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AYB321 Lecture Notes - Indirect Costs, Free Rider Problem, Agency Cost

3 pages36 viewsFall 2012

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Lecture 2: Organisational Architecture
Economist’s View of Behaviour
Economic choice:
o Limited resources, unlimited wants
o Assigning priorities to wants chose most preferred option
People are not necessarily selfish
Opportunity cost: cost of using a resource for a given purpose is its value in its best alternative use
Marginal costs and benefits are the incremental costs and benefits associated with making a decision
Managers responses to problems are likely to depend on their understanding of people’s motives and their
forecast of people’s reactions – their responses thus depend on their underlying model of behaviour. Most
managerial actions attempt to change the behaviour of individuals.
Management need to understand what motivates their employees before choosing a policy to address the
situation. There are 5 models:
o Economic model
Assumption: individuals act to maximise their utility
Implication: align interests of employee with the firm provide bonuses to hard workers and
make decisions which increase firm value
Managers can impact behaviour by appropriately designing the opportunities facing
Most useful model in reality most consistent explainer of behaviour, most useful to
managers as it provides concrete guidance on how to alter behaviour. Desired behaviour can
be encouraged by changing the feasible opportunities facing the decision maker.
o Happy-is-Productive model
Assumption: exert high effort when happy (not because of rewards)
Implication: increase job satisfaction e.g. higher pay, gym memberships
o Good-citizen model
Assumption: employees place interests of the company first
Implication: communicate what is required by employees
o Product-of-the-Environment model
Assumption: behaviour of individuals is determined by upbringing
Implication: focus on hiring and firing
o Only-Money-Matters model
Assumption: people only respond to monetary incentives misinterpretation of economic
Implication: use monetary incentives only
Incentive Conflicts with Firms
Individuals are creative maximisers of their own utility
Manager/owner conflicts:
o Choice of effort free rider problem e.g. larger team = people working less hard
o Perquisite taking giving bonuses
o Differential risk exposure
o Differential horizons NPV of market value
Agency Theory
Agency relationship: one party, the principal, engages another party, the agent, to perform some service on
the principal’s behalf
Many agency relationships exist within firms
o Both parties gain some benefit e.g. employer/employee. It is in the best interest of both parties to
make it work. It is the role of both to try to minimise conflict which results in costs
Incentives of principals and agents are not naturally aligned which leads to agency problems
There are three types off agency costs (used to reduce conflict):
o Monitoring costs: incurred by the principal e.g. employee auditors
o Bonding costs: incurred by the agent e.g. purchase insurance
o Residual loss: loss in gains from trade that results due to the divergence of interest in the agency
Total Agency Costs = Monitoring Costs + Bonding Costs + Residual Loss
o There is a maximum which can be spent on monitoring and bonding costs.
o Maximise spending in these areas until they are fully offset by the residual loss
Implicit Contracts
Promises and understandings e.g. suppliers will not shirk on quality
These are difficult to enforce in a court of law as not explicit
Reputational Concerns
These are a powerful force to motivate contract compliance
The market can impost substantial costs on individuals for unethical behaviour e.g. employees have a
reputation to uphold
o This is why implicit contracts work
The Fundamental Problem Facing the Firm
Fundamental problem facing firms:
o Objective: product output customers want at the lowest possible cost
o But: information dispersed and lack of natural incentives
The principal challenge in designing both firms and economic systems is to maximise the likelihood that:
o Decision makers have both relevant information to make good decisions and
o The incentives to use the information productively
Information + Incentives = Productive Decisions
Organisational Architecture
Decision rights assignment: who gets to make what decisions?
o Important information for economic decision making is held by many individuals it is expensive to
o Decision makers may not have appropriate incentives to make effective decisions even if they have
relevant information.
How does a firm maximise the likelihood that decision makers have both relevant
information to make good decisions and the incentives to use the information productively?
Rewards how are people rewarded for meeting performance goals?
Performance evaluation what are the key performance measures used to evaluate managers and
Architectural Determinants
Companies operating in the same industry tend to develop similar architects
o Technology = computers, telecommunications, production methods
o Markets = competitors, customers, suppliers
o Regulation = taxes, antitrust, international
Strategy can be influenced by organisational architecture
o Company may decide to enter a new part because its decision and control systems are especially
suited for this new undertaking e.g. supermarkets and petrol stations
Changing architecture: not a costless process. Management should assess the costs as well as the benefits in
evaluated the merits of restructuring.
o Direct costs: new architecture has to be designed and communicated to employees throughout the
company. May require costly changes in the firm’s accounting and IT systems
o Indirect costs: changes in architecture are likely to affect some positively and others negatively.
Dealing with the associated incentive problems of implementing change can be expensive.
Frequent change within a firm causes uncertainty about job assignments and will promote
more short-term rather than long-term focus
Corporate Culture
The ways work and authority are organised
o Expectations of how individuals behaved are part of the formal architecture
o Corporate culture should foster expectations which promote productive choices by employees
The ways people are rewarded and controlled
Organisational features such as customs, slogans and social rituals (soft culture)
o Can be used to communicate organisational architecture.
o Less tangible features such as rituals and role models can be important in reinforcing and
communicating architecture.
The firm’s hard and soft cultures must be compatible with each other.
Advantage: defines the key components of a firm’s corporate culture and analyses how managers might
affect culture through identifiable actions
Managerial Implications
Organisational architecture represents a powerful framework for identifying problems quickly and crafting
solutions effectively:
o Does the business strategy fit the environment?
o What are the key features of the current architecture?
o Does the architecture fit the business environment and strategy?
When managers are unable or unwilling to implement appropriate architecture, firm value can be created
o Firing the manager
o Corporate control seeking experienced management
o Product market competition economic Darwinism
Business Environment
(Technology, Markets, Regulation)
Business Strategy
Organisational Architecture
Incentives and Actions
Firm Value

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