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«Employees and Entrepreneurship Co-ordination and Spontaneity in Non-hierarchical Business Organizations Ivan Pongracic, Jr. Hillsdale College, USA ...»

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Employees and


Co-ordination and Spontaneity in

Non-hierarchical Business Organizations

Ivan Pongracic, Jr.

Hillsdale College, USA


Edward Elgar

Cheltenham, UK • Northampton, MA, USA

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© Ivan Pongracic, Jr 2009

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher.

Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc.

William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data ISBN 978 1 84720 806 4 Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall M1627 - PONGRACIC PRELIMS.qxd:Graham Q7 7/10/08 15:16 Page v Contents Foreword by Peter Boettke vii Foreword by Frederic Sautet ix Acknowledgments xi

1. Introduction 1 Understanding decentralization developments 4 The pros and cons of decentralization 8 Modern economic theory of the firm and decentralization 15 Outline of the book 16

2. The hierarchical theory of the firm 20 Coase’s theory of the firm 21 Williamson’s continued development of the Coasian research program 24

3. The knowledge problem in firms 42 The institutional taxonomy 45 The knowledge problem in firms 51 Decentralized decision-making through hierarchical flattening

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An important way in which firms have been handling the problem of internally dispersed knowledge, or the double Hayekian knowledge problem, is by decentralizing decision-making through flattening of organizational hierarchies. This process has been given many different names: decontrolling, demanaging, empowering. They all refer to the same process: removal of some, or all, layers of middle management and giving employees the power to make some, and in some cases many, decisions. Managers and/or owners voluntarily transfer some power to ‘call the shots’ to the employees.

In other words, the owner ‘chooses who gets to be the decision-maker in production, that is, whether the organizational structure will be participatory or non-participatory’ (Minkler 1993a, p. 18). Decentralized firms are participatory in the sense that non-top-management workers participate in the decision-making in the firm. In some cases the decision-making is limited to an employee’s own narrow sphere of operations, but in other cases the decision-making granted to employees encompasses even longterm strategy. In addition, the proper amount of decision-making decentralization fitting the particular circumstances often cannot be known in advance, but rather must be discovered by the owners/managers through a process of dynamic interaction between the firm and the markets in which it operates.

An interesting example of just such a case can be seen in a 1989 Harvard Business Review article, ‘Managing without Managers’ by Ricardo Semler, president of Semco S/A, Brazil’s largest marine and foodprocessing machinery manufacturer (at least at the time). The article attempted to explain the radically decentralized managerial structure in his company. It was not a very large company (only 800 employees), and it did not deal in work that most people would think of as knowledge work – it was basically a manufacturing company. Semco reduced ‘management levels to three – one corporate level and two operating levels at the manufacturing units’ (p. 78): the top level consisted of five ‘counselors’ including Semler himself; the intermediate level was formed of heads of eight divisions referred to as ‘partners’; the bottom layer consisted of all other employees, ‘associates’ and ‘coordinators’. As Semler put it, ‘Counselors, partners, coordinators and associates. Four titles.

Three management layers’ (ibid.). The company combined the flat managerial structure with a system of profit sharing. The reason that the employees were allowed to claim a share of the profits was that, though

Semler was the president of the company, he was not the key decisionmaker in his own company:

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Semco is, to be sure, an extreme case, but it successfully illustrates the measures that some companies are – successfully – taking to become more competitive. If Semco did not actually exist, I am certain that most economists would confidently claim that such an intra-firm structure is the stuff of fairy-tales; and yet Semco showed dramatic productivity gains and became the market leader through these practices.

The scant existing economic literature on hierarchical decentralization

has explained the success of such firms strictly in epistemological terms:

‘[T]he primary advantage of participatory organizations may lie in their utilization of dispersed knowledge’ (Minkler 1993a, p. 18) and ‘The decentralized structure produces knowledge that would be impossible to produce in a different organizational structure’ (Sautet 2000, p. 127).

In decentralized structures a greater amount of knowledge is utilized simply by giving the decision-making power to those workers who are in the best position to make the decisions. Oticon is another effective example. In M1627 - PONGRACIC TEXT.qxp:Graham Q7 7/10/08 15:17 Page 61

The knowledge problem in firms 61

Chapter 1, I described Oticon’s experimentation with radical decentralization of decision-making as a response to loss of market share and the threat of bankruptcy. Oticon was in trouble because it did not keep up with competitors’ innovations, which mostly centered around the development of an in-the-ear hearing aid. Once the decentralization was undertaken, it was soon discovered that Oticon employees, working independently of the company commands and unbeknownst to their managers, actually did develop the in-the-ear hearing aid technology, but owing to the inflexibility of the hierarchical organizational structure existing at the time they were unable to bring the product to the manufacturing stage. The management did not think to tap the knowledge of their employees until Kolind restructured the company and made it radically decentralized (he referred to it as

the ‘spaghetti organization’), as seen in the following quote:

One of the things soon to be realized when the spaghetti organization became a reality was that Oticon actually already had almost fully developed an in-the-ear hearing aid back in 1979... A result of the spaghetti organization was that work on the old in-the-ear hearing aid could be resumed. (Foss 2001c, p. 12)

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[A] basic problem in the old organization had been that commercially important knowledge simply didn’t reach the relevant decision-makers. A reflection of this is the example... of Oticon employees already having invented the in-the-ear hearing aid, that invention basically being shelved and forgotten until the spaghetti organization recovered it. (Ibid., p. 14) The decentralized organization form is often the result of the managers recognizing that they themselves cannot make a decision that is as good as the decision that the employee will make, because the managers do not possess the proper knowledge to do so. Oticon was decentralized based on this assumption, and CEO Kolind was proven absolutely correct, as the above anecdote shows. This knowledge asymmetry is obviously very relevant in the areas of knowledge work, as discussed above, and, to the extent that more work is becoming knowledge work and the workers are becoming more knowledgeable, decentralized organizational forms are likely to become more common.15 Though decentralization of decision-making has innate logical appeal in the cases of knowledge work, we find it being tried even in manufacturing.

The accepted wisdom in manufacturing firms has been that the workers are there simply to carry out the work which has been precisely set out for them through specified orders handed down from above. There was not much consideration given to the possibility of dispersed knowledge in M1627 - PONGRACIC TEXT.qxp:Graham Q7 7/10/08 15:17 Page 62

–  –  –

Saturn’s organizational structure would have been unthinkable in the US even 20 or 30 years ago. But more recently there have been many examples

of manufacturing firms with decentralized decision-making not only surviving but actually thriving, as Minkler explains:

–  –  –

the local emergence of unforeseen contingencies is either neglected or given a static mechanism design interpretation. (Foss 1999, p. 471) Foss emphasizes the superior ‘response to unforeseen contingencies’ as the main benefit of decentralized decision-making, an issue not studied much in modern economics, mostly owing to the great difficulty of mathematically modeling dynamic factors in the face of uncertainty. In light of this, it shouldn’t be surprising that we find the most fruitful discussion of decentralization of decision-making in management literature, as Foss also


There is, in fact, an enormous management literature that explicitly addresses how to handle the knowledge dispersal problems (not just the incentive problems) that exist in, typically, multinational firms. The focus is normally on choosing the right degree of decentralization... The literature explicitly begins by rejecting the idea that top management in large firms, such as [Asea-BrownBoveri], can simply centralize all the relevant knowledge and issue in a top-down fashion the relevant commands to different business units. This is seen as plainly absurd; and the arguments advanced in favor of this judgment are closely related to Austrian arguments against central planning: the size, complexity, and partially tacit character of the relevant knowledge, in addition to the need for flexibility and local adaptation, makes centralization not only inefficient, but truly impossible. Firms must resort to other means to handle dispersed knowledge. (Foss 1997, p. 187) Management is a practical discipline, so maybe it is to be expected that on this issue it was ahead of economics:17 management theory follows managerial practices, and the practitioners do not have the luxury of assuming away the very real problem of internally dispersed knowledge. In attempting to handle the knowledge problem, managers discovered this tool of decentralization of decision-making. As Mises explained in Bureaucracy ([1944] 1983), this is the result of even division managers being ultimately guided by the bottom line of profit: managers must in the end contribute to a larger firm profit to justify the operation of their divisions, and in some cases the divisions run by the managers who gave greater decision-making power to their employees showed a consistently better performance, maybe owing to the enhanced response to the unforeseen contingencies mentioned above.

Allowing the employees with the greatest knowledge of time and place to make the appropriate decisions will give firms the greatest ‘capability to react quickly to change’ and ‘promote innovation’ (Minkler 1993b, p. 569). This response to unforeseen contingencies, noted by Foss as the central benefit of decentralization, becomes more important as a market becomes more rivalrous, and survival no longer depends simply on cost M1627 - PONGRACIC TEXT.qxp:Graham Q7 7/10/08 15:17 Page 64

Employees and entrepreneurship

minimization but rather rapid adjustment to unexpected actions by competitors. Minkler explains the benefits of decentralization in the following way: ‘[A]s global markets demand greater flexibility, on-the-spot decisions become crucial and workers become “knowledge” workers – they come to have decision-making advantages over superiors higher up the hierarchy’ (Minkler 1993b, p. 569).

We can see that desire for flexibility in the following example by Langlois:

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