Paul Milgrom

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Paul Milgrom : biography

April 20, 1948 –

Organizational Economics

In the late 1980s, Milgrom began working with John Roberts to apply ideas from game theory and incentive theory to the study of organizations. Early on in this research, they focused on the importance of complementarities in organizational design. Activities in an organization are complementary, or synergistic, when there is a return to coordination. For example, a company that wants to make frequent changes in its production process will benefit from training workers in a flexible manner that allows them to adapt to these changes.

Milgrom and Roberts first came on the ideas and applicability of complements when studying an enriched version of the classic news vendor problem of how to organize production that allowed both make to order after learning demand and make to stock (Milgrom and Roberts, 1988). The problem they formulated turned out to be a convex maximization problem, so the solutions were end points, not interior optima where first derivatives were zero. So the Hicks-Samuelson methods for comparative statics were not applicable. Yet they got rich comparative statics results. This led Milgrom to recall the work of Topkis (1968), particularly Topkis’s theorem, which led to their development and application of complementarity ideas in many spheres. The incorporation of these methods into economics, discussed below, has proved very influential.

In perhaps their most famous paper on organizations, (Milgrom and Roberts, 1990b) Milgrom and Roberts used comparative statics methods to describe the development of "modern manufacturing," characterized by frequent product redesigns and improvements, higher production quality, speedier communication and order processing, smaller batch sizes, and lower inventories. Subsequently, Milgrom and Bengt Holmstrom (1994), used similar methods to identify complementarities in incentive design. They argued that the use of high-intensity performance incentives would be complementary to placing relatively few restrictions on workers and decentralizing asset ownership.

In an influential paper, Milgrom and Roberts (1994) applied the framework of thinking about change of a system of complements to tackle some key issues in organizational economics. They noted that when organizations adapt by changing one element in a complementary system, it can often be the case that performance will degrade. This will make change a hard sell within organizations. Milgrom and Roberts suggested that this is why businesses had been unable to replicate Lincoln Electric’s performance incentive system because the classic piece rate contract was supported by a string of human resource policies (e.g., subjective bonuses, lifetime employment) as well as production management policies (including organizational slack on delivery), and, perhaps most importantly, deep trust between workers and management. Thus, successful replication would require getting all of these elements in place. Milgrom and Roberts used the same theory to forecast the difficulties Japanese businesses would have in adjusting to change in the decade and a half following the recession that began in the early 1990s; a prediction that was borne out by subsequent experience.

In a series of papers, Milgrom studied the problem of lobbying and politicking, or "influence activities" that occur in large organizations. These papers considered models in which employees are affected by post-hiring decisions. When managers have discretion over these decisions, employees have incentives to spend time attempting to influence the outcomes. Since this time could instead be spent on productive tasks, influence activities are costly for the firm. Milgrom shows that firms may limit the discretion of managers in order to avoid these costs (Milgrom, 1988). In a paper with John Roberts, Milgrom also studied a model in which employees have information that is valuable to the decision maker. As a result, allowing some degree of influence is beneficial, but excessive influence is costly. Milgrom and Roberts compare various strategies that firms might use to discourage excessive influence activities, and they show that typically, limiting employees’ access to decision makers and altering decision-making criteria are preferable to the use of explicit financial incentives (Milgrom and Roberts, 1988). In another paper, with Margaret Meyer and Roberts (1992), Milgrom studied the influence costs that arise in multiunit firms. They demonstrate that managers of underperforming units have incentives to exaggerate the prospects of their unit in order to protect their jobs. If the unit were embedded in a firm whose other units were more closely related, there would be a lower threat of layoffs, because reassignment of workers could occur instead. Similarly, if the unit were independent, there would many fewer opportunities to misrepresent its prospects. These arguments help explain why divestitures of underperforming units occur so frequently and why, when such units do not become stand-alone firms, they are often purchased by buyers operating in related lines of business.