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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

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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®.

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• 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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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.