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«DRUID Working Paper No 03-10 “Tying the Manager’s Hands”: How Firms Can Make Credible Commitments That Make Opportunistic Managerial ...»

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DRUID Working Paper No 03-10

“Tying the Manager’s Hands”:

How Firms Can Make Credible

Commitments That Make Opportunistic

Managerial Intervention Less Likely


Kirsten Foss, Nicolai J. Foss and Xosé H. Vàzquez-Vicente

“Tying the Manager’s Hands”: How Firms Can Make Credible

Commitments That Make Opportunistic Managerial

Intervention Less Likely

Kirsten Foss

Department of Industrial Economics and Strategy Copenhagen Business School Solbjergvej 3, 3rd floor; 2000 Frederiksberg Denmark; kf.ivs@cbs.dk Nicolai J. Foss Department of Management, Politics, and Philosophy Copenhagen Business School, Blaagaardsgade 23B, DK-2200 Copenhagen N Denmark njf.lpf@cbs.dk Xosé H. Vázquez-Vicente Department of Business Management and Marketing Faculty of Economics and Business, Universidade de Vigo Campus das Lagoas-Marcosende, 36200- Vigo Spain; xhvv@uvigo.es 29 May 2002; 24 September 2002; 10 December 2002; 1 April 2003; 20 August 2003 Abstract We discuss and empirically examine a firm-level equivalent of the ancient problem of “tying the King’s hands,” namely how to maximize managerial intervention for “good cause,” while avoiding intervention for “bad cause.” Managers may opportunistically intervene when such intervention produces private benefits. Overall firm performance is harmed as a result, because opportunistic managerial intervention harms employee motivation. The central point of the paper is that various mechanisms and factors, such as managers staking their personal reputation, employees controlling important assets, strong trade unions, corporate culture, etc. may function as constraints on managerial proclivities to opportunistically intervene. Thus, firms can make credible commitments that check managerial proclivities to opportunistically intervene. We derive 5 hypotheses from these ideas, and test them, using path-analysis, on a rich dataset, based on 329 firms in the Spanish food and electric/electronic industries.

Key words: Managerial opportunism, credible commitments, organizational design, transaction cost economics JEL Codes: D23, D74, L22, M12, ISBN 87-7873-142-9 Acknowledgements The comments of Sven Haugland, Thorbjørn Knudsen, Torben Pedersen, Frank Stephen and Xosé M. García Vázquez are gratefully acknowledged. The field survey has benefited from financial support by SXID, a Research Unit of the Galician Government, through grant PROY99–10, and by CICYT, an agency of the Spanish Government through grant SEC99I. Introduction In this paper we discuss and empirically examine a firm-level equivalent of the ancient problem of “tying the King’s hands” (Root 1989). A key theme in much of the work on the theory of the firm (e.g., Coase 1937; Malmgren 1961; Casson 1994; Williamson 1996; Foss 1997; Wernerfelt

1997) is that the exercise of authority in the form of managerial fiat in response to changes in the environment provides a reason why firms exist. Such managerial intervention will typically override existing instructions of employees, and in firms where employees are given considerable discretion, managerial intervention may furthermore amount to overruling decisions made by these employees on the basis of delegated decision rights.

A fundamental (though arguably somewhat neglected) set of problems is that the option to intervene (1) “… can be exercised both for good cause (to support expected net gains) and for bad (to support the subgoals of the intervenor)” (Williamson 1996: 150-151), (2) it may be difficult to verify the nature of the cause, and (3) promises to only intervene for good cause are hard to make credible because they are not enforceable in a court of law. There is thus a problem of “… credibly [promising] to respect autonomy save for those cases where expected net gains to intervention can be projected” (Williamson 1993: 104). A primary challenge  in theory as well as managerial practice  is therefore how to maximize managerial intervention for “good cause,” while avoiding intervention for “bad cause.”1 In this paper, we contribute to the understanding of this problem by examining how firms can make credible commitments that make (perceived and/or real) opportunistic managerial intervention (Dow 1987; Kreps 1990), “intervention for bad cause,” less likely. Our overarching perspective on these issues is mainly drawn from organizational economics (e.g., Milgrom 1988;

Jensen and Meckling 1992; Bijl 1996; Milgrom and Roberts 1996; Williamson 1996; Aghion and Tirole 1997; Baker, Gibbons, and Murphy 2000), and on political economy work on credible commitments (e.g., Weingast and Marshall 1988; Miller 1992; Miller and Hammond 1994; Moe 1997). However, in order to lend further support for our arguments, we also draw on ideas about psychological contracts in organizations (Argyris 1960; Rousseau 1989; Coyle-Shapiro and 1 Milgrom and Roberts (1996: 168) argue that “… the very existence of centralized authority is incompatible with a thorough going policy of efficient selective intervention. The authority to intervene inevitably implies the authority to intervene inefficiently.” While we agree that “first-best intervention” is strictly impossible, “second-best intervention” is feasible.

Kessler 2000; Tepper and Taylor 2003), extrinsic and intrinsic motivation (Osterloh and Frey 2000), and psychological research on decision-making (e.g., Bazerman 1994).

Our argument begins from the observation that all firms that are larger than the one-man firm rely on both the use of managerial authority and employee discretion, that is, the ability of employees to control resources including their own human capital. While authority is needed, for example, to manage residual interdependencies, discretion may be rationally delegated to employees, because it stimulates motivation and fosters local learning and the use of local knowledge. A considerable body of work in organization theory, including organizational economics, has addressed issues that relate to the distinction between authority and delegation, such as the optimal span of control (Williamson 1970), the design of information structures (Galbraith 1974), and optimal delegation given the moral hazard problem (Jensen and Meckling 1992; Armstrong 1994; Aghion and Tirole 1997). In these treatments, authority is a matter of control and the giving of orders. Other issues that are implied by the distinction between authority and discretion have arguably been given less attention, notably how the exercise of authority in the form of opportunistic managerial intervention harm motivation, diminishing the beneficial effects of discretion.2 From this perspective, a basic problem in organizational design is that beneficial delegation is hard to sustain under the property rights structure characterizing the firm in which delegated decision rights are always “loaned, not owned” (Baker et al. 1999).

Thus, those who hold ultimate decision rights (i.e., authority) may use these to renege on delegation, overrule decisions made on the basis of delegated rights, and selectively intervene for bsad cause. This harms employee motivation. However, managers may be constrained by various mechanisms, including implicit contracts (Kreps 1990; Baker et al. 1999) or explicit credible commitments (Brocker et al. 1992; Moe 1997) that reduce the incidence and severity of such harmful interventions.

The design of the paper is as follows: We develop a notion of authority that goes beyond the picking of well-defined actions from an employee’s action set (as in Simon 1951) and also includes the power to delegate and constrain discretion, as well as the ability to veto subordinates’ decisions. We also focus on the costs and benefits of delegating discretion to employees. We then turn to a discussion of the motivational problems that may arise when managers exercise authority by reneging on the delegation of discretion, that is “opportunistic However, see Rousseau (1989), Robinson and Rousseau (1994), and Robinson and Morrison (1995) for organizational behavior work, and Aghion and Tirole (1997) and Baker, Gibbons and Murphy (1999, 2002) for organizational economics work, that has a strong bearing on these issues.

managerial intervention.” It is often in an organization’s interest to avoid such managerial intervention. There are various mechanisms that may credibly constrain the flexibility of managers to intervene opportunistically. Some of these are external to the firm (e.g., tight labor and capital markets, strong labor unions), and some are internal to the firm. In the latter category are credible commitments undertaken by managers themselves (e.g., managers staking personal reputations), as well as employees controlling critical resources. A number of hypotheses are derived and tested on data from the Spanish electronics and food industries. To the best of our knowledge, the present paper represents the first empirical, firm-level work on these issues.

–  –  –

Authority and Delegation of Discretion Simon (1951) provides a classic notion of authority. Authority is defined as the situation in which a “boss” is permitted by a “worker” to select actions, A0 ⊂ A, where A is the set of the worker’s possible behaviors. For the worker to accept the assignment, it must lie within his “zone of acceptance.” A limitation of this notion of authority is that it seems to be based on the boss having all the information, the worker being merely a passive instrument who reacts to instructions based on this information. This is a notion that does not square easily with the (alleged) increasing importance of partly self-managing knowledge-workers in modern production (e.g., Purser 1998).

Simon (1991: 31) himself later noted that authority may be understood more broadly, namely as a command that takes the form of a result to be produced, a principle to be applied, or goal constraints, so that “[o]nly the end goal has been supplied by the command, and not the method of reaching it.” However, even this is arguably too narrow. Usually, some aspects of “the method of reaching” an end goal are specified, so that employees are seldom granted full discretion. Indeed, a function of authority is the placing of restrictions on the decision rights that are granted to employees with respect to how they reach an end goal (Milgrom 1988; Barzel 1997; Holmström 1999). Authority in the sense of placing restrictions on behavior is exercised in order to avoid costs associated with unwanted externalities, including, but by no means limited to, the costs of morally hazardous behavior. Such externalities may also include coordination failures, such as scheduling problems, duplicative efforts (e.g., of market information gathering or R&D), and cannibalization of product markets and other instances of decentralized actions being inconsistent with the firm’s overall strategic planning. These externalities arise when employees exercise discretion.

Discretion may be defined as the ability of an agent to exercise control over a resource, that is, she is able to allocate that resource to a purpose that she, for whatever reason, finds suitable (Barzel 1997). There are various reasons why firms may delegate discretion. For example, if the employee is better informed than the manager with respect to how certain tasks should be carried out, and this knowledge is costly to communicate (Casson 1994; Melumad et al. 1995), efficient co-location of decision-making rights and knowledge requires that employees are delegated discretion with respect to how they use their expertise in problem solving (Jensen and Meckling 1992). Also, delegation may be undertaken for motivational rather than knowledge-based reasons. Thus, a long tradition in social psychology (probably beginning with Roethlisberger et al. 1939) and more recently in the empowerment literature (Conger and Canungo 1988; Thomas and Velthouse 1990; Gal-Or and Amit 1998), suggests that increasing the delegation of discretion to employees often “… raises the perceived self-determination of employees and therewith strengthens intrinsic motivation” (Osterloh and Frey 2000: 543). In turn, this may lead to an increase in creativity in the pursuit of goals.3 Expert knowledge is better utilized and learning is fostered (Mudambi et al. 2003). In contrast, decreasing the level of delegated discretion may crowd out intrinsic motivation, particularly when this frustrates the employee’s “… beliefs regarding the terms and conditions of the reciprocal exchange

agreement” (Rousseau 1989: 23). These arguments suggest the following hypothesis:

Hypotheses 1: Employee motivation depends positively on the degree of delegation of discretion.

Some reservations and potential critiques should be noted at this point. First, it is conceivable that discretion may harm motivation if employees do not have the knowledge or personality to command such discretion.

Second, employees may feel uncomfortable with increased discretion because it may imply responsibilities without additional pay or benefits. In short, employees need to have not just the opportunity, but also the ability and incentive to engage in self-management (cf. Mowday et al. 1982). We hypothesize, however, that on the aggregate (firm) level, the positive motivational effects of increased delegation dominate the negative ones, and that opportunity to engage in self-management is at least to some extent matched by a corresponding ability to do so. Third, in the model we later test, we assume a linear relation between delegation and motivation and performance. This, too, may be criticized. We have tested whether the inclusion of the squared variable for delegation improves the goodness of fit and provides a significant coefficient. However, it turns out that the coefficients are not significant and that, although the absolute and incremental goodness of fit increases slightly, the parsimounious goodness of fit decreases considerably. We therefore opted for not including this squared variable.

We further argue that the motivational effects of increased delegation give rise to improved employee productivity. Partial evidence for this is the finding that giving R&D personnel the right to share research findings with others and to publish such findings increase R&D productivity (McMillan et al. 2000; Mudambi et al. 2003). In turn, increased employee productivity causes firm performance to improve.

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