UNIT 1: ORGANIZATIONAL ECONOMICS

1. Organization
Looking the Cambridge dictionary you will find the following entries to the definition of
organization:
- A group whose members work together for a shared purpose in a continuing way
- The activity of planning an event or activity.
- The way in which something is done or arranged.

The definition that we propose in this course, in the sense that fits better with the contents of the
course, combines much of the elements above:

People select to participate or not and the way to participate. They are free and can create an
arrangement and its elements. The characteristic of this arrangement between that persons will
be:
- The distribution of decision making (work): continuous activities of planning and
executing similar events or activities.
- The compensation from this work: distribution of the organization results (share
purpose).

In other words à An arrangement between a group of persons establishing the tasks (continuous
activities of planning and executing similar events or activities) or contributions of each member
and the distribution of the organization results (shared purpose) or compensation from their
contributions.

Example: University
- Purpose: transferring knowledge
- People that are imply are: students, professors, administration, government
- Output: knowledge for the students
- Our contribution as students is money and coming here…
- The contribution of professors is time, giving knowledge…

They do some activities, and someone are financing these activities. We can mention different
organizations:
- NGO: non-governmental organizations
- UN: United Nations
- NATO: north Atlantic treaty organization
- WTO: world trade organization

But our course will talk about business organization, specifically à Firms

1.1 Elements of the firm

Therefore, a description of the organization consists on the identification of the following
elements:
a) The group of members involved in the arrangement
b) The tasks or decisions that make each one of the members of the organization.
c) The results associated to the organization
d) The compensation received by each one of the members

In sake of simplicity, during the course we are going to reduce the group members to two, let’s
call them entrepreneur (principal, person with formal authority) and worker (agent, person with
real authority), where:

- Entrepreneur is the person that has the formal right to define the purpose of the firm, what
the firm must do and who will receive the consequences of the behavior make in the name
 of the firm by others. They can delegate the decisions to other person who are the workers.
So they are the persons that consider to delegate or not the decisions.
- In consequence worker is the agent of the entrepreneur, so we can consider them as the
real authority who make the decisions, if they receive the delegation.

We are going to call the results of the organization as the value created.

The compensation of the worker as its wage and the compensation of the entrepreneur as its
profits.

The sum of the profits and wages must be equal to the value created.

VA = W + P

In other words, if the compensation of the worker is established beforehand, the value created is
maximized when the organization maximizes the profits of the entrepreneur. They will obtain VA
and they must decide how to share it between them. This is what we will study the way how they
decide these questions.

1.2 Existence of an organization

The questions that we will analyses will be: Why does exist firms (voluntary organizations)? The
necessary condition is for the existence of a firm is: the members accept to make decisions on
behalf of the organization by delegation.

Our focus will be on organizations where persons can freely participate in the
arrangement. Usually, businesses are identified as such kind of organizations. We admit that
theoretically this distinction is quite clear, but empirically perhaps it does not exist such pure
typology of organizations. For example, firms' actions could have consequences on climate,
therefore persons are participating involuntarily in the organization.

Therefore, a Business exists when every stakeholder accepts to participate. In other words, they
accept that there is a delegation of decisions:

One person (worker) makes decisions (work) on behalf of another person (entrerpeneur or
company).

1.3 Delegation
And the main question: when the enterpreneur is going to centralize the decision or when he will
delegate the decision à The delegation (centralization) of decision making.

The course focuses on the analysis of the main determinants that a concrete decision is going to
be delegated (or not).

For simplifying the exposition, the analysis will be conducted under the assumptions made in
Section 1.2, the delegation is a necessary condition for the existence of an organization. In other
words, when an entrepreneur is going to delegate a certain decision making to a worker. The way
to show it is through a organizational chart (organigrama).

Elements of the organizational chart:

- Hierarchical levels: concatenation of delegation, times that a decision has been delegated.
- Span of control (direct/indirect)
o Direct: the number of persons to whom an executive has delegated a decision
o Indirect: the number of persons to whom an executive or a person on behalf of
the executive has delegated a decision
- Departments: common characteristics of the decisions made by the different subordinates
 - Empirical evidence

We have to differentiate between:

- Micro approach: the delegation of a concrete decision. A person (enterpreneur) is
considering to delegate or not a decision making to another person (worker)
- Macro approach: we will use the above analyses to study the main evidence of macro
approach. We try to derive implications about the main element related with the
organizational charts.

2. Economics
The approach we will use during the course to decide whether to delegate or not a decision
is quite close to the one proposed by Becker and Murphy (1992) and follows what is usually
called a cost-benefit analysis quite extended among economists. The decision will be
delegated when the benefits of delegation (BD) exceed its costs (CD), algebraically:
BD>CD. Otherwise the decision will be centralizing (cost-benefits analysis):

- ------------------------------------ 0 ------------------------------------ + (BD-CD)

Centralization Delegation

This difference is nothing more than the difference between comparing the results that the
company would obtain if the decision were delegated with the results, it would obtain if it
were centralized.

In the following sections there is a list of the components of these benefits and costs. The
next topics will discuss these components in more detail.

For each of these components and following economists approaches, the course offers a
formal definition and the theoretical tools to help its monetary quantification. A summary
of these components can be found at the following link.

Obviously, the selection is based on my personal experience and tastes, and this is not the
unique approach to the topic. This has been a usual topic of analysis for sociologists or
management which contributions can be followed in journals like organization science.

2.1 Benefits of delegation

The entrepreneur obtains time that he can dedicate to make other decisions.

For delegation benefits (BD) we will understand as the difference between the maximum
wage that the employer would be willing to pay to the worker (WM) to which he will
delegate the decisions, minus the minimum wage that the worker wants to earn (W) for
having to make those decisions:

BD= WM - W

A necessary (but not sufficient) condition for delegation of decisions has to be that the
benefit of the delegation is positive.

2.2 Costs of delegation

By the costs of the delegation, we mean the fact that the worker may end up making decisions
other than what the employer would make. This can lead to worse results (at least a priori
and from the entrepreneur's perspective) or, if not, the entrepreneur has to introduce
mechanisms to avoid such errors, which come at a cost.
Two concepts are important to talk about the costs:
- The worker´s compensation
- The development of (or changes in) information system (the processes of generation,
storage, distribution of the information inside the organizations).
Information system:
o When the information is provided à Direct costs: resources employed
o But our question is: which are going to be the cost when the information is
not provided à indirect costs: in which we are going to try to study the
differences in the decision made with lack of information by the entrepreneur
and the worker.

When the information arrives late the total cost will be the sum de direct and indirect cost,
but we are going to assume that the information arrives on time.

The information will have value when they make different decision when the information is
not provided.

Errors are basically caused by a lack of information and the mechanisms are substantially to
generate, transmit and process such information, i.e. to establish information systems. That
is why it is important to calculate the value of such information (I) and the cost of
establishing such information systems (SI).

If the value is greater than the cost (I>SI) the information will be transmitted. In this case
the cost of delegation will be equal to the cost of transmitting the information or
implementing an information system (CD=SI).

Otherwise, (SI>I) the information will not be transmitted. In this case the cost of delegation
will be the value of possible errors, (CD=I).

The different decisions can be causes by different types of costs:

- Knowledge. If they can different knowledge, they can make different decision. One
of the reasons why a decision of then is different. Information about the theories that
the entrepreneur uses to make decisions. Differences in these theories can lead to errors
in decision-making by the worker. The transmission of such information on theories will
be called Formation.
- Coordination. Information on the strategic decisions previously made by the
entrepreneur. Ignoring such decisions may cause errors in decision-making by the
worker. Upon transmission of such information on the strategic decisions of the
entrepreneur we will call it Coordination.
- Nature states. Information about the states of nature that have occurred before making
the tactical decision. Knowing the realization of these states of nature is what we will call
information throughout the course.
- Motivation. Information about the tactical decisions that the worker has made. Ignoring
such decisions can make it difficult for the worker to monitor. Such supervision is
necessary for the Motivation of the employer's employer to pursue the objectives.

(a partir de aqui solo esta en las notas del profesor no en el power)

 3. Decision making

In a delicious book, Think, fast and slow, Daniel Kahneman presents a summary of how
psychologists believe that people make decisions.

People either think fast or do it slowly. Fast thinking has low effort cost for individuals and
would come to correspond to fast and intuitive decision-making.

Thinking slowly has to do with rational decision-making and consumes a lot more brain
energy, i.e. people have to make a harder effort.

The book describes a number of errors, differences with rational behavior, that people often
incur when making decisions quickly or intuitively. This approach is what has developed
the behavioral economy, the main reason why the author was awarded with the Nobel Prize
in Economics in 2002

Clearly to understand these mistakes it is necessary first to know how decisions should be
made rationally or slowly.

In the introduction of this subject we will focus on rational decision making. There is no
need to insist that this will mean thinking slowly.

3.1 Knowledge

Throughout the course we will assume that people use their knowledge to make predictions about
the future. Based on these predictions they make their decisions. Choose the action with a better
predicted result.

In this course, we refer to personal knowledge as the set of beliefs that a certain person has about
the certainty of the different possible theories. Therefore knowledge is an static concept..

Just for clarification purposes, let us to formalize a little bit our arguments.

In accordance with the definition above, the knowledge of person n, can be expressed as a vector
of beliefs, Kn =(bn,1, ....,bn,t, ... bn,T), where ,bn,t ∈∈[0,1] is the probability that person n assigns to
the fact that the theory t is true. T is the total number of possible theories.

Cognition and knowlege. A theory t can be cognized or not by person n. In the case that t is not
cognized , bn,t= 0, otherwise bn,t ≥0. Therefore bn,t= 0 could represent the situation when a theory
is not cognized or it is cognized but person n is sure that this theory isn't true.

Group Knowledge. Let us to assume that exists a group of N persons. In this case the knowledge
of the group can be represented by a matrix K, using for example as rows the vectors representing
the knowledge of each person:

Matrix K
We are going to talk about common knowledge when the knowledge is the same for all the
persons in the group, n=1...N. In this case all the rows of matrix K will be the same so we
can use a vector (instead of a matrix) and only one subindex (instead two) K= Kn = (b1,
....,bt, ... bT), Most traditional models in economics and management assumes common
knowledge which represents the true world, b1=1 and bt≠1 =0.

A similar approach than followed here can be found for example in Van den Steen (2010).
Further discussion on the topic can be found in Samuelson (2004).

3.2 Theories

Theories are mental constructs that allow us to describe how we believe the world works
and therefore make predictions about the consequences of our actions.

The basic elements of a theory are:

Decision variables or endogenous variables. Variables that the decisor can modify by
choosing from several alternatives called strategies.

Exogenous variables or nature states. A set of variables that the decisor cannot modify. In
cases where the value of the variable is not known, it is usually represented as a random
variable. To each and every possible state of nature we assign a probability.

Predictions or results. Consequences (in monetary terms during the course) of a series of
decisions and realizations of the states of nature.

A theory t is therefore a function relating results with exogenous and endogenous variables.
For example, let us to focus in the simplest case that ft () is a methematical function
representing the theory t which relates the result R to a certain alternative ae and the
realization of a nature state or random variable ε: R= ft (ae ,,ε). Take note that we can use
the inverse function ε=ft-1 (ae ,,R) and obtain the probabity that the result R is produced
when alternative ae is developed according with the theory t.

For a finite number E of alternative strategies and nature states S, a theory t can be
represented as a matrix Mt (R X E) which components are the probabilities assigned to each
of the R possible results, Vr= (r1,..., rr, ..., rR) where rr is a monetary value conditioned on
the each one of the E available strategies or alternatives V a = ( a1, ..., ae, ..., aE) where
ae represents a certain alternative.

Theory t: Matrix Mt

The elements of each column sum 1. Obviously, the simplest matrix is the case that E=S=2
and a maximum number or results R=4. This situation can be easily represented by a decision
tree. In the course we are going to use decision trees as the way to represent theories.

3.3 Decisions
Persons use their knowlege for computing the expected value of each possible action or
alternative.

Using the terminology defined, the preson n is going to obtain a vector VE with the
expected values of each alternative or strategy in the following way:

VE =∑t=1T bt,n Vr Mt = Vr ∑t=1T bt,n Mt

The vector VE has E elements representing each one the expected value of the strategy e. The
opimal strategy is going to be the one with the highest expected value.

Let us to name X= ∑t=1T bt,n Mt

X is a matrix of R rows and E columns and all the elements have values between 0 and 1, and
the elements of each column sums one.

For making a decision is the same to say that the knowledge of preson n is Kn =(bn,1, ....,bn,t, ...
bn,T) than person n uses the theory represented by matrix X (or the knowledge of person 1 is just
this theory; the belief associated to this theory is 1 while it is 0 for the rest of theories):

VE = Vr X

Why complicate the things? This will not be equivalent for the case of learning by experience.

4. Typologies of theories

We are going to present different typologies of theories on the basis of how those theories
generate the matrix of probabilities Mt and the decisions with which they are related. Some
implications about the restrictions on the values of beliefs are also derived.

4.1 Unidecisional theories

Theories where results are obtained after making a single decision.

We can fomalize a little bit this definition. It will be useful first to define when a theory t is
related or unrelated with a certain decision.

A theory t is unrelated with a certain decision, when the columns of the matrix Mt are all the
same, pr/e,t = pr/t for all the estrategies e. In short, the matrix Mt with an original dimension
R X E can be summarized by a matrix R X 1 or a column vector with elements pr/t . Under
this theory the expected results will be the same independently of the alternative or strategy
chosen.

A unidecisional theory is the one which is related with one decision and unrelated with the
rest of decisions.

Comparing two unidecisional theories t=A , B they could be:

- Independent: They are related with a different decision.

- Rivals: Both theories are related with the same decision but make different
predictions, pr/e,A≠ pr/e,B for at least one strategy e and result r. In this way the
expected results may be different (Rivals in results) and also the actions finally
recommended by the theory (Rivals in action).
 - Identical: Make exactly the same predictions pr/e,A= pr/e,B for all the strategies e
and results r.

4.2 Types of theories and beliefs

The typology of theories implies restrictions on the beliefs of the persons.

Just to put some examples, let us to reduce the number of possible theories and persons to
two, N=T= 2.

Case 1. The theories are independent and cognized by both persons, common knowlege.
This could be represented by bn,t= 1 for all the presons n and theories t.

Case 2. Those theories are independent and there is specialization, each person cognizes a
different theory. This could be represented by bn,t=n = 1 while bn,t≠n = 0.

Case 3. Those theories are rival and cognized (at least one theory) by both persons. This
implies that bn,1 + bn,2 =1 for any person n. Take note that bn,t=n = 1 while bn,t≠n = 0 also
fullfils the restrictions above. In this case it could be interpreted as the presons have
ideologies, or each person has a theory. Although a person cognizes the theories of the
others, the probability assigned to those theories is null.

4.3 Multidecisional theories

Theories related with two or more decisions that a person has to make in order to obtain a
certain result.

These theories involve sequential decisions. The same individual cannot carry out two
activities at the same time. Such theories often represent what are commonly referred to as
projects.

5. A knowledge economy

Obviously, firms produce and sell products, something that is not clearly considered in the
previous sections. This section tries to clarify the relationships between product markets and
the labour or financial markets. For that purpose we assume that production is generated in
jobs. For each job we can distinguish the following steps:

1. Production
2. Cash-flows generation
3. Cash flows distribution: Capitalists and workers compensation

5.1 Production

Assume that the annual production is developed in a set of J jobs. In fact, jobs can be
considered as the number of employees in the economy.

A job j requires a full time worker with a minimum knowledge kj that have acess to use an
asset Aj .

kj can be understood as a set of independent unidecisional theories (or a multidecisional

theory covering such number of decisions).
If the worker has more knowledge or has an access to more assets, the result will be the
same: a continuous annual production of qj >0 outputs. Otherwise the production is going
to be 0 outputs.

The asset can be prefectly used in the same job the next year. The asset has not require
further investments.

Given the assumptions above, we can define the total production of the economy
as Q= ∑ qj .

5.2 Cash-flows generation

The annual Cash Flows are generated by the fact that qj units of product are sold at a price
pj, CFj = pj qj.

The prices in the product markets pj indicate how the production is distributed among the
job occupations. Let us to define p as the weighted average price of the J products, and p
=1, the production is expressed in terms of purchase power parities:

Q = ∑𝑝𝑗𝑞𝑗 then 1 = ∑𝑝𝑗𝑞𝑗/𝑄

Where 𝑝𝑗𝑞𝑗/𝑄 is the percentage of the total production appropriated by the stakeholders (the
capitalists and the worker) of the job j.

Therefore, the total production Q = ∑𝑊𝑗j+ ∑𝑅𝑗 has to be distributed among worker (Wj)
and capitalists (Rj) of each job j.

5.3 Capitalists compensation

Let us to assume that the assets can be easily replicated just investing an amount of Aj and
there is a financial market where any amount of money can be borrowed and lent at the same
price: a continuous compounding annual interest rate of r. Therefore, this is an exogenous
variable for anyone.( Further details can be found in the Section 2 of the Human Capital
Theory).

In this case, any person can invest Aj and offer Wj=qj- r Aj to a worker currently in job
j. Therefore we expect that the current capitalists' compensation is Rj = rAj . Otherwise an
alternative investor can pay more to the worker and obtain a return higher than r. In the case
that the worker leaves the job, the current capitalist is going to obtain zero.

In this case, the total value of the assets in the economy is going to be A= ∑ Aj .

Therefore, the importance of the investment in asset j over the total investments in the
economy is Aj / A. The total compensation of capitalists in the economy is rA.

5.4 The compensation of workers

The amount to be distributed among the workers is:

∑Wj = Q - rA
Let us to assume that any job can be easily replicated by a worker with at least the same
level of knowledge than the required for developing the job. The consequences of this
assumption are:

1) Jobs j requiring the same level of knowldege (kj=k) pays the same wage:

Wj= pjqj - r Aj = W(k)

2) Jobs i recquiring higher levels of knowledge (ki=k+1) generate higher wages:

W(k+1) / W(k) = eα

We are going to refer to this parameter α > 0 as the productivity of a theory. Take note
that α = Ln(W(k+1)/W(k)) so it is an approximation of the percentual increase of wages due
that one more theory has been learnt. Obviously it can be discussed what is a unit of a theory
and how to measure it.

Any way, we can write the next wage function:

W= e C+αk

W0 = e C , is the wage paid in jobs without knowledge requirements k=0, then it can be
interpreted (and consequently C) as the price of labour.

Therefore, if Q , A and the productivity of a theory are given, then the rate of return is going
to determine the price of the labour. Let us to define K = ∑ e αkj as an index of the knowledge
accumulated in the economy. Then:

e C= 𝑄−𝑟𝐴/K

5.5 Product prices

For a particular job, CFj = Wj = Rj , therefore, our assumptions imply that:

pj = (Wj + Rj) / qj = (e C+αkj +rAj) / qj

In other words, knowing the characteristics (k j,Aj, qj) of all the jobs in the economy (j=1…J),
the return on assets r and the productivity of the theories α, then we can derive the prices of
the outputs of each job pj .

5.6 Changes in decision making

The next sections of the course can be understood as the comparison of different excluding
occupations, usually an established one, represents the current way of making decisions,
versus a new or innovative occupation, which represents an alternative way of making
decisions.

The assets used are not going to play any role in our agumentations, so implicitly we are
going to compare occupations that require the same level of Assets. In this sense, two
occupations that deals with the same volume of knwledge kj will be different when they
have a different production qj or Cash Flows, CFj = pj q j .
This production or Cash-Flows is what we are going to identify along the course as the
results of the occupation and for simplicity we are going to express it in monetary terms
and can be interpreted as the labour productivity of the workers measured in terms of
purchase power parity.

By the same volume of knowledge we are referring to:

1. Theories that take the same time to be learnt. Those theories could produce different
results because one of them is more productive than the other, see human capital theory.

2. The same theories. The theories could produce different results due the way in which
they are used, the rest of the course.

An important point in the course is the existence of firms or organizations, where there is
delegation, somebody (workers) works on behalf of another person (entrepreneur). In next
chapters we extend our model of occupations for incorporating such relationships, or in other
words why some occupations are joined in the same organization.

During the course we are going to omitt the discusion on how exactly the decisions
affect pj and q j , but one could call for the relationship established in the previous Section
4.3