Economic approaches to organization
Chapter 1 The economic problem
1.1 The economic problem
Economic problem: is identified in any situation where needs would not be met as a result of scarcity
of resources – ‘resources’ being quite broadly conceived as meaning all factors that may contribute
towards the satisfaction of human needs. It may be rephrased as the problem of how to make the
best use of the available resources.
What is the optimal allocation of the scarce resources over the alternative uses that can be made of
then? Resources that are optimally allocated are said to be used with efficiency.
Economic approaches to organizations are fruitful whenever the problem to be studied has an
economical aspect, that is whenever part of the problem deals with the optimal allocation of scarce
resources. Economics has an important contribution to make the understanding of organizations:
Economic approaches to organizations focus specifically on the economic problem of optimal
allocation of scarce resources.
The economic contribution to our understanding of an organization problem increases when the
economic problem forms a greater part of the organizational problem that we are trying to
understand.
Basic conceptual framework is used to explain the fundamental economic approach to organizations.
The framework will clarify the crucial role of information and the various ways in which information
can be mediated.
1.2 The division of labour (arbeidsverdeling)
Adam smith says about the division: the greatest improvement in the productive powers of labour,
and the greater part of the skill, dexterity and judgment with which it is anywhere directed, or
applied, seem to have been the effects of the division of labour.
Division of labour refers to splitting of composite tasks into their component parts and having these
performed separately. Example about pin factory: increase in productivity could be achieved by
,splitting this work up into distinct tasks and having each worker perform one specific task rather than
making entire pins. Organization charts are one reflection of the division of labour within
organizations.
1.3 Specialization
Why would an increasing division of labour lead to such great productivity increases and, thus to a
growth in ‘the wealth of nations’? Smith gave the following explanation:
1. To the increase of dexterity in every particular workman
2. To the saving of the time which is commonly lost in passing from one species of work to
another
3. To the invention of a great number of machines which facilitate and abridge labour, and
enable one man to do the work of many
Specialized production is more efficient than unspecialized production since a greater amount of
output can be achieved with the same level of labour input (ten men).
Division of labour specialization: when work is split into specific tasks, we may select one that
particularly suits our own needs and capabilities. When we specialize in that task, we can devote all
our attention to improving our performance of that task.
There is a cost to specialization for example when workers have to switch to unfamiliar tasks, because
then the efficiency of doing the work is disturbed.
For the individual specialization has the advantage of allowing higher levels of performance to be
reached, but the disadvantage of restricting choice. At the individual level, the limits of specialization
are reached when the satisfaction gained from higher performance is outweighed by the
dissatisfaction from too narrow an area of application of one’s skills. Individual limits are thus one
boundary to increasing specialization.
There are also organizational limits to specialization: high organizational specialization may lead to
insufficient collaboration in addressing new challenges. Also, increased specialization requires
increased coordination.
1.4 Coordination
Exchange between goods has to take place. In order to obtain goods and services, people have to
acquire them from other specialized people. Much exchange takes place through markets. Exchange,
though, is broader than just market exchange.
- The goods need to be marketable. Economists speak of goods whenever scarce resources are
involved.
- The transfer of rights need not be mutual.
Whenever exchange takes space we speak of an (economic) transaction. Specialization leads to a
need for coordination since we specialized ourselves and we need to get goods and services of
others. There are two types of coordination: transactions may take place either across markets or
within organizations.
1.5 Markets and organizations
Markets
In the stock market it’s not necessary for buyers and sellers to have any kind of personal contact. The
reason is that the price system is the coordinating device that takes care of allocation. The price
contains all the information you need to base your transaction on: it is a sufficient statistic. If there
are more potential buyers than sellers, the price goes up. This goes on until demand and supply of
stock is in equilibrium. At that point we can say that an optimal allocation of that stock has been
achieved.
, Contrary to the standard assumptions for ideal markets, Coase (1937) maintained that usually there is
a cost associated with using the price system.
- There is usually a cost (if only time) involved in finding out what the relevant prices are.
- When important, a contract is usually drawn up to provide the basis for a market transaction.
- There may be conditions under which it is hardly possible to reach a contractual agreement
that may serve as a basis for market exchange.
Coordination through markets: the price system is the coordinating device. Within organizations, the
price system is, in Coase’s view, replaced by authority as a coordinating mechanism. Markets and
organizations differ most essentially in the way that information is communicated between the
transacting parties.
An ideal market Is characterized by the fact that prices act as ‘sufficient statistics’ for individual
decision-making. Ideal organizations can be characterized as all those forms of coordination of
transactions that do not use prices to communicate information between the transacting parties.
1.6 Information
The actual mix of coordination mechanisms that we will observe in any situation will depend mainly
on the information requirements that are inherent in that situation. Information is presented as the
crucial concept in the framework, explaining how coordination will take place.
There are many situations in which the price cannot absorb all the information (as in an ideal market)
necessary to enable the execution of transactions.
Organizations arise as solutions to information problems. Organizations are more suited to dealing
with certain information problems than are markets. The market/organization mix depends on the
particular information requirements of the situation. Information and communication costs
determine, the relative efficiency of the two broad coordination mechanisms.
1.7 The environment and institutions
Environment: the context in which the trade-offs between market and organization coordination are
made. The environment includes not only economic in nature, but may also be social, political,
cultural or institutional. Economists have particularly highlighted the importance of the institutional
dimension. Organizations do not operate in a vacuum, but live in an environment that:
- Provides the conditions for particular organizations to be created
- Shapes all organizations by exerting economic, social, political and other pressures,
- Is also the ultimate selection mechanism for determining which organizations can survive and
be successful (while other organizations are ‘selected out’ and perish)
Not only organizations but also markets are shaped by environments. In market economies,
governments have a fundamental influence on which markets are allowed to exist and how they
function. Markets are also affected by trade unions, which have an impact on labour markets in many
countries, of environmental pressure groups, which attempt to set standards of acceptable eco-
behaviour in many markets. Markets operate in an environment that:
- Provides the conditions for particular markets to be created
- Shapes all markets by exerting economic, social, political and other pressures,
- Is also the ultimate selection mechanism for determining which markets can survive and be
successful
Institutions have been defined (Douglass North) as: institutions are the rules of the game in a society,
or more formally, are the humanly devised constraints that shape human interaction.
