Decision Making

Introduction

How can you make decisions?

Average the predictions of many people Meet to deliberate and discuss the decision Use the help of a person who you prefer Use some form of a price system where people who are correct are rewarded Put the question on the internet and see how people respond

The Wisdom of the Crowd

The average of the crowd is often an excellent predictor.
The weight of a horse The amount of money in a jar

It works when people are more likely to be right than wrong.

It does not work when people are more likely to be wrong than right (conventional wisdom is incorrect)
Surveys are good in this regard.

The problem is that there is no penalty for a wrong answer, so there is no sorting in a survey. You can do potentially better.

Committees and Discussion

The idea is to gather information in a group discussion rather than averaging. There are serious problems with this approach:
If people have similar views, group discussion tends to lead to extreme results. Other views are crowded out. People are reluctant to present their view if they believe that it is in the minority. The majority will tend to disregard a minority view as being incorrect so that new information is ignored.

It may therefore be better to ask views individually

There is the Eureka situation where groups are good: when it takes several people to put together a solution (crossword puzzles) the solution is seen immediately when it is suggested

Prediction Markets

Prices play the role of information in markets. You can get better results when people are sorted based on their own judgment of the value of their information
The Iowa experiment Google

These are modeled after market economies and the invisible hand.

Overview

1. Markets as a metaphor for economics of organizational design 2. Centralization v. decentralization 3. Coordination

4. Decision making, hierarchy, & control

5. (next lecture) Job design & decision making 6. (next module) Incentives
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1. Organizational Design of an Economy

Adam Smith
he intends only his own gain, & is led by an invisible hand to promote an end which was no part of his intention By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.

Leontief: central planning (centralization) is efficient

coordination, economies of scale, control

Hayek: market (decentralization) is more efficient

costly to move all info. to central planner; decentralization makes better use of specific knowledge of time & place:
How can fragments of knowledge existing in different minds bring about results which, if they were to be brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess?
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Markets as Information & Incentive Systems

Examples of markets as forms of organization

prediction markets (insurance, financial, etc.)

Market economies have 3 important features:

decentralization makes good use of specific knowledge of time & place prices provide good general knowledge for coordination incentives (through ownership)
motivates good decision making moves decision rights to person with most valuable/ relevant specific knowledge motivates investments in human capital motivates creativity / innovation

Organizational Design of a Firm

Org. design must address the same problems
use of specific knowledge of time & place coordination across decision makers incentives for both innovation & adaptation

Can we design an organization to mimic a market?

even if we cant completely, the intuition is very useful

Note, though, the limits of markets

they are best at aggregating information (e.g., into prices or predictions) when coordination in the sense of coordinated actions is important, organizations tend to be set up
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2. Benefits of Centralization
Economies of scale
physical capital managerial talent brand name & reputation design

Better use of central knowledge

aggregated information & experience of the combined organization

Better coordination
knowledge transfer across units consistency / standardization synchronization control common strategy
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Benefits of Decentralization

Better use of specific knowledge dispersed throughout the organization

Prevents senior management from being overwhelmed Training/ development & intrinsic motivation for lower level managers Less bureaucratic/ more manageable scale

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Specific Knowledge
Cost of Transferring Knowledge Costly Specific Knowledge Cheap General Knowledge

Attributes of knowledge / information that make it more specific

costly to transfer
perishable complex

costly to understand
requiring scientific or specialized technical skills subjective or experiential

unreliable / risky to use

noisy (garbling)

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3. Coordination & Structure

The classical approach: centralized hierarchy Decentralization implies that coordination must happen at lower levels of the organization
roughly speaking, 2 kinds of coordination problems: simple & integration

Simple coordination: getting units to act in concert

real-time communication not needed, as long as actions of all units are compatible use incentives, communication, job rotation, culture
e.g., UPS;

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Modularization
Putting people with the most interdependent jobs together amounts to modularizing overall structure
ex: break XP Consulting into smaller divisions
regional? (NA; Europe; Asia) type of customer? (Corporate; Government; Not-for-profit; etc.) practice area? (Strategy; IT; 6s)

You can structure authority w/ some decisions organized by one set of divisions, others a different set
ex: decisions about hiring & compensation determined by region; decisions about training & promotion determined by practice area

Note how complex it starts to get there are clear advantages to reducing overlapping lines of authority
hypothesis: the largest source of dis-economies of scale is bureaucracy (coordination costs)
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Integration
Integration: for some decisions, pockets of specific knowledge throughout org. need to be combined
ex: Apple Computer laptop product design use lateral mechanisms
teams, matrix informal networks e.g., product design
CEO Engineering Sales Production Other

B A

A B B A

the most cumbersome organizational designs tend to involve integration problems

Or, balance the 2 goals of coordination & use of specific knowledge

separate decision management & control (below)

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4. Decision Making, Hierarchy, & Control

Think of decision making as a 4-stage process
1. initiatives 2. ratification 3. implementation 4. monitoring
Decision Management

Decision Control (Hierarchy)

Different stages can be more centralized or decentralized

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Notes on Decision Mgt. v. Control

It often makes sense to separate decision management from decision control
if decision maker has weak incentives
Board v. CEO

can provide benefits of decentralization & centralization at the same time

decentralizing decision management centralizing decision control

The distinction is useful in practice

innovation process managing change empowerment
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How Much Decision Control?

Consider 2 firms with 2 employees

Hierarchy
Gladys Gladys Willie

Flat

The units evaluate new ideas differently

Hierarchy: W evaluates new ideas, passes some to G. G approves or rejects those Flat: G&W both different new ideas

Willie

N = # of ideas each can evaluate per period

flat firm evaluates twice as many ideas per period

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Evaluating New Ideas

Assume new ideas are binary (good or bad / profitable or unprofitable) At first stage, p = probability of correct decision; p > At second stage (hierarchy only), q = probability of correct decision; q > p

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Hierarchy
Accepts p Good Rejects (1-p) Accepts pq

Rejects p(1-q)
Rejects (1-p)

New Idea
Accepts (1-p)
Bad Rejects p

Accepts

(1-p)(1-q)
Rejects (1-p)q
Rejects p

Willie Evaluates

Gladys Evaluates Willies Recommendations

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Flat
Accepts p
Good Rejects (1-p)

New Idea
Accepts (1-p) Bad Rejects p

Gladys or Willie Evaluates

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Results
Flat Rate For One New Idea Accept Good Idea False Negative False Positive Reject Bad Idea Overall Throughput Accept Good Ideas False Negatives False Positives Reject Bad Ideas p 1-p 1-p p Hierarchy p q 1-p q (1-p)(1-q) 1-(1-p)(1-q)

2N p 2N(1-p) 2N(1-p) 2N p

N pq N(1-p q) N(1-p)(1-q) N[1-(1-p)(1-q)]

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Are Hierarchies Conservative?

Most Rate For One New Idea Accept Good Idea False Negative False Positive Reject Bad Idea Overall Throughput Accept Good Ideas False Negatives False Positives Reject Bad Ideas Flat Hierarchy Flat Hierarchy > > > > Middle Hierarchy Flat Hierarchy Flat

Flat Flat Flat Flat

> > > >

Hierarchy Hierarchy Hierarchy Hierarchy

Flat structures
evaluate ideas more quickly evaluate more ideas for the same # of employees make more changes, good & bad have more successes & failures

What kind of environments favor a more hierarchical or flat structure?

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Other Methods to Increase Control

Resources spent on accuracy (a & b) Skills & emphasis of decision makers
liberal v. conservative evaluator conservative org. likely to recruit / train more carefully

Incentives of decision makers

e.g., downside punishments & upside rewards

Constraints on decisions
e.g., budgets

Culture & process

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Structure and Errors

Hierarchical Reduce false positive and increase false negative Approve fewer projects overall Good where careful consideration is needed. Good with traditional industry; regulated industry. Bad for rapid change Second Opinion - symmetrical upside and downside Flat Reduce fall negative and increase false positive Creative people not attracted to hierarchical firm Good when unprofitable projects are not too costly or when profitable projects are likely to be very profitable
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5. Implementation
So what should XP Consulting consider in its structure? First, Modularize overall structure, possibly in overlapping ways
ex: Cambridge Technology Partners makes the problem more manageable put most interdependent parts together, reducing coordination problems

Second, allocate decisions within each division: ask who / what / where / when / why? to identify key specific knowledge
who has valuable specific knowledge? what kind of knowledge? where in (& out) of the organization? when (is timing relevant)? why is it of economic value?

Third, think about what needs to be made consistent or coordinated across the division or whole organization
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Implementation
The last two give strong guidance on what to decentralize & centralize Fourth, go back & refine the overall structure
try to streamline further to cut bureaucracy look for & address coordination problems integration problems require the most attention, & will create most of your day-to-day headaches

Fifth, design jobs (next lecture)

balance benefits of specialization, standardization against benefits of using specific knowledge, intrinsic motivation

In all of this, balance desires for control v. creativity & adaptation

self organizing systems can be extraordinarily powerful; dont be a control freak!

Sixth, design performance evaluation & incentives to match job design (after Midterm)
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6. Economic Ideas

The knowledge problem of organizational design

specific knowledge coordination types & mechanisms incentives & price mechanisms

Decision making
decentralization v. centralization decision management v. control degrees of decision control / hierarchy, & their effects

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Summary Points
The metaphor of a market highlights the role of economics in organizational design
design is largely about creating & making use of knowledge
by its nature, specific knowledge tends to have more economic value

incentives play a crucial role

approximating ownership performance measures are prices

but market approaches are limited when complex coordination (especially of the integration kind) is needed

The concepts apply to design of an individual job, to a workgroup, to structure of a global conglomerate
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