Managerial Economics and

Organizational Architecture

Sixth Edition

JAMES A. BRICKLEY

CLIFFORD W. SMITH

JEROLD L. ZIMMERMAN

William E. Simon Graduate School

of Business Administration

University of Rochester

Mc
Graw
Hill
Education
Contents

Part 1: Basic Concepts

Chapter 1: Introduction 1
Managerial Economics and Organizational Architecture 3
Organizational Architecture 3
Economic Analysis 4
Economic Darwinism 7
Survival of the Fittest 7
Economic Darwinism and Benchmarking 7
Purpose of the Book 9
Our Approach to Organization« 10

Chapter 2: Economists'View of Behavior 14

Economic Behavior. An Overview 15
Economic Choice 15
Marginal Analysis 16
Opportunity Costs 18
Creativity of Individuais 18
Graphical Tools 20
Individual Objectives 20
Indifference Curves 21
Opportunities and Constraints 22
Individual Choice 23
Changes in Choice 26
Motivating Honesty at Merrill Lynch 28
Managerial Implications 30
Alternative Models of Behavior 32
Only-Money-Matters Model 33
Happy-Is-Productive Model 33
Good-Citizen Model 34
Product-of-the-Environment Model 35
Which Model Should Managers Use? 35
Behavioral Economics 37
Decision Making under Uncertainty 38
Expected Value 39
Variability 39
Risk Aversion 39
Certainly Equivalent and Risk Premium 40
Risk Aversion and Compensation 41
Summary 42
Appendix A: Consumer Choice 49
Appendix B: Inter-Temporal Decisions and the Fisher Separation Theorem 61
xvii
xviii Contents

Chapter 3: Exchange and Markets 66

Goals of Economic Systems 67
Property Rights and Exchange in a Market Economy 68
Dimensions of Property Rights 69
Gains from Trade 70
Basics of Supply and Demand 75
The Price Mechanism 76
Shifts in Curves versus Movements along Curves 79
Using Supply and Demand Analysis for Qualitative Forecasts 79
Linear Supply and Demand 80
Supply and Demand—Extended Analysis 82
Price versus Quantity Adjustments 82
Short-Run versus Long-Run Effects 84
Industry Cost Increases and Price Adjustments 86
Prices as Social Coordinators 90
Efficient Exchange and Production 90
Measuring the Gains from Trade 90
Government Intervention 91
Externalities and the Coase Theorem 95
Markets versus Central Flanning 98
General versus Specific Knowledge 98
Knowledge Creation 100
Specific Knowledge and the Economic System 102
Incentives in Markets 102
Contracting Costs and Existence of Firms 103
Contracting Costs in Markets 104
Contracting Costs within Firms 105
Managerial Decisions 106
Summary 108
Appendix: Shareholder Value and Market Efficiency 114

Part 2: Managerial Economics

Chapter 4: Demand 120

Demand Functions 121
Demand Curves 122
Law of Demand 123
Elasticity of Demand 124
Linear Demand Curves 129
Other Factors That Influence Demand 131
Prices of Related Products 131
Income 133
Other Variables 135
Industry versus Firm Demand 135
Network Effects 137
Product Attributes 138
Product Life Cycles 139
Demand Estimation 141
Interviews 141
Price Experimentation 142
 Contents xix

Statistical Analysis 143

Implications 146
Summary 147
Appendix: Demand 154

Chapter 5: Production and Cost 156

Production Functions 157
Returns to Scale 158
Returns to a Factor 159
Choice of Inputs 162
Production Isoquants 162
Isocost Lines 164
Cost Minimization 165
Changes in Input Prices 167
Costs 168
Cost Curves 169
Short Run versus Long Run 171
Minimum Efficient Scale 175
Learning Curves 177
Economies of Scope 178
Profit Maximization 179
Factor Demand Curves 180
Cost Estimation 184
Summary 185
Appendix: The Factor-Balance Equation 191

Chapter 6: Market Structure 193

Markets 195
Competitive Markets 195
Firm Supply 195
Competitive Equilibrium 198
Barriers to Entry 201
Incumbent Reactions 202
Incumbent Advantages 203
Exit Costs 204
Monopoly 204
Monopolistic Competition 206
Oligopoly 208
Nash Equilibrium 208
Output Competition 210
Price Competition 212
Empirical Evidence 213
Cooperation and the Prisoners' Dilemma 214
Summary 217

Chapter 7: Pricing with Market Power 223

Pricing Objective 224
Benchmark Case: Single Price per Unit 225
Profit Maximization 225
Estimating the Profit-Maximizing Price 228
Potential for Higher Profits 231
xx Contents

Homogeneous Consumer Demands 232

Block Pricing 232
Two-Part Tariffs 233
Price Discrimination—Heterogeneous Consumer Demands 234
Exploiting Information about Individual Demands 236
Using Information about the Distribution of Demands 239
Bundling 242
Other Concerns 244
Multiperiod Considerations 244
Strategie Interaction 246
Legal Issues 247
Implementing a Pricing Strategy 248
Summary 250
Chapter 8: Economics of Strategy:
Creating and Capturing Value 257
Strategy 258
Value Creation 259
Production and Producer Transaction Costs 261
Consumer Transaction Costs 261
Other Ways to Increase Demand 262
New Products and Services 265
Cooperating to Increase Value 265
Converting Organizational Knowledge into Value 266
Opportunities to Create Value 267
Capturing Value 269
Market Power 270
Superior Factors of Production 273
A Partial Explanation for Walmart's Success 278
All Good Things Must End 280
Economics of Diversification 282
Benefits of Diversification 282
Costs of Diversification 284
Management Implications 284
Strategy Formulation 286
Understanding Resources and Capabilities 286
Understanding the Environment 286
Combining Environmental and Internal Analyses 287
Strategy and Organizational Architecture 288
Can All Firms Capture Value? 290
Summary 291
Chapter 9: Economics of Strategy: Game Theory 296
Game Theory 297
Simultaneous-Move, Nonrepeated Interaction 299
Analyzing the Payoffs 299
Dominant Strategies 300
Nash Equilibrium Revisited 301
Competition versus Coordination 303
Mixed Strategies 306
Managerial Implications 308
 Contents xxi

Sequential Interactions 310

First-Mover Advantage 312
Strategie Moves 312
Managerial Implications 313
Repeated Strategie Interaction 314
Strategie Interaction and Organizational Architecture 316
Summary 318
Appendix: Repeated Interaction and the Teammates' Dilemma 323

Chapter 10: Incentive Conflicts and Contracts 329

Firms 330
Incentive Conflicts within Firms 332
Owner-Manager Conflicts 332
Other Conflicts 334
Controlling Incentive Problems through Contracts 334
Costless Contracting 335
Costly Contracting and Asymmetrie Information 338
Postcontractual Information Problems 340
Precontractual Information Problems 343
Implicit Contracts and Reputational Concems 347
Incentives to Economize on Contracting Costs 349
Summary 350

Part 3: Designing Organizational Architecture

Chapter 11: Organizational Architecture 355

The Fundamental Problem 357
Architecture of Markets 357
Architecture within Firms 358
Architectural Determinants 360
Changing Architecture 364
Interdependencies and Complementarities within the Organization 365
Corporate Culture 366
When Management Chooses an Inappropriate Architecture 370
Managerial Implications 371
Evaluating Management Advice 372
Benchmarking 372
Summary 373

Chapter 12: Decision Rights: The Level of Empowerment 376

Assigning Tasks and Decision Rights 378
Centralization versus Decentralization 380
Benefits of Decentralization 380
Costs of Decentralization 382
Illustrating the Trade-offs 385
Management Implications 389
Lateral Decision-Right Assignment 393
xxii Contents

Assigning Decision Rights to Teams 394

Benefits of Team Decision Making 394
Costs of Team Decision Making 395
Management Implications 395
Decision Management and Control 397
Decision-Right Assignment and Knowledge Creation 399
Influence Costs 401
Summary 403
Appendix: Collective Decision Making 407
Chapter 13: Decision Rights: Bundling
Tasks into Jobs and Subunits 410
Bundling Tasks into Jobs 411
Specialized versus Broad Task Assignment 411
Productive Bundling of Tasks 415
Bundling of Jobs into Subunits 416
Grouping Jobs by Function 417
Grouping Jobs by Product or Geography 419
Trade-offs between Functional and Product or Geographie Subunits 420
Environment, Strategy, and Architecture 423
Matrix Organization 424
Mixed Designs 426
Network Organizations 426
Organizing within Subunits 426
Recent Trends in Assignments of Decision Rights 427
Summary 432
Appendix: Battie of the Functional Managers 436

Chapter 14: Attracting and Retaining Quaiified Employees 438

Contracting Objectives 440
The Level of Pay 441
The Basic Competitive Model 441
Human Capital 442
Compensating Differentials 444
Costly Information about Market Wage Rates 446
Internal Labor Markets 447
Reasons for Long-Term Employment Relationships 447
Costs of Internal Labor Markets 448
Pay in Internal Labor Markets 449
Careers and Lifetime Pay 449
Influence Costs 454
The Salary-Fringe Benefit Mix 455
Employee Preferences 455
Employer Considerations 457
The Salary-Fringe Benefit Choice 457
Summary 463

Chapter 15: Incentive Compensation 469

The Basic Incentive Problem 470
Incentives from Ownership 473
Optimal Risk Sharing 474
 Contents xxiii

Effective Incentive Contracts 476

Principal-Agent Model 476
Informativeness Principle 482
Group Incentive Pay 483
Multitasking 485
Forms of Incentive Pay 486
Incentive Compensation and Information Revelation 487
Selection Effects of Incentive Contracts 488
Does Incentive Pay Work? 489
Summary 493
Appendix: Multitasking Theory 498

Chapter 16: Individual Performance Evaluation 502

Setting Performance Benchmarks 505
Time and Motion Studies 506
Past Performance and the Ratchet Effect 506
Measurement Costs 507
Opportunem 509
Gaming 510
Horizon Problem 511
Relative Performance Evaluation 511
Within-Firm Performance 512
Across-Firm Performance 513
Subjective Performance Evaluation 513
Multitasking and Unbalanced Effort 514
Subjective Evaluation Methods 515
Problems with Subjective Performance Evaluations 517
Combining Objective and Subjective Performance Measures 520
Team Performance 521
Team Production 522
Evaluating Teams 524
Government Regulation of Labor Markets 525
Summary 527
Appendix: Optimal Weights in a Relative Performance Contract 533

Chapter 17: Divisional Performance Evaluation 537

Measuring Divisional Performance 539
Cost Centers 539
Expense Centers 542
Revenue Centers 543
Profit Centers 544
Investment Centers 544
Transfer Pricing 549
Economics of Transfer Pricing 550
Common Transfer-Pricing Methods 556
Reorganization: The Solution If All Else Fails 560
Internal Accounting System and Performance Evaluation 560
Uses of the Accounting System 560
Trade-offs between Decision Management and Decision Control 561
xxiv Contents

Summary 564
Capstone Case Study on Organizational Architecture:
Arthur Andersen LLP 571

Part 4: Applications of Organizational

Architecture

Chapter 18: Corporate Governance 578

Publicly Traded Corporations 580
Corporate Form of Organization 580
Stock Exchanges 581
Stock Ownership Patterns 581
Governance Objectives 582
Separation of Ownership and Control 582
Incentive Issues 582
Survival of Corporations .583
Benefits of Publicly Traded Corporations 583
Top-Level Architecture in U.S. Corporations 584
Sources of Decision Rights 585
Shareholders 586
Board of Directors 591
Top Management 594
Extemal Monitors 598
International Corporate Governance 601
Market Forces 604
Sarbanes-Oxley Act of 2002 606
Corporate Governance: An Historical Perspective 608
Summary 610
Web Appendix: Choosing among the Legal Forms of Organization A-l

Chapter 19: Vertical Integration and Outsourcing 615

Vertical Chain of Production 617
Benefits of Buying in Competitive Markets 620
Reasons for Nonmarket Transactions 621
Contracting Costs 621
Market Power 624
Taxes and Regulation 626
Other Considerations 627
Vertical Integration versus Long-Term Contracts 627
Incomplete Contracting 628
Ownership and Investment Incentives 628
Specific Assets and Vertical Integration 629
Asset Ownership 632
Other Reasons 633
Continuum of Choice 634
Contract Duration 635
Contracting with Distributors 636
Free-Rider Problems 636
Double Markups 638
Regulatory Issues 641
 Contents xx*

Trends in Outsourcing 642

Summary 645
Appendix: Ownership Rights and Investment Incentives 650

Web Chapter 20: Leadership:

Motivating Change within Oiganizations 654
Leadership 20-3
Vision Setting 20-3
Motivation 20-4
Decision Making within Firms 20-5
Incentive Problems and Organizational Politics 20-5
Understanding Attitudes toward Change 20-5
Changing Organizational Architecture 20-7
Proposal Design 20-9
Maintaining Flexibility 20-9
Commitment 20-10
Distributional Consequences 20-10
Marketing a Proposal 20-11
Careful Analysis and Groundwork 20-11
Relying on Reputation 20-11
Emphasizing a Crisis 20-13
Organizational Power 20-14
Sources of Power 20-14
Tying the Proposal to Another Initiative 20-17
Coalitions and Logrolling 20-18
Is Organizational Power Bad? 20-19
The Use of Symbols 20-20
Summary 20-21
Appendix: Strategie Value of Commitment and Crisis 20-23

Chapter 21: Understanding the Business Environment:

The Economics of Regulation 655
Importance of Regulation to Managers 656
Economic Motives for Government Intervention 658
Defining and Enforcing Property Rights 658
Redressing Market Failures 660
Redistributing Wealth 666
Economic Theory of Regulation 668
Demand for Regulation: Special Interests 669
Supply of Regulation: Politicians 669
Market for Regulation 671
Deadweight Losses, Transaction Costs, and Wealth Transfers 674
Managerial Implications 675
Restricting Entry and Limiting Substitutes 675
Forming Coalitions 678
On Business Participation in the Political Process 679
Summary 681

Chapter 22: Ethics and Organizational Architecture 684

Ethics and Choices 687
Corporate Mission: Ethics and Policy Setting 689
Ethics 689
Value Maximization 690
Corporate Social Responsibility 692
Economists' View of Social Responsibility 693
Corporate Policy Setting 695
Mechanisms for Encouraging Ethical Behavior 698
Contracting Costs: Ethics and Policy Implementation 702
Codes of Ethics 704
Altering Preferences 705
Education 706
Corporate Culture 709
Summary 710

Web Chapter 23: Organizational Architecture and the Process

of Management Innovation 714
Management Innovations 23-3
The Demand for Management Innovations 23-5
The Rise of TQM 23-6
Other Innovations 23-7
Why Management Innovations Often Fail 23-8
Marketing 23-8
Underestimating Costs of Change 23-11
Failure to Consider Other Legs of the Stool 23-12
Managing Changes in Organizational Architecture 23-16
Summary 23-19

Index 715
Web Glossary G-l