to respond to changing market conditions. In this section, we examine how formal and informal institutions interact and jointly define the functionality of organizational forms. The role of informal institutions Research in organization theory has stressed the central role of informal institutions in defining how work is performed and tasks are accomplished within firms (Barnard, 1938; Crozier, 1964; Roethlisberger & Dickson, 1939; Trist & Bamforth, 1951). While formal institutions define the normative system designed by management or the blueprint for behavior (Scott, 1981, p. 82), informal institutions define the actual behavior of players. Thus, Roethlisberger and Dickson (1939, p. 559) observe that Many of the actually existing patterns of human interaction have no representation in the formal organization at all, and these are inadequately represented by the formal 5 organization Too often it is assumed that the organization of a company corresponds to a blueprint plan or organization chart. Actually it never does (1939, p. 559). Consistent with this view, many authors remark that the informal organization, supported by informal institutions within firms, is not only distinct from formal rules, but that it has a critical role in influencing the operation of firms. Thus, decision making within firms is strongly influenced by political processes (Pfeffer, 1978); patterns of communication are largely a function of informal relationships and shared language (Zenger & Lawrence, 1989); tacit knowledge is rooted in organizational routines (Argote, 1999; Nelson & Winter, 1982); perceived obligations between employer and employee transcend job descriptions and formal contracts (Rousseau & McLean Parks, 1993), just to mention a few examples. The

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importance of informal institutions is also recognized in market contexts as well. Granovetter (1985) insists that formal institutions have limited ability to support exchange and thus social networks embodying informal institutions such as norms and trust play a crucial role. Macaulays (1963) famous study on the governance of business relationships is consistent with this view. He observes that businessmen often prefer to rely on a a mans word in a brief letter, a handshake, or common honesty and decencyeven when the transaction involves exposure to serious risks (1963, p. 58). Thus, informal dealings have the advantage of promoting flexibility and responsiveness to changing conditions, avoiding costly renegotiation of contract clauses (Macneil, 1978). The advantages of such informal contracting mechanismscommonly referred to as relational governanceare now extensively discussed. Relational governance supports cooperation through norms and reciprocal obligations that transcend initial contract clauses and economize on the costs to use the legal system (Dore, 1983). This discussion leads to: Assumption 1. Informal institutions strongly influence the functionality of organizational forms. Formal institutions as mechanisms of change The functional consequences of informal institutions call for managerial action seeking their optimization. For instance, Lincoln (1982, p. 11) observes that informal networks are indispensable to organizational functioning, and managers must learn to manipulate them for organizational ends. However, the fact that informal institutions in general are difficult to manipulate engenders major managerial challenges. Fortunately, changes in formal institutions, which can be directly manipulated, appear to strongly influence changes in informal institutions within firms. Internal routines, norms, and networks of influence develop over time in response to an organizations formal structure (Shrader, Lincoln, & Hoffman, 1989; Stevenson, 1990; Tichy, 1980). Research shows, for instance, that the operation of informal networks is influenced by the positions of individuals in the formal hierarchy (Brass, 1984; Krackhardt, 1990). Formal institutions also appear to influence the trajectory of informal elements in interorganizational relationships. Long-term contracts and joint equity stakes (ownership) can create strong commitments between parties and thereby promote the emergence of mutual trust (Doz, 1996; Parkhe, 1993). But changes in formal institutions can also be used to disrupt dysfunctional informal ties between representatives of

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transacting firms. For instance, Humphrey and Ashforth (2000, p. 719) document that U.S. automakers expressed concerns that interpersonal relationships could lead buyers to award contracts to suppliers who had higher unit costs, lower quality and slower delivery times. The adoption of competitive biddingsuch as in the case of business-to-business exchanges through the Internetis seen as an opportunity to circumvent reciprocal deals between sales and buying representatives which may not be in the best interests of one employer or the other. Therefore, since the formal largely orders the direction the informal takes (Dalton, 1959, p. 237), formal institutions constitute a tool available to managers through which informal institutions can be shaped. This supports: Assumption 2. Formal institutions influence the trajectory of informal institutions. The nature of formal and informal changes Several organizational perspectives share the assumption that formal institutions involve discrete modes comprised of bundles of mutually consistent, complementary features. In discussing TCE, Williamson (1991, p. 271) stresses that each viable form of governance is defined by a syndrome of attributes that bear a supporting relation to one another. Organizational economists Milgrom and Roberts (1991, p. 84) also submit that organizations involve activities that are mutually complementary and so tend to be adopted together with each making the others more attractive. For instance, centralization is characterized by structural interdependence between units, lower-powered incentives, and centralized decision making; decentralization is characterized by structural autonomy, higher-powered incentives, and local decision making. Each element reinforces the other: for instance, the use of higher-powered incentives is expected to discipline autonomous units to act efficiently, while autonomy supports those incentives since performance is assessed on an individual basis. On the other hand, the use of one element in isolation or in conjunction with another incompatible element will yield sub-optimal results. Thus, the adoption of higher-powered incentives jointly with centralized decision making is likely to trigger dysfunctional attempts by local managers to influence the central managers decisions or alter performance standards. The assumption that organizational forms are discrete is also pervasive in organization theory. The configuration literature considers that organizational

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structures are composed of clusters of consistent traits (Meyer, Tsui, & Hinings, 1993; Mintzberg, 1979). Miller and Friesens (1980, p. 593) empirical study evidences that changes in organizational variables tend to occur together, or follow one another after a very brief interval, in order to maintain an appropriate balance or configuration. Punctuated equilibrium models describing organizational change share the same perspective. Gersick (1991) use the term deep structure to describe systems with distinct and interdependent parts, which change in an abrupt, comprehensive fashion rather than gradually. Likewise, Tushman and Romanelli (1985) consider that change is followed by periods of convergence that align the diverse activities within a firm into a consistent portfolio. Change (or reorientation) causes consistent changes of these activities toward a new alignment or deep structure, which clearly suggests discrete choices. In contrast with formal organizational structures, which correspond to menus of discrete choices, informal elements are continuously arrayed. Social attachments, for instance, differ in degree rather than in kind. Thus, Granovetter (1973, p. 1361) defines tie strength as a combination of the amount of time, the emotional intensity, the intimacy (mutual confiding), and the reciprocal services which characterize the tie. These elements clearly have continuous flavor. Talking about individual commitment to an organization, Salancik (1977, p. 4) points out that there are degrees of commitment [which derive] from the extent to which a persons behaviors are binding. Krakhardt (1990) uses the continuous measure of individual centrality in a social network to indicate the degree of an individuals power within an organization, derived from his or her ability to control information flows. Thus, while changes in formal institutions are expected to involve discrete, abrupt movements of consistent variables, changes in informal institutions have a more continuous and gradual character. This leads to: Assumption 3. Formal institutions are discretely arrayed, while informal institutions operate comparatively on a continuum. The pace of formal and informal changes Although changes in formal institutions trigger changes in informal institutions, the latter do not respond instantaneously. The concept of inertia, pervasive in organization theory, implies that webs of interdependent relationships, political coalitions, patterns of communication, established routines impede organizational

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change (Hannan & Freeman, 1984; March & Simon, 1958; Nelson & Winter, 1982; Tushman & Romanelli, 1985). The existence of inertia causes the functionality of an organizational form to change slowly, thereby creating a lag between the implementation of a new formal structure and the change in the overall functionality, which derives in large part from informal elements. The concept of inertia is also pervasive in NIE. Building upon Arthurs (1989) and Davids (1985) ideas, North (1990) discusses how institutions exhibit path dependence in that the trajectory of an economic system is largely a function of its past position. North attributes a great deal of such path dependence to informal institutions derived from available mental constructsideas, theories, and ideologies (1990, p. 96), which create resistance to change.2 In the same vein, Greif (1997, p. 89) argues that past behavior, cultural beliefs, social structures, and organizations impact the development of values and social enforcement mechanisms that inhibit flexibility in departing from past patterns of behavior. Literature discussing economic change is that although it is easy to implement changes in formal institutions (laws, decision rights, etc.), existing informal institutions are difficult to disrupt, responding gradual and slowly to formal changes. Thus: Assumption 4. Formal and informal institutions differ in the pace with which they change. Informal institutions possess inertia that slows the pace of change. In the sections that follow, we discuss how the assumptions presented above imply three general propositions based on the relationship between informal and formal institutions: Proposition 1. Formal and informal institutions are interdependent governance mechanisms in that the use of one mechanism can either promote (complement) or undermine (substitute for) the use of the other. Proposition 2. Even in static environments, achieving the optimal functionality of an organizational form may require dynamic changes in formal institutions. Thus,

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under some circumstances, a pattern of vacillation in formal institutions supporting distinct organizational forms (market vs. hierarchy, centralized control vs. decentralized control, etc.) is warranted (Nickerson & Zenger, 2001). Proposition 3. Firm boundaries are determined in large part by the need to adjust informal institutions within hierarchies. In particular, managers must sever the boundary of the firm to suspend dysfunctional informal processes. Each general proposition is explained in turn. Taken together, these propositions exemplify how a more careful examination of the relationship between formal and informal institutions may provide important insight to our understanding of organizational choice. 11

12. INFORMAL AND FORMAL INSTITUTIONS: COMPLEMENTS OR SUBSTITUTES?

If informal institutions influence the functionality of an organizational form (Assumption 1) and their trajectory is determined in part by formal institutions (Assumption 2), then a key question centers on the nature of relationship between these two mechanisms. At the most basic level, one must ask whether the use of one type of institution increases or decreases the functionality of the otheri.e., whether informal and informal institutions function as complements or substitutes. As it turns out, the literature focusing on this issue diverges along several paths. Formal and informal institutions as complements Substitution arguments cluster around two basic claims. A mild perspective, which we refer to as weak substitution, argues that formal constraints are unnecessary because informal relationships based on trust and social norms can support cooperation without the costs and complexity incurred with formal agreements (Ellickson, 1991; Gulati, 1995; Powell, 1990; Ring & Van de Ven, 1994; Uzzi, 1996). Granovetter (1985, p. 489) contends that formal institutions do not produce trust but instead are a functional substitute for it. According to this view, social norms support the emergence of trust because buyers can hope to get some cooperation even when formal instruments are absent. One of the most discussed social norms is reciprocity, meaning that individuals tend to cooperatively respond to generous offers even if this is against their own selfinterest (Berg, Dickhaut, & McCabe, 1995; Dore, 1983; Rabin, 1993). Thus, a buyer can reciprocate a high-quality service by offering an above average price 31

to a seller even if they are not expected to meet one another in the future; anticipating this act of reciprocity, the seller will be motivated to supply a highquality service in the first place. As Hoffman, McCabe and Smith (1998, p. 338) put it, reciprocity functions as an enforcement mechanism because it leads naturally to property rights (emphasis in the original). Thus, weak substitution implies that the presence of informal institutions such as norms and trust reduce the benefits to use formal institutions; the latter become simply unnecessary. A starker substitution perspective, which we refer to as strong substitution, argues that formal institutions are not only unnecessary but also damaging to the formation and operation of informal elements. Macaulay (1963, p. 64) contends that not only are contract and contract law not needed in many situations, their use may have, or may be thought to have, undesirable consequences Detailed negotiated contracts can get in the way of creating good exchange relationships between business units. He argues that some firms discourage the use of an elaborate contract because it indicates a lack of trust and blunts the demands of friendship, turning a cooperative venture into an antagonistic horsetrade (Macaulay, 1963, p. 64). Similarly, Sitkin and Roth (1993, p. 376) posit that legalistic remedies can erode the interpersonal foundations of a relationship they are intended to bolster because they replace reliance on an individuals good will with objective, formal requirements. Ghoshal and Moran (1996) also stress that the use of rational, formal control has a pernicious effect on cooperation.3 They contend that for those parties being controlled the use of rational control signals that they are neither trusted nor trustworthy to behave appropriately without such controls. For the controller, negative feelings arise from what Strickland (1958) described as the dilemma of the supervisor viz., the situation when the use of surveillance, monitoring, and authority led to managements distrust of employees and perceptions of an increased need for more surveillance and control (1996, p. 24) Social psychologists have provided an explanation for this effect: explicit incentives or punishments may reduce partners intrinsic motivation to perform certain tasks (Deci & Ryan, 3 Interestingly, Williamson (1996, p. 271) makes a similar argument, but restricts its application to purely social, non-economic relationships. 1985). This effect has received the name motivation crowding out in economics (Frey, 1997). According to proponents of motivation crowding out theory, reciprocity is a particular form of intrinsic motivation originated from social norms that is violated when formal incentives or punishments are present (Gchter & Falk, 2000). In other words,

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those mechanisms can signal that trust is absent and no reciprocity is expected, thereby framing the relationship in a strictly economic, rather than social, orientation (Lubell & Scholz, 2001; Tenbrunsel & Messick, 1999). One possible consequence is that the outcomes achievable through incentives and controls can be less efficient than those that could naturally flow from an individuals voluntary willingness to cooperate, manifested through social norms and trust. Formal and informal institutions as complements An alternative argument that has received comparatively less attention is that formal institutions complement informal mechanisms. In settings where hazards are severe, the combination of formal and informal safeguards may deliver greater functionality than either institutional type in isolation. As North (1990, pp. 46-47) puts it, formal rules can complement and increase the effectiveness of informal constraints. They may lower information, monitoring, and enforcement costs and hence make informal constraints possible solutions to more complex exchange. Poppo and Zenger (forthcoming) provide supportive empirical evidence. They find that customized contracts appear to support relational governance, characterized by alignment of goals, trust and collaborative orientation. Three distinct arguments support the complementarity proposition. First, formal contracts may both extend the expected duration of a relationship and restrict the gains from one-time deviations from cooperative behavior in an exchange relationship (Baker, Gibbons, & Murphy, 1997). Contracts not only have this source of advantage because of their formal specification of a long-term commitment to exchange, but also can limit the domain and lessen the gain of potential opportunistic behavior through clearly articulated clauses that specify punishments. This reduction in short run gains heightens comparatively the gains from cooperating in the exchange relationship. By contrast, failing to contractually specify elements of the exchange that are easily specified merely heightens incentives for short-run cheating and lowers expectations of cooperation (Baker, Gibbons, & Murphy, 1994; Klein, 1996; Milgrom, North, & Weingast, 1990). Note that complementarity arguments assume that formal institutions are to some extent incomplete, since otherwise any outcome could be legally enforced without the need of informal institutions. Due to the costs to write clauses, limits of enforceability by courts and individuals cognitive limitations (bounded rationality), it is not possible for parties to pre-specify all future contingencies in a comprehensive contract.4 Lazzarini, Miller and Zengers (2001) experiment provides support for the complementarity argument outlined above. Their

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experiment involves buyer-seller exchanges with moral hazard on the part of sellers. To operationalize contract incompleteness, the authors consider that the good being transacted has two distinct dimensions. One dimension is easy to specify and therefore is contractible in advance: buyers can structure contingent payments based on the supplied level of that dimension. The other dimension is difficult to measure and enforce by third parties (such as courts), and thus is noncontractible: no contingent payment can be applied. Lazzarini, Miller and Zenger (2001) find that contractual incentives (contingent payments) applied to the contractible exchange dimension facilitate the enforcement of the noncontractible dimension, precisely because they limit the gains that sellers could attain from short-term defection. For a recent assessment of the incomplete contracting literature, see Tirole (1999). The second argument providing support for the complementarity view is that formal institutions can set the stage for the development of trust within a long-term interaction. This is a direct implication of Assumption 2: formal mechanisms can influence the trajectory of informal elements. Cooperative behavior in the presentas a result of supporting formal mechanismsreinforces an expectation of cooperation in the future. Supportive of this logic, empirical work suggests that past success in contracting with a particular exchange partner yields greater success in the present (Anderson & Weitz, 1989; Larson, 1992). Formal contracts help ensure that the early, more vulnerable stages of exchange are successful. Durkheim (1933) appears to have this idea in mind when he writes that in order for [parties] to co-operate harmoniously, it is not enough that they enter into a relationship, nor even that they feel the state of mutual dependence in which they find themselves. It is still necessary that the conditions of this co-operation be fixed for the duration of their relations. The rights and duties of each must be defined, not only in view of the situation such as it presents itself at the moment when the contract is made, but with foresight for the circumstances which may arise to modify it. Otherwise, at very instant, there would be conflicts and endless difficulties (1933, pp. 212-213). Thus, formal institutions may also be designed to create procedures to adapt to changing conditions. Unexpected disturbances may place considerable strain on an exchange relationship (Williamson, 1991, pp. 271-273). Formal contracts that shift from merely specifying deliverable outcomes to providing frameworks for bilateral adjustments may facilitate the evolution of highly cooperative exchange relations. Crocker and Masten (1991, p. 95) suggest that it seems more appropriate to view contracts as means of establishing procedures for adapting

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exchange and resolving disputes rather than purely as incentive mechanisms. In addition, the process of contracting may itself promote expectations of cooperation consistent with relational governance. The activity of creating complex contracts requires parties to mutually determine and commit to processes for dealing with unexpected changes, penalties for non-compliance, and other joint expectations of trade. Hence, the process of developing complex contracts in response to exchange hazards positively affects future exchange performance through the development of social relations resulting from the very act of bilaterally negotiating contract terms. The third argument supporting the complementarity view is that informal elements may also promote the refinement (and hence increased complexity) of formal institutions. As discussed before, informal institutions increase the performance of formal institutions because explicit arrangements are inherently incomplete. Thus, not only do formal institutions promote the stability of informal institutions, but informal institutions also play a role in filling contractual gaps over time. As a close relationship is developed and sustained, lessons from the prior period are reflected in revisions of the contract. Exchange experience, patterns of information sharing, evolving performance measurement and monitoring may all enable greater specificity (and complexity) in contractual provisions and exchange conditions. As a consequence, relational exchanges may gradually develop more complex formal contracts, as mutually agreed upon processes become formalized. An integrated assessment We note that the substitution and complementarity effects described above are not mutually exclusive; the interaction between formal and informal institutions is too complex to accommodate a unique pattern. For instance, even if explicit incentives or control mechanisms reduce individuals intrinsic motivation to provide extra effort, they can at the same time discourage short-term defection. Thus, the effects described above can be best viewed as partial effects; the net outcome is dependent on particular exchange conditions. Although research on this topic is on its early stages, we tentatively outline some specific propositions. We submit that formal and informal institutions act more as complements than substitutes when (1) individuals are not likely to or not committed to transact repeatedly and (2) the procedures involved in the operation of formal institutions are perceived to be fair. When these conditions do not hold, the use of formal institutions may be unnecessary and even detrimental to the operation of informal institutions. The reason for our first claim is that non-repeated interactions provide neither a shadow of the future

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increasing individuals perceived benefits from cooperation (Axelrod, 1984) nor a shadow of the past promoting the gradual development of relational norms and trust (Macneil, 1978; Ring & Van de Ven, 1994). Hence, the benefit of formal institutions becomes relatively more important in new or non-recurring relationships, since informal enforcement will tend to be weak or absent (Lazzarini et al., 2001). One could argue that, instead of relying on formal structures to support non-repeated exchanges, parties might be better off encouraging repeated interaction as a way to create norms and trust (e.g. Dyer & Singh, 1998; Kollock, 1994; Krackhardt, 1992). However, parties must credibly commit to a repeated interaction since at any moment they can switch to alternative partners. Formal arrangements are thus a way to lock parties into relationships with sufficient duration (Baker et al., 1997). In addition, repeated interaction between the same agents limits the opportunities and information that they can attain with external relations (Blau, 1964). Non-recurring exchanges or weak ties are a fundamental way to transfer new information and knowledge between specialized agents (Granovetter, 1973). By contrast, overembedded systems are likely to involve low knowledge diversity and hence less propensity to innovate (Greif, 1997; Uzzi, 1996). Formal institutions are thus crucial for economic growth marked by specialization and fewer recurring exchanges (North, 1990; Zucker, 1986). Our second claim derives from the growing recognition that individual attitudes are dependent on procedural issues, which alter their perceptions about the fairness of processes employed by parties to achieve certain outcomes (Bies & Shapiro, 1988). Consider for instance the effect of contract framing: empirical studies provide evidence that people tend to prefer equivalent contracts that specify rewards or bonuses rather than punishments or damages (Luft, 1994; McLean Parks & Coelho-Kamath, 1999). It is possible that equivalent contracts stipulating bonuses instead of punishments discourage defection without crowding out implicit norms. In addition, the procedural perceptions of formal institutions are dependent on the extent to which parties expect the use of these institutions for certain types of exchanges, i.e., whether their use is taken for granted or not. Thus, Lewicki, McAllister, and Bies (1998, p. 454) argue that quality control people do their work because its their jobnot necessarily because they personally distrust others. Also, two firms engaging in an alliance may employ a formal contract not because they do not trust one another in particular, but because it is a standard procedure in their industry. Thus, whether a formal institution complements or

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substitutes for informal institutions depends in part on how fair that formal institution is perceived to be. In conclusion, formal and informal institutions are not mere alternative ways to govern exchanges. In most cases they are employed simultaneously and interact in complex ways. The complete assessment of complementarity and substitution effects, and in which conditions one effect supplants the other, is an important research agenda both within and outside NIE. THE DYNAMIC ALIGNMENT OF ORGANIZATIONAL FORMS Theories within NIE argue that that the choice of organizational forms involves matching formal structures to strategies, exchange conditions, and environments in some discriminating way (Chandler, 1962; Williamson, 1975). NIE is fundamentally a theory of static alignment and, as such, shares many of the elements of contingent-fit models. Namely, selection and external pressures (e.g., from owners and capital markets) will either prompt managers to choose organizational forms that are aligned to particular exchange conditions, or wash out misaligned forms. Thus, managers choose to govern exchanges through markets when outputs are easily measured (Barzel, 1982; Holmstrom & Milgrom, 1994; North, 1981), and the production of those outputs involves low levels of specialized assets (Klein, Crawford, & Alchian, 1978; Williamson, 1985). By contrast, managers choose hierarchy when outputs are difficult to measure and specialized assets are substantial. Intermediate conditions may favor hybrid organizational forms such as long-term contracts and interfirm alliances (Williamson, 1991). Similar discriminating alignment logic governs the choice of governance forms within the firm. Thus, managers may choose decentralized forms with their incumbent high-powered incentives when innovation is desired, but adopt centralization with its ready access to authority when coordination is desired (Williamson, 1985). Static alignment implies that if the diverse contingencies that affect firms remain stable, then organizational forms should also remain unchanged. Changes in formal mechanisms are precipitated by changes in environment or exchange conditions, which are influenced in part by strategy decisions. The patterns of change in formal governance that we commonly observe, however, are often difficult to reconcile with this theory of static alignment. Many changes in formal governance appear to occur with little change in environment or exchange conditions. Indeed, we seem to often observe firms engaged in vacillating patterns of choice in formal organization (Carnall, 1990, p. 20; Cummings, 1995, p. 112; Eccles & Nohria, 1992, p. 127; Mintzberg, 1979, p. 294). Thus, firms centralize, then decentralize, then

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centralize, etc. Firms outsource an activity, then internalize it, only to outsource it, again. In the choice of compensation, many firms seem to vacillate between aggressive incentive pay for sales personnel and flat salaried pay. Examples of vacillation abound (Nickerson & Zenger, 2001). Six times within 16 years, Hewlett-Packard made fundamental shifts between centralizing and decentralizing core activities within the corporation, without any change in exchange or environmental conditions. Consider also KPMG Peat Marwick. Prior to 1992, the consulting and accounting services firm was structured geographically around local managing partners, which helped to leverage close ties with regional clients into a broad range of services. In 1992, KPMG shifted to a functional structure where associates reported to nationwide practice managers rather than local managers. This structure promoted knowledge sharing and resource allocation within particular consulting and accounting practices. In 1994, KPMG shifted again its organizational configuration to an industry-focused structure based on categories such as healthcare, government services, retail, and manufacturing. This new structure promoted the development of in depth knowledge about client industries. In 1996, KPMG returned to its former geographic structure centered on local managing partners. However, by 1999 they shifted back to an industry-focused industry, although now globally centralized. Within 7 years, KPMG had vacillated among three (discrete) formal structuresgeographic, functional, and industry-focusedwith 5 events of structural change. How do we explain this pattern, since it is very unlikely that within this short period KPMG had faced so many changes in exchange and environmental conditions? Arguably, such vacillation in formal organizational modes can result from managers fickle behavior, thereby being simply a manifestation of noise in the decision making process. However, as Nickerson and Zenger (2001) maintain, a richer understanding of the relationship between formal and informal institutions leads to the conclusion that such commonly observed vacillation can indeed be efficient. The explanation for functional vacillation follows logically from the assumptions described in section 2. As indicated by Assumption 1, the functionality of an organizational form is determined as much by informal mechanisms, as by formal mechanisms . In addition, informal institutions vary systematically in response to changes in formal institutions (Assumption 2). But although managers can influence changes in informal institutions, they only have discrete formal choices or leverse.g., centralization vs. decentralization, make vs. buy, etc.to promote such changes

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(Assumption 3). If the desired level of functionalitywhich is largely dependent on informal institutionslies in between the functionality delivered by these formal levers and change is not too costly, then managers will have an incentive to modulate between two or more discrete formal choices to achieve temporarily the desired intermediate level. Given that informal institutions display inertia (Assumption 4), each switch between formal choices triggers a gradual change in the trajectory of informal elements. Thus, by vacillating between distinct formal choices, managers can influence the trajectory of informal institutions towards a desired position that is unavailable if the organization remains fixed with a particular formal structure. The choice between centralization and decentralization is a useful illustration of the virtues of vacillation. Centralization and decentralization are discrete organizational modes characterized by distinct sets of formal institutions. While centralization involves structural interdependence between units, lower-powered incentives, and centralized authority, decentralization involves structural autonomy, higher-powered incentives, and local authority. These organizational modes also exhibit distinct and conflicting patterns of functionality. Centralization facilitates coordination, but at the cost of low-powered incentives and reduced innovation potential. Decentralization yields high-powered incentives and increased innovation, but at the cost of coordination. Managers would like to maintain a level of functionality such that improved coordination and higher-powered incentives/innovation coexist; by choosing permanently either centralization or decentralization, managers will necessarily sacrifice one of these dimensions of functionality. They can, however, dynamically modulate between these two formal structures to achieve temporarily a level of functionality that lies in between centralization and decentralization. Thus, a decision to change from centralization to decentralization triggers changes in informal elements that alter the functionality of the organizational form. As managers initiate decentralization and the firm begins to reap benefits from higher-powered incentives and innovation, it still enjoys, albeit temporarily, the dense communication channels and social attachments supported by the informal institutions (e.g., routines, norms, etc.) that accompanied the formerly centralized structure. However, these patterns will tend to diminish as time elapses, since the formal change to decentralization will sever social attachments and communication flows within the firm, which in turn will dampen coordination. As a result, the overall organizational performance will migrate towards the steady-state functionality delivered by decentralization.

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When this occurs, managers can do the reverse: they can change the formal structure from decentralization to centralization to restore coordination while keeping some innovation and incentives reminiscent from the decentralized structure. However, after some time, sticky routines and excessive politicking promoted by centralization will cause again a reduction in functionality. Managers will then need to initiate a new cycle by decentralizing the organization in order to alter these informal elements. Nickerson and Zenger (2001) show that this theory provides a counterintuitive result that inertia can be performance enhancing . The reason is that inertia reduces the frequency with which managers must change the formal structure. When inertia is high, informal institutions change slowly in response to changes in formal institutions. Since informal elements are critical determinants of organizational functionality, the latter will remain close to the optimal levelwhich will combine elements of both discrete formsfor a long period of time before a new switch is necessary. Were changes in informal institutions instantaneous (i.e., no inertia), it would not be possible to keep informal institutions at the desired, intermediate level for a time period sufficient to warrant vacillation: they would quickly converge to the steady-state position of the chosen formal structure Thus, the managers task is not simply to observe changes in environment or exchange conditions, but rather to monitor the trajectory of informal institutions and manipulate them indirectly through changes in formal structures. Vacillation between organizational forms comprised of discrete formal institutions is efficient when the costs of change are moderate and the desired functionality lies intermediate to that delivered by either formal form in steady state, since informal institutions will lag formal changes and therefore will stay temporarily at that intermediate position. Hence, taking informal institutions seriously has in this case led us to a conclusion that contradicts a fundamental proposition from NIE (and TCE in particular): rather than statically align institutions to exchange or environmental conditions, under certain circumstances managers must pursue a dynamic alignment by vacillating between discrete formal institutions. In this sense, changes in formal structures can occur even when exchange or environment contingencies remain unchanged.

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13. INFORMAL INSTITUTIONS AND FIRM BOUNDARIES

The prototypical institutional choice in NIE is the choice between market governance and hierarchical governance. This is fundamentally viewed as a choice between two formal institutions. The standard storyderived from Coases (1937) insightis that the institution of hierarchy is chosen when markets fail. Thus, we have well developed explanations for why markets fail and therefore why managers choose to replace markets with internal organization. We have also have a large body of confirmatory empirical evidence: managers appear to choose hierarchy when exchange conditions present hazards in using markets and choose markets when they do not (e.g. Poppo & Zenger, 1998; Shelanski & Klein, 1995). Managers choose hierarchy because hierarchy possesses governance features to which markets have limited access. Namely, hierarchys low-powered incentives discourages expropriation of rents in the presence of specific assets (Williamson, 1985) and avoids dysfunctional responses to incentives when performance attributes are difficult to measure (Holmstrom & Milgrom, 1994). However, as numerous scholars have noted, why managers choose markets is not as well understood. Parallel logic suggests that markets are chosen when hierarchies as institutions fail. Interestingly, Coase (1937) in his seminal paper asks why, if by organizing one can eliminate certain costs and in fact reduce the cost of production, are there any market transactions at all? Why is not all production carried on by one big firm? (1937; reprinted in 1991, p. 23) Coase tentatively answers this question by invoking, among other things, the nebulous concept of diminishing returns to management, prevalent in early industrial organization writings, which asserts that managers have limited ability to coordinate large flows of resources. This explanation is not satisfactory because, for instance, one could solve the problem of diminishing returns by splitting the firm into smaller independent units, and then using internal markets to allocate resources. At a more fundamental level, we must ask why hierarchies cannot selectively use the high-powered incentives of markets and thereby do all that markets can and more (Williamson, 1985, p. 133). What are the limits to using market-like instruments to reduce the deficiencies of hierarchies? Within this perspective, Williamson (1985) provides a more convincing explanation of the limits of firms: it is not possible to selectively intervene inside hierarchies by infusing market-like incentives without incurring additional costs or creating undesirable side effects. He notes, for instance, that 41

performance indicators can be manipulated, and incentives (such as piece rates) can lead to the overutilization of a firms assets by employees. Williamson (1985, p. 142) also briefly mentions the role of fairness considerations in dictating the allocation of gains and losses inside firms, which are rooted in informal institutions. This, however, is only the tip of the iceberg. We submit that a thorough understanding of informal institutions within organizations is critical to understanding the limits of the firm and to developing a theory of firm boundaries. The basic argument is as follows. A key reason why hierarchies reduce market failure is that they trigger the formation of informal institutionsnorms, routines, organizational culture, etc.which affect organizational functionality (Assumption 1) by facilitating communication, coordination and cooperation (Barnard, 1938; Kogut & Zander, 1996). However, such informal institutions also bring side effects. For instance, social attachments cause biased decision making; firmspecific routines constrain the ability of those within the firm to externally communicate and acquire external knowledge. Thus, the problem that managers of hierarchy face is that the informal institutions which hierarchy triggers cannot be selectively shut down with any great success. Consequently, to suspend these informal processes, managers must shift or constrain the boundaries of the firm. Since these informal processes are influenced by formal decisions (Assumption 2), we contend that firms can adjust their formal boundaries to alter the dynamics of informal institutions. Thus, firms suspend hierarchy as an institution (i.e. sever the organizational boundary) to avoid the informal processes that run rampant within their boundaries. This shows that, in taking seriously the concept of informal institutions, we are able to develop a theory of hierarchical failurea theory that allows us to explain why firms constrain their boundaries. While informal features of hierarchies reduce market failure, they create costs that need to be factored in boundary choices. We identify here four critical informal processes, largely based on informal institutions, creating hierarchical failure: (1) influence activities, (2) social attachments, (3) social comparison processes, and (4) development of firm-specific routines. We discuss each in turn. Influence activities Milgrom and Roberts (1990) argue that influence activitiesattempts to influence the allocation of rents within firms in order to preferentially reward particular individuals or coalitionsare the primary costs of internal organization. Hierarchies not only create an environment where individuals can engage in lobbying to distort the allocation of resources, since exchanges are not disciplined by market forces, but also magnify the extent to

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which such activities are feasible. This is because the increased communication channels within hierarchies, although instrumental in facilitating coordination (Eccles & White, 1988; Pfeffer, 1978), represent ways in which individuals can reach and influence decision-makers. In this sense, politicking becomes by itself a fundamental informal institution governing and affecting the functionality of hierarchies. Poppo (1995) provides evidence on how influence activities have implications for boundary decisions. She finds that although hierarchy improves coordination by facilitating the exchange of information between internal units, it engenders difficulty in negotiating internal (transfer) price adjustments due to costly bargaining among divisional managers. Consequently, since the coordination-based benefits of hierarchy necessarily unleash influence activities, firms must constrain their boundaries to interrupt communication channels that facilitate such dysfunctional political behavior. Social attachments Similar to influence activities, social attachments can distort the allocation of resources within firms, which in turn affects the costs of internal organization. Thus, poor decision and resource misallocation may occur even in the absence of lobbying efforts or other influence activities. Such social attachments are largely governed by a host of informal institutions. Thus, decision-makers may overfund projects or divisions with rather limited promise in an act of reciprocity to friends/managers, or underfund projects and divisions with more substantial promise but involving managers with whom they lack such social attachments. Evidence also suggests that reciprocity norms embedded in friendship ties can reduce individuals willingness to negotiate freely and pursue better opportunities (Halpern, 1994). In addition, excessive socialization can induce a bias towards shared perspectives, values, and culture, thereby undermining the firms ability to find innovative solutions (Gruenfeld, Mannix, Williams, & Neale, 1996; Katz, 1982). Thus, to the extent that social attachments within firms lead to biased decision making, managers may wish to limit their boundaries in order to reduce the reach and consequences of these distortions. Resource allocation decisions governed through the market are likely to be less contaminated by such distortions, precisely because they will be less affected Social comparison processes The social norm of equity in the allocation of rewards creates difficulty in the design of compensation schemes within firms (Adams, 1965; Deutsch, 1985). Employees directly, or indirectly through managers, compare their rewards to all other employees within the boundary of the firm. When they perceive rewards to be inequitably distributedi.e., when they consider that their compensation to effort

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ratio is lower than other colleaguesthey reduce effort, seek to alter the distribution, or simply depart the firm (Adams, 1965). All such outcomes are costly to the firm. The challenge that a manager faces in rewarding employees is that employees possess highly inflated perceptions of their own performance, exacerbated by the fact that the manager does not possess a fully accurate measure of performance. Hence, efforts to aggressively reward performance in the absence of accurate performance measures trigger social comparison processes that impose costs upon the firm. In response to these social comparison processes triggered by equity norms, managers simply adopt lowpowered performance incentives. However, this brings two side effects (Zenger, 1994). First, low-powered incentives are likely to reduce employees effort compared to the situation involving high-powered incentives. Second, other firms offering contracts with a closer match between pay and performance will lure more skilled people, since the latter will be able to reap higher rents from their superior talent. Thus, firms offering low-powered incentives are likely to face not only turnover costs, but also the departure of skilled people to other firms (Zenger, 1992). Constraining the boundaries of the firm and more specifically reducing the size of the firm constrains the scope of social comparison processes. The costs of social comparison that are associated with a highpowered incentive scheme are strongly dependent on the size of the firm. In large firms there is a much larger group of individuals who will respond negatively when a colleague within the firm is granted a significant performance-based increase in pay. In small firms, the number of comparisons triggered by a single adjustment in pay is substantially less. Further, in small firms, information about individual performance levels is more easily disseminated. Consequently, a reduction in firm size is likely to enhance consensus about individuals perceived relative performance and hence reduce the costs created by social comparisons. It follows that small firms will tend to offer higher-powered incentives than large firms, since they will face lower inequity perceptions resulting from such incentive policies. For this reason, managers may sever the boundaries of the firms to shut down, at least in part, social comparison processes created by equity norms within hierarchies. Firm-specific routines Firm-specific routines develop as a by-product of repeated interaction within firms, and represent informal institutions in the form of tacit codes of interaction (Nelson & Winter, 1982). While some consider such common vocabulary and procedures as enhancing communication (Allen & Cohen, 1969; Lawrence & Lorsch, 1967), it does not come without cost.

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Tushman and Katz (1980) point out that The evolution of local languages and coding schemes helps the unit deal with its local informal processing requirements; yet, it also hinders the units acquisition and interpretation of information from external areas. External communication is vital, however, both in terms of feedback and for evaluating and acting on the units environment (1980, p. 1072). Thus, idiosyncratic routines can lock partners into one particular field of knowledge and lock them out of external opportunities and sources of information (Cohen & Levinthal, 1990; Leonard-Barton, 1995; Poppo & Zenger, 1998). Employees sharing common vocabulary and interpretations are not only likely to have limited capacity to interpret external sources of information, but also to recognize the importance of those sources (Levinthal & March, 1993). As Katz (1982) explains, One of the main principles of human communication is the strong tendency for individuals to communicate with others who are most like themselves o who are most likely to agree with them. Over time, project members learn to interact selectively or avoid messages and information that might conflict with their established practices and dispositions, thereby reducing their overall levels of outside contact (1982, p. 85). A manager determining firm boundaries must take this effect into account. Theoretical approaches emphasizing the firm as a repository of routines (Kogut & Zander, 1996; Nelson & Winter, 1982), must also consider that these informal elements put limits on an organizations ability to acquire external information and adapt to changing circumstances (Leonard-Barton, 1995). Faced with these two opposing effects, managers will need to monitor the development of firm-specific routines and, if necessary, expose internal units to external sources of information by severing existing boundaries. The discussion above shows that informal institutions within firms are fundamental in determining the limits of firms. While certain informal institutions solve market failure within hierarchies, they also bring their own costs. Thus, informal channels improve coordination but creates avenues for influence activities; social norms create trust and facilitate cooperation but induce biased decision-making and trigger social comparison processes; firm-specific routines are instrumental in facilitating the internal exchange of information but lock the firm out of external sources of information. The paradox is that the same informal processes that help to mitigate market failure create hierarchical failure once they are internalized within firms. We stress that a careful examination of such processes is necessary to develop a more complete theory of the firma theory not only based on how firms expand their boundaries in the presence of market

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failure, but also how they sever their boundaries in the presence of hierarchical failure. CONCLUDING REMARKS NIE has contributed to our understanding of how formal institutions such as explicit incentives, authority, contracts, and ownership can be aligned to exchange conditions to increase organizational performance. Organization theory and economic sociology, in turn, have provided a deep examination of the role of informal institutions such as social norms, trust, routines, and political processes. However, by focusing on each type of institution in isolation, scholars have not paid sufficient attention to the interplay between formal and informal institutions and its performance implications. It is our goal in this paper to demonstrate how the joint assessment of the role of formal and informal mechanisms governing exchanges within and between firms provides new insights and expand the explanatory power of existing theories of organization. The insights generated by this line of research have important implications for business strategy. It is widely recognized that informal institutions have a critical role in the performance of organizations. Informal institutions can be either performance enhancing, such as relational governance, or performance damaging, such as influence activities. In some cases, the same informal institution can promote or undermine performance depending on the circumstances; for instance, firm-specific routines can improve coordination but at the same time reduce an organizations ability to respond to external changes. Thus, it is fundamental that scholars not only outline the benefits or drawbacks of informal mechanisms, but also inform managers about how to adjust them. In most cases, managers have only formal mechanisms at their disposal to change the trajectory of informal processes. Thus far, theories of organization have provided insufficient guidance on how informal institutions can be shaped through changes in formal institutions or by other means. The good news is that there is still much research needed in understanding the interaction between formal and informal institutions and exploring how this articulation can potentially deliver superior performance for those who manage institutions. A more extensive collaboration among disciplines that have traditionally focused on each type of institution will certainly be a necessary step in developing this stream of research.

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14. CASE STUDY- EFFECTIVE MANAGEMENT OF INFORMAL ORGANIZATION STRUCTURE.

A friend of mine, a Claims VP for a medium sized insurance company, recently left his company of almost 30 years. His departure wasnt entirely voluntary. He wasnt sure why, but over the last few years he found it more and more difficult to be effective. It was almost as if he spent all of his time trying to swim upstream. Things that used to be obvious and easy became difficult. And he couldnt understand why. His problem was, unfortunately, a fairly common problem within companies. He failed to understand and manage the informal organization structure within his company. As he learned, this can be a fatal flaw to managers, especially senior ones. Every company has two organization structures, regardless of what people tell you. First, theres the formal structure. This is the one everyone talks about. You can see it on official organization charts. It shows who reports to whom, who is responsible for what and how everyone is supposed to communicate with each other. But then theres another organization that few talk about but is at least equally important. Its the informal organization within the company. Its the structure you follow when you dont have the time to do it the right way. Its based on who knows what, who gets things done, who has influence and power, who must agree before an idea can be effectively implemented. Formal structures are the way a company wants things to work. Informal structures describe the way they really work. Efficient and effective companies recognize this and management makes sure they are never very far apart. They understand that if they are too far apart for too long something is going to break. The problem is that it is difficult to predict what will break. My friend found that out when he failed to include and listen to other key executives, some of whom he thought had nothing to do with what he was changing, as he moved forward with an important series of initiatives. There are two lessons to be learned from my friends experience. The first is rather obvious. Every manager and employee should understand that informal structures exist in companies, that they are not bad and that they must be understood and used appropriately. Ignoring them is done at your own peril. The second lesson is more fundamental. Companies need to periodically look at how things are done, how they are organized and make sure their formal and informal structures are not too far apart. Your formal structure needs to recognize and incorporate the needs that the informal structure is meeting. If you dont like what the informal structure is doing, you can change it. You just need to be careful and fully 47

understand why it is doing what it is doing. Designing an organization structure for a company is like trying to manage a river. You can make changes to help the water move faster or slower in certain areas so traffic, decision-making and communication can be more efficient. But you have to pay close attention to the way the river wants to act naturally. If you dont, the river will always win. Organizational structures that are ineffective fail because employees are too smart to make them work. Instead, they find a better way. In our management consulting practice we spend a lot of time helping companies ensure their organizations are naturally effective. These are structures that accomplish your goals without a lot of unnecessary or inefficient activity. They are structures that include the practical efficiency of previous informal structures.

15. REFERENCES
Adams, J. S. (1965). Inequity in social exchange. In L. Berkowitz (Ed.), Advances in Experimental Social Psychology. New York: Academic Press. Allen, T. J., & Cohen, S. (1969). Information flows in R&D labs. Administrative Science Quarterly, 14, 12-19. Anderson, E., & Weitz, B. (1989). Determinants of continuity in conventional industry channel dyads. Marketing Science, 8, 310323. Argote, L. (1999). Organizational learning: creating, retaining and transferring knowledge. Boston: Kluwer Academic Publishers. Arthur, W. B. (1989). Competing technologies, increasing returns, and lock-in by historical events. The Economic Journal, 99, 116-131. Axelrod, R. (1984). The evolution of cooperation. New York: Basic Books. Baker, G., Gibbons, R., & Murphy, K. J. (1994). Subjective performance measures in optimal incentive contracts. The Quarterly Journal of Economics, 109, 1125-1156. Baker, G., Gibbons, R., & Murphy, K. J. (1997). Implicit contracts and the theory of the firm, National Bureau of Economic Research Working Paper. Barnard, C. (1938). The functions of the executive. Cambridge: Harvard University Press. Barzel, Y. (1982). Measurement costs and the organization of markets. Journal of Law and Economics, 25, 27-48.

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