The Economics of Organizational Architecture

Drawing on the work of Michael Jensen and William Meckling, the co-formulators of “agency cost theory,” the authors argue that there are two main challenges in designing the structure of organizations: (1) the “rights assignment” problem—that is, ensuring that decision-making authority is vested in managers and employees with the “specific knowledge” necessary to make the best decisions; and (2) the “control” or “agency” problem—designing performance-evaluation and reward systems that give decision-makers strong incentives to exercise their decision rights in ways that increase the long-run value of the organization.

The authors provide a number of instructive applications and extensions of the Jensen-Meckling organizational framework. Using a series of short case studies that range from the Barings Brothers’ debacle in the early 1990s and the decade-long restructuring of ITT to the cases of McDonald’s and Century 21, the authors demonstrate the importance of designing performance-measurement and reward systems that are consistent with the assignment of decision rights.

In so doing, the authors also work to dispel the widespread notion, popular among advocates of Total Quality Management, that the widespread use of performance measures and incentives undermines efforts to promote teamwork within large organizations. A number of brief case histories of companies like Xerox and Mary Kay Cosmetics are used to show the critical role of performance measurement and individual rewards in reinforcing a quality-centered corporate culture. As the authors conclude, “It is a mistake to think of the ‘soft’ and ‘hard’ aspects of organizations as mutually exclusive or even as competing.”