2. Introduction
How can you make decisions?
– Average the predictions of many people
– Meet to deliberate and discuss the decision
– Use the help of a person who you prefer
– Use some form of a price system where people who are correct are
rewarded
– Put the question on the internet and see how people respond
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3. The Wisdom of the Crowd
The average of the crowd is often an excellent
predictor.
– The weight of a horse
– The amount of money in a jar
It “works” when people are more likely to be right than
wrong.
It does not work when people are more likely to be
wrong than right (conventional wisdom is incorrect)
Surveys are good in this regard.
The problem is that there is no penalty for a wrong
answer, so there is no “sorting” in a survey. You can
do potentially better. 3
4. Committees and Discussion
The idea is to gather information in a group discussion
rather than averaging. There are serious problems
with this approach:
– If people have similar views, group discussion tends to lead to extreme
results. Other views are crowded out.
– People are reluctant to present their view if they believe that it is in the
minority.
– The majority will tend to disregard a minority view as being incorrect so that
new information is ignored.
It may therefore be better to ask views individually
There is the “Eureka” situation where groups are good:
when it takes several people to put together a solution
(crossword puzzles) – the solution is seen immediately
when it is suggested 4
5. Prediction Markets
Prices play the role of information in markets. You can
get better results when people are sorted based on
their own judgment of the value of their information
– The Iowa experiment
– Google
These are modeled after market economies and the
“invisible hand.”
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6. Overview
1. Markets as a metaphor for economics of
organizational design
2. Centralization v. decentralization
3. Coordination
4. Decision making, hierarchy, & control
5. (next lecture) Job design & decision making
6. (next module) Incentives
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7. 1. Organizational Design of an Economy
Adam Smith
» “… he intends only his own gain, & is … led by an invisible hand to promote an
end which was no part of his intention … By pursuing his own interest he frequently
promotes that of society more effectually than when he really intends to promote it.”
Leontief: central planning (centralization) is efficient
– coordination, economies of scale, control
Hayek: market (decentralization) is more efficient
– costly to move all info. to central planner; decentralization makes better use of
specific knowledge of time & place:
» “How can … fragments of knowledge existing in different minds bring about results
which, if they were to be brought about deliberately, would require a knowledge on
the part of the directing mind which no single person can possess?”
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8. Markets as
Information & Incentive Systems
Examples of markets as forms of organization
– prediction markets (insurance, financial, etc.)
Market economies have 3 important features:
– decentralization makes good use of “specific knowledge of time & place”
– prices provide good “general knowledge” for coordination
– incentives (through ownership)
» motivates good decision making
» moves decision rights to person with most valuable/ relevant specific knowledge
» motivates investments in human capital
» motivates creativity / innovation
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9. Organizational Design of a Firm
Org. design must address the same problems
use of specific knowledge of time & place
coordination across decision makers
incentives for both
innovation & adaptation
Can we design an organization to mimic a market?
– even if we can’t completely, the intuition is very useful
Note, though, the limits of markets
– they are best at aggregating information (e.g., into prices or predictions)
– when coordination in the sense of coordinated actions is important,
organizations tend to be set up
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10. 2. Benefits of Centralization
Economies of scale
– physical capital
– managerial talent
– brand name & reputation
– design
Better use of central knowledge
– aggregated information & experience of the combined organization
Better coordination
– knowledge transfer across units
– consistency / standardization
– synchronization
– control
– common strategy
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11. Benefits of Decentralization
Better use of specific knowledge dispersed throughout
the organization
Prevents senior management from being overwhelmed
Training/ development & intrinsic motivation for lower
level managers
Less bureaucratic/ more manageable scale
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12. Specific Knowledge
Cost of Transferring Knowledge
Costly Cheap
Specific Knowledge General Knowledge
Attributes of knowledge / information that make it more “specific”
– costly to transfer
» perishable
» complex
– costly to understand
» requiring scientific or specialized technical skills
» subjective or experiential
– unreliable / risky to use
» noisy (garbling)
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13. 3. Coordination & Structure
The classical approach: centralized hierarchy
Decentralization implies that coordination must happen
at lower levels of the organization
– roughly speaking, 2 kinds of coordination problems: “simple” & “integration”
Simple coordination: getting units to act in concert
– real-time communication not needed, as long as actions of all units are
compatible
– use incentives, communication, job rotation, culture
» e.g., UPS;
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14. Modularization
Putting people with the most interdependent jobs together
amounts to modularizing overall structure
– ex: break XP Consulting into smaller divisions
» regional? (NA; Europe; Asia)
» type of customer? (Corporate; Government; Not-for-profit; etc.)
» practice area? (Strategy; IT; 6 )
You can structure authority w/ some decisions organized by one
set of divisions, others a different set
» ex: decisions about hiring & compensation determined by region; decisions about training &
promotion determined by practice area
Note how complex it starts to get … there are clear advantages to
reducing overlapping lines of authority
– hypothesis: the largest source of dis-economies of scale is bureaucracy
(coordination costs)
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15. Integration
Integration: for some decisions, pockets
of specific knowledge throughout org.
need to be combined
CEO
– ex: Apple Computer laptop product design
– use lateral mechanisms
Engineering Sales Production Other
» teams, matrix
» informal networks
B A
» e.g., product design
– the most cumbersome organizational designs A B
tend to involve integration problems B A
Or, balance the 2 goals of coordination
& use of specific knowledge
– separate decision management & control (below)
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16. 4. Decision Making, Hierarchy, & Control
Think of decision making as a 4-stage process
Decision Management
1. initiatives
2. ratification
3. implementation
4. monitoring Decision Control
(Hierarchy)
Different stages can be more centralized or
decentralized
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17. Notes on Decision Mgt. v. Control
It often makes sense to separate decision
management from decision control
– if decision maker has weak incentives
» Board v. CEO
– can provide benefits of decentralization & centralization at the same time
» decentralizing decision management
» centralizing decision control
The distinction is useful in practice
– innovation process
– managing change
– empowerment
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18. How Much Decision Control?
Consider 2 firms with 2 employees
Hierarchy Flat
The units evaluate new ideas differently
– “Hierarchy”: W evaluates new ideas, passes Gladys
some to G. G approves or rejects those
Gladys Willie
– “Flat”: G&W both different new ideas
Willie
N = # of ideas each can evaluate per
period
– flat firm evaluates twice as many ideas per period
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19. Evaluating New Ideas
Assume new ideas are binary (good or bad / profitable
or unprofitable)
At first stage, p = probability of correct decision; p > ½
At second stage (hierarchy only), q = probability of
correct decision; q > p
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20. Hierarchy
Accepts
p∙q
Accepts
p
Rejects
Good p(1-q)
Rejects Rejects
(1-p) (1-p)
New Idea
Accepts
Accepts (1-p)(1-q)
(1-p)
Rejects
(1-p)q
Bad
Rejects Rejects
p p
Willie Evaluates Gladys Evaluates Willie’s
Recommendations
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21. Flat
Accepts
p
Good
Rejects
(1-p)
New Idea
Accepts
(1-p)
Bad
Rejects
p
Gladys or Willie
Evaluates
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22. Results
Flat Hierarchy
Rate For One New Idea
Accept Good Idea p pּq
False Negative 1-p 1-pּq
False Positive 1-p (1-p)(1-q)
Reject Bad Idea p 1-(1-p)(1-q)
Overall Throughput
Accept Good Ideas 2Nּp Nּpּq
False Negatives 2N(1-p) N(1-pּq)
False Positives 2N(1-p) N(1-p)(1-q)
Reject Bad Ideas 2Nּp N[1-(1-p)(1-q)]
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23. Are Hierarchies Conservative?
Most Middle
Rate For One New Idea
Accept Good Idea Flat > Hierarchy
False Negative Hierarchy > Flat
False Positive Flat > Hierarchy
Reject Bad Idea Hierarchy > Flat
Overall Throughput
Accept Good Ideas Flat > Hierarchy
False Negatives Flat > Hierarchy
False Positives Flat > Hierarchy
Reject Bad Ideas Flat > Hierarchy
Flat structures
– evaluate ideas more quickly
– evaluate more ideas for the same # of employees
– make more changes, good & bad
– have more successes & failures
What kind of environments favor a more hierarchical or flat structure?
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24. Other Methods to Increase Control
Resources spent on accuracy (a & b)
Skills & emphasis of decision makers
– liberal v. conservative evaluator
– conservative org. likely to recruit / train more carefully
Incentives of decision makers
– e.g., downside punishments & upside rewards
Constraints on decisions
– e.g., budgets
Culture & process
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25. Structure and Errors
•Hierarchical
•Reduce false positive and increase false negative
•Approve fewer projects overall
•Good where careful consideration is needed. Good with
traditional industry; regulated industry. Bad for rapid
change
•Second Opinion - symmetrical upside and downside
•Flat
•Reduce fall negative and increase false positive
•“Creative people not attracted to hierarchical firm”
•Good when unprofitable projects are not too costly or
when profitable projects are likely to be very profitable
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26. 5. Implementation
So what should XP Consulting consider in its structure?
First, Modularize overall structure, possibly in overlapping ways
– ex: Cambridge Technology Partners
– makes the problem more manageable
– put most interdependent parts together, reducing coordination problems
Second, allocate decisions within each division: ask “who / what /
where / when / why?” to identify key specific knowledge
– who has valuable specific knowledge?
– what kind of knowledge?
– where in (& out) of the organization?
– when (is timing relevant)?
– why is it of economic value?
Third, think about what needs to be made consistent or coordinated
across the division or whole organization
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27. Implementation
The last two give strong guidance on what to decentralize &
centralize
Fourth, go back & refine the overall structure
– try to streamline further to cut bureaucracy
– look for & address coordination problems
– integration problems require the most attention, & will create most of your day-to-day
headaches
Fifth, design jobs (next lecture)
– balance benefits of specialization, standardization against benefits of using specific
knowledge, intrinsic motivation
In all of this, balance desires for control v. creativity & adaptation
– self organizing systems can be extraordinarily powerful; don’t be a control freak!
Sixth, design performance evaluation & incentives to match job
design (after Midterm)
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28. 6. Economic Ideas
The “knowledge problem” of organizational design
– specific knowledge
– coordination types & mechanisms
– incentives & price mechanisms
Decision making
– decentralization v. centralization
– decision management v. control
– degrees of decision control / hierarchy, & their effects
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29. Summary Points
The metaphor of a market highlights the role of
economics in organizational design
– design is largely about creating & making use of knowledge
» by its nature, specific knowledge tends to have more economic value
– incentives play a crucial role
» approximating ownership
» performance measures are “prices”
– but market approaches are limited when complex coordination (especially of
the “integration” kind) is needed
The concepts apply to design of an individual job, to a
workgroup, to structure of a global conglomerate
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