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AYB321 Lecture Notes - Lincoln Electric, Opportunism, Risk Aversion

6 pages70 viewsFall 2012

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Lecture 3: The Elements of Organisational Architecture
Assigning Decision Rights to Individuals
Jobs have at least two important dimensions:
o The variety of tasks the employee is asked to complete; and
o The decision authority to determine when and how best to complete the tasks
Centralisation versus Decentralisation
More effective use of local knowledge
Conservation of management time
Training and motivation for local managers
Incentive problems
o Developing control is difficult
o Larger the further down in the
organisation decision rights are placed
Coordination costs and failures
Less effective use of central information
o Observation is critical
o Promote information flows and
coordination amongst decision
makers (costly)
Managerial Implications
Optimal level of decentralisation depends on the firm’s environment and strategy
Choosing where within a given hierarchical level of decision should be made is critical
Common factors across firms:
o The benefits of decentralisation to be highest rapidly changing environments where timely use of
local knowledge is important;
o The benefits of decentralisation to increase as the firm enters more markets (corporate strategy);
o Centralised decision-making to have particular advantages where coordination of activities within
the firm is important
Global competition decentralisation trend
o Larger firms with more specific knowledge, higher diversification and less regulation are more likely
to have a greater degree of decentralisation
o Pressure to cut costs, produce higher-quality products and meet consumer demands
Technological changes rate of change: respond quickly or lose profitsdemand for middle managers
o Rate of information transfer has increased
o Allowed many firms to flatten management structures reduced
Reducing costs of information transfers
Assigning Decisions Rights to Teams
Team refers broadly to the many different types of work groups that have decision making authority
o Permanent business unit or a small section
o Temporary project team to design products, recommend actions etc.
Benefits of team decision-making
Improved use of dispersed specific knowledge
o Individuals with specific knowledge are directly involved in the process
Employee buy-in
o Employees more likely to support the final decision and actively implement it
Costs of team decision-making
Collective-Action Problems
o Slow not always efficient or rational
o Can be subject to manipulation
Free-Rider Problems
o Team members bear the full costs of their individual efforts but share the gains which accrue to the
o This problem can be reduced through appropriate performance-evaluation and reward schemes but
these are costly to administer
Managerial Implications
Teams will be most productive when (cost/benefit):
o The relevant specific knowledge is dispersed and;
o The costs of collective decision making and controlling free rider problems are low
Optimal team size. Again, cost/benefit increase the size of team increases both:
o Knowledge base
o Incentives to free-ride and costs of collective decision making
Optimal sixe is where the additional costs of adding a new member are equal to the
incremental benefits
Decision Management and Control
There are four steps:
Initiation: generation of proposals (ideas, recommendations)
Ratification: choice of decision initiatives to be implemented
Implementation: execution of ratified decisions
Monitoring: measurement of the performance of decision agents and implementation of rewards
Which of these can be decentralised and which need to be maintained a higher level?
Decision Management: the initiation and implementation of decisions
o Initiation
o Ratification
Decision Control: the ratification and monitoring of decisions
o Implementation
o Monitoring
Allocating Decision Rights Basic Principle:
If decision makers do not bear the major wealth effects of their decisions, decision management and decision
control will be held by separate decision makers
Influence Costs
o Seeking to influence decision-makers
o Arguing over decisions
o Making rivals look bad
o Not working as a team
Firms can use bureaucratic rules that purposefully limit decision making e.g. promotion on seniority
o Bureaucratic rules negate the benefits of decentralised decision rights
The Level of Pay
Basic Competitive Model:
If a firm pays:
o Too little
Not able to attract qualified employees
High turnover
o Too much
Long queues for job openings
Low turnover
Will do poorly in the market place
Compensating Differentials
Jobs vary in many dimensions:
How does a firm know what wage rate is
o The quality of the work environment
o The geographic location
o The exposure to danger
To attract employees to less desirable jobs, firms must increase the level of pay, individuals self-select.
Premium known as a compensating wage differential
o e.g. choice of lifestyle over wage
Costly Information about Market Wages
Compensation data is typically not readily available
Two important indicators of whether a firm is paying the market wage rate:
o Number of applicants for job openings
o Quit rate
Consider the trade-offs between incremental compensation and turnover costs
Incentive Compensation
Combination of fixed salary and variable (performance based) component
Basic problem: owners and employees have different objectives
o effort is often not observable;
o output is difficult to measure; and
o is affected by factors beyond the employee’s control.
Standard agency problem: Employees have the incentive to renege on their promise and provide less effort.
They are paid anyway and are better off not working so hard.
o Most of the costs of exerting effort are borne by employees while much of the gains go to the
Compensation is used to:
o Motivate employees
o Share risk more efficiently
Minimise risk fixed salaries
Maximise incentives link pay to performance
Factors that favour high incentive pay:
o The value of output is sensitive to the employee’s effort;
o The employee is not very risk averse;
o The level of risk that is beyond the employee’s control is low;
o The employee’s response to increased incentives is high (the employee exerts substantially more
o The employee’s output can be measured at low cost.
Informativeness Principle
Exists because of imperfect information
It is productive to include all performance indicators which provide additional information about effort
(assuming measures available at low cost)
Measuring effort with more precision reduces the costs of inefficient risk bearing
Group Incentive Pay
Benefits (despite free-rider problems):
Low cost;
Emphasises cooperation and teamwork;
Employees less likely to harm other members of the group.
Motivates employees to monitor each other for bad performance.
Group pay increases the awareness of employees about the stock-price performance and
profitability of the company.

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