Firms reorganise to grow

By Paul Walker 02/09/2012

Lorenzo Caliendo, Ferdinando Monte and Esteban Rossi-Hansberg have a new column up at on the subject Firms reorganise to grow (by hiring workers that know and earn less). The basic idea is that firms that reorganise production to grow account for almost 40% of the value added created in the manufacturing sector. They add layers of management, increase by 7% the average hours worked in the firm, and reduce the average wage at pre-existing layers of managers or workers by 11%.

The Caliendo, Monte and Rossi-Hansberg column presents new stylised facts about the way firms organise production and explains how recent advances in economic theory can help to understand these findings.

In recent research (Caliendo et al. 2012) we identify a number of robust empirical patterns on the organisation of firms as well as the changes in this organisation as firms grow. We find that:

  • Firms that expand (or contract) significantly are exactly those involved in a reorganisation process;
  • Firms that do not reorganise typically change very little.

One part of the literature on firms thinks of firms as hierarchies of knowledge. This idea of a division of knowledge within a firm was first recognised by Demsetz (1988) and formalised by Becker and Murphy (1992). What these works suggested was simply a new interpretation of the role of the firm. Given that there are limitations to what a worker can know, the competence that a firm has to possess to produce must be divided into manageable portions and allocated between the workers. The actions of the different groups of workers are then coordinated by the firm’s management. Thus workers who produce on the basis of knowledge they themselves do not possess, have their activities directed by someone who does possess (at least more of) the necessary knowledge. This gives a rationale for management. As there are asymmetries in information among workers, management is required to coordinate the activities of the different groups of employees. If the workers knew everything about the production process they could carry out production without coordination. In this way, direction is a substitute for education, that is, a substitute for the transfer of the knowledge itself.

Caliendo, Monte and Rossi-Hansberg make the point that it is useful to interpret the data  if we think of firms as hierarchies of knowledge.

  • Production requires labour and knowledge.
  • Knowledge is embedded in individuals and is costly to acquire.
  • The organisational problem is then the result of the limited time of individuals.

This time constraint implies that it is not optimal to have only very knowledgeable employees, but to have many agents with basic knowledge and fewer experts that focus on exceptions. Subordinates save the time of knowledgeable expert by dealing with the simple problems. This is the essential role of organisations.

  • Firms are hierarchical with a large base of workers, who know and are paid less, and with higher layers of management with more knowledgeable employees that earn more.

The next question worth asking is, Are firms different in their organisation? Caliendo, Monte and Rossi-Hansberg present new evidence on this point.

We use administrative data from the French manufacturing sector on the balance sheet of firms and the occupations of their workers from 2002 to 2007. To construct a picture of the organisation of firms our empirical analysis is guided by Caliendo and Rossi-Hansberg (2012). We can distinguish up to three layers of management (supervisors, senior staff and CEOs) above clerks and blue collars whom we refer to as production workers.

Firms do, in fact, differ in their organisation. On average firms have 1.5 layers of management above their production workers, many small firms have only production workers, and about as many large firms have all three of them (the maximum we can observe). Larger firms (i.e. firms that employ more workers and add more value) tend to have more layers of management. This fact makes perfect economic sense. If an artisan wants to produce more, he or she can of course hire other workers that perform exactly his or her tasks, but it is better just to hire apprentices, who know only the most common operations (and are therefore cheaper), and use his or her own time to deal with more infrequent matters. Organisations allow exactly this leveraging of the time of managers through the extensive use of a less able workforce. The data shows that firms are hierarchical, in the sense that higher layers of management tend to have fewer employees and pay them more than lower layers.

Now we get to the point of reorganising a firm. The question is, When do reorganisations occur?

Looking at all the firms with a given organisation type (i.e. with the same number of layers of management), we find that the larger the firm, the higher the likelihood that it will reorganise its production by adding one layer (symmetrically, the smaller firms are more likely to contract their production by dropping one). This fact also makes economic sense. Firms can respond to a given increase in the demand for their product with or without a reorganisation. In the latter case, they just expand their production base, i.e. they hire more workers. By doing so, however, a strain is put on the time of the managers above them, who now would have to deal with more people (and more problems). Hence, firms expanding this way must have more employees at each layer and must pay them more (in order for them to be more knowledgeable and ask less). Hence, the average wages at all layers must rise. Among all the firms with a given organisation, those which grow in this way are the small ones, since they employ fewer employees and so expanding the knowledge of all of them is cheaper. In contrast, if the firm is relatively large, it makes sense to add one layer of managers and reduce the knowledge of everyone below. In this case, firms grow by reorganising.

Another advantage of a more extensive division of labour was noted as far back as Charles Babbage. In his book “On the Economy of Machinery and Manufactures” Babbage observed that the greater the division of labour with workers knowing less about the overall production process reduced the less time required for learning any requisite skills. This results in a lessening of the period during which a new entrant to the workforce would be relatively unproductive and unremunerative. Because less knowledge and training was required to learn to undertake a single operation, as opposed to that required to undertake many different operations, a new employee would more quickly reach a situation where he generates a profit for his employer.

Caliendo, Monte and Rossi-Hansberg now ask, Why is growth through reorganisation different?

The data tells us that when firms reorganise, they have a larger number of employees than they used to in all layers, but the average wage at all pre-existing layers falls. Following the logic above this drop in average wages has a very clear economic rationale. The objective of the reorganisation is exactly to economise on the knowledge of all pre-existing layers. Apprentices are hired exactly because they know less than the master, and can deal with the most frequent and basic issues. So firms that expand by reorganising pay their workers less, because they prefer to employ less knowledgeable workers.

Caliendo, Monte and Rossi-Hansberg conclude that

While, in our data, only about 13% of the firms go through reorganisation episodes in a given year, these episodes account for almost 40% of the value added created in the manufacturing sector. These findings shed light on the process through which firms grow. Most of the existing literature documents a ‘firm size – wage premium’, whereas average wages are higher for larger firms; we show that this relation is just the result of the composition of many firms that grow little and raise wages, and a few firms that reorganise, grow a lot, pay the new top manager more, but reduce average wages in all pre-existing layers […] Our analysis also explores the export behaviour of firms. Accessing a foreign market is a particularly important form of expansion for many firms, and we find that the same facts described above are reproduced for the subset of firms that grow and start exporting (or, of course, shrink and stop exporting). In particular, firms who start exporting are more likely to reorganise their activity than firms who keep operating only domestically, and new exporters who reorganise tend to reduce (rather than increase) average wages paid at all pre-existing layers.