INSTITUTIONAL ECONOMICS: ORGANISATIONS

We define organisations as durable, planned arrangements to pool productive resources in order to pursue one or several shared purposes. These resources are coordinated within some kind of hierarchical order by a mix of internal rules and commands.

We shall discuss the nature of organisation, agent opportunism and styles of management. Then we shall examine the different theoretical approaches to organisation.

An organisation creates durable coalitions of property rights of its members (i.e. workers and owners), reduces their freedom to dispose of their property rights, but because of the commitment to the organisation reduce coordination costs, they enhance the value of the property rights.

The definition of an organisation contains the constitutional element of having a unifying purpose or set of purposes. The goals may be set autonomously by the capitalists, or arise from consultation and participative decision-making among the workers. In this respect, organisational coordination always differs from the coordination of independent agents in the market place, where ex-post coordination dominates.

Organisations are coordinated by ex-ante plan, which plans, commands and controls activities, and, thus, implies some kind of hierarchy. The hierarchical aspect may be strong (many directives) or weak (much self-responsibility). In any case, not all aspects of an organisation’s activity can be planned and commanded, so internal rules (i.e. habits, routines, norms and culture) have an important part in organisations.

The nature of hierarchical command elements in a business organisation has a great impact on its performance and flexibility. It is suggested that that heavy reliance on hierarchical commands may stress cohesion and tight coordination, but it often conflicts with the limits of knowledge of the capitalists, and of the cognition of the workers. Command structures often require costly control, measurement and monitoring. This may also undermine the motivation and creativity of its workers. These problems tend to weigh more heavily in a complex, changeable world, so that de-emphasising hierarchy and command confers competitive advantages. Senior managers, therefore, emphasise flat hierarchies, teamwork and performance-derived rewards for successful internal competition, and try to motivate workers by imbuing them with the business culture.

The mix of reliance on directives and internal rules has a great impact on organisational costs. That mix depends on the quality of the team. The better educated, trained and motivated the various workers are, the more will shared-rules serve to create a competitive advantage over organisations that rely heavily on specific commands. Indeed, quick changes in markets require complex, changeable responses by motivated killed who act responsibly within firms. In organisations that rely heavily on internal rule coordination, it may sometimes even pay to give members scope to commit errors or to risk their own experiments because that may well unearth useful new information.

Do the risk-bearing principals have effective and direct control over the organisation and its detailed operation? This is the central issue of corporate governance in any organisation.

‘Agent opportunism’ describes a situation, when there is a danger that the agents may act opportunistically in their own self-interest, and neglect the interest of the principals. They may try to shirk risks and opt for the quiet life. A frequent manifestation of agent opportunism is satisficing, adjusting performance standards to lesser outcomes rather than pursuing excellence or risking creative-entrepreneurial action.

The principal-agent problem becomes a focal concern of management, preventing or containing opportunism by obtaining sufficient information about the performance of the workers. Managers can use appropriate incentives and mixes of command and internal rules. There are a number of powerful checks:

1. effective internal institutions: regular internal and external audits to ensure openness and accountability, imposition of budget controls, shareholder meetings, and audit committees, incentive pay, share options, job tenure dependent on performance;
2. competitive capital markets tend to evaluate the performance of share companies;
3. new specialised information market and the business press reduce monitoring costs;
4. competitive market for managers and management teams;
5. markets for corporate control of firms, usually through takeovers and mergers;
6. product market also reflect the performance of management teams. Losing market share can act as a signal of managerial opportunism.

Competition and transparent information rules enhance principals’ control, and threaten and disciplines opportunistic managers.

The traditional approach of ‘scientific management’ (Taylorism) was to rely heavily on top-down commands, whereas the flexible pursuit of changing opportunities by creative, entrepreneurial firms requires a management style based on decentralised, informal rules.

See Table 1 for a comparative study of organisational behaviour of scientific versus participative management.

However, caution is required when discussing ideal types of business organisation. Usually, only a small group of workers have any real scope to make decisions concerning their organisational practices. The nature of the product has significant influence on business organisation – there is very little creativity in organising simple standard products. Consensus-building complements managers’ control system in inducing workers to work harder – another system of exploitation. The nature of the organisation depends on the industrial organisation of the sector: internal work flexibility may require external inflexibility and rigidities in dealing with other firms. The nature of flexibility depends on whether we are discussing volume production, tasks and activities, work organisation, inter-firm alliances and collaboration, and product and service switches and diversification. The collapse ‘flexibility’ into one term obscures its many dimensions, some of which are contradictory.

We shall examine two new institutionalist approaches, and suggest an alternative framework, derived from old institutional economics.

The School argues that there is no vital distinction between ordinary market exchange and the organisation of resources within the firm. It denies that there is any essential difference between the exchange of everyday commodities in the market and the employment contract within the firm. The only major difference between them is the importance of team production by workers and the consequent difficulty of monitoring and rewarding their individual contributions to the collective effort. The School argues that there is a need for a ‘monitor’ to minimise ‘shirking’ amongst the workforce.

An important consequence of this argument is a rejection of the idea that there is any specific form of power or authority relation between employer and employee within the firm.

The employment contract is viewed as continuous re-negotiation between the two parties. The terms of employment are implicitly bargained over for every instant of working time, in part because employment contracts are never fully specified at the outset and have to cover complex and unforeseen contingencies.

However, the School fails to note and understand the function of the asymmetrical authority relation inside the firm. The very impossibility of concluding a full, explicit contract in advance necessitates a broad contract of employment that allows the direction of labour by management within the firm, in which ‘labour power’ is hired and worker submits to an authority relation. Another weakness is that it fails to consider the time and resources in actually renegotiating the contract. The costs and resources would be quite prohibitive, and also disruptive to working practices and team-solidarity.

Unlike the Property Rights School, here, a conceptual difference exists between the market and the firm. The question is raised: Why do firms exist? The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. Williamson has developed his central thesis that economic institutions such as the firm have the main purpose and effect of economising on transaction costs. So the firms arise because they are less costly than continuous recourse to the market.

Transaction costs involves search and information costs, bargaining and decision costs, policing and enforcement costs. Though, these various aspects of transaction costs can be reduced to information costs. However, in this approach, ‘information’ is treated just like any commodity, and subject to the marginalist rule that its consumption is optimal when the marginal cost of information search and acquisition is equal to its expected marginal return. Yet, how are we to have any expectation of information’s marginal return?

A related weakness is that there is no distinction made between sense data and information. There is no regard made to the processes of assessment or computation that can lead to different conclusions depending on the method of calculation and the cognitive framework.

A further weakness is that Williamson’s theory largely relates to calculation of costs. However, without a theory of rules and norms it is more difficult to explain or interpret the activities within the firm because market adjustments of supply and demand do not occur there. When these activities are explained, it is not primarily in terms of prices and costs, but in terms of the structures and methods of administration and control.

Therefore, the function of the firm is not simply to minimise transaction costs, but to provide an institutional framework within which, to some extent, the very calculus of costs is superseded. In this regard, there must be some reservation about any explanation of the nature of the firm in terms of transaction costs. The first is that the concept is based upon the idea of calculating subject, which has been criticised in earlier lectures. The second is that in the particular case of the firm, the appropriateness of rational calculation is less than it would be in the case of the market, because calculation must necessarily be based on socially generated cost norms.

There are at least two major differences between the market and the firm in the way they evaluate information. First, market institutions create and legitimate norms and conventions through the interaction of relatively autonomous traders typically without long-term commitments to each other. By contrast, the firm is a social institution that generates other conventions and rules (e.g. loyalty) on a more permanent basis. Second, the norms and conventions of the market relate, most crucially, to the matter of price. Within the firm, however, there is no single, clear quantitative expression of a price norm to which actors can relate.

What must be incorporated in the theory is the function of the firm in reproducing and developing the habits and routines that are appropriate as an alternative to the optimising, rational calculus of profit and loss. The nature of the firm is not simply a minimiser of transaction costs, but a kind of protective enclave from the potentially volatile and sometimes destructive speculation of a competitive market. Habits and traditions within the firm are necessarily more enduring because they embody skills and information that cannot always or easily be codified, or made subject to a rational calculus. What the firm achieves is an institutionalisation of these rules and routines within a durable organisational structure. The firm has an ability to store and reproduce a large number of habits and routines. Thus, the firm contains a great mass of skills and technologies upon which its productive capabilities depend.

Also relevant is the extent to which the firm embodies and sustains a degree of trust between its members. If trust and cooperation are functional to the efficiency of the firm, then a form of organisation in which they are promoted could well be superior in terms of performance. Whilst all firms embody trust and loyalty in some measure, firms that promote these attributes to a greater degree are more likely to be efficient. For example, more participatory forms of organisation provide evidence of higher productivity. In contrast to the market practices, the firm engenders loyalty and trust, and reduces opportunistic and self-seeking behaviour. Without this ability to generate cohesive and less atomistic behaviour the firm would not be able to function.

Thus, a key to understanding the nature of the firm is its ability to mould human preferences and actions, so that a higher degree of loyalty and trust are engendered. So, it is a mistake to assume that the supposedly self-seeking, rational calculations of the market can be readily transferred, and can characterise human relation in a firm.

Consequently, we are unable to understand the nature of the firm either by excluding non-contractual elements, such as loyalty and trust, or the opposite position of regarding them as dominant, to the exclusion of self-seeking calculation.