Jensen & Meckling Specific and General Knowledge, and Organizational Structure * As played by George Clooney “…we analyze the institutional devices through which decision making rights are assigned in markets and within firms and the devices used to motivate agents to make proper decisions.” (p. 1) Goals: 1. What is the difference between general and specific knowledge? 2. What difference does it make for organizational structure?

How do markets & firms “solve the rights assignment and control problems”? “Alienability solves the control rights problem” (p. 12) Those with the knowledge buy the decision rights; or those with the decision rights buy the knowledge (p. 5) Who should have the rights & Rewards and punishments (p. 13) What is the assignment rights and control problems? – Control problem is agency problem of info asymmetry and different interests (Madison and factions) Review definition of alienability – ability to sell and capture the proceeds of the sale. Foreshadow Ostrom who defines additional property rights. In markets decision maker should reap the benefits or suffer the penalties of the decision (control system). Problem is EXTERNALITIES which means that individuals do not bear full costs and others have interests in the decision. P. 15 – “Franchise is mixture of firm and market systems that use alienability of rights as part of the control system.” “Firms must obtain advantage from the suppression of alienability… (p. 14) Knowledge considerations are one cause of the emergence of firms.” “The assignment and enforcement of decision rights in organizations are a matter or organizational policy and practice, not voluntary exchange.”

“…the CEO in the typical firm cannot generally use alienability to solve the firm’s organizational problems…Organizational problems within the firm must therefore be solved…by devising a set of rules of the game for the firm which: Partition out the decision making rights to agents throughout the organization. Create a control system that a) provides measures of performance; b) specifies the relationship between rewards and punishments and the measures of performance. …knowledge of these rules of the game enables one to make good predictions about an organization’s behavior and effectiveness.” p.21

Costly to transfer! General Knowledge Specific Knowledge “particular circumstances of time and place” Tastes, preferences, problems (e.g. this machine is out, that worker is sick, or this buyer is patient.) Examples p. 6 “Specific knowledge… is often acquired jointly with the production of other goods.” (p. 6)

delays in actions are costly.” (p. 7) “Effective transfer” of knowledge: “The recipient of knowledge is presumed to understand the message well enough to act on it.” Play game of telephone The CEO should tell Professor Smith to write “Transferring information through multiple channels is not a very effective method of preserving knowledge” on the board. Point about timing – Peyton vs. stock prices – both move fast, but one is easier to convey and understand. Speed alone is not the key. Do people always tell the truth? Will employees give the boss bad news? Because time is often important in taking advantage of opportunities for arbitrage or for exploiting knowledge of unemployed resources, delays in actions are costly.” (p. 7)

Herbert Simon Shari Gifford The limitations on human mental and sensory faculties mean that storing, processing, transmitting and receiving knowledge are costly activities.” (p. 4) Herbert Simon Models of Bounded Rationality (1982) http://en.wikipedia.org/wiki/Herbert_Simon Shari Gifford “Limited Attention as the Bound on Rationality” (2005)

Optimal Allocation of Decision Rights “The key to efficiency is to assign decision rights to each agent at each level to minimize the sum of the costs owing to poor information and the costs owing to inconsistent objectives” p. 19 Agency costs = designing + implementing + maintaining system + residual loss from bad decisions Because of BOTH bounded rationality and the scarcity of time and space, all decisions can’t be made by the CEO Assumption that CEO’s incentives are aligned with organizational optimization Others have different INTERESTS (factions) Talk about costs first – brainstorm Why not at the intersection? Emphasize that we make decisions on the margin! Costs of Control systems… budgets, measures, job descriptions in next slides… ?

“Minimizing cost for given total output often seems to degrade into a system where managers are rewarded for minimizing average cost per unit of output…measuring performance by average cost per unit of output will virtually never be consistent with firm value maximization in the absence of a quantity constraint” p. 25. Control mechanisms: Budgets Profit centers vs. cost centers Job descriptions (next slide – when you canot measure quanitiy…)

“Where the production, transfer, and application of knowledge are the primary goods being offered, however, exchanges tend to take the form of long-term relationships, and the most common of these is employment contracts…The transaction costs emphasized by Coase (1937) and Williamson (1975) are one reason such contracts emerge. Single proprietors who contract on a case-by-case basis for production and application of all knowledge would soon find themselves swamped by transaction costs in all but the smallest scale firms.” p. 15 Incentive to invest in firm-specific knowledge Virtual organizations Scientific knowledge

“Particularly challenging information transfer problems arise in situations where optimal decision-making requires integration of specific knowledge located in widely separate individuals. Integrating the specific knowledge of marketing, manufacturing, and R&D personnel to design and bring a new product to the market is an example” p. 8.

Observability of outcomes : “…optimal architectures will differ across companies. Such structural differences are not random but vary in systematic ways with differences in certain underlying characteristics of the companies themselves.” BSZ p. 345 Type of Information General & Specific Knowledge Cost of bad decisions! Marginal cost of poor incentives = marginal cost of bad decisions Greater decision rights require greater incentives Greater incentives require measuring outcomes Greater decision rights require greater incentives Greater incentives require measuring outcomes Speed increases the cost of knowledge transfer Speed of Decisions Observability of outcomes Outcomes cannot easily be traced back to specific decisions by individuals Risk and risk aversion can dilute incentives Inability to measure Precludes incentives “The tendency for large organizations to avoid pay-for-performance incentive plans and to rely instead on promotion-based rewards is an interesting phenomenon that is as yet poorly understood by economists.” (p. 28)

Incentive Pay (see Ch. 15 in text) Key problem: if you can’t observe effort agents can easily blame poor performance on bad luck (see p. 460 in text) Fixed wages Commissions 1. Observability of output 2. Risk aversion of agents 3. Forces beyond agents’ control Bring up risk of concentration of human capital for professionals (MD, teacher, CEO – firm specific capital, risk) Malpractice risk Teachers compensating differential of relatively low pay for level of education Volatility of the industry (GM, banks, sales

Trade-offs Trust Specific Information Knowledge Asymmetry Monitoring Transactions Costs Decision Rights Trust Incentives