Economics not only helps to understand how markets work, but also applies to understanding situations that are totally outside the marketplace, where buyers and sellers are not independent autonomous actors, making decisions pertaining to their own private property and their own welfare. These situations are generally described as the ‘economics of group behavior’, where there are often informal or formal rules set up that govern acceptable economic behavior. We are particularly interested in behaviors inside one kind of group, the firm. How do we know that resource allocation is working properly inside the firm? How do we keep resources working effectively and productively? In competitive markets, these kinds of “problems” would give rise to high costs and failure of the firm.

In situations where firm failure isn’t likely, where the firm has monopoly power, poor productivity only results in wasting profits. The economics of Management provides some guidance on how to keep resource allocation optimal and efficiency high inside of organizations. And, the understanding of how decisions are made help us understand the nature of incentives imposed on managers, and the kinds of reactions we can expect.

The “firm” is a collection of economic activities (people doing separate jobs) that could have been done independently, and the output of all that work traded on markets (like outsourcing does, when we shed an internal function and “buy it” on the open market for such services). But, the firm is nothing but a collection of such functions, welded together by “management”.

Why do firms exist? Because an owner (plus other investors) believed that there would be a worthwhile return on investment if a bunch of separate economic functions were pooled together inside an organization and managed with the output being sold to someone. Essentially, the “firm” represents a collection of part of the supply chain for some product or service. Why would one believe that doing all these functions “off market” would be able to “beat” the market in terms of efficiency? In simple terms, because the transactions costs of using markets can be largely avoided if the specialized functions can be managed in a non market environment. Transactions costs include shopping to find the right suppliers, finding customers, negotiating, waiting, getting information you need, and lots of other things. The transaction costs of doing business in markets is often high. Witness the way bookstores and other retailers went out of business because of Amazon and other internet companies. By making shopping for books more convenient Amazon proved that many book buyers don’t want to spend their time browsing before buying, they just prefer to spend less time, with less inconvenience, just going on line and browsing there and buying what they want. Transactions costs used to be high for buying books (drive to Harvard square, park, look here, ask questions there, and 2 hours later I am back home). Amazon proved just how expensive the market transaction costs of shopping actually are. They made a nice business by offering a business model that vastly reduces consumer transaction costs.

Back to the rationale for a firm in the general sense. A firm’s business model is to bring together

(1) a set of target customers whose unmet needs are known,

(2) a product/service that meets those needs, and

(3) a production process that is composed of carefully integrated and standardized functions that can economically produce that product/service and get it where and when the customers need it.

So, a firm may bring together 100s of special business functions (such as product development, testing, painting, assembly, packaging, selling, customer relations, advertising, lead generation, billing, financial analysis, shipping, employee recruiting, etc etc etc.)

All of these and hundreds of others could’ve been purchased in markets from venders. But, the firm was formed by bringing together people with these skills, financial resources, a space to operate (or a virtual space) and a management team. Management’s job is to make an efficiently functioning team to meet the customer’s needs. They put a fence around these people, isolating them from the markets for all the vendors who perform the same functions on open markets (eg marketing consultants, billing services, outsourcing companies who do some of these things, employee evaluation specialists, and all the others). Firms are groups of people, working under the guidance of management, and isolated from markets.

So how does management coordinate all these functions and get things done efficiently, on time, and up to quality standards? What ensures cooperation when management asks employees to do it for the benefit of the business? What ensures that employees will work hard and effectively when maybe some of them are more interested in having fun or shirking duties in some way? What ensures that management itself will guide the firm in a direction preferred by the owners (residual claimants)? There are three kinds of issues about whether the firm business model will work to provide a reasonable return to the owners:

1. Which direction will management take the firm? Is this what owners want? What can owners do to get what they want?

The separation of ownership (stockholders) and control in corporations is a longstanding issue. Of course, in small businesses, there is no separation at all, because the owner is likely the manager. In The Modern Corporation and Private Property (1932), by Berle and Means first set out the issue. In the corporation, managers, not owners, have control. Absent interventions, managers will maximize their own interests subject to keeping the owners happy enough to keep them in their jobs. Absent interventions, managers will not optimize the interests of owners. Basically, modern thinking is clear if you look at the way managers are compensated today. Managers are paid a salary, but it is minor compared to other forms of compensation, much of it contingent on profit performance of the firm (including bonuses and stock options). This essentially creates incentives for managers to act “like owners” would act. With lots of stock, the managers are, in fact, owners too. This essentially “aligns” the interests if Ownership and Control in the corporation. Now, such incentives are often pushed far down in the management structure of corporations.

2. The second issue is getting cooperation inside the organization.

Cooperation is something that is needed in groups of any kind, because their point is to bring together people with common interests to get something to happen. The business is a unique kind of group. It brings people together, but their relationship isn’t social, nor do they have common interests, they are there to earn their piece of the economic pie for themselves and their family. Why are they even in a particular firm? Because the benefits of being there exceeded the benefits of their next best alternative (opportunity cost). What are those benefits? It may be purely a higher salary that got some of them there. It may be the better fringes or a particular fringe that caused others to say yes (in this case, these persons may have actually given up a higher salary elsewhere to come). It may be the convenient location (again, they may have given up salary to be nearby). It may have also been the prospect of a better career potential in this firm than the next best offer (again, they may have been willing to give up salary now, to have better salary in the future). Whatever, we are likely to have a “group” in any firm that is diverse in many dimensions.

So, what is the cooperation problem? People do not shed their personal objectives when they take a job, indeed the job situation is a vehicle for achieving many personal objectives (income, recognition, social, etc.). So, when management tells them to “cooperate” in some way, it sometimes (not always) sets up a situation where the benefits of doing what management prefers are contingent on what the other person does. This “interdependence of interests” is endemic to group activity. Lets use an example: What if a firm sells two products to the same customers (say men’s clothes, women’s clothes) and has two different managers charged with sales management. Their manager requests that they share business intelligence-type information on a big customer (say Neiman Marcus). will they fully cooperate just because the manager asks them to? What determines if they will fully cooperate with each other to adhere with management’s instructions?

Are their interests aligned with the interests of the firm (the request by management). There are many possible answers to this depending on the people involved. But, it is common in the workplace for the interests of the individuals involved to prefer to not cooperate. The situation is illustrated by the simple model of the prisoner’s dilemma. Basically, it describes a situation where (1) both parties can get the best results for themselves personally if they both cooperate with management’s directive, (2) both parties get the worst payoff personally if both of them fail to cooperate, but (3) each of them will have an incentive to not cooperate, and they wont. This is because when they think about their decision, regardless of which assumption they make about what the other person will do (cooperate, not cooperate) they will individually get a better payoff if they don’t cooperate. To illustrate, the table shows how the situation looks from my perspective. It creates an incentive for me to fail to cooperate. Because, i am better if regardless to Tom’s behavior if i take the position of failing to cooperate. If the situation looks like this to Tom, then we have a prisoner’s dilemma.

	If Tom cooperates	If Tom fails to cooperate
My payoff if I cooperate	100 I do well if we cooperate together on info sharing	60 I don’t do well cooperating when Tom doesn’t, he may be able to use my information to swing the buyer his way. Maybe he’ll get the next big promotion, not me.
My payoff if I don’t cooperate	120 I do even better because I get benefits from his information and he doesnt get mine. Maybe I will use Toms data and be able to get the next big promotion.	80 If we both fail to cooperate we do less well than if we had cooperated

The situation arises all the time, when one person’s interests depend on the actions by other people. What if I am asked to come in and help the team write the proposal on Saturday. Do I cooperate, or not. I may see the issue as better for me to not do it, whether Tom does. And, also better for me if Tom does not. What if I am asked to “work together” with another division manager in hiring temp typists from the pool of people we have available. There may be a good outcome for each of us for cooperating, but we may “pass” because as we each see it, regardless what we assume about what the other person will do, we are better off not cooperating.

So how can we resolve prisoners dilemmas, or other kinds of “interdependent” situations inside organizations? The obvious ways are:

1. Hire tough managers, who don’t give flexibility to delegees (‘my way or the highway’ managers)
2. Provide some sort of incentives to cooperate
3. Discourage independent decision making by the parties— make them decide together, or maximize the communication between them so they are not speculating about what the other is doing or thinking

The point here is that it may be tough throughout the firm to achieve the desired benefits for the firm by getting people to work together in groups. The efficiencies of the firm are, to some extent, determined by how well people work together when their personal payoff depends, in part, on the actions of others. Obviously, situations of personal rivalry (“which of us is going to get the promotion”) are deadly without one of the solutions noted above.

The problem gets much bigger in more than 2 person games like this. The problems of “interdependence” of results for separate parties was mainly developed by RAND people trying to figure out what the cold war would result in. What were the incentives for the USA and the USSR to fire first, or not fire first. Obviously, the answers depend on what we assume about the assumptions we make about the other guy’s incentives and related behavior. The John Nash equilibrium (the scientist in “A Beautiful Mind”) shows how such a dilemma, played as a game many times (allowing players to learn how the other person chooses), will always result in a non cooperative strategy by both parties (not good).

3.  A third problem of interdependence of outcomes inside firms is abusive consumption of “common” or “free” services. This is the same problem that exists in society at large with “free” public services (roads, parks, clean air, clean water, etc.). Inside firms workers (and the managers) have access to ‘common’ services (office space, free food or refreshments, phones, computers, space for parking, others). People in the company and their departments and business units do not have to “buy” such services from vendors because they are made available by the company. The problem with “common services” is that the demand for them reflects the price paid for them by users. If the price is zero more people use them. And, their volume of use by every decision maker reflect good incremental decision making: if the amount I have to pay for an increment of service is zero, then I should continue to consume it until the incremental benefit is zero. So, the problem with “common services provided to a group for free” is that the usage will tend to be very high. This is the “tragedy of the commons” discussed in the text (but not in the PR textbook). Roads are cluttered. Water is overused and often becomes unclean because of usage patterns. Air too is not private property, so nobody can charge for using it. So, guess what, it is squandered as corporations are not charged for using it up by replacing it with polluted air, and drivers are not charged for doing the same thing. The economics of the environment is basically a story about how the lack of private property for many environmental resources has led to overuse because the price is too low (zero).

So how to fix these problems inside firms? (or elsewhere)

1. Charge fees for using the resource (make departments pay for their space in calculating their P&L or their contribution margin using some sort of fee or transfer prices). Charge tolls for roads. Charge taxes to buy gasoline.

Inside firms, the problem usually arises because departments or business units try to get more than their share of “free” corporate services (borrowing consultants from another department, using common space for meetings, getting corporate PR department support for particular publicity programs, etc). In consulting companies this is a huge issue. How do you treat the “lending” and “receiving” departments fairly inside the company? How do you limit the “overuse of what appear to some managers to be “free” resources available in other areas of the company? Transfer pricing! You set prices on this stuff for use within the company. So, if you borrow a consultant from another group to work for a week, your budget gets charged a price for it. Or when you use common meeting rooms, you get charged for it, etc. This kind of thing limits overuse of “common” (but valuable resources that have opportunity costs).

2. Regulate or set rules for group behavior (whether the group is employees, or citizens, or drivers). Clean air and clean water Acts are regulatory mechanisms (which businesses largely hate because to meet the regulatory requirements they have to spend money in order to not continue to replace clean resources with dirty versions of the resource). In Mexico city, where road congestion and smog are horrific) they issue license plates that are good for M,W, F and Sunday, or good for T,TH, Sat and Sunday. The idea is stop all the cars from being out and about on any given day (except Sunday). Space use standards (who is allowed what size office) and monitoring of long distance phone calling are examples of firm rule.
3. Privatize (often associated with outsourcing inside businesses). Like our mailroom and cafeteria providers here at Simmons. In the past, services got overused because nobody was paying attention and it was free (space use by departments, coffee in the mornings, use of phones) or because of some “quid pro quo” system of corruption whereby the gatekeeper for the ‘common services’ could help her friends, who were gatekeepers of other services. So, some people got free mail services, some got free food, some get the newest computers, etc. Under outsourcing, or privatization of the function, the consumers must “pay the vendor” because the vendor has private property and is going to charge for it and not give it away free because you are a friend or someone who can offer a quid pro quo. So, outsourcing is often a way to clean up the “tragedy of the commons” and corruption inside businesses. Of course, outsourcing is also a way to (1) stop spending management resources on a non strategic business function like the cafeteria and (2) to get rid of assets on the balance sheet that have nothing to do with generating revenue for the firm—contributing to improved asset use efficiency and a “better” balance sheet.

Budgeting and Resource Allocation in the Firm

Simple decisions are subject to decision making where incremental cost is weighed against incremental revenue. In business speak, this is the rule of contribution margin. As long as the variable costs are covered by the price we can charge, contribution margin (p-AVC) is positive and we should go for it—because doing it will contribute positively to the firms profit. There is a separate topic on this blog dealing with contribution margin.

But mostly, business decisions are more complex because there are multiple alternatives that often have to be weighed. And often there are multiple products being sold. These kinds of multiple alternative decisions are called allocation decisions. Everything is scarce and every use of money, management time, and activity from the top internal experts must be carefully considered because there are opportunity costs to consider. There are two rules to follow to maximize profit (net benefits). These are simple cost benefit rules too :

1. in most cases the decision to do something or not is best made by considering the incremental benefits vs the incremental costs. This is the same thing as contribution margin. This term is important in the language of business. It means additional revenue we’ll get minus the additional costs incurred. The rule says that we should add or keep activities where contribution margin is positive, because profit is higher if we do. We should likewise shed projects or activities where contribution margin is negative.

2. The second rule is about allocating a fixed amount of resources across streams of competing activities (multiple products, multiple locations) . How to assign 10 salespeople against 2 product lines, or how to allocate a fixed budget across all departments. This rule says that we should allocate our fixed resources across activities such that the incremental benefits we get from the last unit of resource going to each of the activities is equal.

An example will help: The ACME software division managers are considering what their mix of marketing monies should be between two activities: “lead generation” activities and “research to refine customer segments”. The Marketing budget is $100,000 for the year. The chart below shows the payoff (yield) to spending various fractions of the budget on each of the two activities. Note that spending all the budget on “lead generation” caps the total benefits at 46,000. Spending only on “research” caps the benefits of the entire budget at 91,000. What is the best mix of marketing spending (they have to add to 100,000)? Which allocation will give us the biggest bang for the buck?

Total Yield to “Lead Generation”               Total Yield to “research”                         budget alloc                                   marginal benefit                          marginal benefit

5K                                          10,000 k           10 k                                25,000 k       25 k

next 5K (total=10)               18,000               8                                         45,000       20

total is 15                               25,000               7                                         57,000       12

20                                           31,000               6                                         68,000         11

25                                           36,000               5                                         78,000         10

30                                           40,000               4                                        87,000         9

35                                           43,000               3                                         95,000         8

40                                           45,000               2                                         102,000       7

45                                           46,000               1                                         107,000         5

50                                           46,000               0                                         111,000         4

55                                           46,000               0                                         114,000         3

60                                           46,000               0                                         116,000         2

65                                           46,000               0                                         117,000         1

70                                           46,000               0                                         117,000         0

Higher spending levels       46,000           0                                         117,000         0

If we spend just 5K on lead generation we will get a 10K return. If we spend another 5k on lead generation, the return will be 18k for the 10k in spending. Spending 5k in research, on the other hand, will get us 25K. Spending 10k on research will get us a total return of 45k.

If the manager of “lead generation” says, “ Why don’t you give us both half the budget (50k)”, what would we say? For starters, we’d say that a budget for “lead generation” in excess of 36K makes no economic sense at all. For budget beyond that level, we get back less than we put into it.

If we had a total budget of 20K, where would we spend it between these two departments, which allocations gives us the biggest bang for the buck? Looking at the first 5k increment, the biggest payoff is to give it to “research”, where we’d get a return of 25. The second 5K of budget would get 20 if we put it in research, or 10 if we gave it to lead generation. So we’d give that 5k to “research” too. In fact, we’d put the whole 20 k in the “research” activity, because the last increment gets us 11K there, but only 10 k in the “lead generation” activity.Game theory in economics provides insights into “failure to cooperate” and mechanisms for solving that problem. This was reviewed above in the “prisoners dilemma” and the “tragedy of the commons”.

Another illustration is evident in the “economics of dieting” article I often assign. The point of the article is to note that motivation is better (to diet, to sell, to win, to keep customers satisfied) if there are only two outcome options: to succeed, or to fail. Two alternatives make the incentives quite sharp. Sometimes (usually) there are three options: to succeed, to fail, to make a good (but not successful) effort. The third option, if it exists, dulls the incentive to succeed. To sharpen the incentive to succeed, the third option can be eliminated. The military metaphor of the general moving his army into a position with their back against the sea removed the 3^rd option of “retreat” so as to motive them to “win” and not “lose” the battle. This motivational insight (removing the third option) is not new, but it is pretty amazing how often we have 3^rd option in our decision making, and how often we take it ! Think of your own examples.

So, eliminating the 3^rd options for employees, for vendors, for customers is something to consider. Possibly putting prices (sticks or carrots) on such options would help too, in order to prevent “muddling through”.