FORMAL AND INFORMAL

ORGANIZATION

Sérgio G. Lazzarini
IBMEC São Paulo
ESNIE, May 2006
(Based on Zenger, Lazzarini & Poppo, In: The New
Institutionalism in Strategic Management, 2001)
Formal vs. informal institutions

 Formal: rules that are readily observable through written

documents or rules that are determined and executed
through formal position, such as authority or ownership.
 Ex: explicit incentives, contractual terms, and firm
boundaries as defined by equity positions.
 Informal: rules based on implicit understandings, being in
most part socially derived and therefore not accessible
through written documents or necessarily sanctioned
through formal position.
 Ex: social norms, routines, and political processes.
An immense opportunity for
interdisciplinary integration
 Organizational economists have focused on formal institutions
(Coase, 1937; Williamson, 1985; Barzel, 1982; Holmstrom &
Milgrom, 1994 etc…).
 Organizational theorists and economic sociologists have stressed
the role of informal mechanisms in governing exchanges both
internal (Crozier, 1964; Roethlisberger & Dickson, 1939; Trist &
Bamforth, 1951) and external to the firm (Granovetter, 1985;
Powell, 1990; Uzzi, 1996).
 Hart (2001, p. 15): “it has been difficult to incorporate norms into
the theory of organizations… although there has been some
interesting recent work on this topic, this work has not to date
greatly changed our views about the determinants of organizational
forms.”
Assumption 1. Informal institutions strongly
influence the functionality of organizational
forms
 Roethlisberger and Dickson (1939, p. 559): “many of the
actually existing patterns of human interaction have no
representation in the formal organization at all, and these
are inadequately represented by the formal organization
… Too often it is assumed that the organization of a
company corresponds to a blueprint plan or organization
chart. Actually it never does.”
 Some other key contributions: Chester Barnard (1938);
Michel Crozier (1964); Pfeffer (1978, 1992).
 In inter organizational relationships: Granovetter (1985);
Macauley (1963). Macneil (1978).
Assumption 2. Formal institutions influence the
trajectory of informal institutions

 “The formal largely orders the direction the

informal takes” (Dalton, 1959, p. 237).
 Internal routines, norms, and networks of
influence develop over time in response to an
organization’s formal structure (Shrader, Lincoln,
& Hoffman, 1989; Stevenson, 1990; Tichy,
1980).
Assumption 3. Formal institutions are
discretely arrayed, while informal institutions
operate comparatively on a continuum

 Formal organizations as bundles of mutually-reinforcing

attributes (Williamson, 1991; Milgrom & Roberts, 1991).
Ex:
 Centralization: structural interdependence between
units, lower-powered incentives, and global decision
making.
 Decentralization: structural autonomy, higher-
powered incentives, and local decision making.
 Informal elements as continuously arrayed: tie strength
(Granovetter, 1973); level of commitment (Salancik,
1977), centrality in informal networks (Krackhardt, 1990),
and so forth.
Assumption 4. Formal and informal institutions
differ in the pace with which they change.
Informal institutions possess inertia that slows
the pace of change
 Inertia: relationships, political coalitions, patterns of
communication, established routines impede
organizational change (Hannan & Freeman, 1984; March
& Simon, 1958; Nelson & Winter, 1982; Tushman &
Romanelli, 1985).
 In Economics: path dependence (Arthur, 1989; David,
1985). North: importance of “available mental constructs
—ideas, theories, and ideologies” (1990, p. 96) creating
resistance to change.
Proposition 1. Formal and informal institutions
are interdependent governance mechanisms in
that the use of one mechanism can either
promote (complement) or undermine
(substitute for) the use of the other.
Complementarity vs. substitution

 Complementarity: formal contracts and explicit incentives

reduce gains from short-term defection and hence
increase the value of honoring long-term, informal
agreements (e.g. Klein, 1996; Baker, Gibbons & Murphy,
1994).
 Substitution: formal contracts and explicit incentives
damage the operation of social norms (Macaulay, 1963;
Frey, 1997).
 Mixed evidence thus far! (e.g. Fehr & Gächter, 2000;
Lazzarini, Miller & Zenger, 2004).
Proposition 2. Even in static environments,
achieving the optimal functionality of an
organizational form may require dynamic
“vacillation” of formal elements (Nickerson &
Zenger, 2001).
Vacillation at HP (allocation of decision
rights)

Centralize Centralize

Share price Decentralize

(divided by
S&P index)

Centr.
Dec.

Source: Nickerson & Zenger (2003)

Vacillation

 The functionality of an organizational form is determined

as much by informal mechanisms, as by formal
mechanisms (Assumption 1).
 Informal institutions vary systematically in response to
changes in formal institutions (Assumption 2).
 Managers only have discrete formal choices or
“levers”—e.g., centralization vs. decentralization—to
promote such changes (Assumption 3).
 Given that informal institutions display inertia
(Assumption 4), each switch between formal choices
triggers a gradual change in the trajectory of informal
elements
 3
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Managerial intervention
Proposition 3. Firm boundaries are determined
in large part by the need to adjust informal
institutions within hierarchies. Managers must
sever the boundary of the firm to suspend
dysfunctional informal processes.
Informal processes leading to
hierarchical failure
 Influence activities (Milgrom & Roberts, 1990; Poppo,
1995); politics (Pfeffer, 1978, 1992).
 Social attachments (Katz, 1982; Halpern, 1994).
 Social comparison processes inhibiting high-powered
incentives (Adams, 1965; Deutsch, 1985; Zenger, 1992,
1994).
 Firm-specific routines creating difficulty to access
external knowledge (Katz, 1982; Leonard-Barton, 1995).
 Such informal processes cannot be selectively shut down
with any great success. Firms may suspend hierarchy as
an institution to avoid the informal processes that run
rampant within their boundaries.
Discussion #1: (How) Can vacillation of
boundary choices improve performance?
Examples:
JPMorgan outsources IT to IBM in 2002 in a $5 billion deal; re-
integrates again in 2004.
UBS outsources IT to Perot Systems in 1996; re-integrates in 2004.
Discussion #2: (How) Can explicit
incentives change organizational culture?
 Example: Algar (Brazilian telecom firm) would like to
develop a “marketing-oriented culture” whereby all
employees should actively sell products even if their
are not in the functional area of sales.
 They crafted explicit incentives such that 20% of
individual bonuses will be based on whether the
employee helped sell some product.
 They plan to abort the explicit incentives in 2 years,
assuming that the new values and norms will be
created as a consequence of the incentive program.
 Will it work?