Economic Foundations
of Strategy
Chapter 1: Behavioral
Theory of the Firm
Joe Mahoney
University of Illinois
at Urbana-Champaign
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
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
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.
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.
Barnard (1938)
The Functions of the Executive
 Barnard maintains 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.”
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.
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”
Barnard (1938)
The Functions of the Executive
 Inducements – Contributions Balance:
– The effectiveness of an organization depends upon
what the organization secures and the personnel
produce (the contributions) and how the organization
distributes the resources (the inducements)
• Inducements include: “material inducements,
personal non-material opportunities; desirable
physical conditions; ideal benefactions;
associational attractiveness; adaptation of
conditions to habitual methods and attitudes; the
opportunity of enlarged participation; and the
condition of communion” (1938: p. 142).
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.
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.”
Barnard (1938)
The Functions of the Executive
 Barnard maintains that coordination is a
creative act.
 Barnard also maintains that organizations
endure in proportion to the breadth of the
morality by which they are governed.
• “Old men and old women
plant trees.”
Simon (1947)
Administrative Behavior
 Organizations influence individuals’ habits;
 Organizations provide means for
exercising authority and influence
over others; and
 Organizations influence the flow of
communications.
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.
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.
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.
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;
– Permits Coordination of Activities.
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.
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.
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.
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.
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
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.
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).
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 shortterm behavior.
 Filtering of information is not a passive process
but an active process involving attention, which
is influenced by hopes and wishes.
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).
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.
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.
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.
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.
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.