Economic Foundations of Strategy Chapter 1: Behavioral Theory of the Firm

1. Economic Foundations of StrategyChapter 1: Behavioral Theory of the Firm Joe Mahoney University of Illinois at Urbana-Champaign Power Point Set #2

2. Behavioral Theory of the Firm: • Barnard (1938): The Functions of the Executive • Simon (1947): Administrative Behavior • March and Simon (1958): Organizations • Cyert and March (1963): A Behavioral Theory of the Firm • Simon (1982): Models of Bounded Rationality

3. Barnard (1938) The Functions of the Executive • Barnard’s purpose is to provide a comprehensive theory of cooperating behavior in formal organizations. • Essential features are: • The willingness to cooperate • The capability to communicate • The existence and acceptance of purpose

4. Barnard (1938) The Functions of the Executive • Barnard notes that successful cooperation is the abnormal, not the normal condition. What we observe from day-to-day are the successful survivors among innumerable failures. • Failure to cooperate and failure of organization are characteristic facts of human history.

5. Barnard (1938) The Functions of the Executive • Barnard emphasizes the important role of informal organization within formal organizations. • Informal organization is to be regarded as a means of maintaining the personality of the individual against certain effects of formal organizations, which tend to disintegrate the personality.

6. Barnard (1938) The Functions of the Executive • Barnard argues that there exists a “zone of indifference” in each individual within which orders are acceptable without conscious questioning of their authority. • Barnard submits that he regards nothing as more “real” than “authority.”

7. Barnard (1938) The Functions of the Executive • Barnard notes that the fine art of executive decision-making consists in not deciding questions that are not pertinent, in not deciding prematurely, in not making a decision that cannot be made effective, and in not making decisions that others should make. Such good judgment by the executive then preserves morale, develops competence, and preserves authority.

8. Barnard (1938) The Functions of the Executive • Barnard observes that the executive process transcends the capacity of mere intellectual methods. The terms pertinent to the executive process are: • “feeling” • “judgment” • “sense” • “proportion” • “balance” • “appropriateness”

9. Barnard (1938) The Functions of the Executive • Barnard maintains that coordination is a creative act. • Barnard also argues that organizations endure in proportion to the breadth of the morality by which they are governed. • “Old men and old women plant trees.”

10. Barnard (1938) The Functions of the Executive • 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.”

11. Barnard (1938) The Functions of the Executive • Barnard 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 meritocracy.

12. Simon (1947) Administrative Behavior • Simon’s primary thesis is that decision making is at the heart of organization and must be derived from the logic and psychology of social choice. Three roles of the organization are emphasized: • Organizations influence individuals’ habits; • Organizations provide means for exercising authority and influence over others; and • Organizations influence the flow of communications.

13. Simon (1947) Administrative Behavior • Simon maintains that it is precisely in the realm where behavior is intendedly rational, but only limitedly so, that there is room for a genuine theory of organization. • Organizational behavior is the theory of intended and bounded rationality.

14. Simon (1947) Administrative Behavior • Organizations enable stable and comprehensible expectations among members; • Organizational members “satisfice” and use simple rules of thumb to inform decisions; and • Rules of thumb or organizational routines are the counterpart of individual habits.

15. Simon (1947) Administrative Behavior • Simon suggests the following mechanisms of organizational influence: • Divides work among its members; • Establishes standard operating procedures; • Transmits decisions by authority; • Provides formal and informal channels of communication; and • Trains and inculcates its members.

16. Simon (1947) Administrative Behavior • Equilibrium of the Organization: • Simon maintains that in order for organizations and individuals to continue to engage in mutually beneficial transactions that there needs to be an inducements – contributions balance.

18. Simon (1947) Administrative Behavior • “Zone of Acceptance” • Sales contract versus employment contract • An incomplete contracting approach • A real options perspective • Authority Relationship: • Enforces Responsibility of Individual; • Secures Expertise in Decision Making; nd • Permits Coordination of Activities.

19. Simon (1947) Administrative Behavior • The Brain as Scarce Resource: • The information-processing systems of modern civilization swim in an exceedingly rich soup of information. In a world of this kind, the scarce resource is not information; it is processing capacity to attend to information.

20. Simon (1947) Administrative Behavior • The Brain as Scarce Resource: • Attention is the chief bottleneck in organizational activity, and the bottleneck becomes narrower and narrower as we move to the tops of the organizations.

21. March and Simon (1958) Organizations • Managers must continually search for complementarities to inform their task allocations; • An organizational model that neglects economic incentives will be, for most humans, a poor predictive model; and • Organization behavior can often be predicted by knowing past behavior and routines.

22. March and Simon (1958) Organizations Features of their model of organization structure: • Optimizing is replaced by satisficing; • Alternatives of action and consequences of action are discovered sequentially through search processes; and • Each specific action deals with a restricted range of situations and a restricted range of consequences.

23. March and Simon (1958) Organizations • Search is partly random, but in effective problem solving search is not blind. • The design of the search process is itself often an object of rational decision. • Optimizing models • Satisficing models

24. Cyert and March (1963) A Behavioral Theory of the Firm • Four research commitments: • Focus on a small number of key economic decisions made by the firm; • Develop process-oriented models of the firm; • Link models of the firm as closely as possible to empirical observations; and • Develop theory with generality beyond the specific firms studies.

25. Cyert and March (1963) A Behavioral Theory of the Firm • Organizations are viewed as consisting of a number of coalitions and the role of management is to achieve a Quasi- Resolution of Conflict and Uncertainty Avoidance. • Problemistic Search that is stimulated by a problem with (or lack of) an existing routine is assumed to be motivated, simple-minded, and biased (reflecting unresolved conflicts within the organization).

26. Simon (1982) Models of Bounded Rationality • To encompass goal conflict and uncertainty we need to know something about perceptual and cognitive processes in order to predict short-term behavior. • Filtering of information is not a passive process but an active process involving attention, which is influenced by hopes and wishes.

27. Simon (1982) Models of Bounded Rationality • A rabbit-rich world is a lettuce-poor world, and vice versa. Similarly, in an information-rich world, an abundance of information means a dearth of something else: a scarcity of whatever information consumes. Information consumes the attention of its recipients. • Information systems need to listen and think more than they speak. Stating the organization problem in this way leads to a very different system design (that deals with information overload).

28. Simon (1982) Models of Bounded Rationality • Substantive Rationality: • Behavior appropriate to the achievement of given goals within the limits imposed by given constraints. • In this economics view, given the goals, rational behavior is determined entirely by the characteristics of the environment in which such behavior takes place.

29. Simon (1982) Models of Bounded Rationality • Procedural Rationality: • The traveling-salesman problem in operations research is a theory of efficient computational procedures to find good solutions --- a theory of procedural rationality. • It is a search for better heuristics --- which Simon regards as the heart of intelligence.

30. Simon (1982) Models of Bounded Rationality • Procedural Rationality: • Organizational economics is a description and explanation of human institutions, whose theory is no more likely to remain invariant over time than the theory of bridge design. Decision processes, like all other aspects of economic institutions, exist inside human heads. Decision processes are subject to change with every change in what humans know, and with every change in their means of calculation. • A business firm equipped with the tools of operations research does not make the same decisions, for example, concerning inventory management, as it did before it possessed such tools.

31. Simon (1982) Models of Bounded Rationality • Procedural Rationality: • The shift from theories of substantive rationality to theories of procedural rationality requires a basic shift in scientific style, from an emphasis on deductive reasoning within a tight system of axioms to an emphasis on detailed empirical exploration of complex algorithms of thought.

32. Simon (1982) Models of Bounded Rationality • Procedural Rationality: • Complexity is deep in the nature of things, and discovering tolerable approximation procedures and heuristics that permit huge spaces to be searched selectively is at the heart of intelligence, whether human or artificial.