As a result of the spectacular scandals surrounding Enron, Arthur Andersen, Global Crossing, WorldCom, and Adelphia, the business environment has changed dramatically. “Corporate governance” is now the watchword in corporate board rooms, capital markets, and government agencies. Executives now face additional government regulations, stiffer penalties for misleading public disclosures, as well as a more skeptical investment community. The common perception is that bad people caused the massive failures of the past and that more government oversight will solve these problems. We disagree. We argue that these business debacles primarily resulted from badly designed organizational architectures. The blueprints for their destruction were designed into the firms’ “organizational DNA.” This book examines how organizations govern themselves by designing corporate control mechanisms that channel managers’ incentives into actions that create—not destroy—firm value. The topic is critical to anyone who works in or seeks to manage organizations—whether they are for-profit or not-for-profit.

Thirty 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 expected to encounter. Few students expected they would be responsible for the pricing decisions of their future employers. Most sought positions in large firms, eventually hoping to manage operations, marketing, finance, or information systems staffs. Traditional microeconomics courses offered few insights that were obviously relevant for such careers. But a new generation of economists began applying traditional microeconomic tools to problems involving corporate governance, incentive conflicts, executive compensation, and mergers and acquisitions. These economists focused on the internal structure of the firm, not on the firm’s external markets. This book draws heavily from this research on organizations and applies it to how organizations govern themselves.

New Demands: Relevant Yet Rigorous Education

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 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 facing this post-Enron world. 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 will likely 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 are shifting from functional organizational structures (manufacturing, marketing, and distribution) to flatter, more process-oriented organizations. Moreover, this 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 elements that cut across traditional functional areas. For that reason, 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 three 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 were founded on powerful economic tools of analysis that examine how managers can design organizations that motivate self-interested individuals to make choices that increase firm value. Our fourth edition continues to focus on the fundamental importance of markets and organizational design. We use the failures of Enron (Chapter 1), Arthur Andersen (Chapter 22), and Adelphia (Chapter 10) as case studies to illustrate how poorly designed organizational architectures can be catastrophic. Other books 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. Our primary objective in writing this book is to provide current and aspiring managers 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.

The Conceptual Framework

Although the popular press and existing literature on organizations are replete with jargon—TQM, reengineering, outsourcing, teaming, venturing, empowerment, and corporate culture—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.

Through 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; the firm’s ultimate success or failure can be traced back to its organizational architecture, which will affect 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 allow 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 would purchase taller stools.

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. For example, the effect of the 9/11 terrorist attacks on demand curves is described in Chapter 4 and how one devastated company located in the World Trade Center responded is discussed in Chapter 14. 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, 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.
• Cases and end-of-chapter problems 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.

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 level. 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 Parts 1 and 2—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.

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. Part 3 (Chapters 11 through 17) develops the organizational architecture framework; we recommend that these be covered in sequence. Finally, Part 4 (Chapters 18 through 23) covers 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.