Hennart, Jean-Francois. (1993). “Explaining the Swollen Middle: Why Most Transaction are a Mix of ‘Market’ and ‘Hierarchy’,” Organization Science 4(4): 529-547. Hennart, Jean-Francois. (1993).

Motivation Extend Transaction Cost Theory to respond to critiques: TCE is only a theory of market failure—it does not explain why firms succeed. TCE does not distinguish between transaction cost and management costs TCE neglects the complexity of actual institutions Most transactions cannot be categorized as either pure market or pure hierarchy. *No attempt is made to systematically incorporate the criticisms, though some are addressed.

6 Main 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. Two ways to reconcile opportunistic individuals’ interests: Internal control (clan solution) – clan has congruent goals. External control (focus is 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.

Market (rewards outputs) Cheating Costs Market (rewards outputs) Hierarchy (rewards behavior) Organizing Costs Information Bargaining Enforcement How is the price system used in employment relations? Shirking Costs Because of diminishing returns to measuring output and constraining behavior, both firms and markets will often use a mix of price and behavior constraints. Answer: bonuses, piece work schemes, stock option plans, etc. --Sales reps could have a base salary with a bonus option.

Shirking…?

2 Organizing Costs from Measuring Shirking & Cheating The Model Transaction Costs Property Rights Agency Theory 2 Organizing Costs from Measuring People=Risk Neutral

Cheating

Model cont. 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.

Using Price Incentives in the Firm Ceteris Paribus, should be used more when: Large and diversified firm Low managerial expertise (discern behavior & quality) Limited knowledge and/or costly to supervise activities

Discussion Can we use the framework developed by Mahoney 1992 (non-separability and low/high task programmability)? What else would (does) it need? How does this paper relate to Chi 1994? (Especially with regards to cheating) The paper discussed the rise and fall of piecework and/or profit centers. What do you see happening in the future and why? Outsourcing Global Economy New Incentive Schemes Yes and No. I think that it will work, but we should also add an element of Residual Claimancy amounts to the substitution of price constraints for deficient behavioral constraints Would it be better for profit centers to be their own businesses (and eliminate the myopic behavior)? Would that reduce cheating?