1. Organizations in Concept and Practice Chapter 12 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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3. Tote That Barge (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 There have always been lots of unpleasant jobs. Quite possibly one of the worst appears in Russian artist Ilya Repin’s nineteenth-century painting “Barge Haulers on the Volga.” But are you sure all of the people in the picture are actually working and none are just acting like they are working?

4. What’s Next? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 To resolve problems like this one we introduce the concept of organizations or hierarchies, in which some individuals have authority to issue orders that others are expected to obey and face penalties if they do not.

5. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5

6. Team Production (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 In production, people often work together in teams. We call a group a team if three assumptions are satisfied: 1.Several resources must be combined to produce output. 2.Total output cannot be separated into individual outputs. 3.The resources are owned by different persons who will need to agree beforehand on organizational relationships that define their responsibilities toward one another.

7. Free Riding and Monitoring Team Effort (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 Assume for now that the barge haulers are paid equal shares of the revenue they earn from making trips between points A and B. Revenue per trip is determined in a competitive market, and they cannot influence price. A team member cannot monitor the efforts of other members without so distracting himself that his own productivity falls. As a group the barge haulers may benefit so greatly from having a boss that they will pay to hire one.

8. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8

9. Setting the Stage (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 The barge haulers pointed up the importance of team production and the efficiency of forming an organization consisting of the workers and a boss but only with the following unrealistic assumptions: 1.No specialization: No hauler had a specialty that distinguished him from the others and required him to be supervised in a different way. 2.No outsiders concerned with performance: It did not matter to barge owners or others whether the team worked slowly or quickly. 3.No investments: Workers needed no other equipment to haul barges. 4.No risks: A team faced no risks beyond its control. A trusted boss: The haulers assumed that their boss would work hard for them but could not monitor that person’s effort, examine his reputation, or compare him to other bosses.

10. The Costs and Benefits of Specialization - A Quick Course in Pin Making (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Smith called the specialization of workers and their assignment to different tasks the division of labor. He saw it as a major cause of rising incomes at the dawn of the industrial age. In a famous passage he tells of his visit to a pin factory where he saw the making of a simple pin divided up into 18 distinct operations.

11. The Costs and Benefits of Specialization - The Costs of Being a Generalist (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 A single worker can perform all the steps in pin making. He could be in business with no more than a wire cutter, a file to sharpen the points, a device to put heads on the pins, and paper to stick them onto for packaging. His rudimentary tools and forced multitasking leave him with only a few marketable pins per week.

12. The Costs and Benefits of Specialization - First Step Toward Specialization: A Purchasing and Marketing Cooperative (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 Begin with several independent persons, each a self-contained pin factory. One Monday Jones offers to take money supplied by the others to market and buy a week’s supply of wire for all of them, with compensation for his time. They might do even better by hiring a specialist buyer who understands the wire market and knows how to strike deals. They could also save by contracting with a marketer or wholesaler to purchase their output.

13. The Costs and Benefits of Specialization - Next Step: Independent Workers with Specialized Capital (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Having seen the benefits of hiring specialists to purchase wire and market their output, the pin makers might try to get the benefits of specialization by agreeing that each will work exclusively on some particular step of the process. They each sell their old equipment and invest in new equipment specially suited to their particular task. They will also cut the cost of transferring partially finished pins between themselves by sharing the rent on a building they will occupy. The workers have saved the costs of contracting but now they risk opportunism on all sides.

14. The Costs and Benefits of Specialization - Investment and Risk (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 Coordination of individual investments. The pin makers must coordinate their activities to make sure their investments are not mismatched. Difficulties in diversification. Risk-averse people cut their risks by diversifying their wealth into different forms. Income risk. In the normal course of business, a worker’s income depends on the state of the pin market. Strategic decisions. Our diversely specialized pin workers may have difficulty responding as a group to market opportunities.

15. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15

16. Hierarchy and the Division of Labor (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 The alternative to independent specialization by individual workers is a hierarchy, which we will sometimes call an organization. A hierarchy requires workers to comply with orders from a boss, who need not consult them when making decisions, and to be paid for their cooperation.

17. Supervision and Investment - Who Buys the Capital Goods? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 The boss in the pin-making example had good reason to purchase the workers’ capital goods, because continued ownership of a machine by the person who operates it is almost an open invitation to behave opportunistically. Workers will probably also prefer that the boss own the equipment, because then they will no longer risk losses in its value due to market events they cannot control, and they will be better able to diversify their asset holdings.

18. Supervision and Investment - The Residual Claimant (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Adding responsibility for investment and other financial decisions (e.g., owning or leasing equipment and choosing which risks to insure) to the boss’s supervisory activities turns her into a residual claimant. The person who is both boss and residual claimant has incentives to make value-maximizing operating and investment decisions.

19. Separating Ownership and Management (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 Here we examine separation of the management function from those of finance and residual claimancy. Different skills and opportunity costs: Limits on a manager’s knowledge and capabilities may make her a poor candidate for residual claimant. Risk and diversification: Residual claimants who have interests in more than one firm are diversified in ways that managers who depend on a single employer for most of their incomes cannot be. Ownership and control: Residual claimants ultimately choose a firm’s managers.

20. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20

21. The Sole Proprietorship - The Proprietor’s Problems (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 Because you are the residual claimant, any profit or loss is yours to enjoy or suffer. As a sole proprietor you are also faced with unlimited liability, you can be forced to pay debts with other resources, such as your house.

22. The Sole Proprietorship – The Creditor’s Problems (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 As a sole proprietor, your creditors may limit your loans because unless the agreements give them special rights, which are unlikely on a small transaction, they can only influence your operating decisions by persuasion. Each creditor also faces a liquidity problem, without special arrangements, they cannot cash out on the loan. Finally, the business may be almost inseparable from you. If you die or retire its management may pass to people who are less competent or who have priorities or conflicts that lower its value.

23. Partnerships (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Problems of liability, membership, and decision making lead us to expect that a partnership will be an efficient organizational form only in some special situations. The areas where partnerships are common include single- purpose ventures where the scope for disagreement is likely to be small and long-term plans need not be made, for example, the purchase and remodeling of a building that the partners intend to resell. Professional group practices in medicine, law, and accounting, are another example.

24. The Corporate Form (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 Most large enterprises are corporations, defined as “legal and contractual mechanism[s] for creating and operating a business for profit, using capital from investors that will be managed on their behalf by directors and officers.” Separation of ownership and management distinguishes corporations from proprietorships and partnerships. A corporation’s shareholders are its residual claimants.

25. Shareholders and Managers as Principals and Agents - The Principal/Agent Problem (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 Shareholders are principals and directors are their agents. Shareholders want decisions from the board of directors that maximize the value of their shares. As in other principal/agent situations, shareholders entrust others to perform tasks that they cannot easily monitor.

26. Shareholders and Managers as Principals and Agents - The Principal/Agent Problem (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 If organizing shareholders is costly, the directors will feel more secure if they make opportunistic choices to advance their personal interests instead of maximizing shareholder value. Such choices can take several forms: 1.Executives might use corporate funds in ways that appear legitimate but primarily benefit themselves. 2.They can use corporate funds to acquire social status, underwriting the costs of cultural activities or investing corporate funds to show that they share the political views of influential persons. 3.Free cash flows may be used for investments that do not maximize shareholder value.

27. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27

28. The Influence of Large Shareholders (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Large shareholders (often called block holders) can sometimes influence a corporation’s decisions without making efforts to replace its management. As one example, the California Public Employees Retirement System (CalPERS) annually issues a “focus list” of a few of the 1,800 companies whose shares it holds. CalPERS singles out those it believes are poorly managed or whose bylaws impede shareholders who want to unseat directors or allow other policies that CalPERS believes are not in their shareholders’ interest.

29. Proxies: Voting in New Directors (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 A large shareholder or group can solicit votes for a slate of directors that it has proposed as an alternative to candidates endorsed by the current board, which may include the board members themselves. Shareholders who favor the alternative are said to give their “proxies” (i.e., votes) to those proposing the new directors. The larger the percentage of stock owned by small holders, the costlier it is to wage a proxy fight.

30. Mergers and Acquisitions (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 A merger puts the assets of two corporations under a common management. With some possible exceptions (discussed later), the market for corporate control will be more competitive if a company’s management is not allowed to devise rules or engage in practices that increase the difficulty of acquiring control of its company.

31. Leveraged Buyouts - Tender Offers and LBOs (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 In a leveraged buyout (LBO) the outsider buys the shares with debt collateralized by its other assets—and sometimes also by the target’s assets. The taken-over firm is more highly “leveraged,” that is, it has a higher ratio of debt to equity. LBOs are generally undertaken by specialist organizations that do not intend to take over the target’s day-to-day management. The LBO organization installs directors whose function is to reshape the target to improve shareholder value and then step aside.

32. Leveraged Buyouts - The Target Management’s Defenses (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 A target that is unwilling to cede control to an outsider has two basic defenses: 1.Before any threat materializes it can write bylaws that will raise the outsider’s cost of obtaining a controlling interest in the firm. 2.Management can attempt to ensure that even a successful acquirer gets control of a less valuable firm.

33. Leveraged Buyouts - The Effects of Transactions in Corporate Control (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 The bulk of the evidence on transactions in corporate control is that they increase the combined values of the acquired and acquiring firms. The increase generally stems from gains in economic efficiency rather than increased market power.