Managerial Economics andy
Organizational ArchitectureThijd Edition
JAMES A. BRICKLEYCLIFFORD W. SMITH, Jr.JEROLD L. ZIMMERMAN
» William E. Simon Graduate Schoolof Business Administration
University of Rochester
IrwinBoston Burr Ridge, IL Dubuque, IA Madison, Wl New York San Francisco St. Louis
Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico CityMjfan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto
Contents in Brief
Part 1: Basic Concepts
Chapter 1 Introduction 2Chapter 2 Economist's View of Behavior 14Chapter 3 Markets, Organizations, and the Role
of Knowledge 42
PafT2: Managerial Economics
Chapter 4 Demand 7'4Chapter 5 Production and Cost 106Chapter 6 Market Structure 136Chapter 7 Pricing with Market Power 160Chapter 8 Economics of Strategy: Creating and
Capturing Value 188Chapter 9 Economics of Strategy: Game Theory 226Chapter 10 Incentive Conflicts and Contracts 255
Part 3: Designing Organizational Architecture
Chapter 11 Organizational Architecture 280Chapter 12 Decision Rights: The Level of Empowerment 302Chapter 13 Decision Rights: Bundling Tasks into Jobs
and Subunits 333Chapter 14 Attracting and Retaining Qualified Employees 358Chapter 15 Incentive Compensation 388Chapter 16 Individual Performance Evaluation 418Chapter 17 Divisional Performance Evaluation 450
Capstone Case Study on Organizational Architecture:Arthur Andersen LLP 481s
Part 4: Applications of Organizational Architecture
Chapter 18 Choosing the Legal Form of Organization 488Chapter 19 Vertical Integration and Outsourcing 514Chapter 20 Leadership: Motivating Change within Organizations 551
xvi Contents in Brief
Chapter 21 Understanding the Business Environment:The Economics of Regulation 575
Chapter 22 Ethics and Organizational Architecture 603Chapter 23 Organizational Architecture and the Process
of Management Innovation 629
Glossary 652
Index 663
Contents
Part 1: Basic ConceptsChapter 1: Introduction 2Managerial Economics and Organizational Architecture 4
Organizational Architecture 4Economic Analysis 5
Economic Darwinism 7Survival of the Fittest 7Economic Darwinism and Benchmarking 8
Purpose of the Book 10Our Approach to Organizations 10Overview of the Book 11
Case Study: Barings Bank 12
Chapter 2: Economists' View of Behavior . . 14Economic Behavior: An Overview 15
Economic Choice 16Marginal Analysis ^ 16Opportunity Costs 17Creativity of Individuals 18
Graphical Tools 19Individual Objectives 19Indifference Curves 20Constraints 22Individual Choice 23Changes in Choice 25
Motivating Honesty at Merrill Lynch 26Managerial Implications 29Alternative Models of Behavior 30
Only-Money-Matters Model 30Happy-Is-Productive Model 31Good-Citizen Model 32Product-of-the-Environment Model 32
^h ich Model Should Managers Use? 33Decision Making under Uncertainty 34
Risk Aversion 35Certainly Equivalent and Risk Premium 36Risk Aversion and Compensation 37
Case Study: Interwest Healthcare Corp 37Summary 38
xvii
Contents
Chapter 3: Markets, Organizations, and the Role of Knowledge . . .42Goals of Economic Systems 43Property Rights and Exchange in a Market Economy 44
Dimensions of Property Rights 44Gains from Trade 45
Basics of Supply and Demand 48The Price Mechanism 48Linear Supply and Demand 51Price as Social Coordinators 52Externalities and the Coase Theorem 53
Markets versus Central Planning 56General versus Specific Knowledge 56Knowledge Creation 58Specific Knowledge and the Economic System 60Incentives in Markets 61
Contracting Costs and Existence of Firms 62.^ssContracting Costs in Markets 63
Contracting Costs within Firms 64Managerial Implications 66Case Study: Property Right Security in Russian Deprivatization 67Summary 67
Part 2: Managerial Economics
Chapter 4: Demand ^ 74Demand Functions 75Demand Curves 76
Law of Demand 77Elasticity of Demand 78Linear Demand Curves 82
Other Factors That Influence Demand 84Prices of Related Products 84Income 86Other Variables 87
Industry versus Firm Demand 87Network Effects 89Product Attributes 91Product Life Cycles 92Demand Estimation 93
Interviews 94jj Price Experimentation 95
Statistical Analysis 95Implications 98
Case Study: Personal Video Recorders (PVRs) 99Summary 100Appendix: Demand 101
Contents xix
Chapter 5: Production and Cost 106Production Functions 107
Returns to Scale 108Returns to a Factor 109
Choice of Inputs I l lProduction Isoquants I l lIsocost Lines 113Cost Minimization 115Changes in Input Prices 116
Costs 117Cost Curves 117Short Run versus Long Run 120Minimum Efficient Scale 123Learning Curves 124Economies of Scope 125
Profit Maximization 126Factor Demand Curves 128CojtgFjstimation 129Case Study: Rich Manufacturing 131Summary 131Appendix: The Factor-Balance Equation 132
Chapter 6: Market Structure 136Markets . - . . . . . ' 138Competitive Markets 138
Firm Supply 138Competitive Equilibrium 140
Barriers to Entry 143Incumbent Reactions 143Incumbent Advantages 144Exit Costs 145
k Monopoly 146Monopolistic Competition 147Oligopoly 148
Nash Equilibrium 149Output Competition 150Price Competition 152Empirical Evidence 153Cooperation and the Prisoners' Dilemma 153
Summary 157
Chapter 7: Pricing with Market Power 160Prjpng Objective 161Benchmark Case: Single Price per Unit 162
Profit Maximization 162Estimating the Profit-Maximizing Price 165Potential for Higher Profits 167
Contents
Homogeneous Consumer Demands 168Block Pricing 168Two-Part Tariffs 169
Price Discrimination—Heterogeneous Consumer Demands 171Exploiting Information about Individual Demands 172Using Information about the Distribution of Demands 175
Bundling 179Other Concerns 180
Multiperiod Considerations 180Strategic Interaction 182Legal Issues 183
Implementing a Pricing Strategy 183Summary 184
Chapter 8: Economics of Strategy: Creatingand Capturing Value 188Strategy 189Value Creation 190
Production and Producer Transaction Costs 192Consumer Transaction Costs 193Other Ways to Increase Demand 194New Products and Services 197Cooperating to Increase Value 197Converting Organizational Knowledge into Value 198Opportunities to Create Value 200
Capturing Value 201Market Power .\ 202Superior Factors of Production 204A Partial Explanation for Wal-Mart's Success 210All Good Things Must End 211
Economics of Diversification 213Benefits of Diversification 213Costs of Diversification 214Management Implications , 214
Strategy Formulation 217Understanding Resources and Capabilities 217Understanding the Environment 218Combining Environmental and Internal Analyses 219Strategy and Organizational Architecture 219Can All Firms Capture Value? 220
Case Study: Wal-Mart.com . .- 221Summary 222
Chapter 9: Economics of Strategy: Game Theory 226Game Theory 227Simultaneous-Move, Nonrepeated Interaction 228
Analyzing the Payoffs 229Dominant Strategies 229
Contents xxi
Nash Equilibrium Revisited 231Competition versus Coordination 233Mixed Strategies 236Managerial Implications 237
Sequential Interactions 239First-Mover Advantage 240Strategic Moves 241Managerial Implications 242
Repeated Strategic Interaction 243Strategic Interaction and Organizational Architecture 244Case Study: Holland Sweetener versus Monsanto 245Summary 246Appendix: Repeated Interaction and the Teammates' Dilemma 248
Chapter 10: Incentive Conflicts and Contracts 255Firms 256Incentive Conflicts within Firms 257
Owner-Manager Conflicts 258Other Conflicts 259
Controlling Incentive Problems through Contracts 260Costless Contracting 261Costly Contracting and Asymmetric Information 264Postcontractual Information Problems 265Precontractual Information Problems 268
Implicit Contracts and Reputational Concerns 272Incentives to Economize on Contracting Costs 273Case Study: eBay.com \ 275Summary 275
Part 3: Designing Organizational Architecture
Chapter 11: Organizational Architecture 280The Fundamental Problem 282
Architecture of Markets 282Architecture within Firms 283
Architectural Determinants 285Changing Architecture 289Interdependencies within the Organization 290
Corporate Culture 7 291When Management Chooses an Inappropriate Architecture 294Managerial Implications 295
Evaluating Management Advice 296Benchmarking 296Overview of Part 3 297
Case Study: Eastman Kodak 298Summary 299
xxii Contents
Chapter 12: Decision Rights: The Level of Empowerment 302Assigning Tasks and Decision Rights 304Centralization versus Decentralization 306
Benefits of Decentralization 306Costs of Decentralization 308Illustrating the Trade-Offs 310Management Implications 313
Lateral Decision-Right Assignment 316Assigning Decision Rights to Teams 317
Benefits of Team Decision Making 317Costs of Team Decision Making 318Management Implications 319
Decision Management and Control 319Decision Right Assignment and Knowledge Creation 322Influence Costs 323Case Study: Medford University 325Summary 326App'Shdix: Collective Decision Making 326
Chapter 13: Decision Rights: Bundling Tasks into Jobsand Subunits 333Bundling Tasks into Jobs 334
Specialized versus Broad Task Assignment 334Productive Bundling of Tasks 337
Bundling of Jobs into Subunits 338Grouping Jobs by Function 338Grouping Jobs by Product or Geography 340Trade-offs between Functional and Product or Geographic Subunits 340Environment, Strategy, and Architecture 344Matrix Organizations 344Mixed Designs 346Network Organizations 347Organizing within Subunits 347
Recent Trends in Assignments of Decision Rights 347Case Study: Bagby Copy Company 351Summary 352Appendix: Battle of the Functional Managers 353
Chapter 14: Attracting and Retaining Qualified Employees 358Contracting Objectives 360The Level of Pay 360
The Basic Competitive Model 360Human Capital 361Compensating Differentials 363Costly Information about Market Wage Rates 366
Internal Labor Markets 367Reasons for Long-Term Employment Relationships 367Costs of Internal Labor Markets 368
Pay in Internal Labor Markets 369Careers and Lifetime Pay 369Influence Costs 375
Contents xxiii
The Salary—Fringe Benefit Mix 375Employee Preferences 376Employer Considerations 378The Salary-Fringe Benefit Choice 378
Summary 383
Chapter 15: Incentive Compensation 388The Basic Incentive Problem 389
Incentives from Ownership 392Optimal Risk Sharing 393
Effective Incentive Contracts 395Principal-Agent Model 395Informativeness Principle 401Group Incentive Pay 402Multitask Principal-Agent Problems 403Forms of Incentive Pay 404Incentive Compensation and Information Revelation 405
Does^ncentive Pay Work? 407Case Study: The Debate over CEO Compensation 408Summary 409Appendix: Multitask Principal-Agent Theory 411
Chapter 16: Individual Performance Evaluation 418Setting Performance Benchmarks 421
Time and Motion Studies 421Past Performance and the Ratchet Effect 422
Measurement Costs 423Opportunism 424
Gaming 424Horizon Problem 425
Relative Performance Evaluation 426Within-Firm Performance 426Across-Firm Performance 427
Subjective Performance Evaluation 428Multiple Tasks and Unbalanced Effort : 429Subjective Evaluation Methods 429Problems with Subjective Performance Evaluations 431
Combining Objective and Subjective Performance Measures 433Team Performance 434
Team Production 434Evaluating Teams 436
Government Regulation of Labor Markets 439Summary 440Appendix: Optimal Weights in a RelativePerformance Contract 442
Chapter 17: Divisional Performance Evaluation 450Measuring Divisional Performance 452
Cost Centers 452Expense Centers 454Revenue Centers 456
xxiv Contents
Profit Centers 456Investment Centers 457
Transfer Pricing 460Economics of Transfer Pricing , 462Common Transfer-Pricing Methods 467Reorganization: The Solution If All Else Fails 471
Internal Accounting System and Performance Evaluation 471Uses of the Accounting System 472Trade-offs between Decision Management and Decision Control 473
Case Study: Celtex 475Summary 475Capstone Case,Study on Organizational Architecture:Arthur Andersen LLP 481
Part 4: Applications of Organizational Architecture
Chapter 18: Choosing the Legal Form of Organization 488Descriptive Overview 490
Profit Status 490For-Profit Alternatives 490Descriptive Statistics—For-Profit Sector 493Descriptive Statistics—Nonprofit Sector 494
Framework for Analyzing Organizational Choices 495Managerial Decision: Profit Status 496
Benefits of Nonprofit Status 497Costs of Nonprofit Status \ 497Factors Affecting the Choice of Profit Status 498
Choosing among the For-Profit Alternatives 499Individual Proprietorships 499General Partnerships 500Closely Held Corporations 501Publicly Traded Corporations 502
Governance Mechanisms in Publicly Traded Firms : 503Internal Control Mechanisms 503External Control Mechanisms 506International Corporate Governance 507
Regulatory Responses to Recent Corporate Scandals 508Sarbanes-Oxley Act of 2002 508NYSE Rules on Corporate Governance 509
Summary .-. 509Appendix: Tax Implications: S versus C Corporations 511
Chapter 19: Vertical Integration and Outsourcing 514Vertical Chain of Production 516Benefits of Buying in Competitive Markets 519Reasons for Nonmarket Transactions 521
Contracting Costs 521Market Power 525Taxes and Regulation , 526Other Reasons 527
Contents xxv
Vertical Integration versus Long-Term Contracts 527Incomplete Contracting 528Ownership and Investment Incentives 528Specific Assets and Vertical Integration 529Asset Ownership 533Other Reasons 533Continuum of Choice 534
Contract Length 535Contracting with Distributors 535
Free-Rider Problems 536Double Markups 537Regulatory Issues 540Recent Trends in Outsourcing 541
Case Study: AutoCorp 542Summary 542Appendix: Ownership Rights and Investment Incentives 544
CHapter 20: Leadership: Motivating Change within Organizations . .551Leadership 553
Vision Setting 553Motivation 554
Decision Making within Firms 555Incentive Problems and Organizational Politics 555Understanding Attitudes toward Change .' 556
Changing Organizational Architecture 558Proposal Design 559
Maintaining Flexibility \ 559Commitment 560Distributional Consequences 560
Marketing a Proposal 561Careful Analysis and Groundwork 561Relying on Reputation 562Emphasizing a Crisis 563
Organizational Power 563Sources of Power 563Tying the Proposal to Another Initiative 566Coalitions and Logrolling 567Is Organizational Power Bad? 568
The Use of Symbols 569Case Study: Global Insurance 570Summary ? 571Appendix: Strategic Value of Commitment and Crisis 572
I
Chapter 21: Understanding the Business Environment:The Economics of Regulation 575Importance of Regulation to Managers 576Economic Reasons for Government Intervention 578
Defining and Enforcing Property Rights 578Redressing Market Failures 580Redistributing Wealth .v 586
Contents
Economic Theory of Regulation 588Demand for Regulation: Special Interests 588Supply of Regulation: Politicians 589Market for Regulation 591Deadweight Losses, Transaction Costs, and Wealth Transfers 594
Managerial Implications 595Restricting Entry and Limiting Substitutes 595Forming Coalitions 597On Business Participation in the Political Process 598
Case Study: World Motors 599Summary 600
Chapter 22: Ethics and Organizational Architecture 603Ethics and Choices 605Corporate Mission: Ethics and Policy Setting 607
Ethics 607^sc^-Value Maximization 608
Corporate Social Responsibility 610Economists' View of Social Responsibility 610Corporate Policy Setting 613Mechanisms for Encouraging Ethical Behavior 615
Contracting Costs: Ethics and Policy Implementation 618Codes of Ethics 620
Altering Preferences 621Education 622Corporate Culture 623
Case Study: The Tylenol Tragedy and J&J's Credo ,. 624Summary 625
Chapter 23: Organizational Architecture and the Processof Management Innovation 629Management Innovations 631The Demand for Management Innovations 633
The Rise of TQM 634Other Innovations 635
Why Management Innovations Often Fail 636Marketing 636Underestimating Costs of Change 639Failure to Consider Other Legs of the Stool 639
Managing Changes in Organizational Architecture 643Case Study: Software Development, Inc 644
Summary 646
Glossary 652
Index 663