Econ5026: Strategic Business Relationships
Lecture 7 Week 7: Organisational
Architecture and Decision Making
Dr. IKM Mokhtarul Wadud
School of Economics, University of Sydney
Email: mokhtarul.wadud@sydney.edu.au
Tel: 0413731986, Office: Room 635, Level 6, FASS Bldg (A02)
Econ5026 Strategic Business Relationships, S2 2023
1
Mid Sem test Info
Date: September 21, 2023, Thursday, Start time: 3 pm.
Topic Coverage: Week 1 to Week 5 (product Differentiation)
Test Mode: Short Release Test (AKA Short release assignment)
Total marks: 30 (10 MCQ’s and objective type Q’s for 10 marks plus 3 descriptive questions for 20 marks)
Part A: MCQ/Objective and Part B: descriptive Q’s
Total time allocated: 50 minutes
Additional (not for writing) time is allowed for uploading descriptive answers.
A replacement test is available for those who can’t take the main test for valid reasons (If you have a
successful application for special consideration, a replacement test/exam will need to be scheduled
following the same format of the main test/exam.)
Read the test instruction properly before taking the test.
Econ5026 Strategic Business Relationships, S2 2023
2
What topics are covered
Introduction: Role of economics, thinking like an
economist, Consumer’s choice, Decision under
uncertainty.
Game Theory
Market Structure
Pricing
Product Differentiation
Econ5026 Strategic Business Relationships, S2 2023
3
More information on the time allocation
• Duration: 50 mins test time.
• Plus 30 minutes of upload time to allow you to upload your files as per
your test instructions. Do NOT treat this as extra writing time. The
upload time must be used solely to save and upload your files correctly as
per the test instructions. Manage your time carefully.
• Check that you have saved and named your file correctly and uploaded
the correct file. If your time runs out while you are uploading this is not
considered a technical issue. Only upload handwritten answers to the
descriptive questions, upon converting them into pdf’s. Make sure you
read and follow the instructions properly.
• Please keep track of your time. Your test timer may not update if you
have an internet connection issue. Use the time on your computer so that
you always know how much time you have left. Only questions completed
within the test time will be marked.
Econ5026 Strategic Business Relationships, S2 2023
4
Formats of your answers
• For the descriptive part (Part B), use texts, graphs and mathematical
equations, as you feel appropriate. (handwritten on paper or on a
tab)
• For MCQ/Objective part (Part A), you need to just choose your
answer or write/type your answers in the space provided (for fill in
the blank questions.) – No upload necessary for this part.
• The questions are not difficult, but they have a significant coverage
of the topics, as you would expect.
• For Part B (descriptive answers): (Uploading needed for this part)
Econ5026 Strategic Business Relationships, S2 2023
5
How to Scan your answers for Part B
(Descriptive part)
You can use the following apps.
a) Evernote Scannable (only available on iPhone/iPad) :
https://evernote.com/products/scannable/
b) Adobe Scan:
https://acrobat.adobe.com/au/en/mobile/scanner-app.html
c) Microsoft Office Lens:
https://play.google.com/store/apps/details?id=com.microsoft.
office.officelens&hl=en_US and
https://apps.apple.com/au/app/microsoft-office-lens-pdfscan/id975925059
d) CamScanner: https://www.camscanner.com/ (recommended)

Econ5026 Strategic Business Relationships, S2 2023
6
Reading


You should read Jensen and Meckling (1995) ‘Specific and General
Knowledge and Organisational Structure’, Journal of Applied
Corporate Finance 8(2), pp. 4-18
Chapter 5, Lazear, E. and M. Gibbs (2007) ‘Personnel Economics in
Practice’, Wiley. (available on Canvas)
These readings are accessible through the links provided inside Week 7
module in Canvas
Econ5026 Strategic Business Relationships, S2 2023
7
Markets and Firms
Firms and consumers interact in markets. Markets facilitates
transaction of goods and services.
Firms produce to fulfil the needs of the consumers at the lowest
possible price.
Markets works efficiently on their own– maximising the total surplus
at equilibrium (assuming no market distortions/ failure)…..through
working of (what Adam Smith referred to) as the ‘Invisible Hand’.
Note that centrally planned economy may not produce the same
(free market) outcome.
Econ5026 Strategic Business Relationships, S2 2023
8
Markets and Firms
Markets provide a decentralised allocation mechanism
• Prices aggregate demand and supply side information
• Prices balance opportunity cost of sellers and willingness to pay of
buyers
• Markets effectively use dispersed knowledge
• Provide incentives for innovation and adaptation
Markets are a form of collective intelligence. They are a powerful
information system that is not easily replicated
Econ5026 Strategic Business Relationships, S2 2023
9
Markets and Firms
• Markets may not always allocate resource efficiently
• Market power- Economies of scale and natural monopoly
• Public goods problem
• Externalities (positive such as technological spillover and
negative such as pollution)
• Information asymmetry:
• (i) Moral hazard;
• (ii) Adverse selection
Econ5026 Strategic Business Relationships, S2 2023
10
Markets and Firms

So how does this relate to the firm?

Within the firm, authority decides resource allocation

Ideally a firm will structure itself and have systems and processes in place so that:

Both central and local knowledge could be used effectively.

Decisions are coordinated as needed.

The firm provides strong incentives to make well coordinated decisions.

Individuals in the organisation innovate and adapt.
Econ5026 Strategic Business Relationships, S2 2023
11
Markets and Firms




So let’s try to understand the internal organisation/ structure of a firm.
A firm’s organisational architecture/ structure is defined by the set of implicit and
explicit contracts.
The organisation architecture/structure 
Specifies decision rights via job descriptions.

Uses performance evaluations to identify who is doing a ‘good’ job.

Uses compensation schemes to reward (and punish) decision makers.
A key choice in organisational design is whether to adopt centralised or
decentralised decision-making mechanism.
Econ5026 Strategic Business Relationships, S2 2023
12
Centralisation and Decentralisation
• Consider a firm that operates across two markets: Perth and Sydney.
Suppose that there is a CEO (in Sydney) and local managers in Perth and
Sydney.
How might pricing decisions be allocated?
• The CEO could specify prices in both markets (centralisation).
• The decision could be decentralised to each local manager.
• The decision for both markets could be decentralised to a single local
manager.
• Any decentralisation could have limits imposed on them.
What are the costs and benefits of such approaches and decentralised versus
centralised decision making?
Econ5026 Strategic Business Relationships, S2 2023
13
Centralisation and Decentralisation

Benefits of centralisation or centralised decision making:




Economies of scale or public goods – they may be ignored
at ‘local’ level, e.g. advertising or purchasing decisions.
Avoids some difficult incentive issues – you need to
incentivise local decision makers
Better use of ‘central knowledge’
Coordination – allows complementarities and
interdependencies to be factored into the decisions in the
case of centralisation
Econ5026 Strategic Business Relationships, S2 2023
14
Centralisation and Decentralisation

Benefits of decentralisation or decentralised decision making:

Save management time for really important (strategic) decisions.

Develop management skills.



Creates a more enriched job environment and potentially an
important training and motivation incentive tool.
Avoids need to transmit information - this may be costly in time
and money terms
Exploits specific knowledge – allowing more rapid responses to
changes in market conditions.
Econ5026 Strategic Business Relationships, S2 2023
15
Knowledge
Think about some of the knowledge that might be critical in allocating resources in a firm.
• Idiosyncratic knowledge: Knowledge about the skills or preferences of staff, the
characteristics of particular machines, the presence of unemployed resources (such as the
fact there is space in the back of the truck)
• Scientific knowledge: The knowledge how to make a silicon graphics processing unit.
Even if readily available, it is not easily transferred to those without technical skills.
• Assembled knowledge: A storekeeper who has worked in a local store for years will have
assembled a unique body of knowledge about the needs of local customers, and the local
suppliers.
The knowledge for decision making is not held by any one individual. It is distributed
across people in the economy.
This specific knowledge is critical in properly allocating resources, yet it is costly to transfer.
It can be impossible to aggregate for a central decision maker. Even if it could be
aggregated, it would require massive mental ability or computing power to process it.
Econ5026 Strategic Business Relationships, S2 2023
16
Knowledge

Consider the distinction between:

General knowledge - knowledge that is inexpensive to transmit

Specific knowledge - knowledge that is costly to transmit among agents.

Because of the cost of transmitting it, specific knowledge creates two challenges:
a)
b)
The rights assignment problem – who should exercise a decision right?
Control or agency problems – how to ensure the agent acts in a manner
consistent with the interests of the firm (the principal)- post contractual or
moral hazard problem.
Econ5026 Strategic Business Relationships, S2 2023
17
Knowledge
Knowledge considerations:
• People have a limited capacity to accumulate, store, process, and transmit
knowledge. Storing, processing, transmitting and receiving knowledge is costly.
• We may want to collocate knowledge with decision authority (either by moving the
knowledge or assigning decision making authority to the knowledge holder)
• We could transmit knowledge to the decision maker (often this means
centralisation)
• We could assign decision rights to the knowledge holder (usually decentralisation)
In a market economy – the ‘best’ outcome is achieved by optimising decisions on the
part of individuals whereby decision rights are acquired or knowledge is acquired by
those with decision rights
Econ5026 Strategic Business Relationships, S2 2023
18
Decision Rights
Decision right: the right to decide on and take an action.
Decision rights are alienable:
• Decision rights can be sold and the proceeds of sale captured by the owner. i.e.
decision rights are property rights
• Alienability is the means by which knowledge and decision rights are collocated.
In a capitalist economy (markets) the problem posed by knowledge is solved via
alienability.
Alienability is the foundation of markets.
Econ5026 Strategic Business Relationships, S2 2023
19
Decision Rights
Alienability solves the rights assignment problem and the control problem.
Alienability ensures that markets result in:
• Knowledge collocated with decision rights
• Effectively controls decision makers by determining what they can and
cannot do
Alienability and the process of voluntary exchange ensures that knowledge
and decision rights are allocated in an optimal way.
Market prices reflect the capital value of those rights and ensure they are
allocated efficiently because they:
• Measure performance of those who have the decision rights to how assets
are used.
• Effectively reward or punish holders of the decision rights
Econ5026 Strategic Business Relationships, S2 2023
20
Decision Rights
This is not what happens in organisations where decision rights and
their alienability are generally not delegated. The market mechanism is
suspended.
• So how do organisations solve the rights assignment and control
problem?
Ultimately, distribution of knowledge and decision rights is central to
understanding organisations and organisational structure
Econ5026 Strategic Business Relationships, S2 2023
21
Decision Rights
What are the benefits of suspending alienability of decision rights?
• Perhaps there are benefits from economies of scale or scope, or the reduction in
transaction costs. That is, firms must gain a net benefit from the suppression of the
alienability of decision rights.
• Perhaps more importantly, the organisation or firm allows the knowledge to be
collated under one ‘hat’.
Nonetheless the problem remains: how to ensure that the benefits associated with
alienability are not lost in the firm. That is, the incentives to make good decisions
by virtue of the capitalised value of the decision right being incurred by the holder
of the decision right.
Econ5026 Strategic Business Relationships, S2 2023
22
Decision Rights

What must firms do?

They must tradeoff or balance:
a)
b)
Information Costs – information cannot be centralised other than at very high
costs. There must be decentralisation so that the decision rights are assigned to
those with the information needed to make good decisions. Information costs
will fall as decision rights are assigned to those who have the specific
knowledge required to support good decisions.
Agency costs – the sum of the costs of designing, implementing and
maintaining an appropriate incentive control system plus any residual loss.
Econ5026 Strategic Business Relationships, S2 2023
23
Decision Rights

The firm will want to minimise total organisational costs – those associated with
poor information and inconsistent incentives or agency costs. This is
demonstrated in figure 1 in Jensen & Meckling.
Econ5026 Strategic Business Relationships, S2 2023
24
Decision Rights
How?
• A hierarchy: The allocation of decision rights.
• A set of rules: an appropriate incentive and control system.
An incentive and control system
• Partition decision rights: through job descriptions, budgeting,
rules and regulations within the firm
• Create a control system with incentives: specify performance
measurement and rewards/punishment
Econ5026 Strategic Business Relationships, S2 2023
25
Decision Rights
Decisions can be characterised in four stages:
(a) Initiatives: identify options (e.g. cut staff, renegotiate supplier contracts).
(b) Ratification: choose among different options.
(c) Implementation: ask what tactics to use, i.e. how to achieve desired outcome.
(d) Monitoring
Suppose a plant manager is told to cut costs by 10 percent. You may wish to:
• Decentralise option identification and implementation – sometimes referred to as
decision management.
• Centralise ratification and monitoring.
This balances use of specific and general knowledge and recognises incentives.
Econ5026 Strategic Business Relationships, S2 2023
26
Decision Rights
Consider the board of directors in some organisations.
• While the CEO has responsibility for decision management (the
initiation and implementation of major projects for example), the
board exercises decision control by ratifying and monitoring
decisions.
Such an arrangement has the potential to mitigate possible incentive
problems.
Of course, this may not be an option in smaller organisations, but in
those cases, the incentive problem is often muted.
Econ5026 Strategic Business Relationships, S2 2023
27
Flat versus Hierarchical Structures

So what type of decision-making structure should a firm adopt?

Flat structures give individuals control over decision making.


Hierarchical structures allow ‘higher levels’ to veto lower-level
decisions
Consider what each offers.
Econ5026 Strategic Business Relationships, S2 2023
28
The Error Trade-off




Consider a firm that is weighing up whether to branch out into a new
line of clothing.
Two types of errors could be made:
a)
False positive – accept an unprofitable option.
b)
False negative – reject a profitable option.
Trade-off is possible because it is always possible to avoid one type of
errors.
‘Always reject’ means there is no false positives; ‘always accept’ means
there is no false negatives.
Econ5026 Strategic Business Relationships, S2 2023
29
False negative error: reject a good
project given that it is good
The Error Trade-off
Reject all projects
1
Accept all projects
1
Econ5026 Strategic Business Relationships, S2 2023
False positive error: accept a
bad project given that it is
bad
30
Authority Structures
Flat
Hierarchy
Gladys
Gladys
Willie
Under a hierarchical structure, the lower level employee
makes recommendations that are accepted or not. That
authority lies ‘further up’ the hierarchy with Gladys.
Willie
Under a flat structure, either the lower level employee or
other employee (Gladys) can make a decision to accept
or not.
Econ5026 Strategic Business Relationships, S2 2023
31
Authority Structures
Hierarchical:
• Reduces false positives (accept a bad project): projects are scrutinised by
more people
• Increases false negatives (reject good proposals): decision making is
slower, so fewer projects are evaluated
Flat:
• Reduces false negatives
• Increases false positives
An alternative might be a ‘second opinion’, whereby both review all projects:
• Agreement means decision is made.
• Disagreements resolved by some other rule.
Econ5026 Strategic Business Relationships, S2 2023
32
False negative error: reject a good
project given that it is good
Authority Structures and Errors
Under a second opinion structure, even if Willie
rejects a proposal Gladys still reviews it. So, if
half the time the good projects end up being
accepted, then there will be fewer false negative.
But there may also be more false positives
because a project rejected by Willie gets a
second look and might be accepted.
1
Hierarchical structure
Second opinion structure
Flat structure
1
Econ5026 Strategic Business Relationships, S2 2023
False positive error: accept a
bad project given that it is
bad
33
Authority Structures: Payoffs
Frequency
Consider a firm facing a small upside risk and
a large downside risk.
• doing the job well gives a small payoff
• doing the job badly is catastrophic
• want to minimise false positives
• willing to accept higher levels of false negatives
• a hierarchical structure may be better
Econ5026 Strategic Business Relationships, S2 2023
Payoff
34
Authority Structures: Payoffs
Example: $bn loss in the case of Exxon Valdez where alcohol was a consideration.
The ‘project’ here is deciding to proceed before being sober.
• Want to minimise false positives (accepting an unprofitable ‘project’) and
willing to accept higher levels of false negatives (rejecting profitable options).
• Proceeding while intoxicated and having an accident is a false positive (i.e.
accept the ‘challenge’ of going through straits even though it leads to an accident).
• Sobering up before proceeding when proceeding would not have led to an
accident is a false negative (reject proceeding even though you may make it
through the strait without an accident).
In this situation want to reject false positives because they are so costly, therefore a
hierarchical structure is better.
Econ5026 Strategic Business Relationships, S2 2023
35
Authority Structures: Payoffs

Consider a firm facing a small downside risk and a large upside risk.
Frequency
Payoff
Econ5026 Strategic Business Relationships, S2 2023
36
Authority Structures: Payoffs





Doing ‘job well’ gives a large payoff.
Doing a bad job means there is only a small loss – the investment in the
project is limited.
Flat structure that give individuals the opportunity to make decisions
and little supervision reduces the likelihood of a false negative – i.e.
rejecting a profitable project
Think about start up firms where there are opportunities that can
potentially lead to large payoffs.
Encourages creativity.
Econ5026 Strategic Business Relationships, S2 2023
37
Making Better Decisions
Recall our earlier characterisation – how do we get
to the dotted line?
False negative error: reject a good
project given that it is good

1
1
Econ5026 Strategic Business Relationships, S2 2023
False positive error: accept a
bad project given that it is
bad
38
Making Better Decisions

Doing so is costly and requires investing in some ‘technology’ such as better
evaluators.

Consider the example discussed in Lazear (pp. 134-36)

Planes can take the ‘quick route’ through a storm but at the risk of an accident.

Alternatively, they can take the long way around the storm.

Assume that a crash is associated with a large loss of $1bn.

Previous discussion suggests that a hierarchical structure works best here because of
the large downside risk. But here the situation is a little different.
WHY?

Hint: think about the pilots own interests and how they align with that of the airline.
Econ5026 Strategic Business Relationships, S2 2023
39
THUNDERSTORMS AND AIRPLANE TRAVEL
Go through storm
Probability
of crash
10-5
Go around storm
10-9
Cost of
crash
$1 billion
Expected cost
of crash
$10,000
Expected fuel
cost
$17,000
$1 billion
$1
$20,000
• Consider the expected cost of going through the storm: the cost of the
crash (probability weighted) and the fuel.
Expected cost = (10 )($1bn) + $17,000
= $10,000 + $17,000
= $27,000
• Consider the expected cost of going around the storm:
Expected cost = (10 )($1bn) + $20,000 = $20,001
• Here it is all good and a hierarchical arrangement (where the pilot
radios in for instructions) is not needed.
-5
-9
Econ5026 Strategic Business Relationships, S2 2023
40
Making Better Decisions
• The company would always approve when asked for permission
to go around the storm. There is no sense in having the pilot
called in for approval to use the alternative route.
• The pilot is given the full authority to take a longer route
compared to a shorter route when there is a thunderstorm in the
shorter route.
• Hence a flat structure works fine.
Econ5026 Strategic Business Relationships, S2 2023
41
Making Better Decisions




Here the probability of a false positive error is zero. This is so since the shorter route is never taken.
There is no chance that the shorter route would be taken when it would have resulted in a crash.
On the contrary, the probability of committing a false negative error is 1. The shorter route is always
rejected even when it would not have led a crash.
Now suppose that the firm can buy some technology that helps determine if it is safe to avoid a storm.
Assume that the technology forecasts that the route through the storm be taken 9999/10000 times.
Hence the probability of crash when the a ‘fly through the storm recommendation’ is equal to 1 in 100
million. But if the forecaster’s advice to avoid the storm is rejected, then the probability of a crash is 1 in
10.
Probability crashing when going
Probability
recommendation
Go through
Avoid
Through
Around
0.9999
10-8
10-9
10-4
10-1
10-9
Econ5026 Strategic Business Relationships, S2 2023
42
Making Better Decisions


The technology allows better decisions to be made.
With a positive recommendation (fly through the storm) the
expected cost of the trip through the storm is:
Expected cost = (10-8)($1bn) + $17,000 = $17,010.

It is still the case that the expected cost of going around the storm:
Expected cost = (10-9)($1bn) + $20,000 = $20,001
Econ5026 Strategic Business Relationships, S2 2023
43
Making Better Decisions

Two questions to consider:
(1) Should the technology be purchased? This will depend on its cost.
(2) If purchased what type of authority structure should be put in place?
No longer necessarily the case that a flat structure is ideal. The pilot may
not make the same assessment as the technology.
In this case, the authority structure would change when the Forecaster is
purchased…the firm now prefers a hierarchical structure, … the pilot must
request permission to divert around the storm and the airline has the right
to refuse the permission.
Econ5026 Strategic Business Relationships, S2 2023
44
Making Better Decisions

The lesson:




The interplay between information, decision making structures and
incentives is critical.
With central information available, a hierarchical structure is more
likely to make sense.
When not decentralisation is better.
But decentralisation works when the interests of the decision maker
(the agent) and the principal are aligned.
Econ5026 Strategic Business Relationships, S2 2023
45
Bundling Tasks
How should tasks be bundled together?
• Complementary tasks are better performed together
One option is functional grouping of tasks
• E.g. manufacturing, sales, finance
• Gives rise to the U-form organisation (corporate department
keeps control of strategies and decisions)
• Benefits: coordination within functional units; develops
functional expertise and career paths, economies of scale
• Costs: coordination across units: workers focus on their function
and ignore other functions
Econ5026 Strategic Business Relationships, S2 2023
46
Bundling Tasks
Econ5026 Strategic Business Relationships, S2 2023
47
Bundling Tasks
Another option is by product or geography:
• Gives rise to the M-form organisation
• Benefits: decision rights are co-located with specific knowledge;
rewards can be based on local performance, improving incentives
• Costs: territory disputes; interdependencies might be ignored
Econ5026 Strategic Business Relationships, S2 2023
48
Bundling Tasks

Grouping jobs by product or geography?
Gives rise to the M-form or multi-division organisation.
Econ5026 Strategic Business Relationships, S2 2023
49
Bundling Tasks


There are other alternatives

Network organisations

Matrix organisations.
There are benefits and costs of these alternative structures.
-: End of Document:-
Econ5026 Strategic Business Relationships, S2 2023
50