Decision Making

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Introduction

How can you make decisions?– Average the predictions of many people– Meet to deliberate and discuss the decision– Use the help of a person who you prefer– Use some form of a price system where people who are correct are

rewarded– Put the question on the internet and see how people respond

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The Wisdom of the Crowd The average of the crowd is often an excellent

predictor.– The weight of a horse– The amount of money in a jar

It “works” when people are more likely to be right than wrong.

It does not work when people are more likely to be wrong than right (conventional wisdom is incorrect)

Surveys are good in this regard.

The problem is that there is no penalty for a wrong answer, so there is no “sorting” in a survey. You can do potentially better.

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Committees and Discussion The idea is to gather information in a group discussion

rather than averaging. There are serious problems with this approach:– If people have similar views, group discussion tends to lead to extreme

results. Other views are crowded out.– People are reluctant to present their view if they believe that it is in the

minority.– The majority will tend to disregard a minority view as being incorrect so that

new information is ignored.

It may therefore be better to ask views individually

There is the “Eureka” situation where groups are good: when it takes several people to put together a solution (crossword puzzles) – the solution is seen immediately when it is suggested

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Prediction Markets

Prices play the role of information in markets. You can get better results when people are sorted based on their own judgment of the value of their information– The Iowa experiment– Google

These are modeled after market economies and the “invisible hand.”

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Overview

1. Markets as a metaphor for economics of organizational design

2. Centralization v. decentralization

3. Coordination

4. Decision making, hierarchy, & control

5. (next lecture) Job design & decision making

6. (next module) Incentives

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1. Organizational Design of an Economy

Adam Smith» “… he intends only his own gain, & is … led by an invisible hand to promote an end

which was no part of his intention … By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.”

Leontief: central planning (centralization) is efficient– coordination, economies of scale, control

Hayek: market (decentralization) is more efficient– costly to move all info. to central planner; decentralization makes better use of

specific knowledge of time & place:» “How can … fragments of knowledge existing in different minds bring about results

which, if they were to be brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess?”

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Markets asInformation & Incentive Systems

Examples of markets as forms of organization– prediction markets (insurance, financial, etc.)

Market economies have 3 important features:– decentralization makes good use of “specific knowledge of time & place”– prices provide good “general knowledge” for coordination– incentives (through ownership)

» motivates good decision making» moves decision rights to person with most valuable/ relevant specific knowledge» motivates investments in human capital» motivates creativity / innovation

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Organizational Design of a Firm

Org. design must address the same problemsuse of specific knowledge of time & placecoordination across decision makers incentives for both innovation & adaptation

Can we design an organization to mimic a market?– even if we can’t completely, the intuition is very useful

Note, though, the limits of markets– they are best at aggregating information (e.g., into prices or predictions)– when coordination in the sense of coordinated actions is important,

organizations tend to be set up

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2. Benefits of Centralization

Economies of scale– physical capital– managerial talent– brand name & reputation– design

Better use of central knowledge– aggregated information & experience of the combined organization

Better coordination– knowledge transfer across units– consistency / standardization– synchronization– control– common strategy

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Benefits of Decentralization

Better use of specific knowledge dispersed throughout the organization

Prevents senior management from being overwhelmed

Training/ development & intrinsic motivation for lower level managers

Less bureaucratic/ more manageable scale

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Specific Knowledge

Attributes of knowledge / information that make it more “specific”– costly to transfer

» perishable» complex

– costly to understand» requiring scientific or specialized technical skills» subjective or experiential

– unreliable / risky to use» noisy (garbling)

Cost of Transferring KnowledgeCostly

Cheap

Specific Knowledge

General Knowledge

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3. Coordination & Structure

The classical approach: centralized hierarchy

Decentralization implies that coordination must happen at lower levels of the organization– roughly speaking, 2 kinds of coordination problems: “simple” & “integration”

Simple coordination: getting units to act in concert– real-time communication not needed, as long as actions of all units are

compatible– use incentives, communication, job rotation, culture

» e.g., UPS;

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Modularization

Putting people with the most interdependent jobs together amounts to modularizing overall structure

– ex: break XP Consulting into smaller divisions» regional? (NA; Europe; Asia)» type of customer? (Corporate; Government; Not-for-profit; etc.)» practice area? (Strategy; IT; 6)

You can structure authority w/ some decisions organized by one set of divisions, others a different set

» ex: decisions about hiring & compensation determined by region; decisions about training & promotion determined by practice area

Note how complex it starts to get … there are clear advantages to reducing overlapping lines of authority

– hypothesis: the largest source of dis-economies of scale is bureaucracy (coordination costs)

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Integration

Integration: for some decisions, pockets of specific knowledge throughout org. need to be combined

– ex: Apple Computer laptop product design– use lateral mechanisms

» teams, matrix» informal networks» e.g., product design

– the most cumbersome organizational designs tend to involve integration problems

Or, balance the 2 goals of coordination & use of specific knowledge

– separate decision management & control (below)

B

A

Engineering

A

B

Sales

B

A

Production Other

CEO

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Think of decision making as a 4-stage process

1. initiatives2. ratification3. implementation4. monitoring

Different stages can be more centralized or decentralized

4. Decision Making, Hierarchy, & Control

Decision Management

Decision Control (Hierarchy)

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Notes on Decision Mgt. v. Control

It often makes sense to separate decision management from decision control– if decision maker has weak incentives

» Board v. CEO– can provide benefits of decentralization & centralization at the same time

» decentralizing decision management» centralizing decision control

The distinction is useful in practice– innovation process– managing change– empowerment

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How Much Decision Control?

Consider 2 firms with 2 employees

The units evaluate new ideas differently– “Hierarchy”: W evaluates new ideas, passes

some to G. G approves or rejects those– “Flat”: G&W both different new ideas

N = # of ideas each can evaluate per period

– flat firm evaluates twice as many ideas per period

FlatHierarchy

Gladys Willie

Gladys

Willie

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Evaluating New Ideas

Assume new ideas are binary (good or bad / profitable or unprofitable)

At first stage, p = probability of correct decision; p > ½

At second stage (hierarchy only), q = probability of correct decision; q > p

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Hierarchy

New Idea

Good

Bad

Accepts(1-p)

Rejectsp

Acceptsp

Rejects(1-p)

Willie Evaluates

Acceptsp∙q

Rejectsp(1-q)

Rejects(1-p)

Gladys Evaluates Willie’s Recommendations

Accepts(1-p)(1-q)

Rejects(1-p)q

Rejectsp

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Flat

New Idea

Good

Bad

Accepts(1-p)

Rejectsp

Acceptsp

Rejects(1-p)

Gladys or Willie Evaluates

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Results

Flat Hierarchy

Rate For One New IdeaAccept Good Idea p pDּ qFalse Negative p -1 1 -pDּ qFalse Positive p -1 (1- q)(p -1)Reject Bad Idea p (1- q)(p -1) -1

Overall ThroughputAccept Good Ideas 2NDּ p NDּ pDּ qFalse Negatives 2N(1- p) N)1 -pDּ q(False Positives 2N(1- p) N(1- p)(1- q)Reject Bad Ideas 2NDּ p N[1- (1- p)(1- q)]

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Are Hierarchies Conservative?

Flat structures– evaluate ideas more quickly– evaluate more ideas for the same # of employees– make more changes, good & bad– have more successes & failures

What kind of environments favor a more hierarchical or flat structure?

Most Middle

Rate For One New IdeaAccept Good Idea Flat > HierarchyFalse Negative Hierarchy > FlatFalse Positive Flat > HierarchyReject Bad Idea Hierarchy > Flat

Overall ThroughputAccept Good Ideas Flat > HierarchyFalse Negatives Flat > HierarchyFalse Positives Flat > HierarchyReject Bad Ideas Flat > Hierarchy

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Other Methods to Increase Control

Resources spent on accuracy (a & b)

Skills & emphasis of decision makers– liberal v. conservative evaluator– conservative org. likely to recruit / train more carefully

Incentives of decision makers– e.g., downside punishments & upside rewards

Constraints on decisions– e.g., budgets

Culture & process

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Structure and Errors

•Hierarchical•Reduce false positive and increase false negative•Approve fewer projects overall•Good where careful consideration is needed. Good with traditional industry; regulated industry. Bad for rapid change

•Second Opinion - symmetrical upside and downside•Flat

•Reduce fall negative and increase false positive•“Creative people not attracted to hierarchical firm”•Good when unprofitable projects are not too costly or when profitable projects are likely to be very profitable

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5. Implementation

So what should XP Consulting consider in its structure?

First, Modularize overall structure, possibly in overlapping ways– ex: Cambridge Technology Partners– makes the problem more manageable– put most interdependent parts together, reducing coordination problems

Second, allocate decisions within each division: ask “who / what / where / when / why?” to identify key specific knowledge

– who has valuable specific knowledge?– what kind of knowledge?– where in (& out) of the organization?– when (is timing relevant)?– why is it of economic value?

Third, think about what needs to be made consistent or coordinated across the division or whole organization

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Implementation

The last two give strong guidance on what to decentralize & centralize

Fourth, go back & refine the overall structure– try to streamline further to cut bureaucracy– look for & address coordination problems– integration problems require the most attention, & will create most of your day-to-day

headaches

Fifth, design jobs (next lecture)– balance benefits of specialization, standardization against benefits of using specific

knowledge, intrinsic motivation

In all of this, balance desires for control v. creativity & adaptation– self organizing systems can be extraordinarily powerful; don’t be a control freak!

Sixth, design performance evaluation & incentives to match job design (after Midterm)

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6. Economic Ideas

The “knowledge problem” of organizational design– specific knowledge– coordination types & mechanisms– incentives & price mechanisms

Decision making– decentralization v. centralization– decision management v. control– degrees of decision control / hierarchy, & their effects

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Summary Points

The metaphor of a market highlights the role of economics in organizational design– design is largely about creating & making use of knowledge

» by its nature, specific knowledge tends to have more economic value– incentives play a crucial role

» approximating ownership» performance measures are “prices”

– but market approaches are limited when complex coordination (especially of the “integration” kind) is needed

The concepts apply to design of an individual job, to a workgroup, to structure of a global conglomerate