The Value Of Tough Bosses

What does the “logic of group behavior” have to do with the direct interest of MBA students who seek to run businesses and direct the work of others? In a word, “plenty,” as we will see throughout the rest of the book. We will show how the “logic” is central to
19 These points have been made in a much more complete and technical manner by Armenia A. Alton and Harold Demotes, “Production, Information Costs, and Economic Organization,” American Economic Review, vol. 62, pp. 777-795, December 1972 20 Some managers in the Soviet Union are paid less than industrial workers in the United States; however, the ratio of a manager’s salary to a worker’s salary is typically greater in the Soviet Union.
how competitive markets (and cartels) work and will discuss a multitude of ways to apply the “logic” directly to management problems.
For now, we can stress a maxim that emerges from the economic view of group behavior: Being (or having) a tough boss is tough, but a boss who isn’t tough isn’t worth much. And because tough bosses are valuable, and lenient bosses are not, there is a reason for believing that existing organizational arrangements serve to impose the discipline on bosses necessary to ensure that they do a good job imposing discipline on the workforce. Competition will press firms to hire tough bosses, and, as we will show in this chapter, the owners of the firm, or their manager-agents, not workers, will tend to the bosses. That is to say, owners or their agents will tend to boss workers, not the other way around, for the simple reason that worker-bosses will not likely survive in competitive markets. Workers may not like tough bosses, but we will explain that, if given the option, workers would choose to hire tough bosses.21
Everyone recognizes that firms compete with each other by providing better products at lower prices in a constant effort to capture the consumer dollar. This competition takes place on a number of fronts, including innovative new products, cost cutting production techniques, clever and informative advertising, and the right pricing policy. But a continuing theme of this and other management books is that none of these competitive efforts can be successful unless a firm backs them up with an organizational structure that is competitive -- one that motivates its employees to work diligently and cooperatively. Before addressing the issue of organization, however, let’s first examine why workers value tough bosses. Those firms that do the best job in this organizational competition are the most likely to survive and thrive.
The organizational arrangements used by the most successful firms are most likely to be adopted by other firms, because of the force of profit maximization and market competition. So we should expect business firms to be organized in ways that motivate bosses to work diligently at motivating workers to work diligently and at the least cost. We should expect that the choice between workers and owners of capital as to which group will market the better bosses will depend on which group can be expected to press the other to work the most diligently or at the least cost. We have already given away the answer: Owners (or their manager-agents) will tend to boss the workers, a perfectly acceptable outcome for the owners, of course, but also for the workers, which might not be expected. To understand that point, we must first appreciate why workers would want tough bosses.
Take this Job and . . .
Though probably overstated, common wisdom has it that workers do not like their bosses, much less tough bosses. The sentiment expressed in the well-known country song “Take This Job and Shove It” could only be directed at a boss. Bosses are also the butts of much humor. There is the old quip that boss spelled backward is “Double SOB.”
21 As we will see, even when workers own the firm and could be their own bosses, they invariably hire a boss, typically a tough one at that.
And there is the story about the fellow who went to the president of a major university and offered his services as a full professor. Noticing that the fellow had no advanced degree, the president informed him that he was unqualified. The fellow then offered his services as an associate professor and received the same response. After offering his services as an assistant professor and hearing that he was still unqualified, the fellow muttered. “I’ll be a Son-of-a-Bitch,” at which point the president said, “Why didn’t you tell me earlier? I’m looking for someone to be dean of the business school.”
If it were not for an element of truth contained in them, such jokes would be hopelessly unfunny. Bosses are often unpopular with those they boss. But tough bosses are much like foul tasting medicines are for the sick; you don’t like them, but you want them anyway because they are good for you. Workers may not like tough bosses, but they willingly put up with them because tough bosses mean higher productivity, more job security, and better wages.
The productivity of workers is an important factor in determining their wages.22 More productive workers receive higher wages than less productive workers. Firms would soon go bankrupt if they paid workers more than their productivity indicated they should be paid, but firms would soon lose their workers if they paid them less than their productivity.
Many things, of course, determine how productive workers are. The amount of physical capital they work with, and the amount of experience and education (human capital) the workers bring to their jobs are two extremely important, and commonly discussed, factors in worker productivity. But how well the workers in a firm work together as a team is also important (a point that will become more apparent in the “Manager’s Corner” on “The Value of Teams” later in this chapter). An individual worker can have all the training, capital and diligence needed to be highly productive, but productivity will suffer unless other workers pull their weight by properly performing their duties. The productivity of each worker is crucially dependent upon the efforts of all workers in the vast majority of firms.
So all workers are better off if they all work conscientiously on their individual tasks and as part of a team. In other words, it is collectively rational for everyone to work responsibly. But there is little individual motivation to work hard to promote the collective interest of the group, or firm.23
While each worker wants other workers to work hard to maintain the general productivity of the firm, each worker recognizes that her contribution to the general productivity is small. By shirking some responsibilities, she receives all of the benefits from the extra leisure but suffers from only a very small portion of the resulting productivity loss, which is spread over everyone in the firm. She suffers, of course, from some of the productivity loss when other workers choose to loaf on the job, but she
22 It is also true, as we will see in a later chapter, that how wages are paid can be an important factor in determining how productive workers are.23 This line of analysis has been developed at length by Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, Mass.: Harvard University Press, 1965).
knows that the decisions others make are independent of whether she shirks or not. And if everyone else shirks, little good will result for her, or for the firm, from diligent effort on her part. So no matter what she believes other workers will do, the rational thing for her to do is to capture the private benefits from shirking at practically every opportunity. With all other workers facing the same incentives, the strong tendency is for shirking on the job to reduce the productivity, and the wages, of all workers in the firm, and quite possibly to threaten their jobs by threatening the firm’s viability.
The situation just described is another example of the general problem of the logic of group behavior, or more precisely a form of the prisoners’ dilemma that is endemic to that logic. This involves a classic police interrogation technique in which officers separate two suspects, indicating to each that if she confesses, then she will get off with light charges and penalties. Collectively, they might both be better off if neither confesses (which implies that the two suspects work together for their common objective, a lighter sentence), but each can be even better off if she confesses while her cohort doesn’t. More formally, a prisoners’ dilemma is a situation in which each individual is better off by acting independently of other parties in the group, no matter what the other parties do, but all parties in the group are better off by working together.
Consider a slightly different form of the prisoner’s dilemma that is described in the matrix in Table 5.1, which shows the payoff to Jane for different combinations of shirking on her part and shirking on the part of her fellow workers.24 No matter what Jane believes others will do, the biggest payoff to her (in terms of the value of her expected financial compensation and leisure time) comes from shirking. Clearly, she hopes everyone else works responsibly so that general labor productivity and the firm’s profits are high despite her lack of effort, in which case she receives the highest possible payoff that any one individual can receive of 125.25 Unfortunately for Jane, all workers face payoff possibilities similar to the ones she faces (and to simplify the discussion, we assume everyone faces the same payoffs). So everyone will shirk which means that everyone will end up with a payoff of 50, which is the lowest possible collective payoff for workers.26
Workers are faced with self-destructive incentives when their work environment is described by the shirking version of the prisoners’ dilemma (which we have discussed now in several other contexts). It is clearly desirable for workers to extricate themselves from this prisoners’ dilemma. They can double their gain. But how?
24 The payoff can be in dollars, utility, or any other unit of measure. The only important consideration is that higher numbers represent higher payoffs. This is in contrast to the original prisoners’ dilemma example in which the number in the payoff matrix represented the length of prison sentences, so the higher number represented lower payoffs. 25 Of course, not everyone can receive this payoff.26 Jane would receive a lower payoff of 25 if she were the only one who did not shirk, but because of her effort the collective payoff would be higher than if she did shirk, as her effort would raise the payoff to the shirkers to something slightly higher than 50.
Table 5.1 The Inclination to shirk on the Job
Other Workers None shirk Some shirk All shirk
Don’t shirk 100 75 25 Jane
Shirk 125 100 50
In an abstract sense, the only way to escape this prisoners’ dilemma is to somehow alter the payoffs for shirking. More concretely, this requires workers to agree to collectively subject themselves to tough penalties that no one individual would unilaterally be willing to accept. While no one will like being subjected to tough penalties, everyone will be willing to accept the discipline those penalties impose in return for having that discipline applied to everyone else.
The situation here is analogous to many other situations we find ourselves in. For example, consider the problem of controlling pollution that was briefly mentioned in an earlier chapter. While each person would find it convenient to be able to freely pollute the environment, when everyone is free to do so we each lose more from the pollution of others than we gain from our own freedom to pollute. So we accept restrictions on our own polluting behavior in return for having restrictions imposed on the polluting behavior of others. Littering and shirking may not often be thought of as analogous, but they are. One pollutes the outside environment and the other pollutes the work environment.
An even better analogy is that between workers and college students. The “productivity” of a college from the student’s perspective depends on its reputation for turning out well-educated graduates with high grade a reliable indication that a student has worked hard and learned a lot. But students are tempted to take courses from professors who let them spend more time at parties than in the library and still give high grades. But if all professors curried favor with their students with lax grading policies, all students would be harmed as the value of their degrees decreased. While students may not like the discipline imposed on them by tough professors, they want tough professors to help them maintain the reputation of their college and the value of their diplomas. (The ideal situation for each student is for the professor to go easy on him or her alone and to be demanding of all other students.27)
Similarly, workers may not like bosses who carefully monitor their behavior, spot the shirkers and ruthlessly penalize them, but they want such bosses. We mean penalties sufficiently harsh to change the payoffs in Table5.1 and eliminate the prisoners’ dilemma. As shown in Table 5.1, the representative worker Jane captures 25 units of benefits from shirking no matter what other workers do. If she had a boss tough enough to impose more than 25 units of suffering, say 35 units, on Jane if she engaged in shirking, her relevant payoff matrix would be transformed into the one shown in Table 5.2. Jane may not like her new boss, but she would cease to find advantages in shirking. And with a
27 See Dwight Lee, “Why It Pays to Have Tough Profs,” The Margin (September/October 1990): 28-29.
tough boss monitoring all workers, and unmercifully penalizing those who dare shirk, Jane will find that she is more than compensated because her fellow workers have also quit shirking. Instead of being in an unproductive firm, surrounded by a bunch of other unproductive workers, each receiving a payoff of 50, she will find herself as part of a hard-working, cooperative team of workers, each receiving a payoff of 100.
The common perception is that bosses hire workers, and in most situations this is what appears to happen. Bosses see benefits that can be realized only by having workers, and so they hire them. But since it is also true that workers see benefits that can be realized only from having a boss, it is reasonable to think of workers hiring a boss, and preferably a tough one.
Table 5.2 Shirking in Large Worker Groups
Other Workers
None shirk Some shirk All shirk
Don’t shirk 100 75 25 Jane
Shirk 90 65 15
Actual Tough Bosses
The idea of workers hiring a tough boss is illustrated by an interesting, though probably apocryphal, story of a missionary in 19th century China. Soon after arriving in China, the missionary, who was then full of enthusiasm for doing good, came upon a group of men pulling a heavily loaded barge up a river. Each man was holding on to a rope attached to the barge as he struggled forward against the river’s current, while on the barge was a large Chinaman with a long whip with which he lashed the back of anyone who let his rope go slack. Upon seeing this, the missionary experienced a surge of indignation and rushed up to the group of Chinamen to inform them that he would put an end to such outrageous abuse. Instead of being appreciative of the missionary’s concern, however, the Chinamen told him to butt out, that they owned the barge, they earned more money the faster they got the cargo up the river, and they had hired the brute with the whip to eliminate the temptation each would otherwise have to slack off.
The missionary story may be doubted, but the point shouldn’t be. Even highly skilled and disciplined workers can benefit from having a “boss” help them overcome the shirking that can be motivated by the prisoners’ dilemma. Consider the experience related by Gordon E. Moore, a highly regarded scientist and one of the founders of Intel, Inc. Before Intel, Moore and seven other scientists entered a business venture that failed because of what Moore described as “chaos.” Because of the inability of the group of scientists to act as an effective team in this initial venture, before embarking on their
next, according to Moore, “the first thing we had to do was to hire our own boss -¬essentially hire someone to run the company.”28
Pointing to stories and actual cases where the workers hire their boss is instructive in emphasizing the importance of tough bosses to workers. But the typical situation finds the boss hiring the workers, not the other way around. We will explain later why this is the case, but we can lay the groundwork for such an explanation by recognizing that our discussion of the advantages of having tough bosses has left an important question unanswered. An important job of bosses is to monitor workers and impose penalties on those who shirk, but how do we make sure that the bosses don’t shirk themselves? How can you organize a firm to make sure that bosses are tough?
The work of a boss is not easy or pleasant. It requires serious effort to keep close tabs on a group of workers. It is not always easy to know when a worker is really shirking or just taking a justifiable break. A certain amount of what appears to be shirking at the moment has to be allowed for workers to be fully productive over the long run. There is always some tension between reasonable flexibility and credible predictability in enforcing the rules, and it is difficult to strike the best balance. Too much flexibility can lead to an undisciplined workforce, and too much rigidity can destroy worker morale. Also, quite apart from the difficulty of knowing when to impose tough penalties on a worker is the unpleasantness of doing so. Few people enjoy disciplining those they work with by giving them unsatisfactory progress reports, reducing their pay, or dismissing them. The easiest thing for a boss to do is not to be tough on shirkers. But the boss who is not tough on shirkers is also a shirker.
A boss can also be tempted to form an alliance with a group of workers who provide favors in return for letting them shirk more than other workers. Such a group improves its well being at the expense of the firm’s productivity, but most of this cost can be shifted to those outside the alliance.
Of course, you could always have someone whose job it is to monitor the boss and penalize him when he shirks on his responsibility to penalize workers who are shirking. But two problems with this solution immediately come to mind. One, the second boss will be even more removed from workers than the first boss, and so will have an even more difficult time knowing whether the workers are being properly disciplined. Second, and even more important, who is going to monitor the second boss and penalize him or her for shirking? Who is going to monitor the monitor? This approach leads to an infinite regression, which means it leads nowhere. The solution to the problem is the one workers should want by making sure that the boss has some incentive to be tough. The workers should want their bosses to be “incentivized” to remain tough in spite of all the temptations to concede in particular circumstances for particular workers.
28 See Gordon E. Moore, “The Accidental Entrepreneur,” Engineering & Science, vol. 62, no. 4 (Summer 1994): 23-30.
The Role of the Residual Claimant
Every good boss understands that he or she has to be more than just “tough.” A boss needs to be a good “leader,” a good “coach,” and a good “nurse maid,” as well as many other things. The good boss inspires allegiance to the firm and the commonly shared, corporate goals. Every good boss wants workers to seek the cooperative solutions in the various prisoners’ dilemmas that invariably arise in the workplace. Having said that, however, a good boss will invariably be called upon to make some pretty tough decisions, mainly because the boss usually stands astride the interests of the owners above and the workers below. The lesson of this “Manager’s Corner” to this point should not be forgotten, “Woe be to the boss who simply seeks to be a nice guy to all claims.” But firms must structure themselves so that bosses will want to be tough. How can that be done?
In many firms the boss is also the owner. The owner/boss is someone who owns the physical capital (such as the building, the land, the machinery, and the office furniture), provides the raw materials and other supplies used in the business, and hires and supervises the workers necessary to convert those factors of production into goods and services. In return for assuming the responsibility of paying for all of the productive inputs, including labor, the owner earns the right to all of the revenue generated by those inputs.
Economists refer to the owners as residual claimants (a concept first introduced in our discussion of property rights), since they are the ones who claim any residual (commonly referred to as profits) that remains from the sales revenue after all the expenses have been paid. As the boss, the owner is responsible for monitoring the workers to see if each one of them is properly performing his or her job, and for applying the appropriate penalties (or encouragement) if they aren’t. By combining the roles of ownership and boss in the same individual, a boss is created who, as a residual claimant, has a powerful incentive to work hard at being a tough boss.
The employees who have the toughest bosses are likely to be those who work for residual claimants. But the residual claimants probably have the toughest boss of all -¬themselves. There is a lot of truth to the old saying that when you run your own business, you are the toughest boss you will ever have. Small business owners commonly work long and hard since there is a very direct and immediate connection between their efforts and their income.29 When they are able to obtain more output from their workers, they increase the residual they are able to claim for themselves. A residual-claimant boss may be uncomfortable disciplining those who work for her, or dismissing someone who is not doing the job, and indeed may choose to ignore some shirking. But in this case the cost of the shirking is concentrated on the boss who allows it, rather than diffused over a large number of people who individually have little control over the shirking and little motivation to do anything about it even if they did. So with a boss who is also a residual
29 For example, in 1992 wage and salary agricultural workers averaged a 40.6-hour week, while self-employed agricultural workers averaged a 47.1-hour week. See United States Bureau of the Census, Statistical Abstract of the United States: 1993 (113th edition), Washington, DC, 1993: p. 401, table 636.
claimant, there is little danger that shirking on the part of workers will be allowed to get out of hand.
When productive activity is organized by a residual claimant, all resources -- not just labor -- tend to be employed more productively than when those who make the management decisions are not residual claimants. The contrast between government agencies and private firms managed by owner/bosses, or proprietors, is instructive. Examples abound of the panic that seizes the managers of public agencies at the end of the budget year if their agencies have not spent all of the year’s appropriations. The managers of public agencies are not claimants to the difference between the value their agency creates and the cost of creating the value. This does not mean that public agencies have no incentive to economize on resources, only that their incentives to do so are impaired by the absence of direct, close-at-hand residual claimants.30
If, for example, a public agency managed to perform the same service for a hundred thousand dollars a year less than in previous years, the agency administrator would not benefit by being able to put the savings in her pocket. In fact, she would find herself worse off as she would be in charge of an agency with a smaller budget and therefore one less prestigious in the political pecking order. She would also realize that the money she saved by her diligence would be captured by an over-budgeted agency, enhancing the prestige of its less efficient administrator.
The clever public administrator is one who makes sure every last cent, and more, of the budget is spent by the end of the budget year, regardless of whether it is spent on anything that actually improves productivity. Can you imagine a proprietor of a private firm responding to the news that production costs are less than expected by urging his employees to buy more computers and office furniture, and attend more conferences before the end of the year?31
To make the point differently, assume that as a result of your management training you become an expert on maximizing the efficiency of trash pick-up services. In one nearby town the trash is picked up by the municipal sanitation department, financed out of tax revenue, and headed by a public spirited, bureaucratic sanitation professional. In another nearby town the trash is picked up by a private firm, financed by direct consumer charges, and owned by a local businessperson who is proud of her loyal workers and impressive fleet of trash trucks. By applying linear programming techniques
30 Granted, taxpayers could be viewed as the residual claimants to any efficiency improvement resulting from tough managerial decisions in public enterprises, given that efficiency improvement can result in lower tax bills. However, taxpayers have little incentive to closely monitor the activities of public agencies, and, as a matter of fact, do little of it. The reason is simple: Each taxpayer can reason that there is little direct payoff to anyone incurring the costs of monitoring and enforcing greater efficiency in public agencies. [See Gordon Tullock, The Mathematics of Politics (Ann Arbor, Mich.: University of Michigan Press, 1972), especially chap. 7.] 31 You might expect a manager down in the bowels of a large corporation urging his workers to “waste” money at the end of the year, but not someone who has a substantial stake in his or her own decisions. The single proprietor/residual claimant is someone who has total claim to the net income stream, which implies maximum incentive to minimize waste.
to the routing pattern, you discover that each trash service can continue to provide the same pickup with half the number of trucks and personnel currently being used.
Who is going to be most receptive to your consulting proposal to streamline their trash pickup operation, the bureaucratic manager who never misses an opportunity to tell of his devotion to the taxpaying public, or the proprietor who is devoted to her workers and treasures her trash trucks? Bet on this, the bureaucrat will show you the door as soon as he becomes convinced that your idea really would save a lot of taxpayer dollars by reducing his budget by 50 percent.
On the other hand, the proprietor will hire you as a consultant as soon as she becomes convinced that your ideas will allow her to lay off half of her workers and sell half of her trucks. The manager who is also a residual claimant can be depended on to economize on resources despite his or her other concerns. The manager who is not a residual claimant can be depended on to waste resources despite his or her statements to the contrary.32
No matter how cheaply a service is produced, resources have to be employed that could have otherwise been used to produce other things of value. The value of the sacrificed alternative has to be known and taken into account to make sure that the right amount of the service is produced. As a residual claimant, a proprietor not only has a strong motivation to produce a service as cheaply as possible, she also has the information and motivation to increase the output of the service only as long as the additional value generated is greater than the value foregone elsewhere in the economy.
The prices of labor and other productive inputs are the best indicators of the value of those resources in their best alternative uses. So the total wage and input expense of a firm reflects quite well the value sacrificed elsewhere in the economy to manufacture that firm’s product. Similarly, the revenue obtained from selling the product is a reasonable reflection of the product’s value. So proprietors of businesses receive a constant flow of information on the net value their firm is contributing to the economy, and self-interest motivates a constant effort to produce any given level of output, and produce it in the way that maximizes firms’ contributions.
When the one controlling the firm can claim a firm’s profits, those profits serve a very useful function in guiding resources into their most valuable uses. If, for example, consumers increase the value they place on musical earrings (if such were ever made) relative to the value they place on other products, the price of musical earrings will increase in response to increased demand, as will the profits of the firms producing them. The increased profit will give the proprietors of these firms the financial ability, and the motivation, to obtain additional inputs to expand output of this dual-purpose fashion accessory of which consumers now want more. Also, some proprietors of firms making other products will now experience declining profits and find advantages in shifting into
32 Much of the motivation for privatizing municipal services comes from the cost reductions that take place when residual claimants are in charge of supplying these services. There is plenty of evidence that privatization does significantly lower the cost, often by 50 percent or more, of basic municipal services such as trash pick-up, fire protection, and school buses. See James T. Bennett and Manual H. Johnson, Better Government at Half the Price (Ottawa, Ill.: Carolina House, 1983).
production of musical earrings. This redirection of labor and other productive resources continues, driving down prices and profits in musical earring production, until the return in this productive activity is no greater than the return in other productive activities. At this point there is no way to further redirect resources to increase the net value they generate.33
The incentives created by residual-claimant business arrangements do a reasonable job of lining up the interests of bosses with the interests of their workers, their customers, and the general goal of economic efficiency -- using scarce resources to create as much wealth as possible. This alignment of interests is a crucial factor in getting large numbers of people with diverse objectives and limited concern for the objectives of others to cooperate with one another in ways that promote their general well being. Having the residual claimant direct resources is, understandably, an organizational arrangement that workers should applaud. The residual claimant can be expected to press all workers to work diligently, so that wages, fringes, and job security can be enhanced. Indeed, the workers would be willing to pay the residual claimants to force all workers to apply themselves diligently (which is what they effectively do); both workers and residual claimants can share in the added productivity from added diligence.
Certainly this ability to productively harmonize a diversity of interests is a major reason for the emergence and sustainability of residual-claimant business arrangements. But there is another reason why firms are commonly owned and managed by the same person, a reason that helps explain why the typical situation finds the boss hiring the workers instead of the workers hiring the boss.
People differ in a host of ways, and many of their differences have important implications for the type of productive efforts for which they are best suited. For example, both of the authors would have liked to have been successful movie stars, but because we have slightly less charisma than baking soda, we became economists instead. Had we been endowed with even less charm, we would have become accountants. More relevant to the current discussion, however, is the fact that people differ in their willingness to accept risk. Most people are what economists call risk averse; they shy away from activities whose outcomes are not known with reasonable certitude. Such people might, for example, prefer a sure $500 than a 50 percent chance of receiving $1,500 with a 50 percent chance of losing $500 (which has an expected value of $500).34
33 The profits received by firms that are too large to be managed by single proprietors also serve to direct resources into their highest valued uses. But this is true because these firms are organized in ways that allow the owners (the residual claimants) to exert some control over those who manage the firm (the hired bosses). The problem that owners of large corporations face in controlling managers is discussed in subsequent chapters.34 The prevalence of insurance reflects the risk averseness of most people. Insurance allows people to experience a relatively small loss with 100 percent probability (their insurance premiums) in order to avoid a small chance of a much larger loss, but a loss with an expected value that is less than the insurance premiums. It is interesting to note, however, that the same people who buy fire insurance on their house will also buy lottery tickets. Buying a lottery ticket reflects risk-loving behavior since you are taking a small loss with 100 percent probability (the price of the lottery ticket) in order to take a chance on a payoff that is smaller in expected value than the loss. Explanations exist for why rational individuals would buy insurance and gamble. Probably the best known of these explanations was given by M. Friedman and L. J.
But some people are more risk averse than others, as measured by how much less than $500 a sure payoff would have to be before they would no longer prefer it to a gamble with a $500 expected value. And people who are highly risk averse will make very different career choices than those who are not.
Consider the choice between becoming a residual claimant by starting your own business and taking a job offered by a residual claimant. The choice to become a residual claimant is a risky one, requiring the purchase of productive capital and the hiring of workers (thereby obligating yourself to fixed payments) with no guarantee that the revenue generated will cover those costs. The person who starts a firm can lose a tremendous amount of money. Of course, in return for accepting this risk a residual claimant who combines keen foresight, hard work, and a certain amount of luck may end up claiming a lot of residual and becoming quite wealthy. Clearly, those willing to accept risks will tend to be attracted to a career of owning and managing businesses as residual claimants.
Those people who are more risk averse will tend to avoid the financial perils of entrepreneurship. They will find it more attractive to accept a job with a fixed and relatively secure wage, even though the return from such a job is less than the expected return from riskier entrepreneurial activity.
So business arrangements that put management control in the hands of residual claimants not only create strong incentives for efficient decisions, they also allow people to occupationally sort themselves out in accordance with an important difference in their productive attributes and their attitude toward risk. Not only will people who are not very risk averse be more comfortable as residual claimants than most people, they will generally be more competent at dealing with the risks that are inherent in organizing production in order to best respond to the constantly changing preferences of consumers. At the same time, those who are not averse to taking risks are likely less reliable at the relatively routine and predictable activity typically associated with earning a fixed wage than are those who are highly averse to risk.
By having people sort themselves into jobs according to their willingness to assume risk, the risk cost of doing business is minimized. And remember that when firms face competition in either their resource or product markets, they must look to lower all costs as much as possible. Otherwise, the firms’ very existence can be threatened by those firms who pay attention to costs, including costs that are as hard to define as risk costs. If the firms that don’t pay attention to costs avoid outright closure from being underpriced by competitors, they will be taken over by investors who detect an unexploited opportunity -- who buy the firms (or their stock) at a low price and sell them at a higher price after restructuring the firms to lower their costs.
Consider the prospect that more risk-averse workers own their firms and hire the less risk-averse owners of capital (as well as other resources) who would be paid a fixed
Savage [“The Utility Analysis of Choices Involving Risk,” Journal of Political Economy , vol. 56 (August 1948), pp. 279-304]. But the fact remains than in situations that would put a significant amount of their wealth or income at risk, most people are risk averse.
return on their investments (with the fixed return having all the guarantees that are usually accorded worker wages).35 Workers would then, in effect, be the residual claimants, and worker wages would then tend to vary (as do profits in the usual capitalist-owned firm) in less than predictable ways with the shifts in market forces and general economic conditions. Such a firm would not likely be a durable arrangement for even moderately large firms in which fixed investments are important. It’s not hard to see why.36
The workers might be spurred to work harder and smarter because of the sense of ownership, which the proponents of worker ownership argue would be the case. But then, maybe not. Workers might be more inclined to shirk, given they are no longer pushed to work harder and smarter by owner-capitalists. And each worker can reason that his or her contribution to profits is very little (especially in large firms), so little that the power of residual claimacy is lost in the dispersion of ownership among workers. For this reason alone, we would expect most worker-owned firms to be relatively small.
Risk-averse worker-owners would require a “risk premium” built into their expected incomes, and their risk premium would be greater than the risk premium that the less averse owners of capital would require. Hence, the cost of doing business for the worker-owned firm would be higher than for the capitalist-owned firm, which means the worker-owned firms would tend to fail in competition with capitalist-owned firms. Instead of outright failure, we might expect many worker-owned firms to be converted to capitalist-owned firms simply because the workers would want to sell their ownership rights to the less risk-averse capitalists who, because of their lower risk aversion, can pay a higher price for ownership rights than other workers. The net income stream would be higher under the capitalist-owned firm, which means that the capital owners could pay more for the firm than it is worth to the workers. (The worker-owned firms would continue only if the workers were not allowed to sell their supposed ownership rights, which was true in the former Soviet Union and Yugoslavia.)
However, the worker-owned firm would be fraught with other competitive difficulties. Because of their risk aversion, workers would demand higher rates of return on their investments, a fact that would likely restrict their investments and lower their competitiveness and viability over the long run. Moreover, with workers are in control of the flow of payments to the capitalists after they, the capitalists, have made the fixed investment, the capitalists would have a serious worry. The capitalists must fear that the workers would tend to use their controlling position to appropriate the capital through non-competitive wages and fringe benefit payments to themselves, a fear that is not so prominent among workers when capitalists own the fixed assets and pay the workers a fixed wage.37 Therefore, even the capitalists would require a risk premium before they invested in worker-owned firms.
35 In effect, the owners of capital would hold financial assets that would have the look and feel of bonds. 36 For an extended discussion of points in this section, see Michael C. Jensen and William H. Meckling, “Rights and Production Functions: An Application to Labor-Managed Firms and Codetermination,” Journal of Business, vol. 52, no. 4 (1979), pp. 469-506. 37 See the discussion of why workers do not own firms by Benjamin Klein, Robert G. Crawford, and Armen A. Alchian, “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,”
Of course, the workers could make the requisite investment, but we must wonder where they will obtain the investment funds. Out of their own pockets? Would they not want to put their own funds in secure investments? We must also wonder if workers would be interested in investing in their own worker-run firms. Like capitalists, workers can understand the threat to their investments from other workers, given the limited competitiveness of their worker-owned firms and the tendency of workers to restrict investment and drain the capital stock through over-payments in wages and fringes. Workers, however, have an additional problem: if they invest their financial resources in their own firms, then they will have a very narrow range of personal investments. By their work for their firms, they already plan to invest a great deal of their resources in their jobs just by spending time at work. Adding a financial investment means they will restrict the scope of assets in their personal portfolio of investments. That fact alone will increase their aversion to risky investments by their firm, and the longer the term of the investment, the greater the risk. Accordingly, we would expect the investments of worker-owned firms to be for shorter periods than would be the case in capitalist-owned firms, which implies that worker-owned firms would tend to lag in the development and application of new technologies. Such a tendency would once again make worker-owned firms less competitive, especially over the long run.
We are not suggesting that no firms will be worker-owned and managed. After all, some are. Instead, the analysis explains why there are relatively few such firms, and why they are typically small firms, relying primarily on human capital of the owner/workers rather than physical capital. When large firms, such as Weirton Steel and United Airlines, are worker-owned, they are not worker-managed. The worker-owners of such firms immediately hire bosses to make the tough decisions that have to be made to keep a firm viable, but then there are the inevitable tensions that come with worker ownership.
Worker-Owned Firms
Weirton Steel Company was taken over by employees in 1983. For a while it was a big success as workers put in long hours, helped each other outside their narrow work rule responsibilities, and did what it took so they could say “We kept the job moving,” as maintenance worker Frank Slanchik said. But soon distrust built between workers and
Journal of Law and Economics, vol. 21 (1978), pp. 297-326. The problem of appropriation by workers is especially acute if the fixed assets are firm specific because they have no alternative use, which implies a limited resale value. As we have seen in other instances, owners of fixed assets with limited resale values open themselves to opportunistic behavior on the part of the buyer, in this case, the workers, who, once the specific investment is made, can appropriate the difference between the purchase and resale price. Workers hired by their capitalist-owners do not generally have the same worry about their work-related investments with their capitalist-owners. The workers’ investments in their job-related skills are typically not firm specific. If workers need firm-specific skills, the workers can protect themselves from appropriation by having their firm pay for the investment they might make in firm-specific skills. Put another way, when human capital is relatively important on the job, we would expect the workers to also be the owners, which tends to be the case in accounting and law firms in which the ratio of human to physical capital investments tend to be high.
their managers (they still hire managers). The two big issues were money and management control. Slanchik notes, “These two issues are especially likely to crop up in capital-intensive industries such as steel and airlines, which constantly require huge capital expenditures that can be viewed as draining money away from potential wage increases.”38
In July 1994, United Airline workers took an average pay cut of 15 percent for 55 percent interest in the company and 3 of its 12 seats on the airlines board of directors. According to Business Week, worker ownership of United Airlines has worked surprisingly well.39 But even in the case of United, some problems that should have been expected are now evident. The 20,000 United flight attendants never joined the buyout and are still unhappy with the management. And, according to Business Week, “Many other employees still resent the pay cuts they took and suspect the ESOP [Employee Stock Ownership Plan] was foisted on them by greedy corporate executives and investment bankers who walked off with millions.”40 Moreover, the company offended many employees when it announced bonuses for 600 managers under a longstanding incentive-compensation plan. Investors have been reluctant to infuse additional capital into the airline, fearing that the employees would “revolt against cost-cutting decisions.”41
This fear is so far unfounded, but the worker-ownership arrangement took place at the beginning of a very profitable period for airlines, United included. Part of the carrier’s post-buyout success stems from a surge in air travel that has generated a record $2 billion in profits for the industry in 1996. Investors have to worry that when times get tougher in the future, United’s newfound cooperative spirit might be seriously challenged, given that strains are already evident among the different worker groups. The 21,000 United Airlines flight attendants, who have been working without a contract for over a year, are thinking about an attack against United with a tactic known as “Create Havoc Around Our System” – or “Chaos.”42 The tactic consists of unannounced strike of individual flights, which can disrupt the entire schedule of an airline. Although the flight attendant union, the Association of Flight Attendants, says it does not want to invoke Chaos, but given United’s “record profits,” United attendants are “angry” and ready to strike, or so claims Kevin Lum, president of United’s flight attendant association.43
Understandably, investors can’t be sure just how tough United’s workers will be on each other. They also have to fear that the workers would not add their share to the company’s capital stock, by depleting retained earnings with wage increases, and would be tempted to drain the firm of any capital added by outside investors by way of wage
38 Susan, Carey, “ESOP Fables: UAL Worker-Owners May Face Bumpy Ride If the Past Is a Guide,” Wall Street Journal, December 23, 1993, p. 1. 39 See Susan Chandler, “United We Own.” Business Week March 18, 1996, pp. 96-100. 40 Ibid., p. 98. 41 Ibid., p. 99.42 In the WSJ on 24 June 1997 was an article by Susan Carey “United Flight Attendants Warn of ‘Chaos’,” Wall Street Journal, pp. B-1 and B-2. 43 Ibid.
increases. The workers have to worry about the inclination of each worker group to garner firm profits at the expense of other groups and the investors. The workers also have to worry that they have taken over the role of the investors, which is accepting the risk that comes from being residual claimants. The workers’ insecurities can be heightened by the fact that the company’s future will be jeopardized by the absence of the capital that it will need to remain competitive with investor-owned airlines that don’t have the problems and fears that United might have.
We should not be surprised if, at some later date, the workers effectively try to “buy back” some security by selling their stake in their company, giving the investors that right to be tough bosses in exchange for more investment funds and a more certain income stream for workers (with more of their income coming from wages, salaries, and fringe benefits and less of it coming from dividends).
Management Snooping
Technology has given workers a chance to loaf on the job while they appear busy at their desk. All workers have to do is surf the web for entertainment, shopping, and sex sites on their office computers while giving passersby (including their bosses) the impression that they, the workers, couldn’t be more focused on company business. And workers are often good at acting busy and engaged.
At the same time, technology is coming to the rescue of manager/monitors – or bosses who want to be really tough, if not oppressive. Programs such NetNanny, SurfWatch, and CyberPatrol enable managers to block worker access to web sites with certain words on the site, for example, “sex.” However, with the aid of a program called com.Policy from SilverStone Software, managers now can, from their own desktop computers, go much further and check out what worker’s have on their computer screens. The software can take a snapshot of the worker’s computer screen and sends it, via the local area network, to the boss’ screen. If a worker visits an XXX-rated web site or writes a love note to a coworker or someone across the country, managers can know it, and, depending on how tough they want to be, the managers can penalize or dismiss the workers for using company equipment for personal use. Presumably, the managers can, with the aid of the software, increase worker productivity, given that the penalties or threat of penalties, can eliminate worker shirking.
The real question is Should managers use technology that allows them to “snoop” (to use the characterization of the technology’s critics)? Would workers want them to use it? Clearly, there are good reasons managers and workers alike would not want to use the software, it represents an invasion of worker privacy. Many managers and, we suppose, almost all workers, find “snooping” distasteful. But, as in all other business matters, the worker problems must be weighed off against the benefits to the firm and workers.
Workers might not want their privacy invaded at the whim of their bosses, but the workers can understand the now familiar prisoner’s dilemma they are in -- one in which many of the workers might be inclined to misuse their office computers for private gain (entertainment, maintenance of love affairs, and sexual stimulation). In large offices, the
workers can reason that everyone else is misusing (at least to some extent) their computers, that their individual misuse will have an inconsequential impact on the firm’s profitability or survivability, and that they each worker should do what everyone else is doing, take advantage of the opportunity to misuse their computers – even though long-run firm profits and worker wages will suffer as a result of what the workers do (or, rather, don’t do).
Accordingly, workers could welcome the invasion of their privacy, primarily because the gain in income and long-term job security is of greater value than the loss of privacy. Managers can use the software simply because they are doing what their stockholders and workers want them to do, make mutually beneficial trades with their workers, which is, in this case, ask them to give up some privacy in exchange for the prospects of higher wages and security.
At the same time, we should not expect that the above deduction will apply in every worker group. Some worker groups will value their privacy very highly, so highly in fact that in some instances the managers would have to add more to worker wages than the firm could gain in greater productivity from use of the monitoring software. In such cases, use of the software would be nonsensical: it would hurt both the workers and the firm’s bottom line. Put another way, some bosses aren’t as tough as they might want to be simply because, beyond some point, toughness – added “snooping” -- doesn’t pay; it can be a net drain on the company.
Critics of the snooping software are prone to characterize it as “intrusive,” if not “Orwellian.” One such critic was reported to have reacted to the software’s introduction with the comment, “It worries me that with the assistance of a variety of tools that every moment of a person’s workday can be monitored. Workers are not robots that work 24 hours a day without ceasing.”44 We simply don’t see the matter in such black and white terms. The old quip “different strokes for different folks” contains much wisdom, especially in business. We see nothing wrong with employers warning their employees, “The computers are the firm’s, and we reserve the right to snoop on what you are doing with the firm’s equipment as we see fit.” To the extent that the (potential) snooping is seen as a threat to workers, the firm would have to pay in higher wages for the snooping bosses might do. If they did not pay a higher wage for the announcement, workers could be expected to go elsewhere, where the firm explicitly rules out snooping. What is understandably objectionable to employees is the snooping when it is not announced or, worse yet, when managers profess, or just intimate, that they will not use the available technology, but then snoop at will. Such managers not only violate the privacy and trust of their workers, they engage in a form of fraud. They effectively ask their workers to take a lower rate of pay than they would otherwise demand, and then don’t give their workers what they pay for, privacy. Moreover, such after-the-fact snooping doesn’t do what the firm wants, increase beforehand the incentive workers have to apply themselves.
44 As quoted in Lisa Wirthman, “Superior Snooping: New Software Can Catch Workers Goofing Off, But Some Say Such Surveillance Goes Too Far,” Orange County (Calif.) Register, July 20, 1997, p. 1 and 10 (connect section).
Unannounced snooping is just poor management policy on virtually all scores. With announced snooping policies, workers can sort themselves among firms. Those workers who value their privacy or on-the-job entertainment highly can work for firms that don’t snoop. Those workers who value their privacy very little can work for firms that announce that they might snoop. “Different strokes for different folks” can be a means of elevating on-the-job satisfaction.
What firms would be most likely to use the monitoring software (or any other technology that permits close scrutiny of worker behavior)? We can’t give a totally satisfactory answer. Workplace conditions and worker preferences are bound to vary across industries. But we can say with conviction that there is no “one-size/fits-all” monitoring policy. We can only imagine that different firms will announce different levels of snooping -- with some firms ruling it out, other firms adopting close snooping, and still others announcing occasional snooping. And many firms with the same level of snooping can be expected to impose penalties with different levels of severity.
Although we can’t say much in theory about what firms should do, we can note that the snooping software, and similar technologies, would more likely be used in “large” firms where the output of individual workers is hard to detect, measure, and monitor than in “small” firms where output is relatively easy to detect, measure, and monitor precisely because each worker’s contribution to firm output is such a large share of the total. The snooping technology would not likely be used among workers whose incomes are tied strongly to measures of their performance, for example, sales people who are on commission and far removed from the company headquarters. Such workers will suffer a personal cost if they spend their work time surfing the web or writing love notes. Managers should be little more concerned with such workers’ misuse of their company computers than they are concerned about how their workers use their paychecks at the mall. If such workers are not performing (because they are “spending” too much of their pay on net surfing), then the firm should consider the prospect that they need to increase the cost of wasted time by more strongly tying pay to performance (a subject to which we return in a later chapter).
By implication, managers will not likely use the software to monitor employees who are highly creative. “Creativity” does not always happen when workers diligently apply themselves, and often occurs precisely because workers are relaxed, with the ability to do as they pleased without fear of being penalized for goofing off. Firms would probably be more inclined to use the software with employees who are paid by the hour and have little or no personal payoff from working hard and smart. It should go without saying that the more workers value their privacy, the less likely monitoring software will be used. This is because the more workers value their privacy, the more managers would have to pay in higher wages to invade the privacy.
The Reason for Corporations
Competition determines which business arrangements will survive and which will not. The prevalence of single proprietorships is explained by the advantage of this business
form in producing those products the consumers want as inexpensively as possible. But changing circumstances can reduce the competitive advantage of a business arrangement as new arrangements are found to do a better job of organizing productive activity. Technological advances that took place during the latter part of the nineteenth century made it possible to realize huge economies from large scale production in many manufacturing industries. These technological advances shifted the advantage to business organizations that were far too large to be owned and managed by one proprietor, or even by a few. But the advantage of large business firms is reduced by the fact that they make it impossible to concentrate the motivation created by ownership entirely in the hands of those making management decisions.
Those manufacturing firms that developed organizational arrangements that did the best job of reducing the disconnection between the owners’ incentives and the managers’ control were best able to take advantage of economies from large-scale production. The result was a competition that resulted in the development of the modem corporation, the business form that today accounts for most of the value produced in the United States economy, even though small owner-managed firms still make up, by far, the largest number of firms in the economy.
However, it must be remembered (contrary to what is often taught in business books) that the corporation (an organization under which investors have limited liability) was not a creation of the state.45 The corporation emerged before states got into the incorporating business. Groups of private investors formed corporations because they believed that there were economies to be had if they all agreed to create a business in which outside parties could not hold the individual investors liable for more than their investment in the corporation (that is, the investors’ personal fortunes would not be at risk from the operation of the firm, as was and remains true of proprietorships and partnerships). Clearly, such a public announcement of limited liability (made evident with “Inc.” on the end of corporate names) might make lenders weary and cause them to demand higher interest rates on loans. However, the firm would have the offsetting advantage of being able to attract more funds from more investors, increasing firm equity, a force that could not only increase the firm’s ability to achieve scale economies grounded in technology, but would lower risk costs to lenders. Of course, the outside investors could be hard taskmasters, given that they could shift their investment away from firms not maximizing profitably. But that doesn’t mean the workers would find the corporate form unattractive. On the contrary, given the potential scale economies and risk reductions, corporations may provide more secure employment than small proprietorships.
Jack Welch, the chief executive officer of General Electric, has played out the central point of this “Manager’s Corner” because he surely qualifies as a tough boss.
45 Robert Hessen, In Defense of the Corporation (Stanford, Calif.: Hoover Institution Press, 1979) develops this view of the corporation.
Indeed, Fortune once named Welch “America's Toughest Boss.”46 Welch earned his reputation by cutting payrolls, closing plants and demanding more from those that remained open. Needless to say, these decisions were not always popular with workers at GE. But today, GE is one of America's most profitable companies, creating far more wealth to the economy and opportunities for its workers than it would have if the tough and unpopular decisions had not been made. In Welch's words, “Now people come to work with a different agenda: They want to win against the competition, because they know that . . . . customers are their only source of job security. They don't like weak managers, because they know that the weak managers of the 1970s and 1980s cost millions of people their jobs.”47
MANAGER’S CORNER II: The Value of Teams
The central reason firms exist is that people are often more productive when they work together -- in “teams” -- than when they work in isolation from one another but are tied together by markets. “Teams” are no passing and empty management fad. Firms have always utilized them. What seems to be new is the emphasis within management circles on the economies that can be garnered from assigning complex sets of tasks to relatively small teams of workers, those within departments and, for larger projects, across departments. However, “teams” also present problems in the form of opportunities for shirking (which should be self–evident to many MBA students who form their own study and project groups to complete class assignments). A central problem managers face is constructing teams so that they minimize the amount of shirking.
At its defense avionics plant, Honeywell reports that its on-time delivery went from 40 percent in the late 1980s to 99 percent at the start of 1996, when it substituted teams, in which workers’ contributions are regulated by the members, for assembly-line production, in which workers’ contributions are regulated extensively by the speed of the motors that drive the conveyor belts. Dell Computer is convinced that its team-based production has improved quality in its made-to-order mail-order sales. Within twelve months of switching to teams in its battery production, a different company, Electrosource, found its output per worker doubled (with its workforce dropping from 300 to 80 workers).48
If people could not increase their joint productivity by cooperating, we would observe individual proprietorships (with no employees other than the owners) being the most common form of business organization and also the form that contributed most to national production. As it is, while proprietorships outnumber other business forms (for example, partnerships and corporations) by a wide margin, they account for only a minor fraction of the nation’s output. Even then, many proprietorships can’t get along without a few employees. Single-worker firms tend to be associated with the arts. Few artists have
46 Noel M. Tichy and Stratford Sherman, "Jack Welch's Lessons for Success," Fortune (25 January 1993) pp. 86-93.47 Ibid. p. 92.
48 As reported in Paulette Thomas, “Work Week: Teams Rule,” Wall Street Journal, May 28, 1996, p. A1.
employees. Even we are writing this book as a partnership in the expectation that our joint efforts will pay off in a better book than either of us could write alone. We are a “team” of a sort. But notice there are only two of us, and we aren’t about to write a book with a number of others, for reasons explained below. As important as teams can be in business, managers must recognize inherent incentive problems that limit the size of productive teams.
Team Production
To be exact, what do we mean by “team production”? If Mary and Jim could each produce 100 widgets independent of one another and could together produce only 200 widgets, there would be no basis for team production, and no basis for the two to form a firm with all of the trappings of a hierarchy. The added cost of their organization would, no doubt, make them uncompetitive vis a vis other producers like themselves who worked independently of one another. However, if Mary and Jim could produce 250 widgets when working together, then team production might be profitable (depending on the exact costs associated with operating their two-person organization).
Hence, we would define team production as those forms of work in which results are highly interactive: The output of any one member of the group is dependent on what the other group members do. The simplest and clearest form of “team work” is that which occurs when Mary and Jim (and any number of other people) move objects that neither can handle alone from one place to another. The work of people on an assembly line or on a television-advertising project is a more complicated form of teamwork.
Granted, finding business endeavors that have the potential of expanding output by more than the growth in the number of employees is a major problem businesses face, but it is not the only problem and may not be the more pressing day-to-day problem when groups of people are required to do the work. The truly pressing problem facing managers on a daily basis is making sure that the synergetic potential of the workers who are brought together into a team is actually realized, that is, production is carried out in a cost-effective manner, so that the cost of organization does not dissipate the expanded output of, in our simple Mary/Jim example, 50 widgets.49
We often think of firms failing for purely financial reasons. They don’t make a profit, or they incur losses. Firms are said to be illiquid and insolvent when they fail. That view of failure is instructive, but the matter can also be seen in a different light, as an organizational problem and a failure in organizational incentives. A poorly run organization can mean that all of the 50 “extra” widgets that Mary and Jim can produce together are lost in unnecessary expenditures and impaired productivity. If the organizational costs exceed the equivalent of 50 widgets, then we can say that Mary and Jim have incurred a loss, which would force them to adjust their practices as a firm or to part ways.
49We remind the reader that “cost” is the value of that which is foregone when something is done. Cost can be measured in money, but the real cost is the value of that which is actually given up.
Many firms do fail and break apart, not because the potential for expanded output does not exist, but because the potential is not realized when it could be. The people who are organized in the firm can do better apart, or in other organizations, than they can together. That’s what we really mean by reoccurring business “losses.”
Why can’t people always realize their collective potential? There is a multitude of answers that question. Firms may not have the requisite product design or a well-thought-out business strategy to promote the products. Some people just can’t get along; they rub each other wrong when they try to cooperate. Nasty conflicts, which deflect people’s energies at work to interpersonal defensive and predatory actions, can be so frequent that the production potentials are missed.
While recognizing many non-economic explanations for organizational problems, we, however, would like to stay with our recurring theme, that incentives always matter a great deal and they can become problematic within firms. Our general answer to our question, why firms’ potential can go unrealized, is that frequently the firm does not find ways to properly align the interests of the workers with the interests of other workers and the owners. They don’t cooperate like they should.
In our simple firm example, involving only two people, Mary and Jim, each party has a strong personal incentive (quite apart from an altruistic motivation) to work with the other. After all, Mary’s contribution to firm output is easily detected by her and by Jim. The same is true for Jim. Moreover, each can readily tell when the other person is not contributing what is expected (or agreed upon). Each might like to sit on his or her hands and let the other person carry the full workload. However, the potential is not then likely to be realized, given that the active participation of both Mary and Jim is what generates the added production and their reason for wanting to become a firm (or team) in the first place.
Furthermore, Jim can tell when Mary is shirking her duties, and vice versa, just by looking at the output figures and knowing that there is only one other person to blame. Accordingly, when Mary shirks, Jim can “punish” Mary by shirking also, and vice versa, ensuring that they both will be worse off than they would have been had they never sought to cooperate. The agreement Mary and Jim might have to work together can be, in this way and to this extent, self-enforcing, with each checking the other -- and each effectively threatening the other with reprisal in kind. The threat of added cost is especially powerful when Mary and Jim are also the owners of the firm. The cost of the shirking and any “tit for tat” consequences are fully borne by the two of them. There is no prospect for cost shifting.
Two-person firms are, conceptually, the easiest business ventures to organize and manage because the incentives are so obvious and strong and properly aligned. Organizational and management problems can begin to mount, however, as the number of people in the firm or “team” begins to mount.
Everyone who joins a firm may have the same objective as Mary and Jim -- they all may want to make as much money as possible, or reap the full synergetic potential of their cooperative efforts. At the same time, a number of things can happen as the size of
the firm or “team” grows in terms of more employees. Clearly, communication becomes more and more problematic. What the boss says can become muffled and less clear and forceful as the message is spread through more and more people within the firm.
Also, and probably more importantly, as explained in the “logic of group behavior,” incentives begin to change with the growth in the size of groups. Foremost, each individual’s contribution to the totality of firm output becomes less and less obvious as the number of people grows. This is especially true when the firm is organized to take advantage of people’s specialties. Employees often don’t know what their colleagues do and, therefore, are not able to assess their work.
When Mary is one of two people in a firm, then she is responsible for half of the output (assuming equal contributions, of course), but when she is one of a thousand people, her contribution is down to one-tenth of one percent of firm output. If she is a clerk in the advertising department assigned to mailing checks for ads, she might not even be able to tell that she is responsible for one-tenth of a percent of output, income, and profits.
If Mary works for a firm with several hundred thousand workers, you can bet that she has a hard time identifying just how much she contributes to the firm. She can’t tell that she is contributing anything at all, and neither can anyone else. She can literally get lost in the company. If she doesn’t contribute, she and others will have an equally difficult time figuring out what exactly was lost to the firm. Her firm’s survival is not likely to be materially affected by what she does or does not do. She is the proverbial “drop in the bucket,” and the bigger the bucket, the less consequential each drop is. Of course, the same could be said of Jim and everyone else in the firm.
Now, it might be said that all of the “drops” add up to a “bucket.” The problem is that each person must look at what he or she can do, given what all the others do. And drops, taken individually, don’t really matter, so long as there are a lot of other drops around.
Admittedly, if no one else contributes anything to production (there are no other drops in the bucket), the contribution of any one person is material -- in fact, everything. The point is that in large groups and as output expands, each worker has an impaired incentive to do that which is in all of their interests to do -- that is, to make their small contribution to the sum total of what the firm does. All workers may want the bucket to get filled, but to do so takes more than wishful thinking, which often comes in the form of assuming that people will dutifully do that which they were hired to do. The point here is that large-number prisoners’ dilemmas are more troublesome than small-number prisoners’ dilemmas.
A central lesson of this discussion is, as stressed before, not that managers can never expect workers to cooperate. We concede that most people do have – very likely because of genetics and the way they were reared -- a “moral sense,” or capacity to do what they have committed to doing -- that they will cooperate, but only to a degree, given normal circumstances. However, there are countervailing incentive forces embedded in the way groups – or teams – of people work that, unless attention is given to the details of
firm organization, can undercut the power of people’s natural tendencies to cooperate and achieve their synergetic potential. If people were total angels, always inclined to do as they are told or as they said they would do, then the role of managers would be seriously contracted. Even if almost everyone were inclined to do as they were told or committed to doing, still managers would want to have in place policies and an organizational structure that would prevent the few “bad” people from doing real damage to the firm, which, if left unchecked, they certainly could do. The arguments presented also help us answer several questions.
Why are there so many small firms? Many commentators give answers based on technology: Economies of scale (relating strictly to production techniques and equipment) are highly limited in many industries. One very good organizational reason is that many firms have not been able to overcome the disincentives of size, making expansion too costly and uncompetitive.
Why are large firms broken into departments? While it might be thought that the administrative overhead of department structures, which requires that each department have a manager and an office with all the trappings of departmental power, is “unnecessary,” departments are a means firms use to reduce the size of the relevant group within the firm. The purpose is not only to make sure that the actions of individuals can be monitored more closely by bosses, but also that the individuals in any given department can more easily recognize their own and others’ contributions to “output.”
Why do workers have departmental bosses? One reason is that the owners want their instructions to be carried out. Another explanation, one favored by UCLA economists Armen Alchian and Harold Demsetz, is that the workers themselves want someone who is capable of monitoring the output of their co-workers, to prevent than from shirking and to increase the incomes and job security of all workers.50 Workers want someone who is given the authority to fire members who shirk. As discussed under “Manager’s Corner I,” if owners didn’t create bosses, then the workers probably would want them created in many situations for many of the same reasons and from much the same mold as do owners.
Why is there so much current interest in “teams”? As acknowledged, we suspect that the concept of teams in industry has always been around and used for a long time. After all, we have worked as members of “teams” (mainly, departments of business and economics professors) for all of our careers. However, it is also likely that over recent decades, managers probably became far too enamored with the dictates of “scientific management,” which focused on the means of controlling workers with punishments and rewards that come from bosses who are outside (and above) the workers’ immediate working group. Managers tried with some success to reduce shirking with the introduction of the assembly lines, under which the speed of the assembly-line belt determined how fast workers worked (with the presumption that workers would not have much leeway to adjust behavior, which might have been true for the pace of the work

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