TRAMOS FINALES

The tension between real and formal authority is center stage in some of the writings on the diminishing importance of authority compared with, for example, market contracts (or hybrids such as collaborative arrangements supported by, for example, norms (Grandori, 2001)). Two diff erent types of

The use of managerial authority in the knowledge economy 91 arguments support this idea. First, a move toward the knowledge economy may be expected to increase the relative importance of investments in knowledge assets compared with investments in capital. With this change, employers’ costs of monitoring and bargaining with knowledge workers over the actions to be chosen may increase. In turn, this leads to increased costs from moral hazard (Jensen and Meckling, 1992) and from bargaining in all transactions dealing with knowledge workers. Also, investments in knowledge assets and allocation of bargaining power change endogenously (Hart, 1995). That is, in order to create effi cient incentives for knowledge workers to invest in knowledge assets we should expect a reallocation of the real authority that follows from ownership of co-specialized physical assets from managers to knowledge workers.

If we hold everything but the discretion and costs of bargaining with employees constant we should expect the benefi t function from the use of formal authority to move downward, causing a relative decrease in the use of formal authority. However, there are also factors that can off set this move. For example, increased investments in knowledge assets may create more assets specifi city, which in turn raises costs of market contracting and introduces a need for private courts that can handle the specifi c types of confl icts that arise in incomplete contract situations (Williamson, 1985). Thus increasing knowledge workers’ discretion (or authority) does not nec- essarily imply more market transactions. However, the formal authority of the employer may to a lesser extent be accompanied by real authority.

A second type of argument focuses on how information is diff erently dispersed in the knowledge economy compared to the capital intensive one. Grandori (2001), for example, has forcefully stated that changes in the distribution of information may cause ‘authority [as a centralized decision- making system] to fail in all its forms’ (p. 257). Along with the diff erently dispersed knowledge, the choice set of actions available to knowledge workers may become much greater than that available to workers in the capital intensive economy. In such a situation it may be too costly for a central manager to be informed about the entire choice sets of an employee. Knowledge workers then become better able to select actions that create joint value than the employer. However, the employer may interpret the employees’ choices as morally hazardous when they do not benefi t the employer and he may not allow these choices although they maximize the joint satisfaction function. If as Simon (1951) argues the employee cannot make the employer commit to choose actions that maximize their joint satisfaction function, the use of authority becomes ineffi cient. For a given level of uncertainty (variance) employees will demand a higher compensa- tion (compared with the compensation they get from market transactions) in order to meet their participation constraints.11 _{The increased costs of}

meeting employee participation constraints raise the costs of using author- ity relative to market contracting. Thus, the diminished use of authority in a knowledge economy should be attributed to an increased confl ict of interests leaving little scope for the use of authority that satisfi es the par- ticipation constraints of both the employer and the employee. A limited scope within which the participation constraints of both employee and employer are fulfi lled may also arise if changes in work content produce a wider gap between the preferences of the knowledge workers and those of their employers (with no changes in the size of the choice set). For example, it may well be the case that knowledge workers to a greater extent prefer to work on projects that add to their general (non-relation-specifi c) stock of human capital, whereas an employer to an increasing extent wants employ- ees to work on projects that mainly build relation-specifi c experience.

Two mechanisms can ease the problem. One is to introduce diff erenti- ated pay for activities in accordance with the merits to the employer and the costs to the employee. It has in fact been argued that in the knowledge economy we see an increasing use of high-powered incentives within fi rms. Of course this re-introduces the issue raised by Coase (1937), Cheung (1983) and others of the costs of discovering the relevant prices. Another mechanism is for the fi rm to delegate some discretion to knowledge workers and build a reputation for allowing the employee to select actions that maximize the joint satisfaction function (Aghion and Tirole, 1997).12

The reputation has to be robust to evolving changes in the pay-off to the employer and employee of emerging actions (see, for example, Kreps, 1990). The recognition of fi rms as legal entities and the legal protection of corporate identity are factors that ease the use of reputation mechanisms as a means of private enforcement of implicit promises within fi rms as com- pared with across spot markets. Thus, increased distribution of knowledge and the accompanying need for delegation need not result in a relative diminished use of formal authority.

However, as delegation of discretion introduces costs in the form of moral hazard, there will have to be limits to the delegation that takes place within fi rms. The optimal delegation of discretion is, according to Jensen and Meckling (1992), one that balances ‘the costs of bad decisions owing to poor information and those owing to inconsistent objectives’ (p. 264). In order to constrain moral hazard, restrictions are often used in employment relations where assets have many diff erent uses and where only a subset of these uses optimize the joint satisfaction function. This conclusion is in line with the work of Holmstrom and Milgrom (1994), Barzel (1989) and Holmstrom (1999), who argue that employers use restrictions in order to avoid costs of morally hazardous behavior when incentive payments are too costly to implement. Thus, the employer may replace direct monitoring

The use of managerial authority in the knowledge economy 93 of work eff ort by supervision of a set of constraints that the employer has imposed on the employee with respect to the use of the labor services and capital assets (Barzel, 1989). However, since contracting takes place in a dynamic setting in which new opportunities for value creation and for moral hazard arise, the constraints and restrictions may need to be changed over time. The employment contract ensures that the employer has the formal rights to make these changes unilaterally, thereby saving contracting costs. Thus, an increased need for delegation need not imply a diminished role for authority.

To sum up: writers on the knowledge economy have emphasized the importance of increasing misalignment of preferences between employer and employee or the relative increase in employees’ ability to discover value- creating actions which in turn should diminish the relative importance of the use of authority. However, there is no reason to assume that there is a diminished need for the role of formal authority as supported by a fi rm governance structure. It may still be effi cient to use authority supported by fi rm governance to solve confl icts of interest in situations of incomplete contracting (as argued by Williamson, 1985) and to support the building of a credible reputation for delegating discretion. Moreover, delegation of discretion within an employment contract allows for diff erent types of monitoring compared with market contracts, making it easier to counter moral hazard within the fi rm governance structure. Finally, the fi rm gov- ernance structure allows for a fl exible adaptation of constraints to delega- tion as employers have the right to make these decisions unilaterally.

The above discussion has centered on how incentive issues infl uence the relative use of authority in the knowledge economy holding the nature of the coordination problem constant. However, it is also possible that the nature of the coordination problem changes with a move from a physical capital to a knowledge intensive economy. In the following, I make use of an example of a coordination problem that arises between a marketing and a product development function in order to illustrate how changes in the nature of the coordination problem infl uence the relative costs and benefi ts of the use of authority under diff erent conditions of dispersion of information and knowledge between an employer and two employees. For the moment I leave aside the discussion of the incentive issues, thus taking common goals as the standard assumption throughout the example. 4.2 The Use of Authority from a Production Coordination Perspective

The coordination problem consists in carrying out a product develop- ment project. Two employees (in marketing and product development respectively) and a manager are engaged in the project. The choice set for

the marketing employee contains two diff erent product concepts and the choice set for the product developer contains two diff erent technical solu- tions. The coordination problem is that of selecting the concept and the technological solution that under the prevailing contingencies generate the greatest revenue to the fi rm (which in this example is the choice that maximizes joint value). The contingencies facing the fi rm consist of the values (which enter as parameters in the revenue function) for the state of customer preferences and for the state of technological knowledge. Both customer preferences and technological knowledge can change over time.

The way in which the coordination problem can be solved depends on the nature of interdependencies and on the distribution of information and knowledge between the employer and the two employees. Information refers to information about a realized state and the solutions available, while knowledge refers to the ability to specify the revenue function and solve for the optimal solution. Either the superior or the two employees in the fi rm may posses information regarding the choice sets and the kind of states that have emerged. Moreover, either the superior or the subordinate or both may have the knowledge needed to select the optimal combination of product concept and technical solution, given the information available on customer preferences and technological knowledge.

When the informational interdependencies between the choice of product concept and technical solution are complex, coordination requires that the decision maker has information about the contingencies and the solutions facing both design and product development. The coordination problem is characterized by decisiveness when decisions on product concept and tech- nical solution can be made sequentially by diff erent decision makers. For example, customer preferences may be decisive for the choice of product concept and for the choice of technique. This implies that the marketing employee (who selects product concepts) can make a decision without information about the state of technological knowledge or technical solu- tions. Moreover, he only needs to communicate his choice of concept to the employee in product development, who selects the technical solution on the basis of his investigation of the state of technological knowledge. Finally, the coordination problem can be characterized by complete independ- ence, in which case the marketing employee only needs information about the state of consumer preferences and product concepts and the product development employee only needs information on the state of technologi- cal knowledge and technical solutions.

Centralized authority in a setting of complex interdependencies

The employer is the only one who can make the relevant decision if he is the one who possesses all relevant information of states and solutions

The use of managerial authority in the knowledge economy 95 available and the knowledge needed to use that information. Some ex ante communication of the information possessed by the employer will be necessary though, as employees will be unwilling to accept an employ- ment contract unless it specifi es the nature and limits of the choices that the employer can make (Simon, 1951). However, compared with the use of market contracting, which requires a more detailed specifi cation of actions and instructions, the use of order in employment contracts may save some communication costs (Demsetz, 1995). If contingencies or the choice set of actions change, the benefi ts from the use of formal authority supported by fi rm governance structure to make adaptations increase, as more transac- tion costs are saved compared with carrying out the adaptation by means of spot market transactions (Coase, 1937).13

The arguments presented above indicate at least three important vari- ables that may infl uence the relative use of centralized decision making (assuming there are no confl icts of interest). First, the costs of complet- ing contracts over markets in the knowledge economy could have been reduced. For example, the introduction of IT technology in the knowledge economy and the embodiment of information needed for coordination, as well as the development of interface and measurement standards, are factors that reduce costs of re-contracting. However, these factors may infl uence fi rm internal costs of using centralized decision making to the same extent. Second, uncertainty may have been reduced. In the example above, this would be the case if the states of consumer preferences or tech- nological knowledge did not change or if no new product concepts and solutions could be identifi ed. However, a reduction in the level of uncer- tainty is contrary to what most writers on the knowledge economy assume. Finally, the costs to the central manager of obtaining relevant information and of using this may have increased. The latter falls in line with the argu- ments presented in much of the literature on the use of authority in the knowledge economy, where many writers argue that an increased disper- sion of knowledge makes it increasingly diffi cult for the holder of formal (and centralized) authority to reach effi cient decisions (see, for example, Minkler, 1993; Cowen and Parker, 1997; Hodgson, 1998; Radner, 2000). For example, an increase in specialization in production and knowledge in the knowledge economy results in more diverse types of transaction (in terms of choice sets, contingencies and sources of interdependencies) and this increases the costs to managers of ‘discovering the right prices’, result- ing in a reduction of the effi cient size of fi rms and an increase in the relative use of market transactions.

Part of the confusion about the status of authority in a knowledge economy seems to arise because the use of authority is confused with highly centralized decision making. Indeed, the costs that arise due to the limited

mental capacity of managers can be reduced if some discretion and author- ity is delegated to lower-level employees. Delegation has been mentioned in the organization literature as a means of improving decision making under uncertainty (Miller, 1992), economizing on principals’ opportunity costs (Salanié, 1997) and avoiding decision delays under circumstances of volatility and uncertainty (Thompson, 1956; Burns and Stalker, 1961; Mintzberg, 1983). The underlying idea is that delegation of discretion provides an effi cient use of distributed knowledge in fi rms (Jensen and Meckling, 1992) that is costly to communicate to a central decision maker (Casson, 1994).14 _{Uncertainty, unpredictable volatility and some level of}

distributed knowledge and information create the conditions under which there is an economic rationale for the coexistence of authority and del- egation of discretion within hierarchies. This conclusion is based on the assumption that the coordination problem is at least partly decomposable (Simon, 1962). One such situation arises if the coordination problem is characterized by decisiveness.

Delegation in a setting of decisiveness, dispersed information and centrally or dispersed knowledge

When the coordination problem is characterized by decisiveness it is possible to achieve the optimal solution with delegation of discretion to employees. The employer can delegate decisions to the employee who has the relevant information about states and solutions and the knowledge needed to make the choice. When marketing information is decisive for the coordination problem the marketing employee can make the deci- sion and communicate it to the employer, having them select the optimal technique, or they can communicate their decision directly to the product development employee who has obtained information about the state of technology. The choice between centralized decision making and decen- tralized corporation (through markets or within the hierarchy) depends on the trade-off between benefi ts from specialization in decision making and costs of communicating to the employer the states and solutions that have been observed by marketing and product development.

In cases where the design problem is not characterized by natural decisiveness, it may sometimes be effi cient to have the employer impose decisiveness on problems by dispensing with the communication of the decision premises. As an example, the employer can choose to take cus- tomer preferences or technological knowledge as given and make that the ‘normal state’. Decisions will only be made in a consultative manner when the employer or the employee in a marketing department discovers an unusual state. In all other situations they will be made in a sequen- tial manner. An even stricter way of imposing decisiveness is to restrict

The use of managerial authority in the knowledge economy 97 employees from all examination of states. In the latter case decisions are taken in a routine manner and the only role for a central authority is to monitor the adherence to and feasibility of this restriction.

Restrictions on the delegation of discretion may be needed as long as there is some level of interdependence. Costs from delegation of discre- tion arise when knowledge workers do not possess all relevant knowledge. Employees’ exercise of discretion can produce spillover eff ects (that is, ‘externalities’) due to unintended consequences of the actions taken. These harmful spillover eff ects include coordination failures, such as schedul- ing problems, duplicative eff orts (for example, of information gathering, R&D), cannibalization of product markets and other instances of decen- tralized actions being inconsistent with the fi rm’s overall aims, and so on. The use of authority to restrict harmful consequences is effi cient if the employer is better able to form a judgment regarding what types of actions are appropriate. The employer defi nes constraints that only allow the knowledge workers to choose among actions he deems appropriate (Armstrong, 1994). In this way the employer prevents the knowledge worker choosing actions that he knows or believes to be infeasible. If the employer does not know where to set the restrictions ex ante to contracting, he may instead overrule or veto decisions made by the employee (as in, for example, Aghion and Tirole, 1997). That is, even with perfect alignment of incentives between employer and knowledge there is a role for employers as monitors and enforcers of restrictions. The use of restrictions and veto brings attention to the function of authority as a means of constraining ‘the method[s] of reaching’ an end goal, in Simon’s (1991) terminology. Under conditions of uncertainty where the choice set of the knowledge worker and interdependencies in decision change over time, constraints will have to be adjusted. Thus, the role of authority in a setting of distributed knowl-