Why Organizations Fail: Models and Cases

Review by Dan Barron and Mike Powell

To understand organizations, we have to understand their dynamics: how they grow, how they change, and importantly, how and why they fail. “Why Organizations Fail: Models and Cases” (recently published in the Journal of Economic Literature; ungated version) by Luis Garicano and Luis Rayo is a fascinating and accessible account of how organizational economists have grappled with the causes and consequences of organizational failure. The lessons they draw from both classic and modern research should direct future research within organizational economics; their case studies and simple models should become part of our teaching (indeed, a couple of them already have); and their systematic and thoughtful introduction to how economists think about organizational failure should spur discussions within the broader social science community.

The paper highlights several themes surrounding recent organizational failures and, within each theme, develops a parsimonious (yet complete) economic model illustrating the forces that could lead to such failures. Some of the themes here include:

  1. Short-termism and risk hiding: The use of stretch targets may encourage employees to hide risk in order to obtain reliably high measured performance. Hidden risk was responsible for the deadly 2005 explosion at BP’s Texas City refinery and for AIG’s collapse.
  2. Misallocation of authority: Organizational inertia can lead to misallocation of authority as business conditions change. Garicano and Rayo attribute the failure of the Daimler-Chrysler merger to a failure to appropriately centralize decision making to take advantage of the platform sharing synergies they merged to exploit.
  3. Communication failures: To enable superiors to maintain plausible deniability in case things go wrong, decision-relevant information might not be communicated if it might generate a paper trail. Insiders in the intelligence community cite this “CYA” (cover your rear) motive for the intelligence failures that led to the U.S. invasion of Iraq.
  4. Misallocation of talent: Even if all organization members share the same objectives, the most important decisions should be made by those who are the most skilled at processing all decision-relevant information. Garicano and Rayo cite evidence that political appointments misallocated talent to important positions in the Spanish savings and loan industry and led to a large-scale financial meltdown beginning in 2008.

For each of these themes, Garicano and Rayo illustrate their theoretical models with detailed case studies of large organizations that have failed. These discussions are fascinating in their own right, and they provide an important link between the models and the real world. We could imagine including and expanding upon these case studies—either on their own, or accompanied by versions of their models—in undergraduate, MBA, or PhD classes. One really nice feature of the paper is that it is simple but deep; advanced undergraduates should be able to understand the economics behind the models, while a PhD course could use the models as a launching point for a discussion of the recent literatures on delegation, incentives, or communication. Depending on its focus, an MBA course could build on the models, or use the case studies as a starting point for in-class discussion and debate, or both.

One ambitious hope is that the paper will spur communication and collaboration across different disciplines within the social sciences. Both institutional and organizational economics have historically transcended boundaries to draw in researchers from a variety of academic fields, but this dialogue succeeds best if researchers can both carve out a unified set of important phenomena and develop a language for talking about these phenomena. Garicano and Rayo take two important steps in this direction by proposing a shift towards the explicit study of organizational failures and by connecting noted cases of organizational failures to models with precise mechanisms and intuition. By bringing different methodologies to bear on a set of illustrative examples, researchers from different disciplines can hopefully develop a common understanding of why organizations might fail. From there, we can build better policies and practices to halt organizational failure, or to mitigate the effects of such failure on the broader economy.