Week 2

Weber’s model of bureaucracy is an ‘ideal type’ (not a literal description of actual bureaucracies)

Rather a simplified account of the central dimensions of a new technology of human control

Earlier, informal methods of control unsuited for an age of unprecedented military and economic competition

Key to success (in both war and business) was not just armies or technology but ability to harness the energies of a group to a common goal

Weber’s famous essay on bureaucracy provides an account of the forms key features, which include…

1. Rules

2. The separation of person and position

3. The proliferation of written communication and formal records

4. Reward

1. Rules

Bureaucracies governed by “calculable rules” - open, widely understood, and fairly applied – rather than by persons

-Rules establishes a hierarchy, proscribing who give orders to whom

-Rules governs admission of people to the organisation (e.g. what accomplishments required for employment) plus standards for promotion

-Rules setting out routines for performance of work

Weber argued these rules beneficial because (what do you think?)

-Prevent employees from using the organisation for their own ends, rather than the employers (i.e. the Agency problem)

-They reduce the costs/ time of deciding, haggling, arranging and coordinating

1. The separation of person and position

The existence of fixed well-defined roles that specify the rights and obligations of every organisational member (except those at the very top)

In an age in which most people regarded the workplace as an extension of their personal domain, it required participants to interact with each other in terms of their formal work roles, rather than their personal identities

This again reduced ‘haggling’ costs as it make duties clear and eliminated the need to members to negotiate with each other.

1. The proliferation of written communication and formal records

Provides a collective memory – which had previously been inseparable from (and thus a source of considerable power to) persons

Enabled many aspects of organisational history and routine to be written down and retained for the use by occupiers of relevant roles – whoever they might be (codification of knowledge)

Enhances calculability and control (of employees whose performance could be explicitly tracked) and expenses (through the use of double entry bookkeeping) which enables firms to spot fraud and control costs more effectively than in the past

1. Rewards

Lifetime security and compensation and advancement dependent on how well each employee fulfilled his or her official role

Weber argued that this gave employees a strong long-term motivation to please their employers

Note: Here Weber was wrong, lifetime job security has been largely limited to government service and a few large market insulated firms

In sum:

Key dimensions of Weber’s formal model of bureaucracy (clear universally applied rules, separation of person and position, formal rules and records, employment and advancement dependent on qualifications and performance) would all now characterise most large modern organisations.

1. Weber does not use the term Bureaucracy as a disparaging term

2. He regarded it as a more modern and efficient means of organising v. earlier orders based on nepotism and class favouritism

3. To Weber bureaucracy was an ideal that did not exist in reality. It was a standard or model.

4. Weber’s model of bureaucracy is based on legal authority. Managers are given authority by virtue of their position. Obedience is not owed to a person. But to the impersonal authority of the office.

5. His analysis was culture free. Today all undertakings of any size in any culture are bureaucratic to some degree

   
   

Disadvantages of Bureaucracy (which Weber acknowledged)

-Rules and controls may become an end in themselves

-Extreme devotion to rules may lead to inflexibility and an inability to adapt

The Equilibrium of the Corporation (Simon, H., 1947) “Administrative Behaviour”

Simon (1947) defines bounded rationality as follows: Individuals are “intendedly rational, but only limitedly so.”

Individuals have limited ability to process information and limited insight into their own preferences.

Individuals satisfice (rather than maximize), because they rely on habitual rules to make heuristic judgments about the world.

Individuals need to rely on on-going patterns of interaction to make decisions entails that they form organizations.

Organizations are the consequence of the reliance by participants upon the heuristic rules provided by the organization.

Each individual participates in the firm as long as the satisfaction received from the net balance of inducements over contributions exceeds the satisfaction obtained by not participating in the firm.

The ToF is the name given to a set of theories that attempt to explain important aspects of the firm, such as its existence, behaviour, structure and relationship to the market.

Note we addressed some of these questions in session 1 from a historical (Chandler) and sociological (Weber) perspective

Here we are looking at the question as economists tried to grapple with it

Two key questions:

1. Why do firms exist – Transaction cost theory (Coase and Williamson)

2. How do firms align the interests of managers and owners (Agency theory – Jensen & Meckling)

In 1937 Coase raised question: if markets are so good at allocating resources, why do we need firms?

(Converse also true: firms cannot always be better at allocating resources, or we would not have markets)

He argued each way of organising economic activity is costly

Most obvious costs of using the market/price mechanism are

-Discovering the relevant prices

-Negotiating a separate contract for each exchange transaction (‘haggling costs’)

-Enforcement of contracts

With relatively simple goods, it might be simple or easy to use the market. But with a complex transaction it might be very difficult

Firms arise because there are costs to using the price mechanism

The boundaries of the firm were defined by the relative costs of two methods of coordination: markets and the price mechanism v central command and managerial hierarchy

At the time, when communications were poor, and economies of scale were vast, this justified keeping a lot of things inside a big firm

Coase's theory explained why companies existed, but it was not specific enough to predict the conditions under which firms, or markets, would be preferred. 

Williamson made two key assumptions:

1. That in the real-world contracts of any complexity are incomplete

2. That humans can be opportunistic!

   
   

Given these assumption he noted three important dimensions of transactions:

1. The frequency with which they occur (one off transactions have different properties compared to regular repeat transactions)

2. The nature and amount of uncertainty to which they are subject

3. The specificity of the asset being transferred

   
   

The trade off between whether it is cheaper to transact on the market, or to internalize the transaction will depend on the specificity, frequency, and uncertainty of the transaction.

In general markets will tend to be more efficient when transaction less regular, it is easy to write and enforce the contract and involves standard products.

Zenger 2011 – Theories of the Firm – Market Boundary

Brief Overview

Zenger addresses Coase's unanswered question: "Why is not all production carried on by one big firm?" If integration solves market failures, why do firms have limits? His answer: organisations fail when they cannot selectively replicate what markets do nor selectively infuse what hierarchies do.

Critises Transaction cost theory

-They dismiss the dynamics of firms in the market

-> Some firms are better at doing things

-> Learning effects: Some firms are better at internalizing transaction

-> Co-evolution of firms and the environment

Fundamental critique: Transaction costs very mathematical; No governance in there. Omit that some firms are better

• Transaction Cost Economics: Focuses on "avoiding negatives" (minimising transaction costs, preventing opportunism, avoiding market failures)

• Knowledge-Based View: Focuses on "creating positives" (generating value through knowledge combination, coordination, and capability development)

Zenger's Framework: Four Essential Questions

Zenger argues that a complete theory of the firm must address four distinct but interrelated questions:

1. What are the virtues of markets in organising assets and activities?

2. What factors drive markets to fail?

3. What are the virtues of integration (hierarchy/firms)?

4. What factors drive organisations to fail?

Transaction cost economics primarily addresses question 2, whilst the knowledge-based view addresses question 3. Rather than competing, these theories address "distinctly different directional forces on the firm boundary—forces that are tightly interrelated."

Zenger's position is that understanding firm boundaries requires integrating multiple perspectives. Transaction cost theory isn't wrong—it's simply incomplete on its own and needs to be complemented by theories that explain not just why markets fail, but also why firms succeed at creating value through coordination and knowledge combination.

The Three Behavioural Impediments to Firm Growth

1. Politics & Influence Activities

• Internal rent-seeking and lobbying for resources

• Department heads use "connections" to boost budgets/staffs rather than creating value

• Generates influence costs that distort efficient resource allocation

2. Social Attachments & Over-embeddedness

• Firms develop social communities with strong relationships

• Positive: Identity, cooperation, norms for hard work

• Negative: Over-embeddedness becomes a constraint - can't fire poor performers, loyalty to colleagues overrides goals

• Generates attachment costs that prevent necessary changes

3. Social Comparison

• People inside firms compare themselves to colleagues

• Expect fairness and equity in treatment/compensation

• Markets allow differentiated pay; firms face fairness constraints

• Generates social comparison costs that limit performance-based differentiation

Market-Hierarchy Hybrids

Two Types:

• External hybrids: Infusing hierarchy into markets (franchising, alliances, joint ventures)

• Internal hybrids: Infusing market mechanisms into organisations

The Goal: Achieve "best of both worlds" - market virtues (flexibility, incentives) + hierarchical virtues (coordination, authority)

The Challenge: These are attempts at the selective intervention Zenger claims is inherently difficult.

Haier Case: Internal Market Hybrid

What It Is: Chinese appliance company (70,000+ employees) transformed into platform of 4,000+ microenterprises (MEs).

How It Works:

• Internal contracting: Every ME free to buy services from other MEs or go outside

• No internal monopolies: Service providers must compete; can be "fired"

• Market-based incentives: P&L responsibility, external benchmarks

• Voluntary collaboration: Platform owners facilitate, don't command

The Attempt: Infuse market mechanisms (competition, choice, entrepreneurship) whilst maintaining hierarchical benefits (shared platforms, brand, scope economies).

Zenger's Lens: Haier tries to solve the three impediments by creating internal markets, but likely still faces influence costs (lobbying platform owners), attachment costs (harder to fire internal vs external), and social comparison costs (comparing ME performance).

Context in Lecture 2 Framework

The Complete Theory:

1 Coase (1937): Why firms exist → Market transaction costs

2 Williamson (1981): When firms vs markets → Asset specificity, frequency, uncertainty

3 Zenger (2011): Why firms don't expand forever → Organisational failure costs (influence, attachment, social comparison)

The Equilibrium: Firms expand until Cost of organizing internally = Cost of using market

Hybrids (including Haier): Attempts to escape this trade-off by crafting governance enjoying virtues of both markets and hierarchies - but whether they truly succeed or simply face different cost combinations remains an open question.

There is a cost to using a market

But bureaucracy (organising internally) also carries a cost (Williamson: mainly because it reduces individual incentives to perform)

Explains why we see both firms and markets

Implies a natural limit to firm size

Please see appendix

The Agency relationship is where one party (the principal) delegates work to the other party (the agent) who performs that work.

It is concerned with resolving two problems:

1. The problem that arises when the desires or goals of the principal and agent conflict

2. It is difficult or expensive for the principal to verify what the agent is actually doing

   
   

There are many agency relationship, but in particular it has been applied to the relationship between senior managers of the firm (the agents) and the owners/ shareholders of the firm (the principals)

The issue is how to design the relationship to motivate the agent to act in the principal’s best interest:

1. Contracting (Specify behaviour in advance)

2. Monitoring (Observing behaviour (e.g. the board)

3. Incentives (Linking desired outcome to pay e.g.: bonus plans, stock options, long-term incentive plans etc.)

3+1: Miller (2008) also mentions co-operation as a solution to the agency problem – firms delegate the problem of monitoring effort within a group to the group itself (e.g., via team-based compensation), and encourage the group to develop social norms of mutual assistance and sanctions for free-riding.

The evidence: Pay without performance?

Empirical evidence gathered over the past 35 years has failed to establish a statistically significant link between executive pay and stock price performance, as predicted by agency theory.

The strongest empirical correlation is between executive pay and firm size, not between executive pay and firm performance as predicted by agency theory. This is: “the best documented empirical regularity regarding levels of executive compensation”

Note there are two different questions: Is it fair? Is it efficient?

Criticism of Agency Theory:

Frydman 2010 – What happened to senior executive pay

Bebchuk & Fried 2004 – Pay without performance

-No statistically significant link between executive pay and stock price performance, as predicted by agency theory

-Strongest empirical correlation is between executive pay and firm size, not between executive pay and firm performance as predicted by agency theory.

Pepper 2019: Right diagnosis, wrong solution?

-Heavy reliance on extrinsic financial motivation can undermine intrinsic motivation and lead to short-termism, excessive risk-taking, and even corruption—rather than solving the agency problem, it may exacerbate it.

-> made things worse not better for shareholders

Enron as a cautionary tale

-Ken Lay and other directors cashed in stock worth hounders of millions whilst the company was collapsing

-Thousands of shareholders and employees lost pension funds and life savings

-Pursue short-term stock price manipulation rather than long-term value creation

-Take excessive risks with off-balance-sheet SPE (Special purpose entities)

-Agency theory has been hugely influential

-Executive pay has soared

-Right diagnosis, wrong solution? (Pepper, 2019)

-Stock options – Managerial heroin? Induces managers to be, at best short term risk, at worst, corrupt

-Enron as a cautionary tale – did incentive pay make things better for the shareholders, or worse?

Markets and firms (the invisible hand v the visible hand) as alternative ways to organize economic activity

Each has its own related costs:

Markets: Transaction costs

Firms: What Williamson calls “internal organization costs” (bureaucracy)

Plus, the separation of ownership and control gives rise to the agency problem

Implications

-Moden organizations have to manage / balance these costs (transaction/bureaucratic costs, agency costs)

-There is no universally optimal organizational form

-Technology can shift the balance (might reduce transaction costs – eg platform economies or reduce monitoring costs)