INTERNAL ORGANIZATION

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INTERNALORGANIZATION
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Overview

• Introduction
• The neoclassical model of a private ownership
  economy
• Single-period managerial model
• The multi-period profit-maximising model
• Satisfied level of profit and the organizational
  coalition
• Economic organization. Transaction costs theory
• The principal-agent problem
• Corporate governance as a principal-agent problem
• The impact of the macroeconomic environment on
  the enterprise behavior

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I. Introduction

• The main tasks of economic organization are to
  coordinate the actions of individuals they form
  a coherent plan and to motivate the actors to act
  in accordance with the plan.
• Economic organization and strategic decision
  taking have similar importance as technology,
  costs and demand.
• Horizontal vs. Vertical Organization

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• Efficient organization
• - organization which provides minimal
  transaction costs or maximizes value of the
  transaction (normative view)
• - if people are able to bargain effectively
• and can effectively implement and enforce their
  decision, the outcome will tend to be efficient
  (positive view).

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II. The neoclassical model of a private
ownership economy

• Neoclassical economy consists of many consumers
  and many producers who are self -interested and
  seek to maximize their benefits.
• A competitive equilibrium model (Arrow-Debreu) is
  a set of prices and an allocation of goods such
  that sellers wish to supply at the given prices
  the same quantities as those the buyers wish to
  purchase.
• - it exists
• - is unique
• - is stable

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Pareto efficiency

• None can achieve better results without lowering
  the results of the other party.

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• What is required for Pareto
  efficiency ?

Consumers maximize their utility
Maximization of profits with respect to outputs
Maximization of profits with respect to inputs
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• Competitive allocation of goods is an efficient
  one (Pareto efficiency). At the competitive
  equilibrium bargain parties achieve minimal
  transaction costs and maximise value (The Coase
  Theorem).
• No emotion in decision making and no wealth
  effect.
• If the competitive equilibrium of the
  neoclassical economy provide a good description
  of how markets work, there is no need for other
  economic organizations.

• New organizations often arise when market is
  inneficient (Chandler).

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III. Single-period managerial model

• Frequent criticism were made of the profit
  -maximising model profit maximising do not
  describe the goal to which managers aspired

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Profit Maximization
C(q)
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Four main reasons are put forward

• Firms may not be forced by external forces to
  maximise profits.
• Managers do not know and cannot determine the
  concepts of expected marginal revenue and
  marginal cost.
• Managers have goals other than single-period
  profit maximisation to attain.
• Some of comparative static predictions which are
  deduced from profit-maximizing model have been
  observed less frequently than those derived from
  alternative models.

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Baumols single-period sales-maximising model

• Business men aim to maximise their sales revenue
  (market share, compensation of managers,
  increased bargaining power against external
  partners).

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Picture 1 The enterprise maximises sales
revenue
TC
Profit, revenue, costs
TR
p
0
Quantity
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Picture 2 Enterprises reaction on the fixed
costs increase

• If fixed costs (or lump sum tax) rise, the
  constrained revenue maximizer would decrease
  output, the profit maximizer would no.

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Picture 3 Enterprises reaction on the
variable costs increase
If, ceteris paribus variable costs rise, both,
the profit maximiser and constrained revenue
maximiser, would reduce output.
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Picture 4 Enterprises reaction on the
rise of a corporation tax
If rate of corporation tax increases, the profit
maximizer will continue to produce the some
quantity, the constrained sale maximiser will
decrease the quantity.
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Question

• Suppose that managers take profit and sales as
  goods, which give them satisfaction. With the
  help of profit curve and indifference curve show
  the
• Equilibrium in accordance with Baumol hypothesis
• Equilibrium for neoclassical model
• Equilibrium where mangers are concerned only on
  sales.

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Williamsons model of managerial discretion

• Williamson argues that the most important motive
  of managers is to maximize their own utility
  function that depends on
• Number and quality of employees, S
• managerial perks, M
• discresionary investment, ID

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Williamsons model of managerial discretion, cont.

• U f (S, M, ID)
• Actual profit ? TR -TC - S
• Reported profit ?R ? - M TR - TC - S - M
• Minimum (post-tax) profit constraint ?0
• Discretionary investment ID ?R - ?0 T
• T tax on profit

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Comparative static predictions on Q
Model
Lump
Fixed costs
Output
Variable
Profit tax
sum
tax
costs
tax
( T )
( FC )
( Qt )
( VC )
( t )
Profit maximiser
0
0
0
Sales maximiser
Managerial discretion
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IV. The multi-period models of enterprise s
behavior

• Dynamic models differ from the static models of
  the firm by assuming that plans for expansion
  affect current firms operations.
• Dynamic models are built on the assumption of the
  growth oriented managers.

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The Baumol multi-period profit-maximising model

• The firm is assumed to act in a manner which
  maximises the present value of expected future
  profits PV(?).
• PV(?) PV(TR)- PV(TC)

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• The PV (TC) is composed of two types of costs
  output costs and expansion costs. It is
  displaying non-linear properties because of
  disproportionate rise in expansion costs
  (training costs of new employees, crash
  programmes, increased costs of capital
  finance).
• The PV (TR) is also non-linear. It increases at
  the faster rate, with the increase of the growth
  rate of sale revenues.

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• PV(TR) R0 R0(1g)/(1r) R0(1g)2 /(1r)2
  
• R0(1r)(r-g) -1
• ? PV(TR)/?g R0(1r)(r-g) -2
• ?2 PV(TR)/?g2 2R0(1r)(r-g) -3
• If R0 ? 0, r ? 0 and r ? g , PV (TR) curve
  increases as g increases. PV (TR) curve bends
  upwards.

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Picture 6 The enterprise maximises the
present value of expected future profits
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Marriss multi-period managerial model

• Managers aim to maximise their utility that (in
  this model!) depends only on the firms growth
  rate, subject to a threat of being dismissed (for
  example hostile takeover)
• Stockholders are assumed to be wealth maximisers
• n
  ?
  
• S0 ? dt/(1r)t Sn /(1r)n ? dt /(1r)t
• t0
  t0

S0 current share price dt dividend per
share received in year t Sn share price in
year n r discount rate
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Marriss multi-period managerial model, cont.

• If g, once chosen, remains fixed
• ?
• S0 ? d0(1g)t / (1r)t
• t0

• Since d0 D0/N, where D0 total dividend
  payment, we can write
• ?
• S0 ? D0(1g)t / N(1r)t
• t0

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Marriss multi-period managerial model, cont.

• Two-way relationship between growth rate and
  Profit (no external financing)
• g f (Profit) (supply of growth)
• Profit ? (g) (demand for growth)

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Supply of growth

• If the retention ratio is given, greater
  profitability allows faster growth, because it
  allows more to be retained and hence more to be
  reinvested. The supply growth function is a
  straight line.

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Demand for growth

• The main form of firm growth is diversification
• - at low rates of growth, the profitability
  increases with diversification as the growth
  level increase (new products earn high monopoly
  profits, increased efficiency of managers)
• - greater rates of diversification results in
  lower profitability (increasing advertising
  expenditure, greater RD, lower prices faster
  growth of skilled managers)

The demand for growth function is inverted
U-shaped.
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Picture 7 Supply growth curve, demand growth
curve and equilibrium growth (B)
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Marriss multi-period managerial model, cont.

• At given demand for growth curve, the equilibrium
  growth is determined by the position of the
  supply of growth curve which depend on the
  subjective preferences of the management for
  security and tenure.

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Picture 7 Supply growth curve, demand growth
curve and equilibrium growth (B)
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Marriss multi-period managerial model, cont.

• If at the low levels of the retention ratio and
  growth rate, retention ratio increases, current
  dividends will fall at given profitability, but
  their growth rate would increase (g R x P) ?
  supply growth curve will pivot clockwise.

• With increased growth, profitability will
  increase, P (1/R) g, which will outweigh the
  reduction of dividends ? the value of shares
  will rise.
• When the retention ratio has reached a level
  such that the supply growth line passes through
  A, the firm will be maximizing profitability.

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Continued

• If retention is further increased, current
  dividends will be lower due to the lower profits,
  but their growth rate will outweigh this and the
  firms market ratio will still increase.
• Increasing retention rates would cause the
  decrease in dividends that will not outweigh the
  increase in growth rate and hence cause share
  value to fall.

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V. Satisfied level of profit and the
organisational coalition

• Since managers have imperfect knowledge on what
  to base decisions, they act with bounded
  rationality (Simon).
• Managers choose the strategy to achieve the
  satisfied level of profit, they do not maximise
  ? search behavior (rebalancing).
• If aspiration levels are not achieved, the
  managers become apathetic and aggressive.

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V. Satisfied level of profit and the
organisational coalition, cont.

• Firms are composed of individuals who make up the
  organizational coalition (Cyert and March).
• In order to remain in existence the coalition
  members within the firm (as organisation) must be
  satisfied with less than achieving maximum
  objectives (organisational slack) since the
  resources are not available to satisfy them all.

• Organizational slack exist because
• 1) difficult to figure out the proper reward for
  each decison group
• 2) since it is difficult to determine the maximal
  productivity of each group, resources are not
  fully utilized
• 3) Since the full characteristics of the market
  are unknow, firm can not set optimal price,
  production, advertising policy

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Decision making by committee and Arrows
impossibility theorem

• V ??M ?P ?F
• M marketing managers sub-goal (sales
  maximisation)
• P production managers sub-goal (cost
  minimisation, specialisation on a narrow group of
  products)
• F finance managers sub-goal (capital outlay
  minimisation, minimal inventories)

What to choose?
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Arrow's impossibility theorem (from wikipedia)

• The need to aggregate preferences occurs in many
  different disciplines in welfare economics,
  where one attempts to find an economic outcome
  which would be acceptable and stable in decision
  theory, where a person has to make a rational
  choice based on several criteria and most
  naturally in voting systems, which are mechanisms
  for extracting a decision from a multitude of
  voters' preferences.
• The framework for Arrow's theorem assumes that we
  need to extract a preference order on a given set
  of options (outcomes). Each individual in the
  society (or equivalently, each decision
  criterion) gives a particular order of
  preferences on the set of outcomes. We are
  searching for a preferential voting system,
  called a social welfare function, which
  transforms the set of preferences into a single
  global societal preference order. The theorem
  considers the following properties, assumed to be
  reasonable requirements of a fair voting method
• Non-dictatorship
• The social welfare function should account for
  the wishes of multiple voters. It cannot simply
  mimic the preferences of a single voter.
• Unrestricted domain
• (or universality) The social welfare function
  should account for all preferences among all
  voters to yield a unique and complete ranking of
  societal choices. Thus
• The voting mechanism must account for all
  individual preferences.
• It must do so in a manner that results in a
  complete ranking of preferences for society.
• It must deterministically provide the same
  ranking each time voters' preferences are
  presented the same way.
• Independence of irrelevant alternatives (IIA)
• The social welfare function should provide the
  same ranking of preferences among a subset of
  options as it would for a complete set of
  options. Changes in individuals' rankings of
  irrelevant alternatives (ones outside the subset)
  should have no impact on the societal ranking of
  the relevant subset.
• Positive association of social and individual
  values
• (or monotonicity) If any individual modifies his
  or her preference order by promoting a certain
  option, then the societal preference order should
  respond only by promoting that same option or not
  changing, never by placing it lower than before.
  An individual should not be able to hurt an
  option by ranking it higher.
• Non-imposition
• (or citizen sovereignty) Every possible societal
  preference order should be achievable by some set
  of individual preference orders. This means that
  the social welfare function is surjective It has
  an unrestricted target space.
• Arrow's theorem says that if the decision-making
  body has at least two members and at least three
  options to decide among, then it is impossible to
  design a social welfare function that satisfies
  all these conditions at once.

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VI. A firm as an internal organisation. The
theory of transactions costs

• A firm is a nexus of contracts (Cyert, March).
• The firm is embracing both external market
  relationship as well as internal contracts
  (Coase, 1937).

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Coase Theorem

• The parties of any contract have their value
  maximisation as an objective.
• If they bargain efficiently, if they bargain
  until there is no further possibility of mutual
  benefit, the parties draw up a contract which
  maximises the aggregate value (Coase, 1960).
• Efficient bargaining can be done either within
  the firm or on the market.

Depends on transaction costs
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Transaction costs fall into two main categories
The theory of transactions costs

• coordination costs
• outside the firm (costs of using the price
  system)
• within the firm (transmission of directions
  downwards and gathering and trasmissions of
  informations upwards)
• motivation costs
• information asymmetries
• imperfect commitments

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Dimensions of transactions

• Specific assets
• Frequency and duration
• Complexity and uncertainty
• Difficulty of measuring performance
• Connectedness to other transactions

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Bounded rationality and strategic behavior

• Suppose subjects have all relevant information.
  Then by Coase theorem the transaction will take
  place. The equilibrium price will reflect the
  bargaining power of each subject. Despite that
  both parties maximize the joint value. The pie is
  as big as possible.
• In case of limited information economic subjects
  attempt, within the limits of the available
  information, to achieve a satisfactory (not
  maximum!) level of performance
• Since each is attempting to satisfice or optimise
  within constraint of information, which are
  usually not equally distributed, strategic
  behavior is expected.

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Pre- contractual opportunism and adverse selection

• Pre-contractual opportunism is a result of
  informational asimetries.
• When the costs and benefits of different plans
  are known to one party alone or when the
  likelihood of different possible outcomes are
  private information, these informational
  asimetries can prevent any agreeement.
• IF ASSYMETRIC INFORMATIONS, THE INEFFICIENT
  OUTCOME IS AVOIDED WHEN BENEFITS OF EXCHANGE ARE
  LARGE ENOUGH FOR BOTH PARTNERS.

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Market for lemon

• Informational asymmetries cause adverse selection
  ? the market for lemon
• The Market for Used Cars
• Buyers and sellers can distinguish between high
  and low quality cars
• There will be two markets

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Market for lemon, cont.
PL
PH
Initially, the supply of low and high quality
are as shown...
SH
SL
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Market for lemon, cont.
PH
PL
and the demand for high and low quality cars
are as shown.
SH
10,000
DH
SL
5,000
DL
QH
QL
50,000
50,000
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Market for lemon, cont. (ONLY S knows the
quality of a car)
Buyers will find it difficult to determine
quality. They lower their expectations of the
average quality of used cars. Demand for low
and high quality used cars shifts to DM. When
both knew the quality 50,000 of each car was
sold. So now buyers might think that the odds are
50-50 that a car will be high quality,
PL
PH
SH
10,000
DH
SL
DM
5,000
DM
DL
QH
QL
50,000
50,000
75,000
25,000
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Market for lemon, cont.
PH
PL
The increase in QL reduces expectations
and demand to DLM.
SH
10,000
DH
SL
DM
5,000
DM
DLM
DLM
DL
QH
QL
50,000
50,000
75,000
25,000
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Market for lemon, cont.
PL
The adjustment process continues until demand
DL.
SH
10,000
DH
SL
DM
5,000
DM
DLM
DLM
DL
DL
QH
QL
50,000
50,000
75,000
25,000
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Market for lemon, cont.

• With asymmetric information
• - Low quality goods drive high quality goods out
  of the market.
• - The market has failed to produce mutually
  beneficial trade.
• - Too many low and too few high quality cars are
  on the market.
• - Adverse selection occurs the only cars on the
  market will be low quality cars.

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The Lemons Problem - applications

• Medical Insurance
• Question
• Is it possible for insurance companies to
  separate high and low risk policy holders?
• If not, only high risk people will purchase
  insurance.
• Adverse selection would make medical insurance
  unprofitable.

• Asymmetric Information and Daily Market Decisions
• - Retail sales
• - Antiques, art, rare coins
• - Home repairs (what kind of material he uses?,
  it i repired properly?)
• - Restaurants (is the food fresh?

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• Question
• How can these producers provide high quality
  goods when asymmetric information will drive out
  high-quality goods through adverse selection?
• Answer
• Reputation
• Standardized supply (Pizza Hut)
• Screening (medical insurance sends you to a
  doctor)
• Signaling
• Guarantees and Warranties (way of signalling)

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Example of Signaling

• Suppose you are a manager of a perfectly
  competitive firm, and you are selling your
  products for 10,000 euro.You employ 2 groups of
  workers. Group 1 workers (LOW) have marginal and
  average product equal to 1, and group 2 workers
  (HIGH) have marginal products equal to 2. Workers
  are expected to work 10 years.
• How much you would pay them per year, if you
  would be able to separate workers by
  productivity?
• How much you would pay them per year, if you
  could not separate them by productivity?
• Suppose that you provide the following decison
  rule. Anyone with eduaction level of y or more
  is Group 2 worker and is offered a wage of 20,000
  euro per year, and anyone with an education level
  below y is a Group 1 worker and is offered a
  wage of 10,000 euros. Cost of education for
  group 1 is C140,000y , and cost of education
  for group 2 is C220,00y, where y is years of
  schooling. What will be y?

• W1110,00010,000
• W2210,00020,000
• b) W15,000

Increase in earnings gt cost of
education 100,000lt40,000y or ygt2.5 100,000gt20,00
0y or ylt5
2.5ltylt5
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Post-contractual opportunism and moral hazard

• Post-contractual opportunism is an ex post
  concept and refers to opportunistic hidden action
  occuring after contracts are entered into
  realisation.

• Moral hazard occurs when the party to be insured
  can affect the probability or magnitude of the
  event that triggers payment.

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Example Insurance

• After you sign insurance contract you behave
  differently
• After you have signed insurance for car theft,
  you stop locking your car
• Due to asymmetric information insurance company
  can not know if car was stolen because of bad
  luck or because you did not lock it)

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Determining the Premium for Fire Insurance

• Warehouse worth 100,000
• Probability of a fire
• .005 with a 50 fire prevention program
• .01 without the program

Why is there a problem?

• If the insurance can not monitor whether there
  will be a a fire prevention program, if faces a
  dillema
• Program in place, could insure warehouse for a
  premium equal to expected loss from a fire which
  is 0.005100,000500
• If a insurace company sells a policy for 500
  euro, it will incure loss, because expected loss
  is 0.01100,0001000

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Post-contractual opportunism and moral hazard
allocation of resources is not efficient
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Moral hazard in the real life

• Examples
• Partnerships
• team work (job shirking)
• Re-contracting and hold-up

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• How to proceed against moral hazard?
• controllers
• Posting a bond
• hostages
• vertical integration
• franchising

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Transaction costs and the modern corporation

• Te rise of a modern corporation is explained by
  the transaction costs (Chandler)
• First mover advantage
• Oligopoly power and geographical expansion
• Investments in physical assets, marketing and
  management
• Diversification
• Divisional organization (M-form) supplemented
  centralized organization (U-form) and holding
  organization (H-form).

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• U-form one organization, made up of a
  collection of different functions, no one of
  which can conduct business separately.
• H-form a collection of many different (mainly
  unrelated) U-form organizations but
  with weak center
• M-form a collection of many different (mainly
  related) U-form organizations but with strong
  center
• ________________________
• Functional Form (U-form) A structure that
  groups the organization into functional units
  that based on skill and training (e.g. finance,
  marketing, or manufacturing).
• Multidivisional Structure (M-form) A structure
  that groups the organization into units other
  than along functional lines. These units should
  be chosen based upon the independence of units.
  For example, in some firms geographical regions
  can operate semi-autonomously.
• Holding Structure (H-form)

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Examples of M-form and U-form

• A classic example of the U-form was the Ford
  Motor Company before the Second World War. In
  those days, Ford was organized into a number of
  functionally specialized departments production,
  sales, purchasing, and so on. In other words,
  the various departments carried out complementary
  tasks none was independent of the others. By
  contrast, General Motors under Alfred Sloan
  became the prototypical M-form GM comprised (and
  still comprises) a collection of fairly
  self-contained divisions, e.g. Chevrolet,
  Pontiac, and Oldsmobile
• - Maskin et. al (p. 360)
• .

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Picture 9 The Divisional firm
68

• Centre
• identifies activities in the firm
• performs strategic planning
• determines the compensation system
• directs financial resources to divisions
• determines the results of divisions

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The M-form Hypothesis

• the organizational and operation of the large
  enterprise along the lines of the M-form favors
  goal pursuit and least cost behavior more nearly
  associated with the neoclassical profit
  maximization hypothesis than does the U-form
  organizational alternative.
• - Williamson
• Williamsons contention was that all firms would
  have to become M-form if they grew large in order
  to allow the manager to efficiently use
  information.

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Whats behind the M-form Hypothesis? Part I

• Better access to information enables
  organizations to reward employees for effort by
  using performance incentives.
• This in turn enables organizations to increase
  productivity.

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Whats behind the M-form Hypothesis? Part II

• corporate managers must strike a careful
  balance in an M-form. On the one hand, they must
  encourage competition between divisions for
  capital and recognition. On the other hand, they
  must encourage cooperation in those areas where
  synergies exist between divisions in order to
  obtain higher overall levels of performance.
  M-forms that are able to strike this balance will
  outperform both large U-forms and all H-forms.
  This, in a nutshell, is Williamsons M-form
  Hypothesis.
• - Barney and Ouch
• So in addition to being able to use performance
  incentives (the forces of competition) better
  than U-forms, M-forms can partially centralize
  some activities in order to use the forces of
  cooperation, as well.