Managerial Economics & Organizational Architecture 7th Edition (International Edition)

Book Preface

The past few decades have witnessed spectacular business failures and scandals. In 2019, German prosecutors criminally charged top executives at Volkswagen for allegedly misleading shareholders in the months before the so-called Diesel-Gate Scandal became public. Wells Fargo has continued to struggle to regain the confidence of consumers, regulators, and the general public following its 2016 retail banking scandal. In 2007 and 2008, prominent financial institutions around the world shocked financial markets by reporting staggering losses from subprime mortgages. Société Générale, the large French bank, reported over $7 billion in losses due to potentially fraudulent securities trading by one of its traders. JPMorgan Chase bailed out Bear Stearns, a top-tier investment bank, following its massive subprime losses. Washington Mutual and Lehman Brothers were added to the list of “top business failures of all time.” In 2001 and 2002, Enron, WorldCom, and Arthur Andersen, as well as other prominent companies, imploded in dramatic fashion. Around the same time internationally, scandals emerged at companies such as Parmalat, Royal Dutch Shell, Samsung, and Royal Ahold. Due to these cases and many others, executives now face a more skeptical investment community, additional government regulations, and stiffer penalties for misleading public disclosures.

A common perception is that bad people caused many of these problems. Others argue that the sheer complexity of today’s world has made it virtually impossible to be a “good” manager. These views have raised the cry for increased government regulation, which is argued to be a necessary step in averting future business problems.

We disagree with these views. We believe that many business problems result from poorly structured organizational architectures. The blueprints for many of these prominent business scandals were designed into the firms’ “organizational DNA.” This book, in addition to covering traditional managerial economic topics, examines how leaders can structure organizations that channel employees’ incentives into actions that create, rather than destroy, firm value. This topic is critical to anyone who works in or seeks to manage organizations—whether for-profit or not-for-profit.

New Demands: Relevant Yet Rigorous Education

Fifty years ago, teaching managerial economics to business students was truly a “dismal science.” Many students dismissed standard economic tools of marginal analysis, production theory, and market structure as too esoteric to have any real relevance to the business problems they anticipated encountering. Few students expected they would be responsible for their prospective employers’ pricing decisions. Most sought positions in large firms, eventually hoping to manage finance, operations, marketing, or information systems staffs. Traditional managerial economics courses offered few insights that obviously were relevant for such careers. But a new generation of economists began applying traditional economic tools to problems involving corporate governance, mergers and acquisitions, incentive conflicts, and executive compensation. Their analysis focused on the internal structure of the firm—not on the firm’s external markets. In this book, we draw heavily from this research and apply it to how organizations can create value through improved organizational design. We also present traditional economic topics—such as demand, supply, markets, and strategy—in a manner that emphasizes their managerial relevance within today’s business environment.

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Today’s students must understand more than just how markets work and the principles of supply and demand. They also must understand how self-interested parties within organizations interact, and how corporate governance mechanisms can control these interactions. Consequently, today’s managerial economics course must cover a broader menu of topics that are now more relevant than ever to aspiring managers. Yet, to best serve our students, offering relevant material must not come at the expense of rigor. Students must learn how to think logically about both markets and organizations. The basic tools of economics offer students the skill set necessary for rigorous analysis of business problems they likely will encounter throughout their careers.

Besides the heightened interest in corporate governance, global competition and rapid technological change are prompting firms to undertake major organizational restructurings as well as to produce fundamental industry realignments. Firms now attack problems with focused, cross-functional teams. Many firms have shifted from functional organizational structures (manufacturing, marketing, and distribution) to flatter, more process-oriented organizations organized around product or region. Moreover, the pace of change shows no sign of slowing. Today’s students recognize these issues; they want to develop skills that will make them effective executives and prepare them to manage organizational change.

Business school programs are evolving in response to these changes. Narrow technical expertise within a single functional area—whether operations, accounting, finance, information systems, or marketing—is no longer sufficient. Effective managers within this environment require cross-functional skills. To meet these challenges, business schools are becoming more integrated. Problems faced by managers are not just finance problems, operations problems, or marketing problems. Rather, most business problems involve facets that cut across traditional functional areas. Big data, artificial intelligence and data analytics are transforming the way managers make decisions. For these reasons, the curriculum must encourage students to apply concepts they have mastered across a variety of courses.

This book provides a multidisciplinary, cross-functional approach to managerial and organizational economics. We believe that this is its critical strength. Our interests span economics, finance, accounting, information systems, and financial institutions; this allows us to draw examples from a number of functional areas to demonstrate the power of this underlying economic framework to analyze a variety of problems managers face regularly.

We have been extremely gratified by the reception afforded the first six editions of Managerial Economics and Organizational Architecture. Adopters report that the earlier editions helped them transform their courses into one of the most popular courses within their curriculum. This book has been adopted in microeconomics, human resources, and strategy courses in addition to courses that focus specifically on organizational economics. The prior editions presented powerful economic tools and frameworks that enable managers not only to make better strategic and operating decisions, but also to design organizations that motivate self-interested individuals to make choices that increase firm value. Our seventh edition continues to focus on the fundamental importance of both markets and organizational design.

Throughout the book we provide contemporary examples and applications to help students appreciate the managerial relevancy of the material. Among these are case studies of corporate scandals (e.g., Volkswagen and Wells Fargo) that we use to illustrate how poorly designed organizational architectures can be catastrophic. Most other managerial economics textbooks provide little coverage of such managerially critical topics as developing effective organizational architectures, including performance-evaluation systems and compensation plans; assigning decision-making authority among employees; and managing transfer-pricing disputes among divisions. Given the increased importance of corporate governance, this omission has been both significant and problematic. One of our primary objectives in writing this book is to provide current and aspiring leaders with a rigorous, systematic, comprehensive framework for addressing such organizational problems. To that end, we have endeavored to write the underlying theoretical concepts in simple, intuitive terms and illustrate them with numerous examples—most drawn from actual company practice.

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The Conceptual Framework

Although the popular press and existing literature on organizations are replete with jargon—Six Sigma, reengineering, outsourcing, teaming, venturing and empowerment—they fail to provide managers with a systematic, comprehensive framework for examining organizational problems. This book uses economic analysis to develop such a framework and then employs that framework to organize and integrate the important organizational problems, thereby making the topics more accessible.

Throughout the text, readers will gain an understanding of the basic tools of economics and how to apply them to solve important business problems. While the book covers the standard managerial economics problems of pricing and production, it pays special attention to organizational issues. In particular, the book will help readers understand:

• How the business environment (technology, regulation, and competition in input and output markets) drives the firm’s choice of strategy.
• How strategy and the business environment affect the firm’s choice of organizational design—what we call organizational architecture.
• How the firm’s organizational architecture is like its DNA; it plays a key role in determining a firm’s ultimate success or failure because it affects how people in the organization will behave in terms of creating or destroying firm value.
• How corporate policies such as strategy, financing, accounting, marketing, information systems, operations, compensation, and human resources are interrelated and thus why it is critically important that they be coordinated.
• How the three key features of organizational architecture—the assignment of decision-making authority, the reward system, and the performance-evaluation system—can be structured to help managers to achieve their desired results.

These three components of organizational architecture are like three legs of the accompanying stool. Firms must coordinate each leg with the other two so that the stool remains functional. Moreover, each firm’s architecture must match its strategy; a balanced stool in the wrong setting is dysfunctional: Although milking stools are quite productive in a barn, tavern owners purchase taller stools.

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Reasons for Adopting Our Approach

This book focuses on topics that we believe are most relevant to managers. For instance, it provides an in-depth treatment of traditional microeconomic topics (demand, supply, pricing, and game theory) in addition to corporate governance topics (assigning decision-making authority, centralization versus decentralization, measuring and rewarding performance, outsourcing, and transfer pricing). We believe these topics are more valuable to prospective managers than topics typically covered in economics texts such as public-policy aspects of minimum-wage legislation, antitrust policy, and income redistribution. A number of other important features differentiate this book from others currently available, such as:

• Our book provides a comprehensive, cross-functional framework for analyzing organizational problems. We do this by first describing and integrating important research findings published across several functional areas, then demonstrating how to apply the framework to specific organizational problems.
• This text integrates the topics of strategy and organizational architecture. Students learn how elements of the business environment (technology, competition, and regulation) drive the firm’s choice of strategy as well as the interaction of strategy choice and organizational architecture.
• Reviewers, instructors, and students found the prior editions accessible and engaging. The text uses intuitive descriptions and simple examples; more technical material is provided in appendices for those who wish to pursue it.
• Numerous examples drawn from the business press and our experiences illustrate the theoretical concepts. These illustrations, many highlighted in boxes, reinforce the underlying principles and help the reader visualize the application of more abstract ideas. Each chapter begins with a specific case history that is used throughout the chapter to unify the material and aid the reader in recalling and applying the main constructs.
• Nontraditional economics topics dealing with strategy, corporate culture, outsourcing, leadership, organizational form, corporate ethics, and the implementation of management innovations are examined. Business school curricula often are criticized for being slow in covering topics of current interest to business, such as corporate governance. The last six chapters examine recent management trends and demonstrate how the book’s framework can be used to analyze and understand topical issues.
• Problems, both within and at the end of chapter, are drawn from real organizational experience—from the business press as well as our contact with executive MBA students and consulting engagements. We have structured exercises that provide readers with a broad array of opportunities to apply the framework to problems like ones they will encounter as managers.

Organization of the Book

• Part 1: Basic Concepts lays the groundwork for the book. Chapter 2 summarizes the economic view of behavior, stressing its management implications. Chapter 3 presents an overview of markets, provides a rationale for the existence of organizations, and stresses the critical role of the distribution of knowledge within the organization.

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• Part 2: Managerial Economics applies the basic tools of economic theory to the firm. Chapters 4 through 7 cover the traditional managerial-economics topics of demand, production and cost, market structure, and pricing. These four chapters provide the reader with a fundamental set of microeconomic tools and use these tools to analyze basic operational policies such as input, output, and product pricing decisions. Chapters 8 and 9 focus on corporate strategy—the former on creating and capturing values and the latter on employing game theory methods to examine the interaction between the firm and its competitors, suppliers, as well as other parties. These chapters also provide important background material for the subsequent chapters on organizations: A robust understanding of the market environment is important for making sound organizational decisions. Chapter 10 examines conflicts of interest that exist within firms and how contracts can be structured to reduce or control these conflicts.
• Part 3: Designing Organizational Architecture develops the core framework of the book. Chapter 11 provides a basic overview of the organizational-design problem. Chapters 12 and 13 focus on two aspects of the assignment of decision rights within the firm—the level of decentralization chosen for various decisions followed by the bundling of various tasks into jobs and then jobs into subunits. Chapters 14 and 15 examine compensation policy. First, we focus on the level of compensation necessary to attract and retain an appropriate group of employees. We then discuss the composition of the compensation package, examining how the mix of salary, fringe benefits, and incentive compensation affects the value of the firm. In Chapters 16 and 17, we analyze individual and divisional performance evaluation. Part 3 concludes with a capstone case on Arthur Andersen.
• Part 4: Applications of Organizational Architecture uses the framework that we have developed to provide insights into contemporary management issues. Chapters 18 through 23 discuss the legal form of organization, outsourcing, leadership, regulation, ethics, and management innovations.

Fitting the Text into the Business Curriculum

Our book is an effective tool for a variety of classes at the MBA, executive MBA, and undergraduate levels. Although this text grew out of an MBA elective course in the economics of organizations at the University of Rochester, the book’s modular design allows its use in a variety of courses. We have been encouraged by the creativity instructors have shown in the diversity of courses adopting this text. Besides the introductory microeconomics course, this book also is used in elective courses on corporate governance, strategy, the economics of organizations, and human resources management. The basic material on managerial economics is presented in the first 10 chapters. The tools necessary for understanding and applying the organizational framework we develop within this text have been selected for their managerial relevance. In our experience, these economics tools are invaluable for those students with extensive work experience, and for those who didn’t major in economics as an undergraduate. Those with an economics background may choose to forgo components of this material. We have structured our discussions of demand, production/cost, market structure, pricing, and strategy to be optional. Thus, readers who do not require a review of these tools can skip Chapters 4 through 9 without loss of continuity.

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We strongly recommend that all readers cover Chapters 1 through 3 and 10; these chapters introduce the underlying tools and framework for the text. Chapters 4 through 9, as we noted above, cover the basic managerial-economics topics of demand, costs, production, market structure, pricing, and strategy. Chapters 11 through 17 develop the organizational architecture framework; we recommend that these be covered in sequence. Finally, Chapters 18 through 23 cover special managerial topics: outsourcing, leadership, regulation, ethics, and the process of management innovation and managing organizational change. They are capstone chapters—chapters that apply and illustrate the framework. Instructors can assign them based on their specific interests and available time.

Seventh Edition

This book is noted for using economics to analyze real-world management problems. The seventh edition maintains and extends this focus.

Basic economic principles and concepts do not change greatly over time. Key frameworks, such as supply and demand analysis, have existed for over 100 years and have stood the test of time. What does change with reasonable rapidity is the business environment, the quantity of data useful for decision making, and the corresponding demands placed on managers. Examples and illustrations of economic concepts that were highly relevant just a few years ago quickly become outdated and hard for students to relate to.

This edition continues to focus on core economic concepts that are critical for managers. It significantly updates the motivating case studies that permeate each chapter, as well as the problem sets, boxed materials and exhibits. Updated references and recent relevant research are cited. Data has been updated, where appropriate. These changes will help students to better understand how economics can be used both to compete in today’s marketplace and to design more effective organizations.

Supplements

The following ancillaries are available for quick download and convenient access via the Instructor Library material available through McGraw-Hill Connect^®.

• PowerPoint Presentations: Fully updated for the sixth edition, each chapter’s PowerPoint slides are closely tied to the book material and are enhanced by animated graphs. You can edit, print, or rearrange the slides to fit the needs of your course.
• Test Bank: The test bank offers hundreds of questions categorized by level of difficulty, AACSB learning categories, Bloom’s taxonomy, and topic.
• Test Builder in Connect: Available within Connect, Test Builder is a cloud-based tool that enables instructors to format tests that can be printed or administered within a LMS. Test Builder offers a modern, stream-lined interface for easy content configuration that matches course needs, without requiring a download.
• Test Builder allows you to:
  • Access all test bank content from a particular title.
  • Easily pinpoint the most relevant content through robust filtering options.

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  • Manipulate the order of questions or scramble questions and/or answers.
  • Pin questions to a specific location within a test.
  • Determine your preferred treatment of algorithmic questions.
  • Choose the layout and spacing.
  • Add instructions and configure default settings.

  Test Builder provides a secure interface for better protection of content and allows for just-in-time updates to flow directly into assessments.

• Instructor’s Manual: The instructor’s Manual provides chapter overviews, teaching tips, and suggested answers to the end-of-chapter Self-Evaluation Problems and Review Questions.

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