1. 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?

2. 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)
P. 15 – “Franchise is mixture of firm and market systems that use alienability of rights as part of the control system.”
“The process for moving knowledge to those with decision rights has received much attention from researchers and designers of management information systems. But the process for moving decision rights to those with the relevant knowledge has received relatively little attention in either economics or management.” p. 5
“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.”

3. What document is this quote from?
“A right is alienable if its owner has the right to sell a right and capture the proceeds offered in the exchange.” p.2 (see also p. 12)
Pop quiz… what document is this quote from?

4. “…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

5. How does the MARKET “control”?
What do J&M mean by “control”?
“Control is the process and rules governing the measures of performance, and the rewards and punishments meted out in response to individual actions” (p. 12)
How does the MARKET “control”?
See also p. 24: “The control system specifies (a) the performance measurement and evaluation system…, and (b) the reward and punishment system that relates the individual’s rewards to their performance.”
NOTE: p. 25: “It does not take long to discover when the rewarded objective is different from that which is stated “ – foreshadows Kerr paper.

6. “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…)

7. 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)

8. 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)

9. True story: when Professor Kohn was in 4th grade she tried to run away and join the circus to be a juggling clown riding a unicycle.

10. Will staff tell the boss bad news?
Will staff “change” the story to suit their needs?
Will all staff agree on the same “truth” even if they all observe the same situation?

11. 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)
Shari Gifford
“Limited Attention as the Bound on Rationality”
(2005)
“The limitations of (the CEO’s) own mental and communication abilities make it impossible for the CEO to gather the requisite information to make every detailed decision personally…delegating authority…requires consideration of the costs of generating and transferring knowledge…” (p. 17)

12. 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… ?

13. The more specific the knowledge needed to make a decision the more you should allocate the decision right to the person with the knowledge rather than incur the cost of transferring the knowledge to someone else with the decision right.

14. “Changes in information technology have an ambiguous impact on the optimal degree of decentralization…When improved technology makes it easier to transfer specific knowledge effectively from lower to higher levels…there will be a shift toward centralization. When improved technology makes it easier to transfer to lower levels in the organization information that formerly was specific to higher levels…there will be a shift toward decentralization.” (p. 20)
Examples in footnotes.

15. “Increased government regulation tends to increase centralization …by increasing the amount of specific knowledge in the headquarters office dealing with the regulatory agency.” (p. 20)
Banking & finance = apx. 7.2% of economy
Health care = apx. 17%

16. “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 – prior quote on p 15 (starting on p. 14) “Bringing diverse knowledge together…”

17. “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.

18. 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
Key point about job descriptions p. 22: Decision rights are allocated to agents within firms in various ways. Many are allocated directly to individuals or positions through job descriptions…”
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)

19. 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

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