H

Research Paper No. 461

An Organizational Failures Framework
William G. Ouchi
June, 1978

An Organizational Failures Framework

William G. Ouchi

Graduate School of Business

Stanford University

May 26, 1978

June 19, 1978 (Rev.)

An Organizational Failures Framework

Abstract
The paper begins with an explication of Oliver ~Vi11iamsons
market
failures framework, which describes the conditions under which juarket transactions
will be replaced by formal organizations.

It then applies the central ideas

of that framework to two research traditions within organization theory,

suggesting that they can be understood as an organizational fai1ures~~
framework.

These two traditions, that of humanistic organizational psychology

and of open systems theory, each specify conditions under which formal.organizations will not operate effectively.

The paper then distinguishes between

formal organizations and bureaucracies and points out that it is the bureaucratic form, rather than the device of formal organization, which will fail.
The paper next considers the conditions under which both markets and bureaucracies

will fail and contends that they may be replaced by a third form,

the clan.

The properties of markets, bureaucracies, and clans are compared,

and the conditions for failure of each are briefly reviewed.

The paper con-

cludes that the application of the transaction cost approach and of Williamsons market failures framework enables us to see old issues in some productive new ways.

In order to develop a science of large organizations, we ought to be

able to specify the limits of our theories; that is, the boundaries beyond
which principles of formal organization do not apply.

In recent years, there

has been a flowering of research which details the internal relationships between structural properties of organizations as well as a good deal of empirical evidence linking these endogenous variables to the, exogenous variables
of environment, technology, ownership, politics, and other classes of variables.
As our understanding of organizational relationships has deepened, however,
we have seen also that formal organizations fail to achieve an efficient allocation of effort, under a variety of circumstances: when environments or technologies are complex or rapidly changing, when interpersonal relationships
become authoritarian, when objectives are mutually incompatible. In this
paper, I will attempt to specify the first outlines of a framework of organizational failures, that is, to describe the conditions under which formal
1
organizations do not provide effective coordination of human effort.
The paper begins with a brief explication of the market failures framework developed by Oliver Williamson (1975).

This framework describes the

conditions under which market forces fail to bring about an efficient allocation
of resources and will be replaced by formal organizations as the medium of
exchange

Borrowing the central variables of this framework, we next eon-

sider two apparently disparate research traditions within the field of organizational behavior, both of which specify conditions for the failure of formal
organizations

The first and oldest of these is the humanistic point of view,

The idea for this paper came in the form of a challenge from Professor
Williamson at a conference of the Stanford University Organizational Re-.
search Training Program, sponsored by the firm of Booz, Allen ~ Hamilton,
Inc.
I am indebted to Peter M. Blau, John W, Meyer, WilliamE. Moffat,
and Jerry I. Porras for their helpful comments.

-2which has long contended that formal organizations are ineffective under
conditions which undermine trust or which foster dependency between people.
The second and more recent is the line of research which began as open
systems theory and has evolved into a loose coupling point of view, arguing that environmental forces may create conditions which will differentiate
formal organizations to the point of atomization.

We will next see that both

of these apparently disparate points of view contend that formal organizations

will fail under similar circiunstances, in fact the same circumstances which
bring about market failure.

We next observe that both markets and formal

organizations fail when their essential properties of explicit, external

control cannot operate, and that they will be replaced under these circumstances by alternative forms of organized exchange which depend instead on
implicit, internalized forms of control, such as professions and clans.
Finally, we set forth some general conditions under which it is reasonable
to expect the successful operation of each of these alternative mechanisms
of social control: market, bureaucracy, and clan.

THE MARKET FAILURES FRAMEWORK

In the beginning, there were markets~ Each man and each woman was endowed with different skills, so they agreed upon a division of labor inwhich
each used his or her talents to best advantage.
others labors, they exchanged.

Needing the fruits of each

Because they trusted each other and because

that trust was rarely abused, exchange took place simply, without contracts,
lawyers, or auditors.

Then they ate the forbidden fruit, and uncertainty en-

tered their eden accompanied by opportunism; and lying, cheating, and stealing
became commonplace.3

Soon exchange could occur between two people only with

2 As a matter of social history, markets probably are not the oldest form
of exchange. However, it will be helpful here to consider first a fic-.
tional world in which only market forms of exchange exist.
Williamson assumes that opportunism, that is, the inclination to further ones
self interest even through lying, cheating, and stealing, is a universal
human characteristic. Although we may dispute this claim, the issue may not
alter the analysis in this paper. Hopefully, a later study will clearly esttablish the implications of this assumption for the market failures paradigm

-3the protection of iron-clad contracts, lengthy specifications of obligations,

accounting for all possible contingencies of an uncertain future, and extensive auditing of performance.

These new costs of completing a transaction

finally became so burdensome that markets failed, each worker instead entering into an employment relation with a corporation.

These corporations ex-

changed daily wages for the right to specify each persons output each day,
thus doing away with the need for extensive contracts which allow for future
contingencies in an uncertain and complex world, and the corporations appointed
a hierarchy of officers to give these work orders and to closely audit the
performance of each employee.

They were thus banished from paradise into the

purgatory of formal, bureaucratized organizations, and there they suffered

for the rest of their mortal lives.

That, in an allegorical nutshell, is what the new institutional economics

is about, at least as embodied in the work of Oliver Williamson (1975).,

The

only difference is that, in Williamsons view, it is markets that offer the

purgatory of inefficient exchange, and it is hierarchies which come to the
rescue, solving the problems of exchange under conditions of uncertainty and
opportunism.

As students of organizations, of course, we can be expected to

insist that it is we who have the rightful claim to purgatory, and we can
document the many ways in which organizations fail.

But let us first consider

the market failures framework in more detail.

In order to comprehend the paradigm, it is helpful to conceive of market
transactions, or exchanges, as consisting of contractual relationships.

Each

exchange is governed by one of three types of contractual relations, all of

which have the property of being completely specified.

That is, in a con-

tractual relationship, nothing is left to the imagination: because each party

is bound only to deliver that which is specified, the contract must specify
everything about the exchange, including who must dcl iver what under every

-4possible future state of nature.

spot or sales contract.

The simplest form of contract is the

This is what occurs when you walk up to the candy

counter, asking for a candy bar, and pay your 25*.

In such a transaction,

all obligations are fulfilled on the spot, there is money exchanged for candy
now, and there are no future ramifications of the exchange.

Spot contracts

are simple, and all exchange could occur through this medium without burdensome
costs of the transaction.

However, the spot market contract is,by definition,

incapable of dealing with future transactions, and most exchange relationshits involve such long-term obligations, thus ruling out the possibility of
transacting all exchange through this device.
In order to deal with the future, a common device is the contingent claims
contract, a document which specifies, again completely, the obligations of
each party to an exchange, contingent upon all possible future states of nature.
Now, if we could write really complete contingent claims contracts, then all
exchange could take place through this medium.

However, it is simple to demon-

strate that, given a future that is either complex or uncertain, the task of
completely specifying such a contract becomes infeasible, due to the bounded
rationality of individuals.

To leave such a contract incompletely specified

is an alternative, but one that will succeed only if each party can trust the
other to interpret the uncertain future in a manner that is acceptable to him.
Thus, given uncertainty, bounded rationality, and opportunism, contingent
claims contracting will fail.
Now, it would seem that it is unnecessary to deal with the future all at
once by anticipating

it

in one, giant, once-and-for-all contract

Why not

instead employ a series of contracts, each one written for a short period of
time withinwhich future events can confidently be foreseen, thus overcoming
the obstacle of uncertainty and opportunism and permitting sequential spot
contracting, another complete form?

The problem is that, in many exchange

5relationships, the goods or services exchanged are of a somewhat unique nature

(in the case of commodities, such as newsprint, lead pipe, or transistors, they
are not unique) and the supplier requires somewhat specialized knowledge of
how best and most efficiently to supply the customer.

Under these conditions,

the supplier learns over time to be more efficient, and this specialized
knowledge gives him a first mover advantage.

This advantage enables him to

bid more effectively on subsequent contracts than can any potential competitor.
The potential competitors, knowing this, will not waste their time bidding,
thus producing a situation of small numbers bargaining, or bilateral monopoly,
in which there is only one buyer and only one seller.

Under this condition,

the competitive pressures which result in fair prices are absent, and each
party will make opportunistic claims to the other, dishonestly claiming higher
costs or poor quality, whichever is in his selfish interest.

In order to

maintain such an exchange, each party will have to go to considerable expense

to provide adequate audits of the true expenses or performance of the other.
Thus the market relationship will fail, due to the confluence of opportunism
(

with small numbers bargaining, even though the limitations of uncertainty and
bounded rationality have been overcome.
Thus, under some conditions no form of market relationship, of complete
contracting, is feasible.

Table 1 summarizes the conditions which lead to

market failure.

Table 1 About Here

According to the paradigm, no one of the four conditions alone is sufficient
to produce market failure, but almost any pairing of them will do so (the main
pairings are linked with arrows).

It is Williamsons contention that the use

of formal organization (Hierarchy, or internal organization, in his language)

will overcome the shortcomings of market exchange, although he devotes some

-6attention to the shortcomings of formal organizations.

The translation from microeconomics to organization theory is complicated because most microeconomists, including Williamson, do not distinguish between formal organizations, organizations, or bureaucracy.

We

will take up this distinction later in the paper.

The formal organization has two principal advantages over the market
relationship which enable it to function effectively despite bounded rationality, uncertainty/complexity, opportunism, and small numbers bargaining.
First, the formal organization makes use of the employment relation, which is
an incomplete contract.

Although Williamson does not make this exact argu-

ment, we can see that the employment relation is critical due to its use of
legitimate authority.

In accepting an employment relation, a worker agrees

to receive wages in exchange for submitting to the legitimate right of the

organization to appoint superior officers who can:

1) direct the work activi-

ties of the employee from day to day (within some domain or zone of indifference), thus overcoming the problem of dealing with the future all at once;
2) closely monitor the performance of the employee, thus minimizing the problem of opportunism, even though the job may be relatively unique and thus
subject to small numbers bargaining difficulties.

An organizational superior

can monitor the performance of a subordinate much more closely and effortlessly than a customer can audit a supplier in a market relationship.
The second advantage of the formal organization is that it can create an
atmosphere of trust between employees much more readily than the parties to
a market can do so.

Because members of an organization have cause to assume

some commonality of purpose, because they associate,with each other over ,a

long period of time, and because they learn that these long-term relationships will reward good performance and punish poor performance, they develop
trusting attitudes which reduce opportunistic tcndcru. us, thu

ilso rductng

-7-

the need for monitoring of performance.

In summary, the market failures

framework argues that markets fail

when the costs of completing transactions

the inefficiencies

become

unbearable.

At that point,

of formal organization will be preferred to the relatively

greater costs of market transactions, and exchange relationships move from

the one domain into the other.

Although we do not have space to fully con-

sider the argument here, Williamson argues that the transactional efficiency
of formal organization is its only reason for existence.

He contends quite

convincingly that previous arguments to the effect that technological indivisibilities or efficiencies require corporate forms can be shown to be unconvincing.

For one brief example, he argues that steel mills could easily be

owned by cooperatives just as grain silos are, with each step in the production process of steel contracted for by individual owner-worker entrepreneurs.
In this case, the steel industry would consist of hundreds of thousands of
independent entrepreneurs, each performing one small piece of the production
process.

Their transactions with each other would be governed through millions

of individual contracts, each requiring extensive specification and performance

auditing.

The technology provides no imperative to suggest formal organiza-

tions in the steel industry.

On the other hand, the interdependence between

each step in the steelmaking process is so great that the cost of separating
out performance information in a manner that would permit mutually acceptable
attributions of cost and profit would be prohibitive.

Thus, it is again the

reason of minimizing transactions costs that causes steel making to take place
in integrated, formal organizations.

In Williamsons terms, there is no

technological imperative save the indirect effects that technology has on

organizational form through its impact on the costs of information.

-8-

Williamson has provided an integrated view with a small number of concepts with which we can explain a great deal of organization theory.

He en-

ables us to see quite clearly the conditions under which markets fail and, by
the same token, the conditions which formal organizations must fulfill in
order to succeed.

In particular his market failures framework focuses our

attention on the critical nature of explicit performance evaluation and of

trust in combatting opportunism and on the critical nature of legitimate authority in hierarchies for the dual purposes of dealing with uncertainty and of
facilitating evaluation.

We will next apply these central ideas to some of

the literature of organization theory, demonstrating that it can be cast into

an analogous organizational failures framework.

ORGANIZATIONAL FAILURES:

THE HUMANISTIC POINT OF VIEW

Humanistic social psychologists have long argued that formal organizations

will fail under a variety of circumstances: when workers are placed in a dependent state which denies them the possibility of psychological success (Argyris,
1964) when lack of trust between employees distorts cooperation and communication (Likert, 1967), when jobs are specialized to the point of de-humanization (Mayo, 1945), when control is based exclusively on following a set of
rules (Bennis, 1966).

While it is risky for any one person to pretend to

understand the central ideas which underlie so complex a body of knowledge,

it may be that, with the market failures framework as a foil, we can indeed
see more clearly the central tenets of humanistic organizational psychology.
Organizations will succeed to the extent that they are able to motivate
their employees, to release their potential energy and creativity (Maslow, 1954).

In order to do so, they must create working conditions under which people
are able to pursue internally-generated objectives, to experience independence
(Argyris, 1964).

In order for a superior to give subordinates this much free-

dom, he must adopt a trusting attitude towards them, he must hold fundamental
beliefs about human nature which predispose him to give them psychological
independence from his direction and control (McGregor, 1960).

A critical

element of trust, however, is the firm belief that, left to specify their
own objectives, subordinates will choose to pursue objectives which are harmonious with the efficiency objectives of the firm.

However, the interests of indi-

viduals are necessarily different from the goals of the firm, with the result
that such trust is unwarranted and will not develop (Udy, 1962).

Under some

conditions, the adoption of a trusting attitude by management may engender

more compliant attitudes and willing cooperation by subordinates, but this
is rare (Mayo, 1945).
More commonly, modern organizations adopt the attitude that workers are
not to be trusted, that they will willingly lie, cheat, and steal.

Thus the

organization employs a variety of devices which have the sole objective of

closely monitoring not only output but also work behavior, controlling every
action, rewarding desired performance and punishing undesired performance.

To

further this end, jobs are specialized and simplified to the point that each
job can be quickly learned and easily monitored, thus reducing the uniqueness
and thus the bargaining power of each job holder while increasing the auditing capabilities of the organization (McGregor, 1960).

However, these

changes also, have the effect of creating psychologically unsatisfying jobs.

Workers, denied the possibility of psychological growth in their work, be-

come emotionally disabled, manifesting lower levels of motivation and of

energy not only in their work but in many areas of life (Argyris, 1964).
organization, denied the willing cooperation of its employecs, becomes a
battleground and has diminished powers of coordinition

The

-10This unhappy condition is a direct result of the industrialization of

our civilization over a relatively short period of time (Durkheim, 1933: 353373).

In traditional societies, it was indeed true that individual interests

meshed with the interests of the firm, and explicit monitoring and external
control were not necessary.

In those traditional settings, new employees were

typically taken into a firm through an apprenticeship which gave them not
only the technical skills of their craft but also imbued them with the underlying values and beliefs which characterized the group they were entering,.
A work relationship typically extended over a lifetime and even across generations, thus allowing forvery complete merging of individual and organizational
interests (Mayo, 1945).
It may be that opportunism is nothing more or less than incompatibility
of objectives between employee and employer.

When socialization is complete,

an employee who behaves selfishly is contributing to achievement of the objectives of the organization and thus will have no incentives to lie, cheat,
or steal.

When socialization is incomplete, then selfish behavior will be in-

compatible with organizational goals, and thus will be viewed as opportunistic,

and the employee will frequently be tempted to lie, cheat, and steal in order
to accomplish his personal objectives, which diverge from those of the organization.

If modern industrialization does in fact lead to such instability

of employment that socialization is rarely complete (it does not always have
that result, see Ouchi ~ Johnson, 1978), then we can expect opportunism to
be characteristic of most employees.
Now, if I have not done too much violence to the subtletiesof the humanists, we can observe that their organizational failures framework not only

H1

fits but also illuminates Williamsons market failures framework.

The human-

ists have argued, just as Williamson has, that formal organizations can employ
one of two essential mechanisms of control: either they can build up interpersonal trust, thus reducing the danger of opportunism, or else they can closcly

11
monitor performance, thus suppress:ing opportun:ism.

However, we see in the

work of the humanists that these two sty1cs~ofmanaging are directly opposed,
a point which is unclear in the market failures framework.

If we follow

Mayo, we furthermore doubt that the fundamental cond:itions necessary for

the creation of a unity of objectives and values between the members of a
firm can be achieved.

The best that he hopes for is the creation of cohesive

sub-groups within the organization, a device which may bring about psychological protection, but which we can expect to lead to greater needs for control and auditing, as each group now defends its members as they seek to
pursue their common group objectives which may differ from the firms objectives.

(Likerts link-.pin design is one mechanism for coordinating these

differential groups, 1967.)

A great weakness of the humanistic school has been that it cannot point
to an empirical example of organizational failure in the manner that an economist
can point to many examples of market failure.

That is, organizations may

indeed fail psychologically, but,that apparently does not lead to their going
out of business.

An organization which fails to build trust can, according

to the humanists as well as the economists, continue to do business effectively

by relying upon close monitoring of performance.

Put in this form, however,

the argument suggests an explanation for the economic success of firms which
have failed psychologically: the costs of psychological failure are not borne
entirely by the firm, but rather are externalized to the society generally.
That is, employees who reach the point of emotional disability, who become
unsatisfactory workers, are the first to be laid off during depressions or,
in extreme cases, are fired.

The firm which has used up people emotionally

does not have to face the cost of restoring them.

In much the same manner

that firms were able until recently to pollute the a I r and the water without.
paying the costs of using up these resources,

they continue to he able to

pollute our mental health with impunity (Likert, 1967).

12
If we accept this notion of psychological health as an externality,
we then have a consistent view of organizational failure derived from the
humanistic point of view:

An organization will govern exchange relation-

ships more effectively than will a market only if it fosters interpersonal

trust.

Trust will bring about psychological energy and maximum motivation

and productivity, and it will moderate the effects of opportunism.

Therefore,

the organization will be capable of complex transactions without incurring

high costs of monitoring these transactions.

Moreover, a climate of trust

will enlarge the zone of indifference within which each employee allows his
or her activities to be specified, thus further improving the firms ability
to adapt to an uncertain future without pre-specifying obligations in a complete fashion.

Under conditions of industrial instability, the commonality

of interests which is essential to trust will fail to develop.

Organizations

lose most of their advantages over markets under such conditions, and many
organizations without trust could be expected to fail.

However, organiza-

tions are capable in our society of resorting to close monitoring, punish ment, and specialization which will permit them to survive as long as they
do not have to pay the costs of the psychological damage which they create
under this mode of control.

Ultimately, however, we can expect that a society

which has conferred legitimate power upon work organizations will withdraw
at least some of that power if abuses are perceived to be both widespread
and severe (Parsons and Shils, 1951).

It can be argued that just such

a development has been occurring in Western Europe since 1952, when codetermination was adopted in German industry.

In Sweden, Norway, West

Germany, Italy, and France, the former authority of management to hire, fire,
supervise, and promote has been greatly abridged through legal and political
action (Roberts et. al., 1978).

Thus organizational failure, from the

humanistic point of view, is a very present reality.

-13Not all formal organizations adopt this form; it is not inevitable

that formal organizations will lose their capacity for interpersonal trust.
Just as the market failures framework specifies the conditions under which
markets cannot operate efficiently, however, this humanistic organizational
failures framework specifies the conditions under which formal organizations
cannot operate efficiently.
ORGANIZATIONAL FAILURES:

OPEN SYSTEMS AND LOOSE COUPLING

A newer and quite different perspective argues that certain environmental

conditions can bring about the failure of formal organizations.

While this

school of thought is very much in the early stages of development and can be
expected to change, it appears to fit quite comfortably into an organizational
failures framework.
The critical idea is that organizations are systems which are open to
their environments and that the internal structure of organizations is, in
large measure, shaped by the demands of the environment (Katz and Kahn, 1966).
The environment is now seen explicitly not as a simple, homogeneous force
which acts on the organization, but rather as a turbulent field which presents
the organization with a great dealof uncertainty (Emery and Trist, 1965;
Terreberry, 1968; Duncan, 1972).

The principal mode of uncertainty re-

duction used by organizations is specialization of sub-units.

It has

been demonstrated that, given a complex and turbulent environment, the

more successful organizations will allow their subunits to differentiate

to a great extent so that each subunit develops special skills at monitoring- anticipating, and even to some extent controlling that environment
uncertainty (Lawrence and Lorsch, 1967).

The problem is that, given

an environment of sufficient uncertainty and complexity, the degree of

requisite internal differentiation may be so great that the subunits

-14lose their capacity for coordinated effort.

As each subunit gets closer to

its particular critical environment, whether that be the drugstore market,

the financial community, or the solid-state physicists, it develops a language, a point of view, indeed a culture which enables it to better cope~
with that critical relationship. However, if each segment of the environment
facing a single organization is quite different from the others, then the
internal units will become so highly differentiated that they no longer have
a commonality of interests nor an agreement on basic ways of doing things.
At this point, the organization will fail.
Indeed, it has been observed that the metaphors of loose coupling.,
(Weick, 1976) and of nearly decomposable organizations (Simon, 1962) accurately capture the state of many organizations.
boundary of failure.

These organizations are, at the

They exhibit such loose internal connections that the

capacity of the whole to conduct transactions between its partsis severely

diminished.

In particular, studies have demonstrated that hospitals (Becker

and Gordon, 1966) and school systems (Dornbusch and Scott, 1975; Weick, 1976;
Meyer ,and Rowan, 1977) exhibit such loose internal coupling that they are
effectively non-organized

Stinchcombe (1959) has noted that the environmental

uncertainty facing construction companies is so great that they are unable

to employ tightly coupled bureaucratic control and instead rely upon the,
professionalism of the craftsman to control his work activity.
In these extreme cases, we observe two interesting phenomena.

First, ob-

jective or real attempts at direction, evaluation, and control are almOst

completely absent and are replaced with common belief in a set of underlying
values or objectives which all organizational members share.

The actual

progress towards these objectives cannot be measured, in part because each subunit disagrees on just what constitutes movement towards better health care
or schooling, for example.

Instead, these underlying values are maintained

-15through an elaborate set of rituals and ceremonies which have the effect of
,perpetuating an organizational myth,

socially constructed understanding

of purpose and objective to which all can comfortably subscribe (Meyer and
Rowan, 1977).

It has been argued that this effect extends to the most

microscopic levels of organizations, governing even the linking together of

workers and jobs in a manner which permits objectively opposed partiesto
work in harmony (Salancik and Pfeffer, 1978).
The second interesting phenomenon is that loose coupling studies

have centered on schools and hospitals, both of which are highly professional
ized bureaucracies.

Indeed, we may expect that beyond the boundary of organi-

zational failure what we will see as a mechanism of control is the emergence

of professions.

Rather than adopting the traditional view of professionisas

growing out of a movement of skilled and privileged persons into the higher
and more desirable levels of a social structure (see, for example, Ben-David,
1966), we can profitably view them as mechanisms for governing exchange under
conditions of organizational failure.

This comparison will be useful, at

a later point in this paper, as a means of understanding the critical elements

of formal organizations as a mechanism of efficient exchange.
More recently, the loose coupling point of view has begun to evolve into
an ecological paradigm.

This point of view argues that organizational sub-

units will evolve structures which are isomorphic with the micro-environments
which they face (Hannan and Freeman, 1977).

Furthermore, if we accept the

argument that environmental adaptation is necessary to organizational survival,

then it appears that subunits should be as loosely coupled as possible,, so
that each subunit can adapt easily to its own unique micro-environment without
the necessity of simultaneously adapting to the needs of other subunits
(Aldrich, 1972).

The problem, of course, is that this process will lead to

increasing internal differentiation with a consequent decline in the firms

capacity for developing either a commonality of interests which can reduce

-16opportunism or the development of internally comparable techniques of monitoring performance.

A second branch of the loose coupling school is older hut has until
recently been misunderstood.

Parsons (1960) argued that, because, the insti-

tutional, the managerial, and the technical levels of a hierarchy each pursue different tasks and deal with different environments, they retain little
capacity for effective vertical communication, they have little commonality
of interest, and they are capable of little effective performance auditing.
Until recently, that point of view has been regarded as but one more example
of the dysfunctions of bureaucracy and lumped with similar descriptions by
Merton (1957) and by Mechanic (1962).

More recently, however, we have seen

a flurry of studies which have quite convincingly demonstrated that vertical

control-loss is a common property of organizations, both in the private and
the public sectors.

Ouchi and Wilkins (1978) have summarized these arguments

and evidence.
What emerges is at first glance a quite different view of the causes of
organizational failure.

The pull of environmental forces can be so great

that, in order to survive, organizations must allow each subunit to match itself quite exactly to its own micro-environment.

That adapti,ve process will

lead ultimately to such an extreme differentiation between subunits, 1)0th

vertically and horizontally, that they will lose their capacity for coordination, and organizational failure will result
However, we can easily accommodate that line of argument within the concepts of Williamsons market failures paradigm

Organizations must permit

subunits to adapt to local ecological demands in order to cope with environmental uncertainty.

However, as they do so, they develop differentiated,ob-

jectives, standards of performance, and underlying values.

This leads to

heterogeneity of interests, which undermines trust and thus gives rise to

opportunistic behavior

In extreme circumstances, the option ot close per-

formance auditing is also lost because the parties cannot agree even on what

-17constitutes acceptable performance.

Under this condition, organizations

fail, perhaps to be replaced by professions or by communities linked through

their own fabricated social reality.
MARKETS AND BUREAUCRACIES
We began with the contention that when markets fail, they will be replaced by organizations, which have superior monitoring capabilities, greater
flexibility for dealing with uncertainty, and a greater capacity for creating
trust.

We have concluded, however, that while formal organizations may be

superior to markets in contending with informational ambiguity, they may cease

to function effectively as these conditions become more extreme.

Formal

~organizationsare eventually disrupted by the same forces which overcome markets.

What happens when both markets and bureaucracies fail?

Before we can answer this question, we must more clearly define just

what we mean by bureaucracy or formal organization.

The two terms have

come to be synomymous in the language of organization theorists; most of us

would be hard put to describe a formal organization which is non-bureaucratic.
But the distinction between a large organization formally constituted for ,the
purpose of achieving some objective ought to be kept separate from that of
a bureaucratic organization (Kimberly, 1976).

Let us limit the meaning

of bureaucratic to include only that form of organizational control

explicitly described by Weber (1947) and elaborated by Blau and Scott
(1962), Hall (1963), and others.

The essence of bureaucratic organi-

zation, in terms of our discussion, is that it provides for a system

of close monitoring which will protect against the many deleterious
effects of opportunism.

The use of specialized careers, the formaliza-

tion of rules and procedures and of evaluation, the preservation of an

impersonal attitude, and the rule of promotion based only on seniority and
merit, all are methods for enhancing the auditing capabilities of organizations.

-18The bureaucratic control mechanism assumes opportunistic tendencies in

individuals and relies largely

on external evaluation and on external reward

and punishment~ Given this understanding of the bureaucratic mechanism, it

is no:wonder that the humanists have found it to be psychologically damaging
nor that they have had little success at reforming it in theirmold.
Now, all large, formal organizations are not confined to being bureacracies.

We have already noted that some of them are highly professionalized,

relying for control on the internalization of values rather than on external

control.

Williamson (1975) also notes, as have many other economists, that

large, formal organizations may operate in part as internal markets.

In such

organizations, a great deal of effort goes into establishing fair prices

which can be used to govern internal transactions, thus doing away with the
need for auditing at a close level.

Indeed, Williamson argues that close audit-

ing of behavior or decision-making in a profit or investment center environment will vitiate the effectiveness of control (1975:148-150).
If price information is relatively costless, then we can expect exchange
to be governed by markets, with no formal organizations of any sort existing.
If there is some ambiguity present concerning what prices are correct, then
we can expect to see formal organizations which combine some market features
with some bureaucratic features.

If the ambiguity is so great that the fix-

ing of prices is very expensive, then we can expect to see formal organizations organized as bureaucracies, with no internal market mechanisms at work.
Finally, if the ambiguity becomes greater still, we have argued that even
bureaucratic organizations will fail.
The key issue here is the ability to explicitly measure performance.
A market has the most highly refined measures of performance (output, in
this case), reflect in its price mechanism.

The price, in a perfect market,

However, Merton (1957) has observed that goal displacement occurs in

bureaucracies when rule-following norms are thoroughly socialized into
employees. This problem may be regarded as the result of bureaucratic failure to inculcate more fundamental values and beliefs in employees.

-19reflects exactly the value of the good to its most efficient user.

bureaucracy does not require such highly refined external evaluation of value.
Instead, it relies upon the ability to judge whether an individuals performance has satisfied a rule, either a rule which specifies behaviorthat
is acceptable or a rule which specifies a level of output which is acceptable.
Note that an output rule, although quantitatively expressed, differs from
a price.

An actor in a market can make ev,ery decision which faces him based

only on knowing prices.

An actor in a bureaucracy cannot make every decision

properly by knowing the rules, first because there may be too many rules to
guarantee complete knowledge of them, but more basically because an organization can never specify a set of rules so complete that every conceivable contingency is covered.
The difficulty caused by increasing ambiguity of evaluation is that,
in some cases, the desired behavior or outputs are so new, so complex, or
so ambiguous that even a bureaucratic specification of evaluation criteria
is impossible.

For example, prices are inconceivable as the mechanism for

governing the transactions which take place in a research laboratory. Each,

activity is unique and its value difficult to assess, so that prices cannot
be set.

However, in this case the ambiguity is so great that even bureau-

cratic mechanisms cannot b,e specified.

In essence, no form of external evalu-

ation is possible, so great is the ambiguity concerning performance (e.g.,

the value to the organization of various outcomes or behaviors).
When explicit, external evaluation becomes impossible, then the only

form of control remaining is through internal processes.

Thus we observe

in the research laboratory a highly professionalized staff of persons who

have gone through a long period of socialization which guarantees that,
left to their own devices, they will pursue objectives which are acceptable
to the organization

But these forms of internal control are not limited

-20to the professions (Schein, 1971).

There may in addition be other forms

of socialization which are unique to the organization and which provide a

similar internalized form of control.

Lipset, Trow and Coleman (1956)

described such an acculturation process in the International Typesetters

Union, Clark (1970) has called that effect in colleges an organizational
saga, and Ouchi and Johnson (1978) have described in Type Z organization
which relies heavily on acculturation as a mode of control.

Of course, a

wealth of other studies has treated this phenomenon as the informal organization which had demonstrably effective control properties through socialization, although often in a direction which is inimical to the interests
of the organization.

These studies, too, have been relegated to the category

of bureaucratic dysfunctions and have been undervalued by most of us.,

This last mechanism for governing transactions, which depends upon
internalization of organizational objectives by each employee, we will refer
to as the clan.
of control.

Clans rely entirely on internal motivation as their means

Either by selecting pre-socialized members (as a medical clinic

does in hiring only medical school graduates as physicians; Mertons anticipatory socialization, 1957) or by extensively socializing neophytes (as
a police force or a hospital does; Van Maanen, 1975; Feldman, 1976), the
clan assures itself of a set ,of employees who desire to achieve goals which
are congruent with those of the organization.

The clan has the great

strength of being able to operate under conditions of almost limitless ambiguity oncerning the true performance of members.

It achieves control over

members by influencing their objectives, their values, and their beliefs

(see Van Maanen and Schein, 1978) and therefore can ,bring about fair transactions with very limited ability to audit outcomes.

In a pure (but

unattainable) clan, opportunism will not exist; no member will have the
slightest desire to exhibit behavior which is contrary to the interests of

21
other employees or of the firm (Kanter, 1968).

Perhaps it was this situa-

tion, rather than the pure market situation, which characterized eden.

pure clan, like a perfect market, requires no monitoring, no managers,

and provides perfect decisions which lead to a maximization of the welfare
of all.
Although Mayo (1945) emphasized the great stability of organizational
membership that is necessary for complete socialization to occur, Van Maanen
(1975) has shown that a great,deal of socialization can occur within four
months, at least within a police department, which may be relatively more
inclusive (Weick, 1969) than most organizations.

Katz (1978) has also demon-

strated that a great deal of orientation and socialization occurs during the
first few months of employment.

Whether socialization on the relevant dimen-

sions is rapid or slow, it probably rarely achieves the kind of completeness

necessary for it to serve as the sole mechanism of organizational control.
Under conditions of great instability of employment, socialization processes
may be so severely disrupted that the clan will fail.
The very stability and homogeneity required by clans may also bring
about failure.

Total institutions are notoriously hostile to deviantpoints

of view, including those which may represent necessary adaptation to achanging environment.

The internal culture may develop in a manner which is inimi-

cal tO the accomplishment of organizational tasks (see Van Maanen, 1975 for
a striking example), and full acceptance of unusual novices, such as women and
ethnic minorities (Kanter,, 1977) may be especially slow in clan organizations.
MARKETS, BUREAUCRACIES, AND CLANS

In fact, we hav,e now derived not two but three social mechanisms which
can bring about an efficient process of exchange.
simply, as in Table 2.

These can be snmmari zed

-22-

Table 2 About Here

In Table 2, we can discriminate between markets, bureaucracies, and
clans along two dimensions, their underlying normative and informational
prerequisites.

Let us consider each of the dimensions in turn.

The normative requirements here refer to the basic social agreements which
all members of the transactional network must share if it is to function
efficiently, that is, without undue costs of performance auditing or monitoring.

If these minimum social agreements are not present, the mechanism

will fail.

A norm of reciprocity, according to Gouldner (1961) is one of

only two social agreements which has been found to he universal among societies across time and cultures (the other is the incest taboo).

A norm of

reciprocity, protected by the foreknowledge th,at violations will be subject

to severe punishment, provides the minimum protection against opportunism
without which exchange is impossible.

If there were no such widely shared

norm, then a potential trader (say, of fish for boats) would have to consume
so much energy in setting in advance the contractual terms of exchange and
in afterwards auditing the performance of the other party and, where disagreements occur, seeking an acceptable third party to adjudicate, that the costs
of the potential transaction would become unbearable.

Under such conditions,

a division of labor is unthinkable and social existcnce impossible

ihere-

fore, a norm of reciprocity underlies all exchange mechanisms.

A norm of legitimate authority, as discussed above, is critical for two
reasons.

In the first place, it permits the assignment of organizational su-

periors who can, on an ad hoc basis, specify the work assignments of subordinates,
thus obviating the need for a contingent claims employment contract which would be

-23-

either so complex as to be infeasible to write or, i.f it were simple, either so

confining as to seriously hamper the effectiveness of the organization or CIsc
so incomplete as to lead to many disagreements.

In the second place, legiti-

mate authority permits organizational superiors to closely audit the performance of subordinates in a way that is impossible within a market relationship.

In a bureaucracy, legitimate authority will commonly take the rational/

legal form, whereas in clan, it may more commonly take the traditional
form(see Blau and Scott, 1962:27-38). Legitimate authority is not ordinarily
created within the organization but is maintained by other institutions such
as the church and the educational system (Weber, 1947; Blau and Scott, 1962;
Barnard, 1968: 161-184).

While the legitimacy of a particular organization

may be greater or smaller as a result of its managerial practices, it is fundamentally maintained or lost within a society generally.
Common values and beliefs provide the harmony of interests which erase
the possibility of opportunistic behavior.

If all members of the organiza-

tion have been exposed to a long apprenticeship or other socialization period,

then they will share basic, underlying personal goals which are compatible
with the goals of the organization.

In this condition, auditing of performance

is unnecessary except for educational purposes, since no one will attempt on

his or her own topurposely depart from organizational goals.
Taken in order of their scarcity, we can guess that a norm of reciprocity
is universal, that legitimate authority is accepted in most formal organizations,
and that common values and beliefs are relatively rare in formal organizations.
Thus the normative prerequisite for a market mechanism is present in every
society.

The idea of legitimate authority is present in most societies but

can vary widely between organizations in its degree of acceptance;

The human-

ists have often contended that authoritarian management will weaken the

-24legitimacy ascribed to an organizations authority, thus narrowing the

zone of indifference within which tasks can be reordered.

Commonality of

values and of beliefs about how to maximize those values appears to be

relatively uncommon in formal organizations.

Etzioni (1965) has described

this form of control as being common only to total organizations such as~
the military and mental hospitals.

Light (1972) describes its role in ethni-

,cally bound exchange relationships.

However, we have also noted that an in-

complete form of socialization may be effective (accompanied by market or

bureaucratic mechanisms) across a wider range of organizations.

Mayo (1945)

contended that instability of employment,, which upsets the long socialization

period necessary, is the chief enemy of the development of this form of
control.
As for the informational prerequisites of each form of control, we have
already noted many differences between prices and rules, although we have
not explicitly discussed traditions.

Prices are a highly sophisticated form

of information; they provide sufficient information for decision making in

any case.

However, correct prices are difficult to arrive at,

particularly

when technological interdependence, novelty, or other forms of ambiguity are

present to obscure the boundary between tasks or between individuals.
comparison, are relatively crude informatiomial devices.

Rules, by

A rule is specific

to a problem, and therefore a large number of rules is necessary to control

organizational responses.

A decision maker must know the complete setof

rules in order to be assured of applying the correct one in any given situation, which is virtually impossible and thus will lead to errors in decision
making.

Moreover, an organization can never specify acomplete set of rules

to cover all possible contingencies.

Instead, it specifies a much smaller set

of rules which effectively covers the most routine decisions.

f:xceptions are

25-

referred,up the hierarchy where policy-makers can invent rules as needed.

As Galbraith (1973) has pointed out, under conditions of uncertainty or complexity, the number of exceptions will become so great that the hierarchy
becomes overloaded, and the quality of decision-making suffers.
Traditions may be viewed as either more or less refined than prices and
rules.

Traditions are the set of rules which are implicit rather than ex-

plicit and which govern behavior.

Because traditions are not written down

in an organized fashion, they are not easily accessible to neophytes, and a

new member will not be able to function effectively until he or she has spent
a number of years learning the traditions (Van Maanen and Schein, 1978).

In

terms of the precision of performance evaluation which they permit, traditions

may be the crudest of the three.

A tradition is ordinarily stated in a general

way which must be interpreted in order to apply to any particular situation.

On the other hand, the collective set of traditions in a formal organization
may produce a unified, although implicit philosophy or point of view.

If

such a unified view exists, then it may be functionally equivalent to a

~theoryabout how that organization should work.

Clearly, a member who grasps

such an essential theory can then deduce from i.t an appropriate rule to
govern any possible decision, thus producing a very elegant and complete form
of control.

Equally clearly, a disruption of the socialization process will

inhibit the passing on of traditions and will bring about organizational

failure.
OUTLINES OF A GENERAL ORGANIZATIONAL FAILURES FRAMEWORK
Now we can summarize the condit,ions of organizational failure in a
general way.

Interpersonal transactions or exchanges can be governed by any

of three mechanisms:

markets, bureaucracies, and clans.

Not all forms ,of

transactions will take place within the framework of a formal, organi,zation~

-26Bureaucratic mechanisms always exist within formal organizations.

may

exist without or within formal organizations.

Markets

Clans also may exist with-

out (in which case they are professions) or within formal organizations.
Rarely, if ever, will any of the mechanisms exist :in pure form.

Ordinarily,

even external market relationships will contain elements of both bureaucrat.i,c

and clan control.

Formal organizations will typically contain all three

mechanisms, and clans may reflect market and bureaucratic mechanisms.

The

pure types are nonetheless useful for understanding the basic condi,tions
under which transactions can occur.
In the beginning, let us pretend that there were markets.

Under market

control, each individual enjoys complete personal freedom and autonomy.

or his only objective is the maximization of personal well-being.

His

Under a

market mechanism, personal well-being is maximized by engaging in transactions

so that personal profit is maximized.

Assuming perfect prices, that selfish

behavior by individuals will also maximize achievement of the goals of the

collectivity.

All societies have a norm of reciprocity and thus satisfy the

normative prerequisites for market exchange.

possible to achieve.

However, fair prices are rarely

Under the conditions that this informational prer~qui-

site cannot be met, then the parties in a market transaction must resort,to
performance auditing, incomplete contracting, and opportunistic defense.

In

a market relation, these costs of completing transactions, will become so

great .that the market will fail.

On the other hand, in the beginning, there may have been clans (as Mayo,
1945, and Durkheim, 1933 contend).

Under clan control,, each individual has

come tO completely internalize a set of personal objectives or values which

are congruent with those of the organization.

Thus each individual enjoys

complete autonomy and personal freedom to pursue the satisfaction ol his or

her personal well-being.

Performance monitoring i,s unnecessary, so that a

-27-

clan can contend with a great degree of ambiguity regarding performance

evaluation, which neit,her a market nor a bureaucracy ca.n withstand.
clans flourish under conditions in which those other forms fail.
clan needs a great deal of stability of its membership.

Thus

However, a

Because the socializa-

tion process is so long, because traditions are learned slowly, because. the
internalization of values and beliefs must be complete, the clan cannot withstand instability or turnover of membership.

A market can operate effectively

with 100% turnover of buyers and sellers each day.

Because the forces of

industrialization have led to widespread inter-firm mobility among formal

organizations, however (see Ouchi ~ Johnson, 1978) clans fail.

Relying en-

tirely upon socialization and internal control, a clan cannot function i,f i,ts
socialization process is disrupted.
In the beginning, there almost certainly were not bureaucracies.

Bureaucra-

cies do not provide the perfection of decisionmaking capability which is

theoretically possible in the market or the clan.

In bureaucracies, there is

explicitly a divergence between the interests of the individuals and the interests of the firm, so that personal autonomy is limited and freedom constrained.

It is only through an employment contract which implies (or, as in

the case of union contracts, explicitly defines) a zone of indifference that

the interes,ts of the individual are linked to the goals of the organization.
However, the bureaucracy can withstand rates of turnover approaching 25%per
annum, a rate far above that which a clan can tolerate.

It can do this because

its operating rules are explicit rather than implicit and thus can be quickly
learned by a newcomer

It can do ths because

it

relies on external, explicit

auditing of performance and thus need not socialize congruent objectives into
its members, a time-consuming process.

A bureaucracy can also survive under

conditions of ambiguity which will bring about market failure

Because

makes use of a single, incomplete contract (the employment contract, see

it

-28Williamson, 1975:57-81), the bureaucracy can operate effectively under conditions of great uncertainty and complexity, conditions under which cOmplete
contracting is impossible.

These conditions, whi,ch are inimical to the

development of prices, can be dealt with in crude fashion through bureaucratic rules.

However, bureaucracies may have a tendency to promote authori-

tarianism in managers and to therefore punish employees with resulting

psychological damage.

If this condition becomes extreme, then the societal

basis of legitimate authority on which the bureaucracy rests will he undermined, and it will fail.

Ultimately, the society can he expected to internalize

those psychological costs which the firm currently externalizes, bringing

about the failure of abusive firms.
SOME CONCLUDING THOUGHTS
We have observed that under conditions of extreme uncertainty and opportunism, transaction costs may rise generally.

Indeed, Denison (1978) has

observed that, during the period 1965-1975, net U.S. productivity has declined
due to changes in,

. .

the institutional and human environment within which

business must operate~.., (1978:21).

Output per unit of input has declined

for two reasons: 78% of the decline is due to increased costs of air, water,
and safety on the job, and the remaining 22% is attributable to increased
needs for surveillance of potentially dishones,t employees, customers, contractors, and garden-variety thieves.

The resources put into improvements in

air, water, and safety are not a net loss to society although they, may reduce
corporate profitability, and

they are not our major concern

The increased

need for surveillance in business, however, may represent the fact that the
cost of monitoring transactions has risen.

Mayo (1945) might have predicted

this change as one inevitable result of the instability which accompanies

industrialization.

In our framework, we could advance the following explanation:

-29-

exchange relationships, in general, are sul)ject to so much informational

ambiguity that they can never be governed completely by markets.

Thus,

they have been supplemented through cultural, clan mechanisms in each organization and in the economy generally.

,As instability, heterogeneity, and

mobility have proceeded in the U.S., however, the effectiveness of these cultural mechanisms has been vitiated

The result is an increase in bureau-

cratic mechanisms of surveillance and control.

Although the use of bureau-

cratic surveillance may be the optimal strategy under present social conditions,

it is nonetheless true that we as a nation are devoting more of our

resources to transactional matters than we did ten years ago, and that represents a net decline in our welfare.
It is probably true that, to a greater or lesser degree, all organizations
are in a state of at least partial failure.

It may be that the degree of

uncertainty and of opportunism which characterize American society are,such

that no mechanisms of control ever function very well.
served

We have already oh-

that the conditions necessary for a pure market, bureaucracy, or clan

are rarely if ,ever met in reality.

Even a combination of these control mnechan-

isms may be insufficient in many cases, however

In new technologies and in

public sector organizations, the rate of change, the instability of employment, or the ambiguity of performance cvaluation may simply overwhelm ill
rational control attempts
In these cases, exchange in an organizational form becomes institutional(

ized.

It is the central thesis of Meyer and Rowan (1977) that school systems

are, by their nature, incompatible with any form of rational control

They

have no effective price mechanism, they have no effective bureaucratic control, and they do not have internally consistent cultures (see also Meyer
et al, 1978)

Thus school systems (as distinguished from education, which

-30need not be done in large organizations) continue to grow and to survive

because the objectives which they are believed to pursue have been accepted
as necessary by the members of society.

Thus, as long as a school system

or other institutionalized organization continues to symbolically pursue the

accepted objectives, it will be supported by the society.

Since rational

control is not feasible within the school, no one knows whether it is actually
pursuing these goals, but it is the property of an institutionalized organization (the church is another example) that it need not give evidence of performance (see also Ouchi, 1977:97-98).
To some extent, all work organizations are institutionalized.

The fun-

damental purposes of all viable organizations must be at least somewhat

acceptable with respect to broad social values (Parsons and Shils, 1951).
If employees, customers, and the public-at-large all grant legitimacy to the
basic activities of a company, then they will continue to support it even
when they have no evidence that their support will result in desired outcomes.
It is the institutionalization of organizations that permits them to
survive even under conditions which severely limit their capacity for rational
control.

Because no organization can consistently apply effective mechanisms

of internal control, all organizations remain intimately dependent

their legitimacy in the society.

U~Ofl

Ultimately, organizational failure will

occur only when the society deems the basic objectives of the organization
to be unworthy of continued support.
This paper has undoubtedly raised many more questions than it has
answered.

My objective, indeed, has been to see what new kinds of questions

we can ask about organizations by applying a novel theoretical framework ,to

them.

I have glossed lightly over a number of topics which deserve much

closer scrutiny.

The exercise, however, suggests that we can take the old

ideas of uncertainty, of legitimate authority, of socialization and of

-31bureaucracy, and by looking at them through the transactions cost per-

spective, and with Williamsons market failures framework, we can discover

new connections between apparently disparate concerns within organization
theory.

TABLE 1
*

The Market Failures Framework

Human Factors

Environmental Factors

Bounded Rational ity

Uncertainty/Complexity

Opportunism

Small Numbers

Adapted from Williamson, 1975:40

TABLE 2

AN ORGANIZATIONAL FAILURES FRAMEWORK

Mode of Control

Normative
Requirements

Informational
R,,~4rements

Market

Norm of Reciprocity

Prices

Bureaucracy

Norm of Reciprocity
Legitimate Authority

Rules

Clan

Norm of Reciprocity
Legitimate Authority
Common Values E~ Beliefs

Traditions

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