Interesting paper: Inside Organizations

An interesting new paper from Robert Gibbons: Inside Organizations: Pricing, Politics, and Path Dependence. Annual Review of Economics, Vol. 2: 337-365, September 2010. The standard theory of the firm asks questions, mainly, about the boundaries of the firm. Less interest has been shown in the internal organisation of firms. This is beginning to change, as this survey from Gibbons shows. The abstract reads:

When economists have considered organizations, much attention has focused on the boundary of the firm, rather than its internal structures and processes. In contrast, this review sketches three approaches to the economic theory of internal organization—one substantially developed, another rapidly emerging, and a third on the horizon. The first approach (pricing) applies Pigou's prescription: If markets get prices wrong, then the economist's job is to fix the prices. The second approach (politics) considers environments where important actions inside organizations simply cannot be priced, so power and control become central. Finally, the third approach (path dependence) complements the first two by shifting attention from the between variance to the within. That is, rather than asking how organizations confronting different circumstances should choose different structures and processes, the focus here is on how path dependence can cause persistent performance differences among seemingly similar enterprises.

Gibbons explains,

The first approach (pricing) may feel familiar to economists because it can be seen as applying Pigou's (1932) prescription: If markets get the prices wrong, then the economist's job is to fix the prices. The resulting models ask not only what prices should be attached to various actions inside organizations, but also what direct and indirect methods are available to set these prices. Because of its focus on pricing, this approach naturally addresses incentive contracts. Because it also considers indirect methods for setting prices, however, this approach also addresses many structures and processes within and between organizations, including job design, transfer pricing, and outsourcing.

The second approach (politics) considers environments where important actions inside organizations simply cannot be priced, directly or indirectly. As a result, power and control become central, as in models of battles for control, lobbying those in control, and so on. More generally, this approach views the organization as a decision process, so issues of gathering and communicating information naturally arise, in addition to issues of control and decision making. The politics approach has received less attention from economists than has the pricing approach, but it has grown rapidly over the past decade, and it has interesting connections to earlier work outside economics.

Finally, the third approach (path dependence) is not an alternative to either of the first two, but rather a complement to both. This approach shifts attention from the between variance to the within. That is, rather than ask how organizations confronting different circumstances should choose different structures and processes, the focus here is on how path dependence can cause seemingly similar organizations to perform at persistently different levels. One important source of path dependence connects to an important issue in both the pricing and politics approaches: relational contracts (i.e., agreements so rooted in the particulars of the parties' circumstances that they cannot be written down and hence must be self-enforced rather than adjudicated by outsiders such as courts). Whereas both the pricing and politics approaches include work emphasizing the importance of relational contracts in steady-state outcomes, the path-dependence approach enriches the others by focusing on how the dynamics of building and changing relational contracts can affect which steady-state outcomes are reached.

An interesting and important expansion of the standard approach to the theory of the firm into organisational economics, where the internal structure of firms, as well as their boundaries, are looked at.