Organizations, Management Behavior and Economics

Monday, July 17, 2006

Boeing vs. Airbus, revisited

Since we talked about Boeing and Airbus in class, I figured it would be helpful to point you towards a working paper about the race to develop the superjumbo jet and the failed attempt at preemption on Boeing's part. You will notice here that Airbus succeeded because, to use the terminology from your textbook reading, it built a cart with legs and didn't believe that Boeing's wheeled cart was going to stay where it was. (Unfortunately, Airbus' cart broke a few years later, but the original scenario is still relevant.)

Wednesday, July 05, 2006

A Word on Ethics...

As you guys saw in class, the idea of business ethics is a particularly messy one, where conventional wisdom may not always provide the "right" answer. Below is a classic example, courtesy of wikipedia:

Brent Spar or Brent E, was an oil storage and tanker loading buoy in the Brent oilfield, operated by Shell UK. With the completion of a pipeline connection to the oil terminal at Sullom Voe in Shetland, the storage facility had continued in use but was considered to be of no further value as of 1991. Brent Spar became an issue of public concern in 1995, when the British government announced its support for Shell’s application for disposal in deep Atlantic waters at North Fenni Ridge (approximately 250 km from the west coast of Scotland, at a depth of around 2.5 km).

Greenpeace organised a worldwide, high-profile media campaign against this plan. Although Greenpeace never called for a boycott of Shell service stations thousands of people stopped buying their petrol at Shell. Shell's sales went down by 70%. Greenpeace activists occupied the Brent Spar for more than three weeks. In the face of public and political opposition in northern Europe (including some physical attacks and an arson attack on a service station in Germany), Shell abandoned its plans to dispose of Brent Spar at sea - whilst continuing to stand by its claim that this was the safest option, both from an environmental and an industrial health and safety perspective. Greenpeace’s own reputation also suffered during the campaign, when it had to acknowledge that sampling errors had led to an over-estimate of more than one hundredfold of the oil remaining in Brent Spar’s storage tanks. Following Shell’s decision to pursue only on-shore disposal options - as favoured by Greenpeace and its supporters - Brent Spar was given temporary moorings in a Norwegian fjord. In January 1998 Shell announced its decision to re-use much of the main steel structure in the construction of a new harbour facilities near Stavanger.

My advice to the world, when thinking about ethical issues? Make sure you've done your homework before you get your pants all in a twist about what is "right"- it could make everyone better off.

Monday, July 03, 2006

Asset Specificity Example

I think the concept of asset specificity is best illustrated with an example similar to the one I gave at the end of section. Imagine you have a buyer and a seller for parts that go into making a car. The specifications for the parts are very specific, so the parts made can only go into one model of car, and only this supplier can make the parts. Now imagine that the buyer and seller enter into a contract where the seller will provide this part at $100 each. After the parts are made, the seller realizes that the parts are critical to the functioning of the car, and it says that, regardless of the contract terms, it's not going to let the parts go for less then $150 each. Now the buyer is in a bind since it can't just turn around and buy them from someone else. The "holdup" could also go the other way, with the buyer saying wait, I'm going to only pay you $75 each, since I know that once these parts are made you can't sell them to anyone else. See the problem? This could theoretically be avoided if the buyer's and seller's assets were contained within the same firm.

Sunday, July 02, 2006

Jodi's Demsetz Summary

Demsetz argues that Coase’s theory of the firm is still incomplete, and that more attention needs to be given to information costs. (Information costs are one presumably important component of transaction costs.)

In order to have a cogent theory of the firm, we need to take away the traditional assumption of costless information.

Moral Hazard, Shirking and Opportunism:

Demsetz points out that another issue involved with organizations is that of aligning incentives. In section, we briefly discussed the issue of post-contractual opportunistic behavior, or "holdup". The general model assumes a buyer and a seller that make a contract in some state of uncertainty, so that they don't know perfectly what the world is going to be like when it comes time for work to be done. When the true state of the world is revealed, the buyer and seller tend to renegotiate, even though they already had a contract. This is because there are certain items that cannot be contracted on, and contracts are not perfectly enforceable. This renegotiation is costly from a logistical perspective, and could also be costly for the party that doesn't have a lot of bargaining power. The theory is that these holdup problems can be mitigated with internal organization (according to Klein Crawford Alchian).

Given these problems, why do we have markets? Demsetz argues that markets offer high-powered incentives that cannot always be recreated within a firm.

(Obviously preliminary, again stay tuned!)

Saturday, July 01, 2006

Some Incentives Reading...

A student in the other class asked me to recommend some articles on compensation systems and incentives, so I figured I would also put the list here. Most of these articles should be available online through the HOLLIS catalog.

Holmstrom, Bengt and Paul Milgrom. 1991. “Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design.” Journal of Law Economics and Organizations 7: 24-52

Baker, George. 1992. “Incentive Contracts and Performance Measurement.” Journal of Political Economy 100:3.

Lazear, Edward and Sherwin Rosen. 1981. “Rank-Order Tournaments as Optimum Labor Contracts.” Journal of Political Economy 89:5 841-64.

Prendergast, Canice. 1999. “The Provision of Incentives in Firms.” Journal of Economic Literature 37:1 7-63.

Oyer, Paul. 1998. “Fiscal Year Ends and Non-Linear Incentive Contracts: The Effect on Business Seasonality.” Quarterly Journal of Economics. CXIII, 149-185.

Healy, Paul M. “The Effect of Bonus Schemes on Accounting Decisions.” Journal of Accounting and Economics 7 (1985): 85-107.

Courty, Pascal and Gerald Marschke, “M. “An Empirical Investigation of Gaming Responses to Explicit Performance Incentives,” Journal of Labor Economics forthcoming.

Roy, Donald. 1952. “Quota Restriction and Goldbricking in a Machine Shop” The American Journal of Sociology, 57:5 427-442.

You could also look at the articles that these reference for further resources.

Another Way to Find Articles...

Some of you have expressed having problems with accessing materials on reserve. While not everything is available directly online through the Harvard Library system, many of the academic journal pieces can be found rather easily.

1. Go to
2. Click on "e-research (articles)" at the bottom left.
3. Scroll down and click on "Find E-Journals". (Note: For those of you writing research papers and such, the "Find E-Resources" link is also helpful to you. For economics-related topics, the two most useful sources here are EconLit, JSTOR and Lexis-Nexis.)
4. You can then search for the title of the journal with the desired article and go from there. You can also search for the article directly through EconLit or JSTOR, mentioned above.

It is probably useful to play around with these resources to familiarize yourselves with how they work.

Thursday, June 29, 2006

Jodi's Coase Summary

Coase’s goals are to both give a definition of a firm which is representative of the real world and also begin to explain why firms exist. Basic economic theory would suggest that economic production can efficiently take place with a collection of unrelated individuals interacting in their own self interest, without the need for any sort of coordinating mechanism. So why organizations?

At a basic level, Coase defines a firm as an organization in which the price mechanism is suppressed. He gives an example of a worker moving from one department to another not because his marginal product is higher in the new department (as the price mechanism would suggest) but because he is told to so by an entrepreneur-manager. Coase notes that the degree to which the price mechanism is suppressed varies across firms, and relates this suppression to the idea of vertical integration.

Coase explains that coordination can happen either through the price mechanism or through the actions of a coordinating entrepreneur, and notes that there must be something that drives firms in some cases and markets in others. He gives several potential explanations for why we might see firms, but then explains why they are not correct (p.390). One example is the proposition that people prefer to be managed, and Coase points out that this is contrary to the notion of people wanting to be their own bosses. The theory that Coase doesn’t reject is that there are costs to operating in the market, such as the cost of learning relevant prices and negotiating. There are costs involved in making contracts, and these costs can be reduced, though not necessarily eliminated, by establishing long-term contracts within a firm. In this case, a factor of production (eg. an employee) sells the right for the entrepreneur to tell it what to do, within certain boundaries. Therefore the entrepreneur is free to coordinate production within in the limits of the contracts.

There are costs to using the price mechanism above and beyond just having to learn about relevant prices. There can be increased contracting costs since long term contracts are not really possible, and repeated short term contracting may not be desirable. In a firm, a general long term contract can be developed, with the details left to be decided later (within reason). This provides the flexibility needed to mitigate the risk inherent in writing a long term contract. Therefore, firms are more likely to emerge when short term contracts are unsatisfactory. It is also improbable that firms would exist in the absence of uncertainty, since it is uncertainty that makes these long term general (employment) contracts appealing. firms could also exist for tax reasons, since a transaction cost would be present if a sales tax was placed on a purchased good but not an internally produced one.

Coase then embarks on the topic of firm size. What does it mean for a firm to be larger? It means that more transactions are conducted within the firm and organized by the entrepreneur. Given the presence of transaction costs, why do markets exist at all? Why not just one big firm? The other piece of the puzzle is that there are decreasing returns to entrepreneurship (which Demsetz later calls management cost). This is because, as a firm becomes large, there are additional levels of management, which come at a cost, and it gets more difficult to optimally assign people to jobs. This creates some "waste", which is a form of cost of internal organization. The firm will want to internalize transactions until the transaction cost equals the management cost.

Based on this logic, firms will be larger when:
-- management cost is low, or rows slowly
-- there are fewer mistakes in assigning jobs, and hence less waste
-- there are greater economies of scale, and large firms can acquire factors of production at a discount

Coase Resource

In addition to the information I provide about the Coase and Demsetz articles, the following link has a decent overview of the coase article. Note that the Coase Theorem is not explicitly talked about in the paper.

Wednesday, June 28, 2006

Welcome to Econ S-1620!

Hi everyone! This is a site where I will answer questions that are pertinent to the class and will post some information that I think will be helpful to students but didn't have time to cover in section. Just as a reminder, the official course web site is located at: