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How Firms Are Organized

Given that a firm must perform several tasks, how should the tasks be organized? Should each worker perform several different tasks or concentrate on only one or a few? For example, in a shoe manufacturing firm, someone must decide how many shoes to produce and at what price to sell them. Once the number is determined, someone must decide how to produce them, oversee production costs, and keep management informed of any cost changes. All of these decisions must be coordinated if the firm is to maximize profit.

Hierarchies. How should a firm's management be organized? Should one manager be responsible for pricing, another for monitoring production costs, and another for purchasing raw materials? Or should managers be responsible for certain phases of all three functions? Firms use various management organizations. An organization of management is called a hierarchy: the chain of control in an organization. Figure 2.1 shows the hierarchy of a typical organization. Three division managers report to the president, who coordinates the various pieces of information.

Figure 2.1 Firm Organization

Because people have limited information-processing ability, it is impossible for each division vice-president to convey all relevant information to the president. Instead, every time information gets transferred, some information is lost. The benefit from transferring information up the hierarchy is that one individual (the president) can use the combined information from the three divisions to make a coordinated decision that reflects the tradeoff of costs and benefits across all divisions. Within any hierarchy, there is a trade-off between the amount of information from each division and the need for coordinated decisions. [See Williamson (1967, 1975) for a detailed analysis of hierarchies within firms. See also Milgrom and Roberts (1992).] The more detailed the information from each division, the less able is one person to absorb information from several divisions and hence the less coordinated the decision-making becomes.

The president of any company typically knows much less about how a particular market works than a buying agent does and much less about how a particular machine works than the production engineer does. The president's role is to assimilate information from all sources and to make the most important, coordinated decisions—those that cannot be undone quickly. For example, a president is more likely to be involved in a decision to build a highly specialized plant than to purchase a large machine that can readily be resold.

Internal Organization of Large Firms. Large firms that produce several related products may be organized in several ways, two of which are discussed here. [For an excellent, detailed analysis of the internal structure of firms, see Williamson (1975, Chapter 8).] One form of organization involves functional separation, in which the firm has separate divisions for each activity such as production and sales. One benefit of this form is the greater efficiency that occurs when many tasks are handled by one economic unit due to the specialization of labor. An alternative organizational form is the multidivision form (M-form), in which the firm is divided into divisions based on the output produced.

Although all the tasks are usually the same in the two different organizational forms, the hierarchy of command is different, and hence the cost of organizing (monitoring efficiency) can be different. In particular, it is difficult to keep the functional divisions focused on the goal of maximizing overall profits. The reason is that it is hard to calculate the profits for the accounting, manufacturing, or marketing division separately. It is much easier to calculate profits for a division that sells a product than for a functional division. Although it allows less specialization, the M-form stresses profit maximization for each division and holds the managers of each division accountable for any shortfalls.

Until the 1920s, large firms that produced many products used the functional separation mode of organization. A few large firms, notably DuPont, General Motors, Standard Oil of New Jersey, and Sears, Roebuck, devised the M-form in response to their increasing size and diversity. Chandler (1962, 48-49) contended that "the multidivisional type of administrative structure, which hardly existed in 1920, had by 1960 become the accepted form of management for the most complex and diverse of American industrial enterprises."

In the United States, the M-form became prevalent in the 1950s (Williamson and Bhargava 1972), while in other countries its adoption was slower. For example, its widespread diffusion in the United Kingdom did not occur until the 1960s (Steer and Cable 1978; Marginson 1985). In the early 1970s, it appeared that the M-form was used in 70 percent of the major firms in the United Kingdom, in 50 percent in Germany, and in 42 percent in Japan (Cable and Yasuki 1985).

Armour and Teece (1978) tested Williamson's (1975) prediction that adoption of the M-form leads to higher profits. Using a sample of petroleum companies, they found that the percentage of firms that adopted the M-form rose from 16 percent to 78 percent. They also compared the profitability of those firms that adopted the M-form to those that did not between 1955 and 1973 and found that firms that adopted the M-form had much better initial profit performance (about 30 percent improvement in profit) than other firms. By the end of the period, however, there was no difference in profits between those few firms not adopting the M-form and the others. This result may show that some firms have special reasons for not adopting the M-form.


Armour, Henry O., and David J. Teece. 1978. "Organization Structure and Economic Performance: A Test of the Multidivisional Hypothesis." Bell Journal of Economics 9:106–22.

Cable, John, and Hirohiko Yasuki. 1985. "Internal Organisation, Business Groups and Corporate Performance: An Empirical Test of the Multidivisional Hypothesis in Japan." International Journal of Industrial Organization 3:401–20.

Chandler, Alfred D., Jr. 1962. Strategy and Structure: Chapters in the History of the American Industrial Experience. Cambridge, Mass.: The MIT Press.

Marginson, Paul. 1985. "The Multidivisional Firm and Control over the Work Process." International Journal of Industrial Organization 3:37–56.

Milgrom, Paul, and John Roberts. 1992. Economics, Organization & Management. Englewood Cliffs, N.J.: Prentice Hall.

Steer, Peter S., and John R. Cable. 1978. "Internal Organization and Profit: An Empirical Analysis of Large UK Companies." Journal of Industrial Economics 27:13–20.

Williamson, Oliver E. 1967. "Hierarchical Control and Optimum Firm Size." Journal of Political Economy, 75:123–38.

------. 1975. Markets and Hierarchies–Analysis and Antitrust Implications: A Study in the Economics of Internal Organization. New York: The Free Press.

Williamson, Oliver E., and N. Bhargava. 1972. "Assessing and Classifying the Internal Structure and Control Apparatus of the Modern Corporation," in Market Structure and Corporate Behavior: Theory and Empirical Analysis of the Firm, ed. K. Cowling. London:Gray-Mills Publishing Ltd.

© 2000 Dennis W. Carlton and Jeffrey M. Perloff. Reprinted by permission.

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