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BUSSINESS ORGANIZATION: TOPIC 1. INTRODUCTION 1. THE RELEVANCE OF ORGANIZATIONAL ARCHITECTURE AND ITS OBJECTIVES: There is three key aspects of a firm: a) Assignment of decision rights. b) Methods of compensation (incentives). c) Performance evaluation of individuals and units. When assigning decision rights, senior management must also ensure that the company gives come kind of incentive to make value-increasing decisions. Even thogh no two firms might adopt precisely the same architecture, successful firms ensure that the three critical aspects of organizational are coordinated. 2. MANAGERIAL ECONOMICS OBJECTIVES: Which markets to enter Product differentiation. Production choices Pricing decisions. Market analysis and competitor behavior. 3. THE ECONOMIC PERSPECTIVE: Economics provides a theory to explain the way individuals make choices. A framework for analysing decisions. For example, in designing organizations, it is important to keep in mind that individuals respond to incentives. We use economics to examine how managers can design organizations that motivate individuals to make choices that will increase a firm’s value (the role of incentives). Traditional economic analysis generally characterizes the firm simply as a “black box” that transforms inputs into outputs. Little consideration normally has been given to the internal architecture of the firm. In recent years, economists have focused more on questions of organizational architecture.

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There is three key aspects of a firm:a) Assignment of decision rights. b) Methods of compensation (incentives). c) Performance evaluation of individuals and units.

When assigning decision rights, senior management must also ensure that the company gives come kind of incentive to make value-increasing decisions. Even thogh no two firms might adopt precisely the same architecture, successful firms ensure that the three critical aspects of organizational are coordinated.

2. MANAGERIAL ECONOMICS OBJECTIVES: Which markets to enter Product differentiation. Production choices Pricing decisions. Market analysis and competitor behavior.

3. THE ECONOMIC PERSPECTIVE: Economics provides a theory to explain the way individuals make choices. A framework for analysing decisions. For example, in designing organizations, it is important to keep in mind that individuals respond to incentives. We use economics to examine how managers can design organizations that motivate individuals to make choices that will increase a firm’s value (the role of incentives).Traditional economic analysis generally characterizes the firm simply as a “black box” that transforms inputs into outputs. Little consideration normally has been given to the internal architecture of the firm. In recent years, economists have focused more on questions of organizational architecture. In this analysis, ideas of equilibrium represent important constraints on managerial decisions. Understanding how prices and quantities change in response to changes in costs, product characteristics, or the terms of sale is a critical managerial skill.

4. ECONOMIC DARWINISM AND BENCHMARKING: Only the fittest surviveo Competition encourages efficient decisions. o Maximizing shareholder value. o Firms must adapt or close. Appropiate organizational architecture can : lower costs and ensure high quality production.

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Benchmarching generally means looking at those companies that are doing something best and learning how they do it in order to emulate them. Managerial implications of economic Darwinism:o Existing architecture is not random. o Surviving architectures are better relative to competitors. They are not the best in an absolut sense. o As environment change, the appropiate architecture changes.



1. Describing Risky Outcomes- Basic Tools. a. Lotteries and Probabilites. b. Expected Values c. Variance2. Evaluating Risky Outcomes. a. Risk Preferences and the Utility Function. 3. Avoiding and Bearing Risk. a. The Demand for insurance and the Risk Premium. b. Asymmetric Information and Insurance. c. The Value of Information and Decision Trees.

1. DESCRIBING RISKY OUTCOMES: Definition: A lottery is any event with an uncertain outcome. EX: Football Game, Roulette, Investment. Definition: The probability of an outcome (of a lottery) is the likelihood that this outcome occurs. Definition: Probability distribution of the lottery depicts all posible outcomes in the lottery and their associated probabilities. Two properties: The probability of any particular outcome is between 0 and 1. The sum of the probabilities of all posible outcomes equal 1. Definition: Probabilities that reflect subjective beliefs about risky events are called subjective probabilities.

2. EXPECTED VALUE : The expected value of a lottery is a measure of the average payoff that the lottery will generate. Measures centrality. The value of the expected value is real somehow even if it is not a real outcome of the lottery. EV=Pr(A)x A + Pr(B)x B + Pr(C)x C

3. VARIANCE AND STANDARD DEVIATION: The Variance of a lottery is the sum of the probability-weighted squared deviations between the possible outcomes of the lottery and the expected value of the lottery. It is a measure of the lottery’s riskiness. Measures dispersion, risk.

++Variance ++ Risky

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Var= (A-EV)2(Pr(A))+(B-EV)2(Pr(B))+(C-EV)2(Pr(C))

The Standard Deviation of a lottery is the square root of the variance. It is an alternative measure of risk.


*To decide whether the person is risk averse, risk loving or risk neutral we must look at the utility function of the person. The Utility function is a mathematical function that relays happiness, welfare, satisfaction as a function of money, as a function of income. U(w)=w1/2

Risk preferences:

Risk Aversion: Confronted with lotteries of the same expected value takes the one with less variance. Risk loving: Confronted with lotteries of the same expected value takes the one with more variance. Risk Neutral: Confronted with lotteries of the same expected value doesn’t care which option to take.


RISK PREMIUM: The risk premium of a lottery is the necessary difference between the expected value of a lottery and the sure thing so that the decision maker is indifferent between the lottery and the sure thing. **The larger the variance of the lottery, the larger the risk premium. Risk premium is the amount of money you are willing to pay.

++Risk Premium ++ Extreme

pU(I1) + (1-p)U(I2) = U(pI1 + (1-p)I2-RP)

pU(I1) + (1-p)U(I2) = U(EV –RP)

A Fairly priced Insurance policy is the one that pays the expected value of the promised payout.

Asymmetric Information is a situation in which one party knows more about its own actions or characteristics than another party.

Adverse selection is opportunism characterized by an informed person’s benefiting from trading or otherwise contracting with a less informed person who does not know about an unobserved characteristic of the informed person. **A good design of that contract can exclude people you want to be in the contract.

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Moral Hazard is opportunism characterized by an informed person’s taking advantage of a less informed person through an unobserved action. *Se trata de un incentive no deseado. It appears when you buy an insurance.

Decision Trees: A decision tree is a diagram that describes the options available to a decision maker, as well as the risky events that can occur at each point in time. Key Elements: Decision Nodes: indicates a particular decision that the decision maker faces. Each branch of from a decision node corresponds to a possible decision. Chance Nodes: indicates a particular lottery that the decision maker faces. Each branch from a chance node corresponds to a possible outcome of the lottery. Probabilities: Each possible outcome has a probability. The Sum of the probabilities of all possible outcomes from a chance node must add up to 1. Payoffs: is the value of the result from each possible combination of choices and risky outcomes. If the decision maker is risk neutral, payoffs are monetary values. If the decision maker is risk averse or risk loving, payoffs are the utilities associated with the monetary values of the payoffs.

We analyse decision problems by working backward along the decision tree to decide what the optimal decision would be. Steps in constructing and analysing the tree:

1. Map out the decision and event sequence. 2. Identify the alternatives available for each decision 3. Identify the possible outcomes for each risky event. 4. Assign probabilities to the events.5. Identify payoffs to all the decision/event combinations. 6. Find the optimal sequence of decisions.

The value of perfect information is the increase in the decision maker’s expected payoff when the decision maker can –at no cost- obtain information that reveals the outcome of the risky event.

6. SUMMARY: We can think of risky decisions as lotteries. We can think of individuals maximizing expected utility when faced with risk. Individuals differ in their attitudes towards risk: those who prefer a sure thing are risk averse. Those who are indifferent about risk are risk neutral. Those who prefer risk are risk loving. Insurance can help to avoid risk. The optimal amount to insure depends on risk attitudes. The provision of insurance by individuals does not require risk lovers. Adverse selection and Moral Hazard can cause inefficiency in insurance markets. We can calculate the value of obtaining information in order to reduce risk by analysing the expected payoff to eliminating risk from a decision tree and comparing this to the expected payoff of maintaining risk.


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People have unlimited wants. Resources are limited. Choices must be made on how to allocate these scarce resources among the unlimited wants.

2. THE NATURE OF ECONOMIC CHOICE: Individuals assign priorities to their wants and choose their most preferred option from among the available alternatives. Individuals learn from their mistakes.

3. MARGINAL ANALYSIS Marginal costs and benefits are the incremental costs and benefits that are associated with making a decision. It is the marginal costs and benefits that are important in economic decision making. An action should be taken whenever the marginal benefits of that action exceed its marginal costs.

4. SUNK COSTS Benefits and costs that have preceded the decision are sunk (assuming they are nonrecoverable) and therefore irrelevant to the decision.

5. OPPORTUNITY COSTS Because resources are limited individuals face trade-offs. Using limited resources for one purpose precludes their use for something else. The value of the best foregone option is the opportunity cost of the option selected. Explicit costs are direct dollar expenditures. Implicit costs reflect opportunity costs that are not direct dollar expenditures.

6. CREATIVITY OF INDIVIDUALS: Within this economic framework, individuals maximize their personal satisfaction given resource constraints. Indeed, people are quite creative and resourceful in minimizing the effects of constraints.


The economic model of behaviour posits that people acquire good that maximize their personal satisfaction, given their resource constraints (such as a limited income). Economists traditionally use the term utility in referring to personal satisfaction. The Utility Function expresses the relation between total utility and the level of goods consumed. The individual’s objective is to maximize this function, given the resource constraints.

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Preferences implied by the utility function can be illustrated graphically through indifference curves. An indifference curve pictures all combinations of goods that yield the same utility. ** The desired goal is to maximize utility (that is subjected to a budget constraint). This can be shown graphically with indifference curves and budget constraint. Indifference curves have negative slopes.

8. USING BUDGETS TO MOTIVATE WORKERS: Merry Lynch paid its analysts bonuses based on the analyst’s contribution to the banking side of their business. If an analyst rated a company as a poor investment, that company may take its business elsewhere. The analyst’s bonus would be smaller. Analyst’s tradeoff is integrity for money.

9. ALTERNATIVE MODELS OF BEHAVIOUR: Models of behaviour capture the essence of a few of the more prominent views that managers have about behaviour and to illustrate how managerial decision making is affected by the particular view. Only-Money-Matters Model: Some people believe that the only important component of the job is the level of monetary compensation. But as we have already suggested, people have an incredibly broad range of interests, extending substantially beyond money. Happy-Is-Productive Model: Managers sometimes assert that happy employees are more productive than unhappy employees. Managers following this happy-is-productive model see as their goal the designing of work environments that satisfy employees.

The primary difference in the models is what motivates individual actions. In the happy is productive model, employees exert high effort when they are happy. In the economic model, employees exert effort because of the rewards.

Good-Citizen Model: Some managers subscribe to the good citizen model. The basic assumption is that the employees have a strong personal desire to do a god job; they take pride in their work and want to excel. Under this view, managers have three primary roles. Communicate the objectives of the organization to employees, help them to accomplish them and provide them with feedback on performance so that they can improve their efforts. There is no reason to have incentive pay, since individuals are interested instrinsically in doing a good job.

In the good citizen model, employees place the interests of the company first. There is never a conflict between an employee’s personal interest and the interest of their company.

Product-of-the-Environment Model: Hire the right people. People working together. Is people work together they have pressure and they work harder for the company. Economic model: Change relevant costs and benefits + Incentives matter. Managers use to think this way. People with this behaviour think of money and people COMBINATE. Not only money matters.

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Which Model Should Managers Use ?

Behaviour is a complex topic. No behavioural model is likely to be useful in all contexts. Managers are frequently interested in fostering changes in behaviour. If you want to motivate, incentive compensation can be useful. The good citizen model appears less successful in predicting behaviour in business settings. Management would be an easy task if employees would work harder and produce higher-quality products simply on request. The happy-is-productive model also has material limitations. Most importantly, the existing evidence suggests that there is little relation between job satisfaction and performance. Happy employees are not necessarily more productive. Sometimes, maganers might want to follow the implications of the product of the environment model and fire employees with undesirable traits. Yet, this approach is of limited use in solving most managerial problems. Also, given laws that limit discrimination, this approach can subject the firm to potentially serious legal sanctions.



1. **(Mercadona). Not all goes within firms because as a firm grows the problems grow. So it is difficult to manage a huge enterprise. In a huge enterprise it is difficult that one person controls everything. Which is the key of an enterprise architecture to get one enterprise< to work ? INCENTIVES.

2. THE GOALS OF AN ECONOMIC SYSTEM: (through the market or within firms).

a. To satisfy human needs and wants. i. What to produce

ii. How to produce it iii. Who gets it

b. The answer depend on the allocation mechanisms. i. Free markets

ii. Central planning ** At the end of the day the market economy creates allocation (Asignaciones).

3. COMPARING EFFECTIVENESS OF ECONOMIC SYSTEMS: a. Resources allocations is Pareto Efficient if NO alternative helps at

least on eperson without harming anyone else. PARETO EFFICIENT: is a way to compare allocation. One occasion in which there is no alternative. One allocation is efficient in the sense of pareto when one change can only benefit someone by hurting another one- I wont do it but it is efficient pareto. In the other side, if I can improve the situation of someone and not hurting anyone else I will do it but it IS NOT pareto efficient.

b. In free markets, economic decisions are decentralized to individuals. (los individuales no tienen ninguna opinion respeto al precio).

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c. In centrally planned economies, government officials make economic decisions.

4. PROPERTY RIGHTS AND EXCHANGE IN A MARKET ECONOMY: Property rights are specially important if we go through the market. They must be clearly defined. Property rights have TWO properties: 1. We can sell or buy them. 2. We can use them.

a. A property right is a legally enforced right to select use of an economic good.

b. Private rights are assigned to a specific entity. i. Private rights are alienable (if you can sell or buy) in that

they can be transferred to another individual, within limits. ii. Individuals have use rights within limits.

** We could have the property of something and the alienability but not have the right to use it- as acontract of renting.

5. GAINS FROM TRADE: -Fundamental ideas that make free markets better than central planning. The fact that they are different.

a. Individuals trade something they value less for something they value more.

b. Trade creates value. c. Sources of trade gains.

i. Differences in preferences. ii. Comparative advantage.

iii. Specialization . 6. SPECIALIZATION : (Efficiency in the sense of Pareto. Adam Smith).

a. Individuals specialize in producing goods for which they have a comparative advantage.

b. Comparative advantage occurs when an individual has a lower opportunity cost of producing a good.

c. Specialization and trade make both parties better off. 7. BASICS OF SUPPLY AND DEMAND:

a. Demand curve- shows the quantity of a good that consumers are willing to buy at various prices.

b. Supply curve – shows the quantity of a good sellers are willing to offer at various prices.

c. Interaction of supply and demand yields a market-clearing price. 8. SUPPLY AND DEMAND IN THE PC INDUSTRY:

a. When prices are high, the quantity supplied is greater than quantity demanded and a surplus exists.

b. When prices are low, the quantity demanded is greater than quantity supplied and a shortage exists.

c. Only the market-clearing price avoid surpluses or shortages. d. Equilibrum price and quantity avoids surplus and shortage.

Equilibrum is the point where the market gets CLEAN. e. An increase in demand-shift right.

A decrease in demand –shift left. An increase in supply –shift right A decrease in supply- shift left.

** With free trade everyone gets a liitle improvement.

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** Prices are a crutial thing in a free market economy. Prices beyond being what something costs are a supply of information. It is a signal for consumers to know how much to buy and for a firm a signal to know how much to produce.

9. THE NATURE AND FUNCTION OF PRICES: a. Coordinate consumption and production decisions.

i. Prices give suppliers incentives to shift production to high priced products.

ii. Prices give consumers incentives to reduce quantity of high price products.

iii. Goods are rationed to those willing to pay. 10. GAINS FROM TRADE:

a. Consumer surplus – the difference between what consumers are willing to pay and what they actually pay. (Measured as the area bellow the demand curve and above the price).

b. Prodcuer surplus – The difference between the price received and willingness to produce. (Measured as the area above the supply curve and below the price).

11. GOVERNMENT INTERVENTION: a. Consumer and producer surplus can be used to examine the effects

of government intervention on gains from trade. b. Price caps limit the maximum price that can be charged. c. Price floors are a legally set minimum price at which goods can be

traded. **Price caps are maximum prices established. Price floors are minimm prices established.

12. EXTERNALITIES AND THE COASE THEOREM: a. Externalities occur when the actions of one party impose a benefit

or cost on another party outside the exchange (pollution noise, graffiti). **Externalities are something that happens when you are not paying the full costs of your actions. This are one of the main important things why markets may fail. If there weren’t ANY expernalities markets will be efficient. If you have externalities you are affecting the market somehow. There are good externalities and bad externalities. Good as education or recycling.

b. Markets may not be efficient. c. Coase argued market exchange will be efficient if: Property rights

can be traded and transactions costs are sufficiently low. 13. FREE MARKETS VERSUS CENTRAL PLANNING:

a. General knowledge is freely transferable. b. Specific knowledge is expensive to transfer. (is something you need

in your business). i. Centrally planned economies fall because specific

knowledge is not used in the planning process. c. Prices convey general knowledge.

**For Friderich Hayek, who compared free markets and central planning, free markets were superior because the had and have specific knowledge thanks to incentives and it’s easy to get this type of knowledge.

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** Ronald Coase said that externalities where not a problem if property rights where clearly defined and we could trade with them. And, secondly, that transaction costs had to be sufficiently low.

14. SPECIFIC KNOWLEDGE: a. Examples:

i. Idiosyncratic knowledge of particular circumstances. ii. Scientific knowledge.

iii. Assembled knowledge. b. Free markets make superior use of specific knowledge dispersed


a. Types of transaction costs i. Search and information costs.

ii. Bargaining and decision costs iii. Policing and enforcement costs. iv. Opportunity cost of inefficient resource allocation.

b. Optimal economic organization minimizes transaction costs. ** Contracting costs could be BETWEEN FIRMS (going thorough the market) or WITHING FIRMS (staying in the firms). If contracting costs withing the firms are very large we need to go through the market. Problems that arise as the firm becomes larger : Delegation, personal, influence (corruption).

16. FIRMS CAN REDUCE TRANSACTION COSTS: a. Advantages of firms over markets.

i. Fewer transactions ii. Information specialization

iii. Reputational concerns.


1. FIRMS AS NETWORKS OF CONTRACTS: a. Markets use prices to allocate resources. b. Firms use managers to allocate resources. c. Firms have many decision makers. d. The firm is a focal point for a set of contracts. The term focal point indicates that the firm always is one of the parts to each of the contracts that constitute the firm. e. Individual incentives (utility maximization) may not be aligned with the objectives of the firm (profit maximization).

2. FIRMS AS NETWORKS OF CONTRACTS: The firm is a creation of the legal system that has the standing of an individual in a court of law. The firm serves as one party to the many contracts that make up the firm.

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• Choice of effort. Additional effort by managers generally increases the value of the firm, but since the managers expend the effort, additional effort reduces their utility. SALARIES.

• Perquisite taking. It is in the interests of owners to pay sufficient salaries and bonuses to attract and retain competent managers. However, owners do not want to overpay managers. In contrast, managers are likely to want not only higher salaries but also perquisites such as exclusive club memberships, lavish office fur- niture, luxurious automobiles, stimulating day care for children, and expensive French confections. PERKS

• Differential risk exposure. Managers typically have substantial levels of human capital and personal wealth invested in the firm. This large investment can make managers appear excessively risk-averse from the standpoint of the owners, who (at least in a large public corporation) typically invest only a small fraction of their wealth in any one firm.5 Hence, managers might forgo projects that they antici- pate would be profitable simply because they do not want to bear the risk that the project might fail and lead to a reduction in their compensation. RISK AVERSION

• Differential horizons. Managers’ claims on the corporation generally are limited by their tenure with the firm. Therefore, managers have limited incentives to care about the cash flows that extend beyond their tenure. Owners, on the other hand, are interested in the value of the entire future stream of cash flows, since it deter- mines the price at which they can sell their claims in the company. DIFFERENTIAL TIME HOIRIZONS.

• Overinvestment. Managers can be reluctant to reduce the size of a firm, even if it has exhausted available profitable investment projects; they prefer to empire- build. Also, managers often are understandably reluctant to lay off colleagues and friends in

The firm


Insurance providers




Labor unions

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divisions that are no longer profitable. Managers who fire their colleagues bear personal costs (disutility), whereas shareholders receive most of the benefits. OVERINVESTMENT.

4. OTHER CONFLICTS a. Buyer versus supplier. Owners of firms would like to acquire high-quality inputs at low prices, whereas owners of supplying firms would like to provide inexpensive inputs at high prices. b. Free ride or not. c. Management versus labor.

5. THE ROLE OF CONTRACTS IN CONTROLLING INCENTIVE PROBLEMS: a. Contracts control incentive conflicts. b. Contracts define the firm’s organizational architecture:

i. Decision rights ii. Performance evaluation

iii. Reward systems Contracts are a mechanism that help control incentive conflicts. This contracts define the firm’s organizational architecture and this architecture provides an important set of constraints and incentives that helps resolve incentive problems.

6. CONTRACTS: a. Costless Contracting: Ideal contracts would align interests (minimize incentive conflicts) at no or low cost. **Por ejemplo una persona consume demasiados “perks” y la empresa quiere darle a cambio un salario para que no se pase. La empresa puede establecer limites de salario total (ya sea solo dinero o dinero y perks y que el otro decida que es lo que le va mejor mientras que en cualquiera de los casos a la empresa le irá IGUAL de bien una decision que otra. b. Costly contracting and asymmetric information:

i. Contracts are costly to negotiate, write, administer. ii. Parties to contract have asymmetric information on performance levels.


i. Principal contracts with agent for service. ii. Agents have postcontractual incentives to increase their well-being at the

expense of the principals. b. Asymmetric information complicates resolution of agency problems:

i. Principal incurs monitoring costs. ii. Agent incurs bonding costs.

c. Bargaining failuresi. Asymmetric information: individuals may overreach during negotiations

to the point that negotiations stop. d. Adverse selection:

i. Use of private information in manner detrimental to trading partner.

8. IMPLICIT AND REPUTATIONAL CONTRACTS: a. Implicit contracts: Agreements and understandings that can’t be legally enforced. (depend on private incentives).

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b. Reputational concerns can motivate implicit contract compliance.

**Owner-manager conflich does not exist in small companies. As companies grow more problems appear. For example the owner manager conflict. The owner wants profit and the manager wants reputation, better salary, bonuses. **firms exist to reduce transaction costs.


1) STRATEGY : (strategy is different to tactic)a. Definition: General policies intended to generate profits/generate value.

i. Choice of industry ii. Combination of products and services

iii. Competitive and cooperative behaviors. b. Strategies evolve as circumstances ( a firm’s strategy must take into

account long term issues facing the firm). c. Strategies must create and capture value in order to realize sustained


2) TRANSACTION COSTS: Any costs that you experience in a transaction. When you go through the market.

a. Consumer transaction costs. i. Product search

ii. Learning product characteristics and qualityiii. Negotiating for sale. iv. Enforcing agreements.

b. Producer transaction costs i. Negotiating terms

ii. Legal expenses. 3) VALUE CREATION: TO INCREASE DEMAND: In order to make profits it is

important to create value and to capture this value. a. Reduce production costs or producer transaction costs. (shift supply curve

to the right). **Consumer surplus + Producer surplus = Total value created by the industry.

b. Reduce consumer transaction costs (shift demand curve to the right) c. Shift demand to the right by other means d. Devise new products and services. e. Improve product quality (Telefonica. New offers / products into the

market is a way to improve the product quality). f. Price complements so consumers will buy more (printers and ink

cartridges, razors and razor blades). g. Change the price of substitutes (Theatres ban patrons from bringing food

into the theatre, no liquids are allowed past the security gates at airports). h. CONVERTING ORGANIZATIONAL KNOWLEDGE INTO VALUE: Types of

assets (recursos) within a firm:

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i. Hardware-physical assets. Those that are tangible as plant or equipment. You can sell them or buy them.

ii. Wetware – Employee brainpower. Wetware refers to human resources, you can’t sell or buy them, it’s the know-how. In most of the cases strategy comes form wetware, people giving the ideas (bottom-up). Instead of being up-bottom as some orders.

iii. Software –Formulas or recipes for creating value. Those that are intangible as patents or brand reputation. You can sell them or buy them.

iv. Implications – allow employees to experiment and innovate. 4) CAPTURING VALUE: Firms capture value from Software and Hardware but it

only “rents” Wetware. It does the firm little good to reduce transaction/production costs or to increase consumer demand if rivals can copy this changes quickly and enter the market. Such compettion will eliminate the profits.

a. Firms in competitive markets are price takers. b. Firms with market power choose prince and quantity. (They can capture

value if they exploit their market power). –The extremes are monopoly and perfect competition.

i. MARKET POWER RESTS IN. 1. Entry barriers (economists of scale, patents, brand names,

high exit costs) 2. Degree of rivalry (Number and size of competitors) 3. Threat of substitutes (Outside products) 4. Buyer and supplier power (number and size matters). : 5. Introduce new products and services 6. Cooperation with other firms

ii. SUPERIOR FACTORS OF PRODUCTION: 1. People (special talents or skills) 2. Physical assets (Prime real estate, unique equipment). 3. Bidding for specialized assets may erode profits 4. If a resource is adding value to a firm other firms will

attempt to bid this resource away. 5. The price of this resource will rise, raising costs. 6. Initial profits will fall. 7. Team production

a. Interdependencies among workers increase value beyond the “sum of the parts”

b. Luck or foresight may endow firms with unique team production capabilities.

c. Rivals may be unable to pinpoint source of advantage and unable to capture equivalent value.

c. DIVERSIFICATION : i. Benefits

1. Economies of scope 2. Promoting complements

ii. Costs 1. Bureaucracy 2. Incompatible cultures

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d. DIVERSIFICATION AND MANAGEMENT: i. Diversification for earning volatility (may not increase value)

ii. Investors can diversify on their own. iii. Related diversification (can increase value) iv. Capturing the gains (Target firms often obtain the largest gains in a


a. Understanding internal resources and capabilities (physical, human, and organizational capital).

b. Understanding the environment (markets, technology and government regulation).

c. Combining environmental and internal analyses.d. Strategy and organizational architecture. e. FRAMEWORK FOR STRATEGIC PLANNING: f.

g. CAPTURING VALUE: i. Can a firm capture value on a sustained basis?

ii. Markets will bid prices of resources up iii. Environment change iv. Normal rates of return will be earned in the long run.


Vertical integration: You merge with others (contrary to outsourcing). Ex. You buy your retailor.

Outsourcing: Asking someone (a 3d party) to do something on your behalf.



Internal resources and capabilities

Physical Capital

Human capital

Organizational capital

Business Environment







CommunicationGovernment regulation

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Example:KODAK outsources IBM (IT)Kodak has relationships with clients, etc. and deals with all of it through IT. This is why Kodak decides to outsource with IBM.


Pros: Specialization. IBM is specialized in providing IT services, and many firms are asking IBM to do the IT services. IBM has a larger workload on IT services, it is somehow more efficient better technicians, better machinery…)Core business: The real advantage of a firm. (Mango Clothes. They are good at that, specialized. But they need auxiliary services Finances department, RRHH… that are not the main source of value (the core business is).

Topic 8. Organizational Architecture and the Level of EmpowermentOrganizational Architecture is composed by three things:

- Decision-right assignment- Reward system- Performance-evaluation system

The Fundamental Problem that any economic system wants to solve is to produce efficiently. To solve costumers needs in the most efficiently way possible. How markets and firms solve that fundamental problem?MARKETS They solve it by prices, that regulates the economy and tell firms how to produce efficiently.FIRMS the analog to prices in markets are the managers in the firms. They have harder difficulties because they’re not numbers, they have different thinking ways.

• Important information for profit maximizing decisions is – controlled by many individuals– may be costly to transfer

• Decision makers may have incompatible incentives• Organizational architecture helps overcome these limitations

8.1 Architecture within Firms: Once the firms decentralize… • Decision-right assignment

– Empowering employees• Controls

– Employees are granted authority over resources– Incentive may be misaligned

• To align incentives managers must develop a reward and performance evaluation system

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The business environment is out of the reach of the firm: it affects the firm and the organization but they cannot be changed by the firm.The environment should lead to an optimal organization of the firmIt is worried about VALUE: How to create value and how to retain value. Every time that there is a change in business environment you have to ask again that two questionsThe strategy is in your reach, so you can decide your own strategy and you can change it to have different results.If your competitors are decentralized and you are not, they are likely to be quicker than you in adapting to business environment changes but by decentralizing you also have problems like difficult coordination. Determinants of Architecture• Strategy affects architecture and architecture affects strategy• As the business environment changes, architecture will change with it

Managerial Implications• Does the strategy fit the business environment?• Does the current architecture fit the business environment and strategy?

– Does it effectively link specific knowledge and decision rights?– Does it provide incentives to use information productively?

• Given the decision rights system, does the control system fit?• If any of the above questions show a problem, determine what changes in strategy or architecture are appropriate• Determine problems that will be faces if the firm implements these


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THE FIRM’S WORK: transform inputs into outputs by a complex process composed by a lot of tasks. A collection of tasks makes a job. A job is assigned by the manager, so he/she gives you a compilation of tasks that he/she will decide you have to do. 8.2 Centralization vs Decentralization

• Determines which level of the firms’ hierarchy to place the decision right• Production process involves tasks bundled into jobs• Job dimensions: how many tasks do you have to do and what degree of authority you have in each task

– Variety of tasks: few or many– Decision authority: limited or broad

Benefits of Decentralization• Effective use of local knowledge

– Local tastes and preferences– Price sensitivities of particular customers

• Conservation of management time– Senior management focus on strategy

• Training and motivation for local managersCosts of Decentralization

• Potential agency problems– Effective control systems may be expensive

• Coordination costs and failures– Duplication may occur in market analysis

• Less effective use of central information: Local managers may be enforced by “Shortermism” (take decisions basing on short periods). This is unavoidable.

AutoMarkt Example:CEO: Chief executive Manager Conceller delegat (TOP MANAGER OF THE FIRM) CEO- BOB


JOB: Pricing the carsWhat tasks compose that job?

- Analyze the car- Analyze the market- Compare the car with competitors

SUMMARY: BENEFITS AND COSTS OF DECENTRALIZATIONBenefits CostsEffective use of local Knowledge Incentive conflicts (agency problem)Conservation of senior management time Coordination failuresBetter incentives to attract and retain talented employees

Less effective use of central Knowledge

TYPES OF DECENTRALIZION: the most famous, diversification by producing more than one product.

1) Functional



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2) Geographic

3) Product/type of client

TOPIC 9: INCENTIVE COMPENSATION AND PERFORMANCE EVALUATIONIncentive: Owners and employees have different aims.

- Owners wish to maximize profits and want employees to work diligently.- Employees wish to maximize utility and take breaks from working.



Consumer divisionBusiness division


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Incentive problems exist because of conflicts of interest between employers and employees: most of the costs of exerting effort are borne by employees, whereas most of the gains go to their employers. EXAMPLE OF OPTIMAL EFFORT CHOICE:The utility function of an employee increases when the income increase.The utility function of an employee decreases when the effort increase. P= 100e-(1000+e^2) PROFITS 100e = revenue (guanys)1000+e^2= wage, costs.

The firm will pay Ian $3,500 for 50 hours of effortProblems:

- The firm cannot observe Ian’s effort costlessly.- The firm could observe output, but it may difficult to measure and may be

affected by factors beyond the employee’s control. You could not made the income on the out of control things because if economy goes bad people would stop working with efford.

These problems are easily resolved when actions are costlessly observable. Firms can identify the most efficient actions by employees and pay employees only if these actions are taken. However, in most situations employee actions are not observable and firms motivate employees through incentive compensation.Sometimes, there is a simple way to resolve this incentive problem even when the actions of employees are unobservable. The solution is to sell each employee the rights to his or her total output.Incentives from Ownership:

- One way to avoid these problems is to sell employees the rights to their production. In our case, the company could sell the worker the rights to the value of his output (100e)

- This is seen in franchising and managerial buyouts

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- Limiting factors- Wealth constraints- Risk aversion- Team production

Optimal Risk Sharing- Most individuals are risk averse

for given income level, prefer less dispersion in outcomes- Shareholders have diverse portfolio.

less concerned about performance of any one company- Employees receive substantial income from single company

Effective Incentive Contracts- Compensation contracts have two functions

Motivate employees Share risk more efficiently

- Employees prefer fixed income to random income flows- Fixed incomes do not provide strong incentives- Contract must balance these considerations

Basic Principal-Agent Model- Employer is the principal: risk neutral- Employee is the agent: risk averse

Model illustrates tradeoffs between incentives and risk sharing

9.1: The incentive problem: effortOptimal effort level is hot feasible because effort is non-observable & non-contractible.

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9.2: Principal-Agent compensation: outputThe compensation will be based on output, which is observable and contractible. Compensation= fixed + variable.The employee should not be compensated on things that are out of his reach FACTORS THAT FAVOR HIGH INCENTIVE PAY

1. The value of output is sensitive to the employee’s effort (The employee should be able to do something to increase the output)

2. The employee is not very risk-averse (if he is risk averse, he hates variance; it would cost a lot to the company)

3. The level of risk that is beyond the employee’s control is low4. The employee’s response to increased incentives is high ( the employee exerts

substantially more effort)5. The employee’s output can be measured at low cost.

Informativeness PrincipleAny relevant information related to workers output should be included to workers compensationWe take an approximation to evaluate effort; we need a lot of factors to be as precise as it could be.

- Use all appropriate information when evaluating performance- Consider uncontrollable factors such as market conditions- Select benchmarks to support relative performance measurement- By measuring employee effort with more precision, effort choice will be more


PERFORMANCE EVALUATIONEvaluations provide employees feedback on achievement and ways to improve (someone who tells you what is good and what it is not)Evaluations are used to determine rewards and sanctionsPerformance evaluation entails evaluating employees as well as subunit of the firmSETTING PERFORMANCE BENCHMARKSFrom where do the manager get the information? Time and motion studies: IF THE TASK IS SIMPLE YOU CAN RELAY ON OBJECTIVE THINGS LIKE TIME OR QUANTITY

- Engineers estimate the amount of time a task requires - Determines most effective work method


- Employees have incentives to only meet the goal and not exceed it

RATCHET EFFECT is to just do what they ask, not much more because it put a lot of barriers to your next year’s effort because you are doing the things as good as you can and you are asked to do it better each year. So you will stay at the limit asked. (“no t’esforçarás del tot per no haver de fer molt més els seguents anys, si un any ho fas molt millor, els anys seguents haurás de seguir millorant encara més”).MEASUREMENT COSTS: you need to do changes on your monitoring system to control everything you want to control to reward effort.

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- Accounting system may need to be developed- Information systems improved- Value-maximizing firm improves measures as long as incremental benefits justify


OPPORTUNISM:Gaming: Employees may engage in dysfunctional activities to improve their evaluations. Employees will do whatever they can to have the incentive also if they have to lose their most important goal and the quality of their work. Horizon problem: Short-run objective performance measure may cause employees to focus on results that influence their evaluation only over their remaining time with the firm. You need to give workers some patience, and performance evaluation to avoid pressure on workers.RELATIVE PERFOMANCE EVALUATION:You evaluate workers comparing to the relative same workers to adjust your evaluation to the level of the others

- Evaluate worker output relative to their co-workers in the same job- Within the firm:

Jobs not always identical Group has incentive to punish “rate busters” Incentive to hire less competent workers

- Across firms Data hard to obtain

Two problems, people could shirk and do the things worse if they know the average is low and they would effort less because they know that with a relative good work, if they are one of the best ones, they would be more compensated.

TOPIC 10: ETHICS AND ORGANIZATIONAL ARCHITECTUREEthics and Organizational Architecture

- Ethics and organizational architecture are closely related- Corporate performance evaluation systems, reward systems and assignment

of decision rights can be designed to encourage ethical behavior

Although individuals are always trying to maximize their utility and they choose among some alternative to satisfice their well-beingBusiness ethics seeks to proscribe behaviors deemed inappropriate for firms.

- Taking gifts- Bribing government officials- Misrepresenting data (giving a good image of the firm)- Discriminatory practices- Boycotting third parties

To some firms, doing just one of those things it’s a lot of workEthics: 5 MAIN IDEAS

1. Business Ethics is an elusive concept. Abstract, difficult to define as a fixed thing.

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2. If the corporation is to survive, it needs to maximize value to its owners. (THE MISSION)

3. The company’s reputation is part of the “brand-name” capital which has an important impact on results.

4. It’s not about changing employers/managers performances, it’s about setting the right incentives

5. Even if ethics efforts fail, good communication and education makes a difference.

VALUE MAXIMIZATION: the first ethical restriction.- Economic Darwinism: use your assets as good as you can. Use them all with

the most efficiency you can because if you don’t anyone else will do it.o By maximizing a firm’s value, all stakeholders can share a bigger pieo Only those firms that are able to produce quality products at low costs

will survive- Market failure and regulation

o Result in misallocation of resourceso May result in regulation

- Compensating differentials: efficiency wages- Corporate Social Responsibility

o Firms should engage in activities that fall into this category up to the point where the marginal benefit equals the marginal costs

CORPORATE POLICY SETTING- In dealing with questions with potentially contentious ethical implications

firms o Should use input from diverse stakeholderso Be aware of different legal standards in countrieso Understand business norms and standardso Assess the public’s reaction (asking you if you would be happy or

comfortable if what you do would be public or known by the population).

REAL ETHICAL DILEMMAS:- Should we use child labor in an Asian factory? Should we do business with a

company that does so?- Should we pay “fees” to speed up the granting of permits by public officials?- Should we tell our workers that the business is doing badly?

Mechanisms for Encouraging Ethical Behavior- Ethical lapses often arise from conflicts of interest- The following help mitigate these problems

o Repeat sales (things should return to normality and well-being by themselves)

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o Warranties (when you sell a product you are giving two year full warranty)

o Third-party monitors (there are consumers associations or Moody’s that grade your firm. So you accept this grading)

o Disclosure (o Ownership structure

Contracting Costs: Ethics and Policy Implementation- Trade-offs between monitoring and shirking

o Warranties reduce risk

- Prices customers pay will be lower if shirking is expected- Altruism economizes on the costs of policing and enforcing contracts

Codes of EthicsTwo views:

CYNICAL: firms just have the code of ethics to keep doing what they want but with a justification of their actsPOSITIVE: With the code of ethics the firm is about to change. It makes a difference.

- How do firms control ethical behavior?o Have employees voluntarily adopt standardso Write contracts that align interests of those involved to behave

ethicallyo Write codes of ethics and provide training

- Why are they effective?o Altering preferenceso Altering incentives

- Educationo Employees may uncertain of ethical standards

- Corporate culture-

Topic 11 Corporate Governance

- Describes the organizational structure at the top of the firm- Includes

o Top-level incentiveso Partitioning of decision rightso Board of directorso Top managemento Outside monitors

Corporate Structure

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People may prefer to own an asset by a firm than by himself as an individual, because he pay less taxes.

- Corporations have the legal standing of an individual- Shareholders elect a board of directors with primary decision control rights- Shareholder-owners have limited liability- Corporations may establish governance procedures within legal boundaries

Corporate Ownership in Publicly Traded CorporationsBOTH OF THEM ARE PRIVATE!!! Closely held and publicly held

- Stock in closely-held corporations is not freely traded (PRIVATE) Sociedad Limitada (participaciones)

- Stock of publicly-traded corporations may be freely bought and sold (PUBLIC) SA (acciones) Shares

o Widely held corporation No one owner controls more than 10 percent of the shares

CORPORATE GOVERNANCE OBJECTIVES:- Maximizing value, as all the other firms- Protecting assets (shareholders want not that the enterprise sold the assets at

low prices, they have their money on that assets)- Production of proper financial statement that meet legal requirements (as

company become large and large it’s necessary (critical) to accurate the accountability and financial statement)

SEPARATION OF OWNERSHIP AND CONTROL- Incentive issues : Are executive interests aligned with those of stockholders? Not

always, CEO is not always having shares of the enterprise, he is just there to do a work but he doesn’t share liability neither risk

- Survival of corporations : Despite governance concerns, the corporate form seems both productive and resilient

- Benefit of publicly-traded corporation : Ability to raise large amount of capital

Top-level Architecture in US corporations- Decision rights divided among selected stakeholders- Shareholders- Governing board- Top management

Shareholders: free riding problem Ultimate owners

- Limited participation in managemento Elect boardo Board oversees managemento Some ratification rights

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Shareholder Incentives (they can be individuals or institutional investors, institutional have more impact on less free riding, they have more influence on monitoring)ME: 0.00001% GAINSLA CAIXA: 0.5% GAINS MOST IMPORTANT

- Small shareholders (individuals) have incentive to free ride rather than be actively involved

- Institutional investors (e.g. pension funds) differ in incentives to challenge management

- Blockholders internalize more of the benefits of active involvement

Board of Directors: The problem is that no one is controlling the board, it is controlled by himself, self-regulation!!!

- Delegates legal authority to professional managers- Primary function is top-level decision control- Other responsibilities

o Hire, monitor, fire CEOo Authorize strategic directionso Approve large capital outlays

Board Composition and work: endogamia people working there are good friends, school friends, familiar, they know each other, they know the CEO… they do whatever they decide without opposition. Se cubren unos a otros para liarla, asi se tapa todo.

- Size can vary from 4 to 33+- Over half are outside directors- CEO usually sits on board

o Frequently chairs the board

- Much work done in comitteeso Audit o Compensationo Nominating

- Fiduciary responsibilityo Represent the interests of the corporation and shareholderso Good faith errorso Loyalty

- Legal protection through business judgment rule