DECENTRALZED DECISION-MAKING AND SELF- MANAGEMENT IN FIRMS: POTENITALS FOR TRANSACTION COSTS AND TRUSTLESS REVOLUTIONS
YAËL WILLIAM OSSOWSKI
THESIS
Submitted as a partial fulfillment of the requirements for the degree of Master of Arts in Philosophy, Politics, Economics at
CEVRO Institute, 2018
Prague, Czech Republic
Advisor: Dr. Boudewijn Bouckaert
ABSTRACT
Firms exist because exchange within a firm is cheaper than in the market. That is the contribution of transaction cost theory, and it explains why firms form internal organizations.
Experiments in decentralized forms of organizational structure have evolved to empower individuals and remove the traditional role of managers. This has limited or even removed many incumbent transaction costs. Without managers, oversight and monitoring costs are scrapped, thereby leaving more resources for maximizing utility and profitability. Technological mechanisms such as blockchains provide a method by which firms can further eliminate transaction costs by replacing intermediaries and administrative departments with decentralized, distributed trustless networks.
That being the case, how much does organizational structure contribute to transaction costs of a firm, and what methods can a firm implement to better mitigate transaction costs? Conducting interviews and examining case studies in self-management, such as The Morning Star Company,
Valve Corporation, and Zappos, this paper explores how decentralized decision-making and boss- less structures lower transaction costs, and what advantages exists over firms with steep, centralized hierarchies. The introduction of trustless consensus technology provides potential for further decentralizing authority, replacing intermediaries, and minimizing transaction costs within and between firms, and is thus also included as a contribution to the theory of the firm.
1 Table of Contents
INTRODUCTION 3
ONE: FIRM ORGANIZATION, AND MARKET STRUCTURES 4
THEORIES OF THE FIRM 4 THE FIRM’S HIERARCHY 6 MARKET STRUCTURES 9 THE ROLE OF THE ENTREPRENEUR 11
TWO: DECENTRALIZED DECISION-MAKING AND MANAGEMENT 16
SELF-MANAGING ORGANIZATIONS 16 TECHNOLOGY AND FIRM HIERARCHIES 18 TECHNOLOGY AND TRANSACTION COSTS 20 LESS HIERARCHY, MORE COLLABORATION 23
THREE: CASE STUDIES 24
THE MORNING STAR COMPANY AND SELF-MANAGEMENT 24 MANAGING WITHOUT MANAGERS 30 ZAPPOS AND HOLOCRACY 32 CENTRALIZATION AT GENERAL MOTORS 36
FOUR: TRUSTLESS CONSENSUS AND BLOCKCHAIN 39
THE PHILOSOPHY BEHIND THE TECHNOLOGY 39 ITS APPLICATION IN FIRMS 41
FIVE: ANALYSIS: STRUCTURE OF THE FIRM 45
AREAS OF WORK TO BE DECENTRALIZED 45 TRANSACTION COSTS IN DECENTRALIZED FIRMS 48
CONCLUSION 51
ACKNOWLEDGEMENTS 53
REFERENCES 53
2 Introduction
As most businesspeople, managers, and economists of all stripes can attest, a particular level of technological progress has led to innumerable advancements in how we regiment our lives, how we work, and how we organize ourselves to accomplish goals. This has expanded the scope of economic growth and brought forth vast general wealth to individuals in today’s industrial societies. Standards of living have increased steadily for the past few decades. This has been the case for North America, Europe, South America, and increasingly, the Asian and African continents (Easterlin 2000).
Pivotal to this growth has been the efforts of entrepreneurs and business owners, individuals who recognized certain market opportunities and seized upon them. Their method for achieving this was through firms they established and managed to better wield and direct resources to accomplish certain goals. Early literature on the “Nature of the
Firm,” as first proposed by Ronald Coase (Coase 1937), focused on the core reasons for why firms exist and their functions. Put simply, firms exist due to transaction costs. There exist markets for products and ideas, and “forming an organization and allowing some authority to direct resources,” as Coase wrote, saves costs overall.
Many additions have been made to Coase’s original ideas as time has progressed, technology has improved, and new insights have been gained. Post-Coasen theorists have uniquely focused on transaction costs (what Coase called ‘marketing costs’), while others have dedicated efforts to explaining property rights and contract theory within the firm.
And while scholarship on the theory of the firm in the domain of economics has advanced, there are still ideas and concepts to introduce that can also provide usefulness to the fields of organizational studies, strategic management, and entrepreneurial economics.
3 As firms have grown and evolved over time, we have been able to examine how various structures of internal organization deal with transaction costs at every level. More decentralized forms of structure provide us with an opportunity to examine how removing managers and localizing decision-making lower transaction costs and shape the firm.
In this thesis, I propose to add to the theory of the firm for the 21st century by focusing on the why decentralizing key aspects of management and organizational structure lowers transaction costs. The adoption of distributed trustless consensus, known colloquially as blockchains, further decentralizes these structures by removing intermediaries and transaction costs associated with monitoring and verifying information. The methods used to explore these questions are case studies and interview analysis, focused on examples of self-managed companies that have decentralized their management structures with the aid of technological tools. The interview was conducted with a former employee at The Morning Star Company based in Los Banos, California, the largest tomato processing company in the United States.
CHAPTER ONE: Firm Organization and Market Structures
Theories of the Firm
In today’s hyper culture of finance and business, firms are very natural organisms.
Consumers make thousands of decisions per day that reward or penalize certain firms with their business. Politicians are always sure to discuss the impact of legislation on
“small business” and entrepreneurs with firms. City councils, state legislatures, and executive branches of federal governments busy themselves with regulation of firms for the sake of public interest. Entire television channels, websites, and newspapers are dedicated to assessing the inherit value and stock options of firms, and globalization has allowed many firms to expand their economic influence into cultures and countries never
4 before thought possible. Each year, leagues of passionate young people enter business schools in hopes of forming their own firms and striking it rich while providing a superior product or service.
Among OECD countries, an average of 90 percent of the working population is employed in the private sector, either in a firm or as a self-employed entrepreneur themselves (The World Bank 2016). What this number represents, at least in the industrialized West, is that a significant portion of total employment is in the private, not public sector. That means that private firms are responsible for nearly all of a nation’s economic power and growth, and thus the ability of the market to prosper is an important factor in whether a nation will attain wealth and provide for its people. As such, investigating how these firms operate and are structured is an important study for understanding how wealth is created and sustained, and how those examples can be implemented or learned from elsewhere. This is a vital contribution of modern economics, and is why many economists have been awarded Nobel Memorial Prizes for their research into the theory of the firm (including but not limited to Ronald Coase,
Herbert Simon, George Stigler, Oliver Hart, Elinor Ostrom, and Oliver Williamson).
The neoclassical approach to understanding the origin of firms rests upon the idea that resources are scarce, individuals are rational, and that entrepreneurs form firms in order to gain profits using relevant information and technology to maximum utility (Hart
1995). Further questions on the internal structures of firms and the frictions that occur within sparked the additional approaches of exploring transaction costs, property rights, and contracts, which set forth explanatory motivations for specific natures and structures of firms. And while each approach shed additional light on motivations and structures of firms, several factors have brought made it necessary to update these theories.
5 Considering today’s global economy is so reliant on knowledge and technology instead of physical production and assets, for example was not foreseen by early researchers. That has driven economists to try to adapt and modernize the existing theories of the firm for the 21st century. One area that has certainly changed considering those contexts has been governing hierarchies within firms.
The Firm’s Hierarchy
When explaining why firms are different from markets (markets being where people freely exchange goods and services), economist Oliver Williamson offered the notion that firms are extensions of markets, and that they therefore employ different methods to reduce transaction costs. The main structure is the hierarchy, the internal organization of the firm, but it doesn’t differ so much from what happens outside the firm.
“I maintain that hierarchy is not merely a contractual act but is also a contractual instrument, a continuation of market relations by other means” (Williamson, 1991, p.
271). This hierarchy, housed within the firm, is the main concern to investigate in these pages. Hierarchy will be used interchangeably with “organizational structure,” meaning the architecture of an organization: “who collects information, with whom information is communicated, and how decisions are made, which affect the quality of decision making”
(Meagher and Wang 2008, p. 1).
Taking Williamson’s view into account, the structure of a hierarchy within a firm can have significant bearing on how successful said firm will be. Indeed, entire schools of management and comparative organizational analyses are specifically organized around discovering the best methods of structuring hierarchies to reduce transaction costs to gain advantages in the market. It is why certain companies choose to offshore their production, why they use contractors rather than full-time employees, or why they implement a
6 decentralized franchise model that empowers the individual store manager. Costs are high, markets are diverse, and information is scarce.
The two organizational forms to be explored here are that of centralization and decentralization. Under the former, most decisions are made at the top of a hierarchical structure. In the latter, decision rights are practiced by local workers or manager with superior local information.
In most strong hierarchies, there is a clear delineation between a manager and employee. Expectations are that managers, who have the foresight or intuition of entrepreneurs, will make particular decisions based on their assessment of the transaction costs, and delegate them down to employees as a method of reducing them.
Similarly, managers within firms carry this obligation with their own managers or employees in different departments, establishing contracts with various individuals in order to complete their duties. Sometimes, these are explicit written contracts, while other times these are unwritten “unspoken” rules. This is based on the nexus of contracts theory, which posits that firms are made up of a series of internal and external multi- lateral contracts (Jensen 1983). The arrangements of these contracts determine how the firm is organized and run, and what form of hierarchy will take hold in the firm.
In strong hierarchical organizations and firms, these contracts are fairly visible and transparent. Decision-making authority rests with managers that are higher up the hierarchy, and their obligations are usually only to those above them on the hierarchical scale. This particular method of organizing a firm is very centralized, relying on decisions made at the very top and then communicated down to the bottom. That makes tracing decision rights relatively simple, hence why research about centralized organization within firms is very developed and mature. But for firms that organize themselves
7 differently and do not have traditional hierarchies, what do these contracts look like? If individuals within a firm are organized without traditional managers, and have more decision rights and contracts they can execute without direct oversight, what does that mean for the productivity of the firm overall? What difference does having a decentralized organizational structure mean for firms that wish to compete in the market and have an advantage over their competitors?
Advantages to centralization and decentralization of organizational structures are important considerations for this thesis. Decentralized structures ensure that decision- making is localized, making responses more flexible and more informed by local contexts
(Meagher and Wang 2008). Decentralized firms are usually able to better adapt to dynamic circumstances than centralized firms with hierarchical structures, which are best structured to respond to situations that are relatively static. That presents serious challenges to strong hierarchies when conditions rapidly change (Mintzberg 1979).
Large, steep hierarchies within firms can take decisive action and can adopt lessons learned from other divisions or markets, while decentralized firms will more than likely evolve to meet local needs. More centralized firms will tend to be more physical capital intensive, while decentralized structures deal more in human capital (Rajan and Zingales
2001). For individuals in either of these management structures in a firm that deals in specialized knowledge, there are always incentives to breakaway and compete. Such is the nature of today’s more specialized knowledge economies. The task of the entrepreneur or manager, therefore, to provide enough incentives for workers to stay within these structures and not break out of the firm to compete. Hence, the question of whether decentralized or centralized management structures empower workers enough to stay within a firm becomes a pivotal question for today’s age.
8 Distinguishing these differences is necessary to understanding the key advantages of decentralization of a management structure, while still recognizing the benefits of a more centralized system that may fare better for other contexts (such as more capital intensive firms). More will be explored on this subject in the second chapter.
Market Structures
Once we peer out from analysis of a particular firm’s inside hierarchy and organizational structure, we see how the market itself is structured outside the firm. This could be as simple as preferences of consumers or as complex as competition with other firms located in the same space. Every firm is hell bent on maximizing utility and lowering transaction costs. Examining the market structure allows us to infer how firms react and make decisions internally, and ultimately how well those decisions will fare. If a firm can anticipate the market structure and lower transaction costs against its competition, it will prove to be profitable. If it cannot, it will likely fail (Meagher and Wang 2008).
What will limit a firm’s ability to determine the market structure where it is attempting to gain advantage, however, is similar to Hayek’s knowledge problem. It’s what Simon called “bounded rationality,” the idea that rational agents within a firm face limits in communicating and processing information (Simon 1955). Managers within a firm do not have perfect information, and will also have significant delays in processing and sending information to other decision makers within the firm who can use it effectively to lower transaction costs and deliver profits. Recognizing this limit on rationality within a firm proves pivotal to understanding the economics of organization and why various systems succeed when others fail (Van Zandt 1999).
In the quantitative model developed by Meagher and Wang, they test centralization versus decentralization of decision-making in the example of a national
9 firm made up of chains with independent managers, and another firm with a centralized headquarters that makes most of the decisions for its regional chain stores. Consumers must “search” for the store that best accommodates their preferences and needs. It is assumed that consumers choose particular stores based upon their ultimate utility. This could be anything from preference to price to particular brands. That will determine demand.
Once consumers enter these stores, different ideas are tested and tried in order to influence more consumers to frequent the stores. With high product competition in the market, there is always an incentive for stores to gain an advantage over their competitors with innovative ideas. In the centralized firm, innovative ideas are prescribed from the headquarters and stores must adopt them. Because the centralized firm must then communicate these ideas down the chain, this takes time to implement across all stores.
If the idea proves to be a failure, it will also take time for a change to be ordered by the headquarters, as local managers do not have the authority to implement their own ideas.
In a more decentralized firm, store managers can adopt certain innovative ideas either prescribed by the headquarters or developed locally. This cuts down the processing time for the information on whether or not the idea is attracting more consumers and more sales. If an idea fails, they have the ability to quickly change in order to meet that consumer demand. That means decentralized structures are better able to “learn” whether or not certain ideas should be retained in order to attract consumers.
When the centralized and decentralized firms compete in the same market for products sales, they found that decentralization of a firm’s organizational structure is favored and performs better because it can better adapt and change when an idea either
10 succeeds or fails. The changing nature of the market structure, dependent upon consumer preferences and tastes, requires quick processing of information in order to adapt for a solution. In a decentralized model, stores can quickly adjust. In a centralized model, there is more delay. That latter quality raises costs and lowers the probability that a store will be able to retain a consumer.
The field of supply chain management provides many examples of how decentralization has advantages over centralization when it comes to high product volumes and sales in different markets (Schmitt, et al. 2015). However, what studies of companies that rely on national supply chains also reveal, however, is that more centralized firms are able to fix costs in a stable environment, allowing them to deploy more resources to finding better utility and lower transaction costs in a market. With such uniformity, the potential cost savings can easily be reproduced across many local stores.
Therefore, the profitability of a firm is determined by both the market structure and firm’s organizational structure. This example, however, looks at a market structure with high product competition. In a monopoly or duopoly situation, less competition would inevitably favor the firm with the more dominant market position.
The Role of the Entrepreneur
Having dedicated space to exploring the theories of the firm, organizational structures of firms, and market structures, we must also understand the role of the entrepreneur within the firm, and what incentives may exist for them to decentralize their firm’s structure. In Coase’s original paper, he cites the role of the entrepreneur as the ability to “forecast future wants” and to react to price changes (Coase 1937, p. 400). This
11 represents a simple view of the entrepreneur, seen as a manager who rearranges contracts and shifts factors of production when necessary, after they have already scoped out an opportunity for profit. Additional research citing Coase’s work have presented the entrepreneur’s role as much more complex and extraordinary. Rather, as Foss and Klein explain (2017), entrepreneurs “experiment with resource combinations, attempt to circumvent restraints, revise initial plans,” all the while assembling a team and assessing competition in the market. It is the combination of the entrepreneur’s actions, a firm’s organization, market structures, and external factors that will determine whether entrepreneurs “realize profits, achieve personal satisfaction, or meet other objectives
(Foss and Klein 2017, p. 734). In order to gain support, resources, and knowledge to reduce transaction costs and achieve the above objectives, an entrepreneur contracts with employees and managers who are specialized in their roles and add value to the firm. It is only when the firm has grown to a considerable size and information has become costlier that a significant organizational structure will be constructed.
From there, the question to be examined is how entrepreneurs decide how to organize the structures of their firms. Do they organize them at all or do they evolve spontaneously? Is there more investment in human capital or physical capital? In the previous section, we explored how organizational structure and market structure determine whether a firm achieves profitability. The example of the central headquarters issuing a particular idea to its many regional stores gives some insight. At the seat of this headquarters is likely a chairman or president, acting with advice and counsel of vice presidents, managers, and support staff. Perhaps the president is the original entrepreneur, or was placed in his position by a board of directors or advisory group.
12 From the headquarters, the president has determined that the most effective method for trying out new ideas is to source them from his close staff and confidantes in the firm, and then communicate to the regional chain stores via middle managers for them to implement without prejudice. In this example, the entrepreneur has chosen to embrace a steeper hierarchy, dependent on vice presidents, directors, managers, and so on, to carry out the will of the company. Ideas are sourced from a very narrow pool and subordinates are judged on their ability to implement the idea rather than come up with a suitable alternative. In a large company like Apple, Inc., the value of the brand heavily rests on the originality and creativity of its founder, Steve Jobs, and the central vision of a few creative managers. Their decisions and ideas are replicated and taken up at every level of the Apple value chain, providing products that are uniform, simple, and centrally designed, no matter the market or country it is sold in (O'Brien 2015).
Smaller firms in the software or tech space, for instance, may choose to adopt more decentralized structures to fit their needs. In 2012, Yanis Varoufakis (who later served as
Greek Minister of Finance in 2015), served as the in-house economist for the video game company Valve (responsible for the market platform Steam and the successful game franchises Half-Life and Counter-Strike). In a series of blog posts published on the company website in 2012, Varoufakis examined Valve’s self-managing structure and praised its image as a “boss-less corporation” that is entering the new “post-capitalist” age
(Varoufakis 2012). Much like other self-managing organizations, Valve pushes its employees to choose their own teams and projects according to their own strengths and specializations. They team up for various video games projects or applications, and then hold themselves accountable according to their contracts with their teams. This allows for
13 “spontaneous order” that better allocates time, resources, and human capital within the firm, all without the command-and-control managerial authority of traditional bosses.
At Valve, by contrast, each person manages herself while teams operate on the basis
of voluntarism, with collective activities regulated and coordinated spontaneously via
the operations of the time allocation-based spontaneous order mechanism described
above (Varoufakis 2012).
For all the enlightenment brought forth by Varoufakis, however, he fails to recognize that this version of the self-managing firm is due precisely to the capitalistic systems that have evolved over time. Voluntary cooperation in the marketplace, along with well-defined property rights that create incentives for profit, is precisely how one should define an institution in a capitalist system, and it’s exactly what the original entrepreneur of Valve intended when they formed the company. This decentralized structure incorporates the wants, wishes, desires, and future projects of its many employees, rather than the single entrepreneur.
McDonald’s, on the other hand, one of the most successful fast food companies in the world, uses a franchising model that invites owner-managers to run their own stores using McDonald’s brand and products (Norton 1988). Of course, they use central information and implement requirements as found in the franchising contract, but individual managerial decisions are left to the store itself, and the manager must submit significant capital in order to claim the rights to the franchise. The directors of the company from the headquarters set a standard guideline for how the franchises are to be run, but the individual owner-managers make the decisions necessary to follow that guideline. Norton (1988) details the significant incentives for firms to use a franchising model, including the physically dispersed operations, increasing labor-output ratios, and
14 the brand name capital that comes with a major franchise. Most economists consider franchising to be a hybrid model of both the centralized and decentralized internal organization, but for the purpose of this paper, we consider it a decentralized structure.
That is due to the scope of decisions that can be made for the local context by the owner- manager, and the flexibility this manager has adapting particular ideas. That is more characteristic of a decentralized structure than a centralized one.
In seeking to understand how firm structures evolve under various types of entrepreneurs, Miller (1983) puts together a useful typology. He looks at three specific types of firms: simple, planning, and organic. Simple firms, he asserts, are dominated by a centralized command structure with the original entrepreneur and founder at the center. Planning firms use bolder and larger strategies to help achieve larger goals; the entrepreneur in this example is more of a facilitator than an innovator. The last, organic firms, use communicative power and adaptation to gain advantage in the marketplace.
These firms are able to react to changes very quickly and prescribe solutions that fit according to the problems that arise. Organic firms naturally have a decentralized organizational structure that empowers employees with specializations. The role of the entrepreneur in this firm is to set the central strategy and to recruit talent to fill roles and departments. Each typology represents a different type of entrepreneur that evolves somewhat from Coase’s model. A planning model, for instance, anticipates large swings in the market, and the entrepreneur who oversees such a firm places his confidence in a robust bureaucracy. Simple firms, on the other hand, respond to situations as the entrepreneur sees fit. This could be very positive in the case of a talented entrepreneur who forecasts the right opportunities, but it could also lead the firm down a path of failure.
15 CHAPTER TWO: Decentralized Decision-Making and Management
Self-Managing Organizations
In the examples provided thus far, firms have been categorized into centralized and decentralized organizational structures (also known as vertical and horizontal structures). The franchise model of McDonald’s, for example, relies on local contexts for decision-making and ultimate authority, providing us with an example of a decentralized structure with elements of centralization (Minkler 1992). Apple, Inc., on the other hand, in a very capital intensive market with a focus on their products, maintains a centralized management structure (O'Brien 2015). The history and evolution of both of these firms are different, and they’ve empowered people in the firm in different ways. Beyond this classic decentralized vs. centralized model, there is also a new radical approach for decision-making and management within the scope of decentralized models known as a self-managing organization.
Edmondson and Lee (2017) introduce the notion of a Self-Managing Organization
(SMO) to describe a firm that has flattened its hierarchy, decentralized decision-making, and removed the traditional role of managers. This has evolved as a response to centralized managerial hierarchy because of three key factors: central hierarchies have a more difficult time adjusting to changing conditions and landscapes (Mintzberg 1979); they are unable to solve non-routine problems; and they stifle the autonomy and development of individuals within the firm.
In self-managing organizations, decision-rights are more broadly allocated among various individuals according to their specialization and expertise. Teamwork becomes an important currency for success in a firm, and individuals organize themselves around
16 tasks in these groups (Flores-Fillol, Iranzo and Mane 2017). Decision-making thus becomes decentralized according to individual skills.
The Morning Star Company, a Los Banos, California-based tomato processing company, is a firm that uses its own devised system of “Self-Management” to execute work across its various departments. The company, founded by Chris Rufer in 1970, has become a prime example of a decentralized, self-managed organization that provides bountiful insights into what the future of firms could be (Chang, et al. 2013). Individuals in the firm negotiate their own contracts in order to fulfill their duties and obligations.
The contracts, called Colleague Letters of Understanding or CLOUs, contain all the responsibilities of individuals and goals, set the standard for relationships with fellow colleagues, and provide the basis for metrics and key performance indicators of the individual. Each individual’s CLUE is distributed among all colleagues and can be examined at any time, contains layers of contracts confirmed by others, and contains an element of trust (similar to a Blockchain design, as explored in the later chapter). Various elected committees help resolve conflicts that may arise, and colleagues are encouraged to take a more entrepreneurial approach to solving problems within their specialization
(an interview with Self-Management Institute co-founder and former Morning Star
Company colleague Paul Green Jr. can be found in the next chapter).
The other key example for this study is found in the online retailer Zappos, which instituted the self-management philosophy Holocracy in 2013. Holocracy was formalized and first implemented by Ternary, a Pennsylvania-based software company founded by
Brian Robertson. In codifying the company’s self-managing organizational structure,
Robertson and his colleagues devised a system that removes managers and allows individual employees to be assigned particular “roles” that define their work duties and
17 help them keep each other in check. When issues arise, employees hold “governance meetings,” wherein they propose changes to roles and responsibilities (Robertson 2015).
This system was introduced into Zappos because of the CEO’s concern that growth of the size of the firm would limit their productivity and profitability (Edmondson and Lee
2017).
In both of these examples, a more decentralized approach to management within a firm has been implemented in order to solve a problem. What helps facilitate that evolution, and can indeed speed up the adoption of self-management, is advancements in technology and a firm’s ability to adapt that change.
Technology and Firm Hierarchies
When it comes to the future of the firm, it is important to remark how much the changing landscape of resources and technology is already affecting firms in our present context. Rajan and Zingales (2001) analyze how the reliance on human rather than physical capital means the boundaries of today’s firms are more different than they have ever been. The traditional hierarchy has to change in order to accommodate a more individualized approach that rewards knowledge and specialization over physical capital or assets. New tools of communication and personal computing have empowered employees to complete work on their own terms in the environments they construct themselves. Some of that has pushed teams to work remotely away from a central office, and allowed them greater ownership over projects and decisions on procedural matters.
Other factors have rewarded constant connection to work colleagues and work via smartphones and email. These technologies lower the costs of communication and collaboration, and significantly reduce transaction costs across an entire firm (Löhr, et al.
18 2017).
All of this points to the fact that firms have begun shunning traditional centralized hierarchies in favor of self-organization. The reasons for that change are described by
Edmonson and Lee (2017) as: constant uncertainty in the world of technology and finance; the growth of knowledge-based work; and the idea brought by the millennial generation that work and organizations should have more personal meaning than just a job. The decline of traditional work in factories and labor-intensive work environments has certainly facilitated that. The availability and ubiquity of technology, as well, has done the same.
Turco (2016) seconds this point, arguing that corporate bureaucracy is shifting and decentralizing because of young people’s technological habits. Workers want to be more engaged with their work and have more “conversations” rather than directives handed down from above. They want to participate more in decision-making and organically assemble in teams and groups to order to accomplish tasks. Sometimes that means short- term focus on an individual project with just a few colleagues, or a larger project that requires more resources and personnel. Above all, every single employee is empowered to raise their voice and call attention to the specializations.
Her insights were gained from nearly a year embedded at a top technology company in New York City. Chief among them was the “equalizing factor” of social media that each worker brought with them. Young workers are very comfortable and familiar with articulating their wants, desires, and passions on social media. It’s become almost second-nature. If their comments, reactions, and suggestions are accepted on a myriad of
19 topics in the social media sphere, why should it be any different where they work?
That attitude has since carried into their positions and careers, influencing the organizational structure in a way that maximizes autonomy, meaning, and utilization of skills for each individual worker, and invites the formation of more teams. That has significant impact on the firm.
Technology and Transaction Costs
While the use of technology by workers has led to change within traditional organizational structures, so too have transaction costs. In Japan, researchers have been able to witness the changes that have occurred at carmaker Toyota thanks to technological innovation and self-organization over the past decade (Flores-Fillol, Iranzo and Mane
2017). Due to improvements in communication and technology, workers on the floor have had better information that allowed them to make spot decisions saving time and money, without the need for managers to intervene. More specialized tasks were then taken up by individuals who could claim ownership and complete tasks, and duller, more labor- intensive work was delegated to machines and robots who took care of assembly. Workers became more aware of their colleagues’ responsibilities and negotiated contractual arrangements so they could effectively accomplish their tasks. They ordered inventory and arranged products according to the needs of the local factory at their own behest, reducing transaction costs by removing managerial oversight from the equation. Though
Toyota is not on the level of self-management of The Morning Star Company or Valve, it has at least used decentralized organizing principles to better empower workers within the firm, even at the level of the worker in the factory.
20 Though technological change can lower transaction costs, it can also introduce costs that weren’t present before. In order for the firm to absorb those costs, that change must somehow be cost-effective, or cost-negative. For example, maintaining an online server and using the most congruent system for different departments in an organization can be a very costly endeavor, requiring a highly specialized Information Technology department and personnel. As organizations grow in size, the more they require specialized tools maintained by IT departments. If those systems can be introduced and streamlined to save costs, then this change will have been worth it. But if the additional staff and resources put into IT are more expensive to maintain than the value they provide, this can have negative consequences for the firm.
Another example of how technology can increase transaction costs for firms is the need for firms to safeguard their knowledge and knowledge rents, known as investing in
“defense”. As companies gain significant competitive advantages, they must protect that knowledge in order to ensure they can continue to derive value from it (Liebeskind 1996).
Pharmaceutical firms, which invest highly in research and development, have an economic incentive to produce knowledge and keep it out of the hands of their competitors. If their specific chemical compounds can be replicated, and without the costs of the initial R&D, competing firms can easily undercut their costs and gain market dominance. That is why pharmaceutical firms invest in patent protection, legal departments, and mandate strict non-disclosure contracts with employees that protect propriety information. They are driven to centralize their management structures and increase transaction costs within the firm in order to better contain and protect their specific knowledge they’ve invested in. So while cutting-edge R&D and technology have
21 created groundbreaking potential drugs and medicine to save lives, they have also increased the probability that rival drug makers will use their capabilities to copy or access the knowledge from other pharmaceutical firms. That gives private firms incentives to properly control the precise formulas and compounds they produce, whether by legal means of the patent system, or by centralized protections instituted among their staff.
Transaction costs of this enforcement and protection are high, but nowhere as high as compared with a rival drug maker discovering a formula and “undercutting a firm’s knowledge rent” by offering a competing product (Liebeskind 1996).
Added to this, the very idea of technological change, by definition, a reduction in transaction costs. Computers and cell phones lower the transaction costs of collaborating or meeting with colleagues. Fingerprint systems and eye scanners reduce the transaction costs of verifying identity by comparison of physical documents. In his book Tomorrow
3.0, Mike Munger examines the rise of the sharing economy through a revolution in lowering transaction costs. Software apps like Uber and Airbnb help us mitigate the costs of looking for a ride to the airport or an apartment to rent by offering it directly on our phones. The GPS systems in the phones help the drivers identify the passengers, and the login and reputation process helps settle trust. The revolution comes in the form of selling the reduction in transaction costs, which Munger simplifies as addressing the three key issues: “triangulation, transfer, and trust” (Munger 2018, p. 7). Therefore, one can see that thanks to new technologies and software platforms, more opportunities exist for entrepreneurs to enter the space and offer reductions in transaction costs. It’s no surprise academics and entrepreneurs have busied themselves with the Uber-izing of everything under the sun: the idea of reducing transaction costs yet more in our daily lives could
22 mean a true revolution in the way entrepreneurs provide products and we receive them.
That would imply more decentralized structures in firms, dependent on local contexts and conditions in order to lower transaction costs.
Less Hierarchy, More Collaboration
Though the evolution in technological progress and reduction in transaction costs have been incremental and led to visible changes in management of several organizations, the decentralization and empowerment of individual workers in all firms is not a foregone conclusion. Many jobs in the workforce still overwhelmingly use centralized structures and steep hierarchies for no other reason than shifting decision rights and decentralizing authority would prove costlier than the status quo. Thus, identifying potential transaction costs that exist in centralized systems and can be eliminated in decentralized ones is a good step in evaluating which firms can adopt a less hierarchical model.
As proposed by Zabojnik (2002), the idea of a “liquidity restraint” posits that it becomes costly for managers to enforce the execution of their own ideas if employees are resistant to it. Even if a manger has superior information, the employee has less incentive
(other than keeping their job) to follow through with an idea they view as wrong or may not be passionate about. This introduces the idea of an additional cost inherent in centralized hiearchies, centered on an individual employee’s motivation to adopt a particular idea offered by management. Therefore, for all decisions that are given to employees without their input, there is at least some chance that a liquidity restraint will exisit and represent an additional cost to the firm. In a more collaborative setting however, if we follow Zabojnik’s reasoning, an employee that has contributed to the idea
23 and claimed some level of decision rights is more willing to execute that idea that if it had been at the sole urging of the manager.
Though an important issue, it can be argued that such a restraint applies only to knowledge-based firms and jobs. Workers who can be easily replaced in a highly competitve workforce, such as in factory jobs or retail, would then have more of an incentive to follow through on a manager’s ideas than voice their concern or objections.
As in previous examples, jobs and firms that relay more on physical capital may indeed be more prone to centralized hiearchical systems and provide less flexibility for individual employees under managers. It would depend on the best strategy for lowering transaction costs and increasing profitability. This is not always the case, however, as will be explored in a later chapter.
In the examples of The Morning Star Company or Valve, distributed methods for organizing contracts, establishing decision rights, and decentralizing decision-making authority prove very effective in adding additional value while reducing specific transaction costs. These decentralized structures allow for worker flexibility and more personal motivation.
CHAPTER FOUR: Case Studies
The Morning Star Company and Self-Management
Formed in Los Banos, California in 1970 by MBA student Chris Rufer, The Morning
Star Company began as single truck hauling tomatoes back and forth between canneries in California’s premier tomato-growing region. From then on, the company invested in its own plants, processing, and packaging companies to sell diced tomatoes and tomato
24 pastes. Today, it supplies the U.S. with 40 percent of the market in those tomato products, making up to $400 million a year in sales. What makes Morning Star unique, however, is its approach to management. Unlike other companies, there are no managers at this tomato company. Rather, each employee, or “colleague” as they are known, have their own set of responsibilities that they must execute in the course of the day, all the while negotiating for internal contracts with their colleagues (Hamel 2011). This arrangement grew out of Rufer’s desire to create a company that fulfilled the need for individual freedom and allowed people to be creative and caring to their fellow colleagues.
The system empowers each colleague to effectively “self-manage” their own work in order to promote the ultimate goal of “more human flourishing,” according to Paul Green
Jr., a former colleague at Morning Star Company who co-founded the Self-Management
Institute that aims to promote and spread the company’s management style (Green Jr.
2017). I conducted an interview with Mr. Green at Harvard Business School in Boston,
Massachusetts, where he is currently a doctoral student in management, to gain insights on the mission of Morning Star, its successes, and the potentials for more organizations to adopt the principles forwarded by Morning Star.
What is important to include here is the organizational vision of the company, which lays the groundwork for its adoption of self-management:
For Morning Star colleagues to be self-managing professionals, initiating
communications and the coordination of their activities with fellow colleagues,
customers, suppliers and fellow industry participants, absent directives from others.
For colleagues to find joy and excitement utilizing their unique talents and to weave
those talents into activities which complement and strengthen fellow colleagues'
activities (Hamel 2011).
25 By setting itself up as a company that empowers individuals “absent directives from others,” The Morning Star Company relies on the power of “agreement and consensus” between colleagues in the course of their duties (Green Jr. 2017). Every colleague within the company has purchasing authority, and is responsible for filling the needs of their units, whether it be in terms of capital equipment or additional personnel: they are empowered to do the hiring and purchasing on their own, as long as it fits with the broader mission of the organization. In this way, the company very much realizes the dream of management guru Peter Drucker, who envisioned the most powerful management system as the one that would empower individuals by making everyone a “manager” for themselves:
There also is the task of building and leading organizations in which every man sees
himself as a ‘manager’ and accepts for himself the full burden of what is basically
managerial responsibility: responsibility for his own job and work group, for his
contribution to the performance and results of the entire organization, and for the
social tasks of the work community (Drucker, Management: Tasks, Responsibilities,
Practices 1993, p. 284).
Key to Morning Star’s execution of this management philosophy is each colleague’s overall operating plan, known as a Colleague Letter of Understanding (CLOU). This initially began as a paper document that listed individual contracts, obligations, and relationships between individuals in the firm (creating a literal nexus of contracts).
Eventually, a software was developed to help keep track of every colleague’s CLOU, and also to allow all other colleagues to access other CLOUs to add suggestions or to find the specific capability they required in order to fulfill their duties within their specific
26 business unit, of which there are 23 (Green Jr., The Colleague Letter of Understanding:
Replacing Jobs with Commitments 2010).
For each CLOU, a colleague must arrange contracts and relationships with colleagues with varying specializations and responsibilities. The relationships sought are precisely those that will help further the individual mission of each colleague. Whenever questions are brought up on responsibility for a particular project or aspect of work, therefore, colleagues refer to the catalog of CLOUs. If changes are needed, they renegotiate with the colleagues in question. An important assumption of these self- management arrangements is that agreements and relationships entered into voluntarily and of mutual benefit are better in the long run than mandates from a central hierarchy.
For Green, the CLOU is a structured version of an “employee forging and maintaining deep relationships necessary” to complete their work and fulfill their mission. That helps bonds employees together and share a vision that will benefit the company. What’s more, Green says self-management is an ideal system because it doesn’t push the myth that organizations are superiors to individuals. “Firms and organizations don’t exist; they’re concocted in the mind. But people who are dedicated to those firms are real. That’s what we must focus on,” said Green.
If colleagues find themselves in conflict with anyone else in the course of their work, they are encouraged to set up meetings to address mutual responsibilities and adjustments to their CLOUs. If a colleague is found to have shirked their responsibility, this will have an immediate impact on the various colleagues who are reliant on that person for their own areas of concern. That gives each colleague an incentive to encourage their coworkers and hold them accountable. If an issue is deemed irreconcilable and beyond repair, the president is brought in to adjudicate. But in the forty years of Morning
27 Star, that has only happened a handful of times (Green Jr., Questions on Self-
Management at The Morning Star Company 2017).
To the question of compensation, and performance, each business unit within
Morning Star is responsible for defending its results at the end of the year. The highest- performing business units will have an easier time recruiting colleagues and arranging contracts to further their successes going forward. The business units that have fallen in productivity or have lost money, on the other hand, will face a significant amount of
“social risk” – they will be less trusted to collaborate to achieve particular goals and will likely be shunned by more productive business units, depriving colleagues of important relationships and contracts needed to complete their work. That gives each and every colleague a powerful motivator to follow through on their work and avoid shirking their responsibilities, something that has been discussed without end by firm theorists in economics. Could self-management and reliance on colleagues be an antidote to broader shirking within organizations? At least at the individual level, the CLOU seems to do just that. It allows for maximum personal freedom while still maintaining control and ensuring key responsibilities and goals are met.
And how has self-management contributed to the lowering of transaction costs?
First, less time and energy is spent on internal administration. The CLOU becomes the golden standard of setting work responsibilities, assigning daily tasks, and assembling teams necessary to complete a task. Efficiency is rewarded because it helps every colleague save time and find appropriate solutions to their problems. There are little to no “monitoring costs” because employees outsource this monitoring to the CLOU. The system of interconnected arrangements and contracts can preempt bad decisions and ensure employees are highly motivated to accomplish certain tasks they fully understand.
28 Because these solutions evolve organically and originate from the colleagues themselves, there is no “liquidity restraint” that limits an employee’s dedication to the project
(Zabojnik 2002). This is an inherent quality of a decentralized structure.
Second, the ability for colleagues to purchase machines, products, and supplies they need without prior approval ensures each business unit is supplied with items it needs without unnecessary delay. There is no complex hierarchical system for approving purchase orders or balancing costs against another business unit. Ultimately, a colleague makes a determination that an order must be fulfilled according to the local knowledge and it is done. When evaluating the financials for a business unit at the end of the year, if it is determined that certain orders were unnecessary, that colleague will be judged by that result. Hence, each individual who is making a large purchase must weigh the costs of said purchase against its ultimate value. If they cannot justify the cost themselves, then it is guaranteed that their colleagues won’t justify it either.
Third, the reliance on fellow workers and the localized decision-making ensure employees have the right information to make the best determination. They are not subject to “bounded rationality” that limits their information and potentially increases costs as would happen in other managerial structures (Simon 1955). Because colleagues make specific decisions related to their specializations and their departments, they are impacted the most by these decisions and thus must carry the risk of making a bad decision within the firm. As such, colleagues have an incentive to gather as much information as possible within their specialization, so they may make better decisions to fulfill their goals. This includes a decision of whether the firm should contract out a particular task to the market (such as the picking of tomatoes by temporary laborers), or internalize those costs in the firm for maximum efficiency. That determination is made
29 locally by the colleague responsible for organizing the collection of tomatoes. If the costs prove to be too burdensome to engage that labor within the firm, he will choose to outsource, and vice versa.
Fourth, self-management reduces the transaction costs affiliated with managing internal contracts. Because arrangements between colleagues are voluntary and mutually beneficial, it lowers the risks of shirking and lowers monitoring costs. If an arrangement is no longer viable, it can easily be renegotiated in the CLOU. It is expected that as information and circumstances change, so will these internal arrangements between colleagues. Because each individual is responsible for achieving their own goals and metrics, they will use make sure to arrange the best contracts and relationships that will come at the lowest possible cost. This aspect of self-management is the strongest argument for why managers are no longer necessary to fulfilling obligations in this type of firm.
Managing Without Managers
In terms of a hierarchy, Morning Star’s model of self-management upends the need for traditional managers and centralized organizational structures. By giving individual workers the incentive to arrange their own relationships, barter and trade for resources, and hold their colleagues accountable, the traditional role of the manager isn’t needed.
Enforcement and supervision is carried out by colleagues who rely on relationships to get things done. Decisions are made in accordance with individual preferences and overall workability, only reached after a broad consensus has formed between various individuals with varying scopes of work. Within this model of participatory (decentralized) decision- making, the transaction costs of supervising can be drastically reduced. Rather than hiring middle managers to oversee the quality of work of others, colleagues that are
30 directly impacted can provide immediate feedback and negotiate alternative arrangements to ensure the highest quality of work.
Though there may not be managers at Morning Star Company, that doesn’t mean that there aren’t meetings. Constant revisions of CLOUs must be undertaken when colleagues’ duties overlay or needs shift in a position. Each individual must accurately represent their job and their agreements, and prioritize them so that they can achieve the key milestones they have set for themselves. This requires deep interpersonal relationships that can only be achieved through trust, connection, and reputation. At times, it is clear that tensions will flare and disagreements will arise. And because colleagues have an individual mandate to arrange their own needs, they can feel properly empowered to seek alternative arrangements or contracts. In a hierarchical system, this becomes more difficult, as is it involves negotiating with managers who usually hold more authority, are more compensated, and hold more sway within the company. By equalizing relationships between workers, self-management gives every individual the social capital needed to effectively negotiate. As long as they fulfill their contracts, follow through on their commitments to colleagues, and reach their broad goals, colleagues in a self- managed company have every much an advantage when conflicts arise.
As opposed to previous examples of self-managing and more decentralized firms,
Morning Star is also an outlier because it is a physical capital intensive company. They work with tomatoes, large machines, trucks, greenhouses, irrigation equipment, and the production and labeling of aluminum cans for tomato products. It could just as easily have formed as a strict hierarchy under the watch of Mr. Rufer, conscious of the risk of accumulating and working with physical assets such as processors, trucks, and greenhouses to grow tomatoes. But instead, Rufer decided to empower individual
31 employees and grant them their own managerial authority needed to complete their jobs.
That is a level of personal value in work that most hierarchies cannot promise from the outset, and why Morning Star makes such an interesting case study for researchers interested in decentralized decision-making and the evolution of firms.
For Green, organizations become successful because they build up immense human capital and use technology to gain an advantage over their competitors. Even though Morning Star is the furthest thing from a technology company, it has been able to embody the technological process through its adoption and enforcement of the CLOU, reducing the transaction costs normally affiliated with managers. Every colleague has access to everyone else’s CLOU, and it provides a record for what employees have accomplished, what their guidelines are, and how they will be evaluated at the end of the year.
As will be explored in the next chapter, this Colleague Letter of Understanding has the advantage of being scalable, immutable, and distributed to all employees, much like the trustless consensus technology Blockchain that underlies the vision for cryptocurrencies such as Bitcoin. Using the CLOU as a metaphor for Blockchain is a useful practice because it serves the same purpose: to drastically lower transaction costs and relay on the trust and accountability of everyone who honors a CLOU. It may not be as technologically constructed, but the essence remains the same.
Zappos and Holacracy
Another example of a self-managing philosophy is that of Holacracy, introduced in the second chapter. Much like self-management practiced at The Morning Star Company,
Holacracy aims to empower individuals and teams. The individuals in this system are
32 defined by their “roles”, which housed within various “circles” who keep each other accountable. An individual may have many different roles, and participate in different circles.
Figure 1: A pictorial representation of Holacracy As founder Brian Robertson (2015) explains, he devised this method at his software company Ternary in 2007 after asking his team a question: “what gets in the way of people working together as effectively as possible? In the most efficient way possible?”.
More often than not, he was told, it was management: administration, uncertain rules, having to report and update superiors on projects they couldn’t understand, and more.
And in order to overcome that barrier, engineers at the firm proposed learning from their own methods from software development: various individuals have specialized skills, and
33 practice ultimate autonomy and decision-making power where their project is concerned.
Teams working on various projects then collaborate and work together on different projects, and they carry their skills and roles with them. Each member of the team keeps other members accountable because they need their areas of the software to function to order for the entire program to run smoothly.
Therefore, what Robertson concluded is that roles should be defined around the work rather than people, and decision rights should be allocated horizontally rather than vertically. That allows the company to adapt to change rather quickly, to source innovative solutions, and to make sure that all teams and individuals are held accountable to the same standard for the betterment of a strategic goal. Structured meetings held on a regular basis help reallocate decision-making authority and redefine goals where necessary. Individuals are able to negotiate among their fellow workers to find the best solutions and structures for projects to be completed. It was very much founded in the sourcing of software development used by many technology firms (Groth 2015).
According to Robertson, the main effect of implementing Holacracy is that individuals are driven to work more in teams, people know the rules of the game, everyone’s role and specialization is clear, and workers should feel comfortable about challenging how tasks are being completed (Holacracy 2018). Through these means, workers in this structure are able to avoid transaction costs involved with monitoring and administration, thereby increasing efficiency and profitability.
In addition, because regular meetings are called in order to revise “role” arrangements, it allows for inadequacies to be weeded out rather early.
After seeing the success of this at his own company, Robertson decided to branch out and sell this structure of internal organization to other companies who could operate
34 this way. He found an earlier adopter in the Las Vegas-based online retailer Zappos, a subsidiary of Amazon, who immediately took to Holacracy’s promise to decentralize management and empower individual workers to be more like their own bosses and managers. They adopted the alternative management system in 2013.
Because the company was growing so fast in the world of online commerce, CEO
Tony Hsieh wanted to ensure that employees would continue to have autonomy, would be able to manage themselves, and ultimately would be able to be happier and more fulfilled. He explains here why he decided that Zappos should make the switch:
Research shows that every time the size of a city doubles, innovation or productivity
per resident increases by 15 percent. But when companies get bigger, innovation or
productivity per employee generally goes down. So we're trying to figure out how to
structure Zappos more like a city, and less like a bureaucratic corporation. In a city,
people and businesses are self-organizing. We're trying to do the same thing by
switching from a normal hierarchical structure to a system called Holacracy, which
enables employees to act more like entrepreneurs and self-direct their work instead
of reporting to a manager who tells them what to do (Hsieh 2018).
This motivation for self-management is what pushed Hsieh to adopt Holacracy, which he viewed as the current system to achieve it. When he made the transition, he offered a buyout option to those who preferred the older style of management and would leave the company. The rest of the employees would stay and begin the transition to Holacracy.
Overall, 18% of the 1,500 employees took buyouts, and another 11% left without a package
(Reingold 2016). These workers were not convinced by the experiment, which is understandable. Applying a new and radical self-management philosophy after a company already has already established a structured internal hierarchy, as opposed to
35 Morning Star’s birth as a self-management company, can be very difficult. Hence, there are significant transaction costs that can occur when adopting radical new structures of self-management within firms. It takes time for employees to adapt to the new rules, understand their roles, and discover which teams they’ll join and contribute to. Workers who used to be managers will have to learn how to change their roles and redefine their value to the company. All of this presents costs in the short-term, but has huge potentials for saving costs and increasing profitability in the long-term.
As of 2016, Hsieh says Zappos has reached its highest operating profit on record
(Reingold 2016). Of course, that can’t be pointed solely to Holacracy, but it at least proves that internal structures can adapt and workers can become accustomed to these radical experiments in self-management.
Another principle of self-management made implicit in Holacracy is the nonexistence of managers. Among Zappos’ 1500 employees, no one person has direct supervisory duties over another. There are circle “links” who develop lead groups, but these positions are acquired and followed voluntarily, and will depend on the project that individuals are participating in. Any member of a circle is liable to become a “link” at any one time, depending on a project’s focus. These links cannot force employees to do anything, but instead try to provide some starting points for a general direction in the group. We might otherwise call these “highly-motivated” colleagues in the Morning Star
Company self-management system.
Centralization at General Motors
In contract to the previous examples, the case study of General Motors represents a centralized company with a strict hierarchy and rigid international organization (P. F.
Drucker 1999). Peter Drucker, the father of management as a science, often invoked
36 General Motors as an example of a model company that organized practically everything from the top-down. Even as early as the 1920s, GM CEO Alfred Sloan organized each car brand in exactly the same way, albeit with different parts and materials. In later years,
GM bought other car manufactures and integrated them into the central business model, requiring incoming car brands to adopt GM’s precise hierarchy and method of management per department (Drucker, Management Challenges for the 21st Century
1999, p. 27). The idea held by GM’s management over many years and decades was that
GM was the top car company because its model was efficient and its executives made the right decisions. Its processes were determined to be the most efficient of all car companies, and thus central manager made most of the decisions to be carried out in the planning, production, and sale of GM automobiles. Scholars in management theory have called this the execution-as-efficiency model. The ability for managers to execute ideas becomes a measure of efficiency (Edmonson 2008).
Throughout the 1970s and 1980s, GM become one of the most integrated companies in the United States, supplying 70 percent of its own parts, and automotive bodies (Drucker, Management Challenges for the 21st Century 1999). This efficiency gave
General Motors a distinct advantage in terms of costs and speed, and led it to be one of the most profitable manufacturing companies of all time. Other car brands could barely keep up with GM’s low prices and efficient methods. Throughout the 1990s, GM maintained its strict hierarchical system and command structure. Even for its companies owned and operated in continental Europe and the United Kingdom, GM ensured all designs and first prototypes were assembled in Michigan rather than in London or Berlin.
Managers of auto production and auto sales in each country were responsible to the read of Europe, who reported directly to the international manager and then the CEO. The
37 success of the car company has convinced its managers that the inherent value of the firm is best maintained by keeping its structure tight, and to keep local changes to a minimum.
It is this rigid system, however, that brought GM the brink. Due to more competition from Asian and German car makers, GM began to lose its total market share.
Americans began investing in imported vehicles which were assembled in factories without strong unions that promised high wages. Thus, labor costs began eating into GM’s profitability. That, along with the worldwide scaling back of credit, plunged GM into the doldrums. They lost $38.7 billion in 2007 alone (Edmonson 2008). They refused to change in light of changing circumstances around them: labor costs were increasing, competition was becoming more efficient and churning out more affordable cars. All GM was left to do was to sell off some of its car models and ask the Canadian and American governments for bailouts.
Overall, the more centralized organizational structure of General Motors was incredibly effective at producing cars at low costs. Its model designs were exported around the world for years, and it was a household name. But when market structures changed and competition arrived, at the same time that labor costs ballooned, GM was in no position to react. It could only rely on the same centralized model it had overseen since the beginning of the 20th century. $38.7 bill. This is a clear example of organizational hubris. As Edmonson writes: “placing value only on getting things right the first time, organizations are unable to take the risks necessary to improve and evolve” (Edmonson
2008). For General Motors, that strategy worked while circumstances were great, but took a turn for the worse once market structures and entrepreneurs from outside came onto the scene. Thus, GM provides us with an example of a centralized hierarchy. Stable in good times, but unable to react in bad.
38 CHAPTER FOUR: Trustless Consensus and Blockchain
The Philosophy Behind the Technology
Trustless consensus architectures, such as Blockchain, the immutable ledgers underpinning cryptocurrencies like Bitcoin, are poised to bring fresh changes to the structures and organizations of firms, even more so than the Internet or cell phone. But for the purpose of this paper, it is not so much the technology of Blockchain that is of concern but the idea that it represents, and how it can be applied to firms.
Put simply, the trustless revolution, as denoted in the title of this paper, is the notion that distributed ledgers such as the Blockchain will begin replacing various administrative tasks within firms, thereby lowering transaction costs. Much like in the example of The Morning Star Company, the Colleague Letter of Understanding serves the same function as a Blockchain: it is scalable, immutable, and distributed. CLOUs are distributed through the company, safeguarded on the network, and are reviewed and checked at any time by any colleague. As in the definition of Blockchain, the CLOU provides “disintermediated, censorship-resistant and tamper-proof digital platforms of distributed trust, open for all to freely innovate and to transact on” (Mattila 2016, p. 4).
This distributed trust in the ledger provides for smart contracts contained within the blockchain. These are contracts that can be digitally facilitated, verified, and enforced without third parties and intermediaries. It is this advancement that can be applied directly to firms: the removal of intermediaries such as lawyers, banks, and accountants removes so much complexity and transaction costs that firms cannot help put profit from this improved arrangement. In the Blockchain, a series of data blocks are
39 cryptographically chained together and confirmed by various nodes. The distributed ledgers and smart contracts contained within that Blockchain democratize access to
“faster, anywhere-accessible, lower cost, reliable-and-secure high-quality … services”
(Kaivanto and Prince 2017).
What if transaction costs can be significantly cut with a single process and method of organizing information? What if there existed a way for every person in a firm, no matter the position, to cite, monitor, and enforce internal contracts? Or to understand decision rights of each and every employee? That’s what the philosophy of trustless consensus contributes to the understanding of the modern firm.
Naturally, firms that are more prone to adopt technological change will be the first to incorporate trustless consensus into their logical operations and their internal structures. At present, financial technology companies, particularly those in the realm of cryptocurrencies, are the most advanced at integrating this technology. That is due to their level of technological literacy, which we can chart as high compared to the average entrepreneur or small family firm. Therefore, if we want to see where the evolution will spark in terms of decentralized management and trustless consensus, it is more than likely to be in the sphere of cryptocurrency firms. At least some thinkers believe blockchain smart assets will themselves replace these alternative management structures altogether (Swam 2015). I don’t think we have seen that maturity in the theory and application of blockchain technologies just yet, but it could soon be here.
If we revert back to the original theories of the firm, firms exist because they can internalize market exchanges at lower costs than if they take place outside the firm.
Transactions that are internalized within the firm, aided by the advancements in the
40 trustless revolution, therefore, will also be conducted at lower costs. However, what if that is applied to the market structure as a whole? What if companies and customers occupying a particular space are able to use trustless ledger technology to better evaluate and enforce contracts, verify transactions, and transfer resources between each other? If the potentials for the trustless revolution within firms hold true, then the same must apply to the broader marketplace where firms exist and where consumers wield power.
This is what has allowed millions of users of the cryptocurrency Bitcoin to send money virtually with minimal transaction costs, all using decentralized servers, and distributed confirmations recorded by other computers in the network (Mattila 2016).
This has allowed customers and firms to reap the benefits of a more decentralized currency system much more advanced than today’s banking system. The main advantage of this decentralized system rests on three pillars: faster transactions, lower costs, and no intermediaries. Transactions are carried through the network and confirmed by computers along the way, providing many layers of trust that serve to ensure both sides and to solve the problem of asymmetric information. Whereas in previous systems, trust has to be exported to banks, financiers, or loan offices, in a distributed ledger system that trust is inherent in the system. That means the transaction costs found in previous market exchanges no longer apply in this model of peer-to-peer networks. That is the true advancement of the trustless consensus that has led to massive spikes in the prices of cryptocurrencies over the past few years. To be able to carry that system over into the world of firms would prove to be most profitable.
Its Application to Firms
Some researchers have already begun investigating the effects of introducing trustless consensus technology into firms, particular those in the sphere of financial
41 technology, known as “fintech”. Kaivanto and Prince (2017) examine the both direct and indirect transaction costs that can be addressed by distributed ledger technologies in these firms. They point out, however, that introducing this technology does not necessary eradicate all transaction costs that existed previously, and it may even introduce new costs.
It is important – for fintech firms themselves, for costumers, and for regulators – to
recognize that while some risks and transaction costs are drastically lowered, at the
same time some other (new) risks and transaction costs are enhanced. It is more
accurate to think of distributed ledger-based fintech as having a different profile of
risks and transaction costs – including some new risks and transaction costs which
are absent or mitigated in incumbent business models (Kaivanto and Prince 2017, p.
2)
The area in which they say new transaction costs are being introduced is in information asymmetry. Most individuals who understand and can fully implement distributed ledger technologies are programmers or otherwise technologically-savvy people. Therefore, when interacting with coworkers in a firm who may not fully understand the ramification of the technology or its potential, it creates a gap between the knowledgeable employees and those that need further assistance in adapting to the platform. That creates an initial transaction cost. But as in the example of The Morning
Star Company, it did not take long for employees who had never used a computer for work to adapt to using the CLUE software to arrange contracts with their colleagues (Green Jr.,
The Colleague Letter of Understanding: Replacing Jobs with Commitments 2010). After guidance and training, those initial transaction costs were eventually eliminated.
Considering employees would only be responsible for entering and checking data, rather
42 than retooling the underlying algorithms, it is presumed that this knowledge gap can be closed without much issue. When it comes to consumers, it is assumed that their exposure to the distributed ledger technology will be less in-depth than most internal employees in the firm, and thus raise only some concern for those who must deal with internal systems and have have that knowledge gap. But overall, considering the ability for workers to be trained and taught how to use the new technology, this transaction cost would be easy to eliminate.
The principal reason for introducing this technology, it should be remembered, is to embrace a decentralized management approach that removes the need of individual managers who monitor employees. That is what ultimately saves transaction costs, and will allow employees to better organize and implement ideas to achieve their goals. At
Morning Star Company, this function is provided by the universal application of each
CLUE, and in each colleague’s adherence to the stipulations of the CLUE. If that system can be replicated, either through a blockchain or another method, then the gains realized from the lower transaction costs will make any transition worth it in the end.
In a way, the adoption of trustless consensus within firms represents the same paradigm shift found in the transition from labor-intensive work to more knowledge- based work. There are certain inadequacies that are immediately eliminated, and there are others that are introduced as a result of the changing environment and landscape. But overall, the potentials of the new method in the firm presents greater benefits, lower transaction costs, and more profitability. Not every firm will be able to adopt to this new system of trustless consensus right away.
43 But at the same time, its relative low cost has allowed many different types of firms in various industries to experiment. Already, companies in the fields of music, real estate, insurance, notaries, and private security have been able to apply aspects of blockchain technology into the management of their firms with surprising results (Crosby, et al.
2016). Already, IBM has begun integrating its own Autonomic Decentralized Peer to Peer
Telemetry (ADEPT), based on the Bitcoin blockchain’s design, into its network of Internet of Things, responsible for connecting smart devices such as refrigerators and thermostats to your existing digital infrastructure. The excitement surrounding these innovations has led to an investor frenzy into any and all applications which seek to integrate blockchain and trustless consensus. The potentials for firms engaged in this research and development are already valued at billions of dollars, as explored by Crosby et al.
There is enormous interest in BlockChain-based business applications and hence numerous start-ups working on them. The adoption definitely faces strong headwind as described before. However, even large financial institutions such as Visa, Mastercard, Banks, and NASDAQ, are investing in exploring applications of current business models on BlockChain. In fact, some of them are searching for new business models in the world of BlockChain. Some would like to stay that they are even ahead of the curve in terms of transformed regulatory environments for BlockChain. We envision BlockChain technology going through slow adoption due to the risks associated. Most of the start- ups will fail with few winners. Having said this, we should be seeing significant adoption in a decade or two (Crosby, et al. 2016).
One need not fully understand the underlying nature of blockchains and trustless consensus systems to see the value that they can bring to firms. Whether it is for the internal structure of firms or the market structure itself, actors in the market are aware of the potentials for adopting this system and the huge savings in transaction costs. Applied within decentralized structures, these technological advances could represent the next level of profitability and utility maximization.
44 CHAPTER FIVE: Analysis: Structure of the Firm
Areas of Work to be Decentralized
Our case studies above have provided stellar examples of firms that have adopted decentralized management structures. Each of these structural arrangements were adopted for different reasons. For Chris Rufer and self-management at The Morning Star
Company, it was adopted right away because of its effectiveness. At Valve corporation, their decentralized nature evolved naturally out of an appreciation of technology and they decided to embrace it. Zappos, one of the largest firms in the world with a decentralized self-managed structure, unilaterally adopted it over a period of time to ensure employee happiness. In order to try to analyze these firms by their common attributes and thereby methods for understanding how they contribute to the lowering of transaction costs, we turn to a new model created by Edmonson and Lee (2017). They established categories of less-hierarchical organizations which allow us to better interpret and understand their differences. The categories they choose are post-bureaucratic organizations, humanistic management, and organizational democracy. These categories were built from common concepts in place at each firm, including empowerment, participation, self-management, and teamwork. Each category was then mapped to a literature review of relevant topics and case studies, in hopes of better mapping the attributes of decentralized firms.
Seen below, some of these benefits and criteria include flexibility, individual satisfaction, employee ownership, team-based work, increased employee influence, and more. For the purpose of this paper, these categories allow us to determine exactly which transaction costs firms are able to reduce or eliminate as they decentralize their structure.
Where effectiveness and speed is a key determinant, such as in post-bureaucratic and humanistic organizations, we can ascertain a lower level of overall transaction costs.
45
Figure 2 (Edmondson and Lee, 2017, p. 11)
In organizational democracy, the emphasis is on cooperation and teamwork, hoping to eliminate any transaction costs that may be affiliated with conflict resolution and management within a firm. With clear decision rights, employees tend to be collectively responsible while practicing freedom with their role. With such categories in mind, we can continue to evaluate how our case studies stack up against each other when it comes to decentralized of their hierarchical structure.
In breaking down patterns of decision making at self-managing organizations,
Edmondson and Lee therefore create a rubric for grading just how decentralized particular decisions are. At Valve Corporation, we can see that nearly all patterns are fully decentralized. By allowing all employees to choose their own teams, determine their own capabilities and strengths, and add their own strategic vision to that of the company’s,
Valve has the marks of a very decentralized structure. Only overall strategic decisions and personnel management are somewhat formalized. Conversely, at Zappos, these areas are
46 fully centralized by management, leaving the decentralization to other areas such as work execution and work design. Self-management at Morning Star Company is more balanced, allowing complete autonomy in management and work execution, most autonomy in work design and resource allocation, as well as personnel management. The only area which is centralized is that of firm strategy. Considering the company’s scope is the picking, processing, and canning of tomatoes, it is understandable that this key mission would be centralized. If it was decentralized, then the focus of the organization could shift to pick and process strawberries, or cannabis plants, or whatever else employees would prefer to do with their time and energy. Only Valve, in these examples, provides for a somewhat decentralized approach to firm strategy.
What this analysis demonstrates is which particular work areas can be decentralized in a firm, and to what advantage. Differences in the nature of the work, or focus of the company may be the key determinant for deciding whether an area of work is decentralized.
47
Figure 3 (Edmondson and Lee, 2017, p. 13)
Transaction Costs in Decentralized Firms
No matter their explicit motivation for decentralizing authority in various areas of work, however, each company had an implicit motivation for using a decentralized internal structure: transaction costs. Whatever the reason or whatever the area of work, the firm believed that transaction costs could be lowered if less people had ultimate authority and decision-making power over others. That is a profound claim for self- managing organizations to make, as it seems to fly in the face of what has been taught in economics for so long. Usually, the key assumption is that firms develop in order to internalize or “capture” market exchanges to reduce transaction costs. But what the
48 evidence from decentralized firms indicates is that internalizing market exchanges and then dispersing authority over that market exchange can actually lower transaction costs even more. This proves the initial assumption that decentralized management has a greater capacity to lower or eliminate transaction costs because it can capture the market exchange without administrative or monitoring costs that are implicit in centralized firms.
That, however, raises the question: what is the difference between decentralized authority over a market exchange within the firm and a pure market exchange outside of the firm? For one, the mission and capabilities of the firm are internalized by the decision makers, meaning that there is institutional investment in the skills and abilities of the personnel in question. Second, capturing a market exchange within the firm does not necessarily require full managerial oversight. Mergers and acquisitions between firms can be motivated by product stock or market ownership, or perhaps to command and control another company. A firm’s decision to internalize other firms may also be based on the need to further reduce their transaction costs or to realize other entrepreneurial activities they would not have otherwise been able to achieve (Fluck and Lynch 1999).
A recent example is the $13.7-billion-dollar acquisition of Whole Foods Market
Inc. by online retail giant Amazon.com Inc. While Whole Foods gains huge payouts for its private owners, Amazon gains the entire supply chain and food distribution network of
Whole Foods Market stores (Haddon and Stevens 2017). That can be seen as a huge transaction cost saving considering Amazon would like to ship and distribute its products in a more efficient and less costly manner. Access to the nearly 460 stores of Whole Foods
Market gives Amazon an avenue to capture yet more gains in the market by internalizing
49 this structure. It’s also worthy to note that Amazon will allow Whole Foods to operate independently, without direct oversight.
Once we look at implementing trustless consensus, decentralized firms are able to save yet more costs on market exchanges they had originally internalized. If a firm in finance technology hires a law firm for every acquisition or regulatory hurdle, those costs add up. If the techfin firm absorbs the law firm or hires its own legal counsel, those costs are at least internalized, though still high. However, if distributed ledgers and smart contracts are implemented in the firm’s acquisition strategy and regulatory compliance, the need for the firm to have any costs in retaining a law firm all but disappear. This is an extreme example, but it at least represents what many firms are already starting to see as they increase their technological capacities.
If we apply this to General Motors, a centralized firm, the potential for trustless distribution technology could help reduce many transaction costs in the communication of car designs and engine specs. With less reliance on the central office for plans on car production in Singapore or Italy, local offices could implement their plans and results would be automatically updated to the distributed ledger. The managers in Michigan would be able to view that and suggest changes directly. There wouldn’t be as much need for an entire hierarchy of national, regional, and continental managers, thereby removing monitoring costs – likely at great savings to the company. As a very capital intensive company, again, it is much more difficult for GM to adopt a decentralized model overnight. It could, however, use trustless consensus to integrate decentralizing principles that would save costs and remove redundancies between markets. But that would likely be costly in the short-term, considering the rigid hierarchy would be resistant to change.
50
Conclusion
As firms grow and adapt to internalize market exchanges, they devise their own structures for carrying out those exchanges. That is an essential theory of the firm. The existence of transaction costs pushes the firm to bring that market exchange into its own organization. Experiments in decentralization have dispersed decision-making among various departments and individuals in order to attempt to solve that very same problem: to reduce transaction costs. They have decided to shun the traditional role of managers because they have determined that decentralized structures are better methods to achieve profitability and reduce transaction costs.
In these pages, the question of whether decentralized structures are better able to mitigate and reduce these transaction costs than centralized structures was answered by examining different case studies and interviews that featured self-managing organizations and applying categories developed by previous research. The evidence gathered from these case studies points to the finding that, in our case studies, internalizing market exchanges and then dispersing authority without the need for monitoring and administrative costs can actually lower transaction costs even more.
These costs are implicit in centralized firms, but remain flexible in decentralized firms.
Dynamic market structures favor more resilient, decentralized firms, while stable circumstances favor centralized firms. In both cases, however, decentralized firms are able to eliminate the transaction costs involved in monitoring employees and distributing information between employees, thereby empowering them to become more productive and provide more value to the firm. That is what the evidence provided from Valve
51 Corporation, The Morning Star Company, and Zappos provide us in the course of this research.
By analyzing and delineating the advantages and transaction costs savings of self- managing organizations and decentralized structures, this paper has provided insight to the theory of the firm as it relates to the influence of organizational structure. It is hoped that future research can better help quantify these advantages, and provide more incentives for firms to adopt these decentralized structures.
In addition, the introduction of trustless consensus technologies, such as blockchain, or the Morning Star Company’s Colleague Letter of Understanding, have the potential for bringing additional transaction cost savings to firms, eliminating the need for intermediaries and all but eliminating the costs of distributing knowledge. This opens the door for additional research into how adoption of trustless systems will continue to impact the structure and nature of firms into the future. While we are able to witness this change in firms in the financial technology and cryptocurrency spheres, there is not enough case study or research evidence to determine that these structures are, on the whole, more efficient and less costly than decentralized, self-managed firms.
52 Acknowledgements
My thanks to Paul Green Jr. for taking the time to meet me at Harvard Business
School for his insight and experience derived from his time at The Morning Star
Company. Thanks also to Professors Mike Munger and Josef Sima, who provided guidance on the formulation of this thesis and the methods of research employed therein.
And finally, to the CEVRO Institute, for providing a wonderful experiment in decentralized education and learning, devoid of many transaction costs! It was a great learning experience, and I wish the program the best of luck in the future.
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