Sunday, 28 April 2013

50 years of "A Behavioral Theory of the Firm"

In his latest weekly newsletter from David Warsh writes about attending a program celebrating the fiftieth anniversary of the publication of A Behavioral Theory of the Firm by March and Richard Cyert. Warsh says,
The corporate landscape today is, of course, all but unrecognizable compared to what it was when March and Cyert wrote in 1963. The outlines of any number of vivid company stories loomed as I listened to the panels and papers at the conference. In fact, a bountiful new field of organizational economics has grown up in the nexus of the interest in organizations that March shared with Kenneth Arrow, Ronald Coase, Oliver Williamson, Herbert Simon and Sidney Winter.

That field was an empty lot when March started, not long after finishing his PhD, at Yale. A Behavioral Theory of the Firm was a broadside aimed at standard textbook economics, especially the branch of it known as the theory of the firm. The book begins,
The “firm” of the theory of the firm has few of the characteristics that we have come to identify with actual business firms. It has no complex organization, no problems of control, no standard operating procedures, no budget, no controller, no aspiring “middle management.”
In fact the neoclassical model can be seen as a model with no firms at all! As Nicoli Foss remarks,
“With perfect and costless contracting, it is hard to see room for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and wouldn’t need the services of the intermediaries known as firms”.
The ‘Behavioural models’ of the firm have been developed since the 1950s. In these models it is assumed that there is a separation between ownership and control. Behavioural theorists consider the consequences of conflict between self-interested groups within firms for the way in which firms make decisions on price, output etc. The emphasis in these models is on the internal relations of the firm with little attention being paid to the external relations between firms.

Although some of the seminal work on the behavioural theories can be traced back to work by Herbert Simon in the 1950s, the theory has largely been developed by Cyert and March, in their book A Behavioral Theory of the Firm, with whose names it has been connected right up to today.

In behavioural theory the corporation has a multiplicity of different goals. Ultimately these goals are set by top management via a continual process of bargaining between the groups within the firm. An important point here is that the goals take the form of aspiration levels rather than strict maximisation constraints. Attainment of the aspiration level ‘satisfices’ the firm: the behavioural firm’s behaviour is ‘satisficing’ in contrast to the maximising behaviour of the traditional firm. The firm seeks levels of profits, sales, rate of growth etc that are ‘satisfactory’, not those that are maxima. Satisficing is seen as rational behaviour given the limited information, time and computational skills of the firm’s management. The behavioural theory redefines rationality, rationality is now that of ‘bounded rationality’.

Cyert and March argue that there are two sources of uncertainly that a firm has to deal with. The first is uncertainty that arises from changes in market conditions, that is, from changes in tastes, products and methods of production. The second is uncertainty arising from the behaviour of competitors. According to the behavioural theory the first form of uncertainty is avoided, as much as it can be, by search activity, by spending on R&D and by concentrating on short-term planning. A difference between the traditional and behavioural theories is the importance given in the behavioural theory to the short-run, at the expense of the long-run. To avoid competitor-originated uncertainty, Cyert and March arguethat firms operate within a ‘negotiated environment’, that is, firms act collusively with their competitors.

The instruments the behavioural firm uses in decision-making are the same as in the traditional theories. Both theories consider output, price and sales strategy as the major instruments. The difference between the theories lies in the way firm choose the values of these instruments. In the neoclassical theory such values are selected so to maximise long-run profits. In the behavioural theory the choice is made so that the outcome is the ‘satisficing’ level of sales, profits, growth etc. The behavioural theory also assumes that the firm learns from its experience. In the beginning a firm isn't a rational institution in the neoclassical sense of ‘global’ rationality. In the long run the firm may tend towards global rationality but in the short run there is an important adaptive process of learning. Firms make mistakes, there is trial and error from which the firm learns. In a sense the firm has memory and learns via its past experience.

An aspect of the firm neglected by the traditional theory is the allocation of resources within the firm and the decision-making process that leads to that allocation. In the neoclassical theory the firm reacts to its environment, the market, while the behavioural theory assumes that firms have some discretion and do not take the constraints of the market as definite and impossible to change. The important point here is that the behavioural theory looks at the mechanisms for the allocation of resources within the firm, while the neoclassical theory examines the role of the market, or price, mechanism for the allocation of resources between the different sectors of the economy. The concept of of ‘slack’ is used by Cyert and March to refer to payments made to groups within organisation over and above that needed to keep that group in the organisation. Slack is therefore the same as ‘economic rent’ accruing to a factor of production in the traditional theory of the firm. What is significant about the behavioural school is their analysis of the stabilising role of ‘slack’ on the activities of the firm. Changes in slack payments in periods of good and bad business means that the firm can maintain its aspiration levels despite the changes to its environment.

The behavioural theories can be seen as an early attempt to develop a theory of the firm at the level of the individual firm, a theory which, as Oliver Williamson has said of the Cyert and March (1963) book, was an attempt to “pry open what had been a black box, thereupon to examine the business firm in more operationally engaging ways”. But the success of this attempt was limited in economics. Williamson’s interaction with people such as Herbert Simon, Richard Cyert and James March while he was at Carnegie-Mellon University did play a role in the development of the transaction cost theory of the firm but outside of this the behavioural/managerial theories have had little effect on the mainstream economic theories of the firm. Consider the representation of the firm in standard microeconomics textbooks. If you look at both undergraduate and graduate microeconomics textbooks, it is difficult to find a discussion of behavioural or managerial models. Koutsoyiannis (1979) is one of the few that gives serious attention to these models, and it is now more than 30 years old.

In fact the impact of the behavioural theories may have been greater in management than economics. Argote and Greve claimed in a 2007 paper that A Behavioral Theory of the Firm “continues to be one of the most influential management books of all time”.

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