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  • The Economics of Business Organizations

    TEACHER: Hello, Student. As you know we are now going to discuss The Economics of Business Organizations. I’ll appreciate that you begin this Module by mentioning a couple of matters you’d like to know about this subject.

    STUDENT: Let’s see. In connection with the internal organization of firms, I’d like to discuss if some forms of organization are more efficient than others. I’d also like to know what activities are best done within a single firm, and what activities are best done within independent firms that then trade with one another.

    TEACHER: Very well. We’ll also talk about a new perspective on why firms exist, which is based on the idea that firms provide an organization that is able to co-ordinate the resources of a diversity of employees, each of whom has specific limited knowledge. This new approach is known as the knowledge-based or resource-based theory of the firm.

    Now, let’s begin by taking a look at firms as organizations.

    When we were talking in earlier Modules about how firms made decisions on output and pricing, how did we assume these decisions were made?

    STUDENT: We assumed the existence of one central decision-making unit for all the firm's output and pricing choices.

    TEACHER: That's correct; we actually made that assumption. But in real life, a firm’s managers have different motivations, interests and opinions. To reach final decisions, some way to coordinate these conflicting interests must be found.

    One way to reach this objective is Co-ordination by coalition.

    R. M. Cyert and J. G. March conducted a very influential study in the 1960s.(A behavioral Theory of the Firm – Englewood Cliffs, NJ – Prentice Hall).

    The authors consider the firm’s decision making as the outcome of a process of bargaining between a set of involved parties whose objectives differ. Can you think of a categorization of these employees?

    STUDENT: You mentioned managers before, but it can be argued that firms contain many individuals with different roles and goals. Apart from managers, I can think of workers, shareholders, and customers. Obviously there is no particular coherence of interest within groups.

    TEACHER: Correct. The outcome of the interaction of these different individuals is perceived to be an organizational coalition, in which every individual has to make some compromise over objectives, since not all can be simultaneously satisfied.

    STUDENT: But Teacher, internal compromise does no look as the best way to identify the optimal price, product mix, rate of asset utilization, and rate of innovation, does it?

    TEACHER: A sharp observation, Student. It is a fact that firms in which political processes (akin to those in a coalition government) determine outcomes will typically exhibit organizational slack in the sense that they will not be maximizing profit or the value of the firm. This type of firms can survive in spite of being slack (or sub-optimal, using a more sophisticated word) and not maximizing profits as long as the outcome is satisfactory for all parties involved.

    STUDENT: This approach looks somewhat dated to me. It may have worked nicely in the 1960s, but then company riders, hostile takeovers, shareholder’s revolts, etc. etc. appeared on the scene.

    TEACHER: Quite true. While the Cyert and March analysis had great plausibility in the 1960s, it is hard to reconcile with the business environment of the 1990s and the early 21st century. In short, the strong focus on value maximization has made the concept of organizational slack unacceptable at least for public corporations.

    STUDENT: And it is easy to guess that the basic issue is how to achieve a structure within which internal conflict is resolved and the overall goals of the firm are pursued by all parts of the organization.

    TEACHER: We can give such a structure a name: incentive compatibility.

    This is a structure within which individuals have an incentive to perform not only in their own interest but also in the overall firm's interest.

    STUDENT: Nice definition. How can it be implemented?

    TEACHER: A modern version of the Cyert and March approach is based upon identifying the interests of various groups of stakeholders. Remember who the main stakeholders are?

    STUDENT: Sure. The stakeholders in a firm are all those who have a direct economic interest in the firm's results; mainly employees, suppliers, shareholders, and customers.

    TEACHER: Correct. Successful firms have to build their success on a constructive alliance of all interested parties. No firm can succeed in the long term without a high-quality and motivated management, productive employees, and satisfied customers and suppliers.

    STUDENT: Are you not leaving out the all-important shareholders? A firm needs capital and the stock market is a vital source of it; and managers can get fired by shareholders.

    TEACHER: You are right about the vital importance of shareholders, and I am not leaving them out; I only wanted to stress that if a firm has bad relations with any of the groups mentioned before, it will not serve the value-maximizing objectives of shareholders.

    Now we’ll discuss the three basic business structures that have categorized firms in the 20th and are still valid in the 21st century.

    * In a unitary form (U-form) of business there are several departments that perform different functions, but they all report to the chief executive (or the office of the CEO), who is responsible for the overall running of day-to-day operations.

    * In a multi-divisional form (M-form), specific product groups are formed into separate divisions, each with its own functional departments. Every division has its own general manager who is responsible for the day-to-day running of the division. The CEO of the firm is responsible for co-ordination of the activities of the divisions and for providing strategic focus for the business.

    * In a portfolio form (P-form), the main company (the Group, or Holding) is made up of a collection of several wholly, or partly, owned subsidiary companies. Each of the companies within the group has its own chief executive, who is responsible for the day to-day running of that business, and each of these subsidiary companies may itself be U-form or M-form in structure. The Group has a CEO responsible for deciding the strategy of the entire group, including deciding which businesses should remain in the Group portfolio and which others might be acquired. There is a board of directors for the group, usually referred to as the 'main board', and there is a board for each subsidiary company.

    STUDENT: My guess is all companies that started small and grew organically (that is by expanding the existing business rather than taking over other businesses) started out with a U-form structure. And it is a fact that many small businesses today also have such a structure.

    TEACHER: Correct. The M-form structure was first introduced into General Motors in the 1920s by Alfred P. Sloan, in order to handle the problems of running a large manufacturing concern. Other large US companies, such as Du Pont, Standard Oil, and Sears, also reorganized along these lines in the inter-war years. This structure proved to be a considerable success and was widely imitated.

    But by now almost all large public companies have gone further than the M-form structure -although parts of the business may be in this form. These firms are collections of many subsidiary companies and we can consider them as having a P-form structure.

    STUDENT: You are mentioning the facts. Can we look now into the economic reasons for this evolution of structure?

    TEACHER: We’ll do precisely that, right now.

    U-Form Structure

    The unitary form of structure is the natural place to start for any small business. In a start-up manufacturing business the product might, for example, be produced in a small plant. As the product’s sales grow, additional staff will be hired. The business has to have accounts, so the services of an accountant will be hired. At first, the accountant might be part time, but if growth continues, there will be a finance department. Similarly, someone will have to take charge of sales, and eventually there may be an entire marketing department. Having taken on all these new staff, the firm will need a personnel department to handle hiring and firing and terms of employment, etc.

    This chart illustrates what the organizational structure looks like in a U-form business:


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