Formal and informal organization sérgio G. Lazzarini

FORMAL AND INFORMAL ORGANIZATION

• Sérgio G. Lazzarini

• IBMEC São Paulo

• ESNIE, May 2006

• (Based on Zenger, Lazzarini & Poppo, In: The New Institutionalism in Strategic Management, 2001)

Formal vs. informal institutions

• Formal: rules that are readily observable through written documents or rules that are determined and executed through formal position, such as authority or ownership.

• Ex: explicit incentives, contractual terms, and firm boundaries as defined by equity positions.

• Informal: rules based on implicit understandings, being in most part socially derived and therefore not accessible through written documents or necessarily sanctioned through formal position.

• Ex: social norms, routines, and political processes.

An immense opportunity for interdisciplinary integration

• Organizational economists have focused on formal institutions (Coase, 1937; Williamson, 1985; Barzel, 1982; Holmstrom & Milgrom, 1994 etc…).

• Organizational theorists and economic sociologists have stressed the role of informal mechanisms in governing exchanges both internal (Crozier, 1964; Roethlisberger & Dickson, 1939; Trist & Bamforth, 1951) and external to the firm (Granovetter, 1985; Powell, 1990; Uzzi, 1996).

• Hart (2001, p. 15): “it has been difficult to incorporate norms into the theory of organizations… although there has been some interesting recent work on this topic, this work has not to date greatly changed our views about the determinants of organizational forms.”

Assumption 1. Informal institutions strongly influence the functionality of organizational forms

• Roethlisberger and Dickson (1939, p. 559): “many of the actually existing patterns of human interaction have no representation in the formal organization at all, and these are inadequately represented by the formal organization … Too often it is assumed that the organization of a company corresponds to a blueprint plan or organization chart. Actually it never does.”

• Some other key contributions: Chester Barnard (1938); Michel Crozier (1964); Pfeffer (1978, 1992).

• In inter organizational relationships: Granovetter (1985); Macauley (1963). Macneil (1978).

Assumption 2. Formal institutions influence the trajectory of informal institutions

• “The formal largely orders the direction the informal takes” (Dalton, 1959, p. 237).

• Internal routines, norms, and networks of influence develop over time in response to an organization’s formal structure (Shrader, Lincoln, & Hoffman, 1989; Stevenson, 1990; Tichy, 1980).

Assumption 3. Formal institutions are discretely arrayed, while informal institutions operate comparatively on a continuum

• Formal organizations as bundles of mutually-reinforcing attributes (Williamson, 1991; Milgrom & Roberts, 1991). Ex:

• Centralization: structural interdependence between units, lower-powered incentives, and global decision making.
• Decentralization: structural autonomy, higher-powered incentives, and local decision making.

• Informal elements as continuously arrayed: tie strength (Granovetter, 1973); level of commitment (Salancik, 1977), centrality in informal networks (Krackhardt, 1990), and so forth.

Assumption 4. Formal and informal institutions differ in the pace with which they change. Informal institutions possess inertia that slows the pace of change

• Inertia: relationships, political coalitions, patterns of communication, established routines impede organizational change (Hannan & Freeman, 1984; March & Simon, 1958; Nelson & Winter, 1982; Tushman & Romanelli, 1985).

• In Economics: path dependence (Arthur, 1989; David, 1985). North: importance of “available mental constructs—ideas, theories, and ideologies” (1990, p. 96) creating resistance to change.

Proposition 1. Formal and informal institutions are interdependent governance mechanisms in that the use of one mechanism can either promote (complement) or undermine (substitute for) the use of the other.

Complementarity vs. substitution

• Complementarity: formal contracts and explicit incentives reduce gains from short-term defection and hence increase the value of honoring long-term, informal agreements (e.g. Klein, 1996; Baker, Gibbons & Murphy, 1994).

• Substitution: formal contracts and explicit incentives damage the operation of social norms (Macaulay, 1963; Frey, 1997).

• Mixed evidence thus far! (e.g. Fehr & Gächter, 2000; Lazzarini, Miller & Zenger, 2004).

Proposition 2. Even in static environments, achieving the optimal functionality of an organizational form may require dynamic “vacillation” of formal elements (Nickerson & Zenger, 2001).

Vacillation at HP (allocation of decision rights)

Vacillation

• The functionality of an organizational form is determined as much by informal mechanisms, as by formal mechanisms (Assumption 1).

• Informal institutions vary systematically in response to changes in formal institutions (Assumption 2).

• Managers only have discrete formal choices or “levers”—e.g., centralization vs. decentralization—to promote such changes (Assumption 3).

• Given that informal institutions display inertia (Assumption 4), each switch between formal choices triggers a gradual change in the trajectory of informal elements

Proposition 3. Firm boundaries are determined in large part by the need to adjust informal institutions within hierarchies. Managers must sever the boundary of the firm to suspend dysfunctional informal processes.

Informal processes leading to hierarchical failure

• Influence activities (Milgrom & Roberts, 1990; Poppo, 1995); politics (Pfeffer, 1978, 1992).

• Social attachments (Katz, 1982; Halpern, 1994).

• Social comparison processes inhibiting high-powered incentives (Adams, 1965; Deutsch, 1985; Zenger, 1992, 1994).

• Firm-specific routines creating difficulty to access external knowledge (Katz, 1982; Leonard-Barton, 1995).

• Such informal processes cannot be selectively shut down with any great success. Firms may suspend hierarchy as an institution to avoid the informal processes that run rampant within their boundaries.

Discussion #1: (How) Can vacillation of boundary choices improve performance?

Discussion #2: (How) Can explicit incentives change organizational culture?

• Example: Algar (Brazilian telecom firm) would like to develop a “marketing-oriented culture” whereby all employees should actively sell products even if their are not in the functional area of sales.

• They crafted explicit incentives such that 20% of individual bonuses will be based on whether the employee helped sell some product.

• They plan to abort the explicit incentives in 2 years, assuming that the new values and norms will be created as a consequence of the incentive program.

• Will it work?