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Week 1
Barney
Why do firms exist The Economist
Summary of Why Do firms exists? from The Economist.
This article is written in celebration of the 100th birthday of Ronald Coase.
The main question for management theorist is Why do firms exists, why is not
everything done by the market?. Classical economists say very little about this
question: they prefer to focus on the sea rather than on the islands. Adam Smith
talked about a pin factory but nobody continued this story.
Until Coarse picked up the pin factory and restored it to its rightful place. He
published many articles but it wasnt until he was 80 that he was rewarded a
Nobel prize. His central insight was that firms exists because going to the market
all the time can impose heavy transaction costs. He was one of the few to look
inside the black box that the firm is.

He is known for his critics on his colleagues because he thought that they were
too theoretical: they should look at what was really going on in the business
instead of looking in their textbooks.
Mr Coases narrow focus on transaction costs provides only a partial explanation
of the power of the firms. It has led to a fierce backlash of management theorists
who argue that activities are conducted within firms not only because markets
fail, but also because firms succeed: they can marshal a wide range of resources
like corporate culture and collective knowledge, that markets cannot access. This
is aligned with the resource-based theory.
So Coases theory of market failure should be complemented by a theory of
organizational advantages.

Smith, 1776
Summary: An Inquiry into the Nature and Causes of the Wealth of Nations: Book
I
by Adam Smith
An Inquiry into the Nature and Causes of the Wealth of Nationsis widely
considered to be the first modern work in the field of economics. The work is also
the first comprehensive defense of free market policies

Chapter 1
Of 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.
The effects of the division of labour, in the general business of society, will be more easily understood
by considering in what manner it operates in some particular manufactures. It is commonly supposed
to be carried furthest in some very trifling ones; not perhaps that it really is carried further in them
than in others of more importance: but in those trifling manufactures which are destined to supply the
small wants of but a small number of people, the whole number of workmen must necessarily be
small; and those employed in every different branch of the work can often be collected into the same
workhouse, and placed at once under the view of the spectator. In those great manufactures, on the
contrary, which are destined to supply the great wants of the great body of the people, every different
branch of the work employs so great a number of workmen that it is impossible to collect them all into
the same workhouse. We can seldom see more, at one time, than those employed in one single branch.
Though in such manufactures, therefore, the work may really be divided into a much greater number
of parts than in those of a more trifling nature, the division is not near so obvious, and has accordingly
been much less observed.
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 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
peculiar 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.
In every other art and manufacture, the effects of the division of labour are similar to what they are in
this very trifling one; though, in many of them, the labour can neither be so much subdivided, nor
reduced to so great a simplicity of operation. The division of labour, however, so far as it can be
introduced, occasions, in every art, a proportionable increase of the productive powers of labour. The
separation of different trades and employments from one another seems to have taken place in
consequence of this advantage.
This great increase of 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 workman; 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.
First, the improvement of the dexterity of the workman necessarily increases the quantity of the work
he can perform; and the division of labour, by reducing every man's business to some one simple
operation, and by making this operation the sole employment of his life, necessarily increased very
much dexterity of the workman. The different operations into which the making of a pin, or of a metal
button, is subdivided, are all of them much more simple, and the dexterity of the person, of whose life
it has been the sole business to perform them, is usually much greater. The rapidity with which some
of the operations of those manufacturers are performed, exceeds what the human hand could, by those
who had never seen them, be supposed capable of acquiring.
Secondly, the advantage which is gained by saving the time commonly lost in passing from one sort of
work to another is much greater than we should at first view be apt to imagine it. It is impossible to
pass very quickly from one kind of work to another that is carried on in a different place and with
quite different tools. Independent, therefore, of his deficiency in point of dexterity, this cause alone
must always reduce considerably the quantity of work which he is capable of performing.
Thirdly, and lastly, everybody must be sensible how much labour is facilitated and abridged by the
application of proper machinery. Men are much more likely to discover easier and readier methods of
attaining any object when the whole attention of their minds is directed towards that single object than
when it is dissipated among a great variety of things. But in consequence of the division of labour, the
whole of every man's attention comes naturally to be directed towards some one very simple object. It
is naturally to be expected, therefore, that some one or other of those who are employed in each
particular branch of labour should soon find out easier and readier methods of performing their own
particular work, wherever the nature of it admits of such improvement.

Coase (1937) - The nature of the firm - foundation of transaction cost economics
Coase defines two types of coordination:

Transactions that take place across markets (through the price mechanism).

Transactions that take place within the firm (the entrepreneur-coordinator allocates the factors
of production between the different uses)

According to Coase (1937) firms exist because there is a cost of using the price
system. The cost to find out what the relevant prices are and a cost to draw up a
separate contract for each market transaction (in a firm the number of contracts
is greatly reduced: long term, transparent prices, lower perceived risk). Under
some circumstances (e.g. high uncertainty) it may be hardly possible or
extremely costly to reach a contractual agreement which may serve as a basis
for a market transaction. Therefore, the relative cost of transacting under the
market or the firm determines which type of coordination is used; transactions
will be executed at the lowest cost.
Authority of entrepreneurs allocate resources inside the firm. Economists argue
that this is still done on the base of price theory (agency theory). In the end,
make or buy decisions include the transaction costs economics as well. Make or
buy decisions are about integrating a business activity either down- or upstream.
Why, if by organizing one can eliminate certain costs and in fact reduce the cost of production, are
there any market transactions at all?
As firms get larger, there may be decreasing returns to the entrepreneur function.
As the transactions which are organized increase, the entrepreneur fails to place the factors of
production in the uses where their value is greatest (fails to make the best use of the factors of
production)
The supply price of one or more of the factors of production may rise, because the other
advantages of a small firm are greater than those of a large firm.
___________________________________________________________________________
2e Samenvatting
Coase: "The Nature of the Firm"
Themes:

Why do firms exist?

What determines the scale and scope of firms?

In introductory and intermediate economics, firms are assumed to exist, and are
characterized by production functions, cost curves, demand curves, etc.
Observations:
Firms transform inputs into outputs...but so do individuals.
Firms are characterized by employers and employees..but in a way so are
market transactions.
Firms are legal entities...but this is an uninteresting definition that we
won't address.
One can imagine production w/o firms: individual traders exhanging capital and
labor for payment, these being combined and marketed.

Organizations may seem to form "from a distance" -- cartel-types of trade made

on a consistent basis to achieve some purpose, but we would probably not
characterize these as firms.
We normally understand firms as embodying some kind of institutional structure.
Coordination of economic activity in these imaginary worlds would be via
prices/bargaining.

Coase's observation: There are costs to using the price mechanism for
coordinating economic activity. "transaction costs" or "marketing costs"
Given this, alternative institutional arrangements may coordinate economic
activity at a lower cost. For example, it may be less costly for an individual to
direct how resources should be used.
(imagine the costs of bargaining within a firm every time your boss tells you to do
something upon which you have not previously agreed!)
Firms exist to economize on the cost of coordinating economic activity.
Firms are characterized by the absence of the price mechanism.

Sources of transaction costs:

costs of learning prices
cost of negotiating contracts
cost of writing contracts, etc.
This is a transaction-based theory. If it is more efficient for a transaction to be
conducted under alternative institutions, price mechanism will not be used.
Coordination by fiat.

This is an important insight that has been applied toward explaining many
institutions other than firms. Institutions arise in order to economize on
transaction cost (Williamson, etc.) For example, bank clearing houses, commodity
markets, vertical integration, etc.

Scope of the Firm

Follows from above.
If it is more efficient for a transaction to take place within the firm than
under some other institutional arrangement, then it will take place within the
firm.
If not, then it will take place under some other institutional arrangement:

in another firm
mediated by the market.

What limits the scope of the firm?

increasing marginal costs of organizing more transactions within the firm.

decreasing returns of managerial ability (knowledge, computation limits..)
So the scope of the firm is determined at the margin.

MC of organizing one more transaction within the firm equals the cost of using
alternative institutional arrangements.

So, important questions to which Coase's theory provides a set of answers:

Why do firms exist?
What, according to Coase, characterizes firms?
What determines their scale and scope?
But even this theory leaves some gray areas...

Under Coase's definition of the firm, do traveling salesmen who sell the
products of only one firm and get paid solely on commission count as
employees? Or are they independent contractors working for themselves?
How about temps (secretaries and receptionists)? Do they work for a firm?
Which one?
Movie theater chains and distributors are often under the same firm name
(under the legal definition). However, when movies come out, they are
offered to exhibitors on a non-discriminatory basis. United Artists theaters
must bid for the right to show motion pictures distributed by United Artists.
By Coase, are they the same firm?
In the Soviet Union, capital was often allocated across firms by
governmental direction. By Coase, were the individual productive
enterprises firms?
How about the different divisions of Bell which used transfer prices to
allocate goods? Does it matter if the price was a market price or set
internally?

Some examples
How would one form a Coaseian explanation for the Disney-ABC/Cap Cities
merger?
The cost of coordinating the economic activity within Disney and ABC separately
was higher than the cost of doing so together under the direction of Disney's
management. Furthermore, it is less costly to do everything that Disney does
managing by fiat than mediated through the price mechanism.
What is a similar explanation for GM's spinning off EDS?
The cost of coordinating economic activity of these firms separately is lower than
the cost of doing so together under GM's direction.

Alchian, A. A. and Demsetz, H. 1972. Production, Information Costs, and Economic

Organization. American Economic Review, 62
It is a delusion to think that the firm owns all the inputs. A firm doesnt. it has no
power of fiat, no authority, no disciplinary action any different in the slightest
degree from ordinary market contracting between any two people.
To speak of managing, directing, or assigning workers to various tasks is a
deceptive way of noting that the employer continually is involved in renegotiation
of contract on terms that must be acceptable to both parties.
What is the difference between a boss and his employee from a boss and his
customer?

It is in a team use of inputs and a centralized position of some party in the contractual
arrangements of all other inputs. It is the centralized contractual agent in a team productive
process not some superior authoritarian directive or disciplinary power.

1. The Metering problem

Two key demands are placed on an economic organization metering input
productivity and metering rewards. Metering problems sometimes can be
resolved well through the exchange of product across competitive markets.
The classic relationship in economics that runs from marginal productivity to the
distribution of income implicitly, assumes the existence of an organization, be it
in the market or the firm, that allocates rewards to resources in accord with their
productivity.
The problem of economic organization is that analysis tends to assume tends to
assume sufficiently economic or zero costs means, as if productivity
automatically created its reward.
If economic organization meters poorly, with rewards and productivity only
loosely correlated, then productivity will be smaller; but if the economic
organization meters well productivity will be greater.
2. Team production
Usual explanations of the gains from cooperative behavior rely on exchange and
production in accord with the comparative advantage specialization principle with
separable additive production.
Team production is product in which 1) several types of resources are used 2) the
product is not a sum of separable outputs of each cooperating resource. An
additional factor creates a team organization problem 3) not all resources used in
team production belong to one person.
In team production, marginal product of cooperative team member are not so
directly and separably observable.

Clues to each inputs productivity can be secured by observing behavior of

individual inputs.
With detection, policing, monitoring, measuring or metering costs, each person
will be induced to take more leisure, because the effect of relaxing on his realized
rate of substitution between output and leisure will be less than the effect on the
true rate of substitution.
Market competition could monitor some team production. But completely
effective control cannot be expect from individualized market competition for two
reasons.
1. For this competition to be completely effective, new challenges for team membership must
know where, and to what extent, shirking is a serious problem, know they can increase net
output as compared with the inputs they replace.
2. Assume the presence of detection costs, and assume that in order to secure a place on the team
a new input owner must accept a smaller share of rewards
3. The classical firm
One method of reducing shirking is for someone to specialize as a monitor to
check the input performance of team members.

But who will monitor the monitor?

Give him title to the net earnings of the team, net of payments to other inputs.

The added incentive for the monitor is the residual product. The monitor earns his
residual through the reduction in shirking that he brings about, not only by the
prices that he agrees to pay the owners of the inputs, but also by observing and
directing the actions or uses of these inputs.
Managing or examining the ways to which inputs are used in team production is a
method of metering the marginal productivity of individual inputs to the teams
output.
The monitor has an entire bundle of rights:
1. To be a residual claimant
2. To observe input behavior
3. To be the central party common to all contract with inputs
4. To alter the membership of the team
5. To sell these rights that defines the ownership of the classical firm.
Two necessary conditions exist for the emergence of the firm on the prior
assumption that more pecuniary wealth enter utility functions:

1. It is possible to increase productivity through team-oriented production, a production

technique for which it is costly to directly measure the marginal output of the co-operating
inputs. This makes it more difficult to restrict shirking through simple market exchange
between cooperating inputs
2. It is economical to estimate marginal productivity by observing or specifying input behavior.
Simultaneous these two preconditions leads to the contractual organization of
inputs known as the classical capitalist firms with a) joint input productions, b)
several input owners c) one party who is common to all the contracts of the joint
inputs d) who has rights to renegotiate any inputs contract independently of
contract with other input owners e) who holds the residual claim f) who has the
right to sell his central contractual residual status.
Other theories of the firm
Their view of the firms is not necessarily inconsistent with Coases, but they
attempt to go further and identify refutable implications.
Team production, team organization, difficulty in metering outputs, and the
problem of shirking are important in their explanation but not in Coases. Neither
the residual claimant status nor the distinction between employee and
subcontractor status is mentioned by Coase.
The measurement of marginal productivity, which now involved interactions
between workers, especially though their joint use of machines, become more
difficult though contract negotiating cost was reduced, while managing behavior
of inputs become easier because of the increased centralization of activity.

Blau, Scott 1962 Formal Organization: A Comparative Approach

What is the specific and differentiating criterion implicit in out intuitive distinction
of organzations from other kinds of social groupings or institutions?

It has something to do with how human conduct becomes socially organized, but it is not,
whether or not social controls order and organize the conduct of individuals, since such social
controls operate in both types of circumstances.

Social organization: the ways in which human conduct becomes socially

organized, that is, to the observed regularities in the behavior of people that are
due to the social conditions in which they find themselves rather than to their
physiological or psychological characteristics as individuals.
Two main types can influence social conditions:
1. The structure of social relations in a group or larger collectivity of people
2. The shared beliefs and orientations that unite the members of the collectivity and guide their
conduct.
The conception of structure of system implies that the component units stand in
some relation to one another and that the relations between units add new
elements to the situation.
A network of social relations transforms an aggregate of individuals into a group
and the group is more than the sum of the individuals composing it since the
structure of social relations is an emergent element that influences the conduct
of individuals.
Social relation involve:
1. Patterns of social interaction
2. Social relations entail peoples sentiments to one another
The differential distribution of social relations in a group defines its status
structure.
Relations also develop between group, not only between individuals within
groups.
The networks of social relations between individuals and groups and the status
structure defined by them, constitute the core of the social organization to a
collectivity, but not the whole of it.
Other main dimension of social organization is a system of shared beliefs and
orientations, which serve as standard for human conduct.
Common notions arise as to how people should act and interact and what
objectives are worthy of attainment:
1. Common values crystallize

2. Social norms develop

Aside from the norms differential role expectations also emerge.
The two dimension of social organization the networks of social relations and
the shared orientations are often referred to as the social structure and the
culture.
The prevailing cultural standards and the structure of social relations serve to
organize human conduct in the collectivity.
Since the distinctive characteristic of some organizations is that they have been
formally established for the explicit purpose of achieving certain goals, the term
formal organization is used to designate them.
Formal and informal organization
In every formal organization there arise informal organizations. The constituent
groups of the organization develop their own practices, values, norms and social
relations as their members live and work together.
Unofficial norms are apt to develop that regulate performance and productivity.
For informal organizations develop in response to the opportunities created and
the problems posed by their environment, and the formal organization
constitutes the immediate environment of the groups within it.
Formal instituted and informally emerging patterns are inextricably intertwined.
The term informal organization does not refer to all types of emergent patterns of
social life but only to those that evolve within the framework of a formally
established organization.
Social institutions evolve without explicit design.
The terms large-scale or complex organization for formal organization are
misleading because:
1. Firms vary in size and complexity
2. Their size and complexity do not rival those of the social organization of a modern society.
Term bureaucratic organization is also often used. But wide variations have been
found in the degree of bureaucratization in organizations, as indicated by the
amount of effort devoted to administrative problems, the proportion of
administrative personnel, the hierarchical character of the organization, or the
strict enforcement of administrative procedures and rigid compliance with them.

Art. 7:

Kogut & Zander (1992): Knowledge of the firm, combinative capabilities, and the
replication of technology.

The view in this article is differs radically from that of a firm as a bundle of
contracts that serves to allocate efficiently property rights. Rather, they suggest
that organizations are social communities in which individual and social expertise
Is transformed into economically useful products and services by the application
of a set of higher-order organizing principles Firms exist because they provide
a social community of voluntaristic action structured by organizing principles that
are not reducible by individuals.
[1] This article state that firms share and transfer knowledge of
individuals and groups within an organization better than markets can. This
knowledge consist information (i.e. who knows what) and of know-how (i.e. how
to organize a research team). Firms differ in their information and know-how and
these differences, when they are economically interesting, have persisting effects
on relative performance. Thus, a central characteristic to be explained is the
persisting difference in capabilities, that is, the difficulty in their transfer and
imitation. This can be analyzed over two dimensions: codifiability and complexity.
Codifiability and complexity are related, but not identical.
Central to their argument is that knowledge is held by individuals, but is
also expressed in regularities by which members cooperate in social community
(i.e. groups, organization, or network). If knowledge is only held on individual
level, then firms could change simply by employer turnover. Because we now that
hiring new workers is not equivalent to changing the skills of a firm, an analyses
of what firms can do must understand knowledge as embedded in the
organizational principles by which people cooperate within organizations.
A paradox is identified: efforts by a firm to grow by the replication of its
knowledge (i.e. simplification and codification) enhance the potential for
imitation. While knowledge transfer is a desired strategy in the replication and
growth of the firm, imitation is a principal constrain. In other words, for a firm to
growth, it must develop organizing principles and a widely held and shared code
by which to orchestrate large numbers of people and functions. Whereas the
advantage of reducing costs of intra-or inter-firm technology transfer encourage

codification of knowledge, such codification runs the risk of encouraging

imitation.
[2] By considering how firms can deter imitation by innovation, they
develop a more dynamic view of how firms create new knowledge. Creating new
knowledge does not occur in abstraction from current abilities. Rather, new
learning, such as innovations, is a product of a firms combinative capabilities to
generate new applications from existing knowledge. It is local search that
generates a condition commonly called path dependence, that is, the tendency
for what a firm is currently doing to persist in the future. The reason that
knowledge advances by recombination is because firms capabilities cannot be
separated from how it is currently organized. The ability to build on current
technology is instrumental in the deterrence of the imitation of firms knowledge
by competitors. In an environment where there is on-going competition, there is a
short-term consideration, i.e. at what speed and cost can a firm replicate its
current technology and imitate others. Long-term survival involves a complex
tradeoff between current profitability and investing in future capabilities.
Because new ways of cooperating cannot be easily acquired, growth
occurs by building social relationship that currently exists in the firm. What a firm
has done before tends to predict what it can do in the future. In this sense, the
cumulative knowledge of the firm provides options to expand in new but
uncertain markets in the future.

Hodgson, 1998 Competence and contract in the theory of the firm

Summary Hodgson (1997): Competence and contract in the theory of
the firm
There is no consensus among economists on the factors that may explain the
existence, boundaries, structure, and development of the firm. There can
however be made a distinction between two perspectives:
1. The contractual perspective: emphasizes the cost of making and monitoring transactions.
2. The competence perspective: believes the existence, structures, and boundaries of the firm are
somehow explained by individual or team competences that are fostered and maintained by
the organization. Individual or team competences are captured in skills and tacit knowledge.
The competence perspective produces the basis for evolutionary and nonequilibrium theories of industrial competition and development.
Genesis of the competence-based theory of the firm: Adam Smith > wealth of
nations. The division of labour leads to the enhancement of skills through
learning by doing. This already was an insight of dynamic growth and
development, in which individual skills are progressively enhanced. The rise of
neoclassical economics shifted attention away from processes of production
towards the market. Choice, contract, and exchange became central concepts for
economic theory.
Dissatisfaction with this standard analysis has led to a revival of the competencebased approach. Hodgson aims to explain the nature of the firm using
competences rather than an exclusively transaction cost framework. However, he
does not deny the potential role of transaction cost since these may help to
explain some phenomena. His aim is the following: to show that the competencebased approach can answer the key questions concerning the nature of the firm
as least as well as the transaction cost and other contractarian theories. For
future purposes, it is needed to develop a research program in which the two
approaches are conjointly evaluated and tested. This points to the possibility of
hybrid explanations.
Limitations of contractarian approaches
There are three key features of existing contractarian approaches:

1. Given individuals (typically with given preference functions) are assumed. This feature therefore
leads to a neglect of two things:

a. The limits of contracts and exchange, and the necessity of some non-contractual relations,
involving (moral) norms and (tacit) rules. All market-based contractual systems somehow rely on
essentially non-contractual elements (e.g. moral norms + trust) to function.

- Key difference between contractual and competence-based theories of the firm: Coase
(contractual) regards all managerial and entrepreneurial competences as potentially
contractible, whereas Knight (competence) denies that they can all be. In a context of
uncertainty some competences cannot be bought or hired.

b. The processes of radical individual transformation, development, and cognitive learning.

Contractual models fail to acknowledge that for information to become knowledge it must be

interpreted, and different interpretations are always possible, even with the same set of
information. The very act of learning means that not all information is possessed, which would
rule out the assumption of rationality within contractual theories > limited to equilibrium. Within
firms there is interdependence of individual knowledge. Knowledge is embedded in social
structures, and is not immediately transparent. Organizational knowledge interacts with individual
knowledge but is more than the sum of the individual parts. It is context-dependent, culturebound and institutionalized.

2. Technology and production are neglected. Uniformity of technology is assumed, so while

governance models are evaluated, production costs and technology are ignored. Primary emphasis is
thus on the choice of governance structures and the efficient allocation of given resources. It is a
common mistake to treat production as an extension of exchange. There is a key difference between
production and exchange: in contrast to a contract involving the exchange of goods, production
involves the use of labour and the ongoing intentional involvement of a worker. A relationship
between buyer and seller necessarily endures after the contract is agreed, which extends its social
and non-contractual dimension. Trust and loyalty can however not be modelled adequately in an
exclusively contractarian framework.

3. The focus on comparative static explanations overlooks key dynamic aspects of the problem, notably
learning, innovation, and technological development. This is the most serious problem since the
ability of the firm to foster human learning, technological innovation, and research and development
are important for survival. Dynamic efficiency is essentially about learning and innovation, and,
because of this uncertainty, cannot be reduced simply to static terms. Recognition of the firm as a
means of coping with uncertainty is therefore crucial. Uncertainty is not only about future events
themselves, but also about the opportunities available. A dynamic and open-ended approach
challenges the relevance of a long-run equilibrium and admits an ongoing diversity of outcomes.
The viability of competence-based theories
The following definition of the firm is proposed: an integrated and durable
organization of people devoted to the production of goods or services that are
owned as property under law by the firm.
Corporate culture and learning
Principal argument in this essay: an important but not exclusive factor explaining
the existence, boundaries, nature, and development of the firm is the capacity of
such an organization to protect and develop the competences of the groups and
individuals contained with it, in a changing environment. Accordingly, the firm is
able to form and integrate the individual perceptions, preferences, abilities, and
actions of its personnel.
Individuals cannot always be relied upon to cooperate together in a way which
serves the objectives of the organization as a whole. The firm survives and
functions based on formal and informal relations: legal contracts to keep the firm
together as a unit and to motivate the individuals within it, and informal relations
(cultural + moral norms) vital to the integrity of the firm.
Learning depends on acquired cognitive frameworks, but at the same time it is an
essentially open-ended, provisional, and potentially fallible process. A learning
process therefore involves mistakes which become opportunities to learn.
Organizational learning depends on corporate culture, which is more than shared

information. It is formed by both group and individual competences. Firms make it

able to create a richer culture of often tacit norms, routines, and cognitive frames.
It can form human preferences and actions so that a degree of loyalty and trust in
regard to specific activities is ensured. However, markets and exchange also rely
on types of measures of trust. The type and extent of trust generated within the
firm facilitates its organizational integration and its capacity to learn.
It would be a mistake to completely let trust substitute for transaction costs.
Instead, trust is seen as a variable aspect of a dynamic corporate culture. That
culture is a basis for organizational learning and dynamic growth. It is the overall
and dynamic advantage of the organization of the firm that has to be emphasized,
rather than snapshot comparisons of efficiency.
The firm has to generate a unifying culture to survive. The coherence of its culture
reflects the administrative unity of the firm. Decision making and learning can be
decentralized, but strategic activities are centralized to provide coherence.
Strategic activities are used to exploit opportunities for innovation and growth. The
central and divisional corporate cultures together affect the storage and
transmission of information, the acquisition and retention of knowledge, the
framing of decisions and the nature and extent of human learning. However, here
is a negative side to such conformism. While a common corporate culture helps to
provide the coherence of the firm, there are dangers of inertia and resistance to
change. A key point in the competence-based approach is that new competences
have to be managed and organized for much of their potential to be realized.
Due to its static framework, an exclusively transaction cost approach cannot
capture such a symbiosis. The costs of one governance structure are less than
another, and hence one survives.
The existence of the firm
Individual-to-individual relations are more intensive and last longer within the firm
than in exchange or markets (even despite migration of labour). The cohesiveness
and longevity of the firm facilitates the transmission of information and the
generation of practical knowledge > competences. These competences can only
exist in the body of an organized group of individuals only: it would not survive in a
world of just individual agents. The capacity of the firm to safeguard and enhance
both group and individual competences can explain its existence: firms exist
because they can more efficiently coordinate collective learning processes than
market organization is able to do. These efficiency advantages can however be
path-dependent.
The formation of the firm
Knight: by grouping together activities with uncertain outcomes in a single firm
provides an incentive both to set up a firm and to extend its scale for larger
operations.
The boundaries of the firm
In a disequilibrium situation the boundaries of the firm could be moving and are
thus unsettled. So the question is what causes the boundaries to shrink or grow.
Path-dependency is important for this matter: the firm should not be understood as
an optimal organizational configuration, but via an appreciation of its history.

Within the competence paradigm, the boundaries of the firm should be understood
in terms of not only transaction costs, but also in terms of learning, path
dependencies, technological opportunities, selection, and complementary assets.
Conclusion
The competence based perspective emphasizes on both dynamic as static
efficiency, and on both production and allocation. This approach differs from Coase
and Williamson, since they explain the existence of the firm exclusively by
transaction costs. They focus on the diminution of costs related to transactions
between given individuals. The problem is then that the existence of the firm
should be viewed as a dynamic process (cost advantages spread through time),
and can thus not be captured by an equilibrium based analysis. It is therefore
dangerous to reduce the character of the firm to contracts and costs alone. An
emphasis on learning should supplement transaction cost explanations. This
however implies that individuals cannot be taken as given while selecting
coordination and governance mechanisms. Learning capacities are related to
cultural development and transmission within organizations, and this provides an
alternative explanation for the existence of the firm. Learning should therefore
take a central place in the analysis of the firm. The relative efficiency and
dynamism of the firm is thus explained not simply in terms of the summation of
lower costs of atomistic transactions, but significantly also by the dynamic
advantages and efficiency of the firm as a whole.

Study questions:
1. What is according to Adam Smith (1776) the cause of the increase of
welfare in industrialized countries? What are the three factors that lead to
it?
2. Why do firms exist according to (1) Coase (1937), (2) Alchian & Demsetz
(1972), (3) Blau & Scott (1962), and (4) Kogut & Zander (1992)? How do
the explanations offered by these various authors differ?
3. How do contractual theories of the firm (of which Coase (1937) and Alchian
& Demsetz (1972) are examples) and competence theories of the firm (of
which Kogut & Zander (1992) is an example) differ from each other (cf.
Hodgson, 1998)?

Week 2
Eisenhardt (1989) - Agency Theory: An Assessment and Review

Agency theory describes the relationship between one party (the principal)
who delegates work to another (the agent), who performs that work, using
the metaphor of a contract. Agency theory is concerned with resolving two
problems that can occur in agency relationships:
1. The agency problem which arises when (a) the desires or goals of
the principal and agent conflict and (b) it is difficult or expensive for
the principal to verify what the agent is actually doing.
2. The problem of risk sharing that arises when the principal and agent
have different attitudes towards risk.
The focus of the theory is on determining the most efficient contract
governing the principal-agent relationship given assumptions about
people, organizations and information. Agency problem: arises with
incomplete principal information, agent may shirk. two options: buy
control systems or reward outcome. However is a behavior-oriented
contract more efficient than an outcome-oriented contract?
Key idea:

Unit of analysis:
Human assumptions:

Organizational
assumptions:

Information
assumption:
Contracting
problems:
Problem domain:

Principal-agent relationships should reflect

efficient organization of information and
risk-bearing costs.
Contract between principal and agent.
Self-interest.
Bounded rationality.
Risk aversion.
Partial
goal
conflict
among
participants.
Efficiency as the effectiveness
criterion.
Information asymmetry between
principal and agent.
Information as a purchasable commodity.
Agency (moral hazard and adverse
selection).
Risk sharing.
Relationships in which the principal and
agent have partly differing goals and risk
preferences.

Positivist Agency Theory

Focus on identifying situations in which there are conflicting goals and
then describing the governance mechanisms that limit the agents selfserving behavior. There are two propositions:
1) When the contract between the principal and agent is outcome-based,
the agent is more likely to behave in the interests of the principal.
2) When the principal has information to verify agent behavior, the agent
is more likely to behave in the interests of the principal.

Agency Theory and the Organizational Literature

The heart of agency theory is the goal conflict inherent when individuals
with differing preferences engage in cooperative effort, and the essential
metaphor is that of the contract. It assumes the pursuit of self-interest at
the individual level and goal conflict at the organizational level.
Information asymmetry is linked to the power of lower order participants.
In agency theory, goal conflicts are resolved through coalignment of
incentives.
Contributions of Agency Theory
Agency theory reestablishes the importance of incentives and self-interest
in organizational thinking. The theory makes two contributions to
organizational thinking:
1. Information is regarded as a commodity; it has a cost and can be
purchased. Information systems have an important role.
Organizations can invest in such systems in order to control agent
opportunism. Boards can be used as monitoring devices for
shareholder interests. When boards provide richer information:
a. Compensation is less likely to be based on firm performance,
and more based on knowledge of executive behaviors.
b. Top executives are more likely to engage in behaviors that are
consistent with stockholders interests.
2. Agency theory extends organizational thinking by pushing the
ramifications of outcome uncertainty to their implications for
creating risk. Uncertainty is viewed in terms of risk/reward tradeoffs. Outcome uncertainty coupled with differences in willingness to
accept risk should influence contracts between principal and agent.
The conclusions are that agency theory offers unique insight into information
systems, outcome uncertainty, incentives, and risk and is an empirically valid
perspective.

Incentive life-cycles: learning and the division of value in firms, Obloj &
Sengul 2012
This paper argues about the individual and organizational learning mechanisms
leading to the evolution of the division of value between economic actors under a
given contractual arrangement.
In on-going, long term relationships the division of value is ultimately determined
by contractual arrangements. Organizational incentives are concerned both with
incentivizing intended actions (value creation) and specifying the conditions of
value appropriation by employees, they can be seen as an explicit contract
specifying the division of value between a firm and its employees.
The existing work assumes that although the equilibrium division of value can
change per contract, it is static.
However, organizations and individuals can learn how to better respond to a
given incentive regime over time. This provides the possibility that the
effectiveness of that incentive regime as an organizational design instrument is
likely to evolve, even without external changes in the environment. They learn
how to me productive and know how to exploit it.
There are 2 learning mechanisms:

1. Productive learning: employees learn over time and gain experience how to better and
more efficiently conduct tasks induced by incentive instruments, positively
contributing to organizational performance. Leading to a greater value creation.
2. Adverse learning: employees learn over time and gain experience how to exploit a
given incentive design for their own benefit at the expense of the organization.
Employees will appropriate a greater part of the value that they create.
a. Seen as opportunistic behaviour. But adverse learning, or gaming, is different
as it can be learned, not a behavioural trait.
Under a given incentive regime over time, the organizations share of the total
value created will follow an evolutionary trajectory. The introduction of a new
incentive regime will trigger productive and adverse learning that are specific to
a given set of incentives. as the relative attractiveness of productive and adverse
responses to employees changes over time, the evolution of these two
mechanisms will follow different trajectories: productive learning is likely to be
more pronounced than adverse learning early on in the incentive life-cycle, but
over time, their relative prominence should be reversed, and adverse learning
should dominate productive learning. As a result, adverse responses will
outweigh productive responses, and a greater proportion of the value created will
be forfeited due to agency costs.

ORGANIZATIONAL INCENTIVES AND THE DIVISION OF VALUE IN FIRMS

The objective of every incentive regime is to align the employees and

organizations objectives, as to create as much as value for the organization as
possible. But employees try to devise and incentive regime that will let them

appropriate as much as possible value. The division of value within a firm in the
regimes lifecycle is static. The division of value between a firm and its
employees can evolve under an incentive regime. When changing to another
incentive regime both the firm and the employees need to learn which activities,
attention and effort will be optimal for them.

Evolution of value creation and appropriation by employees under a new

incentive regime
Productive learning affects the evolution of value creation and appropriation
under a given incentive regime, as it contributes positively to both value creation
and appropriation by the employees.
Incentive regime changes trigger productive learning, and therefore will disrupt
value creation.

Evolution of the division of value under a new incentive regime

While the presence of productive and adverse learning provides an explanation
for how value creation value appropriation evolve under a new incentive regime,
this study aims to explain the evolution of the relative division of value between a
firm and its employees. The ability to appropriate value for both the firm and its
employees determines the division of value, which will change over time.
The firms ability to create more value and appropriate more of this value will
likely increase over time following an incentive regime change, not only because
the regime it designed to do so but also because firms learn how to make the
new incentive regime more functional.
The employees ability to appropriate more of the value created will likely
increase over time as well, because of the productive and adverse learning in
which they will become more efficient over time due to experience. They will
choose or productive learning or adverse learning, depending on what will allow
them to appropriate more of the value created.

Early in the life-cycle of the incentive regime, the marginal reward for advancing
along the productive learning curve is higher than adverse learning. Later in the
life-cycle adverse learning provides a higher marginal reward than productive
learning curve.
Therefore, employees accumulate more experience along the productive
dimensions in the early stages and later accumulates more experience on
learning along the gaming dimension. There are several reasons why:

1. Institutional barriers such as control systems prevent unwanted, adverse learning,

behaviour. Also the strength of these barriers is stronger in the beginning.
2. Organizations make productive learning more attractive, for example through training
or instructions
3. Informal organization facilitates both productive and adverse learning, but its
facilitating effect on adverse learning lags its effect on productive learning. Learning

across employees is more likely to support productive learning because institutionally

supported knowledge (facilitating productive knowledge) is likely to be exchanged
through the informal network prior to the exchange of non-legitimate practices.
4. It is relatively harder to take advantage of experience gained from prior incentive
regimes along the adverse dimension that on the productive dimension. It will be
faster, easier, and less costly to apply knowledge from prior incentive regimes for
productive learning than for adverse learning.
So formal organization (control systems and institutional support) promotes
productive learning and suppresses adverse learning. Informal organization
(including interaction with other employees) and prior experience promotes both
productive and adverse learning.
Changes in formal organization follow an incentive regime change, changes in
informal organizations follow the changes in the formal organization with a lag.
Therefore organizational adjustment and productive learning in the early period
after the incentive regime change than adverse learning, with the adverse
learning increasing over time.
Therefore, the value appropriated of the organization will be higher in the
beginning, then reach a plateau, and then decrease over time.

DISCUSSION AND CONCLUSIONS

This paper shows that the total value created, the share appropriated by the
organization follows and evolutionary trajectory over time, the incentive lifecycles. After the introduction of a new incentive regime the banks share of the
total value created increased at a decreasing rate and decreased over time and
with experience. Organizational incentives trigger 2 sorts of learning, which
change over time over the life-cycle, which both increase over time and with
experience.
Contributions and future research
Value creation and appropriation co-evolve along the life-cycle of organizational
incentives. This paper shows how and why the division of value can evolve over a
given contractual arrangement, especially learning in response to organizational
incentives, what brings the life-cycle out of equilibrium. Changes in the
organizational incentives trigger learning mechanisms: productive learning
(increasing value creation) and adverse learning (increasing value appropriation
by employees).
Changing a incentive regime might provide benefits (overcoming inertia and
increase the value creation) but also disadvantages (disrupting organizational
processes and thereby creating more risk, fixed costs of regime change, monitor
and coordination cost, implementation cost, etc.). So too much change is not
favourable.
But as organizations continuously become more effective and grow and their
objectives change over time, so incentive regimes need to evolve with that and
fit.

Changes to incentives occur because any given structure can trigger learning
mechanisms that decrease the effectiveness of the incentive regime over time.
Employees become better at gaming the regime, change of regime resets the
adverse learning by employees.

Bowles, S. 2008. Policies designed for self-interested citizens may undermine

"The Moral Sentiments": Evidence from economic experiments

Taxes, subsidies, tournaments, auctions and other incentives can be structured to induce
selfregarding individuals to act in the common interest when market competition alone would
fail to accomplish this. Constitutions and public policies should be designed for knaves
motivated only by their private interest, but they may turn out to be counterproductive.
Economic incentives may diminish ethical or other reasons for complying with social norms
and contributing to the common good. The effects of material interests and moral sentiments
on behavior are additive rather than interactive. This is called the assumption of separability.
Incentives and Market Failures
When individuals do not take into account the effects of their actions on others (external
effects or spillovers), the result of private decentralized decision-making will be inefficient in
the sense that by implementing some other feasible outcome, at least one individual could be
made better off without anyone being made worse off. There are market
failures. Complete contracts eliminate spillovers,internalize the external
effects by assigning claims and liabilities so that each actor owns all of
the benefits and costs resulting from his or her actions, including those
conferred or imposed on others. Prices would do the work of morals. But,
contracts are hardly ever complete, due to information asymmetry, team
production processes and the voluntary provision of public goods. All of
this is the
case in the labor and capital market: agency theory.

Mechanisms can be designed to find a way to assign to each actor the entire
benefits and costs. Societies address market failures through some combination
of incentive-based design and other regarding motives. The separability
assumption commonly fails. Sometimes, explicit incentives and ethical motives
are complementary, but in most cases incentives undermine ethical motives.
Four reasons have been suggested for the failure of the separability assumption:

Framing. Incentives are part of a how a decision situation is represented

and may signal appropriate behavior.
Endogenous preferences. Preferences are endogenous is ones
experiences result in durable changes in motivations and hence a change
in behavior in given situations. Incentives induce more self-interested
behavior, even after they were withdrawn. Economies structured by
differing incentives are likely to produce people with differing preferences.
Incentives change preference because they affect key aspects of how we
acquire our motivations.
Over determination. The introduction of explicit incentives may
overjustify the activity and reduce the individuals sense of autonomy.
Information content of incentives. Principals select incentives based on
their own objectives and their beliefs about how well the agent will perform
his task under each possible incentive. The incentives selected reveal
information about the principals preferences, the nature of the task and
his beliefs concerning the agent. The fact that incentives reveal that the
principal is untrusting or self-aggrandizing helps explain a common pattern
of experimental results. The most plausible explanation of the
effectiveness of peer punishment is that when punished, those who have
contributed less than others feel shame, which they redress by
contributing more subsequently.
Why are Counterproductive Incentives common?
Even if incentives reduce the total gains associated with a project, their use may
give the principal a sufficiently larger slice of the small pie to motivate the
principal to use them.

Why Moral Sentiments and Material Interests are not separable &
Discussion
When ones person itself is the raw material and its transformation or affirmation
is the objective, the presence of explicit economic incentives may have
unintended effects. People want to cooperate but also want to make sure that
others who did not cooperate would be punished. They do not wish to be
exploited.

Larkin, I., Pierce, L., and Gino, F. 2012. The psychological costs of pay-forperformance: Implications for the strategic compensation of employees

As agency theory provides a useful framework for analysing compensation, it fails

to consider several psychological factors that increase costs from performance
based pay. The authors examine how psychological costs from social comparison
and overconfidence reduce the efficacy of individual performance-based
compensation, building a theoretical framework predicting more prominent use of
team-based, seniority-based and flatter compensation.

This paper examines the strategic implications of compensation choices for

nonexecutive employees, as agency theory falls short in this.

THE IMPLICATIONS OF THE INFREQUENCY OF INDIVIDUAL PAY-FORPERFORMANCE

The agency theory in broadly equating the effectiveness of different
compensation, seeking the most efficient compensation system.

AT AND STRATEGIC COMPENSATION

In agency theory costs arise due to differences between firms and employees in
two crucial areas: objectives and information. Two potential costs arise from
these differences: employees may not exert maximum effort and the firm may
pay workers more than they are worth.

Objectives
Firms seek to maximize profit, and increased compensation affects profitability by
motivating employee effort and attracting more highly skilled employees, while
increasing wages.
Employees seek to maximize utility, influenced by compensation.

Information
Two information asymmetries where the agent knows more than the principal:
about the effort exertion and skill level. Overcoming these asymmetries by
providing incentives for workers to exert effort and self-select by skill level.

Predictions of standard AT
Employees work harder when their pay is based on performance.

Firms are more likely to use performance-based pay when they have less
information about actual employee efforts.
Firms are more likely to use performance-based pay when they have less
information about employee skill level, and/or as employee skill level is more
heterogeneous.

Team-based compensation
Firms are more likely to use team-based performance pay (vs individual pay)
when coordination across workers is important, when free riding is less likely, or
when monitoring costs are low (individual effort is not observable).

Basic predictions of AT
When both effort and output are highly observable, firms prefer to use a set
salary.
When individual skill is not observable, compensation both motivates employees
but also attracts specific types of employees. Firms are more likely to use
performance-based pay when employee skills are not observable compared to
when they are.
INCORPORATING INSIGHTS FROM PSYCHOLOGY AND DECISION
RESEARCH INTO AT
In this section the authors discuss how these psychological factors,
overconfidence and social comparison processes, add costs to performancebased compensation systems.

Performance-based pay and social comparison

Individuals generally seek and are affected by social comparison with others,
gaining information about their own performance. Social comparison allows
employees gain knowledge of the pay of others. Employees do not only respond
to their own compensation, but also to the compensation of others. In individual
pay-for-performance systems pay will inevitably vary between employees. When
input and performance is unobservable or perceptions are biased this lead to an
unequal feeling of the employee and therefore effort reduction and reduce
morale.

Perceived inequity in pay can furthermore have a costly asymmetric effect: below
median earners might exit the firm and above median earners may not become
more effective because of the superior pay.

SO: Perceived inequity through wage comparison reduces the effort benefits of
individual pay-for-performance compensation systems and introduces additional

costs from sabotage. Furthermore, random shocks (the employee cannot do

anything about the drop in performance, as it might be due to its environment)
introduce also costs from reduction in effort and sabotage.

Overconfidence and performance-based pay

Employees might be overconfident about their own abilities and too optimistic
about their future. People tend to be overconfident about their ability on tasks
they perform very frequently, find easy, or are familiar with. This implies
implications with employees performing work, as they perform it frequently and
are familiar with it. Therefore, performance-based pay may fail to efficiently sort
workers by skill level. This might cause them to select into performance-based
positions that are suboptimal for their skill set, causing the firm to hire lower
ability workers than they think.
Overconfidence may lead to reduced effort when combined with social
comparison. As they overestimate their ability they might feel superior when
comparing to others and not understand why they earn less or the same.

REDUCING PSYCHOLOGICAL COSTS THROUGH TEAM-BASED AND SCALED

COMPENSATION
As social comparison and overconfidence may make individual pay-forperformance systems less attractive, firms might still favour such sort of system
to increase the value created. This paper argues that there are 2 alternative
systems:

1. Team-based wages: reduces costs of social comparison. This makes it a little more
attractive than predicted by agency theory, which holds that team-based pay will be
based only when there are benefits to coordination across employees that are greater
than the costs of free riding.
2. Scale-based wages: employees are compensated based on seniority, which reduces that
costs of social comparison and overconfidence and are therefore more attractive than
standard AT would predict.
Reducing social comparison costs through intermediate forms of
compensation
Firms with team-based compensation systems keeps the performance-based
incentives, but ties them to the team performance instead of the individual
performance. Reduces wage comparison by equalizing everyones wages in the
same team. However, some issues of social comparison remain, as they only
perceive equality of the pay when they perceive everyones contribution to the
team equal. So contribution in a team should not be highly heterogeneous.

However, there still my occur social comparison between teams. This can be
reduced by scaled wages, employees may view this policy still as unfair but will
not feel personally insulted.

Reducing overconfidence costs through flattening compensation

When individuals in teams are overconfident and the team performs low, they will
feel that the rest of team isnt up to their standard and they might lower their
efforts. So team-based compensation only resolves problems of overconfidence in
individual pay-for-performance when the performances of team members are
observable.
Through flattening wages across the firm, workers are less likely to socially
compare and therefore do not seek to transfer to another team.
By introducing scale-based wages the overconfident workers will observe higher
wages in other firms and therefore leave the company, re-establishing equality.
So getting rid of the overconfident workers.
Scale-based and team performance-based wages will drive out the most
overconfident workers.

IMPLICATIONS FOR FIRM STRATEGY

So, the compensation system might not only be positive as the AT tells us. Social
comparison limits a firm not being able to apply powered incentives or a wide
variance of compensation levels across employees.
Furthermore, high powered performance-based incentives attract overconfident
individuals that bare high risk actions that may lead the firm to bankrupt.
However, overconfident CEOs often lead the firm to more innovation in
competitive industries.

Alvesson, M. and Krreman, D. 2004. Interfaces of control. Technocratic

and socio-ideological control in a global management consultancy firm.

-This paper investigates a variety of forms of management control in a large management

consultancy company
-Although the literature on organizational and management control suggests a wide array of
forms of control, it is common to emphasize a main form of control, either in the form of a
particular organizational structure or in the form of a specific mode of control dominating
-different control forms may be linked to, and supporting and sustaining each other, rather
than subdued and marginalized by a dominant form
Forms of management control
-the exercise of control is a big part of a managers job
-managerial activity that attempts to control behavior typically includes designing and
supervising work processes
-2 types of control:

Socio-ideological: attempts to control worker mind-set

o Social relations and ideology are basic ingredients
o Efforts to persuade people to adapt to certain values, norms and ideas of what
is good for the organization
Technocratic: attempts to control worker behavior
o Management works primarily with plans, arrangements and systems focusing
behavior and/or measurable outputs

-we attempt to demonstrate how control forms interact, occasionally merge and, sometimes,
contradict each other
Ouchi came up with his three approaches to control in an organization's management:

Market control

Bureaucratic control

Clan control

Study questions:
1. Explain what agency theory is with your own words (including the theorys
assumptions and key propositions/relationships).
2. Based on all the papers, what are the strengths and weaknesses of agency
theory?
3. Under which conditions will designing a compensation system according to
agency theory lead to high value creation for the organization?

Week 3

Alchian, A. A. and Demsetz, H. 1972. Production, Information Costs, and Economic

Organization
Two important problems face a theory of economic organization:
- to explain the conditions that determine whether the gains from specialization and
cooperative production can be better obtained within a firm or across markets.
- Explain the structure of the organization.
Alchian and Demsetz first try to explain what kind of power firms has (at first sight, a firm=
input owners cooperate) . A delusion is that the firm is characterized by the power to settle
issues by authority. In fact, the only power a firm has is that it can withhold future business or
by seeking compensation in the courts for any failure to honor an exchange agreement.
The questions that drive this paper are: Exactly what is a team process and why does it induce
the contractual form,called the firm?
The metering problem
The economic organization facilitates the payment of rewards in accord with productivity.
(positively correlated). Consequently, two key demands are placed on economic
organizations: metering input productivity and metering rewards. In the classical analyses of
the economic organization, the analyses of production and distribution tends to assume
sufficiently economicor zero costs--. In other words, it assumes that productivity
automatically created its rewards. However, the assumption of zero costs is in reality not
correct due to metering problems.
All in all, if the economic organization meters poorly, then productivity will me smaller, but if
it meters well than productivity will be greater.
But what makes metering difficult and hence induces means of economizing on metering
costs?
Team production
In general, with team production it is difficult, solely by observing the total output, to either
define or determine each individuals contribution to this output of the cooperating inputs.
Team production is defined as a production in which
1) several types of resources are used and
2) the product is not a sum of separable outputs of each cooperating resource;
3) not all resources used in team production belong to one person (which is team organization
problem).
It is possible to increase production through team effort. Think of two men loading bulky
cargo onto a truck. By working together, they can load the cargo in far less time than if they
worked separately; the product of their efforts exceeds the sum of their individual

contributions. When there is a team effort like this, you have information problems: it is hard
to tell who is shirking.
Furthermore, It is possible to meter each input's (laborer's) marginal contribution, either by
observation or specification of the inputs.
The classical firm
One method to reduce shirking is for someone to specialize as a monitor to check the input
performance of team members. But who monitor the monitor? Solution: give the monitor the
residual value. (this can been seen in the current organizations. Stakeholders/shareholder
monitor the firm and receive residual value (e.g. dividends. ). The monitor earns his residual
through the reduction in shrinking that he brings about.
To discipline team members and reduce shirking, the residual claimant must have power to
revice the contract terms and incentives of individual members without having to terminate or
alter every other inputs contract.
It is this entire bundle of rights that resolves the shrinking-information problem of team
production better than does the noncentralized contractual arrangement. The bundle consist
out of:
1. To be a residual claimant
2. To observe input behavior
3. To be the central party common to all contract with inputs
4. To alter the membership of the team
5. To sell these rights, that defines the ownership of the classical firm (capitalist, freeenterprise).
In summary, two condition exist for the emergence of the firm:
1. It is possible to increase productivity through team-oriented production.
2. It is economical to estimate marginal productivity by observing or specifying input
behavior.
Compared to other theories of the firm
This theory builds further upon the insights provided by Ronal Coase & Frank Knight. (e.g.
markers do not operate costless and sometimes firms can work cheaper). To move further
from this, it is necessary to know what is meant by a firm and explain the circumstances under
which the cost of managing resources is low relative to the cost of allocating resources
through market transaction.
Also, this paper also suggests a definition of the classical firm (which was absent before).
Shortest summary, the main message:
The Alchian-Demsetz Approach
Measurement or metering problems are a reason that firms exist , according to Alchian &
Demsetz (1972). Members have an incentive to cooperate because jointly they can produce
more than solely. Shirking among team members increases (shirking = behavior that range

from cheating to merely giving less than ones best effort). When it is not possible to monitor
the individuals contribution, each on the members will be rewarded equally. This will increase
shrinking.
The firm exist so it can monitor the efforts. A hierarchy emerges. But who monitors the
monitor? Solution: give the monitor the residual value. (this can been seen in the current
organizations. Stakeholders/shareholder monitor the firm and receive residual value (e.g.
dividends. )

Cabrera, A. and Cabrera, E. F. 2002. Knowledge-sharing dilemmas.

This paper looks at previous research to see why people are hesitant to participate in
knowledge sharing within firms and what management can do to solve these problems.
Research shows that the problem with an knowledge sharing culture do not lie with technical
problems but with the willingness of employees to share information.
First the article shows that knowledge are resource which can lead to competitive advantage
because they meet the VRIN requirements. It is valuable, rare (and unique because it is path
dependent) hard to appropriate by third parties (because of its supra-individual character) and
difficult to imitate because it is causally ambiguous.
We look at organizational knowledge at two dimension. The degree of articulation,
tacit/explicit and degree of aggregation, individual and collective forms of knowledge (so
whit who does it resides). This gives us four classes of knowledge: 1) individual-tacit
(embodied knowledge), 2) individual-explicit (embrained knowledge), 3) collective-explicit
(encoded knowledge) 4) collective-tacit (encultured and embedded knowledge).
Collective knowledge emerges from interaction and dialogue among the members of a
community or an organization. So knowledge creation is the result of a double process of
combination and exchange of knowledge. (Exchanging knowledge will have feedback, which
enhances the knowledge)
There are different dilemmas, which the sharing of knowledge faces. Social dilemmas
describe paradoxical situation in which individual rationality leads to collective
irrationality .For instance individual attempts to maximize pay-off can result in collective
damage.
The public-good dilemma is that everyone has access to the public knowledge of a firm but no
one knows who is and who is not contributing, which tempts individuals to free ride.
The resource dilemma is that when everyone uses a certain resource (knowledge) this will
deplete the resource for future use.
These dilemmas make it that people do not want to share their knowledge because they feel
that the social fence is to high (the effort spend does not outweigh the benefits)
Three main areas are given in which these dilemmas reside and how to overcome them:
Restructuring the pay-off function
This is making the rewards higher of the cost of contributing lower so that it is easier for
people to share knowledge or that the gains of doing so far outweigh the costs. This can be
done by:
Assure employees have the time to make knowledge available to others (make it a standard
task of them)
Increase individual pay-off through a cooperation-contingent transformation or a public-good
transformation. 1) Cooperation-contingent is when an incentive reward is offered. However
this may result in people giving a lot of low quality knowledge. 2) Public-good transformation
is a incentive when the public knowledge makes money for the team. This stimulates high

quality knowledge since else the incentive is not given. This is thus a gain sharing or profit
sharing plan.
Also the incentives do not have to be money but can also be status rewards, put them in the
newsletter for instance. The most effective way is to align its human resource policies with
this new role demanded from employees.
Increasing efficacy
When groups are getting to big people tend to feel that they cannot make a difference by
sharing their knowledge. Therefore increasing efficacy is very important. There are two
distinct types of efficacy: 1) information self-efficacy, the believe that the information is
helpful to co-workers were they to receive it. This expectancy will be higher if individuals
believe the information truly increases the value of the shared good. 2) Connective efficacy is
the belief that others will actually receive the information if it is contributed.
Feedback mechanisms are thus important, for instance by having rating systems or let the
contributors know how much their knowledge is used.
In addition employees need to be assured that there will be a minimum critical mass of
contributions to the knowledge repository. They dont want to think they are the only one
doing anything. Thus groups can not be to small, but when groups are getting bigger it is
important to let everyone know they are part of the team which leads to them feeling more
involved. Training programs help let employees feel part of the team, it also shows them that
people are thus going to use their information which motivates them to produce more of it.
Promoting group identity and personal responsibility
This is the sense of being part of the group as mentioned earlier. The probability of
cooperating increase when 1) interaction among participants are frequent and durable, 2)
participants are easily identifiable, 3) there is sufficient information available about each
individuals actions (people are not anonymous but have a face).
Communication between members is thus an impotent tool for establishing group identity. A
possible solution to the knowledge-sharing dilemma may be to create knowledge-sharing
groups and make it clear to employees that they belong to a specific group.

Ostrom, E. 2000. Collective action and the evolution of social norms. (2000)
Zero contribution thesis:
Rational self-interested individuals will not act to achieve their common or group interests.
The idea that rational agents are not likely to cooperate, even when that would be to their
mutual benefit, is also shown in the prisoners dilemma.
this dilemma, along with other dilemmas are viewed as collective action problems.
The zero contribution thesis underpins the assumption that individuals cannot overcome
collective action problems and need to have externally enforced rules to achieve their own
long-term self-interest.
! However, this thesis contradicts observations of everyday life. Individuals in all parts of the
world voluntary organize themselves to get the benefits of trade, provide mutual protection
against risks and create and enforce rules to protect natural resources. On the other hand,
research confirms that the temptation to fee-ride is a universal problem and people invest
resources in monitoring and sanctioning the actions of each other.
A substantial gap exist between the theoretical prediction that self-interested
individuals will have extreme difficulty in coordinating collective action and the
reality that such cooperative behavior is widespread. This study will first focus on
experimental evidence and potential theoretical explanations and secondly on realworld evidence.
Laboratory evidence on rational choice in collective action
Models on rational individual action rational egoists have found that this assumption works
well in predicting the outcomes of auctions and competitive market situations. Subjects do not
arrive at the predicted equilibrium in the first round, but behavior closely approximates the
predicted equilibrium by the end of 5 rounds of the experiment. After a huge number of those
experiments 7 general findings can be considered as the core facts;
1) Subjects contribute between 40 and 60 percent of their endowments to the
public good in a one-shot game as well as in the first round of finitely repeated
games.
2) After the first round, contribution levels tend to decay downward, but
remain well above zero. A repeated finding is that over 70 percent of subjects
contribute nothing in the announced last round of a finitely repeated sequence.
3) Those who believe others will cooperate in social dilemmas are more likely
to cooperate themselves. A rational egoist in a public good game, however, should
not in any way be affected by a belief regarding the contribution levels of others.
The dominant strategy is a zero contribution no matter what others do.
4) In general, learning the game better tends to lead to more cooperation, not less.
5) Face-to-face communication in a public good gameas well as in other
types of social dilemmasproduces substantial increases in cooperation that are
sustained across all periods including the last period. Subjects use the time to discuss
the optimal joint strategy, to extract promises from one another, and to give verbal
tongue-lashings when aggregate contributions fall below promised levels.
6) subjects will expend personal resources to punish those who make below-average
contributions to a collective benefit, including the last period of a finitely repeated

game. No rational egoist is predicted to spend anything to punish others, since the
positive impact of such an action is shared equally with others whether or not they also
spend resources on punishing.
7) The rate of contribution to a public good is affected by various contextual factors
including the framing of the situation and the rules used for assigning participants,
increasing competition among them, allowing communication, authorizing sanctioning
systems or allocating benefits.
These facts are hard to explain using the standard theory that all individuals who face
the same game evaluate decisions in the same way!
Building a theory of collective action with multiple types of players
From the experimental findings one can formulate the key assumptions that need to be
included in a revised theory of collective action.
Assumption of two types of norm-using players:
1. Conditional cooperators: individuals who are willing to initiate cooperative action
when they estimate others will reciprocate and repeat these actions as long as a
sufficient proportion of the others involved reciprocate. They will tend to be
trustworthy in collective dilemmas as long as the proportion of others who return trust
is relatively high. They tend to vary in their tolerance to for free riding. When they are
disappointed they will reduce their contributions. If they do so they discourage other
conditional cooperators from further contributions.
2. Willing punishers: these are players that are willing to punish free riders through
verbal rebukes or to use costly material payoffs when available. They might also
reward those who have contributed more than the minimal level. Some conditional
cooperators may also be willing punishers.
Together, conditional cooperators and willing punishers create an opening for
collective action and a mechanism for making it grow.
Evolutionary process
Evolutionary process explains the emerge and survival of multiple types of players. According
to this approach, those carrying the most successful strategies for an environment reproduce at
a higher rate. Eventually the more successful strategies come to prominence in the population.
During the Pleistocene survival was dependent on aggressively seeking individual returns
and solving many day-to-day collective problems. Those who learned how to recognize who
was deceitful and who was a trustworthy reciprocator had advantage over others.
Indirect evolutionary model: players receive objective payoffs, but make decisions based on
the transformation of these material rewards into intrinsic preferences. Those who value
reciprocity, fairness and trustworthiness add a subjective change parameter to actions that are
consistent or not consistent with their norms.
Prisoners dilemma games: if two players trust each other and cooperate, they can both receive
a moderately high payoff. However, if one player cooperates and the other does not, then the
one who did not cooperate receives an even higher payoff, while the other receives little or
nothing. For a rational egoist playing this game, the choice is not to trust, because the
expectation is that the other player will not trust, either. As a result, both players will end up
with lower payoffs than if they had been able to trust and cooperate.

Social norms may lead to individuals behave different than others. Depending on how
strongly they value conformance with (or deviance from) a norm. Rational egoists can be
thought of as having intrinsic payoffs that are the same as objective payoffs, since they do not
value the social norm of reciprocity. Conditional cooperators are trustworthy types and would
have an additional parameter that adds value to the objective payoffs when reciprocating trust
with trustworthiness. Therefore different types of players are likely to gain different objective
returns.
Only trustworthy types would survive in a world with complete information: as new
entrants of the population would adopt the preferences of those who obtained the
higher material payoffs in the past.
Only rational egoist would survive in a world where there is no information about
player types: first players will trust second players as long as the expected return of
meeting trustworthy players exceeds the payoff obtained when neither player trusts
each other.
Norms seem to have a certain staying power in encouraging a growth of the desire to
cooperate. While cooperation enforced by externally imposed rules can disappear very
quickly. Therefore external rules and monitoring can crowd out cooperative behavior.
Worst of all worlds: when external authorities impose rules but are only able to
achieve weak monitoring and sanctioning. The mild degree of monitoring discourages
the formation of social norms, while also making it attractive to deceive and defect
because there is a low risk of being caught.
Field studies of collective action problems find a huge number of contextual variables
conducive or detrimental to collective action:
The type of production and allocation functions; the predictability of resource flows; the
relative scarcity of the good; the size of the group involved; the heterogeneity of the group;
the dependence of the group on the good; common understanding of the group; the size of the
total collective benefit; the marginal contribution by one person to the collective good; the
size of the temptation to free ride; the loss to cooperators when others do not cooperate;
having a choice of participating or not; the presence of leadership; past experience and level
of social capital; the autonomy to make binding rules; and a wide diversity of rules that are
used to change the structure of the situation.
Design principles for self-organized collective action
- The presence of clear boundary rules this enables participants to know who is in and
who is out and thus with whom to cooperate. This is the first step to create more
greater trust and reciprocity.
- Local rules that restrict the amount, timing and technology of harvesting the resource
- If a group of users is going to harvest from a resource over the long run, they must
devise rules related to how much, when, and how different products are to be
harvested, and they need to assess the costs on users of operating a system. If some
users get all the benefits and pay few of the costs, others become unwilling to follow
rules over time.
- Most of the individuals affected by a resource regime can participate in making and
modifying their rules - Fair rules of distribution help to build trusting relationships,
since more individuals are willing to abide by these rules because they participated in
their design and also because they meet shared concepts of fairness. \
- Most long-surviving resource regimes select their own monitors, who are accountable
to the users or are users themselves and who keep an eye on resource conditions as
well as on user behavior.

Resource regimes use graduated sanctions that depend on the seriousness and
context of the offense This enables a regime to warn members that if they do not
conform they will have to pay ever-higher sanctions and may eventually be forced to
leave the community.
Access to rapid, low-cost, local arenas to resolve conflict among users or between
users and officials - Rules, have to be understood to be effective. There are always
situations in which participants can interpret a rule that they have jointly made in
different ways. By devising simple mechanisms to get conflicts aired immediately
and resolutions that are generally known in the community, the number of conflicts
that reduce trust can be reduced.
Minimal recognition of the right to organize by a national or local government
When they dont have this right, participants rely almost entirely on unanimity as the
rule used to change rules. Unanimity as a decision rule for changing rules imposes
high transaction costs and prevents a group from searching for better matched rules at
relatively lower costs.
The presence of governance activities organized in multiple layers of nested
enterprises.- among long-enduring self-governed regimes, smaller-scale organizations
tend to be nested in ever-larger organizations.

Threats to sustained collective action

1) efforts by national governments to impose a single set of rules on all governance units in a
region 2) rapid changes in technology, in factor availability, and in reliance on monetary
transactions; 3) transmission failures from one generation to the next of the operational
principles on which self-organized governance is based; 4) turning to external sources of help
too frequently; 5) international aid that does not take account of indigenous knowledge and
institutions; 6) growth of corruption and other forms of opportunistic behavior; and 7) a lack
of large-scale institutional arrangements that provide fair and low-cost resolution mechanisms
for conflicts that arise among local regimes, educational and extension facilities, and
insurance mechanisms to help when natural disasters strike at a local level.

Bridoux, F., Coeurderoy, R., and Durand, R. 2011. Heterogeneous motives and collective
value creation.
Introduction
Resource-based view researchers have increasingly paid attention to the role of human
motivation in realizing the value creation potential of resources. Their main argument is that
value creation depends not only on the firms resources but also on the motivation of
employees to leverage these resources. But only individual effort will not be enough; it
requires employee cooperation to create the full potential value. The dilemma is that the
maximization of individual employees material payoffs conflict with the achievement of the
collective goal of creating value for the firm. So what is the best way for managers to solve
this dilemma?
Outline of this article:
First introduce the heterogeneity of employees motives to cooperate in creating value
collectively. (1)
Second, they examine 3 main ideal-type motivational systems that differ with regard to their
sanctioning mechanisms and their understanding rationale for individuals cooperation. (2)
Third, they extend the baseline model by comparing the motivational effect of the three idealtype systems under different conditions of observability of individuals contribution to
collective value creation. (3)
How does this article contribute?
Motives and motivational systems form a significant source of differences between firms. By
analysing the impact of the interplay between a firms motivational system and its employees
mix of motives on collective value creation, it may become clearer what type of system will
work best.
From individual motives to collective value creation (1)
Collective value creation comes from coordinated and cooperative efforts undertaken by
multiple agents within firms to exploit the value created potential of the firms resources.
Recent RBV studies stress the importance of also looking at behavioural micro foundations at
the individual level. If you dont take this into account, you assume that all agents are
homogeneous which causes that you cannot examine differences in the level of employees
motivation to create value while this is presumably a major source of differences of
performances between firms.
Collective value is a public good because its creation benefits the firm as a whole, including
individuals who do not cooperate to create it as well as those who do. It generally occurs
under the conditions of low observability by managers because it is harder for them to assess
both individual contributions and the reasons why contributions vary across individuals.
Because the managers cannot adequately reward every individual for a collective task, selfinterested individuals will tend not to contribute even though cooperation is optimal for the
collective. (public good dilemma).
This suggests that if everybody were self-interested, nobody would ever contribute to the
collective. This contradicts with the outcomes of several studies which show that people are
willing to contribute to the public good. Therefore we introduce motivational foundations at

the individual level that more realistically reflect the social dynamics underlying cooperation
in public good situations than the homogeneous assumptions of either benevolence
(everybody always contributes) or self-interest (nobody ever contributes).
Heterogeneous motives to cooperate and motivational systems
Model of outcome transformation: social psychologists have found that there are 2 classes of
individuals:
- Self-regarding: only care about maximizing own payoffs.
- Reciprocator: care about enhancing both joint payoffs and the fairness of the payoffs.
Behavioural economists have gone further studying one type of reciprocator: the strong
reciprocators. This individual is motivated not only by personal monetary payoffs but also by
others monetary payoffs and by the fairness of the distribution of payoffs across individuals,
and is ready to sanction (un)fairness at a material cost to himself.
In this article they only use self-regard and strong reciprocity as the two motives to cooperate.
Only these two because they have been found to matter most in explaining the level of
cooperation that can be sustained in groups of interacting individuals drawn randomly from
the general public.
A way to influence employees motivation to collectively create value is via the motivation
system. This has 2 different mechanisms: motivational effect and the sorting effect.
Motivational effect: depending on the type they are, individuals react differently to a firms
motivational system. Self-regarding individuals only look at the balance between personal
costs of and personal benefits from cooperating. While strong reciprocator individuals look
not only at their own personal payoffs from cooperating but also to the fairness of the firms
motivational system. Two sources of (un)fairness exist: horizontal (co-workers, free riding)
and vertical (employee versus boss, is the employee being exploited?)
3 types of ideal motivational systems: (2)
1) Homogeneity-based motivational system: based on benevolent cooperation. Assumes that
all individuals are benevolent contributors to the creation of value. There are no sanctioning
mechanisms.
2) Homogeneity-based motivational system: based on individual monetary incentives.
Assumes that all employees are self-regarding. There are only management sanctions.
Managers should provide individual incentives on the basis of individuals contributions.
3) Disciplined cooperation: stems from public good dilemmas. Sanctioning implemented by
strong reciprocators help maintain high levels of cooperation because there are no sanctions
from a vertical authority.
Motivational effect and collective value creation: a baseline model
In this research they compare the 2 types of individuals with the 3 different types of
motivational systems.
In these cases we assume that observability of managers is low while observability by coworkers is high.

Homogeneity-based motivational system:

- Proposition 1: With a motivational system based on benevolent cooperation, collective value
creation is highest when only strong reciprocators are involved and decreases as the
proposition of self-regarding individuals grows.
- Proposition 2: With a motivational system based on individual monetary incentives,
collective value creation is highest when only self-regarding individuals are involved and
decreases as the proportion of strong reciprocators grows.
Heterogeneity-based disciplined cooperation:
- Proposition 3: With a motivational system based on disciplined cooperation, collective value
creation is highest when the number of strong reciprocators is just sufficient to discipline selfregarding individuals and decreases as the proposition of strong reciprocators grows or
declines.
Comparing the motivational effects of the 3 systems:
- Proposition 4: RBV work that assumes homogeneity suggest two motivational system
(individual monetary incentives and benevolent cooperation) that are comparatively superior
when the firms workforce is actually relatively homogeneous with regard t the employees
motives to cooperate. In contrast, the model based on disciplined cooperation helps to create
greater collective value when employees motives are more heterogeneous.
In some cases, the observability is not always as assumed above, therefor they research what
the consequences of this are for the collective value created.
If observability by managers is high,
proposition 5: The higher the observability by managers, the larger the efficiency domain of a
motivational system based on individual monetary incentives.
If observability by managers and co-workers is low, proposition 6:
The lower the observability by co-workers, the narrower the efficiency domain of a
motivational system based on disciplined cooperation.
Now we have looked at the two motives but what influences the mix of these motives is the
sorting effect. It is double-sided because some system will attract people with particular
motives (self-selection effect) while people in charge of the firm will select and retain people
with particular motives (selection effect). Results of this:
- In firms with an individual monetary incentives system, self-selection increases the
proportion of self-regarding individuals, which is positive for collective value creation.
- In firms with a benevolent cooperation system, self-selection increases proportion of strong
reciprocators, which is also positive for collective value creation.
This all leads to:
- Proposition 7: Over time, self-selection increases the homogeneity of the firms workforce,
which positively affects collective value creation in a firms with a individual incentives
system or benevolent cooperation system, and self-selection erodes collective value creation
in firms whose motivational system is based on disciplined cooperation.
Managers can of course also influence the firms mix of motives, therefore:

- Proposition 8: a motivational system based on benevolent or disciplined cooperation yields

the highest collective value creation over time only if the costs of maintaining the mix of
motives within the efficiency domain of this system are smaller than the value gap.
Discussion
The article contributed to RBV literature in 4 ways:
1. It deals with the different types of motives to cooperate and the influence of these
motives in the value created.
2. It proposes that the motivational system put in place by managers is a key determinant
of firms success in leveraging their mix of motives to create value collectively.
3. The article compares three motivational systems and it recognizes the importance of
sanctioning by peers to sustain cooperation in firms. This sanctioning is also explained
elaborately.
4. It shows the important role of management: to foster collective value creation,
managers should reflect on whether their firms motivational system align with the
mix of motives present in the firms workforce.

Rule Enforcement among Peers: A Lateral Control Regime

Emmanuel Lazega (2000)
Theories of collective action show that members conformity to rules governing the
management of common resources requires social control and informal conflict resolution
mechanisms. Compliance to the rules is depending on compliance by others, and
therefore members spend time and energy monitoring each other. Formal procedures are
used against members who violate the rules, but often as a last resort, especially when
monitoring and sanctioning are undertaken, not by external authorities, but by the participants
themselves. In such a case, infractors are likely to be assessed graduated sanctions
(depending on the seriousness and context of the offense) by other members, by officials
accountable to these members, or by both. If an individual breaks the rules more
systematically, sanctions can escalate until members punish the offender (and themselves) by
breaking previous agreements.
The issue of conformity is of particular importance in formally egalitarian bodies in
which partners are all nominal, interdependent, equals:

Free-rider problems quickly arise in such settings, because even a member who did
not contribute effectively to the firm's revenues imposes a cost on the partnership as a
whole, by reaping the benefits of partnership. As a consequence, monitoring and
early graduated sanctions are considered to be particularly important for ensuring that
partners' individual commitment to contribute remains credible.

However, in such contexts, hierarchical control is relatively weak, and there is

reluctance, at an early stage to use formal procedures against colleagues to overcome
free-riding and maintain solidarity. Direct command or use of administrative
hierarchy are not considered appropriate means for exercising control, because
professionals have many ways of neutralizing formal authority. Therefore, a secondorder free-rider problem arises as well - the problem of who will bear the costs of
monitoring and enforcement among the formally equal members.

In effect, enforcement through negative sanctions can be costly for the sanctioner,
particularly when control is mobilized for the protection of the common good in such a
formally egalitarian body. This can result in:

infractors may accumulate resentment;

partners may blame the sanctioner - especially if he/she has personal ties with the
deviant party - for failing to achieve results. The issue thus becomes: how then
does the organization keep costs of enforcement low?

The paper argues that informal processes contribute to maintaining low costs, in
particular the appropriate use of social resources or 'relationships' between members.
As part of what Freidson calls 'the rule of the collegium', members tend to avoid
open face-to-face conflicts, as well as direct and coercive exercises of power.
Therefore, graduated sanctions start with unobtrusive and unsolicited advice and the

spread of gossip. In effect, social ties provide access to infractors and focus their
attention, because they represent the existence of underlying resource dependencies.
References to such actions:

Freidson and Rhea's (1963) - colleagues informally 'talk to' infractors in order
to curb behaviour perceived to be unprofessional or opportunistic.

Mintzberg' s (1979) words, there is 'mutual adjustment' among peers working in

'adhocracies'.

Others refer to this process as gaining 'quasi-voluntary compliance'

Achieving autonomous regulation (Reynaud 1989),

concertive control (Barker 1993), or compliant control (Heckathorn 1990).

(Levi

1988),

Colleagues show infractors that lack of conformity has been detected, must be
discussed, and may involve external social costs, such as stopping exchanges at various
levels. Because interdependent partners need social resources to perform effectively, they
are also more exposed to pressures from partners who control these resources. These
processes help peers maintain an enduring collegial organization (Webern1920; Waters
1989).
The second-order free-rider problem can be decomposed into two issues. First,
the cost of sanctioning, and second, the incentive to sanction. The two issues are related
because lower costs will make lower incentives work, but otherwise they are independent.
This paper deals mainly with the first issue. Following the individual's preferences for
sanctioners leads to lowering sanctioning costs because if there is an interest in getting the
infractor going again, then members are sensitive to the efficiency of the sanction. It is also
likely that there is some selective organizational learning involved in the choice of
sanctioners: individual interests lead to lower costs which lead to good joint outcomes,
which reinforce the influence of individual interests on the sanctioning regime. However,
of particular importance to the argument of this paper, social relations among members are
the key to the process of mutual adjustment, i.e. the way in which a formally egalitarian
organization obtains this quasi-voluntary compliance with its rules and agreements.
Hypotheses: The Shape of a Lateral Control Regime
The relationship between cost of control and choices of suitable sanctioners in a
collegial organization plays itself out in the following ways. Members are interested in
getting the infractor going again to the degree that they are dependent on resources
controlled by the infractor. Thus, in the case examined here, partners are interested in
sanctioning what is likely to happen and what is likely to work. Based on this
argument, we can predict:
Hypothesis 1: The more similar members are to infractors in terms of their formal
organizational attributes, the more likely they are to be chosen to act as sanctioners for
these infractors.

If costs of interaction are reduced by structural proximity, sanctioning is more

likely to happen. It can be argued that it is also more likely to hap pen if the cost of interaction
is also lowered by easy access to the infractor. We can therefore also predict:
Hypothesis 2: Members connected to infractors through personal ties are more
likely than others to be chosen to act as sanctioners for these infractors.
Since partners are also interested in sanctioning what is likely to work, we can predict
that the relative seniority level of sanctioner and infractor is an important variable. Seniority is
often considered to be a substitute for hierarchy and formal . Being sanctioned by people
'from below' would be considered a loss of status and would increase the cost of
intervention. In addition, senior partners often have more incentives than others to act
as sanctioners (because compensation systems tend to reward seniority). Therefore:
Hypothesis 3: The more partners are equal or superior to the infractors in terms of
seniority, the more likely they are to be chosen to act as sanctioners.
Partners have a strong interest in getting the malfunctioning partners back to work and in
preventing damage to them, because they depend on them for resources. Therefore they
will choose as sanctioners other partners with whom they have a close relationship so as to
better control the process. Thus:
Hypothesis 4: The more personal ties members have with an infractor, the more likely
they are to choose as sanctioners other members with whom they are also personally close.
When they are not so close to the sanctioners, they will choose as sanc tioner someone
who is powerful, so as to fend off interference from other partners. Therefore:
Hypothesis 5: The more control partners have over resources in the firm, the more likely
they are to be chosen as sanctioners.
Seniority is defined by the rank of part ners in the letterhead, which is mainly based on
age and years with the firm.
Discussion and Conclusion
To summarize, this examination of a formally egalitarian partnership shows that the
organization stands to gain 'quasi-voluntary compliance' with its rules and agreements by
reducing members' costs of intervening on behalf of the common good. Partners have a
strong interest in getting the malfunctioning partners going again and in preventing damage
to them, because they depend on them for resources.
Therefore, partners are interested in sanctioning that is likely to happen and that is
likely to work.

is more likely to happen if the cost of interaction is lowered by easy access to the
infractor and by the existence of personal ties between sanctioner and infractor.

it is likely to work if sanctioners tend to be more senior than infractors and if they are
powerful. However, the kind of status carried by these powerful sanctioners
suggests that they are also chosen so as to prevent the possible preferential treatment
for some infractors that is induced by close relationships with them.

Spreading and shifting costs of control helps the organization keep early monitoring and
sanctioning costs low, and therefore try to keep members motivated to carryon monitoring
and sanctioning each other. This lateral control regime can thus help members find an early
solution to the so-called second-order free-rider problem in formally egalitarian
interdependent groups, i.e. the problem of who should bear the costs of enforcing previ ous
agreements. Because it offers a specific organization early enforcement of rules and
decisions, the lateral control regime can indirectly help in ensuring that cooperation
remains possible.
Limitations to the lateral control pattern work:
First, It is only one informal mechanism helping partners choose sanctioners to compel
each other, at an early stage, to contribute the required efforts and resources before they
decide to switch to more formal disciplinary mechanisms (committees, votes, etc.).

The article deals only partially with the second-order free-rider problem and it does
not explore whether and when lateral control is needed.

Also, the article does not deal with graduated sanctions (sanctions of different
severity), only with the lowest level of this graduation ('talking to').

Second, the logic of how a managerial problem is handled in a firm may be specific to its
socio-emotional, or expressive, character - as opposed to a more instrumental, taskoriented problem.
Third, different individual-level behavioural assumptions can be made to explain choices
of sanctioners. Partners choosing sanctioners are indeed sensitive to the issue of costs which
define, in part, the second-order free-rider problem. They rely on various commonalities of
interests among protagonists of the control situation. Thus the lateral control regime can
indeed be said to contribute to group solidarity by reducing the costs of control
(Hechter 1987) for most partners. Nevertheless, senior partners may also be chosen as
sanctioners because they have more traditional legitimacy to intervene on behalf of the
common good. A 'lateral control culture' might also be at work - a set of learned choices
(Swidler 1986) that enable well socialized partners, at this early stage, to match sanctioners
and infractors in a way consistent with the 'rule of the collegium'. Such learned ways would
make the choice of sanctioners more compatible with face saving unobtrusiveness
(choices of sanctioners might have to signal to infractors that the firm is not going out of
its way to remind them of their obligations), stress avoidance of conflict escalation, and
could also be explained by factors attributed to the subjective make-up of actors.
Study questions:
1. What is team production? What problems does it bring?
2. Based on all paper, identify the controls (i.e., motivational devices or tools) managers
could use to encourage cooperation in firms. Discuss the advantages and drawbacks of
these controls.
3. Compare the motivation systems discussed by Bridoux, Coeurderoy and Durand
(2011) and Lazega (2000) to your experience of motivation systems in group/team
projects. What similarities and differences can you see in how control is exercised?

Week 4

Burns, T. and G. Stalker. 1961. Mechanistic and organic systems.

This paper outlines two formally contrasted management systems (mechanistic and organic) that both
represent a rational form of organization, in that they both, be explicitly and deliberately created
and maintained to exploit the human resources of a concern in the most efficient manner feasible in
the circumstances of the concern.
A mechanistic management system is appropriated to stable conditions, while the
organic form is appropriated to changing conditions. These changing conditions gives rise
constantly to fresh problems and unforeseen requirements for action that cannot be broken
down or distributed automatically arising from the functional roles defined within a hierarchal
structure. The characteristics of both systems are listed in the table below.

Observations:

While the organic systems are not hierarchic in the same sense as are mechanistic,
they remain stratified (i.e. the lead is taken by whoever shows himself most informed
and capable). The location of authority is set by location.

The area of commitment to the concern the extent to which the individual yields
himself as a resource to be used by the working organization is far more extensive in
organic than in mechanistic systems.

The emptying out of significance from hierarchical command system, by which cooperation is ensured and which serves to monitor working organization under a
mechanistic system, is countered by the development of shared beliefs about the
values and goals of the concern.

The two forms of systems represent a polarity, not a dichotomy; there are intermediate
stages between the extremities empirically known to us. Also the relation of one form
to the other is elastic, so that a concern oscillating between relative stability and
relative change may also oscillate between the two forms.

The organic form from departing from the familiar clarity and fixity of the hierarchical
structure, is often experienced by the manager as an uneasy, embarrassed, or chronically
anxious quest for knowledge about what he should be doing, or what is expected from hum,
and similar apprehensiveness about what others are doing. The desire for more definition is
often in effect a wish to have the limits of ones task more nearly defined. It follows that the
more definition is given, the more omniscient the management must be, so that no functions
are left whole or party undischarged, no person is overburdened with undelegated
responsibilities, or left without authority to do his job properly. This requires rules or
traditions of behavior proved over a long time and a equally fixed, stable task.
A second distinctive feature of the organic system is the pervasiveness of the working
organization as an institution (combine with others to serve the general aims of the concern).
The less definition can be given to status and roles, the more the organization becomes
determined by the real tasks of the firm as he sees them than by instruction and routine

Mechanistic management system

The specialized differentiation of functional tasks
into which the problems and tasks facing the
concern as a whole are broken down;
The abstract nature of each individual task, which
is pursued with techniques and purposes more or
less distinct from those of the concern as a whole;
The reconciliation, for each level of hierarchy, of
these distinct performances by the immediate
superiors, who are also, in turn, responsible for
seeing that each is relevant in his own special part
of the main task;
The precise definition of rights and obligations
and methods into the responsibilities of a
functional position;
The translation of rights and obligations and
methods into the responsibilities of a functional
position;
Hierarchic structure of control, authority, and
communication;

A reinforcement of the hierarchic structure by the

location of knowledge of actualities exclusively at

Organic management system

The contributive nature of special knowledge
and experience to the common task of the concern;
The realistic nature of the individual task,
which is seen as set by total situation of the
concern;
The adjustment and continual redefinition of
individual tasks through interaction with others;

The shedding of responsibility as a limited

field of rights, obligations and methods;
The spread of commitment to the concern
beyond any technical definition;
A network structure of control, authority, and
communication. The sanctions which apply to the
individuals conduct in his working role derive
more from presumed community of interest with
the rest of the working organization in the survival
and growth of the firm, and less from a contractual
relationship between himself and a nonpersonal
corporation, represented for him by an immediate
superior;
Omniscience no longer imputed to the head of
the concern; knowledge about the technical or

the top of the hierarchy, where the final

reconciliation of distinct tasks and assessment of
relevance is made;

A tendency for interaction between members of

the concern to be vertical;

A tendency for operations and working behavior

to be governed by the instructions and decisions
issued by superiors;
Insistence on loyalty to the concern and obedience
to superiors as a condition of membership;

A greater importance and prestige attaching to

internal (local) than to general (cosmopolitan)
knowledge, experience, and skill.

commercial nature of the her and now task may be

located anywhere in the network; this location
becoming ad hoc centre of control authority and
communication;
A lateral rather than a vertical direction of
communication
through
the
organization,
communication between people of different rank,
also, resembling consultation rather than command;
A content of communication which consist of
information and advice rather instructions and
decisions;
Commitment to the concerns task and to the
technological ethos of material progress and
expansion is more highly valued than loyalty and
obedience
Importance and prestige attach to affiliation
and expertise valid in the industrial and technical
and commercial milieux external to the firm.

Walker, A. H. and Lorsch, J. W. 1968. Organizational choice: Product vs. function.

Classical theory
Classical organization theorists suggest the choice between functional & product
Departments should be based on 3 criteria:
Which approach permits the maxim use of technological knowledge?
Which approach provides the most efficient utilization of machinery & equipment?
Which approach provides the best hope of obtaining required control & coordination?
However this approach fails to recognize the complex trade-off between these three criteria.
Trade-off
Highly specialized functional units
1

++ Improved control of production costs

++ Efficiencies if functions such as product & marketing

-- Difficult to achieve coordination & integration among units

Product units
4

++ Collaboration between specialists

-- Functional specialist feel less identification with functional goals

6
Differentiation vs. integration
Differentiation = differences in behaviors & thought patterns between specialists
Needed for functional specialist to perform their jobs effectively
Integration = collaboration between specialized units or individuals
When there is more differentiation it is harder to achieve integration, but organizations need

both.
To do this there have to be well-developed means of communication among specialists &
specialist need to be effective in resolving cross-functional conflicts
Recent theories
Recent theories say choice of structure should be based on how it affects differentiation,
integration & specialists ability to communicate, resolve conflicts & make joint decisions.
When there is the right mix between differentiation & integration, there is a better chance of
organization accomplishing economic goals

Case study
Functional structure plant
Differentiation:
o Goal orientation: differentiated & focused goals
o Time orientation: less differentiated & short term
o Formality of structure: less differentiated with more formality
Integration: somewhat less effective
Conflict management: confrontation, smoothing-over, avoidance, restricted
communication pattern
Effectiveness: efficient & stable, less successful in improving capabilities
Employee attitude: satisfaction, less stress, also less involvement
Product structure plant
Differentiation
o Goal orientation: less differentiated & more diffuse
o Time orientation: more differentiated & longer term
o Formality of structure: more differentiated with less formality
Integration: more effective
Conflict management: confrontation of conflict, open face-to-face communications
Effectiveness: successful in improving plant capabilities, less effective ein stable
production
Employee attitude: stress, involvement, less satisfaction

Galbraith, J. R. 1971. Matrix organization designs How to combine functional and project
forms.
Two new forms of organization as response to of high technology:
Free-form conglomerate & matrix organization
Matrix organization; alternative form than project organization and
functional structure
matrix design tries to achieve the benefits of both forms
Functional structure; group together activities which have a common
product, customer, geographic area, business function
(marketing/engineering) or a common process. For example, it minimizes
the number of technical engineers necessary because specialized
resources are shared across products and projects.
Problem: simultaneously completing all tasks on time, while fully using all
resources is impossible
Project organization: facilitates coordination among specialties to
achieve on time completion and meet budget targets. Problems can be
tackled quickly, whereby impact on other specialties is reduced.
Problem: duplication costs, because resources are needed at the same
time. And no one is responsible for the long run technical development of
a specialty.
Problem is that when choosing one organizational form, the benefits of
the of the organizational form are surrendered. If the functional structure is
adopted, the technologies are developed but the projects fall behind
schedule. If the project organization is chosen, there is better cost and
schedule performance, but technologies are not developed as well.
Answer: matrix organization
The Standard Product Co. : Hypothetical company that changed from
functional structure to matrix organization. Standard was selling its
products through functional organization. Every year a number of changes
were made in the product lines. Major management problem was to
coordinate the flow of work form engineering through marketing. Therefore
there were several integrating mechanisms:
Rules and procedures; if everyone follows the rules, the behavior is
integrated without having to maintain an on-ongoing communication
Planning processes; for less repetitive actions, the procedure was not
specified, only the goal that needs to be achieved. In that way individuals
could the procedure appropriate to the goal. Therefore schedules and
budgets were designed
Hierarchical referral; when there are situations for which there are no rules
or there are problems that the goal could not be achieved, then the
problem will be referred upward in the hierarchy.
Direct contact; to prevent top executives to from becoming overloaded
with problems, as many problems as possible were resolved by managers
at lower levels.

Liaison departments; where there is a large volume of contracts between

departments, a liaison department evolves to handle the transactions.
A significant change occurred in the market for Standards major
product lines. A competitor came out with a new design utilizing an
entirely new raw material.
Task force
Standards lack of experience with the new material led to the
deterioration of usefulness of plans and schedules at all levels. Therefore
the majority of the problems were referred upward, which led to overloads
of the directors.
Response: new coordination mechanism to meet the scheduled due dates;
distance between the sources of information and the point of decision
must be reduced. At the same time, decentralization must not only be
local in scope. Therefore they had to increase decisionmaking at lower
levels without losing the inputs of all affected units.
Solution: a group with representatives from all the major departments that
make joint decisions: Task force. This group met every other day to discuss
and resolve joint problems. The group had both the information and
authority to make good group decisions. The result was effective
coordination and the task force members returned to their regular duties.
As the new product was introduced, competitors came up with new
products based on improvements in the raw material. Standard began to
redesign across all its product lines with a set up task force structure in
advance.
Teams
In order to meet target dates, top-management was drawn into day-to-day
decisions on a continual basis. This was leaving little time to think about
the third generation product line.
Response: again they had to find a way to push a greater number of
decisions down to lower levels and at the same time considering all
departments.
Solution: team structure; team consisted of representatives of all functions
and were formed around major product lines. There were two levels of
teams; one at lower levels and one at middle-management level. Problems
that the lower level could not solve were referred to middle level, and after
to top-management. The teams unlike the task force were permanent.
Standards strategy required the addition of highly skilled, educated,
technical people to continue to innovate and compete in a high technology
industry. These specialist could dominate a team because of their superior
knowledge. And their personalities were different than other team
members which made conflict resolution more difficult.
Product managers
The technical people were upsetting the power balance because others
could not challenge them on technical matters.

Response: Decisions must be made with a general managers perspective

who could influence a reasonable balance among the joint decision
makers.
Solution: the general manager chose three technical men and made them
product managers in charge of three major product lines. They had to be
the chairman of product team meetings and facilitate decision making.
Since these men did not have formal authority, they had to resort to their
technical competence and interpersonal skills to be effective.
Product managers departments
Standard was now following a strategy of product innovation and
introductiom. As the number of new products increased, decisions were
more made around product considerations. The frequent needs for
tradeoffs between engineering, production and marketing increased the
influence of the product managers. Therefore (1) their salaries became
substantial and (2) they had an greater voice in the budgeting process.
Plus there was an accumulation of staff around the products, which
became the product departments.
Response: there was a lack of information developed on product costs and
revenues for deletion, addition and pricing decisions.
Solution: New information system that reported costs and revenues by
product as well as by function. This gave managers the need for staff and
a basis for more effective interfunctional collaboration.
Sub-product managers
Two concerns for the general manager: 1. The concern for the quality of
decisions made at low levels, were not always made in best interest of the
firms as a whole. 2. Technical people were having moral and turnover
problems. These people were spending a lot of time in meetings (because
decisions were made at lower levels) while they preferred to work on
technical problems.
Response: more product orientation on lower levels and improve the moral
of technical people.
Solution: subproduct manager; chosen from the functional organization
and represent the product line within the function. He would report both to
the functional manager and the product manager, creating a dual
authority structure. Because he would participate in meetings technical
people did not have to.
Standard has now moved to a pure matrix organization. Difference with
other two forms:
1. Dual authority relationship
2. Power balance between the product management and functional
sides
How do I choose a design?
Not all organizations need a matrix design. As shown in figure 3. The
choice is between a range of alternatives between pure functional

organization and a pure product organization with the matrix being

halfway between. This is a continuum of possibilities.
Product lines
The greater the diversity among product lines the greater the rate of
change of products in the line the greater the pressure to move towards
product structures. When product lines are diverse, it becomes difficult for
managers to maintain knowledge in all areas. Plus the faster the rate of
new products the more unfamiliar task are. Therefore there must be
greater product influence in the decision process.
Interdependence
The functional division of labor in organizations creates interdependencies
among the subunits. Organizations usually devise mechanisms that
uncouple subunits, such as in-process-inventory and backlogs. If there is a
tight schedule, departments can resolve their own problems. If rapid
response to market changes is a basis of competition then schedules are
squeezed and activities run parallel rather than in series. The tighter the
schedule the greater the force to move to product organization.
Level of technology
The use of new technologies requires expertise in technical specialties,
engineering and manufacturing, and marketing. If expertise is critical to
competition the organization must acquire it internally. If the organization
wants to make effective use of its expertise, the functional form is
superior. The greater the need for expertise the greater the force to move
to functional organization.
Economies of scale and size
It is more expensive to buy small facilities for product divisions than large
ones for functional departments. The greater the economies of scale the
greater the force to move to functional organization.
The size of an organization is important because it modifies the effect of
expertise and economies of scale. The greater the size the smaller the
costs of lost specialization and lost of economies of scale.

Mintzberg, H. 1979. The Structuring of Organizations.

Main implication: The organizations type of environment, its production
system, even its age and its size, can in some sense be chosen to achieve
consistency with the elements of its structure.
In sharp contrast to the implications of the contingency theory, that states
that organizations can select their situations in accordance to their
structural design just as much as they can select their designs in
accordance with their situations.
Six basic parts of the organization

1. The operating core: where basic work of producing products and

services is done
2. Strategic apex: where organization is managed from a general
perspective
3. Middle line: managers who stand in direct line relationships between
strategic apex and operating core
4. Technostructure: staff analysts who design the systems by which
work processes and outputs are formally designed and controlled
5. Support staff: specialists who provide support to the organization
outside of its operating workflow
6. Ideology: halo
organization

of

beliefs

and

traditions

that

surrounds

Six basic coordinating mechanisms

Fundamental ways in which organizations co-ordinate their work.

the

1. Mutual adjustment
Co-ordination of
communication

work

by

the

simple

process

of

informal

Used in the simplest of organizations and paradoxically in the most

complex, because it is the only means that can be relied upon under
extremely difficult circumstances
2. Direct supervision
One person co-ordinates by giving orders to others
Comes into play after a certain number of people must work
together
Co-ordination can also be achieved by standardization
3. Standardization of work processes
Specification, the programming, of the content of the work directly
Typically the job of the analyst to program the work of different
people in order to co-ordinate tightly
4. Standardization of outputs
Specification of the results
Interfaces between jobs is predetermined
Such standards generally emanate from the analyst
5. Standardization of skills (as well as knowledge)
Looser ways to achieve co-ordination
Worker rather than the work or the outputs that are standardized
Workers are taught a body of knowledge and a set of skills which are
subsequently applied to the work

 Standardization typically takes place outside the organization. In

effect standardization standards do not come from the analyst but
they are internalized by the operator
6. Standardization of norms
Workers share a common set of beliefs and can achieve coordination based on it
The essential parameters of design
Design parameter deal with the design of individual positions and the
designs of superstructure.
1. Job specialization
-

Decision what each person will do: how specialized job is, how many
tasks it contains and how much control the person has over tasks.

In determining these aspects of job specialization, the organization

designer is essentially establishing the division of labour in the
organization.

Jobs that have few and narrow tasks are referred to as horizontally
specialized. Those with many and broad tasks as horizontally
enlarged.

Jobs that involve little control by those who do them are called
vertically specialized. Those which are thoroughly controlled by
the worker are referred to as vertically enlarged.

2. Behavior formalization
-

Extent to which the work content of tasks will be specified.

Organizations formalize the behavior of their workers in order to

reduce its variability, ultimately to predict and control it.

3. Training
-

Some tasks are too complex to be rationalized and then formalized.

They acquire some standardized body of knowledge and set of skills.

Training often takes place in some formal institutions.

Formalization and training are basically substitutes for one another.

Both are designed to program the work of work of the individual, but
formalization focuses on unskilled work, while training is oriented
toward complex, professional work.

As training takes power from all the other parts of the organization
and puts it into the hands of the professional workers themselves,

professional tasks must be controlled by those who actually perform

them.
4. Indoctrination
-

Socialization refers to the process by which a new member learns

the value system, the norms, and the required behavior patterns of
the society, organization or group in which he is entering.

It takes place informally. But some also take place more formally
through the process known as indoctrination.

5. Unit grouping
-

Establishment of a managerial superstructure.

A hierarchy of authority is constructed through which flows the

formal power to control decisions and actions.

Hierarchy is generally represented by an organizational chart, an

organigram

On what basis are positions and units grouped into larger groups?
What size should each of the units be?

Fundamental way to co-ordinate work in organization for four

reasons: (a) establishes a system of common supervision among
positions and units (b) typically required positions and units to share
common resources (c) assessed on common measures of
performance (d) encourages mutual adjustment among members

Positions and units can be grouped by function, by market, by

means or by ends

6. Unit size
-

Span of control of the managers

Assumption in classical literature that co-ordination was

synonymous with direct supervision: `No supervisor can supervise
directly the work of more than five or, at the most, six subordinates
whose work interlocks.

The greater the use of standardization for co-ordination, the larger

the size of the work unit

The greater the need for mutual adjustment, the smaller must be
the size of the work unit. When tasks are rather complex yet tightly
coupled, neither direct supervision nor any form of standardization
suffices to effect the necessary co-ordination. It must be co-ordinate
by informal, face-to-face communication among members.

For mutual adjustment to work effectively, the work unit must be

small enough to encourage convenient, frequent, and informal
interaction among all its members.

7. Planning and control systems

-

Need for planning and control systems to standardize outputs and

liaison devices to encourage mutual adjustment.

Distinction between action planning systems - which focus on

before-the-act determination of outputs - and performance
control systems - which are more oriented to after-the-fact
monitoring of results

8. Liaison devices
-

How to encourage mutual adjustment across units, when grouping

has the known tendency to discourage inter-unit communication

Liaison devises - formal parameters of structural design - have

developed to stimulate mutual adjustment across units.

Four are of particular importance, in ascending order of their

capacity to encourage mutual adjustment:

a. Liaison positions: jobs created to coordinate the work of two units

directly, without to pass through vertical managerial channels. They
carry no formal authority per se.
b. Task forces and standing committees: institutionalized forms of
meetings which bring members of a number of different units
together. First to deal with a temporary issue and second in a more
permanent and regular way to discuss issues of common interest
c. Integrating managers: essentially liaison personnel with formal
authority
d. Matrix structure: functional groupings pose work-flow problems
and market-based ones impede contacts among specialist. Three
ways to deal with the residual interdependencies:
o Different type of grouping can be used at the next level in the
hierarchy
o Staff units can be formed next to line units to advise on the
problem
o One of the liaison devices already discussed can be overlaid
on the grouping.
The concept of matrix structure is to balance two (or more) bases of
grouping. There is a permanent form and a shifting form of matrix
structure.

How do these liaison devices relate

parameters we have already discussed?

to

the

other

design

They are most logically used with work that is (a) horizontally specialized,
since specialization impedes natural coordination (b) complex/
professional (c) interdependent, so that coordination is necessary. Liaison
devices, as agents of mutual adjustment instead of standardization, are
obviously associated with organic structures.
Vertical and horizontal decentralization
Centralized = when all power is located at a single point in the
organization
Decentralized = when the power is dispersed among many individuals
-

Vertical decentralization: Delegation of formal power down the

hierarchy to line managers

Horizontal decentralization: Extent to which formal or informal

power is dispersed out of the line hierarchy to non-managers.

Selective decentralization: Dispersal of power over one or a few

kinds of decisions to the same place in the organization.

Parallel decentralization: Dispersal of power for many kinds of

decisions to the same place.

Centralization has one great advantage in the organization: by

keeping all the power in one place, it ensures the very tightest form of
coordination.
So why bother to decentralize? One brain is not big enough to
understand all that must be known. Decentralization allows the
organization to respond quickly to local conditions to many different
places, and it can serve as a stimulus for motivation, since capable
people require considerable room to maneuver if they are to perform at
full capacity.
So, we distinguish between six different types of (de)centralization:

Type 1: Centralization
1 Direct supervision clearly constitutes full horizontal centralization, since
all power rests with the managers.
2 Vertically centralization since a dependence on direct supervision for
coordination means that each manager tightly controls those below him.
Type 2: Limited horizontal decentralization (selective)
3 Standardization of work processes through coordination
4 Centralization in the vertical dimension, with a limited and selective
degree of decentralization in the horizontal dimension
Type 3: Limited vertical decentralization (parallel)
5 Reliance on standardization of output
6 Form of vertical decentralization, since a few division managers can
retain the lions share of the power.
Type 4: Horizontal decentralization (parallel)
7 Standardization of skills
8 Professionals can work rather autonomously in large units
Type 5: Selective horizontal and vertical decentralization
9 Experts work in small units and co-ordinate by mutual adjustment
10
Combination of vertical decentralization - delegation to work groups
at different levels in the hierarchy - and horizontal decentralization - a
varying distribution of power within each group.

Type 6: Decentralization
11

Standardization of norms for co-ordination

12
Purest form of decentralization, the most democratic form of
structure
The situational factors
Age and size of the organization
H1: The older the organization, the more formalized its behavior.
H2: The larger the organization, the more formalized its behavior.
H3: The larger the organization, the more elaborate its structure.
H4: The larger the organization, the larger the size of its average unit.
H5: Structure reflects the age of founding of the industry.
Technical system of production
H6: The more regulating the technical system (the more it controls the
work of the operators), the more formalized the operating work and the
more bureaucratic the structure of the operating core technical systems
that regulate the work of the operators.
H7: The more complex the technical system, the more elaborate the
administrative structure.
H8: The automation of the operating core transforms a bureaucratic
administrative structure into an organic one.
Environment
H9: The more dynamic the environment, the more organic the structure.
H10: The more complex the environment, the more decentralized the
structure.
H11: The more diversified the organizations markets, the greater the
propensity to split it into market-based units, or divisions, given favorable
economies of scale.
H12: Extreme hostility in its environment drives any organization to
centralize its structure temporarily.
H13: Disparities in the environment encourage the organization to
decentralize selectively to differentiated work constellations.
Power

H14: The greater the external control of the organization, the more
centralized and formalized its structure.
H15: The power needs of the members tend to generate structures that
are excessively centralized.
H16: Fashion (haute structure) favors the structure of the day (and of
the culture), sometimes even when inappropriate.
Configurations
These elements seem to cluster naturally in a certain number of ways,
which are called configuration.

1. The simple structure

-

One or a few top managers, one of whom dominates by the pull to

centralize, and a group of operators who do the basic work.

The absence of standardization means that the structure is organic.

Dynamic but simple environment.

Organization is often young and small.

2. The machine bureaucracy

-

Large techno-structure to design and maintain its systems of

standardization.

Limited amount of horizontal decentralization, reflecting the pull to

standardize.

Middle line hierarchy is usually structured on a functional basis all

the way to the top, where the real power of co-ordination lies. So
structure tends to be rather centralized in the vertical sense.

Environment and production system of the machine bureaucracy

must be fairly simple.

3. The professional bureaucracy

-

Standardization of skills rather than of work processes.

Pull to professionalize dominates.

Power not only to the professionals themselves but also to the

associations and institutions that select and train them. Structure
emerges as highly decentralized horizontally.

Professional bureaucracy is called for whenever an organization

finds itself in an environment that is stable yet complex. Complexity
requires decentralization.

4. The divisionalized firm

-

Dominant pull to Balkanize.

It is not a complete structure. Each division has its own structure

Encourages the organization to replace functional by market-based

units.

Supervision controls the divisions.

5. The adhocracy
-

For innovation, bureaucratic structures are too inflexible, and the

simple structure are too autocratic. Use of adhocracy.

Dominated the experts pull to collaborate.

Organic structure that relies for coordination on mutual adjustment

among its highly trained and highly specialized experts.

All distinctions of conventional structure disappear in the adhocracy.

Environment is complex and dynamic.

6. The missionary
-

Dominated by the pull to evangelize.

Loose division of labor, little job specialization as well as reduction of

the various forms of differentiation.

Standardization of norms, the sharing of values and beliefs among

all its members. Key to insuring this is their socialization.

Strikwerda, J. and Stoelhorst, J.W. 2009. The emergence and evolution of the
multidimensional organization
The multidivisional (M-form), was the most successful organization form in the
twentieth century. Definition of the M-form: Firms that employ the M-form
organize their activities in separate business units and delegate control over the
resources needed to create economic value to the managers of these units.
Four principles of the M-form:

1.
2.
3.
4.

The firm is organized in separate business units.

Business units managers are accountable for creating economic value.
Resources are allocated unequivocally to business units.
The task of the corporate parent is to add value to the activities of the business units.

Two reasons for the M-forms popularity and success:

1. By creating an internal market the M-form stimulates entrepreneurship.

2. The M-form offers a simple way to exploit synergies.
Problems with the M-form:

High employee costs

Internal battles over resources
Lack of standardization
Lack of cooperation
Loss of market opportunities

The M-form assumes that each of the firms customers only needs to deal with
one business unit, and that each of the firms business units can control all
resources needed to serve its market. It is only on these two assumptions that
business units can truly operate independently. These assumptions are violated
as soon as there are opportunities for cross-selling or system integration across
the products of the different business units, complementarities among the
resources of the different business units, or economies of scale in the use of
resources across business units. There is a crucial trade-off involved in choosing
between the unequivocal resource allocation and lines of authority that have led
to the success of the M-form, on the one hand, and the creation and the
exploitation of the kind of synergies that product and financial markets
increasingly require, on the other. Many contemporary firms violate the principle
that is central to the M-form: that business units are self-contained. Most
business units now depend at least in part on resources that are controlled by
other units. This raises fundamental questions about the status of the M-form in
contemporary firms.
The need to exploit synergies across business units was widespread, but it was
unclear which organizational designs are most appropriate to achieve this. This
led to a research project to explore the ways in which leading Dutch
organizations, including subsidiaries of foreign multinationals, have adapted the
M-form to better exploit synergies across business units.
The results of the study illustrate the fundamental tension between the need for
contemporary firms to exploit synergies and their need for clear accountability.
An unexpected finding was that a number of firms in the study have evolved an
organizational form that signals a new way of resolving this tension. These firms
are organized around multiple dimensions (e.g., region, product, and account)

and simultaneously hold different managers accountable for performance on

these dimensions. This multidimensional organization form is based on different
principles than the M-form, the most notable of which is that resources and
market opportunities are organized separately, so that unit managers are
deliberately made dependent on each other to achieve their objectives. The
multidimensional organization also differs from the matrix organization. In
particular, it avoids the situation where employees have two bosses. This is made
possible by a different way of organizing information and by a planning and
control process in which the customerrather than any one of the dimensions for
which managers are held accountable (e.g., country or product line)is seen as
the main profit center.

Fjeldstad, D, Snow, C.C, Miles, R.E. and Lettl, C. 2012. The architecture of collaboration.
Firms increasingly face competitive pressures related to rapid and
continuous adaptation to a complex and dynamic and highly
interconnected global environment.
pressing challenges include keeping pace with shorter product life
cycles, incorporating multiple technologies into the design of new
products, co-creating products and services with customers and partners
and leveraging the growth of scientific and technical knowledge in many
sectors.
In response, there are fundamentally new organization designs which are
based on an actor-oriented scheme, which exist of three main
elements.
1) Actors who have the capabilities and values to self-organize
2) Commons where the actors accumulate and share resources
3) Protocols, processes and infrastructures that enable multi-actor
collaboration
In industries where knowledge is complex, growing and widely diffused,
innovation extends beyond the individual firm. To cope with the complexity
of knowledge, many firms use multiparty collaboration, which has been
shown to reduce risk, speed product to market, decrease the cost of
product development and provide access to new markets and
technologies.
traditional organizational forms use hierarchy mechanisms to control
coordination which can constrain collaboration within and across firms.
Architecture: fundamental organization of a system embodied in its
components, their relationships to each other and to the environment, and
the principles guiding its design and evolution.
over time the concept of architecture moved from a focus on design of
specific structures to a focus on principles that foster coherence, growth
and change.
The hierarchical scheme: the dominant scheme used to explain
organization designs.
Hierarchy = a complex system in which each of the subsystems is
subordinated by an authority relation to the system it belongs to.
Hierarchy is used for control and coordination; setting goals and
monitoring the goal fulfillment, allocation of resources, and managing
interdependencies.
Higher level members have the authority to resolve conflicts at
lower levels, because they have a broader view of the organization
Higher level members typically have capabilities related to control
and coordination which supersede (vervangen) those of lower level
members
Higher level units control the goals and actions of subordinate units
(principle-agent relationship)

Lower level interdependencies can be resolved at higher levels by

planning and standardization
Units of organization at the same hierarchical level may also interact
at non-hierarchical ways through formal and informal relations

Simple hierarchy
Functional form: activities are hierarchically controlled, and
interdependencies are managed by forecasting and planning at
higher levels. Strengths are specialization and economies of scale.
Limitations is the ability to accommodate diversity and variability in
the organizations environment.
Divisional form: general motors introduced divisions as an added
layer in the hierarchy that allows for effective adaptation to
differentiated market demand. Benefit is the ability to collect and
process information about customer preferences and requirements
to meet those demands. Thus this form enables exploitation of
economies of scope in the service of differentiated customer
demand. Limitation is constrained resources sharing across divisions.
Matrix forms
Hybrid structure with two or more distinct hierarchies. Market-facing units
draw on different upstream capabilities both in the existing businesses and
in developing and delivering new products and services. Typically
customer facing units have budgets which they use to obtain resources
from the functional dimension of the matrix. The matrix form seeks to
capture both the efficiency and specialization of the functional form and
the customer focus and flexibility of the divisional form.
Multi-firm networks
Firms can chose to focus on their core activities and to outsource noncore
activities to external providers. Result: vertically integrated activities are
performed by multi-firm networks. Benefits are flexibility, the variety of
capabilities that can be assembled and the economies of scale can be
achieved at each activity. Multi-firm networks are hierarchical as they are
organized around a lead firm that works dynamically with network
partners to produce and deliver products and services.
Conclusion; traditional organizational forms vary across three main factors
1. Division of labour: determined by the types of functions needed
2. Number of hierarchical levels: determined by the span of control
3. Number of superiors: reflects variety across functions, product
groups and regions
The actor-oriented scheme
The twenty-first century is marked by globalization of communication,
financial and logistic services, which reduce the costs of interaction and
enables new ways of organization. In addition, there is a need for rapid,
effective responses to opportunities and challenges that put pressure on
hierarchical organizational forms.

this results in calls for collaborative organization designs

An answer could be that hierarchies are made more complex to deal with
the complexity of the environment, but this implies control and
coordination costs. The limitation of hierarchy as coordination and control
mechanism is that it imposes delay on the interaction between
organizational units and partners. And in large organizations it is hard for
upper-level managers to fully understand how resources contained both
inside and outside the firm, should be organized to take advantage of
opportunities and overcome challenges. When uncertainty increases
because of new products, new markets and new technology, there is more
information and the hierarchy will become overloaded.
From hierarchy to actor oriented
New organization designs are emerging in which rich sets of resources are
made available to large sets of actors who self-organize unlimited sets of
projects.
- Common to these designs is that organizational actors are able to
form collaborative relationships and that there is a reliance on selforganization and local decision making.
- The collaborating parties must be able to manage their common
resources and goals.
- Control and coordination are based on direct exchange among the
actors themselves, rather than by hierarchical planning, delegation
and integration.
The nature of decisions about which projects to pursue, which
resources to share, and how returns will be divided is a major
difference between previous organizational forms. The hierarchical
scheme establishes superior-subordinate relationships, and the
actor-oriented schema establishes networks of relationships.
Elements of the scheme
1) Actors who have the capabilities and values to self-organize; control
and coordination are accomplished via direct interaction among
actors themselves.
2) Commons where the actors accumulate and share resources; Actors
who have the knowledge, information, tools and values needed to
set goals, and assess the consequences of potential actions for the
achievement of those goals, can self-organize. Commons refer to
resources that are collectively owned and available to the actors, an
example is shared knowledge.
3) Protocols, processes and infrastructures that enable multi-actor
collaboration; Infrastructures- systems that connect actors allow
actors to connect with one another as well as access the same
information, knowledge and other resources. Self-organizing actors
use protocols to guide their collaboration. Protocols are codes of
conduct (gedragscodes) for example the division of labour.
Together these elements create a function within organizational
contexts consisting of transparency, shared values, norms of
reciprocity, trust and altruism (niet-egoistisch). They enable large

groups of collaborating actors to self-organize with the minimal use of

hierarchical mechanisms.

Study questions:
1. What are the specific strengths and weaknesses of the various organizational forms
discussed in Burns & Stalker (1961), Walker & Lorsch (1968), Galbraith (1971), and
Mintzberg (i.e. his five configurations)?
2. Mintzberg (1979) discusses six basic coordination mechanisms as possible solutions to
the coordination problem. How do these mechanisms compare to the solutions to the
coordination problem in the different organizational forms discussed by Bartlett &
Ghoshal (1993), Strikwerda & Stoelhorst (2009), and Fjeldstad et al. (2012)?
3. The papers show that over time, as the research on organizational structure matured,
researchers have identified new organizational forms (e.g., the multidimensional form
identified by Strikwerda & Stoelhorst, 2009). Do you think that the literature will soon
have identified all organizational forms? Why or why not?

Week 5

Leiblein, M. 2003. The choice of organizational governance form and performance:

Predictions from transaction cost, resource-based, and real options theories.
Purpose of the paper
Provide background material on each theory as well as to indentify the similarities and
differences in the assumption underlying these perspectives.
Similarities in perspectives
- Bounded rationality
- Specific investment
- Uncertainty
Transaction cost Economics (TCE)
The firm is seen as an efficiency-induced administrative instrument that facilitates exchange
between economic actors.
Efficient organization necessitates matching transaction costs which require higher levels of
coordination with organization governance forms which provide the necessary level of
coordination in a cost effective manner.
Transaction costs include
- Writing and negotiating contracts
- Monitoring and enforcing contractual performance
TCE advices to select a governance form that minimizes production and transaction costs
Because of economies of scale and specialization that is available in the market and because
of the administrative and incentive limits to managing economic transactions within a firm the
Theory generally assumes that a simple market contract is more efficient or a lower cost
mechanism to manage economic exchanges than hierarchical organization. But because
contracts are incomplete (caused by bounded rationality) in certain situations the cost of
market exchange increases and surpass it efficiencies.
Primary assumptions
- Bounded rationality: Individuals are limited in their ability to plan for the future and to
accurately predict and plan various contingencies that may arise, no matter how hard they try.
Therefore it is costly in time and resources to acquire and interpret information about the
contracting environment. Bounded rational managers will find it costly (both in time and
resources) to negotiate and write complete contracts that fully describe each partys
responsibilities and rights for all contingencies that could arise during a transaction. Causing
contracts to be incomplete.
- Opportunism: Economic actors are self interested with guile. Not all parties are engaging in
opportunistic behaviour but it is costly to indentify untrustworthy individuals ex-ante.
Because contracts are incomplete according to the first assumption (bounded rationality) there
are circumstances that are not accounted for. Individuals will need to renegotiate the terms of
the contract to include the new situation. Renegotiations give room for a party to take
advantage of the vulnerabilities of ones trading party in hopes of a more favorable
distribution of joint economic profit generated by the exchange.

To avoid such a situation, managers adopt costly mechanisms to monitor and enforce
contractual performance.
Main Theoretical predictions
Opportunistic behavior most likely occurs in economic exchange that involve significant
specialized investment.
- As the level of specialized investment increases, the difference between earning and
opportunity costs are created that may be subject to hold up. Meaning that the party
without(or lower) specific investment can take advantage of the vulnerability of the other
party. This creates costly opportunistic bargaining.
- The (potential) victim of these costs can engage in inefficient positioning tactics. This party
will limit, for instance, its specific investment which will lead to decreased economic value
that will be created in the exchange.
Uncertainty
By increasing the number of contingencies that may affect a market contract, uncertainties
raises the potential for opportunistic behavior as well as the expected costs of writing and
enforcing a complete contract.
Uncertainty also increases when a firm is not allowed/able to measure the contribution of any
individual activity. This increases the need for superior monitoring and administrative control.
Organizational forms are
- Unilateral market contracts
- Intermediate or hybrid forms like alliances
- Hierarchical integrated firms
Asset specificity and organizational form
- Site : co-location of facilities to minimize inventory or production costs
- Physical: Co-specialized assets that are customized for a particular purpose
- Human Assets: Employees development of firm specific skills and knowledge
- Dedicated assets: Additional investments in plant or equipment to sell increased output to
particular customer
- Brand name capital: investment in reputation
- Temporal: investment made to facilitate timely response or coordination of human assets
Market failure is particularly likely in situations where both high investment specificity and
uncertainty are present.
RBV
States that firms may enjoy persistent performance advantages due to relative superiority with
which their resources meet the need of customers.
Gives two primary conceptual insights
- It recognizes that factor markets exist wherein firms may develop or buy resources needed
for product market competition
- Points out that the resources that which lead to persistent performance differences are much
broader in nature and more difficult to accumulate than the tangible resources and factors of
production typically emphasized by Neoclassical theory.
Primary assumptions
- Firms are profit maximizing entities directed by bounded rational managers:

Managers are assumed to lack the knowledge foresight and skill to accurately predict and plan
for all the various contingencies that may arise in their search for profitable opportunities
- Firms must make up front investments for the opportunity to engage in the process of
creating new resources whose eventual value is inherently ambiguous and uncertain. Resource
are heterogeneous (firms posses different bundles of resources)
Resources are immobile (these differences between firms resources bundles persist over time).
Main theoretical implications
- RBV suggests that firms may gain temporary competitive advantage by leveraging
valuable- resources that enable firms to develop and implement strategies that have effect on
customers willingness to pay or reduce the opportunity costs of suppliers.
Rare resources wherefrom demand exceeds supply
Non substitutable- can uniquely be used to help conceive and implement a strategy
- RBV indicates that competitive advantage might be sustainable if there are ex post limits to
competition
- RBV states that for a firm to enjoy economic profit it must generate more value from its
resources than expected at time of their acquisition or development. These are ex-ante limits
to competition which exist through uncertainty or if a firm has unusual insight about the
future value of a resource.
- RBV predicts that firms may generate sustained economic profits by continuously
leveraging valuable rare and costly to imitate resources in ways that their competitors cannot
anticipate.
A firm with a unique and valuable productive capacity will be more likely to internalize those
activities that are complementary to its unique features than firms that lack this capability
Firms are agued to be more effective that other governance forms such as markets at
combining and diffusing knowledge because of their superior coordinative attributes and
information processing abilities.
Firms exist because they are better than markets at creating, recombining and transferring
certain types of knowledge.
Firms are able to transfer knowledge that is difficult to understand, codify a lower cost to
wholly owned subsidiaries than to third parties.

Gilley, K. M. and Rasheed, A. 2000. Making more by doing less: An analysis of

outsourcing and its effects on firm performance
Gilley, Rasheed (2000)
advance understanding of the relationship between org reliance on outsourcing strategies
and firm performance
Quinn (1992) by allowing outside specialist org to concentrate on certain tasks, firms may
increase their performance by focusing more narrowly on things they do best
Bettis, Bradley & Hamdel (1992) outsourcing my reduce org innovation, may shift
knowledge to supplier org and may reduce control over a firms activities. Outsourcing may
destroy long-run CA.
Definitions Outsourcing
(earlier literature)
- the significant contribution by external vendors in the physical and/or human resources
associated with the entire or specific components of the IT infrastructure in the user
organization
- the reliance on external sources for manufacturing components and other value-adding
activities.
(this article)
The fundamental decision to reject the internalization of an activity
May arise in two ways:
1) Substitution of external purchases for internal activities (discontinuation of internal
production and an initiation of procurement from outside suppliers). Reduces a firms
involvement in successive stages of production, substitution based outsourcing may be
viewed as vertical disintegration
2) Abstention. Outsourcing need to be limited to those activites that are shifted to external
suppliers. Abstention based outsourcing is unique from basic procurement, because the former
only occurs when the internalization of the good or ervice outsourced ws within the acquiring
firms managerial and/or financial capabilities. Reflects a decision to reject internalization.
Internalization of the activity in question SHOULD BE AN OPTION otherwise not
outsourcing.
Advantages Outsourcing
- improved financial performance (cost advantages (manufacturing cost decline and
investment in plant and equipment can be reduced) especially in short-run
- nonfinancial performance (heightened focus on core competencies)(organizational
commitment to specific type of technology may constrain flexibility in the long run) (allows
for quick response to changes in the environment in ways that do not increase costs associated
with bureaucracy).
additional: promote competition among outside suppliers, thereby ensuring availability of
higher-quality goods and services in the future. Quality improvements. Spreads risk. No
investment in certain technology.
Disadvantages Outsourcing

- Likely to lead to a loss of overall market performance. Declining innovation by the

outsourcer. Loss of long-run research and development competitiveness (often used as a
substitute for innovation). Lose touch with technological breakthroughs.
- Suppliers gain knowledge of the product being manufactured, they may use that knowledge
to begin marketing the product on their own.
Others:
- cost savings associated with outsourcing may not be as great as they seem. The transaction
cost associated with repeated market-based transactions, especially overseas can be significant
(dollar has to stay stable)
- outsourcing requires a shift in overhead allocation to those products or activities that remain
in-house. Degrades the apparent financial performance of the remaining products or
activities. Raises vulnerability to subsequent outsourcing spiral.
- Longer lead times resulting from spatial dispersion cause several problems (larger
inventories, communication and coordination difficulties, lower demand fulfilment and
unexpected transportation and expediting costs.
Theory development
Two generic types of outsourcing: peripheral outsourcing and core outsourcing.
Peripheral occurs when firms acquire less strategically relevant, peripheral activities from
external suppliers.
Core when firms acquire activities that are considered highly important to long-run success.
Two fundamental properties (Outsourcing Intensity) overall reliance on outsourcing
Breadth the number of activites outsourced as percentage of the total numbers of activities in
which the firm could be engaged
Depth farming-out a higher portion of the value of each outsourced activity. Outsource a
higher portion of that activity on average.
Together determine a firms reliance on outsourcing strategies.
Performance Implications of Outsourcing Intensity
Competency-based view: a firm should continuously invest in those activities that constitute
its core competence while outsourcing the rest.
Resource-based view: Sustained CA is possible only through developing resources and
capabilities that are valuable, rare, imperfectly imitable, and non-substitutable. Inputs that are
trader should be procured from the market, because investments in their creation are unlikely
to lead to any SCA.
- Perhiperal Outsourcing Reducing peripheral activities allows firms to focus on those
activities they do best. May greatly improve the quality of those (outsourced) activites.
Outsourcing to lowest-cost suppliers may lead to incremental improvements in a firms
overall cost position. H1: Positive effect on firm performance (not supported)
- Core Outsourcing Declining innovation and eventual competition from suppliers, resulting
in reduced firm performance. The transfer of specialized knowledge necessary when firms
outsource near-core activites may also place the firms future performance in jeopardy. Firms
outsourcing activities very near their strategic core will achieve lower levels of performance
relative to firms that retain tight control over these activities. H2: Negative effect on firm
performance (not supported)

Moderating Relationships
When certain conditions exist, the positive effects of peripheral outsourcing and the negative
effects of core outsourcing may be increased or reduced.
- Generic Firm Strategy
Peripheral incrementally lower total cost improved cost position; competitiveness;
superior performance. It is proposed that a cost leadership strategy strengthens the
positive effect (or reduces any negative effect) of peripheral outsourcing on firm
performance.
Additionally, pursuing differentiation strategy stand to gain less. The incremental cost
improvements are less significant to differentiators. It is proposed that a differentiation
strategy weakens the positive effect of peripheral outsourcing on firm performance.
H3: A firms business level strategy moderates the relationship between outsourcing
intensity and firm performance such that, for a cost leader any positive effect of
outsourcing on performance is strengthened, and any negative effect is weakened; and,
for a differentiator, any positive effect weakened and any negative effect is strengthened.

- Environmental Dynamism
The effect of outsourcing may increase with increasing levels of environmental dynamism. By
relying on outsiders for peripheral and near-core activites in more dynamic environments,
firms are able to take advantage of emerging technologies without investing large amounts of
capital in them. When new technologies emerge, outsourcing firms may switch suppliers, to
exploit any cost or quality improvements that may then be available.
May decline in stable environments. 1) benefits associated with changes in tech are much less
pronounced 2) more difficult to avoid the transfer of knowledge associated with shifting
activities to external org.
H4: Environmental dynamism moderates the relationship between outsourcing intensity
and firm performance such that any positive effect of outsourcing on firm performance
is strengthened and any negative effect of outsourcing on firm performance is weakened,
as dynamism increases.
Research Method
-

Results
Neither peripheral outsourcing intensity nor core outsourcing intensity was a significant
predictor of any of financial, innovation or stakeholder performance. Hypothese 1 and 2 were
NOT SUPPORTED.
Firm strategy as moderator. Effects of outsourcing are not the same for firms pursuing
different strategies. For cost leaders, there is a positive relationship btween outsourcing and
performance. The benefits of outsourcing are more fully realized by firms pursuing cost

leadership or innovative differentiation strategies. The finding of cost leader is consistent with
H3, whereas the finding for innovative differentiators is the opposite of what was predicted.
Environmental Dynamism as a Moderator. Contrary to H4, it appears that the benefits of
peripheral outsourcing to the firm performance actualy decline in more dynamic
environments. The finding suggest that firms operating in stable environments have more gain
from outsourcing.
Discussion
Highly likely that outsourcing has an ffect on the individual functionl areas in which it occurs.
This study at firm-level.
Dangers associated with outsourcing may not be as large as they appear (no sign effect on
innovation performance).
Stable environments stakeholder performance was positively related to a firms level of
peripheral outsourcing contradictory reason; transaction costs associated with
negotiating, monitoring and enforcing outsourcing arrangements increase in more dynamic
environments. In rapidly changing environments, powerful suppliers with specialized skills
may be albe to exert higher levels of bargaining power over outsourcing firms.
Limitations
- Generalizability limited
- No firms in introduction-stage only one in declining
- Less than 6 percent had unionized employees
- Firm size may be an issue (larger firms outsource more assumption)
- generalization to service firms might be difficult (this were all manufacturers)
- common method bias (independent and dependent construct are measured entirely with selfreported data
- the measure of outsourcing
- fit among firms outsourcing intensities, business-level, strategies and environments

Noteboom. B. 2004. Governance and competence: How can they be combined?

Abstract
Transaction cost economics faces serious problems concerning the way it deals, or fails to
deal, with bounded rationality, the efficiency of outcomes, trust, innovation, learning and the
nature of knowledge. The competence view yields an alternative perspective on the purpose
and boundaries of the firm. However, the competence view cannot ignore issues of
governance and, in spite of serious criticism, transaction cost economics yields some useful
concepts to deal with them. This paper aims to contribute to the development of theory and
empirical research that connects governance and competence perspectives.
Introduction
Can the theory of governance be reconciled, based on transaction cost economics (TCE) and
the resource or competence perspective of the firm?
TCE faces fundamental criticism concerning the way it deals, or fails to deal, with bounded
rationality, the efficiency of outcomes, trust, innovation, learning and the nature of
knowledge. In spite of criticism, TCE still retains some valuable insights that should be
preserved in a new synthesis.
Theoretical issues
2.1 Bounded rationality, foresight and efficiency
Williamson claimed that he fully accepts bounded rationality: there is fundamental
uncertainty concerning future contingencies. However, one can take such uncertainty into
account, infer the hazards that follow from it and conduct governance accordingly (in a
discriminating alignment) and efficiently (in an optimal fashion).
We are not Myopic: "We are not so stupid as to not take uncertainties into account when we
design governance." We can to some extent take uncertainty into account. Firms can spread
risks by participating in different markets for example. To deal with real or radical
uncertainty, we can construct scenarios of possible futures, prepare contingency plans for
them, and identify the robustness of strategies across different scenarios.
TCE makes only limited contact with the subject of learning, we may be mistaken about
hazards and may learn about them as events unfold.
TCE seems to fall back on the notion of selection: inefficient forms of organisation will be
selected out of the market. However, in selection, it is not the best possible but the best
available in the population that survives. For example, in the presence of economies of scale,
inefficient large firms may push out efficient small firms, and thus inefficiency may survive.
2.2 Time
Williamson claims that his theory is inter-temporal, incorporating the passage of time, and he
claims that this is central to TCE. It makes a distinction between ex ante considerations
(before commitment of transaction specific investments) and ex post considerations (after
commitment). However, TCE does not go far enough and is not consistent.
TCE does not assume that everyone is equally opportunistic but that, prior to a transaction,

one can have no reliable information about one's partner's degree of opportunism, and
therefore one has to assume opportunism as a basis for governance, to avoid the hazard
involved.
Williamson does not seem to be aware of the price one pays for opportunism. There is much
evidence in the trust literature that distrust breeds distrust and may even elicit opportunism.
Then the assumption of opportunism may become self-fulfilling, with considerable costs of
contracting and loss of perspective for a fruitful relationship.
Agent based computational economics (ACE), Agents are modeled as adaptive, learning to
revise their assessment of trustworthiness, the weight they attach to it relative to profitability,
and revising their own opportunism. This type of model illustrates that complexity and pathdependence in interactive relations often preclude the achievement of optimal outcomes: those
turn out to be achieved only occasionally.
2.3 Trust and opportunism
Williamson has been ambiguous about trust, trust can be discarded. Scholars accept the
possibility of opportunism but reject Williamson's neglect of trust.
At some level, trust is inevitable. Markets could not work without non-calculative trust.
Complete lack of trust beyond calculative self-interest would prevent one from entering into
any relation.
What is the basis for genuine trust?
*

Trust includes elements of control or deterrence, including both legal coercion and
control by incentives and dependence, as well as elements that go beyond control, as a
basis for 'goodwill' or 'benevolence': if we do not include the latter, we conflate trust
and power. The first (control/deterrence) is part of calculative self-interest, but the
latter (benevolence) is not.

Trust has been defined as the expectation that a partner will not engage in
opportunistic behavior, even in the face of countervailing short-term opportunities and
incentives.

Foundations of trust beyond calculative self-interest. Norms and values concerning

decent behavior, or ethics, which constrain opportunism.

Williamson rejected other foundations of genuine trust, such as loyalty based on

empathy, identification, friendship and reciprocity. However, such socialpsychological phenomena also play a role in business relations.

Basis for trusting behavior also lies in routinisation. When things go well for a while
in a relationship , one tends to take at least some of it for granted. Williamson warns
for trust that becomes blind.

2.4 Dynamic capabilities

There is considerable confusion concerning the similarities and differences between the
notions of 'resource, competence and capability'. For example, is knowledge a resource, a

competence or a capability?
*

A competence is action oriented, and entails an ability and a position to employ

resources.

Resources include not abilities but entities, such as tangible assets, intangible assets
such as knowledge in the sense of 'knowing that' and 'knowing why', or 'declarative
knowledge', and access to finance and to markets of inputs and outputs.

The capabilities of a firm form a wider concept, in the ability to configure

competences and resources, in exploitation.

TCE focuses on static efficiency, we require a perspective of dynamic efficiency or

innovation, incorporating shifts of knowledge, technology and preferences.
Internally firms should concentrate on the activities at which they are best (core competences)
and outsource other activities as much as strategically possible.
Considerations of capabilities are strategically more crucial than transaction costs. Dynamic
capabilities entail that, in addition to the usual considerations of efficiency, flexibility and
speed, learning is an important goal of collaboration.
2.5 Knowledge and learning
TCE has no explicit theory of knowledge and learning. The implicit view is that of naive
realism.
Author proposes a different theory. People observe, interpret and evaluate the world according
to categories or mental frameworks of perception, interpretation and evaluation.
We cannot make independent claims of realism, since we cannot 'climb down from our minds
to see how knowledge is attached to the world'. The variety of views that people have, from
different experiences, yields the only opportunity we have for correcting our errors of
knowledge. Variety of knowledge entails two different dimensions: the number of knowledge
sources involved, and the cognitive distance between each two of them.
In organizations a focus is needed of shared perceptions, interpretations and values, in order
to achieve common goals. This yields the idea of an organization as a sense making system, a
system of shared meaning, a focusing device, or interpretation system. This is a more
fundamental function for organizations than the need to reduce transaction costs. However,
such organizational focus creates risk of myopia. Need for reducing and bridging cognitive
distance.
*

Reducing cognitive distance entails convergence of cognition, in identification.

Bridging cognitive distance entails the ability to understand and communicate with
people who think differently.

Distance in inter-firm collaboration should not be integrated but maintained. where outside
partners remain immersed in outside relations with others.

Husted, B.W., and Folger, R. 2004. Fairness and transaction costs: The contribution of
organizational justice theory to an integrative model of economic organization
This article integrates two fields that have remained largely independent of one another:
organizational justice and transaction costs economics. Transaction costs consist of search,
bargaining, monitoring, enforcement, and other costs not directly related to the production of
goods or services. Rarely are the social-psychological dimensions of these objective features
taken into account. Although economic transactions are human activities, human behavior in
the economics literature is usually reduced to such simplifying assumptions as shirking and
bounded rationality.
This article argues that transaction costs can also derive from the difficulty of evaluating the
fairness of a specific exchange of goods and services. Fairness refers to the perception by a
person that a decision, outcome, or procedure is both balanced and correct.
The difficulty of perceiving fairness depends on two attributes of the exchange: performance
ambiguity and goal incongruence. Performance ambiguity refers to the difficulty of measuring
performance. Goal incongruence is defined as the degree to which parties to an exchange have
incompatible objectives.
The Impact of Governance Mechanismson the Perception of Fairness
Transaction-cost economics fails to take into account the value-expressive effects of
specific governance mechanisms. These value-expressive effects include a willingness by the
other party to honor mutual rights, which signals a concern for dignity and community and
leads to an inference about the others motives as well-intentioned, fair-minded, and
trustworthy.
The lack of accountability of value-expressive effects leads to three problems: transactioncost economics may lead people to use (a) the wrong governance mechanism or (b) the right
mechanism either for the wrong reason or (c) in the wrong way.
Transaction cost economics may lead people to use the wrong governance mechanism
because TCE does not distinguish between cognitive and interest-driven forms of conflict.
Cognitive conflicts relate to disagreements about matters of facts. Conflicts of interest deal
with disagreements about goals or preferred outcomes. These differences in conflict affect the
perception of the fairness of procedures which differ in the amount of process control and
decision control given to disputants.

Process control refers to the extent and nature of a disputants control over the
presentation of evidence

Decision control is the extent and nature of a disputants control over the actual
decisions made

Additionally, according to Strickland (1958) and Kruglanski (1970) surveillance drives out
trust and thus the perception of fairness. Once you start monitoring someone you start to trust
that person less. As long as trust exists, a trustor will perceive fairness in the trustees
behavior even when such a belief may not be justified in terms of current outcomes.

Trust includes the belief that a trustee does not exploit a trustor even when the
opportunity arises. Thus, there is an implicit belief by the trustor that an exchange with
the trustee is fair

Second, transaction cost economics may lead people to use the right governance mechanism
for the wrong reason because TCE purely acts from a transaction cost perspective. However,
if transactors want procedures to adopt trust and the governance mechanism adopted assumes
that all transactors are self-interested, the governance mechanism will only decrease trust.
Third, transaction cost economics may lead people to use the right governance mechanism in
the wrong way, because transaction-cost economics does not count for the details of dynamic
function. Fairness perceptions are potentially unstable (subject to change over time). Hence,
there is a possibility that the perceptions of unfairness may arise after the governance
mechanism has begun to operate.
Thus, the perception of fairness depends not only upon the presence of a given procedure, but
also upon the way the interaction occurs. When communication dynamics are neglected, the
perception of decisions is unfair, even though appropriate procedures are in place. Hence,
proposition 1:
Proposition 1. When transactors perceive that interactional justice (truthfulness, respect,
justifications, and trust) exists, governance mechanisms will have a more positive impact on
the perception of fairness.
The Impact of the Perception of Fairnesson the Creation of Transaction Costs
Search and bargaining activities are ex ante costs related to putting in place governance
mechanisms that insure that exchanges are fair. Monitoring, renegotiation, and enforcement
costs are ex post costs that arise after reaching an agreement and either guarantee the fairness
of continuing exchange until the terms of the contract are successfully fulfilled. Although
transactions may initially be viewed as fair, unforeseen disturbances may arise that require
further bargaining, monitoring, and enforcement costs in order to reassure the parties that the
exchange continues to be fair.
By failing to give attention to the informal aspects of the transaction, the governance
mechanism may unintentionally increase transaction costs by reducing the perception of
fairness in the exchange because the responses to injustice (shirking, breaching, pilfering,
etc.) imply concrete costs. These responses to injustice constitute an additional set of
transaction costs, which we refer to as fairness- response transaction costs. Hence,
proposition 2:
Proposition 2. The greater the perceived unfairness of a governance mechanism, the greater
the transaction costs created by that governance mechanism.
The Relationship Between Transaction Costs and Governance Design
A single-minded focus on ex ante alignment cannot sufficiently foresee and anticipate to all of
the possible conflicts that a transaction may suffer. As a result of the dynamic, nonequilibrium nature of the relationship, the organization cannot accurately calculate all of the

costs associated with each governance mechanism, and thus leads to the implementation of an
inappropriate structure. Hence, proposition 3:
Proposition 3. The greater the ex post transaction costs created by perceived unfairness, the
more likely that the governance mechanism will fail (be misaligned).
One of the implications of this model is that organizations will become involved in positive
feedback loops. Usually implementation is carried out by the same people, after each change
in governance design. The same people will see different changes in governance design
negatively, and as a result, the perception of fairness in the transaction decreases. This
decreased perception of fairness will increase the fairness-response transaction costs of the
governance mechanism. Consequently, it will be necessary to redesign or restructure to reduce
transaction costs. The firm ends up in a positive feed- back loop where it is constantly
restructuring.
Conclusion
TCEs assumption of opportunism may lead to a self-fulfilling prophecy by creating the
conditions of mistrust it assumes. Justice theory asks us to take a more fine-tuned approach by
taking the assumption of opportunism as a variable that may or may not be present in any
given situation. By taking seriously the tendency of most people to incorporate fairness
considerations into their rationality, justice theory complements and supplements the
structural approach to governance design of transaction-cost economics to allow for an
enactment of governance mechanisms that will in fact reduce transaction costs

Mahnke, V. 2001. The process of vertical dis-integration: An evolutionary perspective on

outsourcing
This paper is concerned with the process, context and strategic impact of vertical disintegration letting suppliers take-over activities previously performed in-house. It develops
propositions regarding scope, speed, and switching costs in the process of vertical disintegration based on evolutionary economics.
This paper argues that an evolutionary perspective on firm boundaries with its strong
focus on knowledge, as well as processes of search, learning and capability development is
particularly useful for developing a theory of firm boundaries that is close to managerial
concerns. Building on insights in evolutionary economics, propositions are developed
regarding scope, speed, and switching costs in the process of vertical dis-integration of which
outsourcing is a particular instance.
Outsourcing
While the question of why firms should outsource certain activities is an increasingly relevant
question for business practitioners, it is also a central question in the perhaps dominant
theories of the firm: Modern transaction-cost economics and the resource-based view.

Transaction-cost economics and vertical dis-integration:

Transaction-cost theory has emerged as the most often used theory of vertical
boundary choice. It is premised on the idea that high levels of three transaction
attributes uncertainty, frequency, and especially asset specificity are positively
related to internal procurement of activities.TCE suggests that outsourcing entails
transaction costs including searching, contracting, controlling, and recontracting, and
that supplier markets do entail some risks for buyers with respect to price, quality, and
time. In sum, transaction-cost economics seems to suggest that managers may consider
a shift from internal to external procurement if production cost reductions can be
obtained through outsourcing and hold-up risks are low.
TCE has been criticized because it blackboxes the historical context, the interrelationship among transactions, as well as long-term consequences of boundary
choices

The resource-based view and vertical dis-integration:

The resource-based view suggests that differential firm-performance is related to
differences in a firms costs and strategic advantages obtained through building, using,
and defending resource positions. Factors, which influence how resource positions are
built, used, and maintained, rather than structural industry features alone, determine
how firms increase the wedge between the willingness of customers to pay for
product/service offerings and the opportunity costs of production and supply.
One problem with this approach is that strategic capabilities and resources are
often hard to identify in practice so that at any particular moment in time, managers
face difficulties in judging whether they are dealing with resources and capabilities of
critical strategic need.

Nonetheless, combining resource based and transaction-cost reasoning, Quinn and Hilmer
suggest to simultaneously consider the potential for competitive advantage (resource-based
view) and the degree of strategic vulnerability (transaction-cost economics) in making
decisions on whether to outsource a particular activity. They recommend that managers
answer the following questions:
- What is the potential for obtaining competitive advantage in this activity, taking into
account transaction costs?
- What is the potential vulnerability that could arise from market failure if the activity is
outsourced?
- What can we do to alleviate our vulnerability through structuring arrangements with
suppliers to afford appropriate controls, yet provide for necessary flexibility in
demand?
While these are important questions that may contribute to guiding a firms outsourcing
decision, they do little to help managers understand switching costs during the process of
vertical dis-integration, fail to relate the process of outsourcing to competitive dynamics, and
downplay long-term consequences on maintaining and developing the dynamic capabilities of
the firm.
An Evolutionary Perspective on Vertical Dis-Aggregation
Unlike transaction-cost theory and the resource-based view, evolutionary theory provides the
core of a process theory of economic organization. Although, evolutionary theory has not
focused directly on the question of vertical dis-integration, it yields important insights
relevant to the process of outsourcing. In particular, evolutionary theorists assume three
central elements of evolutionary explanations:
Boundedly rational actors are assumed
The central units of analysis are search processes, problem-solving procedures and
path-dependent learning in organizations
Sensitivity to the contextual embededness of organizational capability maintenance
and development is emphasized
Switching costs during governance change
Even if a company could reliably identify why certain activities should be outsourced, an
evolutionary perspective on governance change suggests that there are at least two process
complications that give cause to switching costs: Governance inseparability and
complementarity of capabilities. The switching costs associated with these problems are
neglected in conventional theories of the firm, but they become obvious in an evolutionary
process perspective.

Governance inseparability: In essence, the authors assert that there are exit barriers on
a governance level because a firms past governance choices significantly influence
the range and types of governance mechanisms that it can adopt in future periods.

Complementary capabilities: Complementarity of capabilities is the technical

corollary of governance inseparability. It is an essential insight in the evolutionary
literature that capabilities develop in a context-dependent and path-dependent manner,
their connection stems from the experience-based learning.

In sum, switching costs exist when there are costs in breaking prior commitment and
separating capabilities through interfaces that are tacit, causally ambiguous, socially complex
or taken for granted.

Specifying interfaces, knowledge articulation, and codification: Thescope of activities

that a firm can outsource at any point in time depends on prior contractual
commitments and the consequences of breaking them, required articulation and
codification of interface specification between activities that are intended to be
transferred from internal to external procurement, as well as the capabilities and
motivation of participants in the process of vertical dis- integration. Additionally,
however, an evolutionary perspective on the process of vertical dis-integration
considers that outsourcing processes take place in a particular, competitive context.

Vertical dis-integration and competitive dynamics

Firms are not isolated entities; they are embedded in exchange and production relations. There
might be external factors within the competitive environment of the firm that limit or facilitate
varying degrees of vertical dis-integration, including the extent of the market, the nature of
innovation regimes, as well as imitation dynamics.

The extent of the market: Whether or not capabilities can be successfully deployed,
however, depends on how easy they can be imitated, protected, challenged by
competitors, or, alternatively supported by complementors. In other words, they
depend on the capability configuration of the competitive and institutional
environment in which the local firm operates; to which it responds; which it may try to
shape, and on which it draws.
Imitation dynamics: Firms engaged in outsourcing face a critical concern: successful
outsourcing often requires putting valuable knowledge-assets at risk. While vertical
dis-integration may help companies to access capabilities that they cannot build in a
reasonable time frame themselves, outsourcing also gives vendors a window to
valuable knowledge that they may leak to other clients, including competitors.
Innovation regime: Outsourcing innovative activities can be complicated to the extent
that one innovative activity depends on simultaneous development of another. While
autonomous innovation can be pursued independently from other innovations, the
benefits of systemic innovation can be realized only in conjunction with related,
complementary innovations. If innovations are of the systemic type in the sense that
simultaneous innovation in a related technology is required, then coordinatedadjustment and information flows between development efforts are required.

Vertical Dis-Aggregation and Dynamic Capabilities

This section argued that vertical dis-integration can contribute to a firms dynamic capability
through focused learning in the outsourcing firm, overcoming competence traps, and by
limiting the risk of experimentation in the exploration of new competence. Outsourcing can
also raise incentives to learn through the re-drawing of implicit contracts, relaxing socialcomparison issues and, by making credible commitments to high-powered incentives. On the
other hand, outsourcing can have a negative impact on dynamic capabilities by undermining
absorptive capacity, hollowing-out current capability endowments, and increasing search costs
in vendor selection.
Conclusions
This paper has argued that an evolutionary-process perspective on firm boundaries with its
strong focus on knowledge, as well as processes of search, learning and capability
development is instrumental in developing a theory of firm boundaries that is close to
managerial concerns. Building on insights in evolutionary economics, refutable propositions
have been developed regarding scope, speed, and switching costs in the process of vertical
dis-integration, of which outsourcing is a particular instance. This paper has argued that the
scope of vertical dis-integration will be lower if firms operate in constrained labour markets;
in technological regimes; with higher degrees of unionization; and when they are engaged in
the development of systemic innovations. These propositions are not obvious in current
theories addressing firm boundaries. Nonetheless, they are of crucial managerial concern.

Langfield-Smith, K., and Smith, D. 2003. Management control systems and trust in
outsourcing relationships
Abstract
Outsourcing is a form of strategic alliance that has increased in popularity over the past
decade. However, there has been limited research that studies the design of management
control systems (MCS) and the role of trust in such inter-firm relationships. This paper draws
on a model by van der Meer-Kooistra and Vosselman [Acc. Organ. Society 25 (2001) 51] to
examine how control mechanisms and trust are used to achieve control in a single case study
of an electricity company and its outsourced IT operations. An analysis of the characteristics
of the transaction, environment and parties, indicated that the control strategy adopted
appeared to be a trust based pattern of control, rather than a market based or bureaucratic
based pattern. Control was achieved through outcome controls and social controls developing
over time, and through the development of trust, particularly goodwill trust. This paper adds
to the growing knowledge of the design of control systems and trust in outsourcing
relationships.
Globalization and competition create difficulties in developing and maintain expertise and
skills necessary to compete successfully. Outsourcing of core and non-core activities is a form
of strategic alliance. But they come of course with high risk since there are different
objectives and potential for opportunistic behavior. Governance structures such as
management control systems (MCS) and development of trust help reduce risk and decrease
failure.
Outsourcing: contracting of any service or activity to a third party
Design of MCS for outsourcing relationships not very prominent. Outsourcing relationships
encompass uncertainty and risk for both parties, are complex and there is a need for flexibility
and adaptation.
Within-firm control systems
Organizational control system consist of formal, explicitly designed controls AND unwritten
informal, social controls that cannot be designed explicitly.
Formal designed controls: distinction between
- outcome controls (that measure and monitor outputs of operations/ suitable when high
output measurability and low task programmability)
and
- behavior controls (that specify and monitor individuals behavior/ suitable when low output
measurability and high task programmability).
Social controls (clan): develop from shared norms, values and beliefs and rely on
internalization of goals/ suitable when both output measurability and task programmability are
low.
Trust and control systems

Some claim that control mechanisms and trust are complementary, others that control systems
are damaging trust.
Trust is developed over time and is essential to strengthen relationships between partners,
allows alliances to flourish and reduces the possibility of opportunistic behavior.
Characterized as an alternative uncertainty absorption mechanism to provide increased
information, which is important in outsourcing relationships.
Three definitions of trust:
-

Contractual trust: based on honesty, assuming the other party will honor the agreement
(whether in writing or not)
Competence trust: based on perceptions of ability and expertise, expecting a
technically competent partner (in usually specified agreements).
Goodwill trust: perceptions of the partners intention to perform in line with the
specified
agreements
(integrity,
responsibility,
dependability)

Transaction Cost Economics (TCE) and Control

TCE: firms choose efficient organizational forms or governance structures based on
transactional issues
Three forms of governance structures:
-

markets (control through free competition)

hybrids (strategic alliances) (control through long-term contracts)
hierarchies (control through authority)

Appropriate structure determined by three aspects of transactions:

-

Frequency of transaction
Uncertainty
Asset specificity: the degree to which an asset can be redeployed to alternative use
without loosing productive value (also: opportunity loss when a relationship is
terminated early)- in high levels it creates dependency between the parties, increases
switching costs, makes governance situations more difficult.
But: social context?
TCE-based models of management control
Spekl introduces two control archetypes for outsourcing relations: hybrid arms-length
control and hybrid exploratory control.
Van der meer-kooistra & Vosselman identified three management control types for
outsourcing relationships:
-

market based pattern: suits transactions with high task programmability, high output
measurability, low asset specificity, and high task repetition. Market prices linked to
the quality of the output (from the outsourcers side). No detailed contracts but
disciplined by the possibility of returning to the market for competing bids.
Transaction environment: low uncertainty, many available suppliers.
bureaucracy based pattern (~hybrid arms-length): suits transactions with high task
programmability, high output measurability, moderate asset specificity and low-

medium repetitiveness. Controls formal and rigid, detailed contracts that monitor
performance. Contracts are specific and long term, trust mainly important in the early
stages. In order for the ousourccer to be selected he must have high levels of
competence and contractual trust. Transaction environment: low uncertainty,
predictable future
trust based pattern (~hybrid exploratory): suits transactions with low levels of task
programmability, low levels of output measurability, high asset specificity and low
repetition. Transaction environment: highly uncertain and risky and so trust becomes
main control mechanism. Initial selection derives from perceptions of competence,
contractual, and goodwill trust (->also overcomes information asymmetry). Control
systems more informal, also as social controls. Since output and activities cannot be
measured trust is necessary to achieve control.
(Hybrid exploratory control similar except asset specificity is moderate instead of
high. Why?: belief that high asset specificity increases potential opportunistic behavior
and information leakage BUT goodwill trust and contractual trust lessens that.)

In sum:
In a market based pattern, there are no explicit control mechanisms and trust is not relevant in
achieving control.
Under a bureaucratic based pattern, outcome controls and behavior controls are the prime
control mechanisms, and trust plays a minor role in achieving control.
Under a trust based pattern, outcome controls and social controls emerge over time, and trust
plays a significant role in achieving control.

1. What are the assumptions of transaction cost theory in its original formulation (TCT)?
What are do Noteboom (2004) and Husted and Folger (2004) criticize in this original
formulation?
2. According to (1) transaction cost theory (TCT), (2) the resource-based
view/competence view, and (3) Mahnkes evolutionary perspective what are the
factors that should be taken into account when choosing the governance form for an
activity? Explain how each of these factors influences the decision to make or buy
according to the theories. Please note that factors are variables in a theory, meaning
that they can be high or low.
3. If a firm has decided to outsource an activity, (1) what are the most important criteria
to choose a firm to outsource to?, (2) what should the outsourcing contract specify?,
(3) how should the outsourcing relationship be managed once the contract is in effect?

Week 6

Montgomery Corporate diversification (1994)

Multiple-line businesses are here to stay and will remain a dominant feature in the economic
landscape.
Why do Firms diversify?
There are three comprehensive perspectives that synthesize a number of individual points:
-

The Market-Power View (positive relationship to firm performance): diversified firms

will thrive at the expense of non-diversified firms not because they are more efficient,
but because they have access to what is termed conglomerate power. There are three
ways in which conglomerates may yield power in an anti-competitive way:

Cross-subsidization: a firm uses its profits from one market to support

predatory pricing activities in another.

Mutual forbearance: competitors meeting each other in multiple markets

recognize their interdependence and compete less vigorously.

Reciprocal buying: the interrelationships among large diversified firms

foreclose markets to smaller competitors.

The Agency View (negative relationship to firm performance): managerial in nature

and is consistent with neither profit maximization nor efficiency. Young and rowing
businesses have plenty of profitable opportunities in which to reinvest earnings, but
mature businesses have opportunities, which become scarce, and managers being to
use cash flows from earlier innovative efforts to pursue increasingly far-flung
opportunities (free cash flow). There are two other reasons why a self-interested
manager might pursue excessive expansion:

A manager might direct a firms diversification in a way that increases the

firms demands for his or her particular skills (managerial entrenchment).

Although shareholders can efficiently diversify their own portfolios, managers

cannot so efficiently diversify their employment risk. Managers may pursue
diversified expansion as a means of reducing total firm risk, which improves
their own personal positions and not benefitting stockholders.

The Resource View: consistent with the efficient use of resources. It focuses on
heterogeneity amongst firms and is a theory of growth, not equilibrium. Rent-seeking
firms diversify in response to excess capacity in productive factors (resources). As
long as expansion provides a way of more profitably employing its underused
resources, a firm has an incentive to expand. But if they can be efficiently sold in the
market, the rationale for diversification evaporates. A firms level of profit and breadth
of diversification are a function of its resource stock. Because firms are different, they
will have different optimal levels of diversification. For a firm with less specific
resources, profits may be maximized at a relatively high level of diversification even
though a firm with more specific resources could obtain absolutely higher profits with
less diversification.

Evidence on Diversification and Firm Performance

Earlier studies found a neutral or negative relationship between diversification and firm
performance. But, narrowly diversified firms, presumable built around more specialized
assets, earn higher levels of profit than do widely diversified firms. Thus, the findings are
inconsistent with the market-power view. The combination of widespread diversification and
a negative average relationship between diversification and performance can be explained in
two ways: (1) the agency view, which suggests that diversification is undertaken for reasons
other than performance maximization and (2) the resource view which suggests that the
average relationship reflects an underlying heterogeneity of firms resources. Firms with more
specific and valuable resources find it optimal to diversify less than firms with less specific
and valuable resources. The more diversified the firm, the lower the productivity of its plants.
What do these Results tell us?
Diversification is not a guaranteed route to success. Firms with higher levels of diversification
are less profitable than firms with lower levels of diversification, acquisitions in themselves
often do not lead to increases in corporate wealth for bidding firms, and many are later
reversed. Firms who diversify around specific resources are more profitable than firms that
diversify more broadly. And managers have an important role. Analyses of acquisitions cannot
evaluate diversification that results from internal development. Firms should stop diversifying
when marginal rents become subnormal, not average rents.
The Direction of Diversified Expansion
In addition to examining the profit implications of diversification, it is also important to
consider the patterns diversification takes, which is related to the firms resources. On the
industry level, Lemelin (1982) found that similarities in distribution and marketing channels
between origin and destination industries were significant predictors of the network of
industries in which a firm would compete, as is R&D intensity and the share of sales going to
the consumer market. At the firm level, results showed rapidly growing firms with extant
resource bases in marketing and R&D were the most likely to pursue diversified expansion.
Existing organizational capabilities (R&D and marketing) often guide diversified expansion.
Summary and Conclusions
The market power view of diversification had tended to emphasize blunt arguments and much
of it failed. The resource and agency views are more promising. Agency arguments help
explain why firms may exceed the efficient level of diversification. The resource view helps
explain the direction of diversified expansion. Firms pursue strategies of diversifying into
related industries.
Whether or not diversification promotes efficiency, is guided by managerial motives and
differs within firms, across firms and across time.

Goold, M. and Luchs, K. 1993. Why diversify? Four decades of management thinking.
In the 1950s, diversifying companies were seen as anti-competitive, for they cross-subsidized
their different businesses to force competitors from the field. In the 1990s, companies were
seen as being uncompetitive, for they add no value to their businesses. What have we learned
about diversification strategies that work and those that dont?
Diversification and Corporate Strategy in the 1950s and 1960s
An important and enduring justification for the diversified company is the argument that
managers of these companies possess general management skills that contribute to the overall
performance of a firm.
General Management Skills. Different businesses required similar managerial skills. Drucker
encouraged managers to study the principles of management and to acquire knowledge and
analyzetheir performance systematically. This continued into the 60s. Professional managers
might be able to use their skills in different businesses. There was widespread respect for
management skills, and business people were encouraged to apply their general management
skills to improve the effectiveness of charities, universities and government. More and more
business school were founded.
Rise of Conglomerates. During the 60s, the growth of conglomerates with numerous
acquisitions of unrelated businesses across different industries provided laboratory
conditions in which the test of general management skills could take place. It was stated that
success of conglomerates was caused by these skills. But, in Britain, it was more about
identifying and buying companies, whose assets were worth more than their stock market
price and less on the application of sound, underlying general management principles by the
top management group. Berg suggested that corporate strategies based on improving the
performance of a diverse collection of businesses would have important implication for the
practice of management and for public policy. Conglomerates seemed to demonstrate that
specialized skills and practices of corporate general managers enabled them to
manage ever greater complexity and diversity.
Conglomerates and Performance Problems.
By the late 60s, conglomerates were encountering performance problems. Stock prices fell
and conglomerate divestitures were needed. Management skills and the corporate objective of
growth were not sufficient to ensure performance in these companies. There was a lot of
profitless growth, and a new approach to the management of diversity was needed.
Diversification and Corporate Strategy in the 1970s
Increasing attention was devoted to the question of the issues on which general managers
should focus their efforts.
The Concept of Strategy. There was a need for senior managers to focus on the strategies of
their companies. It was more than long-range planning or objective setting: it was a way of
deciding the basic direction of the company and preparing it to meet future challenges.
Christensen stated that strategy could simplify the complex task of top managers. It allowed
them to concentrate on the most important issues and simplified management by providing a
framework for decisions. CEOs rapidly accepted this and many firms established formal
planning systems, which got studied by academics. But, this strategy focused on the business
unit and so it was less relevant in order to

define an overall strategy for diversified firms. Andrews then defined the main task of
corporate level strategy as identifying the businesses in which the firm would compete, and
this was known as corporate strategy. But this did not give much practical guidance, and did
not state how resources should be allocated.
Problems with Resource Allocation.
With many divisions competing for funds, how could a company be sure it was investing in
the best projects for future growth? In practice, divisional managers only proposed projects
with acceptable forecast returns, and corporatelevel managers had little basis on which to
choose among projects. Bower then stated that these decisions should be integrally related to a
businesss strategic product and market decisions. So, portfolio planning was introduced by
BCG and this gained wide acceptance.
Portfolio Planning. Managers had a common framework to compare many different
businesses; they could be classified in terms of their strategic position and opportunities.
Managers could set appropriate objectives and resource allocation strategies for different
businesses, determine the overall cash requirements and generation. Portfolio planning
became the basis of corporate strategy.
Problems with Portfolio Management.
While certain businesses appeared to meet all economic requirements of the corporate
portfolio, they did not fit into the corporate family.
Companies made few changes to adapt. Many firms were taking the wrong approach to some
of their businesses. Different types of businesses had to be managed differently, general
management skills thus werent THAT important any more. Portfolio planning did not answer
the question of what contribution the corporation should make to each of its businesses.
Diversification and Corporate Strategy in the 1980s
There was widespread skepticism about the ability of companies to manage and add value to
diverse, conglomerate portfolios.
Cost Cutting at Headquarters.
Attention shifted to cutting headquarters costs. Firms disbanded central functions or turned
central services into profit centers. Line managers in decentralized units
had more authority. The wave of takeovers caused executives to pay increasing attention to
their companys stock price as analysts and raiders identified value gaps: the difference
between current stock market price of a company and its breakup value.
Value-Based Planning.
Executives devoted themselves to the task of creating shareholder value. They
had a new perspective on the link between stock prices and competitive strategy. A companys
stock price is determined by the value of the strategies of its businesses. But to assess this
value in diversified businesses is hard. Value-based planning offered means of evaluation
using a common framework. Business units make strategic choices on the basis of economic
returns, so corporate management have a basis for making decisions on capital allocation. But
this also has limitations, for it does not provide much insight into the kind of corporate
strategies that should be pursued to meet
these criteria. A higher stock price indicates a reward for creating value, but how can
corporations add value to diverse business portfolios?

Stick to the Knitting.

Mintzberg emphasized a need for experience and deep knowledge of a business; businesses
are not mere positions on a portfolio matrix. We need focused organizations
that understand their mission. From the mid-1980s onwards, a goal for many corporations has
been to rationalize their portfolios to overcome the perceived disadvantages of broad
diversification.
Corporate Restructuring.
Restructuring has frequently led to the disposal of corporate assets and has been widely
regarded as a salutary correction to the excesses of broad diversification. It implies a sense of
which businesses a company should retain and which it should divest, but how should core
businesses be selected? Companies should restructure to limit their businesses to one or a few
closely related industries (stick to the knitting). But this does not limit complexity or ensure
companies expand into areas they know. No firm relationship between diversification
strategies and performance has been discovered.
Diversification and Corporate Strategy in the 1990s
Main issues for corporate strategy in the 1990s have emerged as how to identify the
businesses that should form a core portfolio for a corporation, and how to find ways of adding
value to these.
Three main alternative answers to these questions have received support in current
management thinking:
1. Diversification should be limited to those businesses with synergy. Based on
economies of scale. Without synergy, a diversified company is little more than a mutual fund
(Porter). In practice, it is hard to gain benefits from a corporate strategy based on synergy and
the failure rate is high. Much is focused on implementation: what companies have to do to
gain benefits from sharing skills or activities across businesses. Porter aims for horizontal
organization, Bartlett and Ghoshal for a transnational organization. These may capture
synergy. But synergy might not be as important as we think. It remains a powerful concept,
but it is not the one best way to create value. For some, advantages of managing stand-alone
businesses may outweigh the long-term investment required to create linkages among those
businesses.
2. The corporate focus should be on exploiting core competences across different
businesses. A group of businesses is a collecting of competences. Managers must ensure each
part drawn on and contributes to the core competences the corporation is seeking to build and
exploit (Hamel & Prahalad). Divesting may cause the loss of competences. Itami focused on
building invisible assets and Haspeslagh & Jemison support a capabilities-based view of
corporate value creation, defining core capabilities as managerial and technological skills
gained mainly through experience. But core competences may be difficult to identify. Another
risk is that businesses may require similar core competences, but demand different overall
strategies and managerial approaches. Building resources and ensuring they are used to best
advantage is hard. This is not the only way to add value.
3. Successful diversification depends on building a portfolio of businesses which fit
with the managerial dominant logic of top executives and their management style. Dominant
general management logic is defined as the way in which managers conceptualize the
business and make critical resource allocation decisions. When this does not fit the needs of
the business, problems arise.

Goold and Campbell identified different types of strategic management:

Financial Control (distinctive administrative and control systems) Strategic Control
and Strategic Planning.
The Challenge of Diversification
There is no consensus on what sticking to the knitting in practice implies, or on how
companies should be adding value to their remaining core businesses. The search for synergy
and the building of core competences is significant, but dominant logic should be added.
Diversity can only be worthwhile if corporate management adds value in some way and the
test of a corporate strategy must be that the businesses in the portfolio are worth more under
the management of the company in question than they would be under any other ownership. It
may be necessary to restructure portfolios to allow more uniformity in dominant logic and
management style, more effective means of realizing synergies and more sharing of core
competences.

Nippa, M., Pidun, U., & Rubner, H. 2011. Corporate Portfolio Management: Appraising
Four Decades of Academic Research1
Corporate portfolio management comprises key corporate-level strategic decisions,
such as entry into new businesses, allocation of scarce resources to different business units,
and liquidation of value-destroying divisions
The Rise and Fall of CPM in Strategic Management Thinking
Three important paradigms emerged that shaped strategic management thinking for almost
three decades and subsequently fostered corporate diversification activities. First, firm growth
was seen as the most important driver of profitability and success. Second, it was believed
that a corporate economy, or hierarchical coordination, would outperform a market economy.
Mainly due to transaction costs and the supposed inherent advantages of strategic planning
and resource allocation. Third, the development of, and belief in, general management skills
and universal principles of management bolstered the idea that managers educated at leading
business schools were optimally qualified to manage multi business firms efficiently. By the
1980s, however, the pendulum of strategic management thinking started to swing back
toward more focused corporate portfolios. A new dominance of theory-based beliefs in the
superiority of markets (invisible hand) over corporations (visible hand) built on theories of
core competencies or capabilities-oriented corporate strategy.
Does Research on Diversification Eviscerate CPM?
The diversification- performance rationales and empirical evidence can be organized into
three categories: value creation from diversification, value destruction from diversification,
or an inverted U form. First, value-enhancing models propose a consistently positive
relationship between diversification and corporate performance. For instance, Market power
advantages such as cross subsidization; Economies of scale and scope regarding multiple-use
resources; Capital market advantages and more efficient allocation; Corporate diversification
reduces risk, or volatility in rates of return. Second, advocates of value-destroying models
refer predominantly to internal transaction costs and principal-agent reasoning, and argue that
the cost of increasing bureaucracy and subsequent coordination and governance costs exceed
the economic benefits of diversification. Third, authors advocating inverted-U models argue
that there is an optimal level of diversification. On the one hand, some argue that there is a
trade-off between benefits and costs of diversification. Multi-business firms that are engaged
in related markets are able to benefit from synergies or the leverage of resources at reasonable
coordination costs, leading to an increase in profitability compared to focused firms and
limited diversifiers. On the other hand, the more a multi-business firm diversifies in
less-related businesses, the more coordination costs soar and benefits decline, leading to
decreasing profitability.
What Are the Major Causes of Scholarly Criticism of CPM, and How Valid Are They?
The following review of the criticism of CPM instruments makes use of broad categories

that show up in the overall picture: on one hand, scholarly contributions that emphasize
conceptual and methodological deficiencies, and on the other, those that focus on
shortcomings and problems with regard to application, implementation, and outcomes.
To start with the first strain of criticism, some question whether management within multibusiness firms can make reliable decisions based on just two variables - market conditions
and company potential relative to competitors - and a single objective, that is cash flow
balance. Also, critics challenge some fundamental assumptions of the original CPM matrices,
such as the objective of maintaining a balanced portfolio in terms of internal cash flows, the
positive correlation between market share and profitability, and the superiority of investments
in industry growth. Finally, scholars frequently criticized the lack of clear definitions, criteria,
and metrics, particularly with regard to the definition of the relevant markets and SBUs or the
scales and dividing lines of the portfolio matrices. A promising strain of CPM research is
based on a theory of traded and non-traded assets. It emphasizes that internal corporate
diversification is justified only if economically positive interdependencies exist, but even in
this case these synergies bear costs in terms of higher risk. They pointed out that products are
risky assets that are not traded currently but could be traded if their external value exceeded
the internal value potential.
Criticism of traditional CPM instruments highlights problems,
deficiencies, and errors associated with the application of CPM methods resulting from (a)
inadvertent or deliberate misapplication of the instrument, (b) blind implementation of the
prescriptive strategies that follow from the analysis, or (c) the general inferiority of strategic
conclusions from CPM matrices. Three small examples of each point of criticism: First,
managers may choose just those market definitions, boundary lines, and evaluation data that
support their general beliefs or interests, resulting in a more favourable position of the
respective SBU in the grid system. Second, dog businesses are not worthless to the
corporation because they often generate unexpected positive cash flows that can nurture at
least one question mark business. Third, SBUs are classified into a limited number of
categories with specific strategic recommendations based on only few simplistic criteria.
Proposing a Research Agenda for Advancing CPM
First, we need to address criticism of existing CPM instruments, from disagreement about the
relevance of corporate diversification at large as well as from gaps in the existing theory.
Additionally, we need to investigate the application of CPM methods as part of strategic
management processes.
Scholars need to develop more sophisticated CPM methods that integrate important
decision variables (e.g., risk, synergies, locus of control in capital markets) and moderators
(e.g., relatedness of SBUs, industry characteristics, market institutions) to generate greater
insight. Also, there is the need to understand the impact of CPM in different institutional
settings. Future research should focus on two things: (a) developing
instruments that support decision makers in better defining markets, scales, and multiple
mapping to reduce ambiguity and arbitrariness and (b) providing managers with guidelines on
important contingencies that affect the appropriateness and applicability of these measures.
There is a lack of theory development in the CPM literature. Exploring ways to use
real options reasoning in this special field of corporate strategy is an area for further theory
development. Theoretical models of the portfolio problem based on risk and return reasoning
offer a promising starting point for developing concepts that integrate corporate

risk management and corporate strategic planning. However, they have to account for
significant differences between financial and corporate portfolio characteristics. Determining
different forms of balance and respective measures may complement this research field. For
instance, balancing exploration and exploitation.
Misaplication of CPM instruments is a main criticism, but research on its causes is
lacking and outdated. Scholars should investigate how satisfied decision makers are with their
approaches to CPM and what is needed to fill apparent deficiencies and gaps. Also, to
distinguish good CPM practices from less effective ones, future research may compare
the CPM approaches and processes of successful multi-business firms with those of their less
successful peers. Finally, future research should also focus on organizational capabilities and
management skills that are required to effectively implement CPM.
SAMENVATTING2
Corporate portofolio management is at the center of corporate strategy.
Rise and fall of CPM in strategic management thinking
A paradigms emerged that shaped strategic management and fostered corporate diversification
activities:
1. firm growth was seen as the most important driver of profitability and success.
2. A (corporate economy/) hierarchical coordination would outperform a market
economy due to transaction costs and (supposed) advantages of strategic planning and
resource allocation.
3. Belief in universal principles of management that boosted the idea that managers
educated at leading business schools were optimally qualified to manage multibusiness firms efficiently.
However usually diversification occurred in related business domains after th mid-1960s
diversification in weak and non-related conglomerate businesses came into favor. And so,
management of diversified corporations had to formulate and implement efficient corporate
strategies to generate and allocate free cash flow, exploit synergies, identify new growth
opportunities and decide whether to sell low-performing businesses. Name most clearly
attached to this emerging portfolio was D. Henderson (BCG matrix/ market growth and
relative market share basic dimensions).
But in the 1980s strategic management thinking switched back to more focused corporate
portfolios.
Why: dominance of theory-based beliefs in the superiority on markets (invisible hand) over
corporations (visible hand) built on theories of core competencies/capabilities oriented
corporate strategy, and thus lost its economic rationale.
Does research on diversification eviscerate CPM?
Diversification-performance link can be divided in 3 categories: value creation from
diversification, value destruction from diversification, or an inverted U.

Value creation drwas on arguments from market power theory, internal capital market
efficiency reasoning, transactions costs theory, portfolio theory.
Advocates of value destruction refer to internatl transaction costs and principal-agent
reasoning and argue that the cost of increasing bureaucracy and subsequent coordination and
governance costs exceed the economic benefits of diversification.
Advocates of the inverted U models argue that there is an optimal level of diversificationmoderately diversified firms outperform both single-business firms and highly diversified
corporations, since the more a multi-business firm diversifies in less- related businesses, the
more coordination costs.

Empirical evidence:
-

no clear empirical proof of an unconditional economic disadvantage of corporate

diversification
- few studies that support value enhancing models
- inverted-U models have most support in empirical studies and meta-analyses.
What are the major causes of scholarly criticism of CPM and how valid are they?
Firstly, scholars need to recognize which model is being criticized since there are multiple
models. There is no development of criticism they do not build on previous criticism (with a
few exceptions). Finally, there is disagreement among critics with regard to applied methods,
reliability, and generalizability of findings and conclusions.
Criticism of the basic concept and operationalization of CPM matrixes
can management within multi-bussiness firms make reliable decisions based on just two
variables and a single objective (cash flow)?
Oversimplified methods will most likely lead to inferior strategic decisions in addition;
economic value of the market share differs significantly from industry to industry and thus,
firms that make increasing relative market share a strategic priority may neglect other
important drivers of profitability. In addition, the assumption that free cash flow should be

directed from mature or slowly growing marets toward high-growth markets appears to be
unfounded.
Also: lack of clear definitions, criteria and metrics with regard to the definition of the relevant
markets and SBUs or the scales and dividing lines of the portfolio matrices.
However, there is no consistency among critics regarding how to overcome vagueness and
ambiguity and only a few scholars propose a conceptual alternative other than modulating and
sophisticating the basic scheme.
Internal corporate diversification is justified only if economically positive interdependencies
exist but even in this case theses synergies bear costs in terms of higher risk.
Criticism regarding misapplication and outcomes
criticism of traditional CPM instruments highlights problems, deficiencies and errors
associated with the application of CPM methods resulting from:
a. inadvertent or deliberate misapplication of the instrument
b. blind implementation of the prescriptive strategies that follow from the analysis
c. the general inferiority of strategic conclusions from CPM matrices.
Wide scope of their interpretation regarding key elements creates for many opportunities for
pursuing individual interests at the cost of overall corporate objectives.
There is empirical proof that dog businesses are not worthless to the corporation because they
often generate unexpected positive cash flows that can nurture at least one question mark.
Even correct application of CPM matrices may lead to inferior decisions and value destruction
because SBUs are classified into limited number of categories with specific strategic
recommendations based on only few simplistic criteria.
Have scholars systematically investigated actual CPM practices and implementation?
Relative few studies, showed that:
-

firms apply a wide variety of concepts of CPM

portfolio management systems are widely used by dominant vertical and related
diversified firms, whereas conglomerates and single-business firms make little or no
use of CPM
too little growth, too much growth and a lack of strategic thinking motivates managers
to adopt CPM
Defining appropriate SBUs based on clear criteria is a key success factor for efficient
use of CPM
CPM is a valuable concept and/or tool for establishing an accepted framework for
strategic control and for managing the inherent tension of centralization versus
decentralization within multi-business firms
The essence of managing diversity is the creation in each business of a pattern of
influence that corresponds to the nature of the business, its competitive position, and
its strategic mission
Social dynamics (mutual trust) play an important role in the success of CPM
approaches

There is need to actively seek and acquire relevant information based in adequate
organizational structures and sophisticated management processes.
Proposing a research agenda form advancing CPM
Criticizing strategic management tools such as CPM matrices because of oversimplification
requires a clear distinction between instrumental simplification and misleading, logical, or
methodological oversimplification.
Ultimately, oversimplification is more a matter of how managers apply strategic planning
tools than the tools themselves, as these managers have to decide whether additional
information is necessary to substantiate decisions.
Need for the development of more sophisticated CPM methods that integrate important
decision variables and moderators to generate greater insight.
The advancement of concepts such as synergies, parenting advantage, and additional
moderators can add important building blocks.
Most striking gap however is the lack of conceptual approaches, theory-based advancements
and developments of specific theories. Ex. Managing strategic alliances as a portfolio is a
conceptual approach that is promising but unexplored. Thus determining different forms of
balance and respective measures may complement this research field.

Campbell, A. 2005. Going for gold: Wait on amber

Most business leaders and managers collaborate in a quest to discover the new pot of gold that
for the moment is just out of sight, but once discovered, will abundantly reward investors and
stakeholders.
The notion that new business growth is a central strand of the resplendent arc that leads to
success and fortune is embedded in management thinking. In practice, the search for new
sources of growth has proved notoriously difficult. Profitable new businesses, like rainbows,
are elusive. Existing literature suggests that it would be easier if companies embraced more
innovation and less risk-aversion. However, our recent research points to a different
conclusion: rainbows that do indeed lead to the pots of gold are grounded at the start in
caution, rather than hope.
Businesses fail to grow
It is well documented that most attempts to develop new growth fail.
When the core business approaches maturity and investors demand new growth, executives
develop seemingly sensible strategies to generate it. Although they invest aggressively, their
plans fail to create the needed growth fast enough: investors hammer the stock; management
is sacked; and Wall Sreet rewards the new executive
team for simply restoring the status quo ante: a profitable but low growth core business
Reasons for failure different view points:
Kanter3 cites the reason for failure is the fact that different skills are needed to run new
streams of business compared to those required to run the mainstream
Hamel4 considers that the problem lies in the fact that insufficient attention has been paid to
the processes and managerial mindsets needed to maintain a continuous stream of significant
innovations.
Burgelman5 argues that exclusive reliance on top-down strategy is part of the problem. The
real seeds of new
growth are the insights into technology, customer needs and employee capabilities that
operating managers have.
Richard Foster6 argues for more creative destruction: avoid the trap of subordinating the
needs of new projects to the greater status of the existing order, with its culture and politics
that can stifle the more radical solutions promoted by private equity firms.
No significant success stories, therefore set about a research programme that has drawn us to
a different conclusion: managers need to assess opportunities more strategically and be less
activity-driven. The majority of
successful new businesses come from the more traditional route of strategic planning. More
failures result from failures in strategic selection than from failures in entrepreneurial
management.
we have arrived at a new way of thinking about new growth platforms. Its central facet is the
belief that, for any company, there may be a small, possibly even zero, set of opportunities

that will make a significant difference in growth and will fit with its capabilities. We have
devised six rules to help managers. The rules help managers be
cautious in the search for growth opportunities, avoid costly mistakes and yet be ready to
move decisively when a really promising opportunity emerges.
6 rules
*

1. Continue to invest in the core business

If we had put even half the effort into our core businesses that we put into new businesses,
we would have come out ahead.
Unless managements first priority is to maximise the potential from the core, the future
challenge may be survival rather than growth.
*

2. Dont be seduced by sexy markets, but recognise rare games

Rather than focusing on markets that are growing, managers should focus on markets where
they have an advantage and can bring some special resource of competence to the game.
(The exceptions to this advice are where there are dog markets and raregames. Dog
markets exist where there is intense competition and most competitors earn less than their
cost of capital: these should be avoided whether the company has advantages or not. Rare
games exist where new markets open up, with demand
exceeding supply, or where high pricing or outdated processes and habits make it easy for
new, fleet of foot entrants to the market.)
*

3. Look for advantage, but dont play the numbers game

A company should only select opportunities where it has a significant advantage. It is

sometimes difficult to assess the size of that advantage, as competitors may have hidden
advantages. To allow for that fact, and for over-optimism, we recommend that a company
should pursue a project where it can earn 30% better margins than its competitors.
* 4. Be humble about your skills
Dont assume that your existing skill set is sufficient. New markets involve a learning curve
and can involve costly mistakes, such as overspend on marketing and mismanagement of
suppliers. Given such difficulties involved in diversifying, it often pays to look out for
saplings: operating units that already exist within the company that have the potential to be
grown into new legs for the company. They have the advantage of managers in place that have
insight into how to grow the activity, and most of the learning has already been done.
* 5. Search for people as much as potential
The venture capital industry has a saying that there are only three things to think about when
selecting projects
to support: management, management and management. The same applies to new businesses
inside larger companies. Instead of searching for opportunities, companies should search for
entrepreneurial managers who are capable of leading a new business.

* 6. Be realistic about ambitions.

This sixth rule recommends that business opportunities should be reviewed before new
business ambitions are set. Selection rather than action is the key. If we use the analogy that it
is necessary to kiss a lot of frogs before a company discovers a real prince, our strategy relies
on the ability to spot a prince rather than engage in too much energetic kissing of frogs. In our
view, goals audacious and otherwise should be set after a proper screening process.
The New Business Traffic Lights
At ASMC we have developed a screening tool that can be applied to an idea before a business
plan has been developed, alongside a business plan to assess the strategic logic for the
proposal, or to an existing investment that is failing to meet its short-term targets to see if the
strategic logic is still sound. The screen involves four Traffic Lights:
*

1. Does the company have a significant value advantage (green), a small or

uncertain advantage (yellow) or a disadvantage (red) when compared to likely
competitors in this new business?
This involves judgements about the special contribution the company can make, about the
percentage of the contributions that can be turned into values without the risks of entering the
new business and about the likely costs of learning the new business.
*

2. Is the profit pool for this new business average (yellow) a rare game (green),
or a dog (red)?
Judgments about variables, such as Porters Five Forces, were critical to this assessment.
*

3. Does the company have leaders of this new business (and sponsoring managers
in the parent company) who are especially insightful or skilled (green), average
(yellow) or less skilled (red) than likely competitors?
Judgements about the status, drive, business acumen and knowledge of the market,
technology or business model of the likely leaders were critical to this assessment.
*

4. Is the impact of this new business on the existing businesses likely to be

significantly positive (green), small or uncertain (yellow) or significantly negative
(red)?
Judgements about the synergy effects and the likely distraction effects were needed to make
this assessment.
Applying this screen to the portfolio of new business investments in most companies will
result in red lights for many projects. This might result in people regarding us as defeatist or
anti-growth, but our research suggests that it can take five, ten or more years for a company to
develop a significant new growth opportunity that fits.

Chandler, A.D. 1991. The functions of the HQ unit in the multibusiness firm.
Its essentially a paper discussing the role of HQ in multibusiness firms throughout history.
They discuss some examples from the UK, which are not too important, and some from the
US like GE and IBM, which are quite relevant and could be used as examples in the exam.
Apart from that, Im afraid that there are no real insights about diversification etc. in this
paper.
The historical evolution of the multibusiness firm:

In the interwar years in the United States, but rarely before 1950 in Europe, senior
executives rationalized the management of this multimarket growth through the
adoption of some variations of the M-Form with its corporate headquarters and
integrated product or geographical divisions

The M-form came into being when senior managers operating through existing
centralized, functionally departmentalized U-Form structures realized that they had
neither the time nor the necessary information to coordinate and monitor day-to-day
operations, or to devise and implement long-term plans for the several product lines

With the conglomerate, a new form of multibusiness enterprise appeared. It can be

defined as a firm that grew almost wholly by making acquisitions in unrelated
industries.

Implementing the entrepreneurial and administrative functions:

There are three major types of management styles used by senior managers at
corporate HQ: Strategic Planning, Strategic Control and Financial Control

The success of the HQ units adopting those styles to their industries characteristics
determine the effective size and boundaries of their enterprises

Strategic planning category companies are by far the least diversified, operate the
smallest number of businesses, have the highest linkages between divisions and the
highest overlap between business units within divisions

Strategic control companies operate more businesses, have fewer overlaps between the
divisions and on the whole have less synergy between the business units

Financial control companies are the most diversified in the sample

Implementing functions in financial control companies:

The Financial Control companies in Britain grewalmost wholly by

directinternal investment

In these companies the budget is the basic means of control

o It thus is the primary instrument of planning

acquisition,

not by

Current financial performance is the critical measure of achievement

Growth was almost wholly through the buying of new operating units and not through
direct internal investment

Basic function of HQ was then administrative or loss preventive. It was to review the
financial performance of the businesses controlled and to adjust the enterprises
portfolio accordingly (weak sold off, new ones that that met the logic bought)

By the late 1980s companies had learned that growth was limited by the corporate
HQs ability to manage profitably its unrelated operating units

The function of the corporate HQ were primarily administrative or loss preventive

Such controls were effective in service industries and in industries involving relatively
inexpensive production facilities and small R7D expenditures. IN technologically
more complex industries, they had little choice but to concentrate their portfolios in a
small number of groups of related product lines.

Implementing functions in strategic planning and strategic control companies:

The most successful of the conglomerates were those that acquired and managed
companies in industries where financial control alone was sufficient to maintain
profitability

Difference between strategic planning (SP) and strategic control (SC) companies was
that in the first the corporate office played a more decisive role

In SC companies administrative controls were employed much more flexibly than in

those companies using the financial control style or even in those firms relying more
on SC

SC differed from SP companies in that much of the planning developed upon the
divisional HQ

Divisional HQ carried out most of the functions of the corporate HQ in the SP

companies, but under the guidance of corporate office

In defining and implementing strategy, long term gains were sacrificed for short term
ones

IBM:

Since the 60s senior management has been committed to heavy investment in R&D
and to the strategic planning and management development necessary to help assure
long-term payback on that investment

At IBM, the entrepreneurial and the administrative functions have been closely
intertwined and have reinforced one another

GE:

Under Welch they stated to shift away from a SP style to a SC style

He kept the SBUs but greatly reduced their staff

Grouped the business into 3 categories: core, high technology and service

Managers of long established core divisions received little planning or direction from
HQ, and were instead controlled through tight budgets and carefully designed strategic
targets

In the new high tech endeavors, Welch and the HQ continued to play a large role in
strategic planning

New strategy has meant concentration on those products for which production,
distribution and continuing improvement GE has developed impressive organizational
capabilities over time

The management style has moved toward SC

Strategy has become based primarily on the utilization of organizational capabilities

that had been honed over decades

CA lies more in constantly improving products and processes rather than in

developing new products and processes, SC was the most suitable style to carry out
both the entrepreneurial and administrative functions of HQ

DU PONT:

They moved from SC to SP

They were a pioneer in creating the multidivisional form as an answer to management

overload resulting from a strategy of product diversification

The stated objective of the reshaping of the HQ was to break down barriers between
operating division and to have top management develop a corporate rather than a
product or functional perspective

Lesson to learn was that moving into new business based on existing capabilities also
meant that you had to develop complementary ones

They learned that the HQ functions varied with the characteristics of the industries in
which they operated

Bartlett C.A. and Ghoshal, S. 1993. Beyond the M-Form: Towards a managerial theory
of the firm.
Note: maybe a bit too much elaborated on ABB (the firm discussed in the paper), but it gives
a more clear view on differences in the old M-form, compared to the beyond M-form
proposed in this article, in practice. The three processes in the figure at the final page are the
fundamental processes in the new form. Good luck.
Large global corporations are innovating a new organizational form, beyond the
multidivisional form knowledge and expertise, rather than capital or scale as key strategic
resource. Firms had problems with adapting their classic organizational structures and
processes. Article highlights differences from this new form, compared with the old M-form.
Firm (ABB) used as a concrete context for framing a broad new organizational model.
New model will be compared with the old model through three lenses:
1. Chandlers structural description to explicate differences in entrepreneurial process,
compared to the M-form
2. Bowers strategic processes model to highlight the horizontal integration process in
comparison to the M-forms vertical information processing mechanisms
3. Behavioral theory of the firm to explain the importance of macrolevel goal-setting and
learning mechanisms as compliments to the microlevel processes in the m-form that
were the focus of Cyert and Marchs analysis.
Chandlers perspective:
Similarities:
-

The new form stays in line with Chandlers prescription for creating reliable
information and data flows to support the lines of authority formalized information
flow which provides accurate data and helps group executives evaluate performance:
a decentralized organization will only work effectively with a good reporting system
that gives higher level managers the opportunity to react in good time.
Not structured on multiple divisions, but around a business/geographic matrix (article,
page 27 for illustration/example). In this way, ABB can be more globally integrated
while they can also react faster in national environments. This is already deviating
from the standard form, but structure wise, this is still mentioned as a similarity.

Differences:
-

The extent of decentralization of assets and delegation of responsibilities that both

reflect and reinforce a philosophical divergence concerning the locus of
entrepreneurship within the organization philosophical difference
o Radical decentralization (according to ABB). Organized as a federation of
companies, structured as separate and distinct businesses, to the extent
possible, as free-standing legal entities. Hope that employees would lose
false sense of security and belonging to a big organization and that it would
develop the motivation and pride to contribute to their units success.
Only one intermediate level between corporate executives and
managers of the 1300 companies within ABB.

90% of people above the 1300 companies was removed (only 100 left),
staff support really thin.
Also radical redeployment of HR 90% of R&D was allocated to the
1300 companies whose expertise are then linked with those of centers
located in other companies and leveraged broadly across the entire
organization.
Every company responsibility of their own balance sheet

All in line to stimulate entrepreneurial processes first level of the new beyond M-form
model:
-

Front line management creates and pursues opportunities

Middle management reviews, develops and supports initiatives
Top management establishes strategic mission and performance standards

Bowers perspective
Bower describes a process in which the shaping of new strategic inititaitives and the
investment proposals to support them were initied by front-line managers. Middle-level
managers made resource commitments, because projects that reached top management
through the layers were almost never rejected, so practically, middle managers did that. Top
managements controls the structural context the set of organizational forces that influenced
the processes of definition and impetus.
-

In line with ABB top management structured context and developed policies.
Philosophy was described as decentralization under central conditions.
Also front-line managers were the primary developers of new strategic ideas and
investment proposals
Middle managers needed to focus on business planning and resource allocation
Needs expert staff whose primary role is to perform the adversary role in the planning
process

Differences:
However, knowledge is, unlike capital, a resource that is difficult to accumulate at the
corporate level and allocate according to top managements evaluation of strategic need.
Specialized knowledge is far away in the front-line. This needs a powerful horizontal
integration process to ensure that the entire organiation benefits from the specialized resources
and expertise developed in its entrepreneurial units. Therefore, ABB reduced demands placed
on middle managers by the intensive vertical information processing tasks and the complex
politically driven decision making processes that were at the heart of Bowers model.
-

Problem of information asymmetry to system-wide information sharing.

o Within ABB governed by strict rules concerning definition, format and timing
ensures that managers around the company receive the same information at
the same time regardless of their hierarchical level. Reduces pressure on
middle managers and keeps top-management in touch with front-line.

o Informal communication processes reduce middle managers need to close the

information gap
Middle managers have 10 to 20 companies reporting directly to them, so a wide span
of control without sufficient staff support to provide the independent expertise and
adversarial challenge that drove the information screening process in Bowers more
vertical model.
o ABB handles this by building a sophisticated system into its structure of
internal tension that achieves a similar effect. For every key decision managers
must present and defend proposals to meet the often conflicting interest of two
matrix bosses. In this way, planning and resource allocation decisions go
through a filtering and refinement process which would have been done by
staff support in the old, more vertical model.

Compared to the middle managers role in Bower, where they focused mainly on planning and
budgetting, within ABB (and the new M-form) that is more internal benchmarking, best
practice identification and technology transfer, all aimed at linked and leveraging the
companys widely distributed resources and capabilities (knowledge especially).
This is the integration process:
-

Front-line management: managing operational interdependencies and personal

networks
Middle managers: linked skills, knowledge and resources
Top management: developing and nurturing organizational values

This broad portfolio of task forces, teams and committees also have had a broader impact on
the organizational and management processes: they have served to develop management
perspectives and relationships in ways that have helped to prevent isolationism and to break
down parochialism and they have become forums in which managers can negotiate
differences and resolve conflicts that are inherent in the matrix structure. These changes in
management motivations and behaviors and their consequences for the organizations goalsetting and learning processes come intro sharp focus in the behavioural theory of the firm
(Cyert & March)
Cyert & Marchs perspective
Cyert & March formulated a behaviour based theory of the firm that challenged many
economists classic assumptions.
-

Organizations have been seen as coalitions of participants with disparate demands

o Goal formulation based on internal process of bargaining among coalition
members
o Objectives developed through this process were given stability by internal
control mechanisms (standard operating procedures) yet were adaptable to
changes in the external environment and to internal changes in the coalition.

Behavior was driven by four key concepts:

-

Quasi-resolution of conflict

o Goals established on the basis of local rationality, using decision rules based on
satisfying rather than maximizing objectives.
Uncertainty avoidance
Problemistic search
Organizational learning
o Fragmented in approach,
With shifts tending to reflect the expansionist inclinations of subunits
rather than systematic reviews by top management.
o Short-term in focus
So long as the environment of the firm is unstable and unpredictably
unstable, the heart of the theory must be the process of short-run
adaptive reactions
o Incremental in nature
Because many of the rules change slowly, it is possible to construct
models of organizational behaviour that postulate only modest changes
in decision rules.
o Captured in standard procedures, this makes them impediments rather than
facilitators of effective renewal in a highly competitive, global environment.
As a result, the process of incremental learning at the microlevel tends to be
framed by a much more macroprocess in which top management plays a key
role (in line with the connection between front line and top management?)

In contrast to the view that firms solve pressing problems rather than develop longe-range
strategy, focus for ABB managers at all levels is placed on developing clear and shared
strategic objectives Corporate vision.
To ensure implementation of this corporate vision, new structures and processes allow
managers at all levels to transfer broad objectives into specific business and market strategies:
-

Managers at all levels examine implications of vision for their particular areas of
responsibility (more close to the entrepreneurial models that Cyert and March
rejected)
Annually updated business strategies become the basis for annual budget targets,
broken into very specific subgoals that are negotiated and agreed between business,
geographic and company managements instead of rather vague objectives with
disagreement and uncertainty.

More rational macroframework for goal setting and learning, capturing them both in the third
core organizational process: the renewal process
-

Front line management: managing the tension between short-term performance and
long-term ambition
Middle management: creating and maintaining organizational trust
Top management: shaping and embedding corporate purpose

Leadership within the new model:

Behavioral theory premised on the absence of leadership, while ABBs renewal process is
clearly driven by highly effective leaders at the corporate top level. Top management has gone
from being formulators of corporate strategy to shapers of an institutional purpose with which
all employees can identify and to which they can commit. Instead of being the architects of
formal structure, they have come to see themselves as the developers of organizational
processes that can capture individual initiative and create supporting relationships. From
strategy-structure to a more organic model built around purposes process and people (through
leadership).
A different research perspective
An organization is fundamentally a social structure. Even though actions of and within
organizations may be motivated by a variety of economic and other objectives, they emerge
through processes of social interactions that are shaped by the social structure. Status and
roles become concepts serving to connect culturally defined expectations with the patterned
conduct and relationships that make up a social structure. A much less pathological view of
human nature, compared to economic theories (including shirking, opportunism & inertia).
Article states:
This model assumes that companies ensure positive individual characteristics both by
selecting and promoting those whose personal characteristics predispose them toward the
desired norms of behaviour, and by creating an internal context that encourages people to act
in the way they would as a member of a functional family or a disciplined sporting team.
Thus, the entrepreneurial process is built on the assumption that individuals have the capacity
of personal agency and initiative, then creates the selection devices and support mechanisms
to elicit and encourage such behaviour. Similarly, the integration process both assumes and
shapes collaborative behaviour, and the renewal process is designed to capitalize on the
human motivation to learn while creating a context that drives them to do so.
Important models in the article:

Dyer, J.H., Kale, P. and Singh, H. 2004. When to ally and when to acquire
Study questions:
1. What are the main theoretical perspectives that have been used in the research on
diversification and what are their views on (1) the reasons why firms diversify, and (2)
the performance outcomes of diversification?
2. What are the managerial implications of the thinking about, and research on,
diversification (which lessons for managers can you draw from the diversification
literature)?
3. What do you see as the advantages and disadvantages of the following different modes
of organizational growth: (1) organic growth (i.e. growth realized by developing new
activities within a firm), (2) alliances and joint ventures, (3) acquisitions?