Firms reorganise to grow (by hiring workers that know and earn less)

Lorenzo Caliendo, Ferdinando Monte, Esteban Rossi-Hansberg , 31 August 2012

a

A

How do firms organise production? How does this organisation change as firms grow?

Business people deal with these questions all the time, and the academic literature has developed several strands of theories with answers that go from property rights over core resources to knowledge-based hierarchies (e.g. Hart and Moore 1990 and Garicano 2000). However, the ability of researchers to answer these questions with general empirical support has traditionally been hindered by lack of data.

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.

Hierarchies of knowledge

One branch of the economic literature that we have found useful to interpret the data thinks 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.

This view of the firm is well exemplified by a statement from a former head of General Motors, Alfred Sloan, who already in 1924 wrote: “we do not do much routine work with details. They never get up to us. I work fairly hard, but on exceptions”. Of course, this is not the only way to think about a firm’s organisation. Several other views emphasising, for example, incentive problems have also been proposed (e.g. Calvo and Wellisz 1978 or Quian 1994).

Are firms different in their organisation? New evidence

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.

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.

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.

Conclusion

Reorganisation affects many firm-level outcomes, such as  productivity or the distribution of wages inside the firm. The fact that the behaviour of the firm depends on whether or not it reorganises is potentially very important for understanding aggregate outcomes. 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 (e.g. Brown and Medoff 1989 or Abowd, et al. 1999). 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.

The empirical results that we document suggest that learning about the internal organisation of firms is empirically feasible and essential to understand a wide variety of economic phenomena. They open the possibility of studying, using large national datasets, how firm organisation and its evolution as firms grow affects, for example, the impact of aggregate shocks or other changes in economic activity on productivity, firm entry and exit, wages and other labour market outcomes, as well as welfare.

References

Abowd, J, F Kramarz, and D Margolis (1999), "High-Wage Workers and High-Wage Firms", Econometrica, 67:2, 251-333.

Brown, C and J Medoff (1989), "The Employer Size-Wage Effect", Journal of Political Economy, 97:5, 1027-1059.

Caliendo, L and E Rossi-Hansberg, (2012). "The Impact of Trade on Organization and Productivity", Quarterly Journal of Economics, 127:3, 1393-1467.

Caliendo, L, F Monte and E Rossi-Hansberg (2012). "The Anatomy of French Production Hierarchies", CEPR Discussion Paper 9073.

Calvo, G A, and S Wellisz, (1978). "Supervision, Loss of Control, and the Optimum Size of the Firm", Journal of Political Economy, 86:5, 943-952.

Garicano, L, (2000). "Hierarchies and the Organization of Knowledge in Production", Journal of Political Economy, 108:5, 874-904.

Garicano, L and E Rossi-Hansberg, (2006). "Organization and Inequality in a Knowledge Economy", Quarterly Journal of Economics, 121:4, 1383-1435.

Hart, O and J Moore (1990). "Property Rights and the Nature of the Firm", Journal of Political Economy, 98:6, 1119-58.

Qian, Y (1994), "Incentives and Loss of Control in an Optimal Hierarchy", Review of Economic Studies, 61:3, 527-544.

Sloan, Alfred (1924), "The Most Important Thing I Ever Learned About Management", System, CXXIV.

Topics: Labour markets, Productivity and Innovation
Tags: firms, growth, production

Assistant Professor of Economics, Yale School of Management
Assistant Professor of Economics at Johns Hopkins University, Carey Business School
Professor of Economics and International Affairs, Princeton University