The aim of Chapters 3 to 6 has been to develop a guiding methodology for analysis when measurement of at least one of the factors under investigation is not now and may never be possible. Variables and relations between them were defined and tools for manipulation were proposed. This led to the emergence of model-building techniques that are analogous to those often employed in the examination of scalable phenomena. A logical basis for the conduct of analysis without measurement has thereby been established.

Loose ends, nevertheless, remain. The translation of nonquantifiable concepts into nonquantifiable variables; the meaning of infinity in the absence of numerical calibration; and the representation of time, change, and evolution in such a context all require further explanation. In particular, it is necessary to explore the role these elements play in the conduct of inquiry and the resulting contribution to the understanding of reality that emerges from them. Attention is now turned to these kinds of issues.

The intent of the following discussion is clearly different from that of Section 1.3. The purpose of the latter was to illustrate the notion that what is most often referred to as “scientific analysis” does not – insofar as its philosophical underpinnings are concerned – depend on measurement. Thus organizational constructs (e.g., assumptions, laws, theories), guidelines for argument, and methods of definition, to name a few, retain their meaning and force in nonquantifiable circumstances. But the way in which various facets of reality are represented in analytical constructs, and the implications for the knowledge so obtained, have until now been ignored.

Modernization is a process of change. Economic development is only one of many interdependent aspects of the modernizing process. This is hard to dispute and yet there are practically no current theories of economic development that include sociological, cultural, and political change as a part of their dynamic fabric. Nor, for that matter, are there noneconomic theories that explicitly account for impact on and feedback from economic variables. Either, it would seem, one believes that economic development causes sociological, cultural, and political modulation, and hence is only concerned with economics, or one feels that sociological, cultural, and political modifications are preconditions for economic change, and therefore only the noneconomic factors are important. The obvious truth of the matter is that economic, sociological, cultural, and political transformations are all occurring simultaneously and any theory that does not explicitly allow for this is subject to rather severe limitations.

The purpose of this chapter is to illustrate a way of constructing models in which both economic and noneconomic change may be analyzed simultaneously. The examples presented are syntheses of the efforts of several authors, each writing from the point of view of his own discipline. No claims of comprehensiveness or correctness are made for the results. Because each author has his own concept of what is important, and because he may leave out elements that others regard as essential, the works upon which the following is based cannot be regarded as representative of the thinking within their respective disciplines. Furthermore, any synthesis necessarily retains much of the restrictiveness and many of the failures of the sources from which it is drawn.

So far attention has been directed primarily toward the achievement of two major goals. First, a general methodology was developed to handle variables that seem incapable of measurement. Rules and guidelines enabling construction and manipulation of relations among such variables are thus available. These relations are basic components of the modern systems approach to analysis in social and behavioral science. Simultaneous equations systems, systems of periodic equations, and models of choice have received particular emphasis. The inescapable conclusion is that, except for measurement, nonquantifiable experience may be approached and understood in much the same way as is traditionally realized when the standard quantitative yardsticks are available.

The second goal was to demonstrate, at least at theoretical levels, how this methodology could be applied. Four examples were given: Political structure was defined as a system of simultaneous equations that may determine political systems or cycles. A dynamic model for planning purposes was presented along with a more complex account of society's process of social, political, cultural, economic, and psychological evolution. Lastly, the firm was modeled and analyzed in terms of the social interactions of the individuals it employs. In all instances, knowledge of structural relations and parameter values would, as in the quantifiable case, permit prediction.

Scientific inquiry, however, involves not only the creation of structure, theoretical propositions, predictions and the like, but also the determination of whether the structure, propositions, and predictions manifest themselves empirically. Accordingly, here in Part III, focus shifts to ways of obtaining specific knowledge of parameters and relations for the purpose of prediction or “empirical verification.”

The origins of this volume emerged from an interdisciplinary course in which I participated while at the University of Pennsylvania during the 1969–70 academic year. Four instructors representing their different fields of study were present: an anthropologist, a political scientist, a sociologist, and myself, from economics. Our forty students were among the brightest freshmen and sophomores the university had to offer. The first term we split the class into four sections, and each instructor exposed ten students to a quick but sophisticated introductory survey of his area. For the second term the class was reunited and a single problem was chosen to be considered by the group as a whole. It was hoped the students would develop an appreciation for social science in general rather than the feeling that our four subjects were distinct and unrelated spheres of knowledge.

The problem selected for the second term was to gain some insight into what it means for a society to modernize. Our attention focused on four books, one from each field: W. H. Goodenough, Cooperation in Change (anthropology), D. E. Apter, The Politics of Modernization (political science), E. E. Hagen, On the Theory of Social Change (sociology), and A. O. Hirschman, The Strategy of Economic Development (economics). Frequently we met with our first-term sections to discuss these books from the point of view of our own disciplines; at other times we met as a single group to educate each other and to obtain an overall perspective. Each student summarized his thoughts in a term paper at the end.

This book is an attempt to extend economic theory to the resource allocation choices that are made within a firm or other organization. A number of criteria guided my work. One was that an economic theory of organizations should not depend on restrictive assumptions that employees desire to maximize particular variables such as sales or budgets. Another criterion was that an organization's supplies of its outputs should be derivable from the supply behavior of its individual employees. I also wanted the theory to take account of the investments that employees make in their jobs and to yield implications from this behavior for the organization's internal structure and growth.

My main purpose, however, was to see whether economic theory could provide a wide-ranging set of hypotheses about issues of interest to economists and organization theorists. For example, could economic theory provide hypotheses about the implicit prices that employees attach to resources, employees' supplies of their contributions to outputs, and their demands for information about production possibilities? Could it provide hypotheses about the formal and informal mechanisms by which employees coordinate their activities? Although this book's analysis is only a beginning, I am convinced that economics is a useful tool for analyzing both types of issues. I have also concluded that when economic analysis and organization theory deal with the same issues, their results do not generally conflict. Although economic analysis has a different role in focusing on employees' choices in allocating resources, it does not emerge as a competing approach to organizations, and the many quotations in this book from the literature on organizations suggest that it is often complementary.

This chapter analyzes employees' investment behavior. Investments, such as additions to plant and equipment, improvements in employees' skills, reorganization affecting production domains, and changes in responsibility on an organization's employees are typically believed to reflect the interests of the funding authority. However, an employee often can use resource diversions to make investments that increase his future welfare. Thus, the long-run analysis of economic behavior within organizations should take into account employees' investment behavior as well as the funding authority's.

Employees' investment behavior is determined by: individual employees' time preferences and utilities derived from particular resources; the nature of investment opportunities and their returns; and constraints on the resource diversions available for investment. The constraints on resource diversions of course include responsibility, which also can restrict the particular investments that employees may make. Another constraint is the funding limit on the total resource diversions of an organization's employees in any time period, to be analyzed in Chapter 8. Employees' investments are often directed to increasing the future resource diversions allowed by responsibility. Here, it is assumed either that the resource diversions presently allowed by responsibility sum to less than the funding limit or that employees seek alternative benefits from diversions within this limit that yield them more utility.

This chapter focuses on the nature of employees' investment opportunities, particularly those that influence suborganization and the coordination of employees' activities. The discussion first illustrates how investments can provide returns both to employees and to employers.

We have seen why the employer finds it in his interest to delegate to an employee discretion over a subset of the organization's productive activity. This chapter explores the ways the employee can use this discretion to increase his own welfare at the employer's expense and how the employer imposes constraints that limit his costs of this behavior. By connecting an employee's actions or results of his actions with the rent he derives from his employment, these constraints establish the incentives on the employee that the employer controls. Given the employee's discretion over resource allocation and these constraints, the employee's equilibrium resource allocation behavior can be analyzed in the short and long run.

Employees' resource diversions are introduced and the information required for an employer to make inferences about diversions is described. The alternative types of resource responsibility available to employers to limit resource diversions are then considered. After discussing the possible influence of employees' benefits from their resource diversions on the organization's labor supply, we consider how employees' cash salaries are established. Finally, the employer's selection of a type of responsibility to impose on an employee is analyzed.

Employees' resource diversions

This section defines employees' resource diversions and considers the costs and productivity of information that an employer can use to make inferences about diversions.

When an employee's utility function does not contain a variable for his employer's welfare, the employee has the motivation to use his discretion over resources delegated to him to increase his utility at the employer's expense.

This chapter separately analyzes the short-run resource allocation in response to demand of an employee, a private corporation, and a private nonprofit organization. The external demands for private organizations' outputs are taken as given and a managing employee's demand for his employee's output is derived. Based on the analysis of Chapter 4, Section A derives the employer's and the employee's costs of each rate of the employee's delivered output. Section B analyzes an employee's supply behavior in response to a managing employee's demand. Sections C and D respectively analyze the supplies of private corporations and private nonprofit organizations in response to their external demands.

Costs to the employer and to the employee of the employee's delivered output and simplifying assumptions about these costs

This section applies the analysis of Chapter 4 to derive the costs to an employer and to his employee of each rate of the employee's delivered output. Although the employee might not supply part of his output to his employer or to other parties whose receipt of this output benefits his employer, I ignore such quantities (i.e., amounts put to personal use, wasted, or supplied to other parties) in order to simplify the exposition. The exposition is also facilitated by the assumption of a single output. An employee's output can either be a separate intermediate or final output or his determinate contribution to such an output.

The discretion that employees hold over an organization's productive activity and the incentives that they face determine the ways resources are allocated within an organization. This chapter examines the nature and range of employees' discretion by considering the influence delegated to them over the applications of inputs and choices of outputs within the organization's production functions. We first examine these production functions and define an employee's “production domain.” Considered next are the relative costs to an employee and other interested parties of information about his production domain and the concepts of externally and internally designed production domains. Finally, we explore the conditions under which production domains are externally and internally designed.

An organization's production functions, its production domains, and its employees' discretion over resource substitutions

In order to analyze the motivation for delegating discretion to employees over an organization's resource allocation, it is necessary first to consider the nature of the production functions that an organization encompasses. We can then specify an employee's discretion in terms of his influence over possible resource substitutions within these production functions.

Production functions

Organizations usually produce many intermediate and final outputs. The rate of production of each of these outputs can typically be achieved in different ways, that is, with alternative rates of application of the various inputs which can contribute to each output. A production function expresses the set of known technologically feasible ways of transforming inputs into one or more outputs.

This chapter analyzes economic behavior in the second long run, a time period long enough for organizations to merge or change their status, for instance, from private to public or profit to nonprofit. If a merger or change in status increases the amount of economic activity occurring within organizations, the smaller the allocative role of market incentives relative to that of incentives within organizations. If these changes are accompanied by an increase in legislative demand, this additional intervention between citizens' demand and the organization's employees further reduces the allocative role of market incentives.

A change in an organization's status or its merger with another organization is an investment that can be initiated by employees as well as by the funding authority, but the funding authority can exercise the right to approve before one of these changes may take place. The investments that can alter an organization's status in various ways or merge it constitute the supply of these changes. There would be a change in the funding authority's returns from the organization as a result of these investments taking place. Employees' separate investments that influence the funding authority's expectations about these returns are their demands for mergers or changes in organizations' status. Demand affects supply when employees can sufficiently influence the funding authority's expected returns to a merger or change in the organization's status to alter his choice whether to permit it to take place.

In the analysis of the short run it was assumed that current investment behavior has no effect on the same time period's resource allocation. Over longer periods an organization's tangible and intangible capital resources are altered both by employees' investments (analyzed in Chapter 7) and by the funding authority's investments. This and the next chapter analyze price and output determination for public and private organizations during time periods long enough for the investments of employees and the funding authority to influence the outcome.

We have seen that an employee's investments can increase the resource diversions that are allowed by the responsibility facing him. However, an organization's “funding limit” constrains the combined resource diversions of all of its employees, regardless of the amounts allowed by responsibility. Thus, we shall consider the effects of employees' investments within two possibly overlapping time horizons. In the “first long run,” employees' investments can have the fullest possible impact on the resource diversions allowed by responsibility within the funding limit. During this time period an organization's funding limit cannot be changed as a result of a merger with another organization or a change in its status as a private corporation, private nonprofit organization, or a public organization. However, because these changes affect funding limits substantially, they are often objects of employees' investments. Such investments are analyzed in the “second long-run” analysis of Chapter 9.

This chapter first considers the funding limit in each type of organization and then analyzes price and output determination in the first long run.

Although the behavioral postulates underlying demands of private citizens for an organization's outputs are well established, the analogous demand of a legislature cannot be derived from existing theory. Therefore, before analyzing short-run price, income, and output determination for a public organization, it is necessary to consider how a number of important contributions in the political science and public choice literatures can be extended in order to derive a legislature's demand function for a good or service. This analysis also enables us to determine the role of a legislature as the funding authority of a public organization.

An analysis of legislative behavior may seem a detour in a book about economic behavior within organizations, but a legislature is an organization whose funding authority consists of citizens eligible to vote. These citizens' willingness to provide funds to a legislature depends in part on the welfare they derive from public goods, although legislatures find it in their interest also to provide private goods. The analysis will determine the allowable resource diversions that derive from a legislature's capability to tax citizens and then provide economic benefits to them, as well as establish the shares of these resource diversions that go to legislators and to employees in organizations supplying legislative demands. Legislators face costs of negotiating with each other as do employees in other types of organizations.

This book's purpose has been to extend economic analysis to the behavior of an organization's individual employees. We have seen that, as a result, hypotheses can be derived about an organization's internal resource allocation and its supply behavior for short-run and long-run periods. Given an organization's production functions and employees' information cost advantages, it is possible to analyze the extent of employees' discretion over resource allocation and the types of constraints employers place on employees. The degree to which employees can use resources delegated to them to pursue their personal goals can be determined, and the responsiveness of the organization's internal economy to employees' welfare as well as to external economic forces can be established. Within this internal economy the range of derivable hypotheses about supplies, demands, costs, and investment behavior is approximately comparable to the range of existing hypotheses about these variables when organizations are taken as the smallest unit of analysis.

In the short run, where the effects of current investments are not considered, hypotheses about resource allocation have been derived for the cases where overall value and specific responsibility are imposed. We found that when an employee under overall value responsibility derives utility at the margin from personal uses of any of the resources delegated and attributed to him, he infers his employer's marginal value of each of these resources and, given his information about production possibilities, he allocates resources efficiently within his production domain according to these values.

This and the next two chapters analyze the resource allocation behavior of individual employees and of their organizations in the “short run.” The short run is a time period within which current investment behavior does not affect resource allocation. Two types of past investments determine the capital stock underlying the organization's short-run productive activity. The first and more obvious includes the organization's plant and equipment and its employees' skills. The second consists of those investments analyzed in Chapter 7 that determine the division of the organization's production functions into production domains, the information held by employees about production domains, the placing of resource responsibility on employees, and the means by which employees voluntarily coordinate themselves. In the short run all the results of both types of past investments are given and fixed.

This chapter first analyzes resource allocation under overall value and specific responsibility, making the simplifying assumption that there are no technological spillovers among employees' production domains. For each of these two types of responsibility a separate section explains how the equilibrium quantities of an employee's outputs are determined, derives the employee's and his employer's costs of these outputs, determines the employee's uses of each input and output, and derives the implicit prices that he attaches to these resources. The employee's and his employer's demands for information about production domains and preferences are also explained. Resource allocation under these two types of responsibility is contrasted with that occurring under CPOR.