1. Propositions on Organizational Engineering
Shyam Sunder
Yale University
University of Calcutta, Kolkata
January 5, 2006

2. Outline Organizations as alliances among people seeking their goals
Culture of a group is the set of common knowledge expectations its members have from one another
Control as equilibrium or balance: organization is in control if expectations of its members from one another match what its members find in their own best interests
Control threatened by changes in environment; without prompt repair, organization collapses
Strategic management: anticipate threats, redesign and renegotiate alliances to restore control with respect to the changed environment.
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3. Organizational Design
Perspective includes a review of
Organizations,
Expectations,
Common knowledge, and
Culture;
Disruption and threats to control
Strategic management: what top managers do to maintain control
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4. Contract View of Organizations
Work of Barnard, Simon, Cyert and March, Cooper, beginning in the 1930s (“Carnegie School”)
Useful to think about organizations as a set of contracts or alliance among people
Simple, powerful synthesis of economic and organization theories
Can sustain a robust theory of accounting and control (Sunder 1997)
If organization is a set of contracts,
Accounting is the operating mechanism to make the contracts work
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5. Contracts Participating agents promise to deliver resources
In exchange for the promise of inducements
Agents enter contracts if they expect to get more than the opportunity cost of their contributions
To succeed, an organization must have a production function to simultaneously satisfy all contracts
Otherwise dissatisfied agents abandon the alliance
Organization collapses unless an alternative set of contracts that satisfies the condition is assembled
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6. Agent Has personal goals
From his opportunity set, chooses preferred actions
Actions are consistent with his preferences, information and opportunity set
Difficult to model in social sciences without a minimal level of behavioral consistency
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7. Examples of Contracts
Contract is a mutual expectation or understanding among agents
Lunch date
This class
Promising a delivery schedule to customer
Explicit of implicit promise of relevant action
Legal enforceability or written form not necessary
Social conventions play an important role
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8. Players and the Game Individuals have goals; they are the players
Organization is the game in which individuals play to seek their own goals
Perspective is applicable to a broad range of organizations—business, government, society, academia
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9. Business Organizations
For present discussion, consider business organizations
Consider them as an alliance among contributors of
Capital (shareholders, creditors)
Labor (employees, managers)
Factors (vendors)
Cash (customers)
Public services (government)
Support (Community)
Each party gets resources in exchange
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10. Firm as a Set of Contracts
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11. Accounting in Organizations
Operating mechanism for contracts
Necessary to assemble, implement, enforce, modify and maintain the contract set
Five functions
Measure resource contributions from agents
Monitor resource outflows to agents
Relate inflow and outflow for each agent
Maintain liquidity of factor markets
Common knowledge to facilitate contract renegotiation
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12. Measuring Contributions
Receivables and cashier
Receiving dock for supplies
Punch clock and quality control
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13. Measuring Outflows Payroll accounts Tax accounts Cashier Shipping
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14. Contract Fulfillment
Matching resource inflows and outflows to contracts
Performance evaluation
Adjusting contracts to resource realizations
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15. Maintaining Liquidity of Factor Markets
Individuals agents come and go
Finding replacements for departing agents in appropriate factor markets
Convincing new people to participate
Advertising motive in all factor markets
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16. Facilitating Contract Renegotiation Through Common Knowledge
Most contracts are finite term contracts
Motive to bluff at the time of renegotiation
Ex ante agreement to share some information as common knowledge
Common knowledge cannot be used to bluff others
Reduces dead weight losses to society
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17. Expectations
Thinking, anticipating a future event or object (e.g., salary at the end of the month)
Tinged with hope toward our preferences
First moment of a probability distribution which is
Objective (e.g., value of a lottery ticket)
Subjective (e.g., value of a lottery ticket)
Two of these three meanings are subjective
Will coincide only by chance
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18. Human Expectation Formation
Complex
Not well understood
Risk of flying versus driving!
Contracts defined as expectations of resource flows
Customer expectations from cars
Employee expectations from job
Investor expectations of returns
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19. Mutuality of Expectations
Expectations are rarely fixed
All actions create/influence expectations
Firm must manage them (problem of participative budgeting)
With unfilled expectations, people turn away
With overfilled expectations set up disappointment later
Management gurus preach maximization—of profits, growth, quality, EPS, stock prices, etc., instead of setting a target and sticking to it
Pursuit of moving targets (Enron expected 91 percent growth rate in free cash flows for next 6 years)
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20. Common Knowledge
Technical term in philosophy, statistics, game theory and economics
Denotes knowledge that includes knowledge about what others know
Aumann (1976): Two people 1 and 2 are said to have common knowledge of an event E if
both know it,
1 knows that 2 knows it,
2 knows that 1 knows it,
1 knows that 2 knows that 1 knows it,
and so on...
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21. Emperor Has No Clothes
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23. Stock Market Stock Market is like a newspaper beauty contest
John Maynard Keynes, (1936)
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24. Newspaper Beauty Contest
Which Face is the prettiest?
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25. Which face will they judge to be the prettiest?
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26. Which face will they judge to be the prettiest?
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27. LIFO Inventory Accounting
If your inventory prices rise, and end-of-year inventory volume is stable or rising
You can delay paying taxes (higher net present value of cash flows)
But have to report lower income also
Many firms don’t adopt LIFO
Apprehension about stock market reaction (no empirical support)
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28. Beliefs About Others’ Beliefs
Common elements to the three stories about the emperor‘s clothes, stock market and LIFO
Central role of what we believe about others, and about their beliefs
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29. Emperor’s Clothes
The scoundrels made people believe that the clothes will be invisible only to the incompetent and the stupid
People thought that others believed it
Nobody wants to be seen as stupid or incompetent by others, lose his/her job
Visibility of clothes was private, it was easy to fake seeing the clothes
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30. Emperor’s Clothes (Contd.)
Scenario 1: Everyone was privately convinced of their incompetence, and cheered to deny it publicly
Scenario 2: People did not believe they were incompetent just because they could see the naked emperor, but believed that others so believed, and cheered to avoid being seen as stupid
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31. What about the Child?
The child did not know the link between visibility and competence
Child was innocent, and said what he saw
People know children to be innocent
People knew that people knew this
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32. Keynes on Stock Market Price of Microsoft shares is $100
I expect the price to be $125 a year from now.
Is it a good buy?
Rule 1: Yes, if your opportunity cost of capital is less than $25 for the year
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33. Stock Market (Contd.)
What if I now believe that the stock market’s assessment of the value of Microsoft shares a year from now will be $90?
Can I change the beliefs of others in the market?
If not, Rule 2: Sell at $100
Higher order rules
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34. Should I Pay Attention to Others When I Know I Am Right?
What if everyone believes them (who are wrong), and not me (who is right)
Fight them? or
Join them?
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35. What About Accounting
Agency problem: how to induce managers to maximize shareholder value (e.g., choose LIFO)
Solution: Link managerial compensation to shareholder value
Problem 2: Value manipulation
Solution: Use market, not accounting, measures of value
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36. Value Maximizing Manager in an Efficient Market
LIFO can increase NPV of cash flow
But manager maximizes stock price
What does manager believe about how stock prices are determined?
Suppose manager believes that stock prices depend on income, not cash
Then manager is rationally led to reject LIFO even if it saves cash for the firm
After these examples of the consequences of common knowledge assumption, let us consider culture
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37. Culture
In management, culture often treated as a counterpoint to economics
Can think of culture of a group as the common knowledge expectation of behavior of the members of a group
Starting meetings on time
Wearing black on black
Expectations lie at the heart of economic models
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38. Management Controls Again
A viable concept of control from organizations as sets of contracts, expectations, common knowledge and culture
An organization or group is in control when its members find it in their own best interests to behave in a manner that is expected of them by the other members of the group
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39. Control In Versus Control of
Control in organizations distinct from control of organizations
Control in emphasizes
Balance and equilibrium
Symmetry of points of view of agents
Control of emphasizes
Manipulation, even exploitation
Disparity in bargaining powers of agents
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40. Comprehensive Perspective on Control
Rules, incentives, monitoring, enforcement to align behavior and expectations
Consider two traders on eBay
Buyer expects to have the appropriate goods delivered
Seller expects to be paid
When expectations of both are met, the system is in control
The concept extends well beyond the traditional scope to employees and managers to include shareholders, customers, vendors, and others
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41. Threats to Control
Environment of organizations changes continually (factor and product market conditions)
A contract set which is in control today, will not be in control tomorrow if conditions change
Left to itself, the organization will collapse because a fixed set of contracts cannot remain in expectational equilibrium except by sheer chance
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42. If Individual Condition Is Not Met
People who do not expect to get from the organization at least the opportunity cost of their contributions will go elsewhere
This is the definition of opportunity cost
Shareholders will not buy your stock if they can higher risk-adjusted return elsewhere
Customers will not buy your goods if they can get better price or quality elsewhere
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43. If Aggregate Condition Is Not Met
Firms runs out of resources to meet its obligations (expenses exceed revenue)
Some agent(s) disappointed because the promises made to them are not fulfilled
These agents quit (and probably impose additional costs on the organization—e.g., law suits)
If these individuals were essential for the production function of the firm, their departure makes things worse
If they were not essential, the firm did not choose the optimum production function
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44. No Coercion
Matching of agent actions to what others expect of them should not be achieved through coercion
It has to be created through socially legitimate incentives and motivational methods
What is legitimate varies across societies
Performance-based compensation may be considered coercive in some societies but not in others
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45. Not Based on Misunderstanding
Participant actions and others’ expectations of them may just happen to match due to misunderstanding
Such a match is not sustainable; it disappears as soon as the participants get better information
A match based on misunderstanding does not imply control
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46. Not Based on False Promises
A match may sometimes be obtained through false promises—e.g., Ponzi schemes
Again, these are not sustainable
Disclosure of truth destroys the organization
Such a house of cards is not “in control”
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47. Disintegration of Organizations
When actions do not match the expectations, people are disillusioned and quit
Organizations disintegrate
Miscalculation, coercion, misunderstanding, or misrepresentation by agents destroy control
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48. Functions of Top Management
This function goes by many labels (long term planning, strategic management, etc.)
It always amounts to the same thing:
Monitor your environment
Anticipate changes in factor and product markets
Redesign contracts to be in control under the new conditions
Renegotiate contracts
Implement new contracts
Perpetual revision of corporate plans to retain their desirability from the point of view of all participants
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49. Let Me Summarize Control a key concept in management
Need an appropriate model of organizations to study control
Help do accounting and control better
Find appropriate place for control in the intellectual structure of the discipline of management
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50. Role of Accounting
Organizations as sets of contracts or alliances among people
Agents seeking their own goals contribute resources in exchange for inducements
Accounting helps define, implement, enforce and modify contracts, serving a critical function in organizations
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51. Design of Organizations and Controls
Both designs depend on conditions prevailing in the appropriate markets
Market for managerial labor differentiated stewardship model from bookkeeping
Market for capital differentiated financial reporting model from stewardship
Market for products differentiates government and not-for-profit model from private good organizations
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52. Expectations and Common Knowledge
Contracts are based on expectations
Expectations not well-understood yet
First as well as higher orders of knowledge play important part in management
Not always reasonable to assume common knowledge
Breakdown of common knowledge has important consequences for behavior and outcomes in organizations and markets
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53. Culture and Control
Culture of a group can be thought of as expectations its members hold about the behavior of others in the group
An organization is in control if the behavior of its members corresponds to the expectations of others
Control is a state of expectational equilibrium
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54. What’s Management For Changing environment threatens control
Top management must anticipate and deal with these threats to control
Set of feasible corporate plans is too large to contemplate and analyze
Due to time limitations, managers search in the neighborhood of existing plans and settle on satisficing solutions
Simon’s boundedly rational behavior
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55. Thank You Please send your comments to Shyam.sunder@yale.edu
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