STR 403 Class 2:
Organizational Architecture
and Economic Behavior
Professor G. Wedig
Simon School of Business
Class 2
1.
2.
3.
Organizational Architecture
Airtex Aviation Case
Building Blocks – “Economic man”
Wedig: STR 403
ORGANIZATIONAL
ARCHITECTURE
Assignment of Decision Rights
 Reward System
 Performance Evaluation System
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Knowledge and
Organizational
Architecture
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To understand what determines the best organizational
architecture, it is useful to consider types of knowledge in an
organization
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General knowledge – Knowledge that is easy to transfer throughout the
organization in a timely fashion (e.g., last month’s sales)
Specific knowledge – Knowledge that is difficult or costly to transfer
throughout the organization – (e.g., what products or technologies are
most in demand by local consumers or hold the most promise)
What does “costly” mean

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Refers to timeliness (“circumstances of time and place” - Hayek)
Capacity of one person to understand – (e.g., scientific knowledge)
Assembled knowledge – ability to put all of it together – (e.g., physician’s
diagnosis of a complicated patient)
Difficulty in getting reliable, verifiable information (self-interested behavior)
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Knowledge and
Organizational
Architecture

Holding other factors constant, it is preferred to “colocate” knowledge with decision rights (so the right
decision can be made)
The greater the amount of decentralized specific knowledge in
an organization, the more that decision rights should be
decentralized (all else equal)
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Example of Safelite
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Auto glass company
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As company went to remote (off-site) installation, workers
gained a good deal of specific knowledge about the time and
costs of installation
Productivity was unreasonably low
The company decentralized decision rights and added
incentives – productivity increased
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Productive Architectures
 Links
knowledge and decision making
authority.
 Provides
the correct incentives for
productive action.
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Limits to
Decentralization

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Almost organizations will have some amount of specific
knowledge residing throughout the organization
What places limits on decentralization?

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Specific knowledge at the top of the organization (e.g., the
tasks of coordinating)
The ability to provide effective incentives
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A Broader View of
Organizational
Architecture
“What determines the type of information that is important in
an organization?”
One answer – the organization’s
environment and strategy

Examples

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Highly regulated industries pursue strategies that place much specific knowledge at
the executive level
Technology-intensive industries pursue strategies (timely product introduction, etc.) in
which a great of specific knowledge resides lower in the organization
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Summarizing:
Applying the Framework
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What are the key features in the business environment?
Does the strategy fit the environment and the capabilities of
the firm?
What knowledge is key to implementing the strategy and
where does it reside in the organization?
Does the organizational architecture fit the distribution of
knowledge?
Are the “three legs of the stool” internally consistent?
Are there incentive-related problems with allocating decision
rights in this fashion?
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Supporting Organizational
Architecture

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Does anything besides organizational architecture
matter? Do we need to pay attention to other
elements of the firm?
Answer - Yes!
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Much of what occurs in the firm occurs tacitly (without
deliberate thought) reflecting routines
Routines are where the “rubber meets the road”
Routines must support the firm’s overall strategy (for
example, a scientist that makes a novel discovery must have
a supportive company routine to exploit the possibility)
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Building the Supporting
Structure

Corporate culture
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Building Other Elements
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E.g., “Quality is job one!”
Provides a tacit signal about how to proceed
Sets the proper expectation
“Where Thinkers Become Leaders”
New routines must be built over time – Role of leadership, continuous
attention to detail and strategy
Implications for Change


Change is difficult – it encompasses more than a change in organizational
architecture
Change is also difficult because previous routines and corporate culture
must be “rooted out”
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How Organizational
Architecture Relates

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Routines, corporate culture and organizational
architecture must be consistent with one another
For example, corporate culture that stresses excellence
and quality will not be consistent with decision rights and
incentives that do not reward quality
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2. AirTex Aviation
Case
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Problems at AirTex
Prior OA at AirTex
Changes in OA
Evaluating Changes
General Lessons
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Critical Problems

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What were the major problems facing AirTex?
Short run
What needed to be addressed immediately?

Long run
Where did Frank and Ted see themselves in 10 years?
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What Did Ted and
Frank Have to Offer?
Ted: “The company had to need what we had to offer –
which we thought at the time were managerial skills.”
What managerial skills did Ted and Frank bring to the company?
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Previous Organizational
Architecture
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What was the Organizational Architecture at AirTex prior
to the purchase?
Did the old Organizational Architecture contribute to any
of the company’s problems?
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Ted’s Objective
Ted: “provide an environment that encouraged the
managers to make decisions the way I would want
them made”

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If he knows what decisions should be made, why doesn’t he
just make them?
If he does not know what decisions should be made, how
can he design an environment where managers makes
decisions the way he would want them made?
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Changes in the
Organizational Architecture
at AirTex
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Decision rights
Performance evaluation
Rewards
Do the “three legs of the stool” balance?
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Organizational
Alternatives

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What were some of the alternative structures that Ted
could have adopted?
Do you think he made a good choice? Why or why not?
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Cash Management:
An Example
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Would you have given cash and credit to a 20-year old
surfer?
What exactly did Ted give to this and similar managers?
Is there any reason to expect that Ted’s system will
result in a reduction in receivables?
What kinds of knowledge are required in making
decisions to grant credit and to demand repayment?
Does the new system link decision rights and
knowledge?
Do you think the system worked?
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Accounting System
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What roles does Ted’s new accounting system
perform within AirTex?
What is the connection between Organizational
Architecture and the firm’s accounting system?
What is transfer pricing and why is it important?
What is the connection between this class and
managerial accounting classes?
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Summing Up
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Do you think AirTex Aviation will succeed?
Was decentralization the right choice?
Should Frank and Ted stay at AirTex?
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The Outcome
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The “real” AirTex
How it all worked out
“Frank” and “Ted”
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Implication

Does the case suggest that all firms can
succeed if they adopt a good Organizational
Architecture?
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Case “Take-Homes”
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Organizational Architecture and a firm’s managerial
accounting/control system can affect value.
Knowledge and incentives issues are important in designing
Organizational Architectures.
Firm value and survival depends not only on Organizational
Architecture, but also on Competitive Strategy and the
Business Environment.
Economic Darwinism: Competitive forces place pressures on
firms to adopt efficient Organizational Architectures.
This and other classes will present material that will help you
design better Organizational Architectures and internal
accounting/control systems.
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Summary of Key
Ideas to This Point
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Organizational Architecture consists of decision rights,
performance evaluation and rewards
Three legs of the stool must balance
Knowledge and decision making must be “co-located”
(whether DRs are centralized or decentralized)
Environment, Strategy, OA
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Fundamental
Questions
Should the firm use markets or hierarchies?
If the choice is internal markets, then…
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How does firm go about designing incentives and
measuring performance?
What are pitfalls of using incentives and other market
mechanisms?
How can these problems be avoided?
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Needed Foundations
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To understand how to design incentives, we need a
theory of human behavior
To understand how to allocate decision rights and
measure performance, we need to understand how
well-functioning markets perform these tasks
To be able to “trouble-shoot” incentive schemes we
need to understand types of “contract costs”
A better understanding of all of these issues will help
the firm to choose between markets and hierarchies
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CHAPTER 2: THE
ECONOMIST’S VIEW OF
BEHAVIOR
 Why
should we choose the economic
model?
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Economic Model
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Self-interest
Limited means but unlimited wants
Optimization
Clever, creative individuals
Managers should design an architecture that aligns a firm’s
interest with those of its employee
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Formal Model

Primitives
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Utility functions (preferences)
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Not just $
Not just “goods”
Budget Constraint
Implications
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Uniqueness
Efficiency
Comparative statics
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Examples of Creative
Behavior
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Speed limits for automobiles
Typists at Lincoln electric
Anti drug-testing products
Examples from your past organizations?
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Managerial
Implications

Can affect behavior by affecting the marginal costs and
benefits of the decision maker
 Prices
 Incentives and performance evaluation

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Individuals
Programs
Other contractual provisions
 Promises of future business and interaction
Can predict behavior by considering a person’s incentives
Have to be careful with the use of incentives because of
the creative nature of individuals
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Alternative
Models
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Good Citizen

Happy is Productive

Product of Environment
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INTERWEST HEALTH
C. MANZONI
CEO
R. HARRIS
CFO
B. SMITH
HOSP. ADMIN
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W. JACKSON
HOSP. ADMIN.
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Challenges to the
Economic Model?
(Kohn Statements)
“Research shows that rewards succeed at securing
only temporary compliance. Once the rewards run
out, people revert to their old behaviors.”
“It does not follow that doubling a person’s pay will
result in better work.”
“One study examined 90 major U.S. companies and
found that the stock returns were no better for firms
that had incentive plans than for firms that did not.”
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