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Behavioral Theories of Organization

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 Behavioral Theories of Organization

Henrich R. Greve

INSEAD

1 Ayer Rajah Avenue

138 676 SINGAPORE

henrich.greve@insead.edu

Linda Argote

Tepper School of Business, Carnegie Mellon University

5000 Forbes Avenue, Pittsburgh, Pennsylvania 15213

argote@andrew.cmu.edu

Cross-references:

Organization: Overview;
Organizational Decision-Making;
Ecology: Organizations;
Industry Architectures;
People in Organizations;
Strategic Management;
Hierarchies and Markets;
Modularity and Organizations;
Learning: Organizational.

1
 Behavioral Theories of Organization

Abstract

Behavioral theories of organization are a major portion of the field of organizational

studies, as behavioral reasoning is found across a range of theoretical approaches. We review

the role of behavioral theory in the major research traditions of organization theory, starting

with the original behavioral theory of the firm and continuing to evolutionary theory,

population ecology, institutional theory, and transaction cost theory. We also address the

organizational problems investigated by each theory, and we summarize by noting a trend

toward greater integration of the field around behavioral reasoning.

Introduction

Behavioral theories of organization are typically traced back to Cyert and March “A

Behavioral Theory of the Firm,” which sought to “develop an empirically relevant, process-

oriented, general theory of decision making by a business firm” (Cyert and March, 1963: 3).

“Behavioral” was not part of their guidelines for constructing theory; but in order for a theory

to be oriented toward the process of making decisions and to be empirically relevant it had to

focus on actual decision-making behavior. Hence Cyert and March proposed a behavioral

theory of the firm (BTOF) as a counterpoint to theories that were not grounded in observation

of decision-making processes and were not proven to be empirically relevant for firm-level

decisions, though they might still yield useful macro-level predictions.

Modern reviews and reformulations have been divided between attempts to reaffirm

this definition of behavioral and attempts to extend it. A recent review reflects this divide, as

it is open about the definition in keeping with the general growth and diversification of the

behavioral literature, but also notes that behavioral theories have a common foundation in
2
ideas of individual bounded rationality and organizational procedures for decision making

(Gavetti et al., 2012).

Within the field of management, the idea that theories should be built on observation

of decision-making processes is currently so conventional that its opposite can seem to have

mostly historical value. However, the classical definition of behavioral still has some bite left.

Theories of intra-organizational decision making based on equilibrium ideas are not process

theories and hence fail the process part of the definition, meaning that agency or contract

theory, for example, is not behavioral. If a theory conforms to empirical observation, it may

fit the other part of the definition, empirical relevance. Some theories that are phrased at a

very high level of analysis also lack a clear process theory of decision making, or they would

be consistent with multiple process theories of decision making, and such theories are not

behavioral either. Population ecology did not start out as a behavioral theory, although we

will later argue that it has become behavioral.

The process-oriented view of decision making in organizations necessarily implies a

focus on multiple persons, and potentially multiple organizational units, being engaged in

decision making. The earliest formulation of the behavioral theory of the firm emphasized

this through its theory of problemistic search that started locally to a problem but expanded if

the search did not have a local solution, along with its theory of coalitions in decision making

(Cyert and March, 1963). This focus on multiple persons anchors behavioral theories to the

meso level of analysis. Although specific treatments can cross levels of analysis and hence

look at how the meso level interacts with micro level or macro level outcomes, the meso level

is unavoidable. Through its emphasis on observable processes, behavioral theory is also

heavily focused on organizational mechanisms that produce decisions, rather than decisions

as a result of incentives or pressures.

Behavioral theories of organizations need to take into account that behavior is carried
3
out in an organization. Although scholars debate the exact definition of an organization, most

definitions agree that organizations are collections of individuals and groups who perform

interdependent activities that are oriented towards the accomplishment of goals. Other key

characteristics of organizations are that they exhibit some permanence over time and are

embedded in an external environment, but theorists differ in whether they see these

characteristics as defining or as simply frequent. The defining characteristics have

implications for what should be included in a behavioral theory of organization in order to be

a complete theory. We think that organizational theory could address at least the problems

that are listed in Table 1. Indeed, we find that a selection of major theories in the current

literature do address these problems to differing degrees. We indicate this with stars

designating the theoretical perspective that focuses on their solution. Multiple stars are used

to designate that the theoretical perspective emphasizes the particular issue, while a single

star indicates that it provides some treatment.

<Table 1 near here>

Going down the rows, 1) new organizations and forms spread when organizations of

certain kinds become seen as legitimate or efficient means of fulfilling specific purposes.

Population ecology predicts when new organizations will appear as a function of the density

and concentration of existing firms (Carroll and Hannan, 2000). Transactions cost theory

predicts when transaction will occur in the market or in organizations and hence when new

organizations are likely (Williamson, 1991).

2) Behavior is motivated towards the achievement of goals. The goals can be broken

down into sub goals (Cyert and March, 1963), which can be further broken down into tasks

for individuals to perform. Cyert and March (1963) addressed the development of goals

through the concept of aspirations, which are a function of the organization’s past

performance and the performance of similar organizations. The goals are also affected by the
4
organization’s purpose, which is established at its founding and renegotiated periodically.

The task individuals perform in organizations are interdependent: accomplishing one task

affects the accomplishment of another either.

3) These interdependent tasks must be coordinated, which can be achieved through

routines, a concept that grew out of the standard operating procedures of the behavioral

theory of the firm (Cyert and March, 1963) and was developed fully in the evolutionary

theory of the firm (Nelson and Winter, 1982).

4) A behavioral theory of organizations should take into account that organizations

are comprised of individuals, whose participation and performance require motivation.

5) Organizations learn from their experience. This learning is embedded in routines so

that knowledge acquired from past experience can affect future performance (Levitt and

March, 1988; Nelson and Winter, 1982). Sometimes the learning is adaptive and results in the

organization fitting its environment better; other times the learning is maladaptive and the

organization’s fit with the environment is not improved. Population ecology also examines

the extent to which the organization fits its environment, including adaptive processes that

can lead to organizational failure.

Thus, current theories of organizations focus on different organizational problems.

Population ecology focuses on the interplay between the organization and its environment

and studies how the founding and the death or organizations are affected by the ecology of

other organizations and the nature of the environment. Population ecology theories treat

organizations as unitary actors and the early statements of the theory did not examine

processes within organizations or permit learning. By contrast, the Behavioral Theory of the

Firm explicates the internal processes of organizations by including issues such as

coordination, motivation and goal formation. The Behavioral Theory of the Firm also

permits learning. Evolutionary theory also includes issues of coordination and learning from
5
experience, which contributes to path dependence in organizations. Transaction cost theory

focuses on which alternatives will be internalized within an organization and which will be

achieved through market transactions. However, as we will argue in the conclusion, these

traditional boundaries between the theories are increasingly becoming blurred as each theory

is addressing new questions. This is a development that seems to be moving the field toward

a new integration as a connected (but not single) behavioral theory of the firm, where there

had earlier been several separate theories and research traditions with limited communication

between each.

REVIEW

Behavioral Theory of the Firm

The behavioral theory of the firm is a research tradition that traces its origins directly

to “A Behavioral Theory of the Firm” (Cyert and March, 1963), and its emphasis on

organizational learning is closely related to organizational learning theory (Levitt and March,

1988). There is a recent review of the behavioral theory of the firm (Gavetti et al. 2012) so

we review this research briefly and with an emphasis on key contributions and recent work.

One branch of this research has taken the statements on managerial decision making

as a key feature of this theory. A key feature of the stylized decision maker in the behavioral

theory of the firm is a focus on goal variables and adaptation of aspiration levels, and

verification of this assumption is a feature of both older and current work. Adjustment of

risk-taking propensity as a result of performance relative to aspiration levels was not part of

the original formulation of the theory, but has since become central in work on individual

decision making (March and Shapira, 1992), in part as a result of cross-fertilization of ideas

with psychology such as prospect theory.

The focus on goals in the behavioral theory of the firm also carries over to research at
6
the top management team and organizational levels of analysis. Because behaviors differ as a

result of which goals are examined and which parts of the environment are salient, the

question of organizational attention comes to the fore (Ocasio, 1997). The effects of attention

on organizational action are explored in research on outcomes such as the attention of top

management teams and public statements of the organization. This work is closely related to

research that integrates the influences of managerial information seeking, managerial

characteristics, and responses to performance on decision making.

The behavioral theory of the firm predicts that organizations respond to performance

below the aspiration level by engaging in problemistic search. This has been developed into a

research stream on performance feedback, which examines how organizational changes result

from performance below aspiration levels, which in turn adapt as a result of social and

historical comparisons (Greve, 2003). Much of this work is at the organizational level of

analysis, and it shows effects on decisions that seem tailored to quickly recover from poor

performance such as market entry, investment, and innovation launches (Greve, 2003). These

same decisions are risky, however, so the research also shows an increase in risk taking when

performance is below aspiration levels.

An important insight in The Behavioral Theory of the Firm is that organizations learn

from their experience. The knowledge or intelligence they acquire is embedded in standard

operating procedures or routines, which affect future performance. Thus, rather than every

action an organization takes being a result of calculation, many actions are a result of

enacting routines.

Organizational routines are interdependent task sequences performed by multiple

members. Early conceptions of routines emphasized that they conserve lessons from the past

and thereby improve efficiency in the future. Routines were conceived as a source of

stability in organizations and as representing political truces of how tasks should be

7
performed in organizations. Recent work on routines has emphasized that they are a source

of change as well as stability (Feldman and Pentland, 2003) and has conceived the gradual

development of organizational routines as an engine of evolution in organizations (Nelson

and Winter, 1982).

Two strands of research on organizational learning have taken different stances on the

role of organizational experience. One strand, exemplified by research on organizational

learning curves, finds that although there is considerable variation in the rate of improvement,

experience generally improves dimensions of organizational performance (Argote, 2013).

Another strand emphasizes the challenges of appropriately sampling and learning from

experience in organizations (Denrell and March, 2001). These two strands of research have

become intertwined to some extent with researchers explaining the variation in the rate at

which organizations learn from experience and identifying conditions under which

experience is harmful or helpful for organizational performance.

Levitt and March (1988) theorized that not only do organizations learn from their own

direct experience, they also learn from the experience of other organizations. This latter form

of learning has been referred to as vicarious learning or knowledge transfer. Considerable

research has been conducted over the last couple of decades on the mechanisms through

which and the conditions under which one organization learns from the experience of others.

Knowledge transfer across organizations plays a key role in evolutionary theories as well as

learning theories.

The behavioral theory of the firm has since the start shown a concern for the

consequences of the behavioral rules that empirical research uncovered. This has led to a rich

modeling tradition that shows how different behavioral rules affect organizational

performance and adaptation in stable or changing environments (March et al., 2000). Classic

findings include work showing the danger of rapid learning of routines or precise reactions to
8
noisy feedback, both of which can cause an inherently inferior strategy to be chosen. This

argument was further developed into the famous tradeoff between exploration of new

strategies and exploitation of current ones (March, 1991), an argument that has since been

shown to be stable across modeling frameworks (Denrell and March, 2001). Difficulties in

finding the best strategy or structure is an enduring topic in this modeling tradition, and many

treatments focus on how the structure of the environment presents traps or how

organizational structure affects decision making and learning (Fang et al., 2010).

Evolutionary theory

Evolutionary theory is a branch of research that traces its origins back to “An

Evolutionary Theory of Economic Change” (Nelson and Winter, 1982), a treatment that

shared with Cyert and March (1963) a rejection of maximization assumptions and full

rationality. It differed in emphasis by examining gradual development of organizational

routines as the engine of evolution, reasoning through a parallel with human skill

development, and thus lacked the emphasis on stability and discrete change events found in

the theory of problemistic search (Cyert and March, 1963).

Like learning theory, evolutionary theory has since developed many branches, and a

brief review cannot do full justice to this work. A common feature of the work is that it

emphasizes path dependence. Evolutionary processes only differ meaningfully from systems

with equilibrium features when they are not teleological – they do not evolve toward fixed

points that are determined by some maximization process. Rather, multiple end states are

possible, and which one is reached depends on early steps that in turn can be the result of

chance events or the agency of actors who do not fully foresee the consequences of their

actions. Technological paths that get “locked in” by early events are classical examples of

evolutionary processes.

One branch of evolutionary theory examines the evolution of firms. It views the firm
9
as taking on a trajectory determined by its current stock of knowledge and its rules for

altering this stock, and is thus closely related to learning models though it sometimes blends

intra-organizational learning mechanisms with external selection mechanisms (Levinthal and

Posen, 2007). The behavioral assumptions are that managers have some ability to choose

(short-term) superior options, but are prone to make incorrect judgments when short and

long-term payoffs must be traded against each other. Finally, the firm-level evolutionary

work often treats issues of how to design the firm as an effective adaptive system. It typically

assumes that organizations vary in their designs, but their managers do not fully understand

the adaptive consequences of this variation.

Empirically the research focuses on the transformation and replication of knowledge.

Direct investigation of knowledge transformation is challenging, but there has been

theoretical and empirical work on how organizations can influence the knowledge acquisition

process and thus shape the evolution of routines (Zollo and Winter, 2002). Likewise, there is

work showing that organizations can “fix” routines that have reached a high level of

performance in order to prevent experimentation that might lead to lower performance levels

and that replicating routines exactly can be associated with higher performance than attempts

to adapt routines to local conditions (Knott 2001). Finally, because evolutionary processes

are influenced by the level of variation available to select from, manipulating the proportion

of organizational units that are allowed to vary influences the overall rate of change. This can

be done through the form of governance or through managerial routines with some local

autonomy.

Replication is particularly important because knowledge replication is required in

order for an evolutionary theory of the firm to contain something approaching a genetic code

(Winter and Szulanski, 2001). The research has shown that firms are indeed able to make

routines replicable across units, either with or without planned variation according to local
10
conditions, but in so doing they face the dilemma that replicable routines are also more easily

observed and copied by competitors. Researchers have suggested that this dilemma can be

resolved by embedding knowledge in transactive memory systems (Argote and Ren, 2012).

Transactive memory systems are collective systems for encoding, storing and

distributing information. Colloquially known as knowledge of who knows what, transactive

memory systems capture knowledge of who knows what and who is best at what.

Transactive memory systems develop as organizational members gain experience working

together and are idiosyncratic to organizations because they depend on the particular

individuals who are members of an organization. Transactive memory systems are hard for

competitors to imitate. Thus, embedding knowledge in transactive memory systems is more

effective at preventing knowledge spillover to other organizations than embedding

knowledge in routines.

Another branch of evolutionary theory examines the evolution of industries. Research

on technological paths has examined how technological choices are shaped by economic

factors that favor making the same technological choices as other firms in the same industry,

which means that initial leads in adoptions become magnified. Transitions between

generations of technologies have also spurred interest among evolutionary theorists, with a

particular focus on whether the new technology has characteristics that favor incumbent firms

or newly founded firms (Tushman and Anderson, 1986). These empirical studies are built on

evolutionary reasoning in which a central assumption is some form of behavioral myopia in

which firms pursue immediate incentives, even if these lead them to commit to a technology

that will lose in the long run.

Research on the structure of transactions in industries has examined the

reconfiguration of transaction interfaces between firms over time. This work has shown how

new transaction structures are gradually formed from old ones rather than created anew. This
11
process is seen when industries form additional transactional links, as in the creation of a less

integrated industrial structure. It is also observed more generally during periods of industrial

formation or change of boundaries between actors, such as those that occur when major new

technologies create opportunities (Jacobides and Winter, 2005) or market actors seek to

rearrange exchange relations.

Population ecology

Population ecology theory focuses on explaining organizational foundings and deaths

as a function of characteristics of the organization and other organizations in their

environment. Population ecologists theorized that selection was the mechanism through

which organizations changed (Hannan and Freeman, 1977); organizations that fit their

environments were selected and prospered and those that did not fit their environments

perished. Organizational change was seen as rare and likely to harm rather than help an

organization’s survival prospects (Carroll and Hannan, 2000).

Population ecology has produced a large body of empirical research. Carroll and

Hannan (2000) reviewed the population ecology literature and identified important empirical

regularities in it. First, studies generally find a liability of smallness: as organizational size

increases, failure rates decrease. Second, although a liability of newness was once theorized,

recent empirical work that controls for organizational size has found that mortality rates

increase with organizational age. Third, the relationship between births and deaths of firms,

on the one hand, and the number of competing firms in the environment, on the other, is

nonmonotonic. At low levels of firm density, founding rates increase and mortality rates

decrease with increases in density. At high levels of density, however, founding rates

decrease and mortality rates increase. The former effect has been attributed to legitimation

while the latter has been attributed to competition.

Although the original statement of population ecology theory argued that selection
12
and not learning or adaptation was the mechanism through which organizations change, more

recent treatments have acknowledged that learning occurs, although it is regarded as rare

(Carroll and Hannan, 2000). Learning and selection have been productively integrated in

models of organizational performance and survival. Another connection between population

ecology and learning can be found in studies on the success of new entrepreneurial ventures.

Research has found that entrepreneurial firms that spin out of other firms or whose members

have previous experience in other firms perform better than those lacking previous

experience (Carroll and Hannan, 2000).

Population ecology theory intersects with institutional theory on the concepts of

legitimacy and organizational form. As noted previously, there is evidence that as the density

of a population increases, survival prospects of organizations first increase and then decrease.

Population ecologists attribute the initial increase in survival to the increasing legitimacy of

the organizational form. An organizational form is perceived as legitimate when it is taken

for granted as the appropriate way to accomplish certain collective tasks. An active, current

stream of research focuses on organizational form as a specific kind of social identity (Hsu

and Hannan, 2005).

Institutional theory

Institutional theory is a research tradition that traces its origins back to two

foundational articles that discussed how organizational founding and change was driven less

by functional considerations and more by symbolic actions and external influences than the

theory at the time assumed (Meyer and Rowan, 1977). These articles drew on concepts of

bounded rationality that are central to behavioral theories and sketched a broad range of

potential research questions, but much subsequent research drew away from the firm focus of

behavioral theories of organization by emphasizing environmental influences such as the

diffusion of new institutionalized practices among firms

13
 As institutional theory has grown, some branches have moved closer to behavioral

theory. Direct dialogue between the perspectives has been started by researchers who have

noted that the organizational change processes examined by behavioral theory are influenced

by the institutional context (Wezel and Saka-Helmhout, 2006). A growing subfield of

institutional theory concerns institutional logics, which are broadly (but not universally)

shared assumptions and action patterns (Thornton, 1995). At the organization level,

institutional logics can be seen as sources of managerial decision-making rules, and hence

institutional logics research is related to research on the behavioral theory of the firm and

evolutionary theory.

Institutional theory has also moved into examination of the founding conditions for

new firms (Tolbert et al., 2011). This work questions the conventional assumption that

entrepreneurs are rationally able to locate opportunities, and instead posits that key sources of

organization founding activities are institutional features of the social group to which

entrepreneurs belong or the symbolic environment they face. Like population ecology, this

work moves the concerns for decision-making processes and bounded rationality to the stage

of organizational founding.

Transaction Cost Theory

Focusing on firm boundaries, transaction cost theory aims to answer the question of

when activities would occur within the market and when they would occur within the firm

(Williamson, 1991). More specifically, transaction cost theory predicts when the governance

forms of hierarchies, markets or hybrids (e.g., alliances) will be used. Williamson, who was

recognized with a Nobel Prize for his work on transaction costs, theorized that whether

activities would be internalized within a firm depended on their transaction costs. He saw

transactions broadly as transfers of goods or services across interfaces, and argued that when

transaction costs were high, internalizing the transaction within a hierarchy was the
14
appropriate decision. Conversely, when transaction costs were low, buying the good or

service on the market was the preferred option. Three dimensions were developed for

characterizing transactions: uncertainty, frequency and asset specificity, or the degree to

which transaction-specific expenses were incurred. Transaction cost theory is built on

assumptions of bounded rationality and opportunism, defined as self-interest with guile.

A review of the empirical literature on transaction cost theory concluded that findings

regarding asset specificity were generally supportive of the theory while findings for

uncertainty were mixed (David and Han, 2004). Although only a small number of studies

focused on the frequency of transactions; those studies were generally supportive of the

theory. David and Han (2004) further concluded that considerable empirical support existed

for predictions about hierarchies versus markets but less support existed for predictions about

the choice of hybrids over markets or hierarchies.

A debate has raged in recent years about whether transaction costs or organizational

capabilities are the most important determinants of firm boundaries. Emphasizing the

importance of capabilities, researchers have argued that firms internalize activities that they

perform with greater capability than external providers (Jacobides and Winter, 2005). This

debate connects transaction cost theory to the Behavioral Theory of the Firm and

evolutionary theory because organizational learning, which figures prominently in those

theories, contributes to the development of routines and organizational capabilities.

Recent theorizing in transaction costs includes capabilities as well as transaction costs

as determinants of whether firms internalize activities. For example, Argyres and Zenger

(2012) noted that transaction costs and capabilities are intertwined over time: past

governance decisions affect the development of current capabilities and current capabilities

affect future governance decisions. Current research focuses on articulating the relationship

between capabilities and transaction costs.

15
 DISCUSSION

Behavioral theories of organizations – in plural – are important for understanding how

organizations actually work, and they represent the bulk of empirical work done on this topic.

We are unable to give a full review within a manageable number of pages, but we have given

a taste of the work. The range of topics is wider than our table suggests, although new

organizations and forms, forming goals and establishing tasks, motivating members, dividing

and coordinating tasks, and learning and adaptation is still an impressive list of organizational

problems. Likewise, the behavioral theory of the firm, evolutionary theory, population

ecology, institutional theory, and transaction cost theory are important lines of investigation

under the umbrella of behavioral theories of organizations, but they are not the only ones.

Although this field of research is too large and fast moving to make identification of

trends easy, we have observed that theories that start out behavioral remain so, and theories

that initially have little behavioral content incorporate it over time. The behavioral concepts

of organizational learning and knowledge transfer have been central to the behavioral theory

of the firm and evolutionary theory since their inception and remain central, and these

concepts are playing increasing roles in population ecology, institutional theory, and

transaction costs theory. In the population ecology tradition, specific cases of such reasoning

include work examining learning from other organizations, including work arguing that the

transfer of routines from parent firms contributes to the success of their progeny. In

institutional theory, early work on the diffusion of institutional practices emphasized their

symbolic value, but recent work includes considerations of goal- oriented behavior that aligns

the reasoning with behavioral theory. Transaction costs researchers acknowledge that an

organization’s capabilities, which are developed by learning from experience, affect decisions

about whether to internalize tasks.

It is too early to tell the strength of the theoretical movement towards a common
16
ground described here. If it does gain momentum, it will produce a unique result. Research

traditions that started out with little relations to each other will coalesce into an overarching

field of study joined by an interest in creating behavioral theories of organization informed by

ideas of bounded rationality. We think such an outcome would produce an era of dialogue

between the different research traditions, to the benefit of our understanding of organizations.

17
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19
 Table 1: Theoretical Perspectives and Organizational Problems

Organizational Problem Behavioral Theory Evolutionary Population Institutional Transaction

of the Firm Theory Ecology Theory Cost Theory

1) New organizations and forms ** * *

2) Forming goals and establishing tasks *
3) Dividing and coordinating tasks * * **
4) Motivating members *
5) Learning and adaptation ** ** * * *

20

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