Why Organizations Fail

Taken from https://dl.dropboxusercontent.com/u/2021568/GRPublishedJELFinal.pdf

Why do organizations fail?

“Organizations fail due to incentive problems (agents do not want to act in the organization’s interests) and bounded rationality problems (agents do not have the necessary information to do so)” (https://dl.dropboxusercontent.com/u/2021568/GRPublishedJELFinal.pdf, p. 137).

“Agents fail to act together because they do not want to (an incentive problem) or they do not know how to (a bounded-rationality problem). Incentive problems arise due to the presence of asymmetric information or imperfect commitment, which lead agents to act according to their own biases or preferences rather than in the interest of the organization (e.g., Holmstrom 1979; Shavell 1979). Bounded-rationality problems arise due to agents’ cognitive limitations and finite time, which means that even if they want to, agents cannot compute the solution to every problem, nor can they make themselves precisely understood by others (e.g., Simon 1955; Marshack and Radner 1972; Arrow 1974)” (https://dl.dropboxusercontent.com/u/2021568/GRPublishedJELFinal.pdf, p. 138-9) .

What creates incentive problems?

https://dl.dropboxusercontent.com/u/2021568/GRPublishedJELFinal.pdf identifies 4 reasons that employees (agents) and owners have different interests.

1. Short-Termism (p.141)
2. Decentralized Authority and Coordination Failures (p. 147).
3. Communication failures (p.155)
4. Inability to Adapt to Change Due to Organizational Rigidities (p. 163)

What problems occur in the absence of incentive conflicts?

https://dl.dropboxusercontent.com/u/2021568/GRPublishedJELFinal.pdf identifies 2 failures in the absence of incentive conflicts.

1. Hierarchy and the Allocation of Talent (p. 175)
   “organizational failures arise when those giving directions lack the required talent” (p. 176)
2. Coarse Communication and Code Incompatibility (p. 179)

What conclusions do the authors draw?

https://dl.dropboxusercontent.com/u/2021568/GRPublishedJELFinal.pdf draw 6 conclusions.

1. “One general thread throughout our survey concerns the danger of high-powered incentives attached to objectively measured outcomes. … high-powered incentives drive individuals to seek high-probability payoffs in the short term at the expense of exposing the organization to low-probability, catastrophic failures (section 2) and also drive individual effort away from cooperation among team members (section 3)” (p. 183).
2. “The general response suggested by the literature to multitasking failures has three components” )p. 183).
1. “rely on low-powered incentives and on incentives linked to inputs, rather than outputs (Prendergast 2002)” (0. 183).
2. “ the firm is a “subeconomy” and can use a broad set of tools—including decision rights, task assignments, relational contracts, culture, and hierarchies—to solve the motivation and coordination problems it faces” (p. 183).
3. “ to avoid multitask issues, organizations can rely variously on: selecting the “right” type of agents, such as agents who are intrinsically motivated by the aims of the organization (Prendergast 2007, 2008); developing an identity (Akerlof and Kranton 2005; and Bénabou and Tirole 2011); and creating a sense of mission (Dewatripont, Jewitt, and Tirole 1999)” (p. 183).
3. “Another critical source of failures is miscommunication (section 4) …  Truthful communication requires aligned incentives within the organization, for which not only monetary incentives, but also intrinsic motivation in the form of identity or mission, is desirable” (p. 183).
4. “Our survey also suggests that managers must be mindful of the long-term consequences of their decisions (section 5). …  our analysis illustrates how short-term efficiency gains must be weighted against the constraints they place on future cooperation and change” (pp. 183-4).
5. “Finally, organizations must resolve coordination failures in the presence of bounded rationality (section 6)” (p. 184).
6. “A broad message of organizational economics is that organizations exist when there are contractual imperfections and other limitations on collective action that make markets even less effective than organizations. Our models highlight a variety of such imperfections and show how they are responsible for the (mostly inevitable) trade-offs we identify inside organizations” (p. 184).