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Organizing the Firm

The last subject covered by Nicolai Foss and Peter Klein in Organizing Entrepreneurial Judgment is the internal organization of the firm. Foss and Klein argue that the organization of the firm is critical to how entrepreneurial judgment will be manifested at different levels of the firm. Ownership rights are foundational for this organization to occur.

Original and Derived Judgment

Foss and Klein distinguish between original entrepreneurial judgment and derived entrepreneurial judgment within the firm. Original judgment is the judgment which belongs to the owner of the firm. The owner exercises original judgment in forming and executing a business plan. They have decisive control over the structure and goals of the firm. As a firm grows larger, the entrepreneur with original judgment will lack the information to make all firm decisions. At this point, the owner-entrepreneur delegates decision making to other employees within the firm. Foss and Klein call these employees with delegated powers “proxy-entrepreneurs”. They are given the right to exercise derived entrepreneurial judgment over certain decisions. In other words, Foss and Klein argue that the owner-entrepreneur makes “specifying decisions”; defined as a “set of formal and implicit contracts by which the entrepreneur delegates judgment to subordinates in the multi-person organization”.

Foss and Klein assert the truth, which has been underemphasized in the literature, that not all entrepreneurship is beneficial. Some entrepreneurial decisions are productive while others are destructive to the firm. Productive entrepreneurship results from employees using their discretion to create or discover new attributes of firm assets which add value to the firm. Destructive entrepreneurship occurs when employees use their discretion in efforts which reduce firm value.

Those with original judgment have the task of managing derived entrepreneurship. To expand derived entrepreneurial judgment to employees, the owner-entrepreneur will reduce constraints on employees. He then must manage the trade-offs between the productive entrepreneurship and destructive entrepreneurship of his employees. Foss and Klein state some ways this occurs within businesses. Owners can give employees bonuses for value adding outcomes in reward for productive entrepreneurship. They can also give employees direct equity stakes or stock options to incentivize adding value to the firm. To constrain employees judgment, the owner-entrepreneur can do such things as set the “proxy-entrepreneur’s” budget, determine which activities he’s allowed to engage in, assign which people he is allowed to work with, and determine how he’s allowed to use equipment.

Ownership and Internal Organization

Foss and Klein explain that ownership rights are central to the internal organization of the firm. Ownership rights allow the owner-entrepreneur to make contracts with his employees and define how entrepreneurial judgment will be exercised throughout the firm. By loosening contractual constraints on how employees can use firm assets, the owner-entrepreneur expands the scope of entrepreneurship for lower level employees. By tightening the constraints, he decreases the amount of entrepreneurial judgment his employees are allowed to exercise over firm assets.

To manage derived judgment efficiently, ownership needs to clarify two things up front. They must commit to rewarding employees for suggesting projects which the firm adopts. This gives employees incentive to seek out new and improved ways to use firm assets. If the firm does not commit to rewarding employees for finding better uses of assets, the employees will be less likely to take the time and energy to search for these uses as it will be too costly for them. Secondly, ownership must communicate what types of projects it will adopt. This gives employees incentive to focus on searching for projects that ownership wants to pursue and thus makes the searching process more efficient.

Dispersed Knowledge, Authority and Firm Organization

The last section of chapter 8 accounts for dispersed knowledge, most famously articulated by economist F.A. Hayek, and its implications for the firm. Foss and Klein define dispersed knowledge as “knowledge that is not possessed by any single mind and which may be private, fleeting, tacit and subjectively held and is necessary for the effective allocation of resources.” Thus in a firm, management does not have all the knowledge to make the best allocation of resources. Critical knowledge is dispersed throughout the organization to lower level employees.

Foss and Klein argue that management deals with this reality by giving employees discretion. In large organizations, owners will typically set a structure for distributing discretion. Mid managers are delegated decision rights by owner-entrepreneurs. These mid managers then delegate decision rights to employees under them, and so and so forth. Thus the firm is decentralized through this delegation of decision rights.

While management employs mechanisms to decentralize the firm in light of dispersed knowledge, authority is still retained by the owners for final decision making. Foss and Klein argue that a level of centralized authority is still necessary and beneficial even in light of dispersed knowledge. They argue it is better for employees to be constrained and guided to some degree rather than left to act solely according to their own judgment. FK point out a couple reasons why. One is that a need for urgent coordination often arises. Authority, or the right to direct factors of production, must be exercised quickly in such urgent situations. Owners often have decisive knowledge in such cases. They can make a decision based on their information without involving other pieces of information. Therefore a hierarchy of authority is very beneficial when someone needs to make quick decisions with firm assets. The property rights held by the owner-entrepreneurs secure their right to make these final decisions.

Conclusion

To summarize Foss and Klein’s chapter 8 conclusion, tying together entrepreneurship and the firm allows for a dynamic and realistic understanding of how the internal organization of the firm is established and the effects it has on performance. The internal organization determines how derived entrepreneurial judgment will be exercised by employees as circumstances change. The owner-entrepreneur exercises original judgment in determining the amount of discretion his employees will have. Thus, entrepreneurship is exercised in some way at every level of the firm. The owners should not be mistaken as passive bystanders to the actions of the firm, for they are the ones who ultimately establish and adjust over time the structure for how entrepreneurship is to be exercised by firm employees.

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