Economic Approaches to Organizations (6th Edition) PDF

ECONOMIC APPROACHES TO ORGANIZATIONS Sixth Edition Sytse Douma and Hein Schreuder ECONOMIC Why do organizations exist? What is...

ECONOMIC APPROACHES TO ORGANIZATIONS Sixth Edition Sytse Douma and Hein Schreuder ECONOMIC Why do organizations exist? What is the relationship between markets and organizations? APPROACHES TO TO ORGANIZATIONS ECONOMIC APPROACHES When does one perform better than the other? ORGANIZATIONS Find the answers in Economic Approaches to Organizations! Now in its sixth edition, this text emphasizes the importance of economic perspectives and theories in the study of organizations and management. It explains different economic approaches such as behavioural theory of the firm, game theory, agency theory, transaction cost economics, economics of strategy and evolutionary approaches in a non-technical way. Sixth Edition This fully updated edition is packed with practical examples from real-world companies, helping you to understand how the concepts relate to economic and organizational problems happening in the world today. New to this edition: Sytse Douma and Hein Schreuder Introduction of digital platforms as coordination mechanism and platform organizations as new organizational type. Economic explanation of the business models of Airbnb, Amazon, Google, Uber and similar platform organizations. A separate chapter on behavioural economics covering bounds on rationality and self-interest as well as prospect theory. An update of the exciting new field of complexity economics focusing on learning and adaptation. Three application chapters on Mergers and acquisitions, Corporate governance and Hybrid forms (for example, joint ventures, business groups and franchising) offered electronically in addition to the material in the book. This is the ideal text for courses on Organization and Management from an economic perspective. The text can also be used as a supplement to a larger text on Organization and Management or Strategic Management. Economics students will benefit from a concise introduction to a field that is related, but all too often unexplored. Sytse Douma is Honorary Professor of Business Administration at Tilburg University. Sixth Hein Schreuder was Executive Vice President of Corporate Strategy and Acquisitions at Royal DSM N.V. Edition until 2012. He is a Honorary Professor of Business Economics at Maastricht University and Board member of the Vlerick Business School in Belgium. He is also Chairman of Ecorys, a leading research-based economic Hein Schreuder consultancy firm in Europe. Sytse Douma and www.pearson-books.com Front cover image © Getty Images CVR_DOUMA_06_28900.indd 1 27/02/2017 14:06  Economic Approaches to Organizations A01_DOUM8900_06_SE_FM.indd 1 27/02/2017 19:09  At Pearson, we have a simple mission: to help people make more of their lives through learning. 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To learn more, please visit us at www.pearson.com/uk A01_DOUM8900_06_SE_FM.indd 2 27/02/2017 19:09  Economic Approaches to Organizations Sytse Douma Tilburg University, the Netherlands Hein Schreuder Vlerick Business School, Belgium Harlow, England London New York Boston San Francisco Toronto Sydney Dubai Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town São Paulo Mexico City Madrid Amsterdam Munich Paris Milan A01_DOUM8900_06_SE_FM.indd 3 27/02/2017 19:09  Pearson Education Limited Edinburgh Gate Harlow CM20 2JE United Kingdom Tel: +44 (0)1279 623623 Web: www.pearson.com/uk First published 1991 (print) Second edition published 1998 (print) Third edition published 2002 (print) Fourth edition published 2008 (print) Fifth edition published 2013 (print and electronic) Sixth edition published 2017 (print and electronic) © Prentice Hall Europe 1991, 1998 (print) © Pearson Education Limited 2002, 2008 (print) © Pearson Education Limited 2013, 2017 (print and electronic) The rights of Sytse Douma and Hein Schreuder to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. 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ISBN: 978-1-292-12890-0 (print)     978-1-292-17572-0 (PDF)     978-1-292-12895-5 (ePub) British Library Cataloguing-in-Publication Data A catalogue record for the print edition is available from the British Library Library of Congress Cataloging-in-Publication Data Names: Douma, S. W., author. | Schreuder, H., author. Title: Economic approaches to organizations / Sytse Douma, Tilburg University, the Netherlands, Hein Schreuder, Vlerick Business School, Belgium. Description: Sixth edition. | Harlow, England ; New York : Pearson Education, 2017 | Includes bibliographical references and index. Identifiers: LCCN 2016039813| ISBN 9781292128900 (Print) | ISBN 9781292175720 (PDF) | ISBN 9781292128955 (ePub) Subjects: LCSH: Managerial economics. Classification: LCC HD30.22.D69 2017 | DDC 338.5/024658—dc23 LC record available at https://lccn.loc.gov/2016039813 10 9 8 7 6 5 4 3 2 1 21 20 19 18 17 Print edition typeset in 9.5/12.5 pt Stone Serif by 71 by Spi Global (P) Ltd. Printed in Slovakia by Neografia NOTE THAT ANY PAGE CROSS REFERENCES REFER TO THE PRINT EDITION A01_DOUM8900_06_SE_FM.indd 4 27/02/2017 19:09  Contents Preface xi Acknowledgements xv Part I Foundations 1 1 Markets and organizations 3 1.1 The economic problem 3 1.2 The division of labour 5 1.3 Specialization 7 1.4 Coordination 9 1.5 Markets and organizations 10 1.6 Information 14 1.7 The environment and institutions 16 1.8 Historical perspective 22 1.9 Summary: the conceptual framework of this book 24 1.10 Outline of the book 25 Questions 26 Note 26 2 Markets 27 2.1 Introduction 27 2.2 Market interaction: analysis of demand and supply 28 2.3 Decision-making by consumers 29 2.4 Decision-making by producers 31 2.5 Market coordination 32 2.6 The paradox of profits 33 2.7 Competitive markets 33 2.8 The main assumptions underlying standard microeconomic theory 34 2.9 Summary: how according to standard microeconomic theory economic decisions are coordinated by the market 36 Questions 37 A01_DOUM8900_06_SE_FM.indd 5 27/02/2017 19:09  vi  Contents 3 Organizations 38 3.1 The world of organizations 38 3.2 Organizational coordination 39 3.3 Types of organizations 44 3.4 Organizational markets 49 3.5 Organized markets 50 3.6 The rise of the Internet and the digitization of organizations 53 3.7 Digital platforms: a new coordination mechanism 56 3.8 The Platform Organization 59 3.9 Summary: how organizations achieve coordination 62 Questions 64 Notes 64 4 Information 66 4.1 Coordination and information 66 4.2 Hidden information 71 4.3 Hidden action 78 4.4 The value of information 83 4.5 Information as an economic good 86 4.6 Summary: information problems for markets and organizations 88 Questions 90 Notes 91 5 Game theory 92 5.1 Introduction 92 5.2 The prisoner’s dilemma 93 5.3 Coordination games 97 5.4 The entry game 99 5.5 The iterated prisoner’s dilemma 103 5.6 Auctions 105 5.7 Evolutionary game theory 111 5.8 Summary: insights from game theory 116 Questions 118 6 Econs and Humans 119 6.1 Introduction 119 6.2 The social domain versus the economic domain 120 6.3 Economic, social and moral man: bounds on self-interest 121 6.4 Bounds on rationality 124 6.5 Prospect theory 127 6.6 Summary: behavioural economics 130 Questions 131 A01_DOUM8900_06_SE_FM.indd 6 27/02/2017 19:09  Contents  vii Part II Economic Approaches 133 7 Behavioural theory of the firm 135 7.1 Introduction 135 7.2 The firm as a coalition of participants 135 7.3 Organizational goals 139 7.4 Organizational expectations 142 7.5 Organizational choice 142 7.6 From bounded rationality to behavioural economics 145 7.7 Summary: goals and decision-making within the firm in behavioural theory  150 Questions 152 Note 154 8 Agency theory 155 8.1 Introduction 155 8.2 Separation of ownership and control 156 8.3 Managerial behaviour and ownership structure 159 8.4 Entrepreneurial firms and team production 165 8.5 The firm as a nexus of contracts 167 8.6 Theory of principal and agent 169 8.7 Applying agency theory 178 8.8 Summary: agency relations between owners, managers and employees 182 Questions 184 Note 186 9 Transaction cost economics 187 9.1 Introduction 187 9.2 Behavioural assumptions: bounded rationality and opportunism 189 9.3 Dimensions of transactions 195 9.4 Peer groups 200 9.5 Simple hierarchies 202 9.6 Multistage hierarchies: U-form and M-form enterprises 204 9.7 Organizational markets 205 9.8 Digitization and transaction costs 208 9.9 Markets and organizations: are these all there is? 211 9.10 Governance in a three-level schema 223 9.11 Summary: effect of transaction costs on choosing between markets and organizations and organizational forms  225 Questions 227 Notes 228 A01_DOUM8900_06_SE_FM.indd 7 27/02/2017 19:09  viii  Contents 10 Economic contributions to business/competitive strategy229 10.1 Introduction 229 10.2 Industry analysis 232 10.3 Competitor analysis 236 10.4 Competitive strategy 239 10.5 Resource-based view of the firm 240 10.6 Dynamic capabilities 244 10.7 Move and counter move 248 10.8 Summary: how economic analysis can contribute to the formulation of competitive strategies 258 Questions 259 Note 259 11 Economic contributions to corporate strategy 260 11.1 Introduction 260 11.2 Unrelated diversification 263 11.3 Related diversification 271 11.4 Horizontal multi-nationalization 276 11.5 Vertical integration 279 11.6 Summary 284 Questions 286 Notes 287 12 Evolutionary approaches to organizations 288 12.1 Introduction 288 12.2 Giraffes 288 12.3 Organizations and giraffes 290 12.4 Organizational ecology 293 12.5 An evolutionary theory of economic change 302 12.6 Comparison 307 12.7 The evolution of dynamic capabilities 310 12.8 Further developments 317 12.9 Summary: the evolutionary perspective 323 Questions 325 Notes 327 13 All in the family 328 13.1 Introduction 328 13.2 The basic conceptual framework 328 A01_DOUM8900_06_SE_FM.indd 8 27/02/2017 19:09  Contents ix 13.3 Family resemblances 330 13.4 Family differences 333 13.5 Summary: all in the family? 341 13.6 Organizations as complex, adaptive systems 342 Questions 357 Notes 358 Bibliography 359 Index 373 Lecturer Resources ON THE WEBSITE For password-protected online resources tailored to support the use of this textbook in teaching, including three additional online chapters, please visit www.pearsoned.co.uk/douma A01_DOUM8900_06_SE_FM.indd 9 27/02/2017 19:09 A01_DOUM8900_06_SE_FM.indd 10 27/02/2017 19:09  Preface This sixth edition marks the Silver Jubilee of a book originally published in 1991. The book has been translated into five languages – Chinese, Danish, Japanese, Korean and Spanish. It has been gratifying to witness the success of the book, but to us it has been even more satisfying to work on its evolution from one edition to the other. In the fourth edition, we expanded the conceptual framework of our book to include more emphasis on the environmental and institutional context of mar- kets and organizations. In the fifth edition, we split the chapter on economic approaches to strategic management into two separate chapters dealing with business strategy and corporate strategy, respectively, allowing us to address the distinctive strategic tasks at the business and corporate levels of larger, diversi- fied organizations in a more focused approach. In the sixth edition, we have expanded the main text with the following topics: Introduction of a seventh, Internet-based coordination mechanism: Digital Platforms. Demonstration of the rapid rise of the use of such platforms, powered by algorithms and network effects. Discussion of the corresponding organizational configuration to which Digital Platforms give rise: the Platform Organization. Extensive coverage of such Platform Organizations, like Amazon, Google, Uber, Airbnb, Alibaba Baidu and Facebook. A new chapter on Behavioural Economics. When we wrote the first edition back in 1991, behavioural economics was still in its infancy. Since then the field has developed enormously. In the fifth edition, we already introduced several concepts of behavioural economics, such as loss aversion and the endowment effect. In this sixth edition, we devote a whole new chapter to this important new field, which is very relevant for the study of organiza- tions. The chapter on Game Theory has been restructured. The concluding section on organizations as complex adaptive systems has been expanded to reflect the recent developments in this exciting field. In addition, all chapters have been reviewed and updated with new develop- ments and examples. With these expansions, which we deemed necessary, we rethought the basic structure of our book. Since the fourth edition, we had included three ‘applica- tion chapters’ to the book, dealing with: Mergers & Acquisitions, Hybrid Forms, and Corporate Governance. We felt that the book would become too large and unwieldy if we maintained all these chapters. Therefore, we have decided to include part of the material on Hybrid Forms in the present Chapter 9. The full chapter on Hybrid Forms as well as the other ‘application chapters’ on Mergers & Acquisitions and Corporate Governance are now available in updated ver- sions electronically on www.pearsoned.co.uk/douma. A01_DOUM8900_06_SE_FM.indd 11 27/02/2017 19:09  xii  Preface There has been no lack of theoretical developments and demonstrations of the relevance of economic policies and approaches in recent years. Since the publication year of our fourth edition (2008), the world has experienced a severe financial crisis, triggered by the collapse of Lehman Brothers in the USA. This has led to severe pressures on the banking systems of many countries. The term ‘moral hazard’ which may have been a rather arcane, technical term in the first edition of our book has become very familiar to those reading newspaper coverage of the bail out of banks and large corporations that were deemed ‘too big to fail’. The financial crisis has also exacerbated the plight of companies with unsuccessful strategies to cope with rapid technological change (Kodak) or globalization of markets (Volvo). In particular, the increasing force of the ‘digital revolution’ has forced many companies to rethink their business mod- els. Another set of companies have thrived in these circumstances (Alibaba, Apple, BMW, Instagram, Snapchat). In this sixth edition, we will examine these changes, particularly from the perspective of the twin needs for ‘exploration’ and ‘exploitation’ which companies must satisfy for long-term success. As a result of all these new developments, we have had no difficulty at all in coming up with many new boxes illustrating the applicability of the economic concepts and approaches covered in this book. This book is intended for students of organization and management – an important area of study for students of business administration, economics, sociology and organizational psychology. There is no shortage of textbooks on organization and/or management, but most do not include even a short introduction to the various economic approaches to organizations that have been developed in recent decades. This book takes a different approach: it has been designed as an introductory text on the analysis of organizations from an economic perspective. The book has been used successfully as a main text on organization and management courses in many universities and busi- ness schools with an emphasis on economic aspects of management (such as finance, marketing and accounting). In other settings, the book can be used as a supplementary text in conjunction with a more conventional textbook on organization and/or (strategic) management. No prior knowledge of economics is assumed. The economic background needed to understand the arguments made in the text is explained in the text itself, mainly in Chapter 2. Students of economics will also find this book useful. Most textbooks in microeconomics devote little attention to the field of organization and manage- ment. This book offers students in economics a view from their own discipline into a related but usually unknown field. The book starts by comparing markets and organizations. Why do organiza- tions exist at all? Why are not all economic decisions coordinated by the market mechanism? Conversely, why do markets exist at all? Why is not all production carried out by one large firm? Our answer is that information requirements play a crucial role in under- standing why markets and organizations coexist. Markets and organizations offer different solutions to the information problems that are inherent in many situations. Understanding these differences leads to insights where markets are A01_DOUM8900_06_SE_FM.indd 12 27/02/2017 19:09  Preface  xiii most appropriate and where we should expect organizations to perform bet- ter. The different advantages of markets and organizations also explain why we often find that a mix of market and organizational coordination is the optimal solution from an economic point of view. The book consists of two parts. In Part I, Chapters 1 to 6, we lay the founda- tions for the economic approaches to organizations that are discussed in Part II. In Chapter 1, we build, step by step, a conceptual framework to explain the fundamental economic approach to organizations. In that framework, informa- tion is a concept of vital importance. Chapters 2 and 3 explain how markets and organizations work. In particular, these chapters explain how decisions are coordinated by various mechanisms, such as the price mechanism, direct supervision, mutual adjustment and stand- ardization. Chapter 4 then focuses on the information requirements of different types of coordinating mechanisms. How players can coordinate their decisions in different information settings is also the central theme of the discussion of game theory in Chapter 5. Our new chapter 6 summarizes the findings of Behavioural Economics which are most relevant for studying organizations. The first six chapters, which form Part I, thus explain the fundamental concepts and methods underlying the economic approaches to organizations. As the title of this book suggests, there are several different but related economic approaches to organizations. These approaches are discussed and compared in Part II, which consists of Chapters 7 to 13. The approaches are: behavioural theory, which sees the firm as a coalition of groups of partici- pants, each with its own interests; agency theory, which focuses on delegating decision-making to an agent, while the boss (or principal) can only partly observe the agent’s behaviour; transaction cost economics, which focuses on the sum of transaction costs and production costs as determinants of organizational forms; economic contributions to strategic management from the field of industrial organization and game theory, with applications in the areas of business strategy and corporate strategy; evolutionary approaches to organizations, which direct our attention to the development of organizational forms in the context of their interaction with their environments. Chapter 13 compares and evaluates these different approaches and adds the perspective of organizations as complex adaptive systems. As indicated, three areas of the application of the theories and approaches discussed in Part II are available on www.pearsoned.co.uk/douma. Mergers and Acquisitions applies many concepts such as hidden information (adverse selection), hidden action (moral hazard), the winner’s curse and auc- tion theory to the context of the acquisition, divestiture or combination of companies. Hybrid Forms deals with íntermediate’ organizational forms, such as joint ventures, business groups and franchising. These are sets of organizations where coordination between those organizations takes place by means of the A01_DOUM8900_06_SE_FM.indd 13 27/02/2017 19:09  xiv  Preface price mechanism and various other coordination mechanisms simultane- ously. Corporate governance is discussed as a special case of the framework devel- oped in this book. It covers, amongst other topics, agency problems, the use of incentive contracts, and internal and external monitoring. It also elabo- rates on different systems of corporate governance and their evolution in various parts of the world. The field of economic approaches to organizations has been growing sub- stantially since 1991 and this book has been growing as well. The first edition consisted of 185 pages, whereas this sixth edition has increased to nearly 400 pages with an additional 90 pages available electronically. Nevertheless, our ambition has remained the same throughout these years: to present the eco- nomic approaches to organizations in a way that we hope is concise, illuminat- ing and appealing. We welcome the feedback of users whether we have achieved that ambition and any comments or suggestions you may have to improve this book further. An instructor’s manual containing answers to end-of-chapter questions, sug- gestions for further reading for each chapter, additional open questions with answers, multiple choice questions and true/false statements with answers, items for further discussion in the class room, as well as copies of many of the figures found in this edition, is available at no extra cost to lecturers adopting this book as a textbook. An electronic version is available to download at www. pearsoned.co.uk/douma. Sytse Douma Hein Schreuder Visit the Companion Website at www.pearsoned.co.uk/douma to find valuable Lecturer Resources including: Complete, downloadable Instructor’s Manual. Powerpoint slides that can be downloaded.  Three chapters on applications of Economic Approaches to Organizations to the fields of: Mergers and Acquisitions Hybrid Forms, such as joint ventures, franchising and business groups Corporate Governance. A01_DOUM8900_06_SE_FM.indd 14 27/02/2017 19:09  Acknowledgements No book can be written without the assistance of others. We wish to thank first of all our fellow economists who developed and continue to develop the excit- ing field of economic approaches to organizations. We owe a heavy debt to all contributors to this new literature. Their names can be found in the References section. Further, we wish to express our thanks to the anonymous referees of the subsequent editions of this book and to the various editors from Pearson, with whom we have worked over 25 years. Publisher’s acknowledgements We are grateful to the following for permission to reproduce copyright material: Figures Figure 9.5 adapted from Organization Theory: From Chester Barnard to the pre- sent and beyond (Williamson, O. E. 1995) p. 213, © Oxford University Press; Figure 12.1 adapted from www.galluppoll.com, Copyright © 2016 Gallup, Inc. All rights reserved; Figure 12.4b from Indices that capture creative destruc- tion: questions and implications, Revuew d'Economie Industrielle, Vol.110, no. 1 (2nd tr), pp.199–220 (Mazzucato, M. and Toncioni, M. 2005). Tables Table 12.1 from ‘Life and death along gasoline alley: Darwinian and Lamarckian processes in a differentiating population’, Academy of Management Journal Vol. 39, no. 5, pp. 1428–66 (Usher, J. M., and Evans, M. G. 1996), Academy of Management. Text Extract on pages 11–2 from ‘The use of knowledge in society’, American Economic Review, Vol. 35, no. 4 (Hayek, F. A. 1945); Box 1.3 from Blighting the horizon, The Economist; Box 1.5 from ‘Why do firms exist?’, The Economist, 16/12/2010; Box 1.6 from ‘Electronic glue’, The Economist, 02/06/2001; Box 1.7 from ‘The new tech bubble’, The Economist, 14/05/2011; Box 1.8 from Globalization and its Discontents, London: Penguin (Stiglitz, J. 2002); Box 1.10 from ‘Li & Fung: Link in the global chain’, The Economist, 02/06/2001; Box 1.11 from Reinventing the Bazaar: A natural history of markets, New York: W. W. Norton (McMillan, J. 2002) p.14. Copyright © 2002 by John McMillan. Used by permission of W.W. Norton & Company, Inc.; A01_DOUM8900_06_SE_FM.indd 15 27/02/2017 19:09  xvi   Acknowledgements Box 2.1 from The Economist, 17/02/1996 (Cox, S.); Box 2.2 from Oil Industry Sets a Brisk Pace of New Discoveries, The New York Times, 24/09/2009 (Mouawad, J.), © 2009 The New York Times. All rights reserved. Used by permission and pro- tected by the Copyright Laws of the United States. The printing, copying, redis- tribution, or retransmission of this content without express written permission is prohibited; Box 3.6 from Greenspan Concedes Error on Regulation, International Herald Tribune, 23/10/2008 (Andrews, E.L.), © 2008 The New York Times. All rights reserved. Used by permission and protected by the Copyright Laws of the United States. The printing, copying, redistribution, or retransmission of this Content without express written permission is prohibited; Box 3.9 from Smart products, smart makers, The Economist, 21/11/2015, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 3.12 adapted from The rating game: How Uber and its peers turned us into horrible bosses, The Verge (Dzieza, J.); Extract on pages 70–1 adapted from ‘Informational asymmetry, strategic behavior, and industrial organization’, American Economic Review, Vol. 77, pp.184–93 (Milgrom, P. and Roberts, J. 1987), and by kind permission of Professor Milgrom; Box 4.1 adapted from ‘Toyota's long climb comes to an abrupt halt’, The Financial Times, 05/02/2010 (Reed, J. and Simon, B.), © The Financial Times Limited. All Rights Reserved; Box 4.5a adapted from Betting on future movie receipts: beware the Hollywood lemons', Knowledge@Wharton, 28 April 2010, Wharton University of Pennsylvania; Box 4.5b from CTFC approves second Hollywood futures exchange’, The Financial Times, 21/04/2010, © The Financial Times Limited. All Rights Reserved; Box 4.9 from An insurer's worst nightmare. (risk), The Economist, 29/07/1995, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 5.1 from OPEC and the voice of doom, The Economist, 09/06/2000, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 5.6 from ‘Tales of manipulation and design flaws from the crypt of auction history’, The New York Times, 01/06/2002 (Varian, H. R.), © 2002 The New York Times. All rights reserved. Used by permission and protected by the Copyright Laws of the United States. The printing, copying, redistribution, or retransmission of this content without express written permission is prohibited; Extract on page 138 from Good corpo- rations should drive the economy, The Financial Times, 12/05/2015 (Kay, J.), © The Financial Times Limited. All Rights Reserved; Extract on pages 147–8 from ‘Differences between entrepreneurs and managers in large organizations: Biases and heuristics in strategic decision-making’, Journal of Business Venturing, Vol. 12 no. 1, pp. 9–30 (Busenitz, L.W. and Barney, J.B. 1997), Journal of Business Venturing by Snider Entrepreneurial Center, New York University. Reproduced with permission of Elsevier Inc. via Copyright Clearance Center; Box 7.2 from Everything I ever needed to know about Economics, I learned from online dating, Boston: Harvard Business Press (Oyer, P. 2014); Box 7.4 from Evolution of Narcissism: Why We're Overconfident, and Why It Works by Christine Dell'Amore, published September 16, 2011, http://news.nationalgeo- graphic.com/news/2011/09/110914-optimism-narcissism-overconfi- dence-hubris-evolution-science-nature/ (accessed 29 February 2016), Christine Dell’ Amore/National Geographic Creative; Box 7.5 from Misbehaving: the making of behavioural economics, London: Allen Lane (Thaler, R. 2015) p.326, A01_DOUM8900_06_SE_FM.indd 16 27/02/2017 19:09  Acknowledgements  xvii 978-1846144035; Box 7.6 adapted from How Google Works, NY: Grand Central Publishing (Schmidt, E. and Rosenberg, J. 2014) pp. 153–4, From How Google Works by Eric Schmidt and Jonathan Rosenberg with Alan Eagle. Copyright © 2014 by Google, Inc. Used by permission of Grand Central Publishing. All rights reserved and © Google, Inc. 2014 and reproduced by Hodder and Stoughton Limited; Box 8.6 from The Company: A short history of a revolutionary idea, London: Weidenfeld & Nicolson (Micklethwait, J. and Wooldridge, A. 2003), with permis- sion of Orion Publishing Group Ltd and with permission of Random House Inc., New York; Box 8.7 from http://www.iea.org/publications/freepublica- tions/publication/mind_the_gap.pdf iea.org, © OECD/IEA (2007), Mind the Gap, IEA Publishing; Extract on pages 209–10 adapted from How Google Works, NY: Grand Central Publishing (Schmidt, E. and Rosenberg, J. 2014) pp. 81–2, From How Google Works by Eric Schmidt and Jonathan Rosenberg with Alan Eagle. Copyright © 2014 by Google, Inc. Used by permission of Grand Central Publishing. All rights reserved and © Google, Inc. 2014 and reproduced by Hodder and Stoughton Limited; Box 9.3 from ‘Return to vendor: a dress on loan’, The Economist, 03/03/2012, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 9.6 from ‘Building foundations for a durable deal’, Financial Times (Supplement), 13/10/2006 (Gilson, R. J., Goldberg, V., Klausner, M., and Raff, D.), © The Financial Times Limited. All Rights Reserved; Box 9.7a from When and when not to vertically integrate, McKinsey Quarterly, August (Stuckey, J. and White, D. 1993). Copyright © 2016 McKinsey & Company. All rights reserved. Reprinted by permission; Box 9.7b from ‘The machine that ran too hot’, The Economist, 27/02/2010, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 9.13 from Reinventing the Bazaar: A natural history of markets, New York: W. W. Norton (McMillan, J. 2002) p.57, Copyright © 2002 by John McMillan. Used by permis- sion of W.W. Norton & Company, Inc.; Box 9.14 from http://www.wired. com/2014/04/trust-in-the-share-economy/ and http://techcrunch. com/2014/08/08/stellar-uber-and-the-rise-of-computational-trust/, Conde Nast and Jason Tanz, © Conde Nast; Box 9.15 from ‘Economics focus: real- ity bites', The Economist, 17/10/2009, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 10.2 adapted from ‘Record EU fine for glass cartel’, The Financial Times, 13/11/2008, © The Financial Times Limited. All Rights Reserved; Box 10.6 from ‘Pipelines, Platforms, and the New Rules of Strategy’, Harvard Business Review, April, pp. 54–62 (M.W. Van Alstyne, G.G. Parker and S.P. Choudary 2016); Box 10.10 from Corporate sardines, 3 May 2014, The Economist, 03/05/2014, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 10.11 from ’Managing by commitments', June, Harvard Business Review (Sull, D.N. 2003) pp. 82–91; Box 10.12 from Everything I ever needed to know about Economics, I learned from online dating, Boston: Harvard Business Review Press (Oyer, P. 2014); Box 11.2 from ‘Conglomerates valued in emerging markets', The Financial Times, 24/25 September 2011, © The Financial Times Limited. All Rights Reserved; Box 11.3 from http://www.berkshirehathaway.com/letters/2010ltr.pdf, © Warren E. Buffett; Box 11.4 from Larry Page, https://abc.xyz/ (The Alphabet web- site, accessed on 6 March 2016); Alphabet, formerly Google, © 2015 Google Inc. A01_DOUM8900_06_SE_FM.indd 17 27/02/2017 19:09  xviii   Acknowledgements All rights reserved. Google and the Google Logo are registered trademarks of Google Inc.; Box 11.5 from http://www.berkshirehathaway.com/ letters/2010ltr.pdf. The material is copyrighted and used with permission of the author; Box 11.6a from ‘From Dodo to Phoenix’, The Economist, 11/01/2014, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 11.6b from ‘From Alpha to Omega’, The Economist, 15/08/2015, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Extracts on page 304, page 305, page 308, page 309 from An Evolutionary Theory of Economic Change, Cambridge, MA: Harvard University Press (Nelson, R. R., and Winter, S. G. 1982), The Belknap Press of Harvard University Press, Copyright © 1982 by the President and Fellows of Harvard College; Box 12.3 from ‘Slowly does it’, The Financial Times, 27/03/2002, p.11 (Skapinker, M.), © The Financial Times Limited. All Rights Reserved; Box 12.6 adapted from Deloitte/THNK, Scale-up: the experience game, 2015; Box 12.9 from ’The smart technology loser folds', The Financial Times, 11/01/2012, © The Financial Times Limited. All Rights Reserved; Box 12.11 from ‘Partly cloudy’, The Economist, 17/10/2015, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 12.14 from Off the block, The Economist, 29/08/2015, Reproduced with permission of Economist Newspaper Ltd via Copyright Clearance Center; Box 13.7 from Business Models, Business Strategy and Innovation, Long Range Planning, Vol. 43, pp. 172–94 (D. J. Teece 2010), Long Range Planning by European Strategic Planning Federation and Strategic Planning Society. Reproduced with permission of Elsevier Inc. via Copyright Clearance Center. On-page credit Extract on pages 209–10 adapted from How Google Works, NY: Grand Central Publishing (Schmidt, E. and Rosenberg, J. 2014) pp. 81–2, From How Google Works by Eric Schmidt and Jonathan Rosenberg with Alan Eagle. Copyright © 2014 by Google, Inc. Used by permission of Grand Central Publishing. All rights reserved and © Google, Inc. 2014 and reproduced by Hodder and Stoughton Limited Box 7.6 adapted from How Google Works, NY: Grand Central Publishing (Schmidt, E. and Rosenberg, J. 2014) pp. 153–4, From How Google Works by Eric Schmidt and Jonathan Rosenberg with Alan Eagle. Copyright © 2014 by Google, Inc. Used by permission of Grand Central Publishing. All rights reserved and © Google, Inc. 2014 and reproduced by Hodder and Stoughton Limited Figure 9.5 adapted from Organization Theory: From Chester Barnard to the present and beyond (Williamson, O. E. 1995) p. 213, © Oxford University Press Box 9.14 from http://www.wired.com/2014/04/trust-in-the-share- economy/ and http://techcrunch.com/2014/08/08/stellar-uber-and- the-rise-of-computational-trust/, Conde Nast and Jason Tanz, © Conde Nast A01_DOUM8900_06_SE_FM.indd 18 27/02/2017 19:09  Part 1 Foundations M01_DOUM8900_06_SE_C01.indd 1 27/02/2017 18:19 M01_DOUM8900_06_SE_C01.indd 2 27/02/2017 18:19  1 Markets and organizations 1.1 The economic problem Imagine a world of abundance – perhaps a tropical island where you are basking in the sun, with lots of food and a tribe of friendly islanders as your companions. Would you have any economic problems on this island? Well, ‘No’, you may say, ‘I can’t imagine any problem on such an island, let alone an economic problem’. Many people associate economic problems with money. As money would be either absent or abundant on our imaginary island, they would think there would be no economic problems. An economist, however, would not be content with this reasoning. He/she would enquire further, asking, for example, whether you felt you had enough time to enjoy all the pleasures of your island or if your needs for housing, education, culture, friendship and so on had been met. The point is Economic problem that an economist would identify an economic problem in any situation where needs would not be met as a result of scarcity of resources – ‘resources’ being quite broadly conceived as meaning all factors that may contribute towards the satis- faction of human needs. So, yes, you may not have an economic problem on your fantasy island, but only if you could truly say that all your needs would be met. Time to return to the real world, where economic problems abound, whether we apply a narrow definition or the broader one presented above. We do not have enough land to meet all our needs for cultivation as well as ecological pres- ervation. We do not manage to feed the world’s population properly. Many raw materials are in limited supply. Talent is always scarce and so is time. Most people, even in rich countries, do not earn enough money to buy everything that they would like to buy. In short, scarcity is a fact of life in the real world. Given this predicament, the economic problem may be rephrased as the problem of how to make the best use of the available resources. Alternatively, in economic jargon, Optimal allocation what is the optimal allocation of the scarce resources over the alternative uses that can be made of them? Resources that are optimally allocated are said to be Efficiency used with efficiency. This book is concerned with economic approaches to organizations. Now, eco- nomics might not be the first discipline you think of when trying to understand organizational phenomena. Indeed, it will be argued later that economics had for a long time hardly any contribution to make to the study of organizations. The approaches that we present in this book have been developed relatively recently, although in some cases their origins are much older. So, you are quite justified in wondering what insights economics has to offer. Our answer is that economic approaches to organizations are fruitful whenever the problem to be studied has M01_DOUM8900_06_SE_C01.indd 3 27/02/2017 18:19  4   Chapter 1 Markets and organizations Economic aspect an economic aspect – that is to say, whenever part of the problem deals with the (optimal) allocation of scarce resources. Note that we have carefully specified that economics deals with parts and aspects of problems. We believe that there are hardly any ‘purely economic’ problems. Similarly, there are hardly any purely legal, sociological or psychological problems. All these social sciences deal with aspects of real-world phenomena. All illuminate a part of social reality. Whoever believes that economics can explain entirely the ‘marriage market’ or, for that matter, organizational phenomena is guilty of ‘econo- mism’ (which, we are informed, is a contraction of economics and colonialism). There is an equal danger of legalism, sociologism or psychologism, too, whenever the explanatory power of one discipline is exaggerated. Having said that, we do believe economics has an important contribution to make to the understanding of organizations. Two points follow from the perspective outlined above. Economic approaches to organizations focus specifically on the economic problem of optimal allocation of scarce resources (broadly conceived). The economic contribution to our understanding of an organizational prob- lem increases when the economic problem forms a greater part of the organi- zational problem that we are trying to understand. In this book, we present the major strands of the current economic approaches to organizations. In addition, we illustrate some of the applications of those approaches to organizational problems. In doing so, we shall avoid technical expositions and, instead, concentrate on the basic concepts involved. Our aim is to provide a conceptual introduction to these approaches. By focusing on the basic concepts, we hope also to present a more coherent picture of organizational economics than has been provided before. In this first chapter, we build, step by step, the basic conceptual framework that we use to explain the fundamen- tal economic approach to organizations. This framework is shown in Figure 1.1. The framework will clarify the crucial role of information and the various ways in which information can be mediated. This central role of information will be elaborated further in Chapter 4, where we argue that this is the glue that binds the various economic approaches to organizations together. Environment and institutions Division of labour Specialization Coordination Market Information Organization Environmental pressure and selection Figure 1.1 The basic concepts M01_DOUM8900_06_SE_C01.indd 4 27/02/2017 18:19  The division of labour   5 1.2 The division of labour Adam Smith is usually credited as the founding father of modern economics. In his book An Inquiry into the Nature and Causes of the Wealth of Nations (1776), he accords great importance to the division of labour: ‘The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour’. His famous example is that of a pin factory. He showed that a tremendous increase in the productivity of the work of pin-makers could be achieved by split- ting this work up into distinct tasks and having each worker perform one specific task rather than making entire pins (see Box 1.1). Division of labour Division of labour, therefore, refers to the splitting of composite tasks into their component parts and having these performed separately. It is a pervasive phenomenon in modern societies. Box 1.1 The pin factory To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of a labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this particular business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations. Source: Smith (1776) M01_DOUM8900_06_SE_C01.indd 5 27/02/2017 18:19  6   Chapter 1 Markets and organizations Our primeval ancestors were much more self-supporting. They built their own houses, grew or hunted their own food, made their own tools, defended themselves from various threats and so on. Since then, gradually, these tasks have come to be divided into separate sectors in society (such as the private and the public sectors), and, within those sectors, further divided into separate entities (such as government agencies, industries and firms). An economic system has developed in which we normally buy these goods or services in exchange for money. Most of us work in organizations where we earn our money. Looking inside those organizations we can see that the division of labour occurs there as well. We usually perform but a small part of an entire organization’s task. In order to accomplish its task, the organization itself is split into different parts (such as divisions and departments), levels and functions. As a result, we need organiza- tion charts (see Box 1.2) as maps to guide us through the organizational territory. These charts are one reflection of the division of labour within organizations. It was Adam Smith’s contention that the progressive division of labour led to productivity increases that constituted the main source of the increasing ‘wealth of nations’. In the next section we shall see what the basis for this contention was. Here we want to conclude by emphasizing that we take the division of labour as a fact of life in our kind of society. No matter what position we occupy, every time we interact with others to obtain goods or services we need, we may be reminded of this fact. This is what forms the starting point for our conceptual framework, which is outlined in Figure 1.1. Box 1.2 Organization Chart of Brill: a publishing company (May 2011) CEO HR PA EVP S&M EVP Publishing EVP F&O Business Development / Project Coordinator Marketing PU MIA Office Manager E-Publishing Operations Sales System Office PU CLS Legal / R&P North Americas Administration Management Library Sales Application Operational PU ASI / LIN E-Publishing Europe Management Audit Sales ROW PU HIS / SLA Operations Operations F&C Downstream Upstream Sales Support Central Technical PU LAW Accounting MRW / Metadata Europe/ROW Purchasing Support Counsel CDE Books Stock Management/ PU REL / ANJ AR CM/PT Traffic CDE Journals Production PU S&B Production LB Editing Boston M01_DOUM8900_06_SE_C01.indd 6 27/02/2017 18:19  Specialization   7 1.3 Specialization Why would an increasing division of labour lead to such great productivity increases and, thus, to a growth in ‘the wealth of nations’? Smith (1776) gave the following explanation: This great increase in the quantity of work, which, in consequence of the division of labour, the same number of people are capable of performing, is owing to three different circumstances; first, to the increase of dexterity in every particular work- man; secondly, to the saving of the time which is commonly lost in passing from one species of work to another; and lastly, to the invention of a great number of machines which facilitate and abridge labour, and enable one man to do the work of many. Economies of In our present economic terminology, we say that there are economies of specialization specialization to be gained. In the specialized pin factory, the same amount of output can be produced with less labour effort than in the unspecialized factory. Conversely, a greater amount of output can be achieved with the same level of labour input (ten men), as Smith showed. Specialized production is thus more efficient than unspecialized production. Among the reasons for this being true are the ones mentioned in the quota- tion above. Essentially, when work is split into specific tasks, we may select one that particularly suits our own needs and capabilities. When we specialize in that task, we can devote all our attention to improving our performance of that task. We can learn from more experience and we can use that experience to devise methods and instruments to further improve our execution of the task. For all these reasons, a specialized economic system is usually more efficient than an unspecialized one. Division of labour thus leads to specialization, which allows for efficiency gains (Figure 1.2). This is a pervasive phenomenon in society. Let us consider some examples. In the family, household work is usually split into different tasks and the members of the family specialize in distinct tasks (whereas others may be shared). They become good at those tasks, but not at others. Some know exactly where to shop for particular goods and get the best value for money. Some know how to oper- ate the household appliances; perhaps others know how to fix them. Some have specialist skills in filling out the tax forms; others perhaps in monitoring the budget. Whatever the particular distribution of tasks, some degree of specializa- tion is present in all families and, in most families, the efficiency of running the household is seriously disturbed when members have to switch to unfamiliar tasks. In that sense, there is a cost to specialization. Division of labour Specialization Figure 1.2 Division of labour leads to specialization M01_DOUM8900_06_SE_C01.indd 7 27/02/2017 18:19  8   Chapter 1 Markets and organizations Similarly, in sports, specialization leads to higher performance, but comes at a cost. An individual cannot compete, let alone excel, in all sports. Choices have to be made and long, specialized training has to be undertaken. Once specialized, high performance is necessarily restricted to a narrow range of options. Even an admi- rable sportsman such as Novak Djokovic is restricted to playing professional ten- nis. Specialization, building on a unique talent, has allowed him to reach the top in playing tennis, but even Djokovic would not be able to compete at the highest level in two sports (for example, in tennis and golf). In team sports such as hockey or soccer, it is usually very unproductive to switch goalkeepers and field players. Good teams make the best use of their members’ specializations. Specialized skills are scarce. Good teams allocate those members with these specialized skills in an optimal manner to the tasks to be executed and, thus, are organized efficiently. In many fields, such as medicine or transportation, it would even be disastrous to switch specialists. However much we favour variety of work, we are not willing to enter hospitals or board aircraft where the specialists take turns doing each other’s work. For the individual, then, specialization has the advantage of allowing higher levels of performance to be reached, but the disadvantage of restricting choice. At the individual level, the limits of specialization are reached when the satisfaction gained from higher performance (and the consequent rewards) is outweighed by the dissatisfaction from too narrow an area of application of one’s skills (with the resulting boredom and frustration). As many organizations have learned over time, the gains from further specialization are easily offset by the costs of dissatisfaction when those individual limits are exceeded. The conveyor belt, for instance, enabled great gains in productivity, but only to the extent that the workers accepted the range of activities required of them. If such a range becomes too narrow, the gains are offset and a restructuring of activities (for example, into semi-autonomous workgroups) is called for. Individual limits are thus one boundary to increasing specialization. There are also organizational limits to specialization: high organi- zational specialization may lead to insufficient collaboration in addressing new challenges, as illustrated in Box 1.3. More fundamentally, increased specialization requires increased coordination, as discussed in the next section. Box 1.3 The ‘Silo Effect’ of organizational specialization A potential drawback of high organizational specialization is known as the ‘Silo Effect’: There is no principle more fundamental to the market economy than the division of labour. It is the subject of the very first chapter of the founding text of modern economics, Adam Smith’s The Wealth of Nations. And yet, as anyone who has ever worked in a large corporation knows only too well, that principle has its dark side as well. Specialization improves efficiency – but it also leads to tunnel vision and blind spots. Organizing companies into discrete divisions makes responsibilities clearer – but it also leads to bureaucratic rivalry, corporate infighting, and the left hand not knowing what the right hand is doing. In short, the miracle of the division of labour can all too easily degenerate into the nightmare of The Silo Effect, the topic of a new book by the FT’s US managing editor, Gillian Tett. ▶ M01_DOUM8900_06_SE_C01.indd 8 27/02/2017 18:19  Coordination  9 The Silo Effect starts from a taxonomy of the disease. Much silo-building is initially deliberate and its immediate effects are often beneficial. The problems start when the silos become taken for granted. Tett uses Sony as an example. In the 1970s and 1980s, Sony was a watchword for innovation with its Walkman and its Trinitron TV. By the 1990s, however, the company had grown ungovernably large, so its new chief executive Nobuyuki Idei deliberately reorganized the unitary corporation into 10, and then 25, sub-companies. In the short term, efficiency improved and profits rocketed. Over time, however, the reforms began to backfire. Internal competition killed collaboration and innovation slowed... The problem, argues Ms Tett, was Sony’s silos. The firm knew it needed to evolve, but its divisions did not work together on a unified strategy or draw on each other’s strengths. Instead Sony’s staff were concerned with protect- ing or expanding their own turf by producing their own – incompatible – products. The company’s record label, which should have been an asset, was a hindrance: it feared losing revenue and therefore resisted the digital transition....When the digital age arrived, silo-ridden Sony was comprehensively bested by Apple, with its famously totalitarian ethos and relentless commercial focus. We return in Chapter 3 to the digital revolution and the new organizational forms it spawned. In Chapter 12 we discuss ‘inertia’ and in Chapter 13 ‘competency traps’, which are recognizable in the Sony case as well. Sources: Reviews of Gillian Tett, The Silo Effect (2015) in The Economist (29 August 2015) and The Financial Times (https://next. ft.com/content/ac89e9cc-4a55-11e5-b558-8a9722977189) 1.4 Coordination In the previous paragraphs we have seen that division of labour and specializa- tion are pervasive phenomena in society. As a result, hardly any people are eco- nomically self-reliant, in the sense that they produce all the goods and services they wish to consume. In order to obtain those goods and services, they have to acquire them from other specialized people. Exchange In economic terminology we say that exchange has to take place. Goods and services are exchanged whenever the right to use them is transferred. Much exchange takes place through markets. In a market, the right to use particular goods and services is bought (and, of course, sold at the same time). When I buy a piece of soap in my local store, I acquire the right to use the soap, whereas the storeowner acquires the right to use the money I have paid for it. Exchange of goods is usually beneficial to both parties to the exchange. For example, a painter should paint and a cook should cook. They can both specialize when they exchange their products. A nice example is given in Box 1.4. Exchange, though, is broader than just market exchange. First, the goods involved need not be only goods that are marketable. Economists speak of goods whenever scarce resources are involved. We can indeed also exchange favours as they are very scarce and can be used to get things done. Similarly, we exchange information as soon as the right to use the information has been transferred. Second, the transfer of rights need not be mutual. When I offer you some of my time, I am offering you the right to use a scarce resource. An economist would M01_DOUM8900_06_SE_C01.indd 9 27/02/2017 18:19  10   Chapter 1 Markets and organizations Box 1.4 Exchange of art for food In Saint-Paul de Vence, a small village in southern France, there is a restaurant called Colombe d‘Or. This restaurant was a favourite dining place for painters in the first decades of the 20th century. They sometimes “paid” for their meal by offering a painting in exchange for food. This is an example of division of labour. It allows painters to specialize in painting and cooks to specialize in cooking. The Colombe d’Or now has a famous collection of modern art. Source: Based on Kay (2003) regard your use of my time as an example of exchange, whether or not you recip- rocate in any way. Transaction Whenever exchange takes place, we speak of an (economic) transaction. Owing to the division of labour and to specialization, innumerable transactions have to occur in society. As, on the one hand, we are all specialized ourselves and, on the other hand, need the specialized goods and services of others, a vast network of exchange is necessary to allocate the available goods and services. How is that accomplished? How do the parties who are willing to engage in a transaction find Coordination each other? Phrased in economic terminology, how is the coordination achieved within an economic system? Specialization leads to