Arab Open University (Bahrain Branch)

Arab Open University

Bahrain Branch

Faculty of Business Studies

T205 – Systems Thinking: Principles and Practice

Session 23

Hierarchies

Philosophy and properties

Ø  Hierarchies are concerned with the general idea of hierarchy as a device to allow a small ‘centre’ to exercise control over a much larger structure

Ø  The word ‘hierarchy’ stands for any form of direct, centralized control structure

Ø  To widen control, one can adjust the organizational boundary, so that what used to be uncontrolled bits of the environment are now inside the boundary

Ø  Individual employees operate under a regime of administrative procedures and work roles defined by higher-level supervisors

Ø  Management divides up tasks and positions and establishes an authoritative system of order

Ø  Because tasks are often quite specialized, work activities are highly interdependent

Ø  They are well-suited for mass production and distribution

Ø  It is reliable, with high capacity for producing large numbers of goods and services of a given quality

Ø  Its disadvantage is exposed when confronted by sharp fluctuations in demand and unanticipated changes

Ø  Communication occurs in the context of the employment contract

Ø  Relationships matter and previous interactions shape current ones

Ø  The patterns and context of intra-organizational exchange are more strongly shaped by one’s position within the formal hierarchical structure of authority

Ø  Communication and exchange is shaped by concerns with career mobility

Hierarchy and the state (public sector)

Ø  The traditional organizational structure of the public sector was the bureaucracy – the quintessential hierarchy – and it is still widely used

Ø  The state (public sector) operates hierarchically, and is very much concerned with control of its (and our) environments

Ø  You might expect, therefore, that ‘the state’ would be tempted to exert its control by ‘taking over’ large sections of its environment

The drive to expansion

v  Most small companies aim to increase in size for simple functional reasons:

o  Size gives you more economic power. The more economic power you have, the more control you can exert

o  Size also gives you more opportunities for economies of scale and for economies arising from specialization

v  So enterprises often grow organically and incrementally through the natural processes of their own internal structure as they expand into new markets, offer new products, take on new projects, etc.

v  Growth can also happen as a deliberate choice through mergers and acquisitions. These are usually chosen to achieve either vertical or horizontal integration

o  Vertical integration means acquiring or merging with organizations (such as suppliers and distributors) that occur either upstream or downstream of a firm’s own activity

o  Horizontal or unrelated integration can help the organization to grow by diversification – i.e. by acquiring other organizations with related, but complementary products

v  Once the company gets too large to manage as a single entity, the next step has often been the adoption of a divisional structure. In effect, each division became a semi-autonomous internal business. Nowadays this might well be taken to its logical conclusion, with the development of an internal market, or even by spinning off some units completely, as separate companies

v  The final stage is international expansion to evolve into a global multi-national – though modern information technology developments can sometimes mean that a company can nowadays enter the global market at a much earlier stage in the development sequence

Market or hierarchy

Ø  A market option – there are several specialist ‘firms’, each carrying out one stage, buying their input from specialists in the previous stage, and selling their own output to specialists in the next stage. This can be very flexible, but there are inefficiencies in moving the product between stages and in having to negotiate with multiple contractors

Ø  A hierarchical option – all specialists are directly under one roof and are controlled by building a management hierarchy. Coordination between the stages can then be much more efficient, though it also requires additional non-productive costs associated with a management hierarchy which may also have the disadvantage of being rather rigid

Ø  In other words, the transaction costs of exchanges to secure an activity in the market must be compared with the transaction costs of managing the same activity in a hierarchy (make-or-buy decision)

Ø  Other factors influencing decisions about contracting out include:

§  Transaction frequency: if something happens very frequently it is probably better handled in-house

§  Uncertainty: if the load is patchy and unpredictable, it might be better contracted out. But if very fast responses are required, you might still prefer to handle them in-house

§  Management and relative costs: will the in-house option cost more or less than the contracted-out option?

§  Dependency considerations: if the activity is a core activity and central to the organization’s transformation process, you will probably want to retain it in-house

§  Perceived competencies and the level of knowledge required to manage the transactions: who is capable of doing the job best: your in-house team or the external contractor?

§  Asset base: if you already have well-developed in-house physical- and staff-resources in some area, you will probably prefer to use them than to use an external contractor

Markets

The term ‘market’ is used in three very different ways:

• It can be used rather loosely to refer to the ways in which capital, labour, goods, services and commodities are allocated in the modern economy. So there are markets for goods, services and commodities, capital markets, and a labour market for employees and the unemployed. In this sense, ‘market’ really just means: ‘the system of flows of capital’ (or labour, or whatever)
• ‘Market’ is also used in a more specific way, to identify a particular area of competition between firms, as when we speak of ‘the market for personal computers’
• The most general and abstract sense of ‘market’ is its use as a description of a philosophy or set of operational principles. The market concept envisages a set or relationships in which member organizations compete amongst themselves for the resources they want, and where competition allocates resources according to price

As well as being used to describe the exchange of goods, services and resources, this market concept also finds itself being applied to factors of production, such as labour markets and financial markets; areas of activity, such as the leisure market; and to less visible areas, like the informal economy or the market for stolen goods

The nature of markets

Sign graph of the simple image of the market

ü  If demand increases then the price goes up: conversely if demand decreases, then the price goes down;

ü  If the supply increases then the price goes down, while if supply decreases, then the price goes up;

ü  If the price increases, the demand decreases, so the supply decreases;

ü  If the price decreases, the demand increases, so the supply increases.

ü  The overall effect of all this is that the price of a commodity, service or resource changes until the demand for it is in balance with its supply. Demand and price are also affected by quality. Supply is also affected by the limitations of production capacity and hence by investment levels which depend in turn on profit. Profit itself depends on quite a subtle balance of price and demand.

Markets’ philosophy and properties

• Markets are open to all new comers, but while it brings people together, it does not establish strong bonds of altruistic attachments
• The participants in a market transaction are free of any future commitments
• The stereotypical competitive market is the paradigm of individually self-interested, non-cooperative, unconstrained social interaction
• Markets offer choice, flexibility, and opportunity
• They are a remarkable device for fast, simple communication
• No one need rely on someone else for direction, prices alone determine production and exchange
• Markets are a form of non-coercive organization, they have co-ordinating but not integrative effects
• Prices are a simplifying mechanism, consequently they are unsuccessful at capturing the intricacies of idiosyncratic, complex, and dynamic exchange
• Markets are a poor device for learning and the transfer of technological know-how
• In a stylized perfect market, information is freely available, alternative buyers or sellers are easy to come by, and there are no carry-over effects from one transaction to another
• Benefits to be exchanged are clearly specified
• No trust is required
• Agreements are bolstered by the power of legal sanctions
• The value of the goods to be exchanged is much more important than the relationship itself (except if the relationships are commodities themselves)
• The standard strategy is to drive the hardest possible bargain in the immediate exchange

Limitations of the market concept

The market idea only works if its assumptions are valid. In your judgement, how true are the assumptions listed below?

ü  It is easy to judge the nature and quality of goods and resources

ü  Information about prices, quality, alternative suppliers, alternative purchasers, etc., is freely available, and information flows are reasonable

ü  The market is dynamically self-correcting so that profit leads to competition, which leads to less profit and less competition

ü  Ownership of goods and resources is distributed throughout the market, and there are many competing buyers and sellers

ü  It is fairly easy for new firms to enter the market, and for ineffective ones to leave it

ü  Externalities (such as effects of third parties, environmental conservation concerns, government regulation, and so on), are minimal and may be ignored by the market

ü  There is an agreed framework for fair dealing, redress, what constitutes illegal behaviour, and so on

Markets and industries

Ø  The term ‘industry’ usually involves broader groupings than the market concept. Firms in the road transport industry are not a ‘market’ since they are not usually in direct competition (trucking companies buy trucks, not cars), but they do share a lot of interests

Ø  There may also be some competition at the industry level (e.g. for workers with particular skills, or for access to particular resources). Industry members are also close enough to be a potential threat since they could move relatively easily into each other’s markets

What shapes a market or industry?

• The shape of a market or industry is driven by factors such as:

ü  The extent to which it is an oligopoly – i.e. dominated by a few large firms. This factor is sometimes called the ‘level of concentration’

ü  How difficult it is for a newcomer to enter – the entry barrier

ü  The number and power of suppliers and/or buyers

ü  The extent of product differentiation

ü  The threat of product substitution

• An oligopoly develops when a small number of organizations become powerful enough to act as a formal or informal cartel, retaining a high degree of control over the market so that there is very little freedom for market forces to operate, and it is very hard for others to enter the industry. Over the longer term, this may result in a rather static market, with low levels of innovation
• If the level of innovation in an industry or market is quite high, there will be a strong threat of product substitution. A new product can appear which meets an existing customer need in a much better and/or cheaper way (as, for instance, CDs replacing tapes and records)
• In markets where there is a lot of product differentiation, it may be possible for producers to reduce competition by targeting separate markets
• The importance of the number and power of suppliers and buyers can be illustrated by the key role played by small and medium-sized enterprises (SMEs) in the way that an industry or market functions:

§  If there are many SMEs, and they are in good health, this helps to ensure that large organizations do not abuse their market power

§  SMEs are often major sources of innovation and employment

§  Their relationship to large firms as subcontractors affects the overall competitiveness of firms in that sector

Quasi-markets and the public sector

Ø  Services are often purchased by the state on behalf of the public (e.g. to provide care for older people). In recent years it has become common for this to be talked about in terms of the market concept, for instances tendering for residential care provision ‘on the open market’

Ø  But there are some important differences here from what happens when, say, a company buys the services or supplies it needs on the open market

o  Users of those services are not who buy them. There is a (purchaser-provider-user) relationship rather than the simpler purchaser-provider relationship of the conventional market. If something goes wrong with the service, the purchaser is no longer the person who is directly affected, so undermining one of the fundamental assumptions of the market model

o  There are other differences from the ‘classic market’ and it may be better to regard this sort of relationship as a quasi-market with the following characteristics:

§  Demand is influenced and structured by a variety of factors other than strict market ones

§  There may be few buyers of services apart from the state, so service providers may be few in number, competition between them may be very limited, and the ‘market’ may be opaque, problematic to enter, and structured in an unconventional way

§  Measuring the performance and quality of institutions such as schools, hospitals, prisons, etc. is very much more difficult than measuring the quality of most normal commercial products or services

Cultural variation in the ‘market’ idea

Because people in different cultures tend to relate to one another differently in many areas, they also tend to construct their ‘market relations’ differently, and have different understandings about what ‘the market’ means

Limits to markets and hierarchies

• Traditional economists regarded enterprises as ‘black boxes’, being less concerned with what went on inside them, than with questions such as: ‘If prices go up (an input to the black box) what happens to production levels (an output from the black box)
• However, economists are very interested in efficiency, and in due course they began to explore questions such as: ‘Is one very large firm as efficient as the same firm broken up into several smaller firms trading with each other in the market?’
• They began to see that a hierarchy (i.e. a firm) and a market are essentially different ways of managing transactions

Transaction cost theory