The Competitiveness of Nations in a Global Knowledge-Based Economy
Brian J.
Loasby
Organisations as Interpretative Systems
DRUID Summer
2000 Conference
15-17 June, Rebild,
Denmark
Revised 1 June 2000
Content
Rationality, Uncertainty and the Firm
An Economy of Interpretative Systems
Rationality,
Uncertainty and the Firm
It is because of Herbert
Simon’s influence that economists have come to associate organisations
with bounded rationality. Yet the form
of this association is not what Simon (1982) intended: bounded rationality has
typically been restricted to organisations, instead
of being treated as characteristic of all human behaviour,
and the concept of bounded rationality has itself been narrowly conceived. In this paper I wish to explore a wider
conception, which (following Langlois) I prefer to
call bounded cognition, and to argue that organisations
are a response to both the limitations and the potential of human cognition.
Since the theme of this
paper is the significance of interpretation, it is appropriate to begin by
observing how the interpretation of Simon’s own term has been affected by the
increasingly stringent conception of rationality within mainstream economics. From an originally broad notion of purposeful
and intelligent behaviour, which Simon has always
adhered to, rationality has been formalised as a
tautology: action is deduced from a criterion function and an opportunity set,
both of which typically have to conform to strict methodological requirements. In effect, Simon’s claim that decision
premises are important is conceded; but since his further claim that they are
problematic is ignored this concession has no effect: decision premises are
simply another label for the fundamental data. Indeed, in rational choice theory decision itself is meaningless - as is neatly demonstrated by the
inability to predict or prescribe how agents should choose in situations which
yield multiple equilibria. Instead of the process of choosing, we are
offered existence proofs.
Simon’s argument that we
should move from substantive to procedural rationality has no purchase in an
analytical system which has no space for procedures to be followed by agents. Instead, the search for and processing of
information is transformed into another optimisation
exercise, in which it is of course necessary to specify what information is
available in order to set its potential value against the costs of acquiring
it. Economists such as Arrow (1974) have
noted the logical difficulties associated with the notion of appraising the
value of information without knowing its content, or even knowing of its
existence; but effective responses to these difficulties have been confined to
the problem of providing appropriate incentives to the production of
information when this is a public good, and here too the goal is to prove the
incentive-compatability of some particular
configuration, or set of configurations, which, however, may not be
Pareto-optimal.
It is no accident that
attention to the implications of incomplete knowledge for incentive structures
is the route by which economists have come to associate bounded rationality, in
the form of incomplete contracts, with organisation. But even here rational choice reappears; for
although agents are unable to write complete contracts to protect themselves
against opportunism they realise that the
consequences of opportunism, and of the actions necessary to avoid the threat
of opportunism, give rise to potential gains from trade, and are able to realise these gains either by a redistribution of property
rights which will eliminate any incentive to act opportunistically or by an
agreement to
2
establish a hierarchy in which one party will have the right to
determine, within limits which are presumably prescribed in a contract, what
the other shall do. It is naturally assumed
that in both cases the rights will be exercised according to the principles of
rational choice.
We should note that the
effect of these exercises is to isolate any explanation of organisation
from the core concerns of economists with resource allocation. As Frank Halm ([1973]
1984, p. 64) once remarked, “traditional equilibrium theory
does best when the individual has no importance - he is of measure zero”; by
extension it works best when the organisation is of
measure zero as well. Coase (1991a, p. 51) came to recognise
this pervasive concern to protect the analytic core of microeconomics, first in
Robbins’ failure to discuss his explanation of the firm, then in the
development of a theory of economic organisation
which is intended to deduce patterns of resource allocation from market
structure and which consequently “tells us nothing about the organization of
industry” (Coase [1972] 1988, p. 58), and
subsequently in the refusal to admit transaction costs into the theory of
value, which continues to discuss “consumers without humanity, firms without
organization, and even exchange without markets” (Coase
1988, p. 3). Coase
‘s own explanation of the firm, as he has made clear, does not rely on the
incentive to avoid opportunism (Coase 1991b, pp.
70-2); the incentive which matters is to reduce the costs of making appropriate
arrangements to take advantage of future opportunities that are not yet
perceived. As with Simon, the difficulty
is a combination of incomplete knowledge and the cognitive costs of dealing
with this incompleteness; the link between Coase and
Simon is both as obvious and as undeveloped as that between Coase
and Hayek. Such undeveloped links are to
be found throughout the field of heterodox economics; but to explore them is
well beyond the scope of this paper. Making connections, or failing to make
connections, however, is not.
The next step is to make
another link, to Frank Knight. Knight (1921) was the first to identify the restrictions
within which economic theory was becoming formalised,
and to place entrepreneurship and the firm outside those restrictions. He did so by distinguishing between risk,
which characterised a situation in which the chance
of every possible outcome could be established, and in which therefore the
optimal choice was no less strictly entailed by the premises than in situations
that were risk free, and uncertainty, in which there was no means of
determining these chances and therefore no entailment of choice. Whether Knight also envisaged the category of
uncertainty which has been emphasised by Shackle, in
which there is no way of definitively enumerating the set of possibilities, is
not clear; but since this category is very extensive it would be surprising if
Knight was not aware of it. This broader
category will be assumed in most of what follows, but it is not necessary in
order to demonstrate Knight’s conclusion, which was that in cases of
uncertainty decisions must always go beyond the evidence, and depend on the
individual - who is not, therefore, of measure zero. People “differ in their capacity to form
correct judgements as to the future course of events
in the environment. This
capacity, moreover, is not homogeneous, some persons excelling in one kind of
problem situations, others in other kinds, in almost endless variety” (Knight
1921, p. 241).
In his first published
article, George Richardson (1953) took up Knight’s distinction and identified
effective decision taking under uncertainty with specific performance skills,
citing Ryle’s (1949) category of ‘knowledge how’. Risky decisions, by contrast, could be taken
by following a codifiable procedure, which is
available to all (like a production function) and an example of ‘knowledge
that’. Decision theory claims to
assimilate uncertainty to risk by prescribing the use of subjective
probabilities, without paying much attention to the wide variation of
effectiveness in decision-making that is thereby associated with the concept of
rationality, and no attention at all to the implications for both industrial organisation and welfare economics. Welfare economics was Richardson’s focus in
his first paper, and he concluded that whenever there is significant
uncertainty it is likely to matter a great deal who is taking decisions, and
consequently that an important property of any economic system is its ability
to select decision makers - a property which is implicitly assumed in much
economic theory, and occasionally supported by the invocation of selection
mechanisms which have never been justified (Vromen
1995). Richardson is here a single
thought away from his later explanation of industrial organisation
in terms of capabilities, but restricts himself to the welfare implications of
diverse decision-making capabilities; when he later came to write about
productive capabilities (Richardson 1972) the specific problem of “deciding
what to do and how to do it” (Knight 1921, p. 268) received little attention,
though he subsequently returned to it (Richardson 1998b).
Knight demonstrated that
risk provides no explanation for profit, except as an alternative label for
wages, for it gives rise to no activity which cannot
be perfectly duplicated by other people. Profit requires uncertainty, which supplies
opportunities for entrepreneurship, a function which has no place in an equilibrium of rational optimisers.
Entrepreneurs, Knight tells us, specialise in decision-taking under uncertainty, each
choosing a range of activities in which they believe they have an advantage, and
in addition offering employment to those who seek some protection from
uncertainty. The firm as an organisation, therefore, is a response to uncertainty, and,
not surprisingly, has no role in a body of analysis from which uncertainty
(except as falsely-identified risk) is absent.
Though Coase
(1937) did not emulate Knight’s precision, his account of the circumstances in
which a firm is likely to be created excluded the possibility of calculating
optimal future contracts; otherwise why should either the creator of the firm
or its employees be satisfied (which, be it noted, is Simon’s criterion) with
an imperfectly specified contract? Although
at least part of the original uncertainty will be resolved in time, it is
likely to be replaced by new uncertainties which will justify the continuation,
perhaps with modification, of the imperfectly specified contract which
constitutes the firm, and experience within the organisation
may improve the decision-maker’s capabilities of dealing with particular kinds
of uncertainty. Relevant knowledge may
grow, and incentive structures may be improved. As Knight (1921, p. 259) noted, “[t]he problem
of meeting uncertainty thus passes inevitably into the general problem of
management, of economic control”. Such
improved capabilities may include procedures which seem to be effective within
the environment, internal as well as external, of the particular organisation, even though it may not be clear why these
procedures are
4
effective; indeed, as has been observed, the
difficulty of establishing why some ways of running a business seem to work may
well provide substantial protection against actual or potential rivals.
It would be a mistake to
exaggerate the tendency for organisations to converge
on rational choice in the economists’ sense; not only is optimisation
often inappropriate for local decisions, especially within an organisational sub-division (which will be considered
later) but even when optimisation would be appropriate
there may be no adequate basis from which to deduce an optimum. “Much of the error of historians, economists,
and of all of us in daily affairs arises from imputing logical reasoning to men
who could not or cannot base their actions on reason.” This was the view of Chester Barnard (1938, p.
306), whose work provided a major inspiration to Simon. By no means all reasonable behaviour
is strictly governed by the laws of logic; indeed even behaviour
which is called logical is deduced from premises which themselves cannot
ultimately be validated by logical argument. What Simon calls bounded rationality, and in
particular what he calls procedural rationality, includes a good deal more than
logical reasoning, though logical reasoning is certainly important in showing
what is entailed by particular assumptions or proposed actions. Logic is not sufficient to deal with
uncertainty - which is not to claim that it is irrelevant, and organisations are a response to uncertainty. In the broader sense of the term, bounded
rationality leads to organisations, and to many other
phenomena of economic interest. To
develop this argument, it will be necessary to consider the nature of knowledge
and the characteristics of human cognition.
Deductive logic carries
truth values from premises to conclusions; but if we are to rely on it we must
have confidence in those premises. However, the truth of any premises that we use
can never be established beyond doubt; there is no certain knowledge, except
knowledge of tautologies (which can be useful, and is often not obvious). That general empirical truths cannot be
derived by induction was demonstrated by David Hume,
and the use of supposed empirical truths as a basis for deductive reasoning
must therefore be problematic. Hume’s
own response was to abandon the attempt to prove empirical truths, either by
observation or argument, and to turn to the potentially manageable question of
how people came to accept certain empirical propositions as true.
A notable contribution to
this enquiry was made by Hume’s fiend Adam Smith in his earliest surviving
writing, which is a psychological theory of the development of science,
commonly known as the History of Astronomy. Smith ([1795] 1980) postulates three
fundamental human emotions, surprise, wonder (now better described as
perplexity) and admiration, which provide incentives to mental activity. Phenomena which do not conform to expectations
are disconcerting, and a series of such surprises leads to perplexity, and the
inability to make confident decisions. The consequential discomfort stimulates a
search for some principles which will connect these inexplicable phenomena in
the imagination; and success in creating an interpretative system which
connects many phenomena excites admiration among those who have also been
perplexed, which is typically reinforced by the aesthetic appeal of the new
pattern; this leads to widespread
adoption of this system, which is likely to survive until a
new set of surprises stimulates a new search. Smith illustrates his theory (which is itself
an example of the process which he describes) by tracing in some detail the
succession of cosmological systems up to the time of Newton, whose own
theories, Smith insists, should be regarded, not as a description of reality
but as the creation of Newton’s imagination, and thus liable to be superseded
as a consequence of future surprises.
We should note five
features of Smith’s theory. Four of
these have already been mentioned: the failure of existing interpretative
systems as a stimulus to invention, invention as a new set of connecting
principles which, in Popper’s (1963) terms, are falsifiable conjectures and not
the product of purely logical reasoning, the readiness to accept other people’s
systems as a solution to one’s own personal difficulties of understanding, and
the primary motivation in this process as the desire for psychological comfort,
including aesthetic pleasure, rather than the prospect of advantage (Smith
[1795] 1980, pp. 51, 61). The fifth
feature is Smith’s recognition that as scientific knowledge develops it becomes
more specialised, and that this specialisation
leads to the perception of detailed anomalies that would be passed over in a
broader perspective, and thus to an acceleration of the growth of knowledge. This principle of the division of labour as the means of developing knowledge was to become
the foundation of Smith’s ([1776] 1976b) theory of economic growth, set out in
the opening chapters of the Wealth of Nations.
The division of labour leads to the division of knowledge; knowledge grows
by division. Why this is necessarily so
we shall explain shortly. But first we
should note some major consequences. One
consequence that Smith was quick to point out is the dependence of every
specialist on goods and services that are provided by other specialists; in the
form of the co-ordination problem, alternatively expressed as the problem of
resource allocation, this has attracted most attention by economists, who have
nevertheless often ignored two central features of the problem: that there can
be no single pool of knowledge which is accessible to anyone, or indeed to any
group, and that the system is continually generating new knowledge and is
therefore doubtfully represented by models which assume a given set of data. Hayek is the best-known critic of theorising which omits these features; but we may also note
that most of what are perceived as deficiencies in Marshall’s analysis result
from his attempts to incorporate them.
However, for our present
purposes what matters more than the conventionally-defined problem of resource
allocation is the dependence on other people’s knowledge, in production, in
consumption, and in decision-making in general. In contrast to the assumption of new growth
theory that knowledge, once attained, is reusable without cost, it is a
necessary consequence of the means by which that knowledge is generated that
the cost to the potential user of using knowledge which is openly available is
often very high. Our education system is
based on the presumption that the acquisition of knowledge set forth in
textbooks takes several years, and requires considerable expert assistance, and
no-one nowadays is expected to be capable of acquiring knowledge at
first-degree level of half-a-dozen disciplines. There is no general purpose algorithm which
can be applied to all fields of knowledge; each has its own connecting principles
(which, in economics at least, are clustered into sets which are not entirely
mutually compatible) and the
6
principles which give coherence to one body of knowledge often
seem to impede rather than assist the comprehension of knowledge which is differently
organised.
There appears to be an
evolutionary explanation for all this. Conscious
reasoning is a relatively recent development, and the neurological apparatus
which makes it possible is necessarily an adaptation from earlier architecture,
which had hitherto proved sufficient to preserve the antecedents of our
species. Survival and reproduction
depended on skill in identifying crucial features of the environment and taking
appropriate action, and this required some means of
classifying situations and actions and of forming links between them - all
before conscious thought; and performance skills, including skills in
decision-making under uncertainty, still remain substantially within the
domain of tacit knowledge. Domain-specific
networks, developed more or less independently, provided a much likelier
evolutionary pathway than a general capability for serial processing (Cosmides and Tooby 1994);
pattern-making outperforms logic in biological evolution. It is therefore no surprise that conscious
thought should have emerged in the form of reflections on the classification
systems which appeared to be in use and, in particular, in attempts to improve
on classifications which did not seem to be working very well - in Hahn’s
([1973] 1984, p. 59) terms, to devise a better theory and a better policy. As a young Fellow of St John’s College,
Cambridge, Marshall (1994) postulated precisely such a sequence. Despite the fascination of economists with
rational economic agents, it is still obviously true that human beings are far
more skilful at recognising and imposing patterns
than they are at constructing logical arguments; and such skills have
consequences which are difficult to encompass by standard theory.
Now the architecture of the
modern human brain is capable of sustaining any of an extraordinarily large number
of alternative connections, each representing a particular structure of
connecting principles. What is
genetically programmed, apart from sensory perceptions and motor skills, is not
primarily, as with other animals, a common set of capabilities but the
capability of developing connections in response to particular experiences and
actions. This is obviously much more
effective in coping with relatively rapid change than the very slow process of
genetic mutation and selection. But only
a very small proportion of this potential can be realised
within any one brain: each person becomes adapted to a particular set of
situations and activities. Distinct human
communities may therefore acquire distinctive and locally-appropriate shared
patterns of behaviour.
However, there is another
possibility. By appropriate
differentiation among its members, a human community can develop knowledge to
an extent that is far beyond the reach of any single member of that community. The division of labour
is therefore the most important single idea in accounting for the growth of human
knowledge, and also for the problems that this growth causes,
in mutual incomprehension and the neglect of what become, because of the
particular ways in which labour is divided, relevant
interdependencies. To the effects of the division of labour
in creating something roughly analogous to distinctive species of capabilities
we must add, as Marshall did, the equivalent of Darwin’s principle of
variation: even within a single field of knowledge or activity, differences
between individuals’ environments, interacting with differences in
their responses to these environments, lead to some differences
between their knowledge and skills, providing material both for a continuing
selection process and, as Marshall emphasised, for
interpersonal learning.
Both the ability and
willingness of human beings to learn from each other deserve a smmmary explanation. The ability rests on the shared architecture
of the brain which permits differentiation, but which also makes possible what
Adam Smith ([1759] 1976a) called ‘sympathy’, the capacity of imagining oneself
in the situation of another, and thus making sense of another’s actions as a
possible preliminary to choosing one’s own actions. This capacity for understanding is enhanced
by the human need to collect phenomena and situations into categories, and to
develop regularities of behaviour - what we might
call routines - which are relatively easy for others to interpret, rather than
tailoring actions to the specifics of each situation in ways which could only
be understood through knowledge of these specifics, as would be required by the
principle of costless rationality (Heiner 1983). Willingness to learn is explained by
consciousness of the inadequacy of one’s own knowledge and skills, including
skills in decision-making. There are
even striking examples, such as the fashion and education industries, which are
based on the willingness of customers to make the adoption of other people’s
ideas the principle of action.
Ability and willingness to
learn from others often lead to the spread of what is thought to be best
practice or received wisdom, which once established may be resistant to change
in the face of anomalies experienced by any one person - or even by many
people. These are what we often call
institutions, and it is important to remember that they emerge as aids to the
solution of individual problems, which subsequently prove useful in helping to
co-ordinate human interaction (Choi 1993). To begin the study of institutions by focussing on interactions is to neglect these foundations,
which often mitigate the difficulties that are apparently revealed by
game-theoretic approaches. Whether as aids to individual decisions or to
interaction, institutions work by preventing the exploration of excluded
possibilities; many possibilities have to be excluded without examination if
decisions are to be made, but any means of exclusion caries an unknown
opportunity cost. This is true of the exclusions which define the scope of any
theoretical system, and this paper is an attempt to indicate, in the spirit of
Simon, the opportunity costs which are implicit in the exclusion of cognitive
possibilities and limitations from the study of economic systems.
There is a further
consequence which should be noted. If we
expand Barnard’s (1938, p. 163) proposition that “the decision as to whether an
order has authority or not lies with the persons to whom it is addressed, and
does not reside in ‘persons of authority’ or those who issue these orders” from
its organisational context to all kinds of
communication, we shall find that we are remarkably willing to accept the authority
of communications from many different sources on many different topics. In fact, this willingness ceases to be
remarkable if we reflect that it would be impossible to act intelligently if we
were not prepared to take for granted an enormous amount of knowledge,
including knowledge of how to decide what to do, which we cannot possibly check
for ourselves. Of course we can, and do,
check particular items and particular
8
sources, and we certainly do not accept everything that we
are told; but at every point in time we remain heavily dependent on others for
the premises on which we act. The
quality of these premises is therefore a prime determinant of our performance,
and of the performance of economies and societies. That quality depends on the organisation of the growth of knowledge. With the important exception of logical
implications, knowledge can never be known to be true; but Ziman’s
(1978) principle that the reliability of scientific knowledge rests on the
process of generating, criticising and testing within
the relevant scientific community can be extended to all kinds of knowledge. If rationality is indeed to be associated with
purposeful and intelligent behaviour, it must be a
procedural rationality, which is necessarily fallible even in the hard
sciences, but is capable of being analysed and
appraised.
We have thus arrived at two
fundamental principles. First, knowledge
itself is created by organisation, both within each
individual, through the invention and amendment of connecting principles as
explained by Smith, and by the ways in which the field of potential knowledge
is divided up between individuals, through the application of Smith’s principle
of the division of labour, augmented by Darwin’s
principle of variation. This is the
cognitive basis on which we all depend; and it must be respected by any system
for the generation of knowledge, formal or informal, if that system is actually
to improve our understanding and our capabilities. The second principle is that for many purposes
this dispersed knowledge must be reassembled, not only in the form of artefacts (which is an extremely important means of
assembling and transferring knowledge) but also in the form of organised knowledge communities; and the ways in which it
is reassembled constrain what can be done with it. Neither the creation nor the assembly of
knowledge can be adequately represented by models that rely on the economic
concept of rational choice; but that does not imply that either process is
irrational. Our primary focus in this
paper is on the latter principle, though without losing sight of the former;
and so it is to these knowledge communities that we now turn.
A firm is a response to human
cognitive limitations. As Marshall
(1920, p. 138) observed, it is one of the forms of organisation
that aid the growth and use of knowledge, two processes which are “hard to
separate, both in practice and conceptually” (Foss 1999, p. 95). All knowledge depends on organisation,
the imposition of simplifying patterns on complexity, and the firm is a focussing device for the organisation
and structured development of knowledge and skills within a cognitive framework
which is reinforced by the emergence of locally relevant institutions. It is an interpretative system. However, because of the essential
incompleteness of our knowledge, the choice of interpretative system for any
firm, as for any field of knowledge, is problematic. From Knight’s analysis we can recall that the
establishment of an appropriate interpretative system requires the particular
skills that Knight identified with entrepreneurship; and Witt (1998) has re-emphasised the importance of this co-ordinating
role in both the creation and management of firms, in opposition to the kind of
co-ordination which is modelled in so much economic
theory.
As in Austrian capital
theory, the scope and applicability of knowledge depends on structure and
orientation; there is a multitude of possibilities, and consequently room for
many opinions. This is not to be
regretted; as Richardson (1975, p. 359) observed, “it is of the essence of
competition that the participants hold uncertain and divergent beliefs about
their chances of success”, and each of these apparent profit opportunities
rests on a differential valuation resulting from an idiosyncratic and at least
partly tacit way of assembling and interpreting information, as Casson (1982, 1997) has emphasised.
The “tendency to variation” (Marshall
1920, p. 355) between interpretative systems, which, as we have seen, is a
natural consequence of the combined power and limitations of human cognition,
is necessary for continued progress. But
within each firm, complementarity and consistency of
cognitive frameworks are necessary - though certainly not sufficient - conditions
of effective performance and of effective learning. The content of learning is shaped by the
framework within which events are interpreted, as well as by the events
themselves; and these events are most unlikely to be a random sample from the
environment, not least because the firm’s decisions will generate highly
selective interactions with that environment. Therefore firms in the same industry will differ
in their apparent knowledge and in their capabilities, as Marshall pointed out.
These differences will be
consolidated in the process, emphasised by Penrose
(1959), through which many aspects of performance, including decision-making,
become substantially matters of routine, thus releasing time and mental energy
for investigations of novelty. But
although the internal managerial limit recedes as expertise in the management
of current operations improves, the absorption of newcomers takes longer as the
distinctiveness and detail of the organisation’s
procedures increases, and so expansion always requires internal resources. There may also be an increasing problem of
absorbing skills and ideas which rest on other cognitive structures, though it
is also possible that particular kinds of absorptive capacity are among the
skills that are developed - a possibility to which we will return.
The interpretative system
does not only guide the development of each firm’s knowledge and skills, both
productive and managerial. In relation
to the conventional economic theory of the firm, Penrose’s (1959) most
significant analytical innovation was her distinction between resources and
inputs into production, which she called ‘productive services’. In contrast to the firm of price theory,
therefore, a change in resources has no necessary direct implications for a
firm’s choice either of products or of productive techniques. These choices are conjectures, and require a
context, which is provided by the interpretative framework that guides the
perception of opportunities. Resources
have an option value, and may be consciously developed for this reason, as
Penrose (1959, p. 77) emphasises; but the options, or
in Penrose’s phrase ‘productive opportunities’, have to be perceived or created
within the firm. We are still in
Knight’s world of uncertainty, in which presumed knowledge and skills may be
applied in new combinations to conjectured business opportunities, where these
opportunities are, in Shackle’s (1979, p. 26) phrase, “the imagined, deemed
possible”; and both what is imagined and which of these imagined prospects are
subsequently deemed possible is conditioned by the enacted environment,
internal and external, of the particular business. An integrated set of actions for realising credible prospects must then be devised by an
appropriate managerial
10
process; it cannot be deduced. As has been argued above, if there were known
and guaranteed procedures for doing all this, there would be no firms. Of course, any firm may fail in any or all of
these respects, and all firms experience failure.
There is an entrepreneurial
element in all interpretation, and the chief executive
or the board are not the only people who determine the cognitive framework of
the enterprise. Penrose, like Schumpeter,
distinguished between managerial and entrepreneurial services, and assigned the
discovery of new opportunities to the latter; but she explicitly differed from
him in arguing that entrepreneurial services were often associated with managerial
expertise, in an unconscious (but later acknowledged) echo of Marshall’s
recognition that experimentation was both stimulated and guided by
differentiated interpretations of differentiated experience. Marshall (1919, p. 270) even declared that “[c]onstructive speculation is inherent in nearly every
business decision”. This does not mean that entrepreneurship is irrational, for
there is plenty of room for care in working out the logical implications of the
perceptions or assumptions on which a strategy is to be built, or in examining
the compatability between this strategy and what
appears to be reliable knowledge; but it does mean that no entrepreneurial
insight can be arrived at by deduction from premises that are known to be true,
just as no novel scientific hypothesis can be deduced from experimental data.
Because knowledge, whether
true or false, is achieved by imposing patterns, organisational
coherence depends on the use of compatible patterns of interpretation. We should not, however, assume that to be
compatible these patterns must necessarily, or even desirably, be very similar;
as we have seen, distinctive skills within an integrated set of activities
result from different ways of organising knowledge. Therefore an effective firm must constitute
not just an interpretative system, but (especially if it is a firm of any size
and diversity, in skills or markets) a system of interpretative systems. However, what does
need to be similar is the orientation of the business, and the perception of
the environment to which that orientation is meant to correspond. This may be what Simon (1982, 2, p. 329) had
in mind when he argued that it is “more important, in some circumstances, to
have agreement on the facts than to be certain that what is agreed upon is really
fact”; since he has also declared that reality is very different from what is
perceived (Simon 1982, 2, 306) it is apparent that he does not expect economic
agents to converge on the correct model. Competing visions between firms are necessary
features of an evolutionary or experimental economy. But competing visions
within firms, unless very carefully managed, and limited in scope, cause
trouble.
Therefore decision premises
matter, and the major premises have to be supplied by
someone who is necessarily acting entrepreneurially. The ambiguity generated by uncertainty has to
be resolved by the construction of beliefs, and by persuading the members of
the organisation that these beliefs are credible
within the context of the business. We
might suspect that in the absence of any definitively correct model there would
normally be much conflict of interpretation, and although differences of
interpretation between firms contribute to the growth of knowledge, we might
also expect that such differences would provide even greater scope for
opportunism - within as well as between firms - than is envisaged in
transaction cost and property-right models.
However, we must remember
the cognitive limitations of every individual, and the consequent willingness
to accept help and guidance from others in developing procedures for deciding
what to do. Simon has duly noted the
readiness of some people to join organisations is in
order to benefit from the procedures and decision premises that they provide,
and Witt (1998) has argued that entrepreneurial visions may provide sufficient
cognitive stimulus to preempt thoughts of opportunism. There is more to the control of opportunism
than is to be found in the analysis of incomplete contracts, and more to the
analysis of organisation than the control of
opportunism.
Within a firm as within a
single brain, cognitive processes require structure; and the choice of structure
matters. Penrose (1959, p. 149) recognises this with an appropriate definition: “a firm is
essentially a pool of resources the utilisation of
which is organised in an administrative framework”. The creation of an organisational
structure allows the costs of decision-making to be spread over a range of simultaneous
activities or a sequence of activities; it allows, as Coase
(1937) observed, some decisions to be postponed to a later time, when both
knowledge and skills would be improved; and it allows cognitive repertoires,
including knowledge both of how to do things and of how to get things done by
other people, to be developed within what is believed to be a
locally-appropriate framework for each. In
specifying the division of both productive and managerial labour,
the administrative framework not only influences the ways in which resources
are directed to the provision of productive and managerial services, and
consequently the possibilities of modifying and enhancing those resources
through non-random exposure to events, but also helps to shape the perception
(which is necessarily fallible) of new productive opportunities, the
exploitation of which in turn helps to shape the future possibilities of
learning.
Organisational design is an option of difficulties, because it
entails a necessary but fallible abstraction from an integral system, a way of
framing problems which preempts attention and suppresses complexity. This practice is made necessary by our
cognitive limitations, and made fruitful by our ability to develop new maps of
knowledge; but it is also potentially dangerous, because the designed organisation, like all cognitive models, exists in the
space of representations rather than in the space of real phenomena. It not only prescribes where the business will
work on its problems, but even what will be defined as a problem and what will
be acceptable as a solution. (For an explontion of the constraints
imposed by acceptability see Loasby 1995). Complexity is suppressed by the dispersion of
decision premises among sub-units in order to restrict agendas by excluding
consideration of possible interdependencies - which makes optimisation
at these levels inappropriate, as was noted earlier; and in those areas of
managerial responsibility where interdependencies are explicitly targeted
complexity is suppressed by excluding possibly crucial detail. Information routines and management control
and incentive systems preempt attention; as Simon long ago observed, programmed
activity tends to drive out non-programmed activity, and information systems
tend to suppress and distort information - a tendency which is regularly
exploited by management consultants.
12
Barnard (1938) emphasised the need for any formal organisation
to be supported by an informal organisation if it is
to work effectively; and the formal organisation
provides the setting within which the informal organisation,
or local institutional arrangements, develop. The pattern of specialisation
and the relationships within and between specialised
groups generates evidence on which each member of the firm may decide who may
reasonably be regarded as an authority on what topics, and whose intentions - and
competence (Casson 1997, p. 94) - may be trusted. Ménard (1994) has
pointed out that the co-ordination of activities within an organisation
cannot be achieved by hierarchical authority alone, but requires a complex flow
of communications, based on other people’s interpretations, that their
recipients accept as authoritative. These evolving relationships may allow for the
codification of some tacit knowledge, which is necessary for the design of
appropriate technology and information flows, but, as is less often remarked,
it also permits codified knowledge to be expanded into highly-specific tacit
knowledge, or heuristics. It is a matter
of common experience that the informal organisation
of a firm does not always support the formal structure; however, when it does,
the tacit knowledge that it embodies, if appropriately oriented, may provide a
basis for competitive advantage that cannot be quickly or easily imitated
because, unlike the non-specific routines to which Heiner
(1983) drew attention, the connections between situation and action cannot be
identified, and also because of the interdependence between shared norms and
shared cognitive perceptions which is a feature of Smith’s ([1759] 1976a) Theory of Moral Sentiments.
Because the quality of any
interpretative system can be judged only in relation to what it is intended to
interpret, it is not surprising that changes in the activities of a business,
or in the environment in which it operates, are often accompanied by organisational change. New patterns of organisation
are likely to be needed either to develop or respond to new patterns of
knowledge; that is why Schumpeter (1934) was justified in including organisational innovation among his examples of major ‘new
combinations’. The movement from
functional to product based organisation is the most
famous example; the distinction between mechanistic and organic systems,
introduced by Burns and Stalker (1961) is also familiar to specialists in organisational studies. Indeed, since knowledge is itself a matter of organisation, neurologically and cognitively, all
innovation may be interpreted as some kind of organisational
change.
Successful change may not
be easy. There are always costs of
switching to a new cognitive system, especially when the switch entails the
creation of new linkages with other people’s cognitive systems which are simultaneously
being restructured; every well-established organisation
has its own familiar institutions, which may have become almost part of its
identity. Unlearning can be both
cognitively and emotionally difficult. In addition, the shared desire to preserve the
organisational coalition, or truce (Nelson and Winter
1982), may reinforce the tendency for organisational
members to preserve a degree of managerial independence by respecting the
independence of other managers, and to resist any attempt to redefine the
boundaries of that independence. The
capability, as well as the willingness, to develop new interpretative schemes
and new skills may be inadequate, and even the acquisition of ready-codified
knowledge requires an understanding of the appropriate codes, which embody, but
rarely display, the premises
of other interpretative systems. Companies that have been highly successful may
have especial difficulty in introducing innovations which disrupt their
existing business. Either managers are
distracted from what they have learnt to do well, and the existing business
suffers, or the unfamiliar and initially unprofitable requirements of the new
business are slighted. A major source of
error is neglect of the importance of absorptive capacity, or an overestimate
of the absorptive capacity available, because of a failure to appreciate the
differences between interpretative systems. The division of labour
leads to greater knowledge in total precisely because every person and every organisation does not try to learn or do everything.
An Economy of Interpretative Systems
Knowledge is organisation imposed on phenomena. Each business is a self-organising
system, both formal and informal, for the creation of knowledge through the
generation and selection of skills, processes and products; and though it is
natural to think of markets as the arena for economic selection we should not
forget that there is a great deal of internal selection, not all of which
reflects external factors. In businesses
which are consciously striving to innovate, this internal selection may be organised by a division of labour
between roles which are intended to represent alternative plausible perceptions
or what are believed to be major complementary criteria for success, with the
intention of using internal selection not only to reject unsatisfactory
proposals but also to generate more promising alternatives (Van de Ven and Grazman 1997). However, there can be no assurance that any
interpretative system is appropriate, and even less assurance that it will
remain appropriate or evolve in an appropriate way; it would therefore be a
mistake to commit any industry, or any field of study, to one such system. Because every organisation
requires coherence - and perhaps fundamentally because any individual
attempting to control an organisation requires
coherence within his or her own thinking - no single
business is likely to encompass the variety that is appropriate; rivals, and
even new entrants, are essential. That
is the basic case for competition, in all fields of human activity; it will not
be developed here.
Every business can
encompass only part of the total configuration of knowledge and skills that is
required for its success. It is itself a
more-or-less coherent system of interpretative systems, but is also an element
in a much wider network of such systems, which includes both alternative and
complementary assemblages of skills, orientations and activities; and it must
draw appropriately on this network to succeed. The most readily understandable manifestations
of such networks are industrial districts (Loasby
1999), but the equivalents of such districts are common in economic systems. Similar businesses generate variety within a
shared interpretative framework; complementary activities which rest on
substantially different ways of organising knowledge
are better assigned to firms which embody correspondingly distinct
interpretative systems (Richardson 1972).
Not only may the attempt to
incorporate dissimilar though complementary activities within a single organisation tend to suppress the distinctive
interpretative systems that are necessary for the continued growth of
knowledge, but it may also suppress external contacts which are necessary for
such growth. However, Richardson also
argued that
14
arm’s-length market transactions are unlikely to be
sufficient to manage such complementarities; and they are likely to be
especially inadequate for the transfer and absorption of knowledge which is
relevant to product or process improvement. In practice, not many market transactions
between firms are at arm’s length; and all markets rely on a set of
institutions which simplify transactions and provide a foundation for the
growth of understanding between buyers and sellers which provides each party
with what Marshall called its “external organization”. How such understanding may lead to
technological innovation which cannot be achieved through membership of a group
with its own substantial research facilities has been demonstrated by Andersen
(1999).
The present interest in
alliances perhaps leads to an exaggeration of the novelty of these
arrangements; they are certainly much more obvious when they involve large
firms. Neil Kay (1997) has argued that,
although costly to manage, because of the disparities in interest and
incentives between the parties, they are much less costly than full scale
mergers, which would tend, not to resolve these disparities but to multiply
disparities across many more quite distinct activities; in drawing justified
attention to the problems posed by differentiated corporate identities he has
perhaps underrated the advantages of preserving these identities, and their
interpretative systems, in furthering the growth of knowledge within and
between the allied businesses. The
division of labour, supplemented by the variation
within specialisms, which together allow human
communities to make effective use of their cognitive abilities, still offers
the most effective means of increasing human knowledge.
Despite the claims of
management consultants, there are no guaranteed procedures for producing an
optimal design for any organisation. What is being designed is an interpretative
system, and the process of design relies on the interpretative system of its
designer; by Knight’s definition, it is an entrepreneurial activity, and for
entrepreneurial activities optima cannot be defined. We may appropriately conclude with an
assessment by Schumpeter (1943, p. 83), which is quite correctly not restricted
to economic systems.
A system - any system, economic or other - that at
every given point of time fully utilizes its possibilities to the best
advantage may yet in the long run be inferior to a system that does so at no
given point of time, because the latter’s failure to do so may be a condition
for the level or speed of long-rum performance.
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