Economic Organization Theory

Week 6
Week 7
Week 8
Week 9
Week 10
Week 11
Week 12

chapter 3 Vertical boundaries of the firm

Economics Primer, chapter 2

Chapter 3 & 4
Chapter 12
Chapter 13 and 14
Readings
Chapter 11
Readings

vertical boundaries of a firm define the activities that the firm itself performs as opposed to
purchases from independent firms in the market
make-or-buy decision is a firms decision to perform an activity itself or to purchase it from
an independent firm
upstream: early steps in the vertical chain
downstream: later steps in the vertical chain
Arms-length

Long-term

Strategic

Parent/subsidiar

Perform

market

contracts

alliances and

y relationships

activity

transactions

joint ventures

transaction in

contracts to

two or more firms

which the buyers

perform

establish an

and sellers of a

construction

independent entity

product act

related activities

that relies on

independently and

that will exceed a

resources from

have no

period of one year

both parents

internally

relationship to each
other

Less integrated

Benefits

More integrated

Benefits and costs of using the market

Costs

- Market firms can achieve economies of

- Coordination of production flows through

scale that in-house departments producing

the vertical chain may be compromised when

only for their own needs cannot

an activity is purchased from an independent

- Market firms are subject to the discipline of

market firm rather than performed in-house

the market and must be efficient and

- Private information may be leaked when an

innovative to survive. Overall corporate

activity is performed by an independent

success may hide the inefficiencies and lack

market firm

of innovativeness of in-house departments

- There may be costs of transacting with

independent market firms that can be
avoided by performing the activity in-house

Reasons to buy market firms are more efficient (economies of scale, learning economies)
Firms should focus on their strength activities, leave rest to market firms because:
1) market firms may possess proprietary information or patents that enable them to produce at
a lower cost
2) market firms might be able to aggregate the needs of many customers, thereby enjoying
economies of scale
3) market firms might exploit their experience in producing for many customers to obtain
learning economies

chapter 12 Performance measurements and incentives in firms

principal-agent relationship occurs when one party is hired by another to take actions or
make decisions that affect the payoff to the principal
difficulties in agency relationship arise when:
1) the objectives of principal and agent are different
e.g.: managers may wish to limit their personal risk, avoiding risky strategic initiatives
that shareholders view as reasonable
2) the actions taken by the agent or the information possessed by the agent are hard to observe
improved by monitoring, but this has significant limitations:
i) it is often imperfect; not all relevant information can be digested
ii) hiring monitors can be costly
iii) hiring a monitor often introduces another layer to the agency relationship
when principles cannot adequately monitor their agents actions (or find it too
costly) they may prefer pay-for-performance
performance-based incentives
1. The slope of the relationship between pay and performance, rather than the absolute pay
level, provides incentives for effort
2. The firm earns a higher profit when it offers the salary-plus-commission job than with a
fixed salary job
3. The firm can do even better if it sets a higher commission rate
4. Performance-based pay can help resolve hidden information problems as well
problems with performance-based incentives
- if the performance measure is affected by random factors that are beyond the
employees control and therefore subjects the employee to unwanted risk
- if the measure fails to capture all aspects of desired performance
employees may focus on measured aspects at the expense of other equally
important aspects (e.g. high % sales versus low customer service)
certainty equivalent: the certain amount that makes the decision maker indifferent between
taking the risk and taking the certain payment
risk premium: difference between the expected value of a risk and the decision makers
certainty equivalent
three properties of certainty equivalent and risk premium
i) different decision makers will have different certainty equivalents for the same
risk
ii) for a given decision maker, the certainty equivalent is lower (and the risk
premium higher) when the spread or variability in payments is greater
iii) in choosing between two risky outcomes, a decision maker will select the one
with the higher certainty equivalent

risk sharing effect: if one party is risk averse and another is risk neutral, the efficient
allocation of risk places all risk with the risk-neutral party and gives a certain payoff to the
risk-averse party because the risk-neutral party values the gamble at its expected value, but
the risk-averse party values it at a certainty equivalent, less than the expected value
stronger incentives are called for if:
- the employee is less risk averse
- the variance of measured performance is lower
- the employees marginal cost of effort is lower
- the marginal return to effort is higher
3 features of good performance measure
1) a performance measure that is less affected by random factors will allow the firm to tie pay
closely to performance without introducing much variability into the employees pay
2) a measure that reflects all the activities the firm wants undertaken will allow the firm to use
strong incentives without pulling the employees attention away from important tasks
3) a performance measure that cannot be improved by actions the firm does not want
undertaken will allow the firm to offer strong incentives without also motivating
counterproductive actions
In implicit incentive contracts workers expect to be rewarded for their productive efforts,
even if evaluations are subjective and no explicit rewards are written down
Costs to implementing subjective performance assessments
i) supervisors may find it personally unpleasant to reward some employees but not others
may result in everyone getting an average grade: ratings compression
ii) subjective assessments of performance are subject to influence activity
iii) subjective measures may be noisy
promotion tournament: a set of employees competes to win a promotion; the prize is a
substantial increase in compensation
Advantages
Tournaments circumvent the problem of
supervisors who are unwilling to make
sharp distinctions among employees;
incentive to be top performer is strong
counteracts compression in subjective
evaluation

disadvantages
The individual who is best at performing a
lower-level job may not be the right choice
for a higher-level job

Tournaments are a form of relative

performance evaluation common
random factors that affect performance
are netted out

Relative performance evaluation rewards

employees for taking actions that hamper the
performance of other employees

efficiency wage: the wage that is high enough to motivate effort

chapter 13 Strategy and structure
large firms require complex hierarchies: the structure of the firm involves multiple groups
and multiple levels of groupings
1. Departmentalization: partitioning of workers into subgroups
2. Coordination of activities within and between subgroups to attain the firms objectives
when selecting organizing dimensions; managers should consider
- economies of scale and scope
- transaction costs
- agency costs
coordination: the flow of information to facilitate subunit decisions that are consistent with
each other and with organizational objectives
control: the location of decision-making and rule-making authority within a hierarchy
four basic structures for large organizations
1) the unitary functional structure (U-form)
2) the multidivisional structure (M-form)
3) the matrix structure
4) the network structure
1. unitary functional structure
- a single unit is responsible for each basic business function (e.g. finance, marketing,
production, purchasing)
- promotes performance within department
- makes coordination with other departments difficult
- firms with this structure tend to centralize their strategic decision making
- suited to relatively stable conditions in which operational efficiency is valued
- focus on operational efficiency rather than profitability
2. the multidivisional structure
- a set of autonomous divisions led by a headquarters office and assisted by a corporate staff
that provides information about the internal and external business environment
- an interrelated group of subunits (division) as the building block
- divisions can be organized by e.g. product line, geography, customer
- M-form develops in response to problems of inefficiency and agency that arise in U-forms
as they increase in size/complexity
- improves efficiency through a division of labor between strategic and operating decisions
- allows firms to coordinate production, distribution and sales within different markets
- clearly measures how much the performance of each division contributes to overall success

3. the matrix structure

- the firm is organized along multiple dimensions at once
- individuals working at the intersections of the matrix report information to two hierarchies
and have two bosses
- valuable when economies of scale or scope or agency considerations provide a compelling
rationale for organizing along more than one dimension simultaneously
- valuable when important issues are not well addressed by the firms principal organizing
approach
- managers often struggle to meet conflicting demands within the matrix
- suitable when the demands of competing dimensions are roughly equivalent and difficult to
address sequentially
4. the network structure
- workers can contribute to multiple organizational tasks and can be reconfigures and
recombined as the tasks of the organization change
- each individuals tasks, responsibilities and obligations to other workers are negotiated in
discussions between the employees involved
- preferable to other structures when the substantial coordination costs of employing it are
compensated for by technical efficiency, innovation or cooperation
- an alliance network in which separate firms can act collectively through a combination of
informal relationships, bilateral contracts, etc.
- modular organization: self-contained organizational units tied together through a
technology standard
structural choice considerations
1. whether demand-enhancing activities (e.g. advertising, product promotion) & cost-reducing
activities (e.g. downsizing, product rationalization) are profit complements or substitutes
complements: when an increase in the level of one activity increases the marginal
profitability of the other
substitutes: when an increase in the level of one activity reduces the marginal
profitability of the other
2. Whether spillovers of know-how are positively or negatively correlated
positively: if they both primarily benefit a single dimension (e.g. if the introduction
of a new product in one market helps the firm produce or sell the
product in other markets)
negatively: if spillovers from some activity positively one dimension (products) but
reduce benefits on another (geography)

Matrix structure
Never optimal if
Can be optimal if
Spillovers are positively correlated and activities Activities are profit complements but
are profit complements
spillovers are negatively correlated AND if
spillovers do not disproportionately favor
one dimension over another
Activities are profit substitutes and
spillovers are positively correlated AND if
activities are strong substitutes
If spillovers are negatively correlated and
activities are profit substitutes AND if
spillovers are strongly product-specific in
one activity and strongly specific to
geography in the other
The optimal organizational structure for a firm depends on the environmental circumstances

difference
characteristics

conditions

does functional structure

suit?

Example: functional structure

Works well for
Manufacturer of
supercomputers
Less complex business
environment
Customers include large
technology firms, businesses
in sectors requiring extensive
use of data, research
universities; firm and
customers know each other
Threats and opportunities are
fairly predictable and
understandable to all
participants
yes

Works poorly for

Large bank
More complex business
environment
Complex in terms of
products, customers and
regulatory burdens; operate
on a global scale

Volatility of business is high,

e.g. financial crisis is
unpredictable
no, need of more complex
structure, e.g. matrix

Environmental factors that influence relative efficiency of structures

1) technology and task interdependence
2) information processing

1. technology and task interdependence

- a firm employing a well-known and mature technology best off adopting a hierarchical
structure conducive to more stable, standardized and higher volume production
- a firm working with a rapidly evolving and less well-known technology may prefer a
decentralized structure that offers flexibility and responsiveness to change
- technology determines the degree of task interdependence: the extent to which two or
more positions depend on each other to do their own work
reciprocal interdependence: when 2 or more workers depend on each other to do their
work
sequential interdependence: with 2 or more workers/groups when one depends on the
outcomes of the others, but not vice versa
pooled interdependence:
when 2 or more positions are not directly dependent on
each other but are associated through their independent
contributions to the success of the firm
2. efficient information processing
- Garicano models a knowledge hierarchy in which firms encounter problems that differ
according to their difficulty and the frequency
- an optimal organization divides workers into production workers and problems solvers
- information retrieval: firms should be structured to facilitate the efficient retrieval of
information in the varied conditions they face on a regular basis

chapter 14 Environment, Power and Culture

social context
internal: the political and cultural environment within a firm that affects how
managers and employees behave
external: business environment in which the firm operates and the legal, regulatory,
political and cultural environment in which the firm acts
internal context
- power: an individuals ability to accomplish his or her goals by using resources obtained
through non-contractual exchange relationships
- authority: the explicit contractual decision-making and dispute-resolution rights that a firm
grants to an individual
- influence: the use of power in a given situation by an individual
sources of power
power bases: attributes of the individual that convey resources that help an individual gain
power
resource dependence view of power: individuals and firms seek to gain power by reducing
their dependence on other actors, while increasing the dependence of others on them
structural holes: relationships in social networks in which one actor is the critical link
between individuals or entire groups
Accumulation of power
helpful when
There are high agency costs in coordinating
managers and lower-level workers
The firms environment is relatively stable

harmful when
There are high agency costs in coordinating
among levels of upper management
The firms environment is relatively unstable

Culture is a set of collectively held values, beliefs and norms of behavior among members of
a firm that influences individual employee preferences and behaviors on the job

chapter 11 Sustaining Competitive Advantage

important implication from theory of perfect competition
opportunities for earning profit based on favorable market conditions will quickly
disappear as new entrants cause increase in supply & decrease of price to zero profit
! successful incumbents in both competitive and monopolistically competitive markets can do
little to preserve profits unless they can deter entry
(e.g. by the incumbents creating endogenous sunk costs through branding)
BUT conditions that facilitate entry deterrence tend to be absent in perfect
competition/monopolistic competition
Threats to sustainability of competitive advantage under all market structures
- luck / bad luck
- firm may not be protected from powerful buyers/suppliers (bargaining leverage)
Muellers persistence of profitability: firms with abnormally high levels of profitability tent
to decrease in profitability and vice versa; however they do not converge to a common mean
market forces are a threat to profits, but only up to a point
Competitive advantage: the ability of a firm to outperform its industry; to earn a higher rate
of economic profit than the industry norm
sustainable when it persists despite efforts by competitors to duplicate or neutralize it
sustainable when resources and capabilities are scarce and imperfectly mobile
create more value through
- firm-specific assets & factors of production (e.g. patents, brand-name reputation)
- distinctive capabilities (e.g. activities it does better than others)
Resource-based theory of the firm: if all firms in a market have the same stocks of
resources and capabilities, no strategy for value creation is available to one firm that would
not also be available to all other firms in the market
Cospecialized resources: more valuable when used together than when separated (e.g.
employees in productive work teams produce a better collective output than individually)
Isolating mechanisms: the economic forces that limit the extent to which a competitive
advantage can be duplicated or neutralized through the resource-creation activities of other
firms

Comparison entry barriers and isolating mechanisms

What entry barriers are to an industry..
..are isolating mechanisms to a firm
An entry barrier impedes new entrants form
Isolating mechanisms prevent other firms
coming into an industry and competing away from competing away the extra profit that a
profits from incumbent firms
firm earns from its competitive advantage
Isolating mechanisms
1) impediments to imitation: impede existing firms and potential entrants from duplicating the
resources and capabilities that form the basis of the firms advantage
2) early-mover advantages: once a firm acquires a competitive advantage, these isolating
mechanisms increase the economic power of that advantage over time
Shock: fundamental changes that lead to major shifts of competitive positions in a market
(e.g. shifts in demand or tastes, product innovation, etc.)
infrequent shocks & powerful isolating mechanisms sustainable competitive advantage
1. impediments to imitation
i) legal restrictions
- patents, copyrights, trademarks, etc.
- once a patent or operating right is secured, its exclusivity gives it sustainable value
ii) superior access to inputs or customers
- firms often get favorable access to inputs by controlling the sources of supply
through ownership or long-term contracts
- superior access to inputs or customers can confer sustained competitive advantage
only if the firm can secure access at below-market prices or if the firm has unique
resources or capabilities
iii) market size and scale economies
- a scale-based advantage can be sustainable only if demand does not increase too
much; otherwise the growth in demand will attract additional entry or induce smaller
competitors to expand allowing them to benefit from economies of scale
iv) intangible barriers to imitating a firms distinctive capabilities: causal ambiguity,
dependence on historical circumstances, and social complexity
- causal ambiguity: the causes of a firms ability to create more value than its
competitors are obscure and only imperfectly understood (due to the fact that a firms
distinctive capabilities usually involve tacit knowledge) hard to translate success

- historical dependence implies that a firms strategy may be viable for only a limited
time
- social complexity e.g. Toyotas competitors know that Toyotas success depends
largely on trust between it and its suppliers; but difficult to create this trust

2. early-mover advantages
i) learning curve
- a firm that has sold higher volumes of output than its competitors in earlier periods
will move farther down the learning curve & achieve lower unit costs than its rivals
ii) reputation and buyer uncertainty
- consumers with a positive experience will be reluctant to switch to competing brands
iii) buyer switching costs
- arise when buyers develop brand-specific know-how that is not fully transferable to
substitute brands (e.g. when someone knows how to work with a Windows computer,
when he switches to Apple he will have to invest time in order to learn the program)
- firms will increase switching costs (e.g. frequent customer discount cards)
iv) network effects
- consumers often place higher value on a product if other consumers also use it
early-mover disadvantages
- firms may fail to achieve a competitive advantage because they lack the
complementary assets needed to commercialize the product
- firms may fail to achieve a competitive advantage because they bet on the wrong
technologies or products
Creative destruction occurs when something new kills something older. A great example of
this is personal computers. The industry, led by Microsoft and Intel, destroyed many
mainframe computer companies, but in doing so, entrepreneurs created one of the most
important inventions of this century.

Are large firms doomed to be less innovative than smaller rivals?

factors
characteristics
Productivity effect
- which firm will be more productive at research
- patent racing: innovation is a winner-take-all activity rewarded by
patent
Sunk cost effect

- entails the asymmetry between a firm X that has already made a

commitment to a particular technology or products and firm Y that is
planning such a commitment
- when firm X considers a new technology, the costs for the old
technology must be seen as sunk otherwise it may be biased and stick
to the old (bad) technology
- whereas firm Y can compare all the costs and will adapt the best
technology anyway

Replacement effect

-through innovation an entrant can replace the monopolist, but the

monopolist can only replace itself entrant has greater incentive to
innovate

Efficiency effect

- a monopolist usually has more to lose from another firms entry than
that firm has to gain from entering the market
(1 monopolist vs 2 duopolists)
increases monopolists incentive to innovate