Chandler's Explanation of the Development of the Modern Business Organization

Chandler's work is primarily concerned with explaining how bureaucracies superseded markets. As he explained: "The market continues to generate the demand for goods, and the managers make their decisions on the basis of their estimates of market demand. The visible hand of managerial direction has replaced the invisible hand of market mechanisms, however, in co-ordinating flows and allocating resources in major modern industries."

The modern business enterprise is distinguished by two major features.

His basic argument is that modern business organisations emerged when the businesses could be operated more profitably through a centralized managerial hierarchy than by means of decentralized market mechanisms. So, his argument is based squarely in economic logic. Managers figure out the form of organizational structure that will be most profitable, and, one way or the other, organisations with these structures then come to predominate.

Chandler argues that the basic advantages of hierarchical organisations are the routinisation of transactions among units and the integration of units for production, purchasing, and distribution, all of which reduced costs. The ability to schedule the flow of raw material and finished goods more closely and to standardise the processes involved made it possible for firms to use their resources more intensively. Another relative advantage that hierarchical organisations enjoy over the market alternative envolves the the discovery of economically valuable knowledge. This advantage is founded upon three main factors; (i) the superior ability of firms to communicate knowledge among organizational members, and as a consequence, to generate new knowledge, (ii) the ability of firms to create incentives that encourage individuals who would otherwise not do so to engage in the knowledge discovery process, and (iii) the co-specialized, personal, and tacit nature of knowledge, which precludes separating out such knowledge for sale through the market mechanism. In sum, the result of Chandler's theorizing is the construction of an efficiency rationale for the existence of the firm in a competitive marketplace that is not based upon the assumption of opportunistic behavior, and does not rely upon asset specificity or monitoring problems as key explanatory variables.

However, it was only possible to realise these gains "after the development of technology and the growth of the market increased economic activity to a speed and volume sufficient to make existing mechanisms of co-ordination by market forces cumbersome."While goods were produced and moved by traditional methods and sources of energy - wood, wind and water, animals - the daily output of a production unit could easily be supervised by the owners assisted by one or two managers. This changed with the development of the railway and telegraph, and the simultaneous availability of large quantities of coal. These new technologies made possible much greater speed and volume in the production and movement of goods, and necessitated the development of management hierarchies to supervise, monitor, and co-ordinate the new processes of production and distribution. The top-level managers of a few multi-unit companies made the decisions that had previously been made by thousands of small firms.

The first modern business enterprises in the US, the large railway and telegraph companies, appeared in the 1850s. The former became the first "big business." They required centralized operating control and hierarchies when they operated more miles of track than could be personally managed by a single superintendent. These advances were quickly reflected in the development of new forms of distribution. But it took longer for the revolution in production to appear, because more technological development was required. Railways and telegraph encouraged technological innovations that increased output by making it possible for materials to pass through manufacturing plants more rapidly and with greater regularity, a process that was helped further by the new availability of coal as a source of power. Large-batch and continuous-process production methods followed these developments.

After WW1, the large, integrated enterprises adopted an explicit strategy of diversifying into new products for new markets; the searched for products that made use of their technological, marketing, and managerial techniques and skills rather than those that used only existing purchasing, production, and marketing facilities. The strategy of diversification quickly caused administrative problems, however. Middle managers were unable to handle the very different co-ordinating requirements of the several lines of business. Top managers were overwhelmed by the need to supervise by the need to supervise and to allocate resources to many businesses that varied greatly. The response to these problems was the multi-divisional (M-form) organization.

A similar process occurred in the UK, but at a slower pace. One reason for this was that the market was thicker and had already organized itself in terms of large numbers of intermediate product suppliers. Consequently, there was less need for backward vertical integration. Besides, less use was made of mass production, so co-ordination of the flow of goods was less complex and management structures were simpler. Entrepreneurs and their families continued to make policy decisions, so the managerial class remained much smaller than in the US.

Criticisms of Chandler