FORMAL AND INFORMAL ORGANIZATION

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FORMAL AND INFORMAL ORGANIZATION

• Sérgio G. Lazzarini
• IBMEC São Paulo
• ESNIE, May 2006
• (Based on Zenger, Lazzarini Poppo, In The New
  Institutionalism in Strategic Management, 2001)

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Formal vs. informal institutions

• Formal rules that are readily observable through
  written documents or rules that are determined
  and executed through formal position, such as
  authority or ownership.
• Ex explicit incentives, contractual terms, and
  firm boundaries as defined by equity positions.
• Informal rules based on implicit understandings,
  being in most part socially derived and therefore
  not accessible through written documents or
  necessarily sanctioned through formal position.
• Ex social norms, routines, and political
  processes.

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An immense opportunity for interdisciplinary
integration

• Organizational economists have focused on formal
  institutions (Coase, 1937 Williamson, 1985
  Barzel, 1982 Holmstrom Milgrom, 1994 etc).
• Organizational theorists and economic
  sociologists have stressed the role of informal
  mechanisms in governing exchanges both internal
  (Crozier, 1964 Roethlisberger Dickson, 1939
  Trist Bamforth, 1951) and external to the firm
  (Granovetter, 1985 Powell, 1990 Uzzi, 1996).
• Hart (2001, p. 15) it has been difficult to
  incorporate norms into the theory of
  organizations although there has been some
  interesting recent work on this topic, this work
  has not to date greatly changed our views about
  the determinants of organizational forms.

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Assumption 1. Informal institutions strongly
influence the functionality of organizational
forms

• Roethlisberger and Dickson (1939, p. 559) many
  of the actually existing patterns of human
  interaction have no representation in the formal
  organization at all, and these are inadequately
  represented by the formal organization Too
  often it is assumed that the organization of a
  company corresponds to a blueprint plan or
  organization chart. Actually it never does.
• Some other key contributions Chester Barnard
  (1938) Michel Crozier (1964) Pfeffer (1978,
  1992).
• In inter organizational relationships
  Granovetter (1985) Macauley (1963). Macneil
  (1978).

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Assumption 2. Formal institutions influence the
trajectory of informal institutions

• The formal largely orders the direction the
  informal takes (Dalton, 1959, p. 237).
• Internal routines, norms, and networks of
  influence develop over time in response to an
  organizations formal structure (Shrader,
  Lincoln, Hoffman, 1989 Stevenson, 1990 Tichy,
  1980).

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Assumption 3. Formal institutions are discretely
arrayed, while informal institutions operate
comparatively on a continuum

• Formal organizations as bundles of
  mutually-reinforcing attributes (Williamson,
  1991 Milgrom Roberts, 1991). Ex
• Centralization structural interdependence
  between units, lower-powered incentives, and
  global decision making.
• Decentralization structural autonomy,
  higher-powered incentives, and local decision
  making.
• Informal elements as continuously arrayed tie
  strength (Granovetter, 1973) level of commitment
  (Salancik, 1977), centrality in informal networks
  (Krackhardt, 1990), and so forth.

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Assumption 4. Formal and informal institutions
differ in the pace with which they change.
Informal institutions possess inertia that slows
the pace of change

• Inertia relationships, political coalitions,
  patterns of communication, established routines
  impede organizational change (Hannan Freeman,
  1984 March Simon, 1958 Nelson Winter, 1982
  Tushman Romanelli, 1985).
• In Economics path dependence (Arthur, 1989
  David, 1985). North importance of available
  mental constructsideas, theories, and
  ideologies (1990, p. 96) creating resistance to
  change.

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Proposition 1. Formal and informal institutions
are interdependent governance mechanisms in that
the use of one mechanism can either promote
(complement) or undermine (substitute for) the
use of the other.
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Complementarity vs. substitution

• Complementarity formal contracts and explicit
  incentives reduce gains from short-term defection
  and hence increase the value of honoring
  long-term, informal agreements (e.g. Klein, 1996
  Baker, Gibbons Murphy, 1994).
• Substitution formal contracts and explicit
  incentives damage the operation of social norms
  (Macaulay, 1963 Frey, 1997).
• Mixed evidence thus far! (e.g. Fehr Gächter,
  2000 Lazzarini, Miller Zenger, 2004).

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Proposition 2. Even in static environments,
achieving the optimal functionality of an
organizational form may require dynamic
vacillation of formal elements (Nickerson
Zenger, 2001).
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Vacillation at HP (allocation of decision rights)
Centralize
Centralize
Decentralize
Share price (divided by SP index)
Centr.
Dec.
Source Nickerson Zenger (2003)
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Vacillation

• The functionality of an organizational form is
  determined as much by informal mechanisms, as by
  formal mechanisms (Assumption 1).
• Informal institutions vary systematically in
  response to changes in formal institutions
  (Assumption 2).
• Managers only have discrete formal choices or
  leverse.g., centralization vs.
  decentralizationto promote such changes
  (Assumption 3).
• Given that informal institutions display inertia
  (Assumption 4), each switch between formal
  choices triggers a gradual change in the
  trajectory of informal elements

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Performance
? Innovation
Coordination ?
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Proposition 3. Firm boundaries are determined in
large part by the need to adjust informal
institutions within hierarchies. Managers must
sever the boundary of the firm to suspend
dysfunctional informal processes.
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Informal processes leading to hierarchical failure

• Influence activities (Milgrom Roberts, 1990
  Poppo, 1995) politics (Pfeffer, 1978, 1992).
• Social attachments (Katz, 1982 Halpern, 1994).
• Social comparison processes inhibiting
  high-powered incentives (Adams, 1965 Deutsch,
  1985 Zenger, 1992, 1994).
• Firm-specific routines creating difficulty to
  access external knowledge (Katz, 1982
  Leonard-Barton, 1995).
• Such informal processes cannot be selectively
  shut down with any great success. Firms may
  suspend hierarchy as an institution to avoid the
  informal processes that run rampant within their
  boundaries.

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Discussion 1 (How) Can vacillation of boundary
choices improve performance?
Examples JPMorgan outsources IT to IBM in 2002
in a 5 billion deal re-integrates again in
2004. UBS outsources IT to Perot Systems in 1996
re-integrates in 2004.
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Discussion 2 (How) Can explicit incentives
change organizational culture?

• Example Algar (Brazilian telecom firm) would
  like to develop a marketing-oriented culture
  whereby all employees should actively sell
  products even if their are not in the functional
  area of sales.
• They crafted explicit incentives such that 20 of
  individual bonuses will be based on whether the
  employee helped sell some product.
• They plan to abort the explicit incentives in 2
  years, assuming that the new values and norms
  will be created as a consequence of the incentive
  program.
• Will it work?