Managerial Economics and Organizational Architecture Instructors Manual

CHAPTER 1 INTRODUCTION
This chapter introduces the book. It begins with the collapse of Enron Corporation in 2001. This example illustrates how a companys organizational design can affect its profit and likelihood of survival. It points to three critical elements of organizational design, which we refer to as organizational architecture. These elements include the assignment of decision rights, the reward system, and performance evaluation system. The chapter discusses the basics ideas behind economic analysis and how this framework can be used by managers to make better organizational, production, and pricing decisions. The chapter introduces the important concept of economic Darwinism and provides an overview of the book.

CHAPTER OUTLINE MANAGERIAL ECONOMICS AND ORGANIZATIONAL ARCHITECTURE Organizational Architecture Economic Analysis ECONOMIC DARWINISM Survival of the Fittest Economic Darwinism and Benchmarking PURPOSE OF THE BOOK Our Approach to Organizations Overview of the Book CASE STUDY: BARINGS BANK

TEACHING THE CHAPTER We suggest that all students read this short chapter. It summarizes key ideas that will be emphasized throughout the course and provides an overview of the book. The first class for our course occurs before the students have read the chapter. The class is used to summarize the objectives and mechanics of the course and to introduce some key concepts, especially organizational architecture. Primary objectives of this first class are to introduce the course to the students, get them interested and excited about the material, and introduce them to the economic view of organizations. Typically we start with a description of the course and stress that the course will provide students with a powerful framework that they can use for addressing many different types of management problems. We then ask students to consider the following quote:
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The average employee is motivated to do a good job that enhances his/her sense of self-worth. The best way to increase employee output is to show that you trust your employees and empower them. Some students will agree with this quote. Others will bring up incentives and the desire to make money. After this initial discussion, we ask the class whether they always trust auto mechanics, salespeople, stockbrokers, politicians, and shell-game operators. Students do not always trust these people. When asked why, they indicate that these people are likely to be working in their own self interest not yours. We then ask why this general principle should not apply to employees within a firm. If employees are selfinterested, does it always make sense to empower them? After this discussion, we build on the topic by having the students play the voting game. This game is a good ice breaker and is quite useful for subsequent development of the material. The game can be played either individually or by student teams. The game is played as follows: Each individual (or team) is given three 35 index cards. They are asked to write their name (or team number) on the card. The game is played three times. A card is used in each round. Students vote zero or one each round. The votes are recorded on the cards and turned into the instructor. All voting is confidential. The instructor counts the number of zeros and uses the following table for the hypothetical payoffs. The students are given the table prior to play. Note: the number of rows in the table is chosen based on class size. Students are encouraged to act as if the payoffs are real. Number of Zeros in class 0 1 2 3 4 5 6 7 8 9 10

You Vote 0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 $16,000 $18,000 $20,000

You Vote 1 $8,000 $10,000 $12,000 $14,000 $16,000 $18,000 $20,000 $22,000 $24,000 $26,000 $28,000

Individual payoffs increase with the total number of zeros voted by the class. However, individually it is better to vote 1. After each round, the instructor reports the number of individuals who voted zero in the class and the corresponding payoffs for those who voted zero or one. Only aggregate results are reported. Almost always, the payoffs are low because most people vote one. Collectively each individual
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would be better if everyone voted zero (the aggregate payout is maximized). However, it is not in the self interest of individuals to honor a commitment to vote zero. Rather, individuals vote one and hope everyone else votes zero but generally they do not. The students are allowed to discuss the game among themselves after each round. Sometimes they agree that they will all vote zero. However, since the voting is confidential, these agreements virtually always break down. Typically, individuals follow their self interest and vote one. The game ends after the third round. We then discuss the game.

The first question is What does this game indicate about human behavior? A key idea is that people behave in their own self interest. The second question is How could you, as a class, solve this collective action problem? First, the class could solve the problem by changing the nature of the payoffs. For example, all the winnings could be placed in a fund that is split equally among individuals. Second, they could change the decision rights. For example, one individual could be assigned the right to cast all the votes in the class and be rewarded based on total payoffs. Other possibilities exist. All, however, relate to the idea that organizational architecture matters. How you reward and evaluate behavior and how you assign decision rights affects value. The third question is How does the game relate to real organizations? An important idea is that self interest can result in a lack of cooperation and diminished value in organizations. Also important is the idea that the design of the organizational architecture can be used as a managerial tool to affect behavior and value.

The game leads into a natural discussion of the importance of organizational architecture. We then emphasize a key point of the class: Productive architectures link knowledge and decision-making authority and provide the correct incentives for decision makers to take productive actions. This basic idea reflects Hayeks insight into the power of competitive markets. However, it is also a key concept within organizations. The remainder of the class is used to provide a more detailed outline of the course and to give the assignment for the next class. Often we devote a second class to introducing the course. We sometimes use O.M Scott & Sons Company Leveraged Buyout (Harvard Business School Case #9-190148) as an introductory case. While the case is becoming somewhat dated it is still an excellent case for introducing the course and illustrates some timeless principles. We focus the discussion on the motives for the buyout and how it changed the organizational architecture at Scott. We discuss the improvements in performance and get students to make the connection that organizational architecture matters. Usually a number of
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questions about assigning decision rights, optimal board structures, performance evaluation and rewards arise. The intent is not to answer all these questions in the first class. Rather, it is to foreshadow what is to come. An alternative to the Scott Case is to discuss the minicase in the chapter on Barings Bank. This case can be supplemented by assigning the article, Meltdown Barings Bank Collapse, Sunday Times (London), March 5, 1995. We also elaborate on the implications of economic Darwinism. Throughout the course we analyze existing business and organizational patterns. The assumption is that there is a tendency toward organizational efficiency in the marketplace. If so, it is possible to learn from studying existing practice. However, if there is a tendency toward efficiency, is it possible for managers to improve on existing practice? We use a simple example (based on an example developed by E. Lazear) to address these fundamental issues. We use the following slides to present and discuss the example:

Slide 1: Economic Darwinsim Economic Darwinism is the economic counterpart of the biological theory of natural selection: Only those organizations that are relatively most efficient can survive in a competitive marketplace.

Slide 2: Example of Natural Selection 1. As we will see, even if managers choose efficient policies by luck, there will be a tendency toward efficient organization in an industry (in a relative sense).

2. Assumptions a. There is an optimal way to compensate the top managers within the industry. b. New entrants select the optimal compensation scheme with probability = .5. c. Firms fail after the first year if they adopt the wrong scheme. d. New firms enter each year to replace firms that have failed. e. There are 100 firms at any point in time in the industry.

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Slide 3: Example Outcome Year 1 2 3 4 5 6 %Efficient 50.00 75.00 87.50 93.75 96.88 98.44

Slide 4: Implicit Assumptions in Example 1. 2. 3. All firms in the same industry have the same optimal compensation policy. The optimal policy does not change over time. Good managers are just lucky -- not smart. a. Managers do not improve on practices that are relatively efficient. b. They do not learn from observing surviving firms or other types of analysis. Market is quick in punishing suboptimal designs

4.

Note: We use this slide to discuss how variations in these assumptions either complicate or reinforce the example.

Slide 5: Implications 1. Managers can increase the likelihood their firms will survive by understanding organizational theory better. 2. Managers can learn from studying organizational practices of surviving firms. 3. Managers might be able to improve on existing practice. Survival is based on relative efficiency, not absolute efficiency. However, be careful in condemning long-standing practices without careful analysis. 4. Managers must be careful in selecting firms to benchmark. 5. Optimal arrangements can change in dynamic environments. Keep abreast of possible ways to change the architecture and the success rates of firms changing their organizational architectures.

CASE STUDY: BARINGS BANK Francis Baring with his brother John established Barings Bank in London in 1762. Their bank prospered by facilitating international trade. Barings helped finance the British effort in the American Revolutionary War; thereafter, Barings credit reopened
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trade with the United States. In 1803, Barings helped the United States finance the Louisiana Purchase and helped Britain finance its campaigns against Napoleon. The banks influence was such that in 1818 Duc de Richelieu observed, There are six great powers in Europe: England, France, Prussia, Austria, Russia, and Barings Brothers. Barings almost failed in 1890 when loans that it had made in Argentina defaulted. But it survived with the help of a bailout engineered by the Bank of England. The family rebuilt the bank over the following decades. Although it never regained its former preeminence, Barings retained its reputation as a gilt-edged institution run largely by members of the family and owned primarily by a charitable foundation. In the first half of the 1990s, its influence expanded substantially, in part due to its substantial Far East securities business. In late February 1995, Barings board of directors met to review the 1994 results. The bank had a small rise in profitsa quite reasonable result in what had been simply a dreadful year for most of its competitors. One big contributor to those results had been an extremely profitable securities operation in Singapore. But that afternoon, things changed dramatically. The Singapore office trading star, Nick Leeson, unexpectedly walked out of the office and disappeared. As senior management examined the banks records, it became clear that something was seriously amiss. In principle, Leeson engaged in a simple operation: arbitraging security prices between the Osaka Stock Exchange and the Singapore International Monetary Exchange (SIMEX).1 Leeson should have been able to lock in a virtually riskless profit by selling the security on the exchange with the higher price while simultaneously buying an equivalent instrument on the exchange with the lower price. And although price differences are typically small, such arbitrage can produce a substantial profit if done in sufficient volume. In this arbitrage business, although Barings might accumulate large positions on both exchanges, those securities it bought and those it sold should balance. The bank was supposed to face no net exposure to price changes. Yet what management found as they reviewed the banks records was that Leeson had bought securities in both markets. In effect, he had made an enormous bet that the security price would rise. But it had fallen, and now the very solvency of the bank was threatened. It appears that Leeson circumvented the banks internal controls. He had responsibility for both proprietary and customer trading as well as effective control of the settlement of trades within the Singapore office. The Singapore branch was small, and Leeson had effective authority over both trading as well as the branchs back office systems (bookkeeping, clearing, and settlement). He used that power to conceal losses and disguise the true nature of his activitiesand thus he was able to cook the books. For example, he apparently told senior management that a number of his trades were on behalf not of the bank but clients. And the banks internal control systems failed to uncover the deceit. Barings traditionally paid out approximately 50 percent of gross earnings as annual bonuses to managers, senior managers, as well as Leeson, were compensated based on Leesons trading profits.
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The specific securities Leeson traded were futures contracts on the Nikkei 225, the main Japanese stock market index. Part 1: Chapter Overview and Solutions Chapter 1: Page 6

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By early March, the banks aggregate losses totaled $1.4 billion. Leeson was arrested by German police at the Frankfurt Airport. Eventually Leeson was returned to Singapore where he was tried and sentenced to three years in prison. And Barings, Britains oldest merchant bank, had been sold to ING (the large Dutch financial institution) for 1. Thus, Barings owners had lost their entire investment. Analyze how Barings organizational architecture contributed to its failure. The Barings collapse was caused ultimately by a poorly designed organization. For instance, The Wall Street Journal noted: What is emerging from the documents and from interviews with current and former Barings executives is a fatally flawed organization: one that ignored at least several warning signs going back not just weeks and months, but years; one that so wanted to ensure the continuation of profits from Singaporewhich boosted bonusesthat it was reluctant to impose tight controls; one that had a deeply split staff, which ultimately may have contributed to its downfall.2 Three general aspects of the banks organization contributed to the failure: the broad range of authority and responsibilities granted to Leeson, aspects of the firms compensation system, and gaps in the banks systems for evaluating, monitoring, and controlling its employees. First, Leeson had responsibility for both proprietary and customer trading as well as effective control of the settlement of trades within his unit. Granting him such a broad scope of decision-making authority created the opportunity to circumvent the banks internal controls. As the Financial Times observed: In Singapore, Mr. Leeson was in the process of settling transactions as well as initiating them. A watertight line between dealing and operational responsibility, crucial to internal control, was missing.3 In response to the Barings collapse, the SIMEX changed its rules. It required that member firms use different traders for proprietary trading and customer business. It also prohibited the head of trading from taking charge of the settlement process. Second, the banks compensation system encouraged Leeson to speculate while providing senior managers with limited incentives to exercise tighter control over their star trader. Yet a system where managers participate in annual profits but not in lossescan encourage excessive risk taking. This perverse incentive can be most pronounced when a small bet loses and the employee tries to make it up by

M. Branchli, N. Bray, and M. Sesit (1995), Barings PLC Officials May Have Been Aware of Trading Position, The Wall Street Journal (March 6), A1. 3 The Box That Can Never Be Shut. Financial Times (February 28, 1995), 17. Part 1: Chapter Overview and Solutions Chapter 1: Page 7

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doubling the bet. If this second bet also loses, there can be a strong incentive to double up again and go for broke. Third, Leeson compromised the firms performance-evaluation system. He misrepresented his trades as customer trades and hid losses. A better designed and executed monitoring system would have identified these problems long before the solvency of the institution was threatened.

REVIEW QUESTIONS 11: What are the three aspects of organizational architecture? The assignment of decision rights, the reward system, and the performanceevaluation system. 12: Xerox has developed an expert system to assist employees who answer the company service centers 800 number to help callers who have problems with their photocopy machines. The system is designed to lead the employee through a set of questions to diagnose and fix the problem. If the machine operator cannot fix the problem with the assistance of the input from the service center employee, a service representative is dispatched to make a service call. This expert system is designed to evolve more effective prompts as experience accumulates. This will be accomplished by having service representatives call the service center after a service call. The nature of the problem and the actions taken are to be entered into the system. Xerox bases pay for the individuals who answer the 800 number on the number of service calls they handle; it bases compensation for service representatives on the number of service calls they make. What incentives does this create? The individuals who answer the 800 number have the incentives to answer many telephone calls but not to spend time on any given call. Thus, they have incentives to limit the discussion with the customer and to dispatch a service representative even if a longer discussion would address the issue over the phone. The service representatives like this arrangement because they are compensated on the number of service calls they make. Neither the phone representatives nor the service representatives have incentives to take the follow-up activities seriously. The phone people do not want to learn how to serve customers better if it means handling fewer calls. Similarly, the service representatives want to make service calls.

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13:

Briefly describe economic Darwinism. Economic Darwinism is the economic counterpart of natural selection in biology. Competition in the market place weeds out those organizations that are less efficient and fail to adapt to the environment. The result is survival of the fittest.

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The Wall Street Journal 4 reports: Franchisees, who pay fees and royalties in exchange for using franchisers business formats, have become much more militant in recent years about what they see as mistreatment by franchisers. In general, Ms. Kezios is seeking federal and state laws to give franchisees more power in franchise arrangements. Among her goals: creating legally protected exclusive territories for franchisees. How would you expect existing franchisees to react to this proposed regulation? How would you expect a potential new franchisee to react to this proposed regulation? Reducing the likelihood of encroachment by the franchiser benefits the existing franchisees to the extent that it shifts future profits from the franchiser to the franchisee. Thus, existing franchisees are likely to favor the proposed regulation. Potential new franchisees are less likely to favor the proposal. Presumably, they will have to pay a higher price for a new franchise if the franchiser has to grant the franchisee an exclusive territory. The potential franchisee might prefer to have a nonexclusive territory at a lower price. In any case, the franchiser is unlikely to favor the proposal; if it were efficient to convey exclusive territories, the original contract could have been structured that way.

15:

In the process of benchmarking, a colleague of yours notes that Lincoln Electric, a producer of electric arc welders, has much higher productivity than does your company. Unlike your firm, Lincoln has an extensive piece-rate compensation system; much of its employees total compensation is simply the number of units produced times the piece rate for that type unit. Your colleague recommends that your company adopt a piece-rate compensation system to boost productivity. What do you advise?

J.A. Tannenbaum (1995) Activist Fights for the Rights of Franchisees, The Wall Street Journal (May 22). Part 1: Chapter Overview and Solutions Chapter 1: Page 9

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Piece rates are one part of Lincoln Electrics organizational architecture. Piece rates work well for them because they fit well with Lincolns particular economic environment, business strategy, and other elements of the organizational architecture. It might be inappropriate to use Lincoln Electric as a benchmark if the firm is in a different environment or has a different business strategy. (Lincoln Electric will be discussed in more detail in Chapter 16.) 16: In the life insurance industry, we see two major ownership structurescommon stock insurers and mutual insurers. In the common stock companies, the owners its stockholdersare a separate group from its customersthe policyholders. In a mutual, the policyholders are also the owners of the company. It has been argued that mutual insurance companies are dinosaursthey are large, slow, bureaucratic, and inefficient. How would you respond to such an argument? The initial reaction to this argument should be skepticism. Mutual insurance companies have existed for a long time in a competitive environment and thus are likely to have been an efficient form of organization in the past (economic Darwinism). It is possible that the environment has changed in a manner to make this form of organization undesirable. However, before this argument is accepted, it is important to identify these changes and to analyze carefully why mutual insurance companies are unlikely to survive in the changed environment.

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