1. Explaining the swollen middle: Why most transactions are a mix of “market” and “hierarchy”
Jean-Francois Hennart
Organization Science
(1993)
Presented by Daniela Pedraza Novak

2. Goal Motivation Price System Hybrid Hierarchy Market Firm
To develop a model of the choice of institution
To extend Transaction Cost Theory
CONTINUUM
(Organizing Method)
(Institution)
Price System Hybrid Hierarchy Market Firm
The goal of this paper is to develop a model of the choice of institution and its main motivation comes from a desire to extend TCT. Not only because it neglected the complexity of institutions (by focusing on the two extremes of the continuum) but also because it failed to distinguish between transaction costs and management costs. To be able to visualize the model Hennart developed I have visually represented the continuum just mentioned. As you can see, here are the two extremes TCT focuses on. On one extreme we have Price System and on the other Hierarchy.
Hierarchy and the price system are two distinct organizing methods for organizing transactions, each with particular costs and benefits.
Markets and firms on the other hand, are the institutions that use these methods.
Even though markets mostly use prices and firms rely on hierarchy there is no one-to-one relationship between prices and markets or between hierarchy and firms. As a matter of fact, the author argues that it is generally more efficient to use a mix of both methods than to specialize in either. Hybrid arrangements do just this.

3. Focus of the paper The enforcement properties of prices and hierarchy
CONTINUUM
(Organizing Method)
(Institution)
(Enforcement)
Price System Hybrid Hierarchy
Market Firm
Price incentives Behavior Constraints
(indirectly-output) (directly-input)
The paper focuses on the enforcement properties of Prices and Hierarchy, explaining that Hierarchy controls individuals in a direct manner by constraining their behavior while the Price System does it indirectly by measuring their outputs.
For instance, under Hierarchy employees receive a salary to do what they are told to do
Under the price system self-employed individuals are rewarded based on their output
In other words, one uses behavior constraints while the other uses price constraints.
But like I mentioned in our previous slide, and what is more important to remember is that according to the author using a mix of both methods generally minimizes organizing costs ( a concept I will now define)

4. Transaction Costs Management Costs
Costs within markets and firms
Firm
Market
Rewards output Rewards Behavior
Transaction Costs Management Costs
To make sense of this slide we are going to start at the bottom and slowly make our way up.
Organizing costs are the sum of cheating costs and shirking costs and they are the result of bounded rationality, opportunism and a divergence of goals between individuals.
The costs incurred by the price system are referred to as cheating costs, and they are the sum of the cost of measuring output plus the cost of the residual amount of cheating due to imperfect measurements.
The costs incurred by the hierarchy system are referred to as shirking costs, and they are the sum of the cost of constraining behavior plus the residual amount of shirking due to imperfect behavior constraints.
Notice that these costs are now being differentiated by Hennart. Unlike in previous TCT , transaction costs and management costs are now identifiable within this continuum.
Now it is important to notice that each system has its own biases.
Because the price system indirectly guides behavior by rewarding output, outputs and effort might increase (minimizing shirking) However this may incite individuals to reduce the quality of their output (encouraging cheating)
On the flip side, relying on hierarchy results in the opposite bias. Individuals have less incentives to cheat but strong incentives to minimize effort (to shirk) unless properly supervised.
Ultimately, it is important to note that Hierarchy reduces cheating by breaking the connection between outputs and rewards.
+Outputs
+Effort
-Quality
Cheating Costs
Shirking Costs
-Effort
Organizing Costs

5. 3 Questions
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?
Now that we understand the model proposed we can discuss the three questions this article seeks to answer.

6. Choice between Markets & Firms
Total organizing costs are the sum of cheating costs and shirking costs
CS’=CC’+SS’
As behavior constraints replace price constraints (), the level of cheating costs falls, and the level of shirking costs rises
As price constraints replace behavior constraints (), the level of cheating costs rise, and the level of shirking costs falls
The institution chosen will be that for which total organizing costs is the lowest
H = Pure hierarchy
M = Pure price solution
Transactions (output is easy to measure, consequences of not measuring it are low, and behavior is difficult to direct and monitor)
Lets first talk about the choice of institution
Like mentioned before, total organizing costs are the sum of cheating costs and shirking costs
And we can see that in these figures
But what these figures also tell us is that
- as behavior constraints replace price constraints (and we move from left to right), the level of cheating costs falls, and the level of shirking costs rises
- as price constraints replace behavior constraints (and we move from right to left), the level of cheating costs rise, and the level of shirking costs falls
This is key when choosing between markets and firms, as the chosen institution will be that for which total organizing costs are the lowest
So here are two examples: point H and point M
Lets for instance take point M as an example.
M is a pure price solution for transactions, for which output is relatively easy to measure and the consequences of not measuring it are low, but for which behavior is difficult to direct and monitor.
Having said that, we all know M is not very realistic. Just like H isn’t either

7. The Swollen Middle: Hybrids
Institutions combine both price incentives and behavior constraints (using prices to control some behavior)
Examples: stock option plans, price work schemes and bonuses
Result= Lower incentives to shirk and cheat
Diminishing return in measuring output and constraining behavior
In reality, institutional arrangements combine both price incentives and behavior constraints (using prices to control some behavior)
Examples of this are price stock option plans, price work schemes, and bonuses.
For instance, paying an employee a base salary plus a commission related to the number of sales he or she produces is a very common and effective way to lower incentives to shirk and lower incentives to cheat.
The weight of each component in someone’s salary is entirely up to the institution. This is why there are infinite hybrids. This is why the author calls it the swollen middle. Because there are too many.
Additionally, it is important to remember that this mix is tightly related to the concept of diminishing returns in measuring output and constraining behavior.
It is now clear that it will not pay to attempt to measure outputs perfectly. If firms did that, they would lose money. In fact, measurement costs will be incurred only up to the point where the marginal cost of measurement equals its marginal benefit.

8. Price incentives
Firms implement price incentives to reduce the high cost of constraining employee behavior
Two main forms
Piecework schemes – link part of the pay to output
Profit centers – link manager compensation to subordinates’ performance (M Form)
Most likely implemented by:
Large and diversified firms
Low managerial expertise
Limited knowledge regarding costly to supervise activities
One implication of the model is that firms implement price incentives to reduce the high cost of constraining employee behavior.
The article describes two main forms of price incentives: piecework schemes and profit centers
Piece work schemes link part of the pay to output while profit centers link manager compensation to subordinates’ performance. This is typical of M form firms, or firms with separate groups or divisions. Firms with a decentralized approach. As a matter of fact, the higher the costs of monitoring subunits, the greater the benefit of price incentives.
Which leads us to conclude that price incentives are more likely to be implemented by the following firms:
Large and diversified firms, firms with low managerial expertise and firms with limited knowledge regarding costly to supervise activities.

9. Answers to the 3 questions
Why are firms sometimes more efficient than markets at organizing transactions?
Because firms tend to combine price incentives and behavior constraints more effectively (using prices to control behavior)
Why are most transactions arrayed in the "swollen middle," incorporating features of both "market“ and "hierarchy"?
Hybrid arrangements using a mix between price incentives and behavioral constraints, minimize organizing costs
Why don't firms make greater use of price incentives?
Price incentives reintroduce cheating costs. Firms use them when they significantly reduce shirking costs with a minimum increase in cheating costs.
OK. Now that we have talked about the model in depth, we can discuss the answers to the 3 questions posed at the very beginning.
Why are firms sometimes more efficient than markets at organizing transactions?
Because firms tend to combine price incentives and behavior constraints more effectively (using prices to control behavior)
In other words, it is not because they mimic the price system that firms can sometimes incur lower organizing costs than
markets, but because they replace price constraints with behavior constraints
Why are most transactions arrayed in the "swollen middle," incorporating features of both "market“ and "hierarchy"?
Hybrid arrangements using a mix between price incentives and behavioral constraints, minimize organizing costs
Why don't firms make greater use of price incentives?
Price incentives reintroduce cheating costs. Firms use them when they significantly reduce shirking costs with a minimum increase in cheating costs.

10. Summary – 6 Propositions
1. Economic institutions ≠ Organizing methods
(Markets & Firms) ≠ (Price system & Hierarchy)
2. Price System rewards output; Hierarchy rewards behavior
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
4. Price systems minimize shirking; hierarchies minimize cheating
5. Institutions use a mix of price incentives and behavior constraints
Diminishing returns in measuring output and constraining behavior
6. Most institutions are hybrid
Bulging middle of the continuum
Finally, I would like to reiterate the six propositions of the model discussed in this article.

11. Conclusions
The article developed a "comparative institutional" model in which economic institutions are analyzed as a mix of two pure organizing methods, hierarchy and the price system.
No special theory is needed to account for hybrid institutions; they can be analyzed as combinations of the two organizing methods of price and hierarchy
The article developed a "comparative institutional" model in which economic institutions are analyzed as a mix of two pure organizing methods, hierarchy and the price system.
However, the biggest take away is that no special theory is needed to account for hybrid institutions; they can be analyzed as combinations of the two organizing methods of price and hierarchy.