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Managerial Economics and Organizational Architecture

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Managerial Economics and Organizational Architecture Sixth Edition

JAMES A. BRICKLEY CLIFFORD W. SMITH JEROLD L. ZIMMERMAN

William E. Simon Graduate School of Business Administration

University of Rochester

MANAGERIAL ECONOMICS AND ORGANIZATIONAL ARCHITECTURE, SIXTH EDITION

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Library of Congress Cataloging-in-Publication Data

Brickley, James A. Managerial economics and organizational architecture / James A. Brickley, Clifford

W. Smith, Jerold L. Zimmerman, William E. Simon, Graduate School of Business Administration, University of Rochester.—Sixth edition.

pages cm.—(The McGraw-Hill series in economics) ISBN 978-0-07-352314-9 (alk. paper)

1. Managerial economics. 2. Organizational effectiveness. I. Title. HD30.22.B729 2015 658—dc23

2014043202

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

Dedicated to our children— London, Nic, Alexander, Taylor, Morgan, Daneille, and Amy.

PREFACE The past few decades have witnessed spectacular business failures and scandals. In 2001 and 2002, Enron, WorldCom, Arthur Andersen, as well as other prominent com- panies imploded in dramatic fashion. Internationally, scandals emerged at companies such as Parmalat, Royal Dutch Shell, Samsung, and Royal Ahold. In 2007 and 2008, prominent financial institutions around the world shocked financial markets by reporting staggering losses from subprime mortgages. Société Générale, the large French bank, reported over $7 billion in losses due to potentially fraudulent securities trading by one of its traders. JPMorgan Chase bailed out Bear Stearns, a top-tier in- vestment bank, following their massive subprime losses. Washington Mutual and Lehman Brothers were added to the list of “top business failures of all time.”

Due to these cases and others, executives now face a more skeptical investment community, additional government regulations, and stiffer penalties for misleading public disclosures. A common perception is that bad people caused many of these problems. Others argue that the sheer complexity of today’s world has made it virtu- ally impossible to be a “good” manager. These views have raised the cry for in- creased government regulation, which is argued to be a necessary step in averting fu- ture business problems.

We disagree with this view. We suggest that many business problems result from poorly structured organizational architectures. The blueprints for many of these prominent business scandals were designed into the firms’ “organizational DNA.” This book, in addition to covering traditional managerial economic topics, examines how firms can structure organizations that channel managers’ incentives into actions that create, rather than destroy, firm value. This topic is critical to anyone who works in or seeks to manage organizations—whether for-profit or not-for-profit.

New Demands: Relevant Yet Rigorous Education Thirty years ago, teaching managerial economics to business students was truly a “dis- mal science.” Many students dismissed standard economic tools of marginal analysis, production theory, and market structure as too esoteric to have any real relevance to the business problems they anticipated encountering. Few students expected they would be responsible for their prospective employers’ pricing decisions. Most sought positions in large firms, eventually hoping to manage finance, operations, marketing, or information systems staffs. Traditional managerial economics courses offered few insights that obviously were relevant for such careers. But a new generation of economists began applying traditional economic tools to problems involving corporate governance, merg- ers and acquisitions, incentive conflicts, and executive compensation. Their analysis fo- cused on the internal structure of the firm—not on the firm’s external markets. In this book, we draw heavily from this research and apply it to how organizations can create value through improved organizational design. In addition, we present traditional economic topics—such as demand, supply, markets, and strategy—in a manner that emphasizes their managerial relevance within today’s business environment.

Today’s students must understand more than just how markets work and the prin- ciples of supply and demand. They also must understand how self-interested parties within organizations interact, and how corporate governance mechanisms can control these interactions. Consequently, today’s managerial economics course must cover a broader menu of topics that are now more relevant than ever to aspiring managers facing this post-Enron world. Yet, to best serve our students, offering

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Preface vii

relevant material must not come at the expense of rigor. Students must learn how to think logically about both markets and organizations. The basic tools of economics offer students the skill set necessary for rigorous analysis of business problems they likely will encounter throughout their careers.

Besides the heightened interest in corporate governance, global competition and rapid technological change are prompting firms to undertake major organizational restructurings as well as to produce fundamental industry realignments. Firms now attack problems with focused, cross-functional teams. Many firms are shifting from functional organizational structures (manufacturing, marketing, and distribution) to flatter, more process-oriented organizations organized around product or region. Moreover, this pace of change shows no sign of slowing. Today’s students recognize these issues; they want to develop skills that will make them effective executives and prepare them to manage organizational change.

Business school programs are evolving in response to these changes. Narrow tech- nical expertise within a single functional area—whether operations, accounting, fi- nance, information systems, or marketing—is no longer sufficient. Effective man- agers within this environment require cross-functional skills. To meet these challenges, business schools are becoming more integrated. Problems faced by man- agers are not just finance problems, operations problems, or marketing problems. Rather, most business problems involve facets that cut across traditional functional areas. For that reason, the curriculum must encourage students to apply concepts they have mastered across a variety of courses.

This book provides a multidisciplinary, cross-functional approach to managerial and organizational economics. We believe that this is its critical strength. Our interests span economics, finance, accounting, information systems, and financial in- stitutions; this allows us to draw examples from a number of functional areas to demonstrate the power of this underlying economic framework to analyze a variety of problems managers face regularly.

We have been extremely gratified by the reception afforded the first five editions of Managerial Economics and Organizational Architecture. Adopters report that the earlier editions helped them transform their courses into one of the most popular courses within their curriculum. This book has been adopted in microeconomics, human resources, and strategy courses in addition to courses that focus specifically on organizational economics. The prior editions were founded on powerful economic tools of analysis that examine how managers can design organizations that motivate self-interested individuals to make choices that increase firm value. Our sixth edition continues to focus on the fundamental importance of markets and organizational de- sign. We use the failures of Enron (Chapter 1), Société Générale (Chapter 1), Arthur Andersen (Chapter 22), and Adelphia (Chapter 10) as case studies to illustrate how poorly designed organizational architectures can be catastrophic. Other books provide little coverage of such managerially critical topics as developing effective organiza- tional architectures, including performance-evaluation systems and compensation plans; assigning decision-making authority among employees; and managing transfer- pricing disputes among divisions. Given the increased importance of corporate gover- nance, this omission has been both significant and problematic. Our primary objective in writing this book is to provide current and aspiring managers with a rigorous, sys- tematic, comprehensive framework for addressing such organizational problems. To that end, we have endeavored to write the underlying theoretical concepts in simple, intuitive terms and illustrate them with numerous examples—most drawn from actual company practice.

viii Preface

The Conceptual Framework Although the popular press and existing literature on organizations are replete with jargon—TQM, reengineering, outsourcing, teaming, venturing, empowerment, and cor- porate culture—they fail to provide managers with a systematic, comprehensive frame- work for examining organizational problems. This book uses economic analysis to develop such a framework and then employs that framework to organize and integrate the important organizational problems, thereby making the topics more accessible.

Throughout the text, readers will gain an understanding of the basic tools of eco- nomics and how to apply them to solve important business problems. While the book covers the standard managerial economics problems of pricing and production, it pays special attention to organizational issues. In particular, the book will help read- ers understand:

• How the business environment (technology, regulation, and competition in input and output markets) drives the firm’s choice of strategy.

• How strategy and the business environment affect the firm’s choice of organi- zational design—what we call organizational architecture.

• How the firm’s organizational architecture is like its DNA; it plays a key role in determining a firm’s ultimate success or failure, since it affects how people in the organization will behave in terms of creating or destroying firm value.

• How corporate policies such as strategy, financing, accounting, marketing, in- formation systems, operations, compensation, and human resources are inter- related and thus why it is critically important that they be coordinated.

• How the three key features of organizational architecture—the assignment of decision-making authority, the reward system, and the performance-evaluation

system—can be structured to help managers to achieve their desired results.

These three components of or- ganizational architecture are like three legs of the accompanying stool. Firms must coordinate each leg with the other two so that the stool remains functional. More- over, each firm’s architecture must match its strategy; a balanced stool in the wrong setting is dysfunc- tional: Although milking stools are quite productive in a barn, tavern owners purchase taller stools.

Reasons for Adopting Our Approach This book focuses on topics that we believe are most relevant to managers. For in- stance, it provides an in-depth treatment of traditional microeconomic topics (demand, supply, pricing, and game theory) in addition to corporate governance topics (assign- ing decision-making authority, centralization versus decentralization, measuring and

The components of organizational architecture are like three legs of a stool. It is important that all three legs be designed so that the stool is balanced. Changing one leg without the careful consideration of the other two is typically a mistake.

Performance Evaluation (What are the key performance measures

used to evaluate managers and employees?)

Rewards (How are people rewarded for meeting performance goals?)

Decision-Rights Assignment (Who gets to make what decisions?)

Preface ix

rewarding performance, outsourcing, and transfer pricing). We believe these topics are more valuable to prospective managers than topics typically covered in economics texts such as public-policy aspects of minimum-wage legislation, antitrust policy, and income redistribution. A number of other important features differentiate this book from others currently available, such as:

• Our book provides a comprehensive, cross-functional framework for analyzing organizational problems. We do this by first describing and integrating important research findings published across several functional areas, then demonstrating how to apply the framework to specific organizational problems.

• This text integrates the topics of strategy and organizational architecture. Students learn how elements of the business environment (technology, compe- tition, and regulation) drive the firm’s choice of strategy as well as the interaction of strategy choice and organizational architecture.

• Reviewers, instructors, and students found the prior editions accessible and engaging. The text uses intuitive descriptions and simple examples; more technical material is provided in appendices for those who wish to pursue it.

• Numerous examples drawn from the business press and our experiences illus- trate the theoretical concepts. For example, the effect of the 9/11 terrorist attacks on demand curves is described in Chapter 4 and how one devastated company located in the World Trade Center responded is discussed in Chapter 14. These illustrations, many highlighted in boxes, reinforce the underlying principles and help the reader visualize the application of more abstract ideas. Each chapter begins with a specific case history that is used throughout the chapter to unify the material and aid the reader in recalling and applying the main constructs.

• Nontraditional economics topics dealing with strategy, outsourcing, leader- ship, organizational form, corporate ethics, and the implementation of man- agement innovations are examined. Business school curricula often are criti- cized for being slow in covering topics of current interest to business, such as corporate governance. The last six chapters examine recent management trends and demonstrate how the book’s framework can be used to analyze and understand topical issues.

• Problems, both within and at the end of chapter, are drawn from real organiza- tional experience—from the business press as well as our contact with execu- tive MBA students and consulting engagements. We have structured exercises that provide readers with a broad array of opportunities to apply the framework to problems like ones they will encounter as managers.

Organization of the Book • Part 1: Basic Concepts lays the groundwork for the book. Chapter 2 summa-

rizes the economic view of behavior, stressing its management implications. Chapter 3 presents an overview of markets, provides a rationale for the exis- tence of organizations, and stresses the critical role of the distribution of knowledge within the organization.

• Part 2: Managerial Economics applies the basic tools of economic theory to the firm. Chapters 4 through 7 cover the traditional managerial-economics top- ics of demand, production and cost, market structure, and pricing. These four chapters provide the reader with a fundamental set of microeconomic tools and

use these tools to analyze basic operational policies such as input, output, and product pricing decisions. Chapters 8 and 9 focus on corporate strategy—the former on creating and capturing values and the latter on employing game the- ory methods to examine the interaction between the firm and its competitors, suppliers, as well as other parties. These chapters also provide important background material for the subsequent chapters on organizations: A robust understanding of the market environment is important for making sound orga- nizational decisions. Chapter 10 examines conflicts of interest that exist within firms and how contracts can be structured to reduce or control these conflicts.

• Part 3: Designing Organizational Architecture develops the core frame- work of the book. Chapter 11 provides a basic overview of the organiza- tional-design problem. Chapters 12 and 13 focus on two aspects of the as- signment of decision rights within the firm—the level of decentralization chosen for various decisions followed by the bundling of various tasks into jobs and then jobs into subunits. Chapters 14 and 15 examine compensation policy. First we focus on the level of compensation necessary to attract and retain an appropriate group of employees. We then discuss the composition of the compensation package, examining how the mix of salary, fringe ben- efits, and incentive compensation affects the value of the firm. In Chapters 16 and 17, we analyze individual and divisional performance evaluation. Part 3 concludes with a capstone case on Arthur Andersen.

• Part 4: Applications of Organizational Architecture uses the framework that we have developed to provide insights into contemporary management is- sues. Chapters 18 through 23 discuss the legal form of organization, outsourc- ing, leadership, regulation, ethics, and management innovations.

Fitting the Text into the Business Curriculum Our book is an effective tool for a variety of classes at the MBA, executive MBA, and undergraduate level. Although this text grew out of an MBA elective course in the eco- nomics of organizations at the University of Rochester, the book’s modular design al- lows its use in a variety of courses. We have been encouraged by the creativity instruc- tors have shown in the diversity of courses adopting this text. Besides the introductory microeconomics course, this book also is used in elective courses on corporate gover- nance, strategy, the economics of organizations, and human resources management. The basic material on managerial economics is presented in the first 10 chapters. The tools necessary for understanding and applying the organizational framework we de- velop within this text have been selected for their managerial relevance. In our experi- ence, these economics tools are invaluable for those students with extensive work experience, and for those who didn’t major in economics as an undergraduate. Those with an economics background may choose to forgo components of this material. We have structured our discussions of demand, production/cost, market structure, pricing, and strategy to be optional. Thus, readers who do not require a review of these tools can skip Chapters 4 through 9 without loss of continuity.

We strongly recommend that all readers cover Chapters 1 through 3 and 10; these chapters introduce the underlying tools and framework for the text. Chapters 4 through 9, as we noted above, cover the basic managerial-economics topics of demand, costs, production, market structure, pricing, and strategy. Chapters 11 through 17 develop the organizational architecture framework; we recommend that these be covered in

x Preface

sequence. Finally, Chapters 18 through 23 cover special managerial topics: outsourc- ing, leadership, regulation, ethics, and the process of management innovation and man- aging organizational change. They are capstone chapters—chapters that apply and il- lustrate the framework. Instructors can assign them based on their specific interests and available time.

Sixth Edition This book is noted for using economics to analyze real-world management problems. The sixth edition maintains and extends this focus. Changes from the fifth edition include:

• Learning objectives have been added to focus on the core concepts of the chap- ter to aid in the assessment of learning outcomes.

• Extended and more in-depth coverage of important managerial economics concepts, including supply and demand analysis, comparative advantage, con- stant versus increasing cost industries, price competition with differentiated products, inter-temporal decisions (Fisher Separation Theorem) and behav- ioral economics.

• Managerial applications, examples, exhibits, and other boxed materials have been updated.

• Key managerial insights from important recent research in organizational economics have been added.

• Data has been updated, where appropriate.

• We have responded in various ways to reader feedback from earlier editions.

Supplements The following ancillaries are available for quick download and convenient access via the Instructor Library material available through McGraw-Hill Connect®.

• PowerPoint Presentations: Fully updated for the sixth edition, each chapter’s PowerPoint slides are closely tied to the book material and are enhanced by animated graphs. You can edit, print, or rearrange the slides to fit the needs of your course.

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• Computerized Test Bank: McGraw-Hill’s EZ Test is a flexible and easy-to- use electronic resting program that allows you to create tests from book- specific items. It accommodates a wide range of question types and you can add your own questions. Multiple versions of the test can be created and any test can be exported for use with course management systems. EZ Test Online gives you a place to administer your EZ Test-created exams and quizzes online. Addition- ally, you can access the test bank through McGraw-Hill Connect®.

• Instructor’s Manual: The instructor’s Manual provides chapter overviews, teaching tips, and suggested answers to the end-of-chapter Self-Evaluation Problems and Review Questions.

Preface xi

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xii Preface

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xiv

ACKNOWLEDGMENTS No textbook springs from virgin soil. This book has its intellectual roots firmly planted in the work of dozens who have toiled to develop, test, and apply organiza- tion theory. As we detailed in the preface to the first edition, the genesis of this book was a course William Meckling and Michael Jensen taught on the economics of or- ganizations at the University of Rochester in the 1970s. Bill’s and Mike’s research and teaching stimulated our interest in the economics of organizations, prompted much of our research focused on organizational issues, and had a profound effect on this text. No amount of citation or acknowledgments can adequately reflect the encouragement and stimulation that they provided, both personally and through their writings.

Bill and Mike emphasized three critical features of organizational design: (1) the assignment of decision rights within the organization, (2) the reward system, and (3) the performance-evaluation system. These three elements, which we call organi- zational architecture, serve as an important organizing device for this book. As read- ers will discover, this structure offers a rich body of knowledge useful for managerial decision making.

Important contributions to the literature on the economics of organizations have been made by a host of scholars. Through the work of these individuals, we have learned a tremendous amount. A number of our colleagues at Rochester also con- tributed to the development of the book. Ray Ball, Rajiv Dewan, Shane Heitzman, Scott Keating, Stacey Kole, Andy Leone, Glenn MacDonald, Larry Matteson, David Mayers, Kevin Murphy, Michael Raith, Mike Ryall, Greg Schaffer, Ronald Schmidt, Larry Van Horn, Karen Van Nuys, Ross Watts, Gerald Wedig, Michael Weisbach, and Ron Yeaple offered thoughtful comments and suggestions that helped to clarify our thinking on key issues. Don Chew, editor of the Journal of Applied Corporate Fi- nance, provided invaluable assistance in publishing a series of articles based on the book; his assistance in writing these articles improved the exposition of this book enormously. Our collaboration with Janice Willett on Designing Organizations to Create Value: From Strategy to Structure (McGraw-Hill, 2003) enriched our under- standing and exposition of many important topics.

This project also has benefited from an extensive development effort. In addition to generations of Simon School students, dozens of colleagues both in the United States and overseas formally reviewed the manuscript and gave us detailed feedback, for which we are very grateful. We offer our sincere thanks to following reviewers, for their thorough and thoughtful suggestions:

Avner Ben-Ner, University of Minnesota Arnab Biswas, University of West Florida Ben Campbell, The Ohio State University Xiujian Chen, Binghampton University Kwang Soo Cheong, John Hopkins University Abbas Grammy, California State University—Bakersfield Charles Gray, University of Saint Thomas Folke Kafka, University of Pittsburgh Brian Kench, University of Tampa Tom Lee, California State University—Northridge Matthew Metzgar, University of North Carolina Ronald Necoechea, Roberts Wesleyan College Harlan Platt, Northeastern University

Acknowledgments xv

Farhad Rassekh, University of Hartford Amit Sen, Xavier University Richard Smith, University of California—Riverside Neil Younkin, Saint Xavier University

We owe special thanks to Henry Butler, Luke Froeb, Mel Gray, and Chris James; each provided insightful comments on the material. In addition, we are grateful for feedback from over 500 individuals who completed various surveys. Their thoughts served to guide our refinement of this work. We appreciate the efforts of Kathleen DeFazio who provided secretarial support. Finally, we wish to thank our colleagues at McGraw-Hill/Irwin—especially Mike Junior—for their encouragement to pursue this project. Through their vision and publishing expertise, they provided us with insights and feedback to help expand our audience while adhering to our mission.

This book represents the current state of the art. Nonetheless, development is on- going as the research evolves and as we continue to learn. Managerial Economics and Organizational Architecture covers an exciting, dynamic area. We hope that a small portion of that excitement is communicated through this text. Reviewers, instructors, and students frequently mention the relevance of material to the business community, the accessibility of the text, and the logical flow within the text’s framework. However, in the final analysis, it is instructors and their students who will determine the true value of our efforts.

We appreciate the extensive feedback we have received from many readers; their generous comments have improved this edition substantially. Although we had a def- inite objective in mind as we wrote this book, it is important to be open to sugges- tions and willing to learn from others who are traveling a similar yet distinct path. Al- though we are unlikely to please everyone, we will continue to evaluate suggestions critically and to be responsive where consistent with our mission. If readers would like to share their thoughts on this work or their classroom experiences, please feel free to contact any of us at the University of Rochester. Many thanks in advance for the assistance.

jim.brickley@simon.rochester.edu cliff.smith@simon.rochester.edu

jerry.zimmerman@simon.rochester.edu

xvi

Contents in Brief

Part 1: Basic Concepts

Chapter 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Chapter 2 Economists’ View of Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Chapter 3 Exchange and Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

Part 2: Managerial Economics

Chapter 4 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Chapter 5 Production and Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Chapter 6 Market Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Chapter 7 Pricing with Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223 Chapter 8 Economics of Strategy: Creating and Capturing Value . . . . . . . . . . 257 Chapter 9 Economics of Strategy: Game Theory . . . . . . . . . . . . . . . . . . . . . . . 296 Chapter 10 Incentive Conflicts and Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 329

Part 3: Designing Organizational Architecture

Chapter 11 Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355 Chapter 12 Decision Rights: The Level of Empowerment . . . . . . . . . . . . . . . . . 376 Chapter 13 Decision Rights: Bundling Tasks into Jobs and Subunits . . . . . . . . 410 Chapter 14 Attracting and Retaining Qualified Employees . . . . . . . . . . . . . . . . 438 Chapter 15 Incentive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469 Chapter 16 Individual Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 502 Chapter 17 Divisional Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 537

Capstone Case Study on Organizational Architecture: Arthur Andersen LLP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571

Part 4: Applications of Organizational Architecture

Chapter 18 Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578 Chapter 19 Vertical Integration and Outsourcing . . . . . . . . . . . . . . . . . . . . . . . . 615 Chapter 20* Leadership: Motivating Change within Organizations . . . . . . . . . . . 654 Chapter 21 Understanding the Business Environment:

The Economics of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655 Chapter 22 Ethics and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . 684 Chapter 23* Organizational Architecture and the Process

of Management Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 714

Index 715

Glossary* G-1

*These Web chapters and the Glossary can be found online via the Instructor Library material available through McGraw-Hill Connect®.

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Contents

Part 1: Basic Concepts Chapter 1: Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Managerial Economics and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . 3

Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Economic Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

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

Purpose of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Our Approach to Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10

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

Economic Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 Marginal Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Creativity of Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18

Graphical Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Individual Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Indifference Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Opportunities and Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Individual Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Changes in Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Motivating Honesty at Merrill Lynch . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Alternative Models of Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Only-Money-Matters Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Happy-Is-Productive Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Good-Citizen Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Product-of-the-Environment Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Which Model Should Managers Use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Behavioral Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 Decision Making under Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Expected Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Variability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Certainly Equivalent and Risk Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Risk Aversion and Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Appendix A: Consumer Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Appendix B: Inter-Temporal Decisions and the Fisher Separation Theorem . . . . . . 61

xviii Contents

Chapter 3: Exchange and Markets . . . . . . . . . . . . . . . . . . . . . . . . . 66 Goals of Economic Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Property Rights and Exchange in a Market Economy . . . . . . . . . . . . . . . . . . . . . . . 68

Dimensions of Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Gains from Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

Basics of Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 The Price Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 Shifts in Curves versus Movements along Curves . . . . . . . . . . . . . . . . . . . . . .79 Using Supply and Demand Analysis for Qualitative Forecasts . . . . . . . . . . . .79 Linear Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Supply and Demand—Extended Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82 Price versus Quantity Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82 Short-Run versus Long-Run Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .84 Industry Cost Increases and Price Adjustments . . . . . . . . . . . . . . . . . . . . . . . .86

Prices as Social Coordinators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Efficient Exchange and Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .90 Measuring the Gains from Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Government Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 Externalities and the Coase Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

Markets versus Central Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 General versus Specific Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Knowledge Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100 Specific Knowledge and the Economic System . . . . . . . . . . . . . . . . . . . . . . 102 Incentives in Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Contracting Costs and Existence of Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Contracting Costs in Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Contracting Costs within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

Managerial Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Appendix: Shareholder Value and Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . 114

Part 2: Managerial Economics Chapter 4: Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Demand Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

Law of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Elasticity of Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 Linear Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

Other Factors That Influence Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Prices of Related Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Other Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Industry versus Firm Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 Network Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Product Attributes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Product Life Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Demand Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

Interviews . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Price Experimentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142

Statistical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 Appendix: Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154

Chapter 5: Production and Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Production Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

Returns to Scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .158 Returns to a Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .159

Choice of Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162 Production Isoquants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162 Isocost Lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .164 Cost Minimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165 Changes in Input Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .167

Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .168 Cost Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .169 Short Run versus Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .171 Minimum Efficient Scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175 Learning Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .177 Economies of Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .178

Profit Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179 Factor Demand Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .180 Cost Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .184 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .185 Appendix: The Factor-Balance Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .191

Chapter 6: Market Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195 Competitive Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195

Firm Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .195 Competitive Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .198

Barriers to Entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201 Incumbent Reactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .202 Incumbent Advantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .203 Exit Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204

Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204 Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .206 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208

Nash Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .208 Output Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .210 Price Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .212 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .213 Cooperation and the Prisoners’ Dilemma . . . . . . . . . . . . . . . . . . . . . . . . . . . .214

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217

Chapter 7: Pricing with Market Power . . . . . . . . . . . . . . . . . . . . . . 223 Pricing Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .224 Benchmark Case: Single Price per Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .225

Profit Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .225 Estimating the Profit-Maximizing Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . .228 Potential for Higher Profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231

Contents xix

Homogeneous Consumer Demands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .232 Block Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .232 Two-Part Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .233

Price Discrimination—Heterogeneous Consumer Demands . . . . . . . . . . . . . . . . . .234 Exploiting Information about Individual Demands . . . . . . . . . . . . . . . . . . . .236 Using Information about the Distribution of Demands . . . . . . . . . . . . . . . . .239

Bundling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .242 Other Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244

Multiperiod Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .244 Strategic Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .246 Legal Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .247

Implementing a Pricing Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .248 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .250

Chapter 8: Economics of Strategy: Creating and Capturing Value . . . . . . . . . . . . . . . . . . . . .257

Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .258 Value Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .259

Production and Producer Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . .261 Consumer Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .261 Other Ways to Increase Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262 New Products and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265 Cooperating to Increase Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .265 Converting Organizational Knowledge into Value . . . . . . . . . . . . . . . . . . . . .266 Opportunities to Create Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .267

Capturing Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .269 Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .270 Superior Factors of Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .273 A Partial Explanation for Walmart’s Success . . . . . . . . . . . . . . . . . . . . . . . . .278 All Good Things Must End . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280

Economics of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282 Benefits of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .282 Costs of Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .284

Strategy Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Understanding Resources and Capabilities . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Understanding the Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .286 Combining Environmental and Internal Analyses . . . . . . . . . . . . . . . . . . . . .287 Strategy and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . .288 Can All Firms Capture Value? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291

Chapter 9: Economics of Strategy: Game Theory . . . . . . . . . . . . . . 296 Game Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .297 Simultaneous-Move, Nonrepeated Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299

Analyzing the Payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299 Dominant Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .300 Nash Equilibrium Revisited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .301 Competition versus Coordination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303 Mixed Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .306 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .308

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Sequential Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310 First-Mover Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .312 Strategic Moves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .312 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .313

Repeated Strategic Interaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .314 Strategic Interaction and Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . .316 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .318 Appendix: Repeated Interaction and the Teammates’ Dilemma . . . . . . . . . . . . . . .323

Chapter 10: Incentive Conflicts and Contracts . . . . . . . . . . . . . . . 329 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330 Incentive Conflicts within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .332

Owner-Manager Conflicts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .332 Other Conflicts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .334

Controlling Incentive Problems through Contracts . . . . . . . . . . . . . . . . . . . . . . . . .334 Costless Contracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .335 Costly Contracting and Asymmetric Information . . . . . . . . . . . . . . . . . . . . . .338 Postcontractual Information Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .340 Precontractual Information Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .343

Implicit Contracts and Reputational Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . .347 Incentives to Economize on Contracting Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . .349 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350

Part 3: Designing Organizational Architecture

Chapter 11: Organizational Architecture . . . . . . . . . . . . . . . . . . . . 355 The Fundamental Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357

Architecture of Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .357 Architecture within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358

Architectural Determinants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .360 Changing Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .364 Interdependencies and Complementarities within the Organization . . . . . . .365

Corporate Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .366 When Management Chooses an Inappropriate Architecture . . . . . . . . . . . . . . . . . .370 Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .371

Evaluating Management Advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .372 Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .372

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .373

Chapter 12: Decision Rights: The Level of Empowerment . . . . . . . 376 Assigning Tasks and Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .378 Centralization versus Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .380

Benefits of Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .380 Costs of Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .382 Illustrating the Trade-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .385 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .389

Lateral Decision-Right Assignment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .393

xxii Contents

Assigning Decision Rights to Teams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394 Benefits of Team Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394 Costs of Team Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .395 Management Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .395

Decision Management and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .397 Decision-Right Assignment and Knowledge Creation . . . . . . . . . . . . . . . . . . . . . .399 Influence Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .401 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .403 Appendix: Collective Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .407

Chapter 13: Decision Rights: Bundling Tasks into Jobs and Subunits . . . . . . . . . . . . . . . . . . .410

Bundling Tasks into Jobs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .411 Specialized versus Broad Task Assignment . . . . . . . . . . . . . . . . . . . . . . . . . .411 Productive Bundling of Tasks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .415

Bundling of Jobs into Subunits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .416 Grouping Jobs by Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .417 Grouping Jobs by Product or Geography . . . . . . . . . . . . . . . . . . . . . . . . . . . .419 Trade-offs between Functional and Product or Geographic Subunits . . . . . .420 Environment, Strategy, and Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . .423 Matrix Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .424 Mixed Designs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426 Network Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426 Organizing within Subunits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .426

Recent Trends in Assignments of Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . .427 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .432 Appendix: Battle of the Functional Managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . .436

Chapter 14: Attracting and Retaining Qualified Employees . . . . . . 438 Contracting Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .440 The Level of Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .441

The Basic Competitive Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .441 Human Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .442 Compensating Differentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .444 Costly Information about Market Wage Rates . . . . . . . . . . . . . . . . . . . . . . . .446

Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .447 Reasons for Long-Term Employment Relationships . . . . . . . . . . . . . . . . . . .447 Costs of Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .448

Pay in Internal Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .449 Careers and Lifetime Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .449 Influence Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .454

The Salary–Fringe Benefit Mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .455 Employee Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .455 Employer Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457 The Salary–Fringe Benefit Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .457

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .463

Chapter 15: Incentive Compensation . . . . . . . . . . . . . . . . . . . . . . . 469 The Basic Incentive Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .470

Incentives from Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .473 Optimal Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .474

Contents xxiii

Effective Incentive Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .476 Principal-Agent Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .476 Informativeness Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .482 Group Incentive Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .483 Multitasking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .485 Forms of Incentive Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .486 Incentive Compensation and Information Revelation . . . . . . . . . . . . . . . . . . .487 Selection Effects of Incentive Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .488

Does Incentive Pay Work? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .489 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .493 Appendix: Multitasking Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .498

Chapter 16: Individual Performance Evaluation . . . . . . . . . . . . . . . 502 Setting Performance Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .505

Time and Motion Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .506 Past Performance and the Ratchet Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . .506

Measurement Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .507 Opportunism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .509

Gaming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .510 Horizon Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .511

Relative Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .511 Within-Firm Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .512 Across-Firm Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .513

Subjective Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .513 Multitasking and Unbalanced Effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .514 Subjective Evaluation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .515 Problems with Subjective Performance Evaluations . . . . . . . . . . . . . . . . . . .517

Combining Objective and Subjective Performance Measures . . . . . . . . . . . . . . . . .520 Team Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521

Team Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .522 Evaluating Teams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .524

Government Regulation of Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .525 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .527 Appendix: Optimal Weights in a Relative Performance Contract . . . . . . . . . . . . . .533

Chapter 17: Divisional Performance Evaluation . . . . . . . . . . . . . . . 537 Measuring Divisional Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539

Cost Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .539 Expense Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .542 Revenue Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .543 Profit Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .544 Investment Centers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .544

Transfer Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .549 Economics of Transfer Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .550 Common Transfer-Pricing Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .556 Reorganization: The Solution If All Else Fails . . . . . . . . . . . . . . . . . . . . . . . .560

Internal Accounting System and Performance Evaluation . . . . . . . . . . . . . . . . . . . .560 Uses of the Accounting System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .560 Trade-offs between Decision Management and Decision Control . . . . . . . . .561

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .564 Capstone Case Study on Organizational Architecture: Arthur Andersen LLP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571

Part 4: Applications of Organizational Architecture

Chapter 18: Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . 578 Publicly Traded Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .580

Corporate Form of Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .580 Stock Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .581 Stock Ownership Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .581 Governance Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582

Separation of Ownership and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582 Incentive Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .582 Survival of Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .583 Benefits of Publicly Traded Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . .583

Top-Level Architecture in U.S. Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . .584 Sources of Decision Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .585 Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .586 Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .591 Top Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .594 External Monitors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .598

International Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .601 Market Forces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .604 Sarbanes-Oxley Act of 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .606 Corporate Governance: An Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . .608 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .610 Web Appendix: Choosing among the Legal Forms of Organization . . . . . . . . . . . A-1

Chapter 19: Vertical Integration and Outsourcing . . . . . . . . . . . . . 615 Vertical Chain of Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .617 Benefits of Buying in Competitive Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .620 Reasons for Nonmarket Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .621

Contracting Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .621 Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .624 Taxes and Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .626 Other Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .627

Vertical Integration versus Long-Term Contracts . . . . . . . . . . . . . . . . . . . . . . . . . .627 Incomplete Contracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .628 Ownership and Investment Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .628 Specific Assets and Vertical Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . .629 Asset Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .632 Other Reasons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .633 Continuum of Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .634

Contract Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .635 Contracting with Distributors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .636

Free-Rider Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .636 Double Markups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .638 Regulatory Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .641

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Trends in Outsourcing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .642 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .645 Appendix: Ownership Rights and Investment Incentives . . . . . . . . . . . . . . . . . . . .650

Web Chapter 20: Leadership: Motivating Change within Organizations . . . . . . 654

Leadership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-3 Vision Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-3 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-4

Decision Making within Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-5 Incentive Problems and Organizational Politics . . . . . . . . . . . . . . . . . . . . . .20-5 Understanding Attitudes toward Change . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-5

Changing Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-7 Proposal Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-9

Maintaining Flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-9 Commitment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-10 Distributional Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-10

Marketing a Proposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Careful Analysis and Groundwork . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Relying on Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-11 Emphasizing a Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-13

Organizational Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-14 Sources of Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-14 Tying the Proposal to Another Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . .20-17 Coalitions and Logrolling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-18 Is Organizational Power Bad? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-19

The Use of Symbols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-20 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20-21 Appendix: Strategic Value of Commitment and Crisis . . . . . . . . . . . . . . . . . . . . .20-23

Chapter 21: Understanding the Business Environment: The Economics of Regulation . . . . . . . . . . . . . . . . . . .655

Importance of Regulation to Managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .656 Economic Motives for Government Intervention . . . . . . . . . . . . . . . . . . . . . . . . . .658

Defining and Enforcing Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . .658 Redressing Market Failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .660 Redistributing Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .666

Economic Theory of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .668 Demand for Regulation: Special Interests . . . . . . . . . . . . . . . . . . . . . . . . . . .669 Supply of Regulation: Politicians . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .669 Market for Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .671 Deadweight Losses, Transaction Costs, and Wealth Transfers . . . . . . . . . . . .674

Managerial Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .675 Restricting Entry and Limiting Substitutes . . . . . . . . . . . . . . . . . . . . . . . . . . .675 Forming Coalitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .678 On Business Participation in the Political Process . . . . . . . . . . . . . . . . . . . . .679

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .681

Chapter 22: Ethics and Organizational Architecture . . . . . . . . . . . 684 Ethics and Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .687

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Corporate Mission: Ethics and Policy Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . .689 Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .689 Value Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .690 Corporate Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .692 Economists’ View of Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . .693 Corporate Policy Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .695 Mechanisms for Encouraging Ethical Behavior . . . . . . . . . . . . . . . . . . . . . . .698

Contracting Costs: Ethics and Policy Implementation . . . . . . . . . . . . . . . . . . . . . .702 Codes of Ethics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .704

Altering Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .705 Education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .706 Corporate Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .709

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .710

Web Chapter 23: Organizational Architecture and the Process of Management Innovation . . . . . . . . . . . . . . . . .714

Management Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-3 The Demand for Management Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-5

The Rise of TQM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-6 Other Innovations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-7

Why Management Innovations Often Fail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-8 Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-8 Underestimating Costs of Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-11 Failure to Consider Other Legs of the Stool . . . . . . . . . . . . . . . . . . . . . . . .23-12

Managing Changes in Organizational Architecture . . . . . . . . . . . . . . . . . . . . . . .23-16 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23-19

Index 715

Web Glossary G-1

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chapter

1 C H A P T E R O U T L I N E

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

E nron Corporation was created in 1985 by the merger of two gas pipeline companies. Convinced that impending deregulation of the energy business would create opportunities for firms with the vi- sion to recognize and the willingness to exploit them, Enron moved

aggressively to build and implement an innovative business model. It was a pioneer in the trading of derivative securities tied to assets like natural gas, electricity, and coal. In its transformation from a traditional, capital- intensive gas pipeline company, it established a dramatically smaller re- liance on hard assets, a flatter management structure, and an entrepreneur- ial, risk-taking environment—one that was quite open to creative and unconventional products and practices. It garnered tremendous recognition for these accomplishments; for six years in a row, it was named “Most In- novative” among Fortune’s Most Admired Companies list.

By 2000, Enron operated in several different business segments: transportation and distribution, supplying gas and electric transmission ser- vices; wholesale services, providing energy services and other products to energy suppliers and other firms; retail services, offering business cus- tomers energy products and services; broadband services, providing various service providers with access to a fiber-optic cable network; and other busi- nesses, including water resources and wind energy. In 1990, 80 percent of Enron’s revenues came from its regulated gas pipeline business, but by 2000, over 90 percent of revenues came from its wholesale energy opera- tions and services segment. Enron’s management argued that vertically integrated giants—like ExxonMobil, whose balance sheet was awash with oil reserves, gas stations, refineries, and other hard assets—were dinosaurs. “In the old days, people worked for the assets,” said CEO Jeffrey Skilling. “We’ve turned it around—what we’ve said is the assets work for the people.”

To finance this rapidly expanding array of businesses Enron relied on its bright young CFO, Andrew Fastow. In addition to tapping traditional sources of debt and equity capital, Fastow made extensive use of sophisti- cated partnerships whose financing details were kept off Enron’s balance

Introduction

L E A R N I N G O B J E C T I V E S

1. Define organizational architecture and discuss how economics can be used to help managers solve organizational problems and structure more effective orga- nizational architectures.

2. Define Economic Darwinism and discuss its implications related to the bench- marking of business practices.

P A R T O N E B a s i c C o n c e p t s

2 Part 1 Basic Concepts

sheet.1 For example, to finance its water business, Enron formed Azurix Corporation and raised $695 million by selling one-third of the company to public investors. Enron also formed a partnership called the Atlantic Water Trust in which it held a 50 percent stake. Enron’s partner was Marlin Water Trust, which was marketed to in- stitutional investors. To help attract lenders, Enron guaranteed the debt with its own stock: If Enron’s credit rating fell below investment grade and the stock fell below a stipulated price, Enron itself would be responsible for the partnership’s $915 million debt.

So long as Enron prospered, these guarantees appeared to cost the company little. But several of Enron’s business segments began to experience significant problems. In late summer of 2000, a power shortage in California resulted in blackouts. Enron (along with other energy companies) was blamed by state politicians: California launched an investigation into price gouging by Enron and other power marketers. Enron’s investment in water concessions in Brazil and England ran into political ob- stacles. For instance, British regulators cut the rates that it was allowed to charge its customers. Enron had a 65 percent stake in a $3 billion power project in India. But the power plant became embroiled in a dispute with its largest customer, who refused to pay for electricity. Following the September 11, 2001, terrorist attacks, the pre- cipitous fall in oil prices generated losses for Enron’s trading operations, and tech- nology changes produced a glut of broadband services.

After reaching a peak of nearly $70 billion in August 2000, Enron’s market value collapsed. Its bankruptcy filing in December 2001 is one of the most spectacular business failures ever seen.2 November 2004 saw it emerge from one of the most complex bankruptcies in U.S. history. After 2006 Enron existed as an assetless shell corporation.

What went wrong? According to BusinessWeek,

Enron didn’t fail just because of improper accounting or alleged corruption at the top. . . . The unrelenting emphasis on earnings growth and individual initiative, coupled with a shocking absence of the usual corporate checks and balances, tipped the culture from one that rewarded aggressive strategy to one that increasingly relied on unethical corner cutting. In the end, too much leeway was given to young, inexperienced managers without the necessary controls to minimize failures. This was a company that simply placed a lot of bad bets on businesses that weren’t so promising to begin with.

Thus, BusinessWeek suggests, Enron’s problems were rooted in a fundamentally flawed organizational design. At fault were three key aspects of the company’s cor- porate structure. First, in the course of flattening its management structure, Enron delegated an extraordinary level of decision-making authority to lower-level em- ployees without retaining an appropriate degree of oversight. Second, performance was evaluated largely on near-term earnings growth and success in closing deals. Third, the company offered enormous compensation to its top performers, which en- couraged excessive risk taking. Enron’s internal risk management group was charged with reviewing deals, but the performance appraisals of the 180 employees within the group were based in part on the recommendations of the very people who

1It should be noted that Fastow was recognized by CFO Magazine in October 1999 with their CFO Excellence Award for Capital Structure Management.

2While the largest U.S. corporate bankruptcy at the time, Enron is now far from the largest. Lehman Brothers ($691 billion in 2008), Washington Mutual ($327 billion in 2008), WorldCom ($103.9 billion in 2002), General Motors ($91 billion in 2009 and CIT Group ($80.4 billion in 2009) were all greater in size.

Chapter 1 Introduction 3

generated the deals. Enron’s problems appear to stem, at least in part, from its organizational design.

Managerial Economics and Organizational Architecture Standard managerial economics books address a number of questions that are im- portant for organizational success:

• Which markets will the firm enter?

• How differentiated will the firm’s products be?

• What mix of inputs should the firm use in its production?

• How should the firm price its products?

• Who are the firm’s competitors, and how are they likely to respond to the firm’s product offerings?

Addressing these questions is certainly important—and in this book, we do—yet this tale of Enron’s implosion suggests that this list is woefully incomplete. It is also im- portant to address questions about the internal organization of the firm. A poorly de- signed organization can result in lost profits and even in the failure of the institution.

With the benefit of hindsight, it seems easy to identify elements of Enron’s orga- nization that, if changed, might have reduced the likelihood of its collapse. But the critical managerial question is whether before the fact one reasonably could be ex- pected to identify the potential problems and to structure more productive organiza- tions. We believe the answer to this fundamental managerial question is a resound- ing yes. To examine these issues, a rich framework that can be applied consistently is required.

We are not, of course, the first to recognize the importance of corporate organiza- tion or to offer analysis of how to improve it. The business section of any good book- store displays a virtually endless array of prescriptions: benchmarking, empower- ment, total quality management, reengineering, outsourcing, teaming, corporate culture, venturing, matrix organizations, just-in-time production, and downsizing. The authors of all these books would strongly agree that the firm’s organization and the associated policies, adopted by management, can have profound effects on per- formance and firm value; and all buttress their recommendations with selected sto- ries of firms that followed their advice and realized fabulous successes.

The problem with such approaches, however, is that each tends to focus on a par- ticular facet of the organization—whether it be quality control, or worker empower- ment, or the compensation system—to the virtual exclusion of all others. As a con- sequence, the suggestions offered by the business press are regularly myopic. These publications tend to offer little guidance as to which tools are most appropriate in which circumstances. The implicit assumption of most is that their technique can be successfully adopted by all companies. This presumption, however, is invariably wrong. Ultimately, this literature fails to provide managers with a productive frame- work for identifying and resolving organizational problems.

Organizational Architecture

In contrast to the approach of most business best sellers, we seek to provide a sys- tematic framework for analyzing such issues—one that can be applied consistently in addressing organizational problems and structuring more effective organizations.

4 Part 1 Basic Concepts

In this book, we offer a framework that identifies three critical aspects of corporate organization:

• The assignment of decision rights within the company • The methods of rewarding individuals • The structure of systems to evaluate the performance of both individuals and

business units

Not coincidentally, these are the same three aspects of the organization we identified in the Enron case.

We introduce the term organizational architecture to refer specifically to these three key aspects of the firm. We hesitate to simply use “organization” to refer to these three corporate features because common usage of that term refers only to the organization’s hierarchical structure—that is, decision-right assignments and report- ing relationships—while it generally ignores the performance-evaluation and reward systems. We thus use organizational architecture to help focus specific attention on all three of these critical aspects of the organization.

Stated as briefly as possible, our argument is that successful firms assign decision rights in ways that effectively link decision-making authority with the relevant infor- mation for making good decisions. When assigning decision rights, however, senior leadership—including both management and the company's Board of Directors— must also ensure that the company’s reward and performance-evaluation systems pro- vide decision makers with appropriate incentives to make value-increasing decisions.

Depending on its specific circumstances, the firm will assign decision-making authority differently (some will decentralize particular decisions but centralize oth- ers) and will tailor its reward and performance-evaluation systems. Even though no two firms might adopt precisely the same architecture, successful firms ensure that these three critical aspects of organizational architecture are coordinated.

Our approach is integrative in the sense that it draws on a number of disciplines: accounting, finance, information systems, marketing, management, operations, politi- cal science, and strategy. But what also distinguishes our approach most clearly from that of the best sellers is our central reliance on the basic principles of economics.

Economic Analysis

Economics long has been applied to questions of pricing policy—for example, “how would raising the price of the firm’s products affect sales and firm value?” We ad- dress standard managerial-economics questions involving pricing, advertising, scale, and the choice of inputs to employ in production. In addition, we apply these same tools to examine questions of organizational architecture. For example, “how would changing a division from a cost center to a profit center change incentives, alter em- ployee decisions, and impact firm value?”

In essence, economics provides a theory to explain the way individuals make choices. For example, in designing organizations, it is important to keep in mind that individuals respond to incentives. Managers and employees can be incredibly re- sourceful in devising methods to exploit the opportunities they face. This also means, however, that when their incentives are structured inappropriately, they can act in ways that reduce the firm’s value. In choosing corporate policies, it is critical that managers anticipate potential responses by customers, suppliers, or employees that might produce undesirable outcomes. Neglecting to do so invites individuals to “game” the system and can result in utter failure of well-intentioned policies.

Chapter 1 Introduction 5

We use economics to examine how managers can design organizations that moti- vate individuals to make choices that will increase a firm’s value. For example, the evidence suggests that the problem highlighted in the accompanying box on chief executive officers slashing R&D budgets prior to their retirement is not widespread.3

The research suggests that these perverse incentives can be controlled by basing the CEO’s incentive compensation on stock prices and by managing CEO succession, so that decision rights are gradually transferred to the successor over the years prior to the final departure. Moreover, CEOs’ postretirement opportunities for election to board seats appear linked to performance over the final years of their tenure.4

Standard economic analysis generally characterizes the firm simply as a “black box” that transforms inputs (labor, capital, and raw materials) into outputs. Little consideration traditionally has been given to the internal architecture of the firm.5 In recent years, economists have focused more on questions of organizational architec- ture.6 But little effort has been devoted to synthesizing the material in an accessible form that emphasizes the managerial implications of the analysis. We apply the basic tools of economics to examine the likely effect on a firm’s value of decisions such as centralization versus decentralization, the bundling of tasks into specific jobs and jobs into business units within the firm, the use of objective versus subjective per- formance measures, compensating employees through fixed versus variable (or “in- centive”) compensation, and retaining activities within the firm versus outsourcing. In sum, we examine how managers can structure organizational architecture to mo- tivate individuals to make choices that increase the firm’s value.

R&D and Executive Turnover Suppose a firm links the CEO’s bonus to earnings and the CEO plans to retire in two years. The CEO might reduce the firm’s research and development budget to boost earnings this year and next. Five years down the road, earnings will suffer with no new products coming on stream. By then, however, this CEO will be long gone. In fact, research suggests that this can be a problem for some R&D-intensive firms.

Source: P. Dechow and R. Sloan (1991), “Executive Incentives and the Horizon Problem,” Journal of Accounting and Economics 14, 51–89.

ACADEMIC APPLICATIONS

3K. Murphy and J. Zimmerman (1993), “Financial Performance Surrounding CEO Turnover,” Journal of Accounting and Economics 16, 273–315.

4J. Brickley, J. Linck, and J. Coles (1999), “What Happens to CEOs after They Retire? New Evidence on Career Concerns, Horizon Problems, and CEO Incentives,” Journal of Financial Economics 52, 341–378.

5Of course, there are several notable exceptions: F. Knight (1921), Risk, Uncertainty, and Profit (London School of Economics: London); R. Coase (1937), “The Nature of the Firm,” Economica 4, 386–405; and F. Hayek (1945), “The Use of Knowledge in Society,” American Economic Review 35, 519–530.

6For example, R. Coase (1960), “The Problem of Social Cost,” Journal of Law and Economics 3, 1–44; S. Cheung (1969), “Transaction Costs, Risk Aversion, and the Choice of Contractual Arrangements,” Journal of Law and Economics 12, 23–42; A. Alchian and H. Demsetz (1972), “Production, Information Costs, and Economic Organization,” American Economic Review 62, 777–795; K. Arrow (1974), The Limits of Organization (W. W. Norton: New York); M. Jensen and W. Meckling (1976), “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, 305–360; Y. Barzel (1982), “Measurement Costs and the Organization of Markets,” Journal of Law and Economics 25, 27–48; O. Williamson (1985), The Economic Institutions of Capitalism: Firms, Markets, Rational Contracting (Free Press: New York); and B. Holmstrom and J. Tirole (1989), “The Theory of the Firm,” in R. Schmalensee and R. Willig (Eds.), Handbook of Industrial Economics (North-Holland: New York).

6 Part 1 Basic Concepts

In this analysis, ideas of equilibrium—the interplay of supply and demand in product, labor, and capital markets—represent important constraints on manager- ial decisions. Understanding how prices and quantities change in response to changes in costs, product characteristics, or the terms of sale is a critical manage- rial skill. For example, the more than five-fold increase in crude oil prices from below $12 per barrel in 1999 to over $135 in 2008 prompted oil companies to

MANAGERIAL APPLICATIONS

Economic Incentives and the Subprime Mortgage Crisis “Subprime mortgages” are made to borrowers who do not qualify for standard market interest rates because of problems with their credit histories or inability to prove that they have enough income to support the monthly payments. In March 2007, the value of U.S. subprime mortgages was estimated at $1.3 trillion with over 7.5 million mortgages outstanding. During the second half of 2007, investors in subprime mortgages such as banks, mortgage lenders, real estate investment trusts, and hedge funds reported losses of close to $100 billion as a result of subprime mortgage defaults and devaluations. The stock market fell and became quite volatile as more details about the mortgage crisis were revealed over time.

One important factor that contributed to this crisis was the incentives of the mortgage brokers that originated the loans. Mortgage brokers, who originated nearly 70 percent of residential mortgages in recent years, don’t lend their own money. They are paid for originating loans, which are sold to other investors who bear the primary risk. In many cases, the more loans they originate, the higher their compensation.

The financial incentives for originating mortgages motivated financial companies to offer products that made it easier for borrowers to qualify for the loans. For example, companies began offering “stated income loans” that required no proof of income. Consistent with the theory in this book, some borrowers overstated their incomes. In a recent review of 100 of these so-called liar loans, almost 60 percent of the stated amounts were exaggerated by over 50 percent. For example, in Atlanta a borrower received a $1.8 million loan by stating that he and his wife were top executives at a marketing firm who earned more than $600,000 per year with personal assets totaling $3 million. In reality, he was a phone company technician who earned $105,000 per year with savings of only $35,000.

The financial incentives and associated lack of controls produced not only risky loans but also billions of dollars of fraud. Rings of fraudulent borrowers would (1) recruit people with good credit to apply for very large loans using false income and asset statements, (2) find home appraisers to significantly inflate the values of the underlying properties, (3) pay the much lower asking prices to the sellers, and (4) pocket the difference, splitting the proceeds among the members of the ring. The houses then would go into foreclosure as the loans were not repaid.

Banking executives subsequently testified that they did not foresee this problem—“fraud was not really a consideration in our world.” The premise of this book is that a careful analysis of the underlying organizational architecture (incentives and decision-right assignments) can help managers anticipate these types of problems and develop mechanisms to reduce their severity.

Source: M. Corkery (2007), “Fraud Seen as a Driver in Wave of Foreclosures,” The Wall Street Journal (December 21), A1.

MANAGERIAL APPLICATIONS

Creative Responses to a Poorly Designed Incentive System A manager at a software company wanted to find and fix software bugs more quickly. He devised an incentive plan that paid $20 for each bug the Quality Assurance people found and $20 for each bug the programmers fixed. Since the programmers who created the bugs were also in charge of fixing them, they responded to the plan by creating bugs in software programs. This action increased their payoffs under the plan—there were more bugs to detect and fix. The plan was canceled within a single week after one employee netted $1,700 under the new program.

Source: S. Adams (1995), “Manager’s Journal: The Dilbert Principle,” The Wall Street Journal (May 22), A12.

Chapter 1 Introduction 7

increase production, encouraged petrochemical companies to alter their input mix to economize on a now-more-expensive input, made salespeople reevaluate their decisions about contacting potential customers by phone rather than in person, and encouraged auto producers to focus more on gas economy in the design of new models. Yet these incentives to change depend on the structure of the organization. For instance, a salesperson is less likely to switch to greater reliance on telephone and mail when the firm reimburses all selling expenses than when salespeople are responsible for the costs of contacting potential customers.

Economic Darwinism Survival of the Fittest7

The collapse of Enron, Charles Darwin might have noted, is an example of how com- petition tends to weed out the less fit. As described in The Origin of Species, natural history illustrates the principle of “survival of the fittest.” In industry, we see economic Darwinism in operation as competition weeds out ill-designed organiza- tions that fail to adapt. Competition in the marketplace provides strong pressures for efficient decisions—including organizational decisions. Competition among firms dictates that those firms with low costs are more likely to survive. If firms adopt in- efficient, high-cost policies—including their organizational architecture—competi- tion will place strong pressures on these firms to either adapt or close.

Fama and Jensen suggest that “the form of organization that survives in an activ- ity is the one that delivers the product demanded by customers at the lowest price while covering costs.” This survival criterion helps highlight that while a well- crafted organizational architecture can contribute to a firm’s success, it is not suffi- cient for success. The firm must have a business strategy that includes products for which the prices customers are willing to pay exceed costs. The potential for value creation by a company that manufactures only buggy whips is quite limited no mat- ter how well structured the firm’s organizational architecture.

Nonetheless, given a firm’s business strategy (including its product mix), its choice of organizational architecture can have an important impact on profitability and value. An appropriate architecture can lower costs by promoting efficient pro- duction; it also can boost the prices customers are willing to pay by helping to ensure high-quality production, reliable delivery, and responsive service.

Economic Darwinism and Benchmarking

In the biological systems that Darwin analyzed, the major forces at work were ran- dom mutations in organisms and shocks from the external environment (for instance, from changes in weather). But in the economic systems on which we focus, pur- poseful voluntary changes occur. For instance, in order to compete more effectively with Coke, Pepsi copied many of Coke’s practices. Pepsi spun off its fast-food chains

7This section draws on A. Alchian (1950), “Uncertainty, Evolution, and Economic Theory,” Journal of Political Economy 58, 211–221; G. Stigler (1951), “The Economics of Scale,” Journal of Law and Economics 1, 54–71; and E. Fama and M. Jensen (1983), “Separation of Ownership and Control,” Journal of Law and Economics 26, 301–325.

8 Part 1 Basic Concepts

(Taco Bell, KFC, and Pizza Hut) to focus on its core business—just as Coca Cola had done. Also, Pepsi changed its network of bottlers. One analyst remarked, “Pepsi is starting to look a lot more like Coke.”8 In fact, this practice has been formalized in the process of benchmarking.

Benchmarking generally means looking at those companies that are doing some- thing best and learning how they do it in order to emulate them. But this process also occurs in less formal ways. As Armen Alchian argued, “Whenever successful enter- prises are observed, the elements common to those observed successes will be asso- ciated with success and copied by others in their pursuit of profits or success.”9 For example, if the cover article in the next Fortune reports an innovative inventory con- trol system at Toyota, managers across the country—indeed, around the globe—will read it and ask, Would that work in my company, too? Undoubtedly, the managers with the strongest interest in trying it will be those within firms currently suffering inventory problems.10 Some will achieve success, but others may experience disas- trous results caused by unintended though largely predictable organizational “side effects” (like Fastow’s unchecked incentive for risk taking).

8N. Harris (1997), “If You Can’t Beat ’Em, Copy ’Em,” BusinessWeek (November), 50. 9A. Alchian. “Uncertainty, Evolution, and Economic Theory,” The Journal of Political Economy, Vol. 58, No. 3 (Jun., 1950), p. 218.

10This raises the question of why any firm with an innovative idea would voluntarily disclose it. Perhaps the free publicity outweighs the lost competitive advantage.

MANAGERIAL APPLICATIONS

Economic Darwinism: The Growth in Lead Directors The collapse of Enron in December 2001 and subsequent scandals at Adelphia, Tyco, WorldCom, and other companies in 2002 shook public confidence in corporate governance. In July 2002, the United States enacted the Sarbanes–Oxley Act, which mandated substantial changes in corporate accounting and governance practices. Additional scandals and failures during the 2007–2008 financial crisis raised additional concerns about corporate governance and motivated additional legislation and regulation.

These events altered the basic business environment for publicly traded corporations. Over the past decade, investors, regulators, stock exchanges, the media and the general public have placed increased pressure on corporate boards of directors to become more independent and diligent in their monitoring of CEOs. One important trend in corporate governance has been the large increase in presiding and lead directors. Presiding directors are independent directors (a director with no other direct ties to the company or corporate management) who chair executive sessions of outside directors. Lead directors are more powerful, taking on additional responsibilities (such as serving as the principal liaison between the independent directors and the CEI and taking the lead role in overseeing formal evaluations of board members and the CEO). In 2003, only 36 percent of S&P 500 firms had presiding or lead directors, compared to 90 percent in 2013. Over 60 percent of the S&P 500 firms with presiding or lead directors in 2013 employed the more powerful position of lead director.

If you were to benchmark the current governance practices of large publicly traded corporations, you would find the appointment of a lead director is a dominant surviving practice in the current business environment. “One size,” however, is unlikely to fit all firms. Managers should not simply adopt the prevailing organizational practices of other firms. More careful analysis is required.

Source: Spencer Stuart (2013), “Spencer Stuart Board Index 2013,” www.spencerstuart.com.

Chapter 1 Introduction 9

Although competition tends to produce efficiently organized firms over the longer run, uncritical experimentation with the organizational innovation du jour can ex- pose the firm to an uncomfortably high risk of failure. Organizational change is ex- pensive. Moreover, successful organizations are not just a collection of “good ideas.” The elements of a successful organization must be carefully coordinated: The differ- ent elements of the firm’s architecture must be structured to work together to achieve the firm’s goals. For this reason, it is important to be able to analyze the likely con- sequences of a contemplated organizational change and forecast its impact on the en- tire firm.

This concept of economic Darwinism thus has important managerial implica- tions. First, existing architectures are not random; there are sound economic ex- planations for the dominant organization of firms in most industries. Second, sur- viving architectures at any point in time are optimal in a relative rather than an absolute sense; that is, they are the best among the competition—not necessarily the best possible. Third, if the environment in which the firm operates changes—if technology, competition, or regulation change—then the appropriate organiza- tional architecture normally changes as well. These three observations together suggest that although improvements in architecture are certainly always possible, a manager should resist condemning prevailing structures without careful analysis. Before undertaking major changes, executives should have a good understanding of how the firm arrived at its existing architecture and, more generally, develop a broader perspective of why specific types of organizations work well in particular settings. Finally, an executive should be particularly skeptical of claimed benefits of proposed organizational changes if the environment has been relatively stable.

Purpose of the Book The primary thrust of this book is to provide a solid conceptual framework for ana- lyzing organizational problems and structuring an effective organizational architec- ture. The book also provides basic material on managerial economics and discusses how it can be used for making operational decisions—for example, input, output, and pricing decisions. This material additionally supplies a set of tools and an un- derstanding of markets, that is, important for making good organizational decisions.

MANAGERIAL APPLICATIONS

Organizing Xerox Service Center Xerox has developed an expert system to assist employees who answer the company service center’s 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. Discuss the incentives these compensation practices create.

10 Part 1 Basic Concepts

Our Approach to Organizations

We begin with two basic notions: People act in their own self-interest, and individu- als do not all share the same information. As we have indicated, this framework sug- gests that the three critical elements of organizational architecture are the assignment of decision rights, the reward system, and the performance-evaluation system. Suc- cessful organizations assign decision rights in a manner that effectively links deci- sion-making authority with the relevant information to make good decisions. Corre- spondingly, successful organizations develop reward and performance-evaluation systems that provide self-interested decision makers with appropriate incentives to make decisions that increase the values of their organizations.

It is also important to note that modern organizations are extremely complex and that developing an understanding of how people within them behave is difficult. As in any book that addresses this set of topics, we face difficult trade-offs between adding more institutional richness to infuse more texture of the actual environment versus omitting details to keep the analysis more focused and manageable. At certain points (especially where little prior formal analysis of the problem exists), we take quite complex problems and discuss them in terms of simplified examples. Nonethe- less, our experience suggests that in these cases, we derive important managerial in- sights to these topics through our admittedly simple examples.

Finally, we believe that a powerful feature of this economic framework is that it can be extended readily to incorporate a broad array of other managerial policies such as finance, accounting, information systems, human relations, operations, and marketing. In this sense, this book can play an important integrating role across the entire business curriculum. Such integration is becoming increasingly important with the expanded use of cross-functional teams within the business community.

MANAGERIAL APPLICATIONS

Transfers of Organizational Architecture across the Global Economy In 1996, Tianjin Optical & Electrical Communication Group was typical of a Chinese state-owned company. Although the electronics manufacturer boasted skilled technicians, mismanagement left the company at the brink of bankruptcy. Motorola, Inc., changed that. It offered to take Tianjin Optical as a supplier, but only if Tianjin adopted the U.S. telecommunications company’s quality-control and management practices. By 1999, Tianjin Optical was selling a third of its production to Motorola and reported a small profit. “Now, we think we can survive,” says Zhang Bingjun, Tianjin Optical’s chairman.

Each Tianjin employee receives an average of two weeks a year in classroom instruction stressing modern management practices. That effort has paid off: The Tianjin assembly lines produce a slim cellular phone every 2 seconds with virtually the same defect rate as in Motorola’s U.S. plants. Motorola also provides training for more than 100 outside suppliers to boost the quality of their output. Motorola budgets about $2 million annually to “show [potential suppliers] Western management practices and create a mindset where they understand what we’re doing and why,” says a training director, Ying Shea.

This assistance in establishing a more effective organizational architecture and internal operating policies provided by a U.S. multinational corporation to its Chinese partners is but one example of the vital role that foreign businesses play within the Chinese business sector. Since China opened itself to foreign investment three decades ago, foreign companies have become an important conduit for economic reform. They have introduced not just modern production technology but also more efficient organizational architecture to the Chinese business community. Some estimates suggest that including these collateral benefits, foreign firms and their joint ventures account for as much as a fifth of China’s trillion-dollar economy.

Source: E. Guyot (1999), “Foreign Companies Bring China More Than Jobs,” The Wall Street Journal (September 15), A26.

1 2

Chapter 1 Introduction 11

ANALYZING MANAGERIAL DECISIONS: Société Générale

Société Générale was founded in the 1860s and in 2013 was France’s third largest bank. Beginning in the mid-1980s, it pioneered some of the most com- plex instruments in international finance and became a global powerhouse in trading derivatives like futures and options. Through its trading activities, the bank earned billions of dollars and gained the respect of bankers throughout the world. In January 2008, Risk, a monthly magazine about risk management, named Société Générale its “Equity Derivatives House of the Year.”

In late January 2008, Société Générale an- nounced that it had discovered fraudulent securities trading by one of its low-level traders, Jérôme Kerviel. The bank reported that it expected the fraud to cost it a staggering $7.14 billion, making it one of the largest financial frauds in history. The announcement shocked the financial markets and made front-page headlines around the world. Ob- servers questioned whether the bank could ever re- gain its former reputation and whether it could con- tinue to exist without merging with another bank.

Société’s CEO Daniel Bouton asserted that the fraud was the result of one employee’s illegal activ- ities, did not involve other employees at the bank, and represented the aberrant and unexplainable ac- tions of one “rogue trader.” He characterized Kerviel’s actions as “irrational” since the trades were made on behalf of the bank “netting the trader no personal gains.” Bouton emphasized that Kerviel was a low-level employee who had an an- nual salary and bonus for 2007 of less than $145,700.

In principle Kerviel engaged in a quite simple operation: arbitrage-trading on small differences between various stock market indexes such as the CAC in France and the DAX in Germany. Kerviel should have been able to lock in a virtually riskless profit by selling a security on the exchange with the higher price, while simultaneously buying an equiv- alent 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 busi- ness, although Société Générale might accumulate large positions on both exchanges, those securities

that it bought and those it sold should balance. The bank was supposed to face little net exposure to price changes.

What the bank discovered was that Kerviel had bought securities on both markets. In effect, he had made enormous bets that European stock prices would increase. But they had fallen, and as a result the bank incurred a substantial loss.

The subsequent investigation revealed that Kerviel had been placing huge unhedged bets on European stocks for over a year. Prior to becoming a trader he had worked in the bank’s trading ac- counting office. His knowledge of the bank’s risk- management system allowed him to conceal the trades and bypass the firm’s control system. He knew the timing of the nightly reconciliation of the day’s trades and would delete and then re enter his unauthorized transactions without being caught. Bank managers, however, had apparently dismissed several warning signs about Kerviel’s transactions. For example, the surveillance office at Eurex, one of Europe’s biggest exchanges, alerted a compli- ance officer at the bank that for seven months a trader named Kerviel had engaged in “several transactions” that raised red flags. Kerviel’s super- visors accepted his explanations for these trades apparently without much investigation.

Various bank officials, investigators, and traders who worked with Kerviel have concluded that So- ciété Générale “allowed a culture of risk to flour- ish, creating major flaws in its operations” that en- abled Kerviel’s actions to proceed. Several current and former employees interviewed by the New York Times, indicated that Société Générale traders were rewarded for making risky investments with the bank’s money and that it was not uncommon for traders briefly to exceed limits imposed on their trading, despite controls meant to prohibit this ac- tivity. Risk taking apparently was “embraced, as long as it made money for the bank.” Top execu- tives and other managers at the bank had received large bonuses because of the bank’s successful trading operations.

Kerviel told investigators that all he wanted was to be respected and to earn a large bonus. He had come from a modest background and did not have the

12 Part 1 Basic Concepts

A. Alchian (1950), “Uncertainty, Evolution, and Economic Theory,” Journal of Political Economy 58, 211–221.

M. Jensen (1983), “Organization Theory and Methodology,” The Accounting Review 58, 319–339.

M. Jensen and W. Meckling (1992), “Specific and General Knowledge, and Organizational Struc- ture,” Journal of Applied Corporate Finance 8:2, 4–18.

1–1. Briefly describe Economic Darwinism.

1–2. The Wall Street Journal11 reports that

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 pro- tected 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?

Solutions to Self-Evaluation Problems 1–1. Economic Darwinism is the economic counterpart of natural selection in biology. Competi-

tion in the marketplace weeds out those organizations that are less efficient and fail to adapt to the environment. The result is survival of the fittest.

1–2. 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 fran- chise if the franchiser has to grant the franchisee an exclusive territory. The potential fran- chisee might prefer to have a nonexclusive territory at a lower price. In any case, the fran- chiser is unlikely to favor the proposal; if it were efficient to convey exclusive territories, the original contract could have been structured that way.

1–1. What are the three aspects of organizational architecture?

1–2. 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

Review Questions

Self-Evaluation Problems

Suggested Readings

educational pedigree of many of his coworkers who had advanced degrees in math or engineering from the prestigious Grandes Ecoles—the MITs of France. He was noted for working very long hours and had worked his way up in the bank from being a clerk to a trader. One of his primary goals was to have his supervisors recognize his “financial genius.”

1. Do you agree with Société Générale’s CEO that Kerviel’s actions were “irrational”?

2. Discuss how the bank’s organizational archi- tecture contributed to the problem.

3. What lessons might you learn from this case if you were an executive at another bank?

Source: This application is based on a series of articles from the New York Times published in early 2008. In particular see N. D. Schwartz and K. Bennhold, 2008, “A Trader’s Secrets, a Bank’s Missteps,” nytimes.com (February 5).

11J. A. Tannenbaum (1995), “Focus on Franchising: Franchisee Gains,” The Wall Street Journal (June 19), B2.

Chapter 1 Introduction 13

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 sys- tem to boost productivity. What do you advise?

1–3. In the life insurance industry, we see two major ownership structures—common stock in- surers and mutual insurers. In a common stock company, the owners—its stockholders—are a separate group from its customers—the policyholders. In a mutual, the policyholders are also the owners of the company. It has been argued that mutual insurance companies are dinosaurs—they are large, slow, bureaucratic, and inefficient. How would you respond to such an argument?

chapter

2 C H A P T E R O U T L I N E

Economic Behavior: An Overview

Economic Choice Marginal Analysis Opportunity Costs Creativity of Individuals

Graphical Tools Individual Objectives Indifference Curves Opportunities and Constraints Individual Choice Changes in Choice

Motivating Honesty at Merrill Lynch Managerial Implications Alternative Models of Behavior

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

Which Model Should Managers Use? Behavioral Economics Decision Making under Uncertainty

Expected Value Variability Risk Aversion Certainty Equivalent and Risk Premium Risk Aversion and Compensation

Summary Appendix A: Consumer Choice Appendix B: Inter-Temporal Decisions and the Fisher Separation Theorem

I n May 2002, Merrill Lynch agreed to pay $100 million to settle charges that its analysts had recommended stocks to clients that they privately thought were poor investments. Internal e-mails provided strong sup- port for this claim leveled by the New York State attorney general. For

example, InfoSpace, an Internet services company, was rated highly in ana- lysts’ reports distributed to clients, yet privately the analysts suggested that it was a “powder keg” and a “piece of junk.” Although InfoSpace’s share price dropped from $261 to $14, Merrill analysts never recommended sell- ing the stock. Merrill analysts rated Excite@Home “accumulate or buy,” while privately the investment team called it a “piece of crap.”

This episode at Merrill sent shock waves through other major investment houses—indeed through the entire investment community. Other investment firms publicly stated that they were taking strong steps to make sure that the situation at Merrill would not be repeated within their organizations. Fortune magazine ran a cover story entitled, “In Search of the Last Honest Analyst.”1 The scandal generated significant concerns throughout the world among both the general public and government regulators. For example, the New York attorney general began a sweeping investigation of analysts at Salomon Smith Barney and other investment firms that had recommended WorldCom to investors. In July 2002, WorldCom became the biggest company ever to file for bankruptcy in U.S. history. In December 2002, the nation’s 10 top investment banks agreed to a $1.2 billion settlement with regulators aimed at “protecting investors from brokerages’ conflicts of interest.”

Economists’ View of Behavior

L E A R N I N G O B J E C T I V E S

1. Describe the economic model of behavior. 2. Define and apply marginal analysis in managerial decisions. 3. Define and apply the concept of opportunity costs. 4. Use graphs to explain, predict, and affect behavior in a wide range of

applications.

5. Contrast the implications of the economic model with those from other behavioral models used by some managers.

6. Identify the key concepts that are used to mitigate risk when making decisions under uncertainty.

1June 10, 2002, issue.

Chapter 2 Economists’ View of Behavior 15

Managers at Merrill, Salomon Smith Barney, and other investment companies had to act quickly to address this potential problem. As a first step, management had to understand what motivated the Merrill analysts to mislead their investment clients. Only then could they choose a policy to redress the situation. If management thought this problem was caused by a few dishonest employees, the appropriate response would have been to try to identify and fire those employees. If, instead, management believed the problem was caused by disgruntled employees taking out their frustra- tions on customers, a potential response would have been to adopt a job-enrichment program to increase employee satisfaction and, it would be hoped, analyst honesty. Alternatively, Merrill Lynch might have created incentives through its compensation plan that caused its analysts to issue misleading investment reports. If so, the appro- priate response would be to restructure its compensation plan. Many other assump- tions and responses are possible.

The example of Merrill Lynch illustrates a general point: Managers’ responses to problems are likely to depend on their understanding of people’s motives and their forecast of people’s reactions—their responses thus depend on their underlying model of behavior. Most managerial actions attempt to change the behavior of indi- viduals, such as employees, customers, union officials, or subcontractors. Managers with different understandings (or models) of what motivates behavior are likely to make different decisions and take different actions.

We begin this chapter by briefly summarizing the general framework economists use to examine individual behavior. Selected graphical tools are introduced to aid our analysis. Next, we use this economic framework to analyze the problem at Merrill Lynch. The managerial implications of this analysis are discussed. We contrast this economic view of behavior with alternative views and explore why the economic framework is particularly useful in managerial decision making. Finally, we analyze decision making under uncertainty. In Appendix A, we analyze the problem of con- sumer choice in more detail and in Appendix B, we illustrate how the graphical frame- work we present in this chapter can be used for analyzing inter-temporal choices.

Economic Behavior: An Overview Individuals have unlimited wants. People generally want greater wealth, more atten- tive service, larger houses, more luxurious cars, and additional personal material items. They want more time for leisure activities. Most also want to improve the plight of others—starving children, the homeless, and disaster victims. People are concerned about vitality, religion, integrity, and gaining the respect and affection of others.

In contrast to wants, resources are limited. Households face limited incomes that preclude all the purchases and expenditures that household members might like to make. The available amount of land, trees, and other natural resources is finite. There are only 24 hours in a day. People become ill; death is inevitable.

Economic Choice

Economic analysis is based on the notion that individuals assign priorities to their wants and choose their most preferred options from the available alternatives. If Kathy Measer is confronted with a choice between a laptop or a desktop computer, she can tell you whether she prefers one over the other or whether she is indifferent

16 Part 1 Basic Concepts

between the two. Depending on the relative prices of the two products, she purchases her preferred alternative. If Kathy has a weekly budget of $1,000, she considers the many ways she might spend the money and then chooses the package of goods and services that will maximize her personal happiness. She cannot make all desired pur- chases on her limited budget. However, this choice is optimal for Kathy, given her limited resources.

Economists do not assert that people are selfish in the sense that they care only about their own personal consumption. Within the economic paradigm, people also care about such things as charity, family, religion, and society. For instance, Kathy will donate $100 to her church, as long as the donation provides greater satisfaction than alternative uses of the money.

Economists, however, often assume for modeling purposes that people care only about their own wealth to simplify the analysis. While wealth is not the only thing that people care about, it is very important to most people. Economic models based on this simplifying assumption often perform quite well relative to more complicated models that add unnecessary complexity to the analysis. Some situations, however, can require models that are based on different assumptions.

Economists do not contend that individuals are supercomputers that make infalli- ble decisions. Individuals are not endowed with perfect knowledge and foresight, nor is additional information costless to acquire and process.2 For example, Kathy might order an item from a restaurant menu only to find that she dislikes what she is served. Within this economic paradigm, she simply does the best she can in the face of her imperfect knowledge. But she learns from her experience and does not repeat the same mistakes in judgment time after time.3

Marginal Analysis

Marginal costs and benefits are the incremental costs and benefits that are associated with making a decision.4 It is the marginal costs and benefits that are important in economic decision making. An action should be taken whenever the incremental benefits of that action exceed its incremental costs. Mary O’Dwyer has a contract to help sell products for an office supply company. She is paid $50 for every sales call that she makes to customers. Thus, Mary’s marginal benefit for making each addi- tional sales call is $50. Mary enjoys playing tennis more than selling. If she places a marginal value of more than $50 on the tennis that she would forgo by making an

2Economists sometimes use the idea of bounded rationality. Under this concept, individuals act in a purposeful and intendedly rational manner. However, they have cognitive limitations in storing, processing, and communicating information. It is these limitations which make the question of how to organize economic activity particularly interesting. H. Simon (1957), Models of Man (John Wiley & Sons: New York).

3At least this learning appears to occur outside the comics. For decades, Charlie Brown from Peanuts continued to try to kick the football held by Lucy van Pelt. Yet Lucy always pulled the ball at the last second. Few individuals are as incurably optimistic as Charlie Brown—they learn.

4Technical note: Marginal costs and benefits are typically defined as changes in costs and benefits associated with very small changes in a decision variable. For instance, the marginal costs of production are the additional costs from producing a small additional amount of the product (for instance, one more unit). Often decisions involve discrete choices, such as whether or not to build a new plant. In these cases, it is not possible to define a small change in the decision variable. Incremental costs and benefits are those costs and benefits which vary with such a decision. For our present discussion, the technical distinction between marginal and incremental is not important.

Chapter 2 Economists’ View of Behavior 17

extra call, she should not make any more sales calls that day—the marginal costs would have exceeded the marginal benefits. She continues to make additional sales calls as long as the reduction in tennis playing is valued at less than $50.5

Marginal analysis is a cornerstone of modern economic analysis. In economic de- cision making, “bygones are forever bygones.” Costs and benefits that have already been incurred are sunk (assuming they are nonrecoverable) and hence are irrelevant to the current economic decision. Mary paid $5,000 to join a tennis club last month. This fee does not affect her current decision of whether to play tennis or make an extra sales call. That expenditure is ancient history and does not affect Mary’s cur- rent trade-offs.

As another example, consider Ludger Hellweg who owns a company that installs wood floors. He is offered $20,000 to install a new floor. The cost of his labor and other operating expenses (excluding the wood) are $15,000. He has wood for the job in inventory. It originally cost him $2,000. Price increases have raised the market value of the wood to $6,000, and this value is not expected to change in the near fu- ture. Should he accept the contract?

He should compare the incremental costs and benefits from the project. The mar- ginal benefit is $20,000. The marginal cost is $21,000—$15,000 for the labor and operating expenses and $6,000 for the wood. The historic cost for the wood of $2,000 is not relevant to the decision. To replace the wood used on this job costs

MANAGERIAL APPLICATIONS

Marginal Analysis of Customer Profitability Banks often provide multiple products and services to the same customer (checking and savings accounts, mortgages, lines of credits, business loans, credit cards, international banking services, insurance, and so on). In the 1980s, most banks did not consolidate this information, and so it was difficult to determine if serving a given customer was profitable or not. Today many banks use “profitability software” to consolidate information on each customer. Many banks have found to their surprise that the incremental costs for serving many of their customers are larger than the incremental revenues. Fleet Bank, for example, found that as many as one-half of their customers were unprofitable. Armed with this information, banks work hard to maintain high-profit customers, while they either eliminate or alter services to unprofitable customers. For example, at many banks profitable customers are given special designations, such as “Gold Customer Status,” and the banks extend special services to them. Preferred customers are frequently given special toll free lines; branch managers are furnished with their names and are instructed to meet and greet them when they visit a branch. They are assigned personal bankers, who call and introduce themselves. Customers are assigned profitability codes, for example, so employees can know whether they are dealing with a 5, 4, 3, 2, or 1 type customer (five being most profitable). When the loans for unprofitable customers come up for renewal, they are renewed at a higher rate, to try to nudge them into profitability, or possibly to get the customers to take their business elsewhere. In contrast, loan applications by customers in the 4 and 5 categories are quickly processed and given special attention. Banks provide but one example of how firms are making increased use of information technology to do more sophisticated marginal analysis—devoting their efforts to customers and products where the incremental revenues are greater than the incremental costs and eliminating and avoiding unprofitable activities.

Source: A. Hughes (2014), “How Banks Use Profitability Analysis,” Database Marketing Institute, www.dbmarketing.com/ articles/Art195.htm.

5To keep this example simple, we abstract from several issues. We ignore any pleasure Mary receives from the process of selling. Also, selling effort today is likely to have some effect on her future professional progress. Finally, if Mary values a tennis game at 9 A.M. and one at 7 P.M. equally, she will sell during the business day and postpone tennis to the evening.

18 Part 1 Basic Concepts

$6,000. Since the marginal costs exceed the marginal benefits, Ludger would be bet- ter off rejecting the contract than accepting it. This example illustrates that in calcu- lating marginal costs, it is important to use the opportunity cost of the incremental resources, not their historic (accounting) cost.

Opportunity Costs

Because resources are constrained, individuals face trade-offs. Using limited re- sources for one purpose precludes their use for something else. For example, if Larry Matteson takes four hours to play golf, he cannot use that same four hours to paint his house. The opportunity cost of using a resource for a given purpose is its value in its best alternative use. The opportunity cost of using four hours to play golf is the value of using the four hours in Larry’s next best alternative use.

Marginal analysis frequently involves a careful consideration of the relevant op- portunity costs. If Larry starts a new pizza parlor and hires a manager at $30,000 per year, the $30,000 is an explicit cost (a direct dollar expenditure). Is he better off man- aging the restaurant himself, since he can avoid the explicit cost of $30,000 by not paying himself a salary? The answer to this question depends (at least in part) on the opportunity cost of his time. If he can earn exactly $30,000 in his best alternative job, the implicit cost of self-management is the same as the explicit cost of hiring an out- side manager: He forgoes $30,000 worth of income if he manages the parlor himself. Both explicit and implicit costs are opportunity costs that should be considered in the analysis. Suppose that Larry’s gross profit from the pizza parlor, before paying the manager a salary, is $35,000 and that he can earn $40,000 in an outside job. Hiring a manager for $30,000 yields a net profit of $5,000 from the pizza parlor. He also earns $40,000 from the outside job, for total earnings of $45,000. If he manages the pizza parlor himself, he earns only $35,000. In this example, it is better for him to work at the outside job and hire a manager to run the restaurant.6

Creativity of Individuals7

Within this economic framework, individuals maximize their personal satisfaction given resource constraints. Indeed, people are quite creative and resourceful in min- imizing the effects of constraints. For instance, when the government adopts new

MANAGERIAL APPLICATIONS

Opportunity Costs and V-8 The Campbell Soup Company used the idea of an opportunity cost to create a successful ad campaign for its V-8 vegetable juice. Upon finishing a soft drink, the fellow in the ad would look into the camera, slap his forehead, and exclaim: “Wow—I coulda had a V-8.” Since one is unlikely to drink both a soft drink and a V-8, the opportunity cost of the soft drink is the forgone V-8—a cost that these commercials sought to convince the viewing audience is quite high.

6Again, to keep the example simple, we assume there is no difference in personal satisfaction between Larry’s outside job and managing the pizza parlor. We also postpone the discussion of consequences for the success of the pizza parlor from hiring a manager versus self-management until Chapter 10.

7This section draws on W. Meckling (1976), “Values and the Choice of the Model of the Individual in the Social Sciences,” Schweizerische Zeitschrift für Volkswirtschaft und Statistik 112, 545–560.

Chapter 2 Economists’ View of Behavior 19

taxes, almost immediately accountants and financial planners begin developing clever ways to reduce their impact. Some self-employed individuals were able to re- duce the impact of recent tax increases by changing their status from a proprietorship to a corporation.

As another example, a 33-year-old Brazilian farm hand recently retired with full social security benefits after he satisfied social security auditors that he had been

ANALYZING MANAGERIAL DECISIONS: Marginal Analysis

You own a business that services trucks. A cus- tomer would like to rent a truck from you for one week, while you service his truck. You must decide whether or not to do this.

You have an extra truck that you will not use for any other purpose during this week. This truck is leased for a full year from another company for $300/week plus $.50 for every mile driven. You also have paid an annual insurance premium, which costs $50/week to insure the truck. The truck has a full 100-gallon fuel tank.

The customer has offered you $600 to rent the truck for a week. This price includes the 100 gal- lons of fuel that is in the tank. It also includes up to 500 miles of driving. The customer will pay $.50 for each additional mile that he drives above the 500 miles. You anticipate that the customer will

bring back the truck with an empty fuel tank and will have driven more than 500 miles. You sell fuel to truckers at a retail price of $4.00/gallon. Any fuel you sell or use can be replaced at a wholesale price of $3.25/gallon.

The customer will rent a truck from another company if you do not accept the proposed deal. In either case, you will service his truck. You know the customer and are confident that he will pay all charges incurred under the agreement.

1. Should you accept or reject the proposed deal? 2. Would your answer change if your fuel sup-

plier limited the amount of fuel that you could purchase from him at the wholesale price? Explain.

MANAGERIAL APPLICATIONS

Creative Gaming of the System The U.S. Government in 2009 promoted the sales of presidential and Native American $1 coins by offering free shipping on any order made to the U.S. Mint (which sold the coins at face value). Enthusiasts of frequent-flyer mileage programs saw a creative way to “game” the government’s offer. Many credit cards are tied to the frequent- flyer programs of major airlines—for every dollar charged on the card, a mile is credited to the relevant frequent-flyer program. Several hundred “mile-junkies” responded by purchasing thousands of dollars worth of coins from the U.S. Mint using their credit cards. Once they received the coins, they deposited the money in their bank accounts to pay off their credit card charges before any interest costs were incurred. For example, Patricia Hansen, a San Diego retiree who loves to travel, ordered $10,000 in coins earning 10,000 miles toward free and upgraded travel. Her husband took the coins to the bank, as soon as they arrived, so that their credit card bill could be paid. The U.S. Mint eventually figured out what was going on and stopped the program that had resulted in increased costs for them, credit card companies, banks, and airlines. This example illustrates an important general point. People often respond to economic incentives in creative ways. Managers and government officials need to craft incentives thoughtfully.

Source: S. McCartney (2009), “Miles for Nothing: How the Government Helped Frequent Fliers Make a Mint,” The Wall Street Jour- nal (December 7), A1.

20 Part 1 Basic Concepts

working since he was three years old. Because Brazil doesn’t specify a minimum re- tirement age, the average Brazilian retires at age 49.8

Similarly, when hackers and corporate spies continue to develop more sophisticated schemes to steal information from Web sites or networks, software tools that detect break-ins also have grown in popularity and sophistication. This intrusion-detection soft- ware was about a $100 million industry in 1999 and is now estimated at over $2 billion.9

Understanding this creative nature of individuals has important managerial impli- cations that we discuss later in this chapter, as well as throughout the book.

Graphical Tools Economists often employ a set of graphical tools to illustrate how individuals make choices. These tools distinguish between the preferences (level of satisfaction) that the individual associates with each potential opportunity and the set of feasible op- portunities that an individual faces. We use these tools throughout this book. They also are used in other courses within the typical business school curriculum, such as in finance, human relations, and marketing courses. Our intent is to introduce these tools so that the reader is comfortable using them in basic business applications. We subsequently apply the tools to analyze the problems at Merrill Lynch. Appendix A provides a more detailed development of the economic theory of individual choice (commonly called the “Theory of Consumer Choice”).

Individual Objectives

Goods are things that people value. Goods include standard products like food and clothing, services like haircuts and education, as well as less tangible emotions such as love of family and charity. The economic model of behavior posits that people ac- quire goods that maximize their personal satisfaction, given their resource con- straints (such as a limited income). Economists traditionally use the term utility in re- ferring to personal satisfaction.

To provide a more detailed analysis of how people make choices, economists repre- sent an individual’s preferences by a utility function. This function expresses the rela- tion between total utility and the level of goods consumed. The individual’s objective is to maximize this function, given the resource constraints.10 This concept can be il- lustrated most conveniently through a simple example where an individual cares about only two goods. The insights from this two-good analysis can be extended readily to the case of additional goods such as food, housing, clothing, respect, and charity.

Suppose that Dominique Lalisse values only food and clothing. In general form, his utility function can be written as follows:

� �

Utility � F(Food, Clothing) (2.1)

8P. Fritsch (1999), “In Brazil Retirement Has Become a Benefit Nearly All Can Enjoy,” The Wall Street Journal (September 9), A1.

9J. D’Allegro (1999), “Intrusion Detection Matures,” National Underwriter (March 8), 9; and Frost and Sullivan (2007), “World Intrusion Detection and Prevention Markets,” www.frost.com

10Clearly, most individuals do not actually consider maximizing a mathematical function when they make these choices. However, this formulation can provide useful insights into actual behavior to the extent that it approximates how individuals make choices. Mathematicians have shown that if an individual’s behavior is consistent with some basic “axioms of choice” (comparability, transitivity, nonsatiation, and willingness to substitute), the individual will make choices as if he or she were trying to maximize a mathematical function.

Chapter 2 Economists’ View of Behavior 21

Dom prefers more of each good—thus, his utility rises with both food and clothing. In Dom’s case, his specific utility function is

Utility � Food1�2 � Clothing1�2 (2.2)

For instance, if Dom has 16 units of food and 25 units of clothing, his total utility is 20 (that is, utility � 161�2 � 251�2 � 4 � 5 � 20). Dom is better off with 25 units of both food and clothing. Here, his utility is 25 (utility � 251�2 � 251�2 � 5 � 5 � 25).

Utility functions rank alternative bundles of food and clothing in the order of most preferred to least preferred, but they do not indicate how much one bundle is preferred to another. If the utility index is 100 for one combination of food and clothing and 200 for another, Dom will prefer the second combination. The second bundle does not nec- essarily make him twice as well off as the first bundle.11 Neither does this formulation allow one person’s utility of a bundle to be compared to another person’s utility.

Indifference Curves

Preferences implied by the utility function can be illustrated graphically through indifference curves. An indifference curve pictures all combinations of goods that yield the same utility. Given his utility function in Equation (2.2), Dom is indifferent between either 16 units of food and 25 units of clothing or 25 units of food and 16 units of clothing. Both combinations yield 20 units of utility, and hence are on the same indifference curve. Figure 2.1 shows two of Dom’s indifference curves. For example, if given a choice between any two points on curve 1, Dom would say that he does not care which one is selected—in either case, he obtains 8 units of utility.

Figure 2.1 Indifference Curves

These indifference curves picture all combinations of food and clothing that yield the same amount of utility. The specific utility function in this example is U � F1�2 � C1�2, where F is food and C is clothing. Northeast movements are utility-increasing. Indifference curve 2 represents all combinations of food and clothing that yield 20 units of utility, whereas curve 1 pictures all combinations that yield 8 units of utility. Other indifference curves could be drawn for different levels of utility.

4 16 25 C

4

16

25

F

Quantity of clothing

Q ua

nt ity

o f

fo od

Increasing utility

1: U = 8

2: U = 20

11This is like rankings on a test—an individual who scores in the 80th percentile is not twice as smart as one from the 40th.

22 Part 1 Basic Concepts

The slope at any point along one of Dom’s indifference curves indicates how much food he would be willing to give up for a small increase in clothing (his utility remains unchanged by this exchange).12 Standard indifference curves that illustrate trade-offs between two goods have negative slopes. If Dom obtains a smaller amount of one good such as clothing, the only way he can be equally as well off is to obtain more of another good like food. If at a point along an indifference curve the slope is 22, Dom is willing to give up 2 units of food to obtain 1 unit of clothing. Alterna- tively he is willing to give up 1�2 unit of clothing to obtain 1 unit of food. This willingness to substitute has important implications, which we discuss later.

Movements up and to the right in graphs like Figure 2.1 are utility-increasing. Holding the amount of food constant, utility increases by increasing clothing (a rightward movement). Holding the amount of clothing constant, utility increases by increasing the amount of food (an upward movement). Thus, in Figure 2.1, Dom would rather be on indifference curve 2 than on 1. He obtains 20 units of utility rather than 8.

Economists typically picture indifference curves as convex to the origin (they bow in, as in Figure 2.1). Convexity implies that if Dom has a relatively large amount of food, he would willingly exchange a relatively large quantity of food for a small amount of additional clothing. Thus, the indifference curves in Figure 2.1 are steep when the level of food is high relative to the level of clothing. In contrast, if he has a relatively large amount of clothing, he would be willing to substitute only a small amount of food for additional clothing. Correspondingly, the indifference curves in Figure 2.1 flatten as Dom has less food and more clothing. The behavior implied by the convexity of indifference curves is consistent with the observed behavior of many individuals—most people purchase balanced combinations of food and clothing.

Opportunities and Constraints

Dom would like more of both food and clothing. Unfortunately, he faces a budget constraint that limits his purchases. Suppose that he has an income of I and the prices per unit of food and clothing are Pf and Pc, respectively. In this single period analysis, we assume that Dom spends all his income on food and clothing. In a multiperiod context, Dom might want to save part of his income or borrow against future income. We examine these possibilities in Appendix B at the end of this chap- ter. Since he cannot spend more than I, his consumption opportunities are limited by the following constraint:

I � Pf F � PcC (2.3)

where F and C represent the units of food and clothing purchased. This budget con- straint indicates that only combinations of food and clothing that cost no more than I are feasible. Rearranging terms, this constraint can be written as

F � I�Pf � (Pc�Pf)C (2.4)

12Recall that the slope of a line is a measure of steepness, defined as the increase or decrease in height per unit of distance along the horizontal axis. Slopes of curves are found geometrically by drawing a line tangent to the curve at the point of interest and determining the slope of this tangent line. The slope at a point along one of Dom’s indifference curves indicates how the quantity of food changes for small changes in the amount of clothing in order to hold utility constant. Since by definition Dom is indifferent to this exchange (he remains on the same indifference curve), he is willing to make the exchange.

Chapter 2 Economists’ View of Behavior 23

Figure 2.2 depicts these consumption opportunities—frequently called a budget line. All combinations of food and clothing on or below the line are attainable. Com- binations above the line are infeasible given an income of I. The F intercept (on the vertical axis) of the line I�Pf indicates how much food Dom can purchase if his en- tire income is spent on food (no clothing is purchased). The C intercept is corre- spondingly I�Pc. The slope of the line �Pc�Pf is �1 times the ratio of the two prices. The ratio Pc�Pf is the relative price of clothing in terms of food. It represents how many units of food he must forgo to acquire a unit of clothing: It is the oppor- tunity cost of clothing. For example, if the price of clothing is $8 and the price of food is $2, the relative price of clothing is 4. To keep total expenditures constant, 4 units of food must be given up for every unit of clothing purchased. The relative price of food is Pf�Pc (in this example, 0.25); 1�4 unit of clothing must be given up for each unit of food purchased.

The constraint changes with changes in Dom’s income and the relative prices of the two goods. As shown in Figure 2.3, changes in income result in parallel shifts of the constraint: Its slope is unaffected. An increase in income shifts the constraint out- ward (up and to the right), while a decrease in income shifts the constraint inward. The slope of the constraint changes with the relative prices of the two goods. As shown in Figure 2.4, if the price of clothing increases relative to the price of food, the constraint becomes steeper. If the price of clothing falls relative to the price of food, the constraint becomes flatter.

Individual Choice

Within this economic framework, Dom’s goal is to maximize utility given his op- portunities. Utility is maximized at the point of tangency between the constraint and

Figure 2.2 Opportunities and Constraints

The constraint reflects the feasible combinations of food and clothing that are attainable given the person’s income (I ). The vertical and horizontal intercepts, respectively, show the amounts of food and clothing that can be purchased if no income is spent on the other good. The slope of the constraint is equal to �1 times the ratio of the prices of the two goods. For instance, if the price of clothing is $8 and the price of food is $2, the slope will be �4. This slope implies that 4 units of food must be given up for 1 unit of clothing. If both goods have the same price, the slope will be �1.

I Pf

I Pc

C

Pf

Pc

F

Combinations above line are unaffordable

Combinations on/below line are affordable

Q ua

nt ity

o f f

oo d

Quantity of clothing

–

24 Part 1 Basic Concepts

an indifference curve.13 Figure 2.5 portrays the optimal choice. Dom could choose points like b and c on indifference curve 1. However, point a on curve 2 yields greater satisfaction (utility) and thus is preferred. Dom would prefer to be at any point on curve 3. Yet, these points are unattainable given his income.

Figure 2.3 Income Changes

This figure shows that there is a parallel shift in the budget constraint when income changes. The slope of the constraint does not change because there is no change in the prices of the two goods. The slope is �1 times the ratio of the prices.