Managerial Economics andy

Organizational ArchitectureThijd Edition

JAMES A. BRICKLEYCLIFFORD W. SMITH, Jr.JEROLD L. ZIMMERMAN

» William E. Simon Graduate Schoolof Business Administration

University of Rochester

IrwinBoston Burr Ridge, IL Dubuque, IA Madison, Wl New York San Francisco St. Louis

Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico CityMjfan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

Contents in Brief

Part 1: Basic Concepts

Chapter 1 Introduction 2Chapter 2 Economist's View of Behavior 14Chapter 3 Markets, Organizations, and the Role

of Knowledge 42

PafT2: Managerial Economics

Chapter 4 Demand 7'4Chapter 5 Production and Cost 106Chapter 6 Market Structure 136Chapter 7 Pricing with Market Power 160Chapter 8 Economics of Strategy: Creating and

Capturing Value 188Chapter 9 Economics of Strategy: Game Theory 226Chapter 10 Incentive Conflicts and Contracts 255

Part 3: Designing Organizational Architecture

Chapter 11 Organizational Architecture 280Chapter 12 Decision Rights: The Level of Empowerment 302Chapter 13 Decision Rights: Bundling Tasks into Jobs

and Subunits 333Chapter 14 Attracting and Retaining Qualified Employees 358Chapter 15 Incentive Compensation 388Chapter 16 Individual Performance Evaluation 418Chapter 17 Divisional Performance Evaluation 450

Capstone Case Study on Organizational Architecture:Arthur Andersen LLP 481s

Part 4: Applications of Organizational Architecture

Chapter 18 Choosing the Legal Form of Organization 488Chapter 19 Vertical Integration and Outsourcing 514Chapter 20 Leadership: Motivating Change within Organizations 551

xvi Contents in Brief

Chapter 21 Understanding the Business Environment:The Economics of Regulation 575

Chapter 22 Ethics and Organizational Architecture 603Chapter 23 Organizational Architecture and the Process

of Management Innovation 629

Glossary 652

Index 663

Contents

Part 1: Basic ConceptsChapter 1: Introduction 2Managerial Economics and Organizational Architecture 4

Organizational Architecture 4Economic Analysis 5

Economic Darwinism 7Survival of the Fittest 7Economic Darwinism and Benchmarking 8

Purpose of the Book 10Our Approach to Organizations 10Overview of the Book 11

Case Study: Barings Bank 12

Chapter 2: Economists' View of Behavior . . 14Economic Behavior: An Overview 15

Economic Choice 16Marginal Analysis ^ 16Opportunity Costs 17Creativity of Individuals 18

Graphical Tools 19Individual Objectives 19Indifference Curves 20Constraints 22Individual Choice 23Changes in Choice 25

Motivating Honesty at Merrill Lynch 26Managerial Implications 29Alternative Models of Behavior 30

Only-Money-Matters Model 30Happy-Is-Productive Model 31Good-Citizen Model 32Product-of-the-Environment Model 32

^h ich Model Should Managers Use? 33Decision Making under Uncertainty 34

Risk Aversion 35Certainly Equivalent and Risk Premium 36Risk Aversion and Compensation 37

Case Study: Interwest Healthcare Corp 37Summary 38

xvii

Contents

Chapter 3: Markets, Organizations, and the Role of Knowledge . . .42Goals of Economic Systems 43Property Rights and Exchange in a Market Economy 44

Dimensions of Property Rights 44Gains from Trade 45

Basics of Supply and Demand 48The Price Mechanism 48Linear Supply and Demand 51Price as Social Coordinators 52Externalities and the Coase Theorem 53

Markets versus Central Planning 56General versus Specific Knowledge 56Knowledge Creation 58Specific Knowledge and the Economic System 60Incentives in Markets 61

Contracting Costs and Existence of Firms 62.^ssContracting Costs in Markets 63

Contracting Costs within Firms 64Managerial Implications 66Case Study: Property Right Security in Russian Deprivatization 67Summary 67

Part 2: Managerial Economics

Chapter 4: Demand ^ 74Demand Functions 75Demand Curves 76

Law of Demand 77Elasticity of Demand 78Linear Demand Curves 82

Other Factors That Influence Demand 84Prices of Related Products 84Income 86Other Variables 87

Industry versus Firm Demand 87Network Effects 89Product Attributes 91Product Life Cycles 92Demand Estimation 93

Interviews 94jj Price Experimentation 95

Statistical Analysis 95Implications 98

Case Study: Personal Video Recorders (PVRs) 99Summary 100Appendix: Demand 101

Contents xix

Chapter 5: Production and Cost 106Production Functions 107

Returns to Scale 108Returns to a Factor 109

Choice of Inputs I l lProduction Isoquants I l lIsocost Lines 113Cost Minimization 115Changes in Input Prices 116

Costs 117Cost Curves 117Short Run versus Long Run 120Minimum Efficient Scale 123Learning Curves 124Economies of Scope 125

Profit Maximization 126Factor Demand Curves 128CojtgFjstimation 129Case Study: Rich Manufacturing 131Summary 131Appendix: The Factor-Balance Equation 132

Chapter 6: Market Structure 136Markets . - . . . . . ' 138Competitive Markets 138

Firm Supply 138Competitive Equilibrium 140

Barriers to Entry 143Incumbent Reactions 143Incumbent Advantages 144Exit Costs 145

k Monopoly 146Monopolistic Competition 147Oligopoly 148

Nash Equilibrium 149Output Competition 150Price Competition 152Empirical Evidence 153Cooperation and the Prisoners' Dilemma 153

Summary 157

Chapter 7: Pricing with Market Power 160Prjpng Objective 161Benchmark Case: Single Price per Unit 162

Profit Maximization 162Estimating the Profit-Maximizing Price 165Potential for Higher Profits 167

Contents

Homogeneous Consumer Demands 168Block Pricing 168Two-Part Tariffs 169

Price Discrimination—Heterogeneous Consumer Demands 171Exploiting Information about Individual Demands 172Using Information about the Distribution of Demands 175

Bundling 179Other Concerns 180

Multiperiod Considerations 180Strategic Interaction 182Legal Issues 183

Implementing a Pricing Strategy 183Summary 184

Chapter 8: Economics of Strategy: Creatingand Capturing Value 188Strategy 189Value Creation 190

Production and Producer Transaction Costs 192Consumer Transaction Costs 193Other Ways to Increase Demand 194New Products and Services 197Cooperating to Increase Value 197Converting Organizational Knowledge into Value 198Opportunities to Create Value 200

Capturing Value 201Market Power .\ 202Superior Factors of Production 204A Partial Explanation for Wal-Mart's Success 210All Good Things Must End 211

Economics of Diversification 213Benefits of Diversification 213Costs of Diversification 214Management Implications , 214

Strategy Formulation 217Understanding Resources and Capabilities 217Understanding the Environment 218Combining Environmental and Internal Analyses 219Strategy and Organizational Architecture 219Can All Firms Capture Value? 220

Case Study: Wal-Mart.com . .- 221Summary 222

Chapter 9: Economics of Strategy: Game Theory 226Game Theory 227Simultaneous-Move, Nonrepeated Interaction 228

Analyzing the Payoffs 229Dominant Strategies 229

Contents xxi

Nash Equilibrium Revisited 231Competition versus Coordination 233Mixed Strategies 236Managerial Implications 237

Sequential Interactions 239First-Mover Advantage 240Strategic Moves 241Managerial Implications 242

Repeated Strategic Interaction 243Strategic Interaction and Organizational Architecture 244Case Study: Holland Sweetener versus Monsanto 245Summary 246Appendix: Repeated Interaction and the Teammates' Dilemma 248

Chapter 10: Incentive Conflicts and Contracts 255Firms 256Incentive Conflicts within Firms 257

Owner-Manager Conflicts 258Other Conflicts 259

Controlling Incentive Problems through Contracts 260Costless Contracting 261Costly Contracting and Asymmetric Information 264Postcontractual Information Problems 265Precontractual Information Problems 268

Implicit Contracts and Reputational Concerns 272Incentives to Economize on Contracting Costs 273Case Study: eBay.com \ 275Summary 275

Part 3: Designing Organizational Architecture

Chapter 11: Organizational Architecture 280The Fundamental Problem 282

Architecture of Markets 282Architecture within Firms 283

Architectural Determinants 285Changing Architecture 289Interdependencies within the Organization 290

Corporate Culture 7 291When Management Chooses an Inappropriate Architecture 294Managerial Implications 295

Evaluating Management Advice 296Benchmarking 296Overview of Part 3 297

Case Study: Eastman Kodak 298Summary 299

xxii Contents

Chapter 12: Decision Rights: The Level of Empowerment 302Assigning Tasks and Decision Rights 304Centralization versus Decentralization 306

Benefits of Decentralization 306Costs of Decentralization 308Illustrating the Trade-Offs 310Management Implications 313

Lateral Decision-Right Assignment 316Assigning Decision Rights to Teams 317

Benefits of Team Decision Making 317Costs of Team Decision Making 318Management Implications 319

Decision Management and Control 319Decision Right Assignment and Knowledge Creation 322Influence Costs 323Case Study: Medford University 325Summary 326App'Shdix: Collective Decision Making 326

Chapter 13: Decision Rights: Bundling Tasks into Jobsand Subunits 333Bundling Tasks into Jobs 334

Specialized versus Broad Task Assignment 334Productive Bundling of Tasks 337

Bundling of Jobs into Subunits 338Grouping Jobs by Function 338Grouping Jobs by Product or Geography 340Trade-offs between Functional and Product or Geographic Subunits 340Environment, Strategy, and Architecture 344Matrix Organizations 344Mixed Designs 346Network Organizations 347Organizing within Subunits 347

Recent Trends in Assignments of Decision Rights 347Case Study: Bagby Copy Company 351Summary 352Appendix: Battle of the Functional Managers 353

Chapter 14: Attracting and Retaining Qualified Employees 358Contracting Objectives 360The Level of Pay 360

The Basic Competitive Model 360Human Capital 361Compensating Differentials 363Costly Information about Market Wage Rates 366

Internal Labor Markets 367Reasons for Long-Term Employment Relationships 367Costs of Internal Labor Markets 368

Pay in Internal Labor Markets 369Careers and Lifetime Pay 369Influence Costs 375

Contents xxiii

The Salary—Fringe Benefit Mix 375Employee Preferences 376Employer Considerations 378The Salary-Fringe Benefit Choice 378

Summary 383

Chapter 15: Incentive Compensation 388The Basic Incentive Problem 389

Incentives from Ownership 392Optimal Risk Sharing 393

Effective Incentive Contracts 395Principal-Agent Model 395Informativeness Principle 401Group Incentive Pay 402Multitask Principal-Agent Problems 403Forms of Incentive Pay 404Incentive Compensation and Information Revelation 405

Does^ncentive Pay Work? 407Case Study: The Debate over CEO Compensation 408Summary 409Appendix: Multitask Principal-Agent Theory 411

Chapter 16: Individual Performance Evaluation 418Setting Performance Benchmarks 421

Time and Motion Studies 421Past Performance and the Ratchet Effect 422

Measurement Costs 423Opportunism 424

Gaming 424Horizon Problem 425

Relative Performance Evaluation 426Within-Firm Performance 426Across-Firm Performance 427

Subjective Performance Evaluation 428Multiple Tasks and Unbalanced Effort : 429Subjective Evaluation Methods 429Problems with Subjective Performance Evaluations 431

Combining Objective and Subjective Performance Measures 433Team Performance 434

Team Production 434Evaluating Teams 436

Government Regulation of Labor Markets 439Summary 440Appendix: Optimal Weights in a RelativePerformance Contract 442

Chapter 17: Divisional Performance Evaluation 450Measuring Divisional Performance 452

Cost Centers 452Expense Centers 454Revenue Centers 456

xxiv Contents

Profit Centers 456Investment Centers 457

Transfer Pricing 460Economics of Transfer Pricing , 462Common Transfer-Pricing Methods 467Reorganization: The Solution If All Else Fails 471

Internal Accounting System and Performance Evaluation 471Uses of the Accounting System 472Trade-offs between Decision Management and Decision Control 473

Case Study: Celtex 475Summary 475Capstone Case,Study on Organizational Architecture:Arthur Andersen LLP 481

Part 4: Applications of Organizational Architecture

Chapter 18: Choosing the Legal Form of Organization 488Descriptive Overview 490

Profit Status 490For-Profit Alternatives 490Descriptive Statistics—For-Profit Sector 493Descriptive Statistics—Nonprofit Sector 494

Framework for Analyzing Organizational Choices 495Managerial Decision: Profit Status 496

Benefits of Nonprofit Status 497Costs of Nonprofit Status \ 497Factors Affecting the Choice of Profit Status 498

Choosing among the For-Profit Alternatives 499Individual Proprietorships 499General Partnerships 500Closely Held Corporations 501Publicly Traded Corporations 502

Governance Mechanisms in Publicly Traded Firms : 503Internal Control Mechanisms 503External Control Mechanisms 506International Corporate Governance 507

Regulatory Responses to Recent Corporate Scandals 508Sarbanes-Oxley Act of 2002 508NYSE Rules on Corporate Governance 509

Summary .-. 509Appendix: Tax Implications: S versus C Corporations 511

Chapter 19: Vertical Integration and Outsourcing 514Vertical Chain of Production 516Benefits of Buying in Competitive Markets 519Reasons for Nonmarket Transactions 521

Contracting Costs 521Market Power 525Taxes and Regulation , 526Other Reasons 527

Contents xxv

Vertical Integration versus Long-Term Contracts 527Incomplete Contracting 528Ownership and Investment Incentives 528Specific Assets and Vertical Integration 529Asset Ownership 533Other Reasons 533Continuum of Choice 534

Contract Length 535Contracting with Distributors 535

Free-Rider Problems 536Double Markups 537Regulatory Issues 540Recent Trends in Outsourcing 541

Case Study: AutoCorp 542Summary 542Appendix: Ownership Rights and Investment Incentives 544

CHapter 20: Leadership: Motivating Change within Organizations . .551Leadership 553

Vision Setting 553Motivation 554

Decision Making within Firms 555Incentive Problems and Organizational Politics 555Understanding Attitudes toward Change .' 556

Changing Organizational Architecture 558Proposal Design 559

Maintaining Flexibility \ 559Commitment 560Distributional Consequences 560

Marketing a Proposal 561Careful Analysis and Groundwork 561Relying on Reputation 562Emphasizing a Crisis 563

Organizational Power 563Sources of Power 563Tying the Proposal to Another Initiative 566Coalitions and Logrolling 567Is Organizational Power Bad? 568

The Use of Symbols 569Case Study: Global Insurance 570Summary ? 571Appendix: Strategic Value of Commitment and Crisis 572

I

Chapter 21: Understanding the Business Environment:The Economics of Regulation 575Importance of Regulation to Managers 576Economic Reasons for Government Intervention 578

Defining and Enforcing Property Rights 578Redressing Market Failures 580Redistributing Wealth .v 586

Contents

Economic Theory of Regulation 588Demand for Regulation: Special Interests 588Supply of Regulation: Politicians 589Market for Regulation 591Deadweight Losses, Transaction Costs, and Wealth Transfers 594

Managerial Implications 595Restricting Entry and Limiting Substitutes 595Forming Coalitions 597On Business Participation in the Political Process 598

Case Study: World Motors 599Summary 600

Chapter 22: Ethics and Organizational Architecture 603Ethics and Choices 605Corporate Mission: Ethics and Policy Setting 607

Ethics 607^sc^-Value Maximization 608

Corporate Social Responsibility 610Economists' View of Social Responsibility 610Corporate Policy Setting 613Mechanisms for Encouraging Ethical Behavior 615

Contracting Costs: Ethics and Policy Implementation 618Codes of Ethics 620

Altering Preferences 621Education 622Corporate Culture 623

Case Study: The Tylenol Tragedy and J&J's Credo ,. 624Summary 625

Chapter 23: Organizational Architecture and the Processof Management Innovation 629Management Innovations 631The Demand for Management Innovations 633

The Rise of TQM 634Other Innovations 635

Why Management Innovations Often Fail 636Marketing 636Underestimating Costs of Change 639Failure to Consider Other Legs of the Stool 639

Managing Changes in Organizational Architecture 643Case Study: Software Development, Inc 644

Summary 646

Glossary 652

Index 663