Jensen & Meckling Specific and General Knowledge, and Organizational Structure Goals: 1. What is the difference between general and specific knowledge?

Jensen & MecklingSpecific and General Knowledge, and

Organizational Structure

Goals:

1. What is the difference between general and specific knowledge?

2. What difference does it make for organizational structure?

* As played by George Clooney

“…we analyze the institutional devices through which decision making rights are assigned in markets and within firms and the devices used to motivate agents to make proper decisions.” (p. 1)

How do markets & firms “solve the rights assignment and control problems”?

“Alienability solves the control rights problem” (p. 12)Those with the knowledge buy the decision rights; or those with the decision rights buy the knowledge (p. 5)

Who should have the rights &Rewards and punishments (p. 13)

“Firms must obtain advantage from the suppression of alienability… (p. 14)Knowledge considerations are one cause of the emergence of firms.”

“The assignment and enforcement of decision rights in organizations are a matter or organizational policy and practice, not voluntary exchange.”

“…the CEO in the typical firm cannot generally use alienability to solve the firm’s organizational problems…Organizational problems within the firm must therefore be solved…by devising a set of rules of the game for the firm which:1. Partition out the decision making rights to agents throughout the

organization.2. Create a control system that

a) provides measures of performance;b) specifies the relationship between rewards and punishments and the measures of performance.

…knowledge of these rules of the game enables one to make good predictions about an organization’s behavior and effectiveness.” p.21

General Knowledge Specific Knowledge

“Specific knowledge… is often acquired jointly with the production of other goods.” (p. 6)

Costly to transfer!

“Effective transfer” of knowledge:

“The recipient of knowledge is presumed to understand the message well enough to act on it.”

Because time is often important in taking advantage of opportunities for arbitrage or for exploiting knowledge of unemployed resources,

delays in actions are costly.” (p. 7)

Herbert SimonModels of Bounded Rationality (1982)

http://en.wikipedia.org/wiki/Herbert_Simon

Shari Gifford“Limited Attention as the Bound on Rationality”(2005)

The limitations on human mental and sensory faculties mean that storing, processing, transmitting and receiving knowledge are costly activities.” (p. 4)

Optimal Allocation of Decision Rights

?

“The key to efficiency is to assign decision rights to each agent at each level to minimize the sum of the costs owing to poor information and the costs owing to

inconsistent objectives” p. 19

Agency costs = designing + implementing + maintaining system + residual loss from bad decisions

“Minimizing cost for given total output often seems to degrade into a system where managers are rewarded for minimizing average cost per unit of output…measuring performance by average cost per unit of output will virtually never be consistent with firm value maximization in the absence of a quantity constraint” p. 25.

“Where the production, transfer, and application of knowledge are the primary goods being offered, however, exchanges tend to take the form of long-term relationships, and the most common of these is employment contracts…The transaction costs emphasized by Coase (1937) and Williamson (1975) are one reason such contracts emerge. Single proprietors who contract on a case-by-case basis for production and application of all knowledge would soon find themselves swamped by transaction costs in all but the smallest scale firms.” p. 15

“Particularly challenging information transfer problems arise in situations where optimal decision-making requires integration of specific knowledge located in widely separate individuals. Integrating the specific knowledge of marketing, manufacturing, and R&D personnel to design and bring a new product to the market is an example” p. 8.

Decision Rights Incentives Monitoring & Evaluation

Characteristic #1:

Characteristic #2

Characteristic #3

Type of InformationGeneral & Specific KnowledgeCost of bad decisions!

Marginal cost of poor incentives = marginal cost of bad decisions

Greater decision rights require greater

incentives

Greater incentives require measuring

outcomes

: “…optimal architectures will differ across companies. Such structural differences are not random but vary in systematic ways with differences in certain underlying characteristics of the companies themselves.” BSZ p. 345

Speed of Decisions

Observability of outcomes

“The tendency for large organizations to avoid pay-for-performance incentive plans and to rely instead on promotion-based rewards is an interesting phenomenon that is as yet poorly understood by economists.” (p. 28)

Greater incentives require measuring

outcomes

Greater decision rights require greater

incentives

Speed increases the cost of knowledge transfer

Outcomes cannot easily be traced back to specific decisions by individuals

Risk and risk aversion can dilute incentives

Inability to measurePrecludes incentives

Incentive Pay (see Ch. 15 in text)

Fixed wages Commissions

1. Observability of output

2. Risk aversion of agents

3. Forces beyond agents’ control

Key problem: if you can’t observe effort agents can easily blame poor performance on bad luck (see p. 460 in text)

Specific Knowledge

InformationAsymmetry

Decision Rights

Incentives

MonitoringTransactions

Costs

Trust

Trade-offs