Chandler’s Living History Joshua Downs 8/31/2014 Chandler’s Living History The Visible hand of vertical integration in nineteenth century America viewed under a twenty- first century transaction costs economic lens Bucheli, Mahoney, Vaaler 2010

Chandler’s Contributions Among scholarly contributions, explaining and analyzing the evolution of U.S. business history within social science frameworks Chandler’s focus on dynamic firm capabilities shares the common denominator of market frictions (small numbers bargaining, asset specificity) with transaction costs theory Thus, we can examine case studies from “The Visible Hand” with a transaction costs theory lens to complement the explanation of shifts from the market-based organization’s dominance prior to 1840 to the subsequent rise of hierarchical organizations.

Market-based Systems: Putting-Out Merchants purchase materials, delivered to workers, arranged for sale of finished goods. Pros: Allowed for extensive production with little capital costs Cons: Inconsistent quality, high inventory costs, material lost in transit and to embezzlement Why it worked: Compensation based on output provided autonomy and productivity incentive Localized production using worker’s homes as facilities (high transportation and capital costs) Component specialization (low training required relative to craftsmen, local transportation must be less expensive than training) Fast growing, low income markets in the South and West for inferior goods Why it didn’t work: Worker compensation based on volume, lack of quality controrl oversight Cannot control production schedule leading to higher inventory costs Workers incentivized to produce higher volume, lower quality

Market-based Systems: Inside-Contracting Manufacturers and “Super Foremen” Manufacturers commit to periodic contracts with foremen, who are credited for volume of produced goods Manufacturers provide raw materials, machinery, rented floor space, utilities, day wages Foremen responsible for hourly labor and associated administrative costs Pros: Higher tech, higher volume production of components at a predetermined and acceptable price Risks associated with volatile labor costs and HR responsibilities assumed by contractor Cons: Limits on responsible equipment and resource use were ignored for higher short term production volume. Quality issues remain but relatively less than Putting-out system Bottom up innovation became periodic, limiting innovation overall (asymmetric information) Poor worker discipline and high absenteeism Why it worked Component specialization and associated mechanical production innovation and standardization Centralized production overcomes issues in communication and transportation of “Putting-out” system Low base wages necessitated high production volumes to reach livable conditions Why it didn’t work Periodic and production volume based nature of contracts incentivized opportunism, project-focus No incentives for independent workers to commit to personal investment in training or deferment to management authority for dispute resolution (Zone of Acceptance)

Shift to Vertical Integration Technological improvements across society increased the capabilities of firms and the size and expectations of the market increased in response. As the level of quality and complexity demanded by the market for mass produced goods began increasing: the costs of oversight and standardization to achieve this level of quality and complexity through a market-based organization increased. Transaction costs associated with the previous market-based organizational systems were no longer acceptable in most industries, as the relative costs of exerting sufficient organizational control through hierarchical integration decreased below the costs of a market-based organization. Innovations in accounting techniques and communication enabled more efficient hierarchical organizations. Mass production of highly complex products required in kind mass marketing capabilities to fully capture these efficiencies, thus mass investments in integrating distribution and retail followed. Not the case for many industries lacking high asset specificity and small numbers bargaining issues. These industries who spurned integration were typically successful, while attempts to integrate lead to losses.

Product Complexity – McCormick, Singer and Electric Companies Complexity of products required highly skilled agents for distribution, sales, financing, & service. Singer pioneered franchising models for distribution and sales to maintain standards while allowing franchise agents autonomy to cater to their particular market’s attributes. Later, Singer added proprietary showrooms and sales employees Zone of Acceptance created, enabling training and organizational coordination to better meet the needs of customers McCormick also employed an exclusive distribution franchise model with the mechanic/managers who operated their warehouses. High-Tech products by GE & Westinghouse required “sales engineers” to ensure quality standard, large investments in human capital. Credible commitment exchange enabled relationship to overcome asset specificity & small numbers issues

Perishability – Swift & United Fruit Company Invention of refrigerated train cars allowed for meat shipments from Chicago to satisfy increasing demand of East Coast Markets. Train Companies unwilling to build expensive refrigerated train cars (asset specificity), meatpackers unwilling to expose themselves to opportunistic independent ice and storage providers (small numbers bargaining) United Fruit Company Bananas only producible south of U.S., can’t be frozen, short shelf-life necessitates rapid movement through channels Independent intermediaries slowed process through inefficient bureaucracy, large amounts of bananas lost to spoilage United Fruit’s forward and backward integration (railways, communications, shiplines, plantations) streamlined bureaucracy, organizational efficiencies allowed access to new markets

Failures in Vertical Integration Explained by Transaction Costs Integration into raw material processing by tobacco and sugar beet producers Integration into distribution and exclusive retail arrangements with pubs by breweries Neither industry had sufficient complexity requiring integration, and all returned to market-based organization after posting losses GE spurned forward integration for low complexity consumer goods i.e., light bulbs, as independent retailers were sufficient to market these products (low asset specificity)

Current Applications On the other hand, innovation intense new product development requires greater levels of coordination between research, production, distribution and after sales servicing Internalization can meet these coordination requirements and provide means for firms to enter new markets like Swift and United Fruit Companies Example: Monsanto Advances in IT allowing for supplier and distributor aggregation, the small numbers bargaining factor is decreasing in intensity Even where it persists, relationship specific IT systems creates mutual sunk costs, thus reducing opportunism through mutual credible commitments IT advances also replace hierarchical employee input for quality control Resulting reduction in transaction costs motivating firms to shift from hierarchy to market-based organization Example: Walmart, Proctor & Gamble

Additional Thoughts and Questions Focus of discussion of organizations polarized on market-based or hierarchical. Williamson & Parmigiani discuss “hybrid” or “spectrum” organizations, which would seem applicable to the transition periods from market-based to hierarchical these firms underwent. Study of transition periods and relative durations and costs could provide greater insight on transaction costs theory as a complement to Chandler’s work. Williamson discusses the strength of legal systems and the importance of reputation as keys for maintaining contract integrity. How could the status of the legal system, labor organization, and information availability during the inside-contracting period enable opportunistic behavior for either party? Besides contemporary examples mentioned, what other examples of integration and de-integration from today can be discussed using transaction costs lens? (ex. Eden McCallum’s facilitated network, Chicago Cubs and Tom Tango)