Unified governance (vertical integration)
The presence of bottlenecks scattered through the steps of a process creates the need for centralized coordination and integrated decision-making within the boundaries of a single firm. In the absence of bottlenecks, different parts of a step process can be carried out with little or no loss of value by two or more separate firms. To see this, let us imagine a production process with labor-saving capital and a growing market,
but no bottlenecks. Consider two firms, Upstream and Downstream. Upstream is responsible for production and can make labor-saving capital investments. Downstream purchases Upstream’s output and is responsible for distribution and marketing: it can make investments that increase the size of the market. By assumption, there are no bottlenecks: either type of firm can increase its capacity without limit.
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Now suppose Downstream has the opportunity to invest in advertising to increase the size of its market. In the absence of bottlenecks, it will increase the quantity of goods ordered from its Upstream supplier. Thus, the Upstream firm will benefit from Downstream’s market-expanding investment (an externality). The higher quantities ordered will then increase the value to Upstream of cost-saving capital investment. Once the investment has been made, lower variable costs will lead Upstream to reduce the price of its intermediate good. Thus, Downstream will benefit from Upstream’s cost-reducing investment (another externality). It will then have incentive to invest again to expand the market.
In effect, Upstream and Downstream firms are in a symbiotic relationship, but they can coordinate their actions in the market, via prices charged and quantities ordered. Even though their choices are complementary,
10 market signals are sufficient to push both firms’ investments in the “right” direction.
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The presence of bottlenecks scattered among the steps causes decentralized decision-making to break down and thus creates a “demand” to place all steps in a single firm under unified governance. For example, suppose Downstream sees an opportunity to increase the size of its market, but Upstream faces a bottleneck in production. Upstream will then not be able to increase its production to meet Downstream’s new demand, and Downstream’s investment will not pay off. Symmetrically, if Upstream invests in labor-saving equipment and Downstream faces bottlenecks in distribution, then Downstream will not increase the quantity of goods ordered. Upstream will gain from lower costs, but will not be able to grow, reducing its return on investment.
If one side attempts to contract with the other to fix its bottleneck, a classic holdup problem ensues. The bottleneck, by definition, constrains the throughput of the entire process. The owner of the bottleneck is thus in a position of great bargaining power vis-a-vis the owner(s) of the rest of the process. He or she has control of a unique asset on which the productivity of non-bottleneck assets depends. Under the standard reasoning of transaction costs economics, the owner of the bottleneck can expect to be paid a significant percentage of the value gain to the entire process that comes from fixing the bottleneck. The expectation of holdup, in turn, reduces the value of systematic management to the owner(s) of the other steps.
In summary, separate firms carrying out interdependent step processes subject to bottlenecks have reduced incentives to invest in market-expanding or cost-savingtechnologies. Even more insidious is the fact that none will have incentives to invest in systematic management to identify and eliminate bottlenecks in its own processes. If each is hostage to the other’s bottlenecks, in equilibrium, none will invest to increase its own throughput, for such investments will be wasted. In effect, non-integrated firms are in a classic coordination game with respect to investments in systematic management: both must invest if either is to benefit.
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Placing Upstream and Downstream’s processes within a single firm under unified governance changes the incentives to address bottlenecks. Within a single firm, information can flow to a central authority who can take appropriate action without seeking permission of a third party. Bottlenecks can be addressed wherever they arise without risk of holdup. A single firm that spans all steps thus has greater incentives to invest in systematic management tools and techniques than separate firms carrying out the same step processes as independent actors pursuing their own interests.
In fact, in the late nineteenth century, across a range of industries, firms like du Pont and Singer that vertically integrated
and then rationalized their flow production systems came to dominate their non-integrated rivals through a combination of rapid market expansion and impressive cost reductions. The result was the emergence of a new class of organizations, which Alfred Chandler labeled “modern industrial corporations” (Chandler Jr
1977).
Hierarchical organization
The large modern industrial corporations that emerged at the turn of the twentieth century were not only under unified governance, they were also organized in a hierarchical fashion by functional departments. Each functional group was responsible for some portion of the flow process—procurement, fabrication of parts, assembly, distribution, and marketing. Proximate units were grouped together under the supervision of a more senior official. These hierarchies generally extended from the very top of the company down to the level of front-line workers.
Viewed strictly as a means of structuring communication linkages, hierarchy is an efficient way to filter large amounts of day-to-day operational information. This was in fact the essence of James Thompson’s theory of design for “boundedly rational” organizations: create groups that mirror the individual’s need to communicate and coordinate actions in real time then create groups of groups according to declining interdependency. The groupings fostered timely mutual adjustments and the hierarchy served as a means of conflict resolution “with each grade in the hierarchy specializing in resolving conflicts of the grade beneath it” (Thompson
1967).
In a flow process, the highest levels of interdependency arise between nearby steps; thus, most of the necessary communication takes place locally. In a hierarchy, only selected information gets passed up to higher levels and then possibly back down to distant groups. The whole can be coordinated by setting consistent objectives for throughput across the whole organization within a given time period.
Groups at the lowest level of the hierarchy can manage to the plan, dealing with small deviations as necessary. Thompson called this “coordination by mutual adjustment” (Thompson
1967: 56). Large deviations can be flagged and passed up to successively higher levels according to their magnitude. Such flags would cause additional problem-solving resources to be allocated to the point of disruption and could also trigger revisions in the plans of other departments. If the functional units are buffered from one another, for example, by intermediate inventories, then the effect of a disruption in one segment will be attenuated in the more distant parts of the enterprise. Thus, a hierarchy is an effective way to match the scope of communication and the scale of responses to the magnitude of random disruptions, wherever and whenever they arise.
The techniques of systematic management relied on new types of information, which had to be collected, analyzed, and transferred up, down and across the hierarchy. The clerks, who kept track of orders, throughput and inventory, plus those in charge of sending plans, updates, policies, and decisions to far-flung parts of the enterprise, were newcomers to business organizations. They did not make, assemble, transport, or sell: they directed, coordinated, analyzed, and supplied expertise to those who did. To be effective, they needed channels of communication with each other and with top managers who set goals and allocated resources. Channels of communication in those times inevitably passed through people—there were no computer-generated reports or automatic responses. Thus, the top managers of large enterprises, like generals of armies, came to be surrounded in their headquarters by a cadre of senior staff. Senior staff members supervised their own hierarchical organizations, but also consulted with one another and designed uniform policies and plans binding on the entire organization.
Direct authority
Charles Perrow has argued that there are three types of control in organizations: (1) direct, fully obtrusive control where orders are given and obeyed and performance is closely monitored; (2) bureaucratic control where people are assigned to specialized roles (tasks), which they perform under looser supervision; and (3) control of the premises of decision making where “the subordinate restricts the range of stimuli that will be attended to … and the range of alternatives that would be considered” (Perrow
1986: 129).
A notable feature of modern industrial corporations was the fact that managers, sometimes through intermediaries such as foremen, exercised direct, “fully obtrusive” control over the flow of work and the actions of workers. Bosses gave orders and they were obeyed. Under the law, failure to obey a boss’ order was grounds for discipline or firing (Masten
1988; Freeland
2016). The question is: What characteristics of a technology make direct control necessary or useful?
I suggest that direct authority is good for three things: (1) synchronization, (2) education, and (3) coercion. Synchronization comes first. Coordinating actions precisely in time is a human skill, not found in other animals. But, especially when large numbers are involved, centralized authority is needed both to keep time (think of an orchestra conductor or the coxswain of a crew) and to design and assign the sequence of coordinated actions (think of a choreographer or an engineer laying out an assembly line).
In high-speed processes, any slowdown for consultation or negotiation will undermine the efficiency of the process and may destroy its effectiveness. Furthermore, if the process involves many people, it is useful to have someone outside the synchronized space, who can first determine a feasible and consistent set of actions (the “plan”) and then identify points of imbalance (bottlenecks) and redress them. Thus, it is best if direct authority is given to a designated actor (or actors) in advance. (Authority over different aspects of the process can be split up among different actors. Thus, a conductor has authority over the tempo of the performance, while a choreographer has authority over the sequence of actions to be performed. Importantly, these actors exercise their authority at different times.)
Direct authority is also useful when one person knows more than another about the task at hand. A teacher can teach basic tasks and skills by giving orders, observing performance, and providing feedback and correction. When the tasks are programmed and the skills are physical, direct authority is an effective and natural method of instruction. Giving orders can be helpful when a student truly does not know what to do. It is only when trying to teach higher-level skills—e.g., judgment under uncertainty or problem selection—that the instructor needs to forgo direct authority for more indirect and unobtrusive methods of control.
Finally, direct authority can be a means of coercion; of making someone do something, he or she would not choose to do on his or her own. A direct order backed up with enforcement can send someone into danger. It can put someone to work on boring, repetitive tasks. It can direct someone to perform actions that are difficult or unpleasant and have no intrinsic value to the actor.
Given this profile, it is not surprising that some of the earliest and most successful uses of direct authority were in military settings. The Roman legions proved in their time that an infantry subject to direct authority and trained to carry out synchronized actions was militarily superior to loosely coordinated cavalry or disorganized hordes inspired by alcohol and plunder.
In the eighteenth and nineteenth centuries, the principles of an authority hierarchy were carried over to commercial enterprises, beginning with cloth and lace factories, extending to railroads, and then to corporations engaged in mass production, such as steel mills, meatpackers, and automakers (Chandler Jr
1977; Hounshell
1985; Landes
1986; Fields
2004). All of these enterprises depended on synchronization of workflow for safety and efficiency. Their production processes were technologically advanced, and thus beyond the comprehension of most workers (who in any case saw only small parts of the overall system). At the same time, the technologies required workers to carry out precise tasks in a strictly timed order. The tasks themselves were often strenuous, boring, repetitive, and even dangerous.
The step-based flow technologies of the late nineteenth and early twentieth centuries thus met all three criteria for the efficacy of direct authority. In their core production, distribution, and marketing activities, most of the enterprises using the new high-flow-through technologies were organized as a hierarchy of “bosses” exercising direct authority over subordinates. Direct authority, bosses, and modern technology thus came to be seen as inextricably intertwined.
13 The technological requirements that made this organizational form efficient then faded into the background. It came to be taken for granted that authority was essential to the way modern firms worked.
However, in the late twentieth century, these assumptions were challenged in two ways: first, by the Toyota Production System which showed how flow processes might be managed more productively by engaging workers in a process of continuous improvement; and second, by the increasing importance of non-flow technologies especially in the realm of information goods and software.