Traditional and Modern Theories of Decision Making - Essay Example

DECISION MAKING A REVIEW OF TRADITIONAL AND MODERN THEORIES TABLE OF CONTENTS Page 3 2 Introduction 4 3 Traditional Theories 4 4 Post-Modern Theories 6 5 Critique 9 6 Conclusions 11 7 Bibliography 13 1 Abstract Traditional Theories of the firm are based on the twin objectives of cost reduction and profit maximization. With these narrow objectives decisions are likely to benefit only the stockholders. There are other stakeholders that get ignored and as a result firms either fail or are unable to grow to their potential. Post Modern Theories take into consideration all stakeholders and strive to make decisions that benefit all stakeholders thereby ensuring all round cooperation and spreading of goodwill. Since these decisions are beneficial to all the net result are higher profits due to greater patronage. The original objective of profit maximization is achieved and growth as well as sustainability assured when firms adapt to these theories. 2 Introduction Firms make business decisions based on strategies. Strategy begins with planning, with objectives at the other end of the spectrum. It is the function of management to make strategies therefore Strategic Management is the process of the management that gives direction to the company about its objectives and the details of how these are intended to be achieved. There are four characteristics of Strategic Management. “Consistency: The strategy must not present mutually inconsistent goals and policies. Consonance: The strategy must represent an adaptive response to the environment and the critical changes occurring within it. Advantage: The strategy must provide for the creation and/or maintenance of a competitive advantage in the selected area of activity Feasibility: The strategy must neither overtax valuable resources nor create unresolvable sub problems”. (Rumelt) However traditionally, from Adam Smith onwards the strategy has revolved around production or input cost and profits. All decisions are therefore aimed at the twin objective of cost reduction and profit maximization. 3 Traditional Theories The traditional or neoclassical theories believe that business firms try to reduce cost of production. Costs are determined by the quantities of inputs multiplied by their price. As production increases, the costs reduce and profit margins increase. But this is demand based. As demand decreases so does output and costs increase resulting in lower profits or even losses. This then is the most simplistic formula that was the driver of a business strategy that accounts for a pure demand and supply situation. However there are many shortcomings in this approach. This does not take into account the behavioral factors that effect decisions. This also ignores that there are hierarchies in a business; that there are superiors and subordinates. Management is scarce and not easily obtained and that it is often more economical and fruitful to hire managers rather than manage by oneself. This brought about the Agency theory that considered stakeholders (Jensen and Mechling, 1976). This showed that aside from owners, there are other groups that are interested in the performance of the firm or company and due to their interest the company requires a strategy that offers profits to one stakeholder and adequate remuneration and facilities to others. The shortcoming in this theory is that since there is a different perspective by different stakeholders, one may put the other to more risk. The case of Enron highlights this fact that the high incentive of lucrative stock options pushed the management to opt for higher risks, resulting in total loss for the shareholders. There was another theory based on Transaction costs. As explained by Oliver Williamson (1985), internal controls on costs were more effective in comparison with contractual costs which could vary even after confirmations due to external factors. It was concluded that it was cheaper to internalize decisions rather than depend on the market costs. Mergers and Acquisitions have brought on complexities of ownerships hence a theory of Property Rights Approach came about with the observation that it is the owner of the asset that has residual control over its use, and not over all uses not specified by contract, custom or law (Alchian and Demsetz, 1972). A merger brings about a change in the property rights of the owner. So the control changes hands. This is different from the income rights of the asset that changes hands, in which case the asset could be diluted of its income bearing capacity. This happens in the case of human capital which holds the knowledge. In case of a takeover, it is likely that the former employees will quit the firm, in which case the income generating capacity of the firm is reduced or lost. Therefore it is advisable to convert this capacity into either the fixed assets of the company, say information systems, or into routines of operation so that the impact is least. In all these theories the motive was profit and the method was through control of costs. However external influences and factors were largely ignored and not accounted for. As a result there were either failures or serious impediments in growth affecting the very continuance and flourishing of firms. 4 Post Modern Theories Various shortcomings and inadequacies of the traditional theories of the firm brought about the Post-Modern theories that revolved around the competitive advantage of the firm. In the modern context (Porter M.1996), the surplus becomes the competitive advantage. The purpose of organizations is that of creating a surplus, as against profit, and maintaining it against competition, finally distributing it among stakeholders. It is achieved by creating a surplus above normal return against the risk in the area in which the firm competes. The surplus is measurable both in monetary or perceptive terms. Financially it can be expressed as profit, return on capital, return on equity, sales, earnings per share, dividends and so on. In non-financial terms it takes shape as good lives, security, care for the environment, leisure, or even an exceptional product. This surplus may be distributed to owners, customers, managers, workers, or can be enjoyed by the community in general. Firms or players covet this surplus in competitive environment and this is what the game theory is all about. They use the industrial or financial capital and innovations and are a continuous process in which they struggle to find cheaper resources and larger markets to face competition. In the end it is the survival of the fittest that can describe the essence of the Games Theory. Another modern theory is the Resource based Competence Theory introduced by Wernerfelt (1959). Primary importance is attached to the resources and competence that is possessed by the firm. The test is their ability to accumulate, protect and deploy competences in search of long-term competitive advantage over competition or rival firms. These competencies determine the scope and boundaries of the firm and their capability to expand and diversify is what distinguishes them from others. Hamel and Prahalad have argued that core competencies are the route to future developments and that they define the inventive and transformational aspect of business today that looks for future positioning. (Hamel and Prahalad 1996)). Without development of these competencies, that have to be extensively deliberated upon prior to planning, the idea of positioning will be superfluous. The Competence Theory is in a way a re-deployment of or a re-invention of Adam Smith (1776) theory of Capital in the Wealth of Nations. At that time he had expounded that specialization in production brings competencies. But today there is a whole new dimension to it with Knowledge or Information becoming a vital tool. This tool makes solution of problems much more efficient than ever before. Add technology to it and it becomes lethal. Competencies are individualistic in nature, but they must be made part of the firm for them to become instruments of competitive advantage that are hard to imitate or replicate. Any firm possessing this becomes very competitive in the market place today. Therefore firms are essentially diverse entities and are distinguished by their unique knowledge bases. (Nelson, R.R., and Winter, S. G., 1982) Knowledge is largely implied and is part of routines. Routines are describable as a set responses and reactions to situations. Synergies are produced by linking various routines. The fundamental idea is to create dynamism between such routines to produce products or services. Such an assembly of routines that is designed for specific purpose creates the core competency. Such assemblies and core activities give rise to Systems. This thinking leads to looking at organizations as live organisms. Morgan (1986) distinguishes eight metaphors for organizations: machine, organism, brain, culture, political system, psychic prison, flux and transformation, and instrument of domination. Each metaphor highlights other aspects of organizational life As a result they are able to adjust to fluctuations or contingencies (Lawrence & Dyer, 1983). Since Organizations are active and they coexist with as well as influence their environment, they end up in making changes that may be strategic, tactical, or even cultural; for example, in developing closer relationships with suppliers or through initiating employee motivation programmes. This gives shape to the Contingency Theory. Contingency theory emphasizes that organizations must develop along with their environment (Lawrence & Lorsch, 1967). Firms with stable markets tend to have a mechanistic approach with clear cut guidelines, assertive communications and standardized methods arising out of set hierarchy. In contrast those with unstable market conditions had an organic form with changing and flexible definitions, open lines of authority and communications. However these are extremes and most cases lie in between. Contingency and its structural form was investigated by Mintzberg (1979) to study the above extremes and it was found that a mixture of structural form, that distributes people along functional lines as well as project related groups, has become a popular way of structuring a largely uncertain environment. It is well understood that competition results in the survival of the fittest. The definition of fittest here would be one that can withstand the vagaries of the environment. Environment would encompass all kinds of external factors including the ecological ones that are assuming alarming importance. In this the firms with inferior structures and strategies die as a consequence of resource constrained competition. (Hannan & Freeman, 1989). There are variations that occour both randomly and in a planned fashion. The result is a cycle of selection-variation-retention of firms. Obviously the beneficial variations are retained and the rest discarded. There is a traditional perspective involved here. In firms, as in individuals, behaviours can be carried forward vertically forward as from old to young or vertically backward as from young to old. They can also move similarly in horizontal fashion as young to young and old to old. (Baum & Singh, 1994). Such organizational changes occour as a result of adoption of technology or innovations or both. 5 Critique With passage of time, experiences gathered through experimentation and cemented by researches theories of firms have evolved and will continue to do so as new horizons are opened up by global expansions and continuous changes in environments. Old resources are becoming scarcer and new ones are replacing them; so the crunch factor is adaptability. Decision making in a firm is becoming more difficult and the traditional theories are too simple in predicting a future course of action. Indeed the external factors are assuming such important proportions that the simple calculation of production cost and the profit no longer seem to be of use in deciding strategy. Of course the relevance of these two traditional needs cannot be denied but they are heavily impacted by the other factors and remain only as desired objectives. The achievement of the objective however becomes more complex and dependant on behaviours. Growth is dependant on momentum and it is an integral part of business strategy. Growth is a also a very difficult decision as it involves investments; and an investment may become wasteful or a burden if there is no adequate return in a reasonable period of time. Corporate strategies have been divided into Five Ps by Mintzberg and they are Plan, Ploy, Position, Pattern and Perspective. While each is a separate type of strategy with its attendant qualifications, yet they are usually present in all strategies to some degree. The real difference lies in the fact that one of them will be dominant and others will play a supportive role. (Mintzberg). Among the strategies, Positioning is a long term objective of corporate operations and requires more attention to detail and a firm commitment to accept the consequences and to overcome roadblocks. It is an assertive policy that will require substantial investments and total cooperation of all stakeholders otherwise it might fail. The stakes are huge and results are very rewarding. The one big risk is that in case the objective is changed due to influence of external factors, the whole strategy will have to be abandoned at great cost. Therefore it has to be planned and well thought out over a period of time. It is preferable to first test this strategy for a short period on a smaller scale to confirm its feasibility and acceptance before making full fledged commitment. 6 Conclusions In the global environment, the play of external factors assumes greater importance. Political, soci-economical, technological and legal changes within and beyond the boundaries began to effect the stakeholders in different ways and perspectives became larger and more diversified. It was no longer the profit, but the share of market and the corporate social responsibility that became equally important. Sustainability became and issue as competition grew along with protectionist attitudes developing at national levels. Growth was seen as an important factor and at times profits became secondary. At the same time both the consumer and the worker assumed great importance for the firm and for the first time all major stakeholders the shareholder, the customer and the worker came to be equally important for the existence, continuity and competitiveness of the firm. Management turned professional and the owner was divested from the firm’s day to day affairs, although he could display his approval or displeasure through the share price valuations. Decision making in the firm therefore is now attuned to getting best values for all the stakeholders, shareholders, workers, customers, management and even the community at large. Successful managements have stopped looking at the singular aim of reducing cost and maximizing profits and are now aiming to satisfying all stakeholders. Indeed the more successful ones like Marks & Spencer’s are investing heavily into saving-the-environment initiatives. In return this has returned the customers to them in appreciation of their efforts and the bottom line has improved and the EPS has zoomed to scale new heights. The new theories of the firm favour decisions that are not limited to the concept of costs and profits but have encouraged bold strategies that redefine their roles in the global and international context. 7 Bibliography Alchian, Armen A. and Harold Demsetz, (1972). Production, Information Costs and Economic Organization, American Economic Review, 62. Baum, J. M.C., and Singh, J. V, (1994). Evolutionary Dynamics Organisations. New York: Oxford University press. Hamel, Gary. and Prahalad, C.K., Competing for the Future, Harvard Business Review, May-June, 1996 Hannan, M. T. and Freeman, J. H. 1977. ‘The Population Ecology of Organisations. American Journal of Sociology, 82: 929-964. Jenson, M and W. Mechling (1976) The Theory of the Firm: Managerial Behaviour, Agency Costs, and Capital Structure, Journal of Financial Economics, 3, 305-60. Lawrence, R.R., and Lorsch, J.W (1967), Organisation and Environment: Managing Differentiation and Integration. Homewood, III.: Irwin. Lawrence, Paul R., and Dyer, Davis., New York: Free Press, 1983 Mintzberg, Henry., THE STRATEGY CONCEPT I: FIVE Ps FOR STRATEGY Mintzberg, Henry California Management Review; Fall 1987; 30, 1; ABI/INFORM Global Mintzberg, Henry. and Waters, James A., Of Strategies, Deliberate and Emergent, Strategic Management Journal, Vol-6, 257-272, 1985 Morgan, G., 1986. Images of Organization, Sage, London. Nelson, R.R., and Winter, S. G, (1982). An Evolutionary Theory of Economic Change. Cambridge, Mass: Harvard University press Porter, M. E. (1991), Towards a Dynamic Theory of Strategy, Strategic Management Journal, 12, p. 95-217. Rumelt, Richard., Evaluating Business Strategy., in Readings in the Strategy Process, Ed. Henry Mintzberg, Prentice Hall, (New Jersey: 1998) Smith. Adam., The Wealth of Nations, London 1776 Wernerfelt, B.(1984). A Resources- Based Theory of the Firm, Strategic Management Journal, 5:171-180. Williamson, O. E. (1985), The Economic Institutions of Capitalism: firms, markets, relational contracting, New York: The Free Press (1985). Read More