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xii Preface

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Preface xiii

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®.

xvii

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 Gene