Does Performance Cause Organizational Form?

21 March 2008 at 9:35 am Peter G. Klein 4 comments

| Peter Klein |

There is a large literature on the performance effects of organizational form. Obviously, for the strategist, getting organizational form right is important only if it leads to superior performance. Of course, the empirical literature recognizes that organizational form, governance, strategy, and other key decision variables are at least partly endogenous. Still, the causal arrows are usually thought to run from strategy to performance.

Ben Hermalin was at Missouri this week to present his paper, “Firm Value and Corporate Governance: Does the Former Determine the Latter?”, which argues that good governance can be the result, not the cause, of good performance. He constructs a model in which the benefits of getting governance right are, on the margin, increasing in the value of the firm’s investment opportunities. Better-performing firms have better opportunities and hence more to gain from designing governance structures that align managers’ incentives with owners. The model is based on an agency framework and applies specifically to managerial governance, but the general problem would seem to apply to a variety of organizational problems and contexts.

The model purports to explain some empirical regularities that do not fit with common theories of organizational governance. Why, for example, do firms leave money on the table by sticking with inefficient forms of governance? (This point is consistent with, but different from, the Demsetz-Lehn critique.) One problem with the model is that it assumes that the firm’s opportunity set is unobservable, so that empirical studies cannot simply include proxies for investment opportunities as control variables, making the positive correlation between governance and performance (as explained by the model) disappear.

More generally, though, I’m struck by how little we’ve learned about the benefits of organizational alignment since Masten, Meehan, and Snyder (1991). Even if organizational form matters for performance, how much does it matter, relative to the other causes of performance (resources and capabilities, industry characteristics, technical and allocative efficiency, etc.)? Getting organizational form right can be tricky; is it worth it?

Entry filed under: - Klein -, Corporate Governance, Strategic Management, Theory of the Firm.

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4 Comments Add your own

1. srp | 22 March 2008 at 2:49 am

Is it cheaper to set up a bad form? If not, how can a bad form ever be “worth it?” Do you have a model of switching cost in mind, where a once-efficient form becomes sub-optimal as the environment shifts but the cost of adapting exceeds the gain in routine performance?
2. Peter Klein | 22 March 2008 at 10:28 am

A switching-costs model would work, as would a model with asymmetric information (firms or managers have different knowledge about the benefits and costs of organizational form, and the “better” firms both are more profitable and have more accurate information about the organization-performance link). Hermalin’s model, however, doesn’t involve either of these, just a standard agency framework in which incentive alignment is costly to the principal. Governance mechanisms, in his model, are an expense — either explicit costs of monitoring or the implicit costs of insuring the agent against risk under performance-based pay. If the firm’s investment opportunities are poor, it is cheaper to let the agent appropriate the marginal dollar for personal use than to invest in good governance to prevent it.
3. Donald A. Coffin | 24 March 2008 at 11:26 am

There is, of course, the real possibility that the optimal structure of the firm (and of governance) changes with external conditions. In this case, a model including switching costs becomes even more important. Clearly the firm will want to adopt an optimal structure when it organizes (assuming the initial costs of any structure are the same). But switching costs can inhibit structural change when the optimal structure changes.
4. Bo | 1 April 2008 at 3:08 pm

Interesting discussion – I am just wondering how you define organizational form (or worse – optimal structure)? The question of whether firms “consciously organize” themselves or if organizational form is an ex post outcome of strategy formulation and implementation (and ultimately performance) is intriguing. Some empirical evidence would seem to suggest the possibility of multiple “optimal” organizational structures in a given industry/competitive environment – i.e. firms adopt distinctly different organizational forms yet are equally successful…do we then attribute this to other factors? The question, as put above, is indeed: does organizational form matter and if so how much and how can we measure its impact separately from other influences?