Organizational Design 595The large-scale firm presents an interesting and important trade-off. On
the one hand, increases in scale and scope offer the advantage of declining
average costs. On the other hand, the division of management responsibilities
raises myriad principal-agent problems. Thus, top management must design
an organizational structure that preserves the advantages of large-scale pro-
duction while mitigating the attendant agency problems and agency costs.
The design of organizational structure involves- Determining the boundaries of the firm,
- Dividing decision-making responsibilities within the firm, and
- Crafting mechanisms for monitoring and rewarding managers and
other firm employees (including hiring, promotion, and
remuneration).
The first item raises the question of which activities the firm should undertake
itself and which activities it should leave to outside contractors and suppliers.
The crux of the second item is the degree to which the firm should centralize
or decentralize decision making. The third item directly addresses the problem
of melding agents’ behavior and interests to those of the firm as a whole.
Naturally, these issues are interrelated.
Note also that organizational structures can be either formal or informal.
Formal structures carefully define decision-making authority and set up specific
mechanisms to monitor and reward. Informal structures, often known by the
term corporate culture,create goals and expectations and foster a social envi-
ronment that informally rewards good performance.
The Boundaries of the Firm
Any firm must decide whether to undertake an economic activity in-house or
to outsource the activity. Most firms rely on outside markets to procure their
most basic inputs, everything from telephone service and office equipment to
automobiles and fuel. We know from Chapter 7 that competitive markets
ensure efficient provision of standardized goods and services at the lowest sus-
tainable prices. Thus the firm can likely procure these standardized inputs from
outside suppliers more cheaply than producing them itself.
Which circumstances might favor undertaking an activity in-house?
Roughly speaking, the firm will undertake those activities that require exten-
sive coordination in production or make use of specialized inputs. For exam-
ple, a large law firm will procure its office space via the commercial real-estate
market and purchase routine supplies and equipment. However, the firm’s
bread-and-butter legal services will be coordinated and provided in-house.
Complex cases require lawyers of many specialties (from first-year associates to
senior partners) working together to meet clients’ needs. Established rela-
tionships within the firm make this easier to do.c14AsymmetricInformationandOrganizationalDesign.qxd 9/26/11 11:03 AM Page 595