Economic Foundations
of Strategy
Chapter 1: Behavioral
Theory of the Firm
Joe Mahoney
University of Illinois
at Urbana-Champaign
Power Point Set #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
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 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.”
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
 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.”
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 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.
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.
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
 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.
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.
nd
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 QuasiResolution 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
short-term 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.