Organizational Economics

 Focuses on economic reasons for the existence of firms  Some parts of OE focus on equilibrium-based models of economics (not all)

 Most economists focus on markets, OE focuses on firms  Organizational economists tend to focus on the relationship between competition and firms

 Transaction Cost Economics (Williamson 1975)  Agency Theory (Jensen & Meckling 1976)  Strategic Management Theory  Co-Operative Organizational Economics

 Coase (1937) questioned the lack of treatment in economics to the theory of the firm.  Firms exist because some exchanges are better managed (cost less) inside organizations as opposed to across markets  Coase placed transaction costs at the center of analysis of firms – which led to TCE

 Teams outproduce individuals  Individuals on teams have incentives to shirk  Teams will assign a monitor who gathers the profits from teamwork and pays members accordingly  The “monitor” is the shareholder, which suggests why firms form

 Williamson 1975  Conditions of Uncertainty around Specificity ◦ Bounded rationality ◦ Opportunism

 Vertical Integration: Make or Buy  Multidivisional form  Ouchi’s (1979) Markets, Bureaucracies, and Clans  Multinational Enterprise  Hybrids

 Focuses on cost minimization  Understates the cost of organizing  Neglects the role of social relationships in economic transactions  Emphasis on opportunism can be harmful

 Do those associated with the firm agree about how it should be managed?  Major themes (Eisenhardt 1989): ◦ Goal misalignment ◦ Information asymmetry ◦ Differences in risk tolerance

 Monitoring  Bonding & Incentives

 Treats people as primarily financially motivated  Ignores other behavioral sciences  Lack of realism in approach to governance  Not necessarily generalizable  Some scholars argue it is self fulfilling

 Why do some organizations outperform others? ◦ Structure-Conduct-Performance (SCP) ◦ Resource Based View (RBV)

 Originated as a search for industries that lacked competition  Overly profitable industries failed to maximize social welfare  Innovation was stifled  Once identified, regulation was used to “remedy” the problem and increase competition

 Performance-enhancing industry attributes: ◦ Industry concentration ◦ Level of product differentiation ◦ Barriers to entry

 Termed “monopolistic competition” by Chamberlain (1933)  Differentiating products allows firms to charge abnormal profits above the cost

 Fewer firms in an industry can lead to collusive strategies  Large economies of scale required to achieve certain profits can lead to performance differences

 Economies of scale  Product differentiation  Cost advantages independent of scale  Contrived deterrance  Government imposed restrictions

 Strategy research now uses SCP concepts to suggest ways firms can reduce competition ◦ Porter’s Five Forces ◦ Model of generic industry structure and environmental opportunities ◦ Strategic groups

 Level of threat  in an industry Threat of rivalry Threat of new entry Threat of buyersThreat of suppliers Threat of substitutes

Industry TypeDefinitionOpportunitiesExamples EmergingNew industry or recent developments First Mover Advantage Intel FragmentedMany firms of similar sizes ConsolidationMcDonald’s MatureSlow increases in demand, repeat business, little product innovation Service and process innovation GE (light bulbs) DecliningConsistently reducing demand in industry Leadership, niche, harvest, divest General dynamics (defense) GlobalSignificant International sales MultinationalNestle

 Firm performance being determined by industry fails to explain heterogeneity within industries  By focusing on “attractive” industries, opportunities in other industries are overlooked  The inversion of the research stream has, in all likelihood, counteracted its original intent of improving social welfare

 Built on the work of: ◦ Penrose (1959) ◦ Schumpeter (1934) ◦ Michael Ricardo  First introduced by: ◦ Rumelt (1984) ◦ Wernerfelt (1984) ◦ Barney (1986) ◦ Teece (1982) ◦ Prahalad and Bettis (1986)

 Unit of analysis: resources and capabilities of firms ◦ Financials resources ◦ Physical resources ◦ Human resources ◦ Organizational resources  Two assumptions ◦ Resources and capabilities can vary significantly across firms ◦ Resources can be immobile (differences may be stable)

 The be sources of superior performance resources must be: ◦ Valuable ◦ Rare among current or potential competitors ◦ Costly to imitate ◦ Without close strategic substitutes  Types of imitation ◦ Role of history ◦ Role of causal ambiguity ◦ Role of socially complex resources and capabilities

 Various studies suggest that firm resources may explain more about its performance than the industry within which it operates  Firms may consider “unattractive” industries ideal for their blend of resources  Instead of reducing social welfare by infringing on competition, RBV focuses on firms doing the best at something

 Tacit Collusion  Strategic Alliances

 Collusion is said to occur when the output of an industry is less than it would be in a competitive environment  Reduced production leads to increased prices, which then lead to improved performance  The collusion can also invite cheating on the agreement by one or more parties  Game theory suggests that incentives to cheat generally outweigh benefits of collusion

 Because explicit collusion is often illegal, tacit collusion is more often engaged in by firms  Tacit collusion requires managers to interpret signals by competitors because no negotiating takes place

 Tacit collusion is easier when there are ◦ Few firms in an industry ◦ Similar cost structures & product offerings ◦ High barriers to entry ◦ Monitoring competitor behaviors is uncomplicated

 Contractual alliance  Joint venture

 Exploit economies of scale  Low-cost entry into new markets  Low-cost entry into new industry segments and new industries  Learning from competition  Managing strategic uncertainty  Managing costs and sharing risks  Facilitate tacit collusion

 Adverse selection  Moral hazard  Hold up

 Governance  Trust

 Why do organizations exist?  Why do some organizations survive and others don’t?  How and why do organizations differ?  How and why do organizations change?  What are the emerging issues?