Organization StudiesChapter 1.3

Organizational Economics

Focuses on economic reasons for the existence of firms

Some parts of OE focus on equilibrium-based models of economics (not all)

What Distinguishes OE from Other Research Streams in Org Studies?

Most economists focus on markets, OE focuses on firms

Organizational economists tend to focus on the relationship between competition and firms

What Distinguishes OE from Other Streams in Economics Research?

Transaction Cost Economics (Williamson 1975) Agency Theory (Jensen & Meckling 1976) Strategic Management Theory Co-Operative Organizational Economics

Four Main Areas in OE

Coase (1937) questioned the lack of treatment in economics to the theory of the firm.

Firms exist because some exchanges are better managed (cost less) inside organizations as opposed to across markets

Coase placed transaction costs at the center of analysis of firms – which led to TCE

Why Do Organizations Exist?

Teams outproduce individuals Individuals on teams have incentives to

shirk Teams will assign a monitor who gathers the

profits from teamwork and pays members accordingly

The “monitor” is the shareholder, which suggests why firms form

Teamwork – Alchian & Demsetz

Williamson 1975 Conditions of Uncertainty around Specificity

◦ Bounded rationality◦ Opportunism

Transaction Cost Economics

Vertical Integration: Make or Buy Multidivisional form Ouchi’s (1979) Markets, Bureaucracies, and

Clans Multinational Enterprise Hybrids

Applications of TCE

Focuses on cost minimization Understates the cost of organizing Neglects the role of social relationships in

economic transactions Emphasis on opportunism can be harmful

Criticisms of TCE

Do those associated with the firm agree about how it should be managed?

Major themes (Eisenhardt 1989):◦ Goal misalignment◦ Information asymmetry◦ Differences in risk tolerance

Agency Theory

Monitoring Bonding & Incentives

Responses to the Agency Problem

Treats people as primarily financially motivated

Ignores other behavioral sciences Lack of realism in approach to governance Not necessarily generalizable Some scholars argue it is self fulfilling

Criticisms of Agency Theory

Why do some organizations outperform others?◦ Structure-Conduct-Performance (SCP)◦ Resource Based View (RBV)

Strategic Management Theory

Originated as a search for industries that lacked competition

Overly profitable industries failed to maximize social welfare

Innovation was stifled Once identified, regulation was used to

“remedy” the problem and increase competition

Structure – Conduct – Performance

Performance-enhancing industry attributes:◦ Industry concentration◦ Level of product differentiation◦ Barriers to entry

SCP – Industry Structure

Termed “monopolistic competition” by Chamberlain (1933)

Differentiating products allows firms to charge abnormal profits above the cost

Product Differentiation

Fewer firms in an industry can lead to collusive strategies

Large economies of scale required to achieve certain profits can lead to performance differences

Industry Concentration

Economies of scale Product differentiation Cost advantages independent of scale Contrived deterrance Government imposed restrictions

Barriers to Entry

Strategy research now uses SCP concepts to suggest ways firms can reduce competition◦ Porter’s Five Forces◦ Model of generic industry structure and

environmental opportunities◦ Strategic groups

Strategic Management & SCP

Porter’s Five Forces

Level of threat in an industry

Threat of rivalry

Threat of new entry

Threat of buyers

Threat of suppliers

Threat of substitutes

Industry Type Definition Opportunities ExamplesEmerging New industry or

recent developments

First Mover Advantage

Intel

Fragmented Many firms of similar sizes

Consolidation McDonald’s

Mature Slow increases in demand, repeat business, little product innovation

Service and process innovation

GE (light bulbs)

Declining Consistently reducing demand in industry

Leadership, niche, harvest, divest

General dynamics (defense)

Global Significant International sales

Multinational Nestle

Industry Structure and Opportunities

Firm performance being determined by industry fails to explain heterogeneity within industries

By focusing on “attractive” industries, opportunities in other industries are overlooked

The inversion of the research stream has, in all likelihood, counteracted its original intent of improving social welfare

Criticisms of SCP

Built on the work of:◦ Penrose (1959)◦ Schumpeter (1934)◦ Michael Ricardo

First introduced by:◦ Rumelt (1984)◦ Wernerfelt (1984)◦ Barney (1986)◦ Teece (1982)◦ Prahalad and Bettis (1986)

Resource Based View

Unit of analysis: resources and capabilities of firms◦ Financials resources◦ Physical resources◦ Human resources◦ Organizational resources

Two assumptions◦ Resources and capabilities can vary significantly across firms◦ Resources can be immobile (differences may be stable)

Resource Base View

The be sources of superior performance resources must be:◦ Valuable◦ Rare among current or potential competitors◦ Costly to imitate◦ Without close strategic substitutes

Types of imitation◦ Role of history◦ Role of causal ambiguity◦ Role of socially complex resources and

capabilities

Sustainable Competitive Advantage

Various studies suggest that firm resources may explain more about its performance than the industry within which it operates

Firms may consider “unattractive” industries ideal for their blend of resources

Instead of reducing social welfare by infringing on competition, RBV focuses on firms doing the best at something

Implications of RBV

Tacit Collusion Strategic Alliances

Cooperative Organizational Economics

Collusion is said to occur when the output of an industry is less than it would be in a competitive environment

Reduced production leads to increased prices, which then lead to improved performance

The collusion can also invite cheating on the agreement by one or more parties

Game theory suggests that incentives to cheat generally outweigh benefits of collusion

Collusion

Because explicit collusion is often illegal, tacit collusion is more often engaged in by firms

Tacit collusion requires managers to interpret signals by competitors because no negotiating takes place

Tacit Collusion

Tacit collusion is easier when there are◦ Few firms in an industry◦ Similar cost structures & product offerings◦ High barriers to entry◦ Monitoring competitor behaviors is uncomplicated

Industry Conditions for Collusion

Contractual alliance Joint venture

Strategic Alliances

Exploit economies of scale Low-cost entry into new markets Low-cost entry into new industry segments

and new industries Learning from competition Managing strategic uncertainty Managing costs and sharing risks Facilitate tacit collusion

Incentives to Form an Alliance

Adverse selection Moral hazard Hold up

Incentives to Cheat in Alliances

Governance Trust

Methods to Reduce Cheating

Why do organizations exist? Why do some organizations survive and

others don’t? How and why do organizations differ? How and why do organizations change? What are the emerging issues?

Big Questions in OE