Specific and General Knowledge, and Organizational Structure

We analyze how the cost of transfering specific knowledge encourages the decentralization of decision rights and how this decentralization generates the rights assignment and control problems. Ignoring agency problems, assigning decisions rights to individuals who have the decision-relevant knowledge and abilities increases efficiency. Self interest on the part of individual decisionmakers, however, requires a control system to motivate individuals to use their decision rights optimally. A capitalist economy solves the rights assignment and control problems by granting alienable decision rights to individuals. Unlike markets, the decision rights assigned to individuals in organizations seldom include the right to alienate those rights. This inalienabiblity of rights requires organizations to solve the rights assignment and control problems by alternative means. They solve these problems by establishing internal rules of the game that: 1) provide a system for partitioning decision rights among agents in the organization, and 2) create a control system that provides a performance measurement and evaluation system and a reward and punishment system. The inherent inefficiency of organizational control systems as compared to alienability means firms cannot survive unless they provide other offsetting advantages such as economies of scale, scope or riskbearing. © M. C. Jensen and W. H. Meckling, 1990 Contract Economics, Lars Werin and Hans Wijkander, eds. (Blackwell, Oxford 1992), pp. 251-274. also published in Journal of Applied Corporate Finance, Fall 1995, and Foundations of Organizational Strategy, Michael C. Jensen, Harvard University Press, 1998. This document is available on the Social Science Research Network (SSRN) Electronic Library at: http://papers.ssrn.com/ABSTRACT=6658 SPECIFIC AND GENERAL KNOWLEDGE, AND ORGANIZATIONAL STRUCTURE Michael C. Jensen Harvard Business School [email protected]