Economic Foundations of Strategy

Joseph T. Mahoney

• Publisher: SAGE Publications, Inc
• Year: 2004
• ISBN:
  9781506317946
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Estrategia empresarial

Economic Foundations of Strategy provides not only the essential basic tenets of strategy, it also shows the inter-relationships of five major theories of the firm: the behavioral theory; transaction costs theory; property rights theory; agency theory; and dynamic resource-based theory. Even though technological, organizational and institutional change advances breathlessly, the theories of the firm provided in this research book are durable principles that have stood, and the author maintains will continue to stand, the test of time. Economic Foundations of Strategy emphasizes the complementarities among these five theories of organization, and the potential for integrating these theories in the evolving science of organization.Applications of these theories to business practice are emphasized throughout the book.

1

Behavioral Theory of the Firm

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The chapter begins with Barnard’s (1938) The Functions of the Executive and is followed by four books from the Carnegie School: Simon’s (1947) Administrative Behavior, March and Simon’s (1958) Organizations, Cyert and March’s (1963) A Behavioral Theory of the Firm, and Simon’s (1982) Models of Bounded Rationality: Behavioral Economics and Business Organization. These books contain some of the best scholarly writings that the research literature has to offer on the behavioral theory of the firm. These research books are worth studying in detail because they continue to be widely cited today and because their clarity and relevance have not yet been surpassed.

The decision to classify the behavioral theory of the firm as part of an organizational economics approach to strategic management has its precedents, notably in the work of Barney and Ouchi (1986). Nonetheless, given that my book is part of a series, it might seem that this topic should be reserved for a research book on the behavioral foundations of strategy. I am sure it will reappear in that context. However, the behavioral theory of the firm also is part of organizational economics. Organizational economics is a multidisciplinary endeavor that draws on the broader field of economics and also gives attention to contributions from organization theory, law, and other areas. As an important example, Herbert Simon, whose 1947 and 1982 books are reviewed in this chapter, was awarded the Nobel Prize in the discipline of economics for work that included his contributions to the behavioral theory of the firm.

Furthermore, the behavioral theory of the firm serves as an important building block in transaction costs theory (Williamson, 1975). This theory is the subject of Chapter 2 and a central topic in organizational economics. Behavioral theory is also an important building block in dynamic capabilities theory and evolutionary economics (Nelson & Winter, 1982). This research is the subject of Chapter 5.

In terms of the five books chosen, Barnard (1938) combines the two cultures of science and art, and it is the aesthetic reading of Barnard that explains the intensity of students’ responses to this work. Barnard offers an intense, structured, and coherent art form that depends on students’ use of their capacities and their readiness to apprehend the aesthetic experience of management based on the author’s intimate, habitual, interested experience (Mahoney, 2002).

Simon (1947) proposes a theory of human choice and decision making that aims to accommodate both those rational aspects of choice that have been the principal concern of economists and those properties and limitations of the human decision-making mechanisms that have attracted the attention of psychologists and practical decision makers. Simon focuses primarily on the decision-making processes that are internal to the organization and describes how organizations influence the decisions of their members, bring about consistency among those decisions, and guarantee that the decisions will be compatible with the overall organizational goals.

March and Simon (1958) persuasively argue that an adequate study of human behavior in organizations must take into account the motivational, attitudinal, and rational aspects of human behavior. Thus, both the works of economists on the planning process and the works of psychologists on organizational communication and problem-solving capabilities contribute to the evolving science of organization.

Cyert and March (1963) emphasize the actual process of making business decisions and provide detailed observations of the ways in which organizations make these decisions. Cyert and March develop an empirically relevant, process-oriented general theory of economic decision making by a business firm that, in my judgment, has stood the test of time. Cyert and March present the rudiments of a behavioral theory of the firm that have proven to be relevant both to economic theory and to the theory of complex organizations.

Simon’s (1982) Models of Bounded Rationality takes up where Administrative Behavior (Simon, 1947) left off—attempting to understand decision making in its most general sense and, in particular, to show that economics and psychology could contribute to illuminating organizational decision-making processes. More specifically, Simon (1982) is concerned with explaining why there has been so little mutual influence of economics and psychology on each other, why a deeper dialogue needs to be developed between these two disciplines, and what the subject matter of their discourse could be.

In the process, Simon (1982) reveals a deep belief in and commitment to the interdependencies and complementarity of the several social sciences.

Simon borrows not only from economics but also from operations research, artificial intelligence, and cognitive psychology for the purpose of building a theory of procedural rationality (i.e., a theory of the processes of decision making) in complex, dynamic circumstances.

Though these arguments are a sufficient introduction to the chapter, I would make a final observation related to teaching. Those in strategic management who teach managers and managers-to-be will know that our students appreciate receiving not only theories for predicting but also theories that provide explanation. In other words, practitioners appreciate know-how but are deeply seeking advances in know-why. It has been my experience in teaching executives that a behavioral theory of the firm resonates with these managers and proves instructive for them. It makes beginning with the work of a practicing manager highly appropriate.

The Functions of the Executive (Barnard, 1938)

In my judgment, this book is the most high-powered intellectual contribution to organization or economic theory ever written by a practicing manager. Barnard’s (1938) purpose is to provide a comprehensive theory of cooperative behavior in formal organizations.¹ Barnard observes that formal organization involves conscious, deliberate, and purposeful cooperation among people. One of the indispensable functions of an organization is to promote communication among these individuals. Another function is to maintain cohesiveness by regulating the willingness of various stakeholders to serve the organization and by maintaining the stability of authority. A third function is to maintain a feeling of personal integrity, self-respect, and independent choice.

But Barnard (1938) maintains that successful cooperation in or by formal organizations is the abnormal, not the normal, condition. We observe from day to day the successful survivors among innumerable organizational failures. Failure to cooperate, failure of cooperation, failure of organization, disorganization, dis-integration, destruction of organization—and reorganization—are the characteristic facts of human history.

The executive is critical. Executives inculcate belief in a common purpose. More concretely, executives synthesize the actions of contradictory forces and reconcile conflicting instincts, interests, conditions, positions, and ideals.

Informal Organization. While Barnard (1938) defines the formal organization as a system of consciously coordinated activities or forces of two or more persons, this book also emphasizes the important role of informal organization within formal organizations. Crucially, Barnard regards informal organization as a means of maintaining the personality of the individual against certain effects of formal organizations that tend to disintegrate the personality. In fact, Barnard concludes that expansion of cooperation and the development of the individual are mutually dependent realities and that a due proportion or balance between them is a necessary condition of human welfare.

Incentives. Barnard (1938) observes that incentives are fundamental in formal organization. Inadequate incentives mean dissolution, unwarranted changes of organization purpose, or failure of cooperation. Hence, in all sorts of organizations, affording adequate incentives becomes essential. The specific means available include (a) material inducements, not just money but other things; (b) personal, nonmaterial inducements, including distinction, prestige, and personal power; (c) desirable physical conditions; and (d) ideal benefactions, by which Barnard means the capacity of organizations to satisfy personal ideals.

The remarks about personal ideals and interests are very much in line with more recent discussions about identity and identification. Barnard (1938) is also contemporary in recognizing the incentives associated with (e) social attractiveness, or the social compatibilities people feel in their work environment; (f) conditions of habitual methods and attitudes; (g) the opportunity for enlarged participation; and (h) the condition of communion, or the feeling of solidarity or comradeship. None of this solidarity happens without effort. In addition to incentives, the book discusses persuasion and the inculcation of motives as important aspects of the organization.

Authority. Authority is the character of a communication (or order) in a formal organization by virtue of which a contributor accepts such an order. Barnard (1938) suggests that a person can and will accept a communication as authoritative only when four conditions simultaneously are met:

• The person can and does understand the communication.
• At the time of the person’s decision, the person believes that the order is not inconsistent with the purpose of the organization.
• At the time of the person’s decision, the person believes the order to be compatible with his or her personal interest as a whole.
• The person is able mentally and physically to comply with the order.

Perhaps the most well-known idea in the book is found in this discussion. Barnard (1938) argues that there exists a zone of indifference in each individual within which orders are acceptable without conscious questioning of their authority. Barnard further maintains that since the efficiency of organization is affected by the degree to which individuals assent to others, denying the authority of an organization communication is a threat to the interests of all individuals who derive a net advantage from their connection with the organization, unless the orders are unacceptable to them also. Thus, nothing is more real than authority.

An interesting corollary can be found in the assertion that the fine art of executive decision making includes not deciding questions that are not now pertinent, not deciding prematurely, not making a decision that cannot be made effective, and not making decisions that others should make. These are interesting, and rather unique, observations; Barnard (1938) argues the proper use of authority preserves morale, develops competence, and maintains authority. However, the natural reluctance of some people to decide, their persistent disposition to avoid responsibility, and their fear of criticism typically overwhelm executives. Executives thus must learn to protect themselves from the excessive burdens of decision making, if they are not already protected by a well-regulated and habitual distribution of responsibilities.

Another contemporary feature of this book is that the executive process Barnard (1938) describes transcends intellectual methods. Feeling, judgment, sense, proportion, balance, appropriateness, and other words are used to describe what executives should aspire to become. Leadership is more a matter of art than a matter of science. The processes used are more aesthetic than logical, derived chiefly from intimate, habitual, interested experience. For Barnard, coordination is a creative act.

Executive responsibility is also emphasized. Whatever morality exists in an individual becomes effective in his or her conduct, and the organization as a collective of cooperating individuals endures in proportion to the breadth of the morality by which it is governed. This assertion is only to say that foresight, long purposes, and high ideals are the basis for the persistence of cooperation (e.g., “old men and old women plant trees”).

Although emphasizing instincts and morality, Barnard (1938) believes that a science of organization is also possible. Barnard recommends that treatises on management be written from various perspectives, including social anthropology, sociology, social psychology, and institutional economics but warns that we should not deceive ourselves by thinking that a science of cooperation and organization will alone promote greater integration of social forces. Inspiration is necessary to inculcate the sense of unity and to create economic ideals. Emotional rather than intellectual acceptance is required.

Barnard (1938) presents a systems view of the organization that contains a psychological theory of motivation and behavior, a sociological theory of cooperation and complex interdependencies, and an ideology based on a meritocracy. These insights greatly influenced Simon (1947), to whose early and influential book we now turn.

Administrative Behavior (Simon, 1947)

Indeed, Barnard wrote the foreword to Simon’s (1947) Administrative Behavior. Barnard writes,“[Simon’s book] has the right ‘feel.’ This means that I find Professor Simon’s apprehension of the structure of organized action consonant with my own experience. It therefore appeals to me as sound” (p. xiii). From Simon’s classic book concerning decision-making processes, readers should be able to discern principles of general organization that apply to administrative organization of great variety. Simon provides us with a self-conscious attempt to develop adequate linguistic and conceptual tools for realistically and significantly describing organizations. Simon’s primary thesis is that decision making is the heart of organization and that the vocabulary of organization theory must be derived from the logic and psychology of human choice.

Simon (1947) provides a brilliant synthesis of the practical teachings of Barnard (1938) and the evolving positive science of organization theory. As already noted, Simon’s Administrative Behavior is a landmark in organization theory as well as the economics of organization. Indeed, the organization theorist William Scott (1987, p. 45) classifies Simon within the paradigm of organizations as rational systems. From the perspective of the rational systems view, the behavior of organizations is considered as actions performed by purposeful and coordinated agents. In this sense, Simon is consistent with the logic of economics and uses the familiar language of information, efficiency, implementation, and design. Unlike neoclassical economics, however, Simon also insists on coming to terms with cognitive limitations, which are discussed in terms of constraints, authority, routines, and bounded rationality. These terms imply that the rationality of organization behavior takes place within clearly specified limits. In short, this landmark book provides an attention-based theory of the firm of interest to both economic and organizational theorists.

Bounded Rationality. Simon (1947) observes that a person does not live for years in a particular position in an organization, exposed to some streams of communication, shielded from other streams of communication, without profound effects on what the person knows, believes, hopes, emphasizes, fears, and proposes. Researchers can understand neither the input nor the output of executives without understanding the organization in which executives work.

The term organization, for Simon (1947), refers to a complex pattern of human communications and relationships. This pattern of relationships provides each member of an organization or group within an organization much of the information and many of the assumptions, goals, and attitudes that enter into decisions. The pattern of relationships provides a set of stable and comprehensible expectations as to what the other members of the group are doing and how other members are likely to react to what is said and done. Every executive makes decisions and takes actions with one eye on the matter itself and one eye on the effects of this decision on the future pattern of relationships—that is to say, on its organizational consequences.

In summary, organizations are important because they provide much of the input that develops an executive’s personal qualities and habits. Organizations also provide those in responsible positions the means for exercising authority and influence over others, a topic discussed in some detail in the following pages. Third, the organization influences the environments of information in which decisions are carried out.

When executives give attention to these indirect consequences, they concern themselves with organization. Sales managers react like sales managers because they occupy particular organizational positions, receive particular kinds of communications, are responsible for particular subgoals, and experience particular kinds of (economic) pressures. Executives can modify beliefs and attitudes by changing the flows of communications and thus modify decisions being made.

Decisions are also influenced by the authority relationship. On the one hand, classical organization theory emphasizes formal lines of authority in a hierarchical organization, implying (as Barnard [1938] observed) that legitimate commands are typically carried out. On the other hand, the human relations school emphasizes the value of broad participation in decision making, demonstrates the importance of informal organization and the consequent limits on formal authority, and raises difficult questions about the human costs of excessively...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Editor’s Introduction
• Foreword
• Acknowledgments
• Overview
• 1. Behavioral Theory of the Firm
• 2. Transaction Costs Theory
• 3. Property Rights Theory
• 4. Agency Theory
• 5. Resource-Based Theory, Dynamic Capabilities, and Real Options
• 6. The Theoretic Building Blocks of Organizational Economics
• References
• Index
• About the Author