3.2  Management Capability

The role of managers is to choose production processes, to implement these effectively, and to remove inefficiencies. They also design and operate the organisational structures that enable the firm to operate effectively and utilise the complementarities existing between capital and skilled labour. This includes the application of human resources management (HRM) techniques which improve the productivity of workforce, by addressing agency issues and ensuring worker motivation and effort. This assessment of managerial capability is organised around two topics: the nature of the contribution that management systems make to firm productivity; and the evidence on managerial performance in New Zealand.

3.2.1Models of management practices

Within the institutional economics literature, various approaches have been utilised to investigate the nature and scope of decision making activities within firms.[8] These utilise in some way the Coasean idea that institutions serve to facilitate exchanges, and operate to manage contractual constraints more than production tasks. A key feature is the management of information – both internal and external – in a changing environment. Three approaches are identified here to indicate something of the range of different, but overlapping, sets of management activities:

• Hierarchies within firms: Managers operating in hierarchical structures undertake a range of functions such as planning, decision making and supervising. Hierarchies provide the means for managing agents’ limited capacity to acquire and process information in complex environments. They allow talented individuals to hold more senior positions and exert more influence. The size of the firm and the extent of senior managers’ influence are limited by the difficulties inherent in supervision, co-ordinating and contracting.
• Human resource management practices: The focus here is on the effective management of employment relationships. The task facing managers is getting the best performance from their workforces using a range of human resource management practices that align workers’ efforts with the aims of the firm. The objective is also to maximise worker input into the efficiency of production by eliciting worker ideas for improvement and assistance in problem solving.
• Operating routines and dynamic capabilities: The emphasis here is on the ability of the firm to adapt to changed circumstances through various knowledge acquisition processes. This knowledge is structured within the firm into the operating routines that guide “business as usual”, and the dynamic capabilities by which firms systematically respond to change. Management has a key role in the development of these knowledge bases and routines. The formation of routines and capabilities economises on bounded rationality, but also creates the possibility of path dependence through retaining ineffective practices.

These models tend to incorporate a limited range of behavioural variables. Other behaviours may also be important for firm success. Bertrand and Schoar (2003) note that to date studies have tended not to include manager characteristics. They provide an initial assessment of how the behaviour and aims (ie, the “style”) of individual managers affect corporate behaviour and firm policies. The use of matched manager-firm panel data enables the independent contribution of managers to be tracked over time as they move between firms. The data on CEO characteristics they include is limited to the position they came from, MBA graduation, and age. They find that these manager characteristics explain a significant proportion of variation in investment, financial and organisational practices.

Hierarchies within firms

The literature on hierarchies within firms points to the important roles of managers across a number of dimensions (see Holmstrom and Tirole (1989), Borland and Eichberger (1998), Radner (1992) and Rosen (1982)). These include managing information flows and decision making, contracting and supervision, incentive structures, internal labour markets, and providing an authority structure. One dimension is the management of information flows within pyramidal management structures. Hierarchies provide the means for managing agents’ limited capacity to acquire and process information in complex environments. Processing wide-ranging information, such as customer or production requirements, must inevitably be decentralised. Higher tiers of management can access more aggregated information, but require it in a more distilled form. Bounded rationality requires that trade-offs be made between costly information collection and decision making where errors are also costly. The costs of coordinating information communications across management layers limit their number.

Hierarchies also allow talented individuals to move into more senior positions. Authority is matched to talent by market forces. The contribution of top managers is multiplicative, in that their influence filters down through the organisation. Conversely, their failures in their supervisory, coordination and arbitration functions also flow down the hierarchy. The contribution of senior manager to firm productivity is, therefore substantial. A related feature of hierarchies, given incomplete internal labour contracts, is that supervision of subordinates is required. The interests of owners, managers and workers need not be aligned. Supervision enables directions to be given across management layers. However, there are limits to how effectively supervision and incentives extend down the hierarchy, potentially yielding a loss of control as the firm increases in size. Thus, the size of the firm and the extent of senior managers’ influence are limited by the difficulties of supervision, co-ordinating and contracting.

Hierarchies also create internal labour markets. These provide source of information about the productivity of worker. They allow career paths, where the accumulated knowledge of the employee and the awareness of their capabilities allows them to be assigned more responsibility. Hierarchies allow yardstick competition where in promotions the performance of agents can be compared. Given incomplete employment contracts and unobservable behaviour, incentive problems arise. These can be addressed in part through supervision, monitoring and incentive arrangements.

Human resource management practices

In a series of papers, Ichniowski, Shaw and Prennushi (1995, 1997), and Ichniowski and Shaw (2003) examine the effect of a range of human resource management (HRM) practices on firm productivity. They argue that these practices are complementary, in that using one more intensely increases the benefits gained from the others. They suggest three main reasons for this: reducing the incentive problems under certain performance pay schemes; eliciting worker ideas; and supporting multi-tasking and problem solving.

These authors collected longitudinal data on measures of productivity for 26 steel plants in the US, and the associated work practices, and technology usage. The investigation of one specific production process limits the effects of other sources of firm heterogeneity on productivity findings (but raises questions about their generality). Work practices measured included work teams, flexible job assignments, employment security, training in multiple jobs, and incentive pay. They found that the adoption of clusters of these practices yielded substantially higher levels of productivity (in terms of steel throughput) than more traditional personnel practices, such as narrow work definitions, strict work rules, hourly pay and close supervision. In addition, they found that the adoption of individual practices in isolation had little or no influence on productivity. They tested models to identify the effects of HRM practices independently of the effects of any changes in management or wages that may have been occurring concurrently. They note that these HRM practices are adopted at all greenfield sites, but that transition costs can hinder their adoption at existing sites.

They see the gains from clusters of HRM practices as evidence of the importance of complementarities that exist amongst these practices. These complementarities are reflected in the high correlations amongst the effects of these variables on firm productivity. That is, individual practices may be more effective when they operate in concert with other practices. In this way they address the full range of personnel management practices that influence workers’ contribution to the productivity of the plant. Together, these “high involvement” practices provide a coherent incentive system. Free riding by individual workers is overcome through both individual incentive contracts, the screening of new hires to assess suitability for teamwork, and also group incentive pay to encourage a culture of teamwork and effort. Appraisals of subjective dimensions of performance were included to recognise worker behaviours where subjective assessment is required, like dependability or problem solving initiative. Other HRM variables included were pledges of employment security which helped the adoption of change, rotation of workers across tasks which increased flexibility and teamwork, communication to address concerns and find productivity improvements, and off-the-job skills training. Labour relations were measured in terms of unionisation of the production line and the grievance filing rate.

More extensive attention has been given to incentives in remuneration structures, for instance by Freeman (2000), Prendergast (1999, 2002), Lazear (2000) and Feldstein (2003). Freeman (2000) notes that studies show a positive relationship between incentive pay and productivity, though with more variable results. Conyon and Freeman (2002) review UK evidence on shared compensation schemes. One question about these studies is whether, following the Ichniowski et al studies, the omission of other HRM variables will bias upwards the estimated contribution of incentive pay schemes.

Operating routines and dynamic capabilities

The emphasis here is on management’s role in enabling the firm to adapt to change. It is a more dynamic perspective on how the changing technological or market environment shapes the way the organisation operates. Peter Gorringe (1993), building on the work of Nelson and Winter (1982), considers the role of firm capabilities and competencies that have been built up over time through various knowledge acquisition processes (such as on-the-job learning, interaction with customers and problem solving). It is often tacit, and specific to the particular processes operating within the firm. This knowledge is structured within the firm into the operating routines by which firms respond, which in turn contributes to the firm’s capabilities and culture. Management has a key role in the development of these knowledge bases and operating routines. These routines have strengths and weaknesses. The formation of routines and capabilities economises on bounded rationality, but also creates the possibility of path dependence around getting stuck in ineffective practices. Competition leads to the selection of routines that are effective, and the modification or demise of routines that are not.

Teece and Pisano (1998) develop the notion of dynamic capabilities by which firms systematically respond to change. Zollo and Winter (2002) view dynamic capabilities as the processes by which operating routines are modified. Their definition is that a dynamic capability is “a learned and stable pattern of collective activity through which the organisation systematically generates and modifies its operating routines in pursuit of improved effectiveness”. Teece and Pisano see dynamic capabilities as key to maintaining competitive advantage in a changing environment. They see them as incorporating strategic management, but also as the ability to systematically adapt and re-configure internal technical, organisational and managerial processes. Thus, a firm’s learning ability strongly influences its competitive advantage. Managers have a role not only in addressing agency and incentive problems within the firm, but also in maintaining its knowledge assets and problem solving competencies that enable it to anticipate and respond. Since building competencies takes time, and these can be slow to adapt, a degree of path dependence is inevitable. Hence, when significant technological changes require substantially different routines to be implemented effectively, this appears more likely to occur through firm entry.

In one application of this perspective on capabilities, Lane and Lubatkin (1998) find that a firm’s absorptive capacity – its ability to locate, assimilate and utilise new external knowledge – is important. With rapid technical change, firms are unable to generate all the knowledge required to adapt, and must utilise external sources to build their own capabilities. Through “learning alliances” with other firms they can accelerate the development of internal capabilities. Lane and Lubatkin explore the effects on learning of the characteristics of the “teacher firm” in terms of their knowledge base, the similarity of the two firm’s organisational arrangements, and the information being offered. They test their model with data on R&D alliances between pharmaceutical (the “students”) and biotechnology companies (the “teachers”).

Knowledge management (KM) policies also appear to improve innovation and productivity outcomes. The suggestion is that in the so-called knowledge economy, practices for acquiring processing and applying knowledge become more important. Kremp and Mairesse (2004) utilise a French data set on manufacturing firms to explore the effects of relatively well defined KM policies. The KM policies investigated include a culture of knowledge sharing, practices to motivate staff to remain in the firm, forging external alliances and partnerships for knowledge sharing, and implementing written KM rules. The data indicates that larger firms, and those more connected with technology intensive industries, are more likely to have introduced KM practices. Those firms undertaking R&D and adopting new management methods had also adopted these practices. The joint adoption by firms of two or more KM practices suggests that they are viewed as complementary. KM usage is found to be positively associated with firm innovation and productivity, after controlling for firm size, industry and R&D effort. (With cross-section analysis, establishing causation is more difficult with limited controls for other factors.)