Presented by Jiyoon Chung Hennart, Jean-Francois (1993). Explaining the swollen middle: Why most transactions are a mix of “market” and “hierarchy.” Organization Science, 4 (4): 529-547. Presented by Jiyoon Chung

Overview Research question: Why do most transactions exhibit features of both markets and hierarchy? Methods of Organizing (the price system and hierarchy) vs. Economic Institutions (markets and firms). A more complete theory of economic institutions should consider simultaneously the costs of organizing transactions (transaction costs) in markets and those of effecting exchange within the firm (management costs) (p. 530).

Organizing Methods vs. Economic Institutions Methods of Organizing: the price system (price constraints) and hierarchy (behavior constraints) The price system rewards agents on the basis of their outputs. Hierarchy rewards on the basis of behavior (inputs). Economic Institutions: markets and firms There is neither a one-to-one correspondence between prices and markets nor between hierarchy and firm.

Prices and Hierarchy with Positive Organizing Costs In a world of zero transaction costs, both the price system and hierarchy would be equally effective (Coase, 1937) (p. 531). However, with bounded rationality, opportunism, and a divergence of goals among individuals, the price system and hierarchy will both incur costs in organizing economic activities. Cheating costs: the sum of the cost of measuring output plus the cost of the residual amount of cheating due to imperfect measurement Shirking costs: the sum of the costs of constraining behavior and of those of bearing the residual amount of shirking

Hybrid Arrangements Determinants of the choice of institution with non-linear organizing costs Explains the presence of transactions exhibiting features of both markets and hierarchy.

The Use of Price Incentives in Firms Employers will use price incentives for those activities about which they have limited knowledge and/or those which are costly to supervise (p. 541). Examples Piecework Profit centers The mix of price and behavior constraints faced by profit center managers should vary in direct proportion to the difficulty of pricing internal transactions (p. 544).

Conclusion Cheating and shirking costs increase more than proportionately as one concentrates in either pure price or behavior constraints. Hence, using a mix of both methods generally minimizes the sum of cheating and shirking costs.

Questions?