Efficiency and rationality in organizations - response to article by Robert Gibbons, in this issue, p. 145

Administrative Science Quarterly,  March, 1999  by John Freeman

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In "Taking Coase Seriously," Robert Gibbons considers the use of formal economic modeling in organizational research. He makes three claims: that internal organization is often imperfect; that such imperfections are consistent with both the utility-maximizing behavior of organization members and transaction cost economizing; and that modeling, especially economic modeling, can be applied to shed light on research issues pertaining to organizations that are not the subjects of common economic analysis.

My essay focuses on the economics of organization and does not quarrel with either the first or the third of Gibbons' claims.(1) The first is perhaps a bit of a straw man, in that even the Weberian legal-rational bureaucratic model was developed as an ideal type against which to compare observed organizational arrangements. For Williamson and other theorists focusing on transaction costs, it is only necessary that enclosing a transaction within the boundaries of an organization is more efficient than not doing so. It is not necessary that such costs be minimized, much less that they be obliterated.

Gibbons' third claim, that modeling can tighten logic, make empirical testing easier to conduct, and provoke new explanations are all correct, in my opinion. I would add that such models also make the accumulation of findings more likely, because the models provide an explicit framework researchers can compare against their findings. Points of inconsistency provoke theoretical reconsideration. This is exactly what is happening in my own area of interest. Hannan's (1998) recent essay on age and size effects on organizational mortality uses formal models to bring empirical research to bear on different and somewhat inconsistent theoretical positions. But Hannan uses symbolic logic to formalize the theories, not the mathematics of game theory. This raises the issue that is most important for organizations researchers: why economic models of organization rather than some other sort of model? To answer this question, we need to understand what the economics of organization is about.

Economics of Organization

The first time I ever punched out at the end of a factory shift, I was astonished to see grown men hunched over the time clock, cards poised for instant insertion into the stamping machine. At the click of the minute hand, rapid-fire card processing was followed by the peel of rubber as cars and pickups sped from the premises. How could a few seconds be worth this exertion of effort, burning of fuel, or loss of rubber from tires? It must be worth it, I thought, because the same thing happened every evening. But the process never occurred in reverse: workers never arrived at the last second, power sliding into the parking lot, running across the street to insert their cards at the very last second. In fact, the same people who raced into the darkness at shift's end often arrived early and prepared for work at their leisure. So minimizing one's time at work was not the point. These workers were being paid for their time and also under a piece-rate system. They routinely calculated their returns from a job that had lasted a certain period of time. And they kept their own books to make sure they were not cheated. So far as their pay was concerned, these men were utility maximizers. Here we have the contrasts that make Gibbons' essay so interesting. Foolishness and rational choice exist side by side in every organization. It is easy to theorize about one while ignoring the other. The challenge is to reconcile them.

The economics of organizations revolves around two basic ideas: that human behavior is fundamentally rational, in the sense that people seek to maximize utilities as they go about their organizational business, and that organizations are set up the way they are because it is more efficient to organize that way. The two may be linked by a set of assumptions that aggregate utility-maximizing behavior of individuals so that seeking these utilities promotes organizational efficiency. Of course, many analyses of organizations by economists do not include such aggregation assumptions. So organizational economists fall into two camps that are not exactly at war with each other but are also not completely supportive of each other. At the risk of oversimplification, these two camps are those of agency theorists and transaction cost economists. Agency theory begins with utility-maximizing players and does not back off from that assumption, but it notes that the consequence can be suboptimal efficiency. As Gibbons states in his essay, such a perspective can treat organizations as "messy." Transaction cost economists assume that markets press organizations to adopt efficient forms of organization while admitting that decision makers in organizations often operate in circumstances that place bounds on the ability of actors to maximize utilities (Williamson, 1975, 1985, 1993).

Economics Old and New

Before we can go very far with this discussion, I should note that the purposes that motivate economic inquiry into the subject of organization are narrower than the purposes of sociologists, psychologists, and most other behavioral researchers. Economists continue to be preoccupied with organizations as economic actors, as production mechanisms. Noneconomists study organizations at least in part because such social constructions are interesting and worth studying in their own right. After all, people in modern societies spend most of their time in organizations. So how these organizations work affects the human condition in many ways that have nothing to do with the products and services they produce.