Firm organisation: theory and strategic perspectives

Slavo RadosevicUCL

Lecture 2

Objective:

• to become familiar with theories of firm within a range of alternative perspectives

Content: • Theories of firm: an overview• Behavioural theory of firm• Agency theory of firm• Transaction costs perspective on firm

– Conglomerates• Evolutionary theory view of firm / Penrose

– Chandler: Firms and firm structure • Summary

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Theories of firm: an overview• Neo-classical theory of the firm (profit maximizer)

– The firm behaves in a rational and consistent way seeking to maximize its utility (profit)

– The firm has access to both complete and certain information about the environment within which it operates

– Firm as a black box• Behavioral theory (Herbert Simon, Cyert and March)• Managerial theories (agency theory): ‘principal -

agent’ analysis • Transaction cost theory (new institutionalism and

boundaries of the firm)• Resource (evolutionary or competence) based

theory

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Behavioral theory (Herbert Simon, Cyert and March)

• The firm is postulated as a coalition of (groups) of participants, such as shareholders, employees, managers, suppliers and customers

• Conflicts between the objectives of various sub-groups within the firms mean that an overall firm strategy seeking to maximize a single objective us unlikely

• The fundamental objective of a firm is survival > a search for solution which is mutually acceptable to all different internal groups within the firm > the firm will generally have several goals

• The idea of maximization is replaced by the notion of ‘satisficing’ > aiming for outcomes which are acceptable or satisfactory for themain internal groups comprising a company, rather than outcomeswhich are optimal for only one or a few groups within the company

• The focus is on the process by which firms determine their economic choices, rather than on the outcomes of those choices, as with maximization models

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The firm as a coalition of groups of participants

Source: Syste Douma and Hien Schreuder (2002) Economic Approaches to Organizations, Third edition, FT, Prentice Hall, pp. 98

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Fundamental differences between behavioural and standard microeconomic theory of firm

Behavioural theory

Standard microeconomic theory

Firm as a coalition of partners Yes Not

Firm has a single objective Not YesInformation can be transferred without cost

Not Yes

Human decision makers are boundedly rational

Yes Not

Source: Based on Syste Douma and Hien Schreuder (2002) Economic Approaches to Organizations, Third edition, FT, Prentice Hall, pp. 98

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Agency theory • The relationship between two people: a principal and an agent who

makes decisions on behalf of the principal• The central question: how the principal should design the agent’s

reward structure• Origin of theory: separation of ownership and control (Berle and

Means, The Modern Corporation and Private Property, 1932) > not single shareholder owns a significant faction of the outstandingstock– The bulk of the dividends goes to the outside shareholders– All the major decisions are taken by the corporate officers– The outside shareholders are unable to control the corporate officers

• Sales revenue as the main goal in management controlled firm– Model 1: Managers seek to maximize utility function subject to profits

exceeding some minimum acceptable level (Maris)– Model 2: Managers seek to maximize growth (Baumol)

• Conflicting objectives of managers: maximizing both the value of the firms and on-the-job consumption

• How well the principal can observe behaviour of agents

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Corporate governance systems• Market oriented systems of corporate governance

(US/UK)– Developed market for corporate control– Mechanism of hostile takeovers as disciplining device – One-tier board system– Not large bloc holders

• Network oriented (stakeholder based) systems of corporate governance (Germany, France, Italy, Spain, Japan, etc.)– Two tier board systems, mainly: executive board (decision

management) + supervisory board (decision control)> employees, banks

– Large block holders have a representative on the board of directors

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Widely held firms vs. Family controlled firms as % of large corporations in various countries (control inferred at 10%)

Widely held Family control Widely held Family controlUK 90 5 Austria 5 15

USA 80 20 Greece 5 65 Australia 55 10 Israel 5 50 Canada 50 30 New Zealand 5 45 Japan 50 10 Norway 5 25

Switzerland 50 40 Singapore 5 45 Ireland 45 15 Taiwan (China) 2.9 65.6 Korea 40 35 Thailand 2.2 56.5

Germany 35 10 Philippines 1.4 42.1 France 30 20 Malaysia 1 57.5

Netherlands 30 20 Indonesia 0.6 68.6 Finland 15 10 Argentina 0 65

Italy 15 20 Belgium 0 50 Spain 15 25 Mexico 0 100

Denmark 10 35 Portugal 0 50 Hong Kong 10 70 Sweden 0 55

Based in majority of countries on 20 largest publicly listed companiesSource: Morck, Wolfenzon, and Yeung (2005), excerpt from table 2

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A stylized control pyramid

Source: Morck, Wolfenzon and Yeung (2005), JEL 10

Family controlled pyramids: economic entrenchment I• The archetypal corporate governance problem in the

modern United States economy, a conflict between atomistic shareholders and professional managers, does not generalize to most other countries.

• Large firms in most countries are typically organized into pyramidal groups controlled by a few wealthy families.

• The ensuing corporate governance problem is conflict between the controlling shareholder of the pyramidal group and public shareholders.

• Such highly concentrated control over corporate assets plausibly leads to a range of market power distortions, especially in capital markets. It also may curtail investment in innovation and augment rent-seeking. All of these effects likely retard economic growth’ (Morck et al, 2005, p. 714, JEL).

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Family controlled pyramids: economic entrenchment II

• The distribution of control over the corporate sector affects economic development > entrenchment > weak institutions place sweeping corporate powers in the hands of a tiny elite group, who then lobby for weak institutions to preserve their concentrated control over the countries large corporations – oligarchic capitalism

• ‘Economic entrenchment explains why family BGs, an institutional advantage early in economic development, become oligarchic capitalism in some countries, but not in others’ (Morck etal, 2005, p., 711)

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Transaction costs economics(Coase, Williamson)

• Why, if the market is an efficient coordinator, some activities are combined together in firms, rather than being coordinated through market (Coase, 1947)

• The process of exchange generally does involve costs• The costs involved in searching for information about prices and

suppliers• The costs involved in negotiating, drawing up, monitoring,

renegotiating, and enforcing contracts• Transaction costs = all those costs not directly incurred in the

physical process of production (institutional costs)– Costs of information, of negotiation, of drawing up and enforcing

contracts, of delineating and policing property rights, of monitoring performance, and changing institutional arrangements

• TCE can be used to explain why we observe different organizational forms, such as simple hierarchies, U-form and M-form firms in different circumstances as well as different degrees of verticalintegration

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Transaction cost theory of firm

• The existence of firms depends on firms having cost advantages over market-based exchange

• Firms develop if: the costs of transaction through markets > the costs of organizing and coordinating production within firms

• The marginal decision to ‘make’ or ‘buy’ then determines the size of the firm

• Assumptions of TC perspective: – Opportunism: individuals pursue their own interests in

deceitful or guileful ways– Bounded rationality: our capacity for wholly rational

decision making is limited by our capacity to acquire, store and process relevant information

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The determinants of choice between market and organization

– Asset specificity: those which have low value in alternative uses so that moving from one use to another causes losses to the owner

• Frequency: when asset specificity or/and volume of transactions are is high we expect transactions to be carried out within organization rather then across markets

– Uncertainty/complexity• Asymmetric information: one of the parties to a transaction is often

better informed about certain aspects of the transaction than the other• Hidden information: people know more about their real abilities and

capacities than potential employers ?> adverse selection• Hidden actions: difficulty to to be sure when the other party has

fulfilled her contractual obligations > moral hazard• Team production: separate contributions to total output cannot be

easily evaluated• Imperfect commitment: inability to give totally credible commitments

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Critique of Williamson's TC approach• It ignores the role of social relations and culture

(organisational forms which are built on trust > networks, clans, trust within firms)

• It is static– the most efficient forms have survived (efficiency

view) > tautology? – silent on the dynamic process of competition between

different organisational forms• Hierarchy also allows scope for opportunism • Within organizations there are other coordinating

mechanisms– standardization of work processes, of skills, of

outputs, of norms, mutual adjustment)

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Organizational forms in between markets and organisations

• Long-term relations between buyers and suppliers (subcontracting)

• Joint ventures• Informal networks (guanxi, blat)• Franchising• Business groups (conglomerates)

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ConglomeratesClarke, R. and T. McGuinnes, (eds.) (1987)

• Related (product extension) vs. unrelated (pure) conglomeration• Transaction cost economizing explanations of conglomerate

growth– Internalization of production of separate goods > if the cost of

conglomerate production of these goods is lower than with marketprovision due to:

• Capital market Ho: A general capital allocation advantage relative to the outside capital market < weak capital market

• Resource utilization arguments: Conglomerates may be better in utilizing the services of their specialized human and non-human resources < market failure in the sale or lease of specialized services

• Financial risk reduction explanation– By diversifying portfolio of activities < > large firms per se have

advantages in raising finance• Managerial motives

– Managers pursue growth maximisation strategies (diversification) > may adopt lower rates of return

– Managers have incentive to reduce the variability in performance of the firm by diversifying

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Resource based theory of firm I• Firms are fundamentally heterogonous > firm as a

hierarchy of organizational routines • The nature of firm’s resources and the way in which these

resources are combined into capabilities > capabilities view of the firm

• Profit is not the result of resource scarcity per se > the capability is scarce but not the underlying resources of capital and labor

• Firm is a repository of knowledge or/and of ‘dynamic organization capabilities’ or collection of capabilities.

• The business firms is a ’both an administrative organization and a collection of productive resources, both human and material. However, it is never resources themselves that are the ‘inputs’ in the production process, but only the services that the resources can render (Penrose, 1959).

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Routines: building blocks for behavioural and capability view of firm

• Notion of routines is essential to a newly emerging evolutionary theory (Nelson and Winter, 1982)

• Organizational knowledge resides mostly in the routines (“practices”)

• Routines (not ‘choices’) drive decision making. • > this view is compatible to behavioural view of firm >

based on the notion of bounded rationality.• Routines also carry the accumulated skill and

knowledge of the firm which would be complex and costly to codify and set down

• > this evolutionary view is compatible to capability view of firm

• > Routines are of dual nature > carriers of capabilities + governance mechanisms.

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Resource based theory of firm II

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• The specific nature of the firm’s facilities and skills is the most significant factor in determining what will be done in the firm and what by the market (Chandler, 1992)

• The growth of the firm can be viewed as an attempt by top managers to fully utilize excess resources (physical, human)

• Source of firm’s distinctive capability (Kay, 1993):– Architecture: the network of contractual

relationships which defines the firm: long term relationships and environment which encourages cooperation and discourages opportunism

– Reputation: commercial mechanism for conveying information to consumers about product quality

– Innovation: > appropriability problem

Resource based theory of firm III

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• To be valuable, the firm’s capabilities have to be reasonably sustainable and appropriable.

• Sustainability and appropriability = (f) – Tradability or transferability. the extent to which capabilities

are marketable rather than immobile or firm specific > the resources behind the capabilities generate rent > this VA or product is not the result of resource scarcity per se

– Replicability. The ease with which potential rivals can copy or imitate the capabilities involved.

– Transparency. The ease with which potential competitors can actually identify what it is that makes a particular firm successful.

– Substitutability. The more difficult it is to find substitute for a capability, the more valuable it will be to a firm.

• > Isolating mechanisms. Those factors which act as natural barriers protecting and sustaining the value of a successful firm’s capabilities. In the absence of isolating mechanisms, capabilities would not be sustainable as sources of value added

Resource based view of competitive advantage

Cornerstones of

Competitive Advantage(MargaretPeteraf)

Heterogeneity

Ex-post limitsto competition

Imperfectmobility

Ex-ante limitsto competition

Rents obtained

Rents capturedby the firm Rents sustained

Rents not offsetby costs

Competitiveadvantage

Peteraf, M. (1993), Cornerstone of Competitive Advantage, Strategic Management Journal, Vol. 14, No. 3. (Mar., 1993), pp. 179-191 23

Chandler: organizational capabilities and industrial restructuring

A narrow view of Chandler’s contribution (Martin, 2001)• The tendency of the first large industrial firms to expand using the

functional (or unitary) organization– A small scale firms that deals primarily in one product or one region has

one purchasing department, one production department, one sales department, etc.

• Bounded rationality places limits on the size of firm for which the functional form is an effective form of business organization

• To cope with managerial loss of control in large, functionally organized firms, innovative entrepreneurs developed the multidivisional or M-form of business organization– The components of the firm are defined in terms of product groups or

regions– Each such division has its own functional subdivisions, and is directed

by a middle manager, an employee, who supervises divisions operations and reports to corporate HQ

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Chandler: organizational capabilities and industrial restructuring II

A broad view of Chandler’s contribution (Dosi,1997)* • Over the last century, organizational learning and organization embodied

technical change have increased their importance as sources of growth• The nature of organizational structures is not neutral vis-a-vis the ability to

accumulate coordinating and technological competences, so that particular forms of corporate organizations entail a higher learning potential than others

• Organizations and technological knowledge is not uniformly distributed and uniformly accessible across countries

• Differential competences in organizational coordination and technological innovations determine differential possibilities of growth not only of individual firms but of the entire countries where firms originated

• But … Ho: the Chandlerian firm no longer dominates the landscape. See Langlois, Essay questions

• ‘Organizational competencies, firm size, and the wealth of nations: Some comments from a comparative perspective’, In Amato, Chandler, Hikino (1997) Big Business and the Wealth of Nations, CUP

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Summary I:• Different theories of firm answer on different questions

related to firm. – Neo-classical & behavioral theories explain what the objective of

firm is.– Agency perspective explains a reward structure within the firm – Transaction cost theory explains what boundaries of firm are. – Resource based view of firm explains what makes firms different

from each other.• Profit maximizing view of firm > firm as a black box of

technological and managerial relationships > the costs are minimized in pursuit of the firm’s profit maximizing objective.

• The divorce of ownership from control justifies the managerial theories of firm behavior > Managerial motivations based on sale revenue maximization, utility maximization or growth maximization are more prominent as compared to pure profit maximization.

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Summary II:• Behavioral theory of firm > the motivations of firms are

more diverse than assumed in the managerial led models. The ideas of coalitions and goal aspirations, and routines + satisificing + use of rules of thumb > more realistic descriptions of firms. Also, this theory can embrace the role of stakeholders in firms’ growth.

• TC view of the firm > explains why firms exist + explains its boundaries in relation to market. However, difficulty to measure TC > any firms’ boundaries may be interpreted as efficient.

• Resource based theory of the firm (capability view) explains sustained competitive advantage in terms of heterogeneity in resources and capabilities. Critical capabilities are imperfectly mobile and cannot be acquired in the open market– Assumption: all elements of firm cooperate > poor on incentives

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Issues for discussion I

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• Please, comment following statement: ‘In conditions of perfect knowledge, the theory of the firm is very simple: there are not firms’ (Brian J. Loasby)

• According to Coase the existed because it superseded the price mechanism. A key player in this was the entrepreneur who allocated resources by command rather than price. The inability of the firm to act like a market arises because of the complexity of exchange. Firms are established to internalize transactions. Is this incomplete or complete contracting view of firm? Explain, why?

• Ownership is intimately associated with contractual incompleteness. Explain!

• The firm in conventional neoclassical economics is an ‘empty box’. Explain!

Issues to think about• ‘The competitive strength of industries and of

nations (..) reflects the learned organizational capabilities of their industrial enterprises’. Please, discuss this proposition.

– Chandler, A.D. Organisational capabilities and industrial restructuring : a historical analysis, J of Comparative Economics 17 (309-337 (1993)

• What were the learned organisational capabilities of Estonian socialist and post-socialist enterprises ?

• How different theories of firm can help us understand the firm restructuring in Estonia?

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Sources used in this lecture I• Williamson, O. E. (1985) The Economic of Institutions of Capitalism,

NY: Free Press• Williamson, OE (2007), Transaction Cost Economics: An

Introduction, Economics Discussion Papers, Available at www.economics-ejournal/eJournal/economics/discussionpapers.org

• Williamson, O. E. (2002) The Theory of the Firm as Governance Structure: From Choice to Contract, Journal of Economic Perspectives , Vol. 16, No. 3, Summer, pp 171–195

• Huascar F. Pessali (2006), The rhetoric of Oliver Williamson’s transaction cost economics, Journal of Institutional Economics(2006), 2: 1, 45–65

• Randall Morck, Daniel Wolfenzon, and Bernard Yeung (2005) Corporate Governance, Economic Entrenchment, and Growth, Journal of Economic Literature, Vol. XLIII (September 2005), pp. 655–720

• Stephen Martin (2001): Industrial organization. A European perspective, Oxford University Press

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Sources used in this lecture II

• Kay, John (1993), Foundations of Corporate Success, Oxford University Press, 1993

• Syste Douma and Hien Schreuder (2002) Economic Approaches to Organizations, Third edition, FT, Prentice Hall

• Clarke, R. and T. McGuinnes, (eds.) (1987) The Economics of the Firm, Basil Blackwell, Oxford ch. 6 Conglomerate Firms’ by R. Clarke

• Chandler, A.D. Organisational capabilities and industrial restructuring : a historical analysis, J of Comparative Economics 17

• David J. Teece ‘The Dynamics of Industrial Capitalism: Perspectives on Alfred Chandler’s Scale and Scope’, Journal of Economic Literature, Vol. XXXI (March 1993), pp.199-225.

• Edith Penrose (1959) The Theory of the Growth of the Firm, Oxford, Blackwell.

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