Incentive to Self-Organize and Scale

To avoid the complexity of a socio-technical transformation in a mature publicly traded corporation, we may build by analogy in simpler terms. Suppose two lumberjacks have the property rights for adjacent properties. They have the option of working together of separately. Even if they are identical in strength, skill, resources, and tools, the processes available grow exponentially if they cooperate. The process option of each individual worker may continue, but entire sets of new options that only cooperation may accomplish become available. If we add two more lumberjacks, there is four times the land, four times the potential output of four individuals, plus the additional options that only groups of two, three, or all four may pursue cooperatively.

It is easy to assume, up to our rough limit of 10 members, that the lumberjacks gain from cooperation additional options as a decision-making unit, using each of their property and abilities in ways that acting individually would lack. However, the larger that group becomes, the more effort they require when attaining consensus on which of the processes to pursue. The group of 10 may elect a leader or vote democratically, but two primary feedback mechanisms will arise. Productivity when the workers act out of sight of the others will become judged on output. Productivity when all work as a group will become judged on direct observation. Once this company of lumberjacks grows beyond 10, there are obvious diminishing returns for direct observation, even an impossibility of observation. Once we collect a group of 40, 70, or 200 lumberjacks, managers who coordinate decisions, observe their team for performance, judged exclusively on productivity become an inevitable recourse. 200 lumberjacks simply cannot cooperate effectively in a single forest through reliance on direct informal interaction.

Likewise, even without introducing the complexity of a legal, accounting, tax, or government system, and even before we consider actual market demand or the possibility of competitors, divisions in the organization emerge to benefit every worker. Specialized knowledge on planting new trees, care for trees over multiple years, coordinating which areas to work, care for the tools, and the preparation and shipping of the logs are not only distinct processes from the original effort of the individual lumberjack, but are also increasingly important to the optimization of long-run residual claims. Therefore, even if we assume it possible for all workers to equally “own” the organization, meaning that all have an equivalent residual claim, knowledge and specialization will still drive the introduction of management and coordination based on the output performance of distributed decision-making units.

If we now add a single competitor to this logging industry, a very simple “game” becomes available. Suppose one the residual claimants of one organization decides to hire workers based on wages and the other remains an equal partnership with no wage employees. The incentive structure of the residual claimants and the wage employees are different, creating fractal changes at scale. While wage employees gain remuneration as they work, they do not bear the risk that that the residual claim is zero. While wage employees may need to know some skills for the job, they will not need to know all the processes of the organization. Also, while the residual claimants may only exit the partnership with some difficulty, the wage employee could exit any time to pursue a better opportunity. Therefore, while residual claimants have incentive to ensure the long-run sustainability of the processes, the wage employees have incentive to maximize the short-run behaviors prescribed by the wages.

Comparing these two competitors, we begin to see advantages to the use of wage workers who do not possess a residual claim. First, because they do not possess a long-run interest in the organization, wage employees may carry out the calculated risks of the managers without fear and hesitation that the collectively-owned organization would. If one of these risks produces a windfall gain, the organization gains competitive advantage. Second, because their focus is on short-run optimization of the behavior pattern demanded by the incentive structure, wage employees can perform tactical activities that require less knowledge of the organization as a long-run system. Wage workers make the workforce more malleable and responsive to incentive structures in aggregate. Third, because the optimal number of workers for any one specialty may change over time, the competitor with a variable pool of wage employees can respond more quickly and with less risk than an organization that is taking on a partner with an equal residual claim to assets they did not originally participate in earning. Fourth, the ability to grow the workforce with wage employees in a boom cycle without increasing the total residual claimants allows the organization to respond to the incentives of fleeting opportunities with a limited subset of the long-run disincentives.

Our first conclusion should be that some introduction of wage employees in each organization is inevitable. If we compare an organization with 10 residual claimants and a variable wage workforce of 5 employees, compared to an organization with any number of residual claimants fixed at a number between 10 and 15, the use of wage employees creates more options and some potential for competitive advantage. However, if we add more organizations, we can also see that the effectiveness in optimizing decision-making becomes as much based on knowledge of coordination and incentive structure as it is of the given hierarchy or individual value production. Where a production process was highly stable, predictable, and productivity easily measured on output, a larger number of residual claimants could cooperate as partners. Where the process is highly variable, requiring little knowledge, and productivity is the result of effect management rather than worker virtuosity, minimizing residual claimants while relying on wage earners will be more effective.

There is significant incentive to assure that an organization builds itself not through the exclusive dichotomy of long-run residual claimants that bear all the risk and short-run wage workers without systemic constraints or incentives. The pressure for stability from wage employees and the necessity of management incentives that more closely align to the optimization of long-run residual claims combine to create a gradation of fixed-claim wage earners with specific performance constraints. The salaried employee and the manager compensated partly in company stock can optimize the preservation of an externally directed mid-run. Neither feel the freedom to leave the company due risk and sunk cost. Neither feel the full freedom to exploit new opportunities held by a partner with equal residual claims.

The clear trade-off in a corporation, reliant on salaried employees with slow aggregation of a small percentage of residual claims, is the increasing and widespread hesitation to act, combined with diffusion of responsibility for emergent decisions. When growth remains strong and fitness of solution to market context remains stable, bureaucratic rationalization continues to preserve the organization rather than the optimization of the residual claim. Once growth stagnates, it becomes clear the organization became fine-tuned to internal signals of political disputes while placing layers of noise between decision-making units and the external signals of the market. Transformation is a paradigmatic shift from a structure no longer adapting its knowledge production to its changing market context, to a new paradigm in its place. The challenge of transformation, primarily, is the development of new knowledge networks that can create sufficient benefit to entice the bureaucrat to make the shift to the new paradigm of systemic incentives and constraints

The nature of the production process and the structure of the industry shape the way market forces reward variations in what is otherwise an identical number of inputs. A tax accounting firm or a law firm may rely primarily on equal partnership or tiered partnership with few wage employees relative to the residual claimants. In an oil or mining endeavor with major risk that only requires capital to pull wage employees and the tools of production from other opportunities, such as applying recent technology to previously unexplored mineral rights, the fewest number of residual claimants necessary to raise the necessary capital optimizes the use of a much larger organization of wage employees, vendors, and contractor firms. Many publicly traded corporations are some mix of options, allowing different residual claims in the form of preferred stock, common stock, bonds, pensions, etc. The selection of incentive structures and systemic constraints provide the administrative context for an organization. Decisions regarding the internal context and the selection of an external context with which it must integrate is the realm of competitive strategy.

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