1. Explaining the swollen middle: Why most transactions are a mix of “Market” and “Hierarchy”?
Jean-Francois Hennart
Organization Science (1993), 4(4):
Presented by Julie Ao, Fall 2017

2. Summary Three questions the paper addresses:
Why are firms sometimes more efficient than markets at organizing transactions?
Why are most transactions arrayed in the “swollen middle” incorporating features of both “market” and “ hierarchy”?
Why don't firms make greater use of price incentives?
Transaction cost theory can be extended by the comparative institutional model
The model builds upon transaction costs and organizational economics, property rights theory, and agency theory
Model of the governance choice between firms and markets
Also includes the hybrid arrangements (both price and behavior constraints)

3. Key Terms Methods of organizing:
Hierarchy: Rewards on the basis of behavior (inputs)
Price system: Rewards on the basis of outputs
Economic institutions (Firms and markets): Institutions that use one or both of the methods of organizing
Price constraints (cheating cost): Cost of measuring output, plus the losses due to fraud
Behavior constraints (shirking cost): Cost of constraining behavior plus the residual amount of shirking
Organizing costs: The sum of shirking costs and cheating costs

4. Hierarchy and Price System
Hierarchy and price system are two external control mechanisms to reconcile the interests of opportunistic individuals.
Hierarchy:
In the absence of organizing costs, hierarchical method of organizing is characterized by centralized information
With positive organizing costs, hierarchy will suffer shirking costs
Price system:
In the absence of transaction costs, information structure of a market is fully decentralized
With positive organizing costs, price system will suffer cheating costs
Hierarchy and price system are substitutes

5. Choice between Firms and Markets
Increase shirking costs will reduce cheating costs
The institution chosen will be that for which total organizing costs is lowest
For transactions with easy- measure outputs, but behavior is difficult to direct, will be organized through the market.

6. Choice between Firms and Markets (Hybrid)
Actual institutional arrangements combine both price and behavior constraints---using prices to indirectly control some behavior (piece work schemes, bonuses paid to employees, and stock option plans)
Example: Paying salespeople a salary plus a commission related to the volume of their sales
Incentives to shirk are lower, and incentives to cheat are lower

7. Conclusions Why are firms sometimes more efficient than markets?
If the reduction in cheating costs achieved by replacing price constraints by behavioral constraints exceeds the resulting increase in shirking costs.
Why most transactions exhibit features of both markets and hierarchy?
Using a mix of both hierarchy and price system generally minimizes the sum of cheating and shirking costs.
Why don’t firms make greater use of price incentives?
There is tradeoff involved between price and behavior constraints.
Price incentives (piecework and profit centers) tend to be used whenever they significantly reduce shirking costs with only a minimum increase in cheating costs.

8. Discussion
Hybrid arrangements (mixed behavior constraints and price constraints)
For salespeople, salary + commission related to their output
Not for all industries
In the movie industry, most actors are paid a flat fee, but only big-name stars are able to negotiate a percentage of the gross (same as film crew)
What are the differences between “hybrid arrangements” (Hennart, 1993) and “hybrid modes” (Williamson, 1991)?
What are the differences between “organizing costs” and “governance costs”?

9. Williamson (1991)
“Hybrid mode is characterized by semi-strong incentives, an intermediate degree of administrative apparatus, displays semi-strong adaptations of both kinds, and works out if a semi-legalistic contract law regime.” (P. 281)
Adaptation (A): Autonomy, neoclassical ideal, respond independently
Adaptation (C) : Cooperation, conscious, deliberate and purposeful efforts of adaptive internal coordination