“Explaining the Swollen Middle: Why Most Transaction are a Mix of ‘Market’ and ‘Hierarchy’,” Organization Science 4(4): 529-547. Hennart, Jean-Francois. (1993). Group 3: Jason Franken Prasanna Karhade Hsiao-Ching Lee Marko Madunic Jennifer Shen

The Swollen Middle: A Mix of “Market”& “Hierarchy” Motivation: TCE does not distinguish between the costs of using hierarchies vs. price systems, and hence neglects the complexity of economic institutions. Purpose: Develop a “comparative institutional” model to analyze institutions (firms & markets) as a mix of two pure organizing methods (hierarchy & price systems).

The Swollen Middle: A Mix of “Market”& “Hierarchy” Three organizing costs to achieve gains from cooperation: Information costs – inform parties of potential gains Bargaining costs – devise the rules for sharing of gains. Enforcement costs – enforce the sharing rules. Distinguish b/w organizing costs w/n markets and firms: Transaction (cheating) costs (in market) – cost of measuring output & consequences of imperfect measurement. Management (shirking) costs (in firm) – cost of directing/ observing behavior (input) & doing so, imperfectly. *If organizing costs are zero, either prices or hierarchy will work, but choice matters due to bounded rationality & opportunism. BADM 546

The Swollen Middle: A Mix of “Market”& “Hierarchy” Two ways to reconcile opportunistic individuals’ interests: Internal control (clan solution) – clan has congruent goals. External control (Hennart focuses on these organizing methods) Price system – indirectly guide behavior by rewarding output. Employs price incentives Suffers cheating costs = imperfectly meter output + residual cheating. Hierarchy – directly specifies behavior & rewards compliance. Employs behavioral constraints Suffers shirking costs = imperfectly meter behavior + residual shirking. Substituting between price system and hierarchy is a trade-off between cheating costs and shirking costs. The chosen institution minimizes total organization costs (cheating costs plus shirking costs) Two ways of reconciling the interests of opportunistic individuals: Internal control (clan solution) – select individuals with congruent goals or invest resources to persuade individuals to internalize particular goals. External control (e.g., hierarchy & price systems). BADM 546

The Swollen Middle: A Mix of “Market”& “Hierarchy” The Continuum b/w Markets & Hierarchies  Hybrids: Institutions often combine price & behavior constraints. Min. total organization costs (cheating costs + shirking costs). A cost-min. mix of constraints requires a nonlinear relationship b/w constraints & amount of shirking/cheating. Hybrid examples: contracts constraining sales rep behavior, restricted licensing, commission, piecework, bonus, stock option. Markets Contracts Piecework Firms Shirking & Cheating Costs Total Organizing Costs Cheating Costs Shirking Costs Markets Contracts Piecework Firms Shirking & Cheating Costs Total Organizing Costs Cheating Costs Shirking Costs

The Swollen Middle: A Mix of “Market”& “Hierarchy” Model (assumes risk-neutral principal & agent): 1) Institution (market; firm) ≠ organizing method (price system; hierarchy). 2) Price systems reward output; hierarchies reward behavior (input). 3) Price systems deter(encourage) shirking(cheating); hierarchies, the opposite. Transaction (cheating) costs – cost of measuring output & consequences of imperfect measurement. Management (shirking) costs – cost of directing/observing behavior (input) & doing so, imperfectly. 4) Bulging Middle is due to diminishing returns in metering output & input. The model consists of 6 points: There is not a 1-to-1 correspondence between economic institutions (markets vs. firms) and methods of organizing (price system vs. hierarchy). The price system meters/rewards output; the hierarchy, behavior (input). Each method is equally effective in a world with zero costs to exchange. Price systems are vulnerable to cheating costs; hierarchies, shirking costs. Price systems minimize shirking; hierarchies minimize cheating. Institutions may find that using a mix of price incentives and behavioral constraints is optimal due to diminishing returns in measuring output and constraining behavior. Most institutions are hybrids; hence, the bulging middle. BADM 546

The Swollen Middle: A Mix of “Market”& “Hierarchy” Price Incentives in the Firm (save monitoring costs): Higher incidence of use if: Large and diversified firms. Low managerial expertise (discern behavior & work quality). Limited knowledge regarding costly to supervise activities. Takes two main forms: piecework & profit centers. Both suffer the reappearance of cheating costs. Piecework – links at least part of pay to output. Frees management from monitoring employee behavior. e.g., 19th century inside contracting (capitalist provides equipment & pays subcontractor by piece); also known in mining as butty or tribute system. BADM 546

Information, Expectations, and the Theory of the Firm Profit Centers (M-form) tie manager compensation to subordinates’ performance. “Quasi-firms” buy inputs & sell outputs to other subunits. Subunit manager rewarded on performance (max. profits). Price & behavior constraints on profit centers should vary in proportion to the difficulty of pricing internal transactions. Grant “full exchange autonomy” to managers when internal transfers of inputs and outputs are few & easily priced. HQs should dictate prices and manager behavior when internal transactions are numerous and difficult to price. The higher the costs of monitoring subunits, the greater the benefits of M-form structures.

The Swollen Middle: A Mix of “Market”& “Hierarchy” Summary: Six Propositions 1) Institution (markets; firms) ≠ organizing method (price system; hierarchy). 2) Price system rewards output; the hierarchy rewards behavior (input). Each method is equally effective in a world with zero costs to exchange. 3) Price systems are vulnerable to cheating costs; hierarchies to shirking costs. In summary, Hennart poses six propositions: There is not a 1-to-1 correspondence between economic institutions (markets vs. firms) and methods of organizing (price system vs. hierarchy). The price system meters/rewards output; the hierarchy, behavior (input). Each method is equally effective in a world with zero costs to exchange. Price systems are vulnerable to cheating costs; hierarchies, shirking costs. Price systems minimize shirking; hierarchies minimize cheating. Institutions may find that using a mix of price incentives and behavioral constraints is optimal due to diminishing returns in measuring output and constraining behavior. Most institutions are hybrids; hence, the bulging middle. BADM 546

The Swollen Middle: A Mix of “Market”& “Hierarchy” Summary: Six Propositions 4) Price systems minimize shirking; hierarchies minimize cheating. 5) Institutions may find that using a mix of price incentives and behavioral constraints is optimal due to diminishing returns in measuring output and constraining behavior. 6) Most institutions are hybrids; hence, the bulging middle. In summary, Hennart poses six propositions: There is not a 1-to-1 correspondence between economic institutions (markets vs. firms) and methods of organizing (price system vs. hierarchy). The price system meters/rewards output; the hierarchy, behavior (input). Each method is equally effective in a world with zero costs to exchange. Price systems are vulnerable to cheating costs; hierarchies, shirking costs. Price systems minimize shirking; hierarchies minimize cheating. Institutions may find that using a mix of price incentives and behavioral constraints is optimal due to diminishing returns in measuring output and constraining behavior. Most institutions are hybrids; hence, the bulging middle. BADM 546