Economics, Organization and

Management: a Review of Milgrom

and Roberts
S.

METCALFE

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What precisely does Miss Jones do on a Monday morning? With this

innocent question, Professor Loasby raises the central dilemma of this fine
book by Milgrom and Roberts1 (Loasby, 1995). It is a dilemma which is
central to any question of management and organization: the dilemma
between management as contemplation and management as action, the
contrast between thoughts and deeds. The economic theory of coordination,
which is admirably expounded here, is essentially contemplative: it is
thoughts about the way in which the economic jigsaw is perceived to fit
together. As a basis for managerial action it is seriously deficient, as any
comparison with a practical management text would immediately show.
Sadly, one must conclude, Miss Jones must complete her studies by looking
elsewhere. Nonetheless, at least some of her education would benefit from
close attention to the ideas contained here, even if the title is misleading; for
the questions of coordination between organizations (primarily but not
exclusively modern, for profit firms) and within organizations are central
defining questions in modern society. They are the questions at the core of
this book, for Milgrom and Roberts suggest that the key role of management
within organizations is to ensure coordination (p. 114), while defining
coordination as primarily an economic problem. In his review, Professor
Loasby has dealt with these aspects of the text in detail; I will not tread the
same ground again. Let me instead deal with some other broad issues relating
to the view of the world adopted by Milgrom and Roberts, and why its link
with managerial action is less than transparent and at best incomplete as a
frame of reference.

"\j
' Economics. Orgamzatitm and Msnagnmit (Englewood Cliffs, NJ: Prentice Hall, Inc., 1992; xviii +
1 621pp.).
1

Oxford Univenity Pros 1995

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J.

(School of Economic Studies, University of Manchester, Manchester M13 9PL, UK)

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The first clue we find is the treatment of bounded rationality which

occupies a good deal of the text. Unless Miss Jones is of such lowly status
that her actions are entirely circumscribed by given decision rules, unless
she is in effect reduced to an automaton, her managerial tasks will involve
discretion, conjecture and the independent gathering of information no less
than the ability to communicate her beliefs and proposals to others. Of
course, one central task in all organizational design is to simplify communication and establish a common language in which beliefs can be expressed.
In knowing where to gather information, how to interpret it and how to
communicate it, she will have to cope with complexity and the fact that
whatever she strives to achieve, the outcome is unlikely to be a global
optimum. For well known reasons, the language of optimization, through
which economists typically discourse, will not match the reality of her
problem.
Now there is nothing intrinsically wrong with the optimization argument
as a method of discourse: given choices, individuals can as well be assumed
to exercise that privilege to the best of their abilities and to the best of their
interests. In fact, as Milgrom and Roberts point out, the hypothesis of
optimization should not be contentious precisely because it is so empty of
empirical content (p. 42) it is simply not parsimonious enough. Rather, the
issues are much deeper. How is the list of choices to be known? how is it
to be discovered and rendered tolerably complete? How does the decisionmaker know the full consequences of each choice? These are central managerial questions and they have to be answered before choice can be rendered
possible. Once answered, the hard work has already been done, making the
choice the minor part of the problem. In truth, the list depends on the
exercise of imagination, it is unlikely to be complete and two managers (or
their decision-making groups) faced with the same circumstances may well
imagine very different consequences from the same list. Indeed, the better
manager is the one who creates a different list a list which gives the firm
sustainable competitive advantages. Yet in many of their examples, Milgrom
and Roberts convey the view that all this is a matter of writing down, scaling
and solving the relevant equations, while identifying the first order (and, of
course, second order) conditions, and that all reasonable people would agree
on what has been written down. As Schumpeter once suggested, when events
are repetitive and environments are unchanged, time and logic may hammer
home an optimal solution, and one can think of many situations where this
luxury is granted. However, for many major managerial problems, this is
not how it appears and, indeed, characterizing the solution to a coordination
problem is not the same as solving that problem. In many cases, the
equations cannot be written down because the basis to project beyond past

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experience is absent. Even if the relevant equations could be written down

they cannot be solved: perhaps initial conditions cannot be identified,
perhaps the measures are ordinal so that second order conditions become
meaningless or perhaps non-linearities are too intrusive. In short, there are
no grounds whatsoever for computational optimism whenever decisions are
of a non-routine, non-repetitive nature. As soon as problems cross a
threshold of complexity, hypothetical deductive arguments are replaced by
procedurally more efficient induction and trial-and-error reasoning. The
Olympian argument simply fails and the more discretion Miss Jones is
allowed, the greater the potential failure.
Reflecting the intrusiveness of bounded decision-making, much of this
book is concerned with action when parties have incomplete information. A
number of implications of bounded decision-making deserve much more
emphasis than they are given. Managers must make decisions, and if they
cannot be guided by rational maximization, they must be guided by other
means. Here Milgrom and Roberts accept a practical reliance on rule-driven
behaviour with the performance of any given set of rules often dependent on
other rules in the firm. Perhaps they do not emphasize enough that rules
make action possible by limiting what is known and, indeed, what can be
known. They have an informative discussion of this interdependence in their
treatment of organization and strategy as design variables. However, to
characterize the design problem at three levels organization structure,
decision rules and behavioural objectives does not take us all that far unless
we can show how managers are to create such design attributes, appraise
them and change them when their performance is unsatisfactory in some
predetermined sense. What is certainly needed are detailed empirical investigations of behavioural rules, organizational structures and how they evolve.
There are two examples we can draw upon here. Consider first their
detailed and informative discussion of finance. Starting from the Modigliani
Miller theorem, they explain how this can fail, not trivially because of the
tax treatment of dividends and capital gains, but substantively because the
financial situation of the firm influences managerial incentives and gives
signals to ill-informed outsiders on the strategies of the firm. But to go from
this rich and informative discussion of why capital structure matters in the
abstract is quite different from stating what the optimal capital structure is
for any randomly chosen firm. Interestingly, the discussion is enriched by
much case study material, as it is throughout the book, but none of this
appears to have anything whatsoever to do with optimality. Indeed, a great
strength of this book is the use of judiciously chosen case study material
which indicates the structural problems and the nature of solutions
solutions which we have no grounds for describing as optimal. They are
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simply the practices which so far work better than the alternatives. Secondly,
substantial parts of the book are concerned with questions of reward and
incentive structures, employment relationships and labour contracts. Yet
many managerial issues remain unilluminated by this emphasis on rewardperformance trade-offs. The productivity of individuals and teams, for example,
surely depends as much on trust, loyalty and reciprocal commitments which
permit effective learning and the accumulation of the skills which give the
whole organization competitive advantages. In short, Miss Jones had better
not ignore Milgrom and Roberts on these matters but she also must learn
some other human skills to motivate, lead and distribute a sense of selfesteem. The economics of coordination as presented here is an important
part of the problem but it is not the decisive part of the managerial problem.
A second consequence of bounded rationality is the asymmetric distribution
of information, the very fact which follows from the division of labour,
distributed capabilities, limited competence and the complexity of problems.
To Milgrom and Roberts, the consequences of the resulting information
asymmetries are negative: the prevention of conditions to apply the theorems
of welfare economics. They follow from guile and opportunism, hold up
problems in the presence of specific assets, adverse selection and moral
hazard, and the allocation of resources to signalling and selection. From a
different viewpoint these asymmetries are entirely productive, and are the
basis for economic progress. Necessarily, our world is a world of asymmetric
information, and such asymmetries cannot usefully be judged as market
failures when they are the very mainspring of the competitive process.
Imperfections of knowledge from the evolutionary perspective are simply the
necessary means for the world to be competitive at all. Thus, while one can
only admire the precise discussion of moral hazard and adverse selection, of
opportunism and guile, and the implications this has for the allocation of
resources of labour and capital, one cannot but feel that a sense of perspective
has disappeared. It is these 'imperfections' which have made progress possible;
it is these imperfections which underpin the hope of successful innovation;
it is these asymmetries which map the creative destruction of modern capitalism. Again, this is something that a Schumpeterian perspective readily incorporates.
Hence we arrive at the third consequence of this boundedness of decisionmaking: it leads to differential behaviour. The elementary fact is competition
as a process driven by the diversity of firms' behaviour: they do different
things and respond to pressures in different ways. If competition is to be
treated entirely as a solution to a coordination problem, the presence of
diversity amounts to very little. However, to equate a state of coordination,
whether by price or by other means, with a state of equilibrium is to mask
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the significance of diverse behaviour as the driving force behind economic

change. This, of course, is the foundation of an evolutionary argument
individuals living in the same world but believing in and perceiving different
worlds as a basis for action.
The limits of the Milgrom and Roberts approach are particularly obvious
when one reflects on the virtual absence of the entrepreneur throughout the
book: the concept only appears in the last chapter in the context of the
development of organizations. Differential behaviour is the essence of entrepreneurship and its exercise is fundamentally incompatible with equilibrium
theory. Creativity, imagination, boldness, discovery and alertness are the
issues, not the passive acceptance of choices defined by clearly specified
constraints. To the manager who lives daily with competition as change and
process, the equilibrium perspective must seem perfectly puzzling. Amongst
many (Hayek included), Georgescu-Roegan (1967) has expressed this with
particular force: 'a perfectly competitive industry involves no competition at
all' while 'the most general form of competition among individuals concerns
a differentiation of product, involving a little innovation, not cut-throat
pricing'. Thus, the world is competitive to the extent that firms create
differential behaviours which map into competitive advantages. Indeed,
much of the discussion of labour contracts fits well with the process view of
competition, individuals deliberately seeking to differentiate and advance
themselves in the eyes of employees. As Milgrom and Roberts observe, rat
races (or tournaments) can be a pretty vicious form of 'market selection',
particularly when the scope for genuine differentiation is limited. Every
colleague has a view on the artificial capabilities of others. Without question
this is a rich and sensitive discussion of central institutions in modern
capitalism. Miss Jones will have no difficulty in recognizing the issues and
accepting the rationale for particular practices.
If there is one weakness in the scope of this book in claiming to provide
a general treatment of management, it is its excessive concern with price
coordination, transfer prices and wage setting are the typical examples of the
internal use of prices by managers, although quantity coordination is not
entirely ignored. The behaviours which develop decisive cost or quality
advantages, in particular technological change and organization design,
receive, by comparison, negligible attention. Yet these are the behaviours
which drive competition, which explain the changing market position of
firms, industries and regions, and which unify a concern with entrepreneurship and asymmetric information. This is not to say, of course, that pricing
behaviour is irrelevant; far from it prices influence the surplus over costs
which is available for the discretionary use of management. The most
significant of these discretionary uses are undoubtedly investments in capacity,
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innovation and organization. For information asymmetry arguments, which

Milgrom and Roberts make very clear, one cannot expect capital markets to
behave efficiently when dealing with these particular behaviours.
In short, from a perspective of the management of change, the problem
is misperceived. Good management involves behaving better than ones rivals
and converting those competitive advantages into expansion at the expense
of rivals. At root, this is a question of the relation between variety generation,
organization and management, and the role of selection processes in enhancing
the relative importance of superior varieties of behaviour. Market processes
are selection processes to be judged not by the rules of static efficiency but
by their dynamic ability to select superior behaviours. Equally, the organization constitutes an internal selection environment in which alternative
conjectures about rules can be tested and implemented. Hence, the firm is
to be seen as an experimental as well as an allocative institution, and
managers are to be seen much as surrogate scientists/technologists, as they
are passive stewards of the resources at their disposal.
All this raises quite different yardsticks with which to judge organizational
design and managerial behaviours. Not only must managers seek to do the
best they can with given knowledge and resources, they must also devote
their attention to increasing their local knowledge and turning it into
competitive advantage. All we know of knowledge generation in complex
environments suggests that this proceeds by inductive trial-and-error means;
that theory is too weak to predict outcomes; and that learning proceeds by
a mix of actual doing and vicarious mental winnowing. The processes which
Vincenti (1990), for example, has so clearly described with respect to the
growth of engineering knowledge surely apply a fortiori to managerial knowledge. We would therefore expect such knowledge to grow incrementally
and cumulatively within traditions of normal management practice, and that
there will be the occasional paradigm shift as some radical new position is
developed and diffused. All this we expect to be a process of variation and
selection, a problem in evolutionary epistemology.
Variation in managerial practice necessarily proceeds blindly. It is neither
random nor unguided; it is simply that the full consequences of new practices
cannot be completely foreseen. It is guided by managerial models which are
embodied in the decision routines of the firm. The central empirical aim
therefore is surely to discover the population of decision rules and how that
population is augmented and diminished over time.
All this points to the need to present the firm as an ever-evolving organization and the managerial problem is one of constraining and stimulating
that evolutionary process. The firm must be efficient to survive today but
unless it is suitably creative, it will not survive tomorrow. Management is
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Reference
Georgescu-Roegan, N. (1967), 'Chamberlins' New Economics and the Production Unit' in R Kuenne
(ed.) Monopolistic Competition Theory Studies in Impact, Wiley' New York.
Loasby, B. J. (1995), 'Running a Business: an Appraisal of Economics. Organization and Management by
Paul Milgrom and John Roberts,' Industrial and Corporate Change, 4, 503-521
Vincenti, W. (1990), What Engineers Know and Hou> They Know it, Johns Hopkins University Press.
Baltimore.

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also judged by its ability to learn and to creatively break with existing
practice. It is the recognition of the need to mix these diverse demands which
is perhaps the greatest omission in this book. In short, resources and
opportunities are not what they are; they are what individual managers and
teams think they are, and their conjectures are probably invalid many more
times than they are valid. Like all good evolutionary processes, there is an
awful lot of waste and destruction for very little creation. It is precisely
because managers and entrepreneurs have dared to think differently that the
economic world of 1994 is not the same as the economic world of 1894.
No one who reads this book can fail to admire the enormous skill and
effort which has been deployed to synthesize a vast literature on the economics of coordination. From this perspective, the authors have written a
definitive text which covers an important part of the space of management
problems. If management were simply stewardship, that would be sufficient,
but it is in the very nature of management that not all can be stewards:
some must set strategy, define directions of change and be willing to do
things differently. Over time, it is this dimension which makes the crucial
difference between success and failure, between growth and stagnation,
between prosperity and survival. To imply that Milgrom and Roberts are
unaware of this would be wholly wrong. But consideration of this dimension
does suggest that their last chapter should have come first.