If an alien came to earth from outer space wearing glasses that show organizations in pink, and markets in green, what would it see? Would it see more green, and describe our activities on earth as a market economy, or more pink, pointing to an organizational economy? What systematic differences would it notice between underlying circumstances that give rise to green systems, and circumstances that give rise to pink, and would the quality of the outcomes differ for markets and organizations? Finally, would the alien be able to give any advice on how to improve outcomes where we try to solve problems by means of organizations?
These are some of the questions addressed by Robert Gibbons, distinguished professor at the Massachusetts Institute of Technology (MIT) Sloan School of Management and professor at the MIT Department of Economics, in his guest lecture on 28 September as part of the University of Pompeu Fabra’s (UPF’s) “Lliçó d’Economia” series. Outside of the United States (US), Professor Gibbons is perhaps most well-known for authoring a popular game theory textbook, “A Primer in Game Theory” (1992). Professor Gibbons has also published widely in a variety of economics sub-disciplines, and has done pioneering work in the development of the field of organizational economics, including acting as the director of an organizational economics working group at the US National Bureau for Economic Research.
According to Professor Gibbons, organizational economics can be viewed as incorporating two streams, one “within organizations” and one “between organizations”:
Whereas the former focuses on the internal structure and functioning of organizations, the latter focuses on organizations’ boundaries (the “make or buy” question) and on relationships between organizations (not only contracts, but also “hybrid governance structures” such as joint ventures, networks, and alliances). Together, these two research streams constitute the emerging field of “organizational economics.” (Gibbons, 2003)
This can be illustrated in the following diagram from Professor Gibbons’ presentation, which also shows with which other fields in economics the two streams overlap.
Figure 1. Two arms of organizational economics and overlap with neighbouring fields.
Source: Gibbons (no date).
One of the key points from Professor Gibbons’ lecture was that organizations tend to be set up to address problems that are too difficult for markets and arms-length contracts to deal with effectively. Such difficulties may arise, for example, due to high transaction costs, hold-up problems, and the inherent incompleteness of explicit contracts. That is why, for example, in a corporation labour is not sold by employees to management by the hour in a spot market. Instead, you have a boss with relatively wide discretion, whose instructions you have agreed to follow without knowing beforehand precisely what they will be!
This idea was set out by Coase in 1937. However, Professor Gibbons believes that economists have not paid sufficient attention to one of the implications of this theory, namely that the problems organizations attempt to address are, on average, inherently more difficult than those addressed by markets in which individuals transact at arms-length. In other words, there is a sample selection problem which could go some way to explaining why we often see organizations performing below the apparent standard of market-based interaction. As explained by Professor Gibbons, we should therefore expect that in organizations, “rule violations, unimplemented decisions, subverted inspections, parochial interests, and undermined missions will be persistent problems, not exceptions” (Gibbons, 2003).
As one example, Professor Gibbons referred during his lecture to General Motors, where poor management has led to the organization requiring billions of dollars of support from the US government. He also referred to the US Department of Motor Vehicles (DMV), where internal organizational issues have resulted in a frustrating experience for US citizens wishing to renew their vehicle licenses. To this list we could add a host of other examples, including the Volkswagen emissions testing scandal and the recent customer accounts scandal at the bank Wells Fargo.
This discussion is summarized in the following graph from Professor Gibbons’ lecture:
Figure 2. Transactional difficulty and effectiveness for firms and markets.
Source: Gibbons, 2003.
The vertical line indicates the threshold level of transaction difficulty where organizations become more effective than markets at facilitating transactions. Therefore markets are observed to the left of this line, and organizations to the right.
If this figure is an accurate depiction of reality, it implies that, despite the fact that organizations achieve better outcomes than markets would have done where transaction difficulty is high, the outcomes observed for organizations remain systematically worse than those observed for markets, due to the inherent difficulty associated with interaction that organizations (try to) facilitate. According to Professor Gibbons, it is therefore problematic simply to compare observed organizational outcomes with observed market outcomes and conclude that markets perform better than organizations, because such a comparison is subject to some degree of sample selection bias.
This analysis provides an initial indication of where the alien from outer space is likely to see organizations, and where it is likely to see markets, through its tinted lenses. This is clearly relevant to the “between organizations” arm of organizational economics. According to Professor Gibbons, it also shows where the “within firms” arm of organizational economics can play a role, namely in investigating how the “Firm” curve in the figure above can be shifted upwards (or its slope made less negative) by improving the internal functioning of organizations. In this respect there is naturally a large overlap between organizational economics and organizational research in other fields, including psychology and sociology.
Coase, R.H. “The Nature of the Firm” (1937). Economica. Vol. 4, No. 16, pp. 386-405. Available at http://www.colorado.edu/ibs/es/alston/econ4504/readings/The%20Nature%20of%20the%20Firm%20by%20Coase.pdf
Gibbons, R. “How Organizations Behave: Towards Implications for Economics and Economic Policy”. Written for the Federal Reserve Bank of Boston Economic Conference, How Humans Behave: The Implications for Economics and Economic Policy (June 8-10, 2003). Available at: http://www.bostonfed.org/economic/conf/conf48/papers/gibbons.pdf
Gibbons, R. “Perspectives on Organizational Economics”. (No date). Available at: http://web.mit.edu/rgibbons/www/Perspectives%20on%20OE.pdf?v2.