Economic Knowledge Organization

Transformation is the systemic restructuring of the knowledge production processes and decision-making networks within an organization. While a precise history and understanding of the organization status quo is impossible, it is also foolhardy to begin a transformation without any respect for the system as we find it. Mature organizations adapt over extended periods of time to a unique pattern of decision-making. The individual workers change continuously, so the organization replicates knowledge of the decision-making processes as patterns of behavior increasingly distant from original context. The systemic understanding of the original context for the behaviors becomes separate from the decision-making units performing the behavior. The origin of organizational knowledge becomes increasingly distant from the processes using outdated knowledge.

Maturity produces stability at the expense of adaptability, just as the bones of an adult gain load-bearing capacity at the expense of the trauma-bearing malleability of the bones in a child. Children rarely need to lift heavy objects but frequently fall, while a young father may frequently lift and move heavy objects but falls that might break his adult bones are very rare. The goal here is not to contend that transformation is impossible or that maturity is superior to malleability. Instead, we should recognize from the outset that each have costs and benefits. The first consideration of any disruptive influence must be what purpose current adaptations serve.

We should “start at the beginning” then, and define what an organization is, why it survives, and what it means that it matures. Every organization is a combination of decision-making units that cooperate collectively in the expectation of individual benefit. However, the decision-making unit is neither the collective nor the individual. The totality does not make decisions independent of the individuals comprising it. The individual, though self-interested, never makes decisions in a vacuum. Therefore, the decision-making units within the organization could be pairs of individuals, formally identified groups, or informal teams who act together. Likewise, these individuals are not exclusively participating in the decision-making unit that performs within the boundary of the organization. The knowledge worker might make decisions within the organization as part of a jobsite decision-making unit, as a family-system provider, as an alumnus of a university, or as a thought-leader in a professional community. If we lose ourselves in consideration of the individuals, we may become convinced of chaos and uncertainty, never knowing if cooperative self-interest will optimize the family, fraternity, or career prospects at the organization’s expense. However, as we scale to include larger groups we find that emergent consistencies hold despite these individual differences. The operational “team” follows patterns of behavior even as individuals join or exit. We should thereby place our consideration of the decision-making unit at this “team” level.

The decision-making unit is not the individual, while each of these individuals participate in a multitude of decision-making units. We need not apply a hard constraint to the number of individuals a decision-making unit may contain in practice, though we may say with confidence that one of two constraints limit this size. First, beyond 10 individuals it will become evident that a subset of members is the informal decision-making unit within the formal collective. These leaders must agree or a decision fails, while the remainder provide knowledge but will defer to group decisions. The ability to remain silent altogether increases as the diffusion of responsibility, whether economic, social, or psychological, spreads across a larger collection. Second, beyond 10 individuals, diminishing marginal returns make it increasingly difficult to ensure that each member is producing the maximum effort on behalf of the group. A large formal group then creates informal smaller groups that ensure their own expectations of cooperative effort and protect their own group from outsiders. In the mature enterprise, there typically exists a mixture of formal hierarchy and informal group dynamics. The formal hierarchy develops each time a costly situation makes the benefit of observers that ensure the productivity of subordinates outweigh the cost of trusting individuals to optimize their own productivity. The informal groups that form as decision-making units distinct from the formal hierarchy do so to participate in the spread of beneficial knowledge that the formal hierarchy cannot provide alone.

To answer the question, “Why do organizations form?” we should rely on an economic definition of value creation as the combination of inputs with knowledge. Value increases through many mechanisms, but knowledge is what makes value increase exponentially for a linear increase of inputs. Moreover, this value is subjective but aggregate. The “owners” of an organization do not own much at all, if ownership is the freedom to dispose of inputs according to any desire. For instance, the owner of an airplane is not free to land on an interstate highway, and the owner of a lake is not free to restrict air traffic or the orbit of satellites overhead. Property is not only material, but also intangible. Property ownership is not freedom of disposal, it is the legal privilege to constrain the use of a mutually identifiable resource. Those who form an economic organization do not create property that they may own it and dispose of freely. Instead, they cooperate to constrain and guide the use of resources to maximize value through the addition of knowledge. All value creation is part of a knowledge process. The “owners” of an organization, whether a sole proprietor, partnership, or the shareholders of a publicly-traded corporation, are the residual claimants to any value leftover.

We will adopt the terminology of the “residual claimant” to maintain strict honesty that the organization is not profit seeking nor the owner of property. Each socioeconomic organization is collection of individuals with knowledge, engaging in cooperative self-interest, making decisions that maximize the incremental subjective value of outputs. The residual claimants receive both the profit and the loss of such value-add activities. The residual claimants invest in a production process, but their residual claim at any time boundary exists as a positive or negative return.

Transformation has a clear economic definition with these concepts as a foundation. Transformation is a paradigmatic shift in decision-making processes needed once an organization can no longer attain the knowledge required to maximize value creation. The resistance to such transformation comes from many sources. The benefits of the new paradigm are often unknown while the cost to the individuals that comprise the organization are often high. The changes necessary for one set of decision-making units may undermine the performance of other decision-making units. The benefits of the new paradigm may benefit newcomers, while incumbents rely on the formal and informal networks to resist this challenge to the processes that benefit them.

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