1 The Story of the Miners and the Landowner

Imagine a landowner with the property rights to do whatever they want with their land. One day they discover that their land might be rich in iron ore. They quickly realise that they should mine their property for the precious metal. However, they are not quite sure how to do this. Fortunately enough, a number of experienced miners live in the same town as the landowner. All the miners have a wealth of experience in mining for different resources. They know the best techniques for drilling into different surfaces, testing for the quality of the ore, and the exploitation of different types of mines.

The economic problem is that the people who know how to run the mine do not own the land. In other words, in the current situation without any economic transaction the land is not used in the most optimal way. There are broadly speaking two possible solutions to address this problem. First, one of the miners can buy the land. Second, the landowner can buy or hire the expertise of (one of) the miners.

The two solutions

Let me start with making the first solution more concrete. Imagine that the owner knows that if they run and exploit the mine, they will earn a total profit of 120 gold coins until the mine is exhausted. The most efficient miner on the other hand could earn 200 gold coins, the second most efficient miner would make 180 gold coins, and the least efficient miner could generate 160 gold coins worth of iron ore. In the ideal scenario, the owner can auction the mine to the three miners who each can bid for the mine. Interestingly, none of the parties involved needs to know the value that the others have attached to the mine. As long as the bid price is below 160 gold coins, all miners will be interested, however only two miners will be willing to bid more than 160 gold coins for the mine. Eventually, the most efficient miner will be the only one left, they will bid 181 gold coins and the owners will accept the bid. The owner makes 61 gold coins more than what they would have made if they would have run the mine themselves. The most efficient miner pays 181 gold coins to the landowner, but they will earn a total of 200 gold coins from exploiting the iron ore. We have arrived at the best possible situation for this four person economy; the most efficient miner is running the mine and creating the highest possible value.

The limitations to this story are clear. For instance, in reality the miners and the landowner will not exactly know how they should value the mine. They might be uncertain about the price of iron ore in the future, they might not know how much iron ore can be mined from the land, or they might be unsure how much work it is to run this specific mine. Another problem is that the miners might not be able to pay the amount they want to bid. They might need financing ^[1]. It is entirely possible that none of the miners are willing to bid more than the 120 gold coins. In that case, the landowner might decide that it is profitable for them to employ one of the miners to do the mining for them. Thus, the second solution to the economic problem is that the owner hires the most capable miner and the owner knows that the miners have more knowledge and experience.

Contracting problems for the landowner

Which one of the two solutions will play out depends on the costs of contracting for both solutions. The cost of buying land involves a number of costs for the buying miner. They will spend a long time and need special instruments to establish the value of the iron ore in the land. One cost for the landowner is that they do not know what the value is of the iron ore and so they might get a low price if the miners have conspired against them. However if the cost of buying and selling the land is not too high, the economic problem is solved. The miner has the land (ownership rights), the miner knows and can decide what to do with the land (decision rights) and the miner is motivated to exploit the mine as good as possible because they can sell the iron ore and reap the profit in gold coins.

On the other hand if the landowner hires a miner for their knowledge, there is still a problem. The landowner holds all the rights to do what they want with the land (decision rights) and they get all the profits of the mine exploitation (ownership rights). However, the miner is more capable in mining and has the right experience to actually do the work. This problem can partly be solved by assigning some decision rights to the miner. For instance, if the miner has sufficient knowledge on mining, they need the decision authority to make the calls on the investment in machines or which drilling techniques to employ.

Granting decision rights to the miner only partly addresses the economic problem. Even though the miner can make the right decisions, they are not necessarily motivated to do so. If they take the right decisions, they will earn a fixed salary. If they take the wrong decisions, they will also earn a fixed salary. These wrong decision might be ones that make the miner’s life a little easier. For instance, the miner might choose to buy expensive machines that do all the work.

The landowner can address this issue by measuring the performance of the miner and rewarding them for good performance. One possible option is that the landowner gives a percentage of the profits from the sales of the iron ore to the miner. The miner is now motivated to increase their earnings by taking the best decisions for the mining operation. We are now again in the best possible outcome for the four person economy. The miner with the best knowledge of how to mine for the iron ore can make decisions on how to operate the mine and they will be motivated to take the right decisions.

Theories and topics

In the story of the mine, the landowner needs to take three crucial decisions.

1. The landowner needs to decide whether they will sell the mine or keep it.
2. If the landowner keeps the mine, they need to decide how much autonomy or decision rights to give to the miner they hire.
3. If the landowner gives decision rights to the miner, they need to decide which performance measures and rewards they will use.

In this simple story, the value of measurement and evaluation, the topic of this book, depends on how much authority the landowner wants to give the miner when they hire a miner. The value of good performance measures thus depends on how easy it is to sell the mine and how much more experienced and knowledgeable the miner is. The main difference between the three different economic theories at the start of this book is which decision they emphasise.

Transaction cost economists argue that the most important determinant of economic organisation is the cost of either buying and selling the land versus the costs of hiring the miner to work as an employee (Williamson, 1979, 1991, 2002). In the next chapter, I will go into the details of where these costs are coming from and how it relates to an organisation’s decision to keep control over their own production process or outsource it to a supplier.

Others argue that the people with the right knowledge should get the decision rights. If the owners of the rights cannot hire the knowledgeable people in the economy they might be better off selling their rights. Specifically, some knowledge can be easily transferred but other types of knowledge, specific knowledge, is specific to people with the right experience or education. These theorists argue that the distribution of specific knowledge ultimately determines how economic transactions will be structured (Jensen & Meckling, 1995).

Agency theorists have argued that what really determines the organisation of firms and economic transactions is whether there are good performance measures available. In one of the following chapters, I will explain how economists define good measures. The agency theoretical explanation argues that if these measures can be used to write an enforceable contract, landowners can reliably grant decision rights to their knowledgeable miners and they do not need to sell their ownership rights (Holmstrom & Milgrom, 1994).

These three theories are not mutually exclusive. They do focus on different decisions and emphasise different choices on how firms should organise themselves. Together, the theories give a good indication of the role of performance measurement in the organisation of a firm. In this book, I take the view that a good understanding of these three perspectives provides a structure to understand how performance measurement and rewards choices affect the organisation as a whole. Similarly, the combination of these theories also helps to understand how other organisational choices increase or decrease the importance of performance measurement. The chapters dealing with these theories and their applications form the core of the book.

Nevertheless, not all the aspects of the structure of organisations has been covered. Other economists have focused on internal labour markets to motivate and select employees. The internal labour market is the result of competition in the organisation for promotions. We will see that promotion decision are not only based on objective but also on subjective performance measures that cannot be used in formal contracts but are still a valuable tool to evaluate and motivate employees (Baker et al., 1994). This part of the book can be fully understood from the perspective of the three core theories but its application is so important for most employees that it deserves its own section.

Next, I branch out to another non-economic perspective. Some researchers argue that not all organisations maximise the economic value of the activities they are undertaking. Specifically, when it is unclear what the best action is, organisations rely on institutions to determine the course of action (Dimaggio & Powell 1983). They might be influenced by pressure of powerful groups, professional organisations, or social customs and norms. Other organisations imitate the decisions of more successful organisations even if that is not necessarily optimal. These institutional influences are explored and we will see how an understanding of institutional forces and power helps us to better understand how organisations make changes to their existing performance measurement systems and how they implement new ones.

References

Baker, G., Gibbs, M., & Holmstrom, B. (1994). The internal economics of the firm: Evidence from personnel Data. The Quarterly Journal of Economics, 109(4), 881–919. https://doi.org/10.2307/2118351

Dimaggio, P. J., & Powell, W. W. (1983). The iron cage revisited institutional isomorphism and collective rationality in organizational fields. Advances in Strategic Management, 48(2), 147–160. https://doi.org/10.2307/2095101

Holmstrom, B., & Milgrom, P. (1994). The Firm as an Incentive System. The American Economic Review, 84(4), 972–991.

Jensen, M. C., & Meckling, W. H. (1995). Specific and general knowledge and organizational structure. SSRN Electronic Journal, 251–274.

Williamson, O. E. (1979). Transaction-Cost Economics: The Governance of Contractual Relations. The Journal of Law and Economics, 22(2), 233. https://doi.org/10.1086/466942

Williamson, O. E. (1991). Comparative economic organization: The analysis of discrete structural alternatives. Administrative Science Quarterly, 36(2), 269–296. https://doi.org/10.2307/2393356

Williamson, O. E. (2002). The Theory of the Firm as Governance Structure: From Choice to Contract. Journal of Economic Perspectives, 16(3), 171–195. https://doi.org/10.1257/089533002760278776