Wednesday, 11 May 2011

Economic Theories of Organizations and their distinction with Standard Microeconomic Theory-A Teaching note

A) Introduction:
This teaching note looks at five assumptions of standard microeconomics which Economic Theories of Organisations[1] aims to look beyond. The standard microeconomic theory that is criticized in this note is based on five assumptions. (Douma and Schreuder, 2008, pp43-44)
Firms are holistic entities: This means that a firm is assumed to be a single, unified entity. The result is that, in standard microeconomics, one does not consider what goes on inside the firm.
Firms have a single objective function: such as to maximize profit or the value of the firm. That assumption means the objectives of the owner(s) of the firm are the only objectives that matter.
Everyone has perfect information: However, organizations arise mainly as solutions to information problems. If we want to understand why not all economic decisions are coordinated by the price mechanism of standard microeconomics, then we have to relax that crucial assumption.
The behaviour of producers and consumers can be described as maximizing behavior: This assumption typifies the “homo economicus”, who knows everything and makes decisions solely on the basis of calculating the solution to some maximizing problem.
Standard microeconomics examines the market independent of environmental context: While this is useful as an analytical approach, the functioning of many markets in the real world cannot be fully understood without including the environmental factors.

B) Breaking away from Standard Microeconomic Theory-Economic Theories of Organizations-
i) Behavioral Theory. (Douma and Schreuder, 2008, pp127-129)-In behavioral theory, the firm is postulated as a coalition of (groups of) participants, such as shareholders, employees, managers, suppliers and customers. That is a major way in which it differs from standard microeconomic theory, which sees the firm as a holistic entity. Each participant receives inducements from the firm in return for the contributions he or she makes to the firm. A participant will remain within the coalition if, in his own opinion, the value of the inducements received is greater than the value of the contributions made.
In behavioral theory we assume that not all people have the same information. For example, an employee may not know exactly how much he could earn with another employer or what the atmosphere between colleagues is really like in another firm.
In behavioral theory we also assume that human beings are boundedly rational. That means human beings are unable to make all sorts of difficult calculations in a split second, nor can they process all the information they receive. It does not mean that humans do not want to maximize something, only that they are not always able to do so. The behavior of human beings is better described as satisficing rather than maximizing. For example, an employee will have an aspiration level with respect to the level of pay he wants to receive. As long as the pay earned is above that aspiration level, the employee is content. Owning to lack of information he may even be content with a lower level of pay than is offered elsewhere.
In behavioral theory concerning the firm, each participant or group of participants has his own goals, usually in the form of aspiration levels. Those goals will generally not coincide. The result is that the firm will generally have several goals, which are arrived at through a bargaining process between the (groups of) participants.
There are four fundamental differences between behavioral theory and standard microeconomic theory. Behavioral theory:
  • Postulates the firm as a coalition of participants;
  • Does not assume that the firm has a single objective;
  • Assumes that information cannot be transmitted without cost;
  • Assumes that human decision makers are boundedly rational.
Several of these characteristics of decision-making within firms have been incorporated in various economic approaches to organizations, which were developed later. That was recognized by Cyert and March when they wrote a preface to the second edition of their classic book “A Behavioral Theory of the Firm” in 1992:

“We had an agenda in 1963. We thought that research on economics and research on organizations should have something to say to each other. We thought that the theory of the firm should be connected to empirical observations of firms. We thought that empirical observations of what happens in firms should be connected to interesting theoretical ideas…The agenda and the first steps we proposed were somewhat deviant from dominant ideas in both economics and organization theory when the book first appeared. In the years since 1963.. a number of the ideas discussed in the book have become part of the received doctrine. In particular, a perspective that sees firms as coalitions of multiple, conflicting interests using standard rules and procedures to operate under conditions of bounded rationality is now rather widely adopted in descriptions and theories of the firm.”

ii) Agency Theory-. (Douma and Schreuder, 2008, page 131)
Agency theory, in its simplest form, discusses the relations between two people-a principal and an agent who makes decisions on behalf of the principal.
Agency relations can be found both within firms (manager and subordinate) and between firms (for example, licensing and franchising).
Within agency theory two streams of literature can be distinguished: the positive theory of agency and the theory of principal and agent.
In the positive theory of agency, the firm is viewed as a nexus of contracts. The main research questions in the positive theory of agency are how do contracts affect the behavior of participants and why do we observe certain organizational forms in the real world?
In the theory of principal and agent, the central question is how should the principal design the agent’s reward structure?
This theory relaxes the assumption of microeconomics that the firm has a single objective function.

iii) Markets and Organizations-Motivation for Transaction Cost Economics-(Douma and Schreuder, 2008, pp 12-13)
Why is not all exchange executed across markets? In fact, this is a rather old question. It was raised most effectively by Coase in 1937, who put it this way:
“If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so…The example given above is typical of a large sphere in our modern economic system…But in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organization necessary?
Coase went on to provide an answer along the following lines. Contrary to the standard assumption for ideal markets, Coase maintained that usually there is a cost associated with using the price system. First of all, there is usually a cost (if only time) involved in finding out what the relevant prices are. Next, when important, a contract is usually drawn up to provide the basis of a market transaction. For instance in the labour market, employment contracts are necessary to specify the conditions under which most exchanges take place. It is costly to draw up those contracts. Finally, there may be conditions under which it is hardly possible (or extremely costly) to reach a contractual agreement that may serve as a basis for market exchange. In those cases, too, organization may provide an alternative.
Therefore, Coase posited markets and organizations as alternatives for the execution of transactions. For markets, the price system is the coordinating device. Within organizations, the price system I is replaced by authority as a coordinating mechanism. The question remains as to the circumstances under which the market will be employed for exchange transactions and the conditions under which organizations will be preferred. Coase’s answer was that it is determined by the relative cost of transacting under these two alternatives. Transactions will typically be executed at the lowest cost. As a consequence, transactions will shift between markets and organizations as a function of the transaction costs under those two alternatives.

Here we conclude by noting that Coase’s analysis (1937) allowed standard economic reasoning to be employed in analyzing both the nature and the size of the firm:
“When we are considering how large a firm will be, the principle of marginalism works smoothly. The question always is, will it pay to bring an extra exchange transaction under the organizing authority? At the margin the cost of organizing within the firm will be equal either to the cost of organizing in another firm or to the costs involved in leaving the transaction to be “organized” by the price mechanism.”

iv) Transaction Cost Economics--(Douma and Schreuder, 2008, pp 161-171)
Division of labour creates opportunities for specialization, which necessitates the coordination of economic decisions. There are two ideal types of coordination mechanism: markets and organizations. In transaction cost economics the fundamental unit of analysis is the transaction. Transactions can take place across markets or within organizations.
Firms exist because, in some cases, the costs of internal coordination are lower than the costs of market transactions. If we want to develop a theory we should specify beforehand in which cases we expect the costs of market coordination to be high compared with the costs of internal coordination. Olivier Williamson has almost single-handedly developed such a theory in numerous publications. (See Williamson (1975), (1985))

Transaction cost economics as developed by Williamson is based on the assumption that human beings are boundedly rational and sometimes display opportunistic behavior. Whether transaction costs for a particular transaction will be high or low depends on the critical dimensions of that transaction.
Bounded rationality will pose a problem only in environments that are characterized by uncertainty/complexity. When you buy petrol for your car, there is not much complexity/uncertainty. You know the product quite well, you do not have to worry about after sales service and the seller does not need any information a bout you, provided you pay directly. To buy petrol you do not need to write and sign a contract.

Now consider the case of a government that wants to buy a new weapon system. In that case it is necessary to write and sign a contract. Such a contract is very complicated. It is likely that bounded rationality in conjunction with uncertainty/complexity makes it costly to write a contract for building a new weapon system.

In Williamson’s view human beings are not only boundedly rational but they also sometimes display opportunistic behaviour. Williamson describes opportunism as “self interest seeking with guile’” and as making self-disbelieved statements. In plain English, trying to exploit a situation to your own advantage.

The mode of a transaction (that is whether a transaction is governed by the market or an organization) is determined by minimization of the sum of production and transaction costs.
There is another factor that determines the mode of a transaction however. It is called atmosphere. The atmosphere factor refers to the fact that participants in a transaction may value the mode of the transaction. (For example-being self employed.) In the framework of transaction cost economics, the atmosphere factor refers to the local environment in which the transaction takes place.

Transaction costs for a particular transaction depend on the critical dimensions of that transaction. There are three critical dimensions of transactions
  • Asset specificity
  • Uncertainty/complexity
  • Frequency

The asset specificity of a transaction refers to the degree to which the transaction needs to be supported by transaction specific assets. An asset is transaction specific if it cannot be redeployed in an alternative use without a significant reduction in the value of the asset. Asset specificity may refer to physical or human assets.

The second dimensions of transactions, uncertainty/ complexity, needs no further explanation: we learned earlier that bounded rationality is a problem only for transactions with a high degree of uncertainty/complexity.

When asset specificity is high, we expect transactions to be carried out within organizations than across markets. However to set up a specialized governance structure (such as a vertically integrated firm) involves certain fixed costs. Whether the volume of transactions conducted through a specialized governance structure utilizes it to capacity is then the remaining issue. The costs of a specialized governance structure are more easily recovered for high frequency transactions. Hence, frequency is the third relevant dimension for transactions.

C. Conclusion-In this teaching note we highlighted important assumptions in microeconomics and then gave an idea of the relaxation of these assumptions in Economic Theories of Organisation.

Coase, R.H.(1937), ‘The nature of the firm’, Economica, vol.4.
Cyert, R.M., and March, J.G.(1963), A Behavioral Theory of the Firm, Englewood Cliffs, NJ:Prentice Hall(2nd edn, 1992)
Douma, S and Schreuder H, Economic Approaches to Organisations:Prentice Hall(Fourth Edition, 2008)
Williamson, O.E.(1975), Markets and Hierarchies:Analysis and Antitrust implications, New York:Free Press.
Williamson, O.E.(1985), The Economic Institutions of Capitalism, New York:Free Press.

[1] Examples of economic theories of organization are the behavioral theory of the firm, agency theory and transaction cost economics.

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