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How does information get communicated in organizations? In new research accepted to The Journal of Industrial Economics, Gorkem Celik and his colleagues Dongsoo Shin (Santa Clara University) and Roland Strausz (Humboldt-Universität zu Berlin) study the information flow in organizations consisting of top management and multiple lower subunits, finding that the optimal hierarchical structures and communication systems differ for different organizations.
According to Simon (1973), organizations are “authority mechanisms”, where information flows from the bottom subunits to top management. Often, executives can’t possibly get into the weeds of the day-to-day activities of every subunit, so they rely on this information being summarized and reported to them. If the organization in question is a firm, then management should give different subunits, such as the production and sales divisions, the incentive to report their information correctly to management. For example, the information of the sales team may pertain to the strength of the demand and the information of the production group may concern the productivity of the firm's technology. It is important for management to learn these different pieces of information to make the right decision (when to enter a new market, introduce a new product, update production plans, etc.). There is an important body of literature in the field of industrial organization on how management can use compensation instruments such as salaries, bonuses, and overtime pay for the subunits to motivate the truthful revelation of information.
In this work, the researchers take a different perspective on information and incentives within organizations. They point out that, once the information from all the subunits is aggregated by the headquarters of the organization, its management finds itself in a position where it has an informational advantage over the subunits. Only management has the “big picture” of the organization. As such, the organization may be prone to top management's abuses of its position at the expense of the lower subunits. For instance, even when the sales division reports low consumer interest for the firm’s product offering and the production division reports problems with its production line, a manager keen on entering a new market can still justify this decision by manipulating the different divisions in the organization: by telling the production group that the sales team has reported high demand and telling the sales team that the production group has reported high productivity. In a highly centralized organization, there would be no checks and balances to prevent management from manipulating information in this way.
In order to examine this information manipulation problem, they build a theoretical model based on a principal-agent framework under asymmetric information. They solve the model by using game theoretical techniques.
Analysis of the model starts with the seemingly puzzling observation that availability of such management manipulation is generally harmful for management itself. The different divisions in the firm would be well aware of the manipulation opportunities for management, so they will be more hesitant when reporting the true nature of their own private information. To truthfully report their information, they will require extra guarantees from management in the form of more generous compensation schemes. This is an additional constraint on management, on top of the usual constraints involved in motivating the subunits: the management has to motivate its “future self” to not manipulate the information that it will receive from the subunits.
How can management reassure the different divisions of the organization that it will not manipulate the information received from them? This work identifies different ways that an organization can avoid this manipulation trap and ensure a healthy information flow.
1) Non-responsive organizational structure: A trivial way to commit to not manipulating information would be to ignore its existence. An organization can always be structured to ignore the news received from its subunits. Obviously, the management of such an organization would make many uninformed decisions that it would soon regret. This organizational form should be considered more like a worst-case scenario providing a lower bound on what an organization could achieve.
2) Removing the barriers between different subunits: Management’s ability to manipulate originates from its unique position to observe the big picture within the organization, thanks to the reports received from its subunits. If the reported information is automatically shared with the different divisions of the organization, management would lose this ability. Unfortunately, there is a caveat to this egalitarian treatment of information: allowing for communication channels between different divisions would make it easier for them to "collude" against management for their own benefit.
3) Reducing the allure of manipulation for management: An organization can also counter the manipulation tendencies of its management by artificially increasing the costs of decisions associated with positive news from the subunits. For example, if the entry to a new market would involve transferring large bonuses to different teams within the firm, then management would have less incentive to manipulate the information to advocate such entry.
4) Decentralized organizational structure: Instead of a highly centralized structure where the management aggregates all information at the headquarters, the organization can opt for an informational hierarchy where information is reported from one subunit to the other up until it reaches to top management. This decentralized structure involves some loss of control for the management, but a more effective use of information. We advocate this hierarchical communication structure especially for organizations whose subunits are likely to have high efficiency.
What does this mean for workers?
Manipulability of information may have unexpected winners and losers. As discussed above, management’s ability to manipulate hinders its duty of aggregating the information dispersed within the organization. In other words, management itself is the first victim to its manipulation capabilities. Paradoxically, the consequences of management’s ability to manipulate can be rather beneficial for the foot soldiers within the organization. Workers employed in the subunits of the organization may benefit from higher compensation and other perks that mainly serve as commitment devices to rein in management’s tendency to manipulate. Put differently, a worker may prefer to work for a management team that is known to be capable of manipulation if the price is right, rather than functioning in a manipulation-free environment.
Information within an organization does not mechanically run from its lower divisions to its headquarters. Ensuring its veracity involves not only giving the right incentives to the primary sources of the information, but also motivating the information aggregators not to abuse their informational advantages at the higher echelons of the organization. This suggests that to avoid playing a game of Broken Telephone, managers and employees alike should consider the flow of information in their organization and how their hierarchy may be impacting the accuracy of the final state of the information.
Celik, G., Shin, D. and Strausz, R. (2021). Aggregate information and organizational structures. Journal of Industrial Economics.
Simon, Herbert A. Applying information technology to organization design. Public Administration Review 33.3 (1973), 268-278.