1. Welcome Strategies of Network Companies Jonathan D. Wareham wareham@acm.org

2. What are Networked Companies?  Supply chains  Procurement systems  Sales channels  Out sourcing  Off shoring  Inter-Organizational Systems  E-Lance and Free-Lance  Web Sevices  New constructions of transacting entities that do business in fundamentally new ways.

3. Where technology affects transactions

4. Why study them?  New methods of transacting offer new challenges for management  Understand what they are  Understand the problems and conflicts  Find and use the right tools to analyze problems and recommend solutions.

5. The basic phenomenon  Advances in Information and Communication Technology have enabled new methods of interacting and transacting.  Buying, selling, contracting, supplier relationships, vendor relationships, price setting, etc…

6. Where the Tools meet the Technology Economics Sociology Management

7. Core Issues  Transacting  In-house or out-source?  Boundary of the firm  Sourcing agreements  Contract management  Employees & personnel management in networks  Intermediaries  Pricing

8. Economics as a Discipline Assumes that people have endogenous utility functions and they pursue them Largely a problem of optimization Must make certain assumptions about people/firms to solve optimization problems Defines generic roles and structures for agents/firms – calculates equilibrium point If you can live with the assumptions and logic, it can be very powerful!!!! Base discipline for Strategy, Finance, Marketing, Accounting…..

9. Sociology  “Sociology is a science which attempts the interpretive understanding of social action in order thereby to arrive at a causal explanation of its course and effects.... Action is social when it takes into account the behavior of others and is thereby oriented in its course“ (Weber, 1947).  Preferences and actions are exogenously determined….The big sponge view

10. Road Map

11. Life Insurance & Suicide

12. Information Asymmetry  Differences among individuals in their information, especially when this information is relevant to determining an efficient plan or determining individual performance.  In simple terms: a situation that exists when some people have better information than others.  Example: Insider trading

13. 2 types of Information Asymmetry 1.Hidden characteristics Things one party to a transaction knows about itself, but which are unknown by the other party. 2.Hidden actions Actions taken by one party in a relationship that cannot be observed by the other party.

14. Scenarios  You rent a car, you’re young, beautiful a free spirited, wind in your hair. Go ahead, trash the car, drive it hard, Why Not????  You’ve been working hard all day. The boss leaves for a few hours. Go ahead, kick back, relax, drink a beer, surf the net….Why Not???

15. Moral Hazard  Originally from the tendency of people with insurance to reduce the care they take to avoid losses or reduce insured losses. Now the term refers to a form of post-contractual opportunism that arises when actions desired or required under the contract are not freely observable.  Situation where one party to a contract takes a hidden action that benefits him or her at the expense of another party.That is.. you do not directly bear the consequences of your actions. 1.potential divergence of interest 2.basis of gainful exchange or transaction 3.difficulties in monitoring and enforcing

16. Solutions I  Signaling  Attempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party.  To work, the signal must not be easily mimicked by other types.  Example: Education… ESADE MBA

17. Solutions II  Improve monitoring  Competing sources of information  Monitoring by markets  Explicit incentive contracts. Linking pay to some operational output  Achieving goal congruence  Sources of social governance eg. reputation, peer approval, morals, religion, culture,  Corporate culture: Workable principles or routines of shared expectations that guide behavior in the face of uncertainty.

18. Problem  Characteristics of population have specific mean and distribution, but those buying insurance have different profile. Why? Examples:  Choice of medical plans  High-interest loans  Auto insurance for drivers with bad records  USAA

19. Adverse Selection  pre-contractual opportunism that arises when one party to a bargain has private information about something that affects the other's net benefit, implying that it would be dis - advantageous for another party to enter the contract  Situation where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics

20. Solutions Screening Attempt by an uninformed party to sort individuals according to their characteristics. Often accomplished through a self- selection device  A mechanism in which informed parties are presented with a set of options, and the options they choose reveals their hidden characteristics to an uninformed party. Example: Price discrimination

21. Opportunism: degrees 1.Self interested behavior 2.Self interested behavior unconstrained by morality 3.Opportunism with guile: you may actually not mind, or even enjoy - doing something at someone else's expense!

22. Opportunism: Debate!!!  Is it soooo bad????  Just how prevalent is it?  How to we mitigate or protect ourselves against it?  If we consciously choose not to be opportunistic, is it because we are simply “good” people, or is it because we believe there will be long term benefits?

23. Buying a Car You are here! Price= 11,000 Nom. Value= 100 Distance= 12mi. Value(dist).=1.89 Price= 15,000 Nom. Value= 95 Distance= 15mi. Value(dist.)=1.05 Price= 10,000 Nom. Value= 140 Distance= 18mi. Value(dist.)=1.94

24. Bounded Rationality  The limitations of human mental abilities that prevent people from foreseeing all possible contingencies and calculating their optimal behavior.  Also includes limitations of human language that prevent people from communicating things that are known.  We assume agents are rational, but only sort of rational  Theoretical garbage can

25. Fairness - Retaliation  Negative Reciprocity & Envy: You hurt me, I will hurt you back! I will even take pleasure in it making you suffer loose something at my expense.  Explanations: Comes from survival instincts in nature  Only in very simple societies do we find less negative reciprocity (people are happy with relatively small shares of money).

26. Altruism & Fariness  Economist world view based on self interested behavior.  I help you, even when I get nothing back for it..  How do we explain it?  Why don’t companies reduce salaries in hard times? The fire people instead

27. An experiment  Imagine you are stranded on a beach on a sweltering day and that someone offers to go for their favorite brand of beer. How much would they be willing to pay?  Subjects agree to pay more if they are told that the beer is being purchased from an exclusive hotel rather than from a rundown grocery. It strikes them as unfair to pay the same.  But a beer is a beer and should be worth the same???  Social preference: I accept prices that I feel are fair to you…

28. Buying a house  I am selling my house for 350,000  If you knew I bought it 3 years ago for 320,000, would you think it is a good deal?  If you new I bought it 3 years ago for 150,000, would you think it is a good deal?

29. What is the average rainfall of New Zealand?  45cm  55cm  63cm  79cm  114cm  123cm  156cm

30. The Law of Small Numbers – Weber’ law (people are petty…) I. You are buying a glass of orange juice. You can buy it here for 4 Euro, or walk across the street and buy it for 3 Euro. What do you do? II. You are buying a big screen TV. You can buy it here for 800 Euro, or walk across the street and buy it for 799 Euro. What do you do? III. the impact of a change in intensity of a stimulus is proportional to the absolute level of the original stimulus. In financial terms, a $500 gain on a $100 investment is greater psychologically than a $500 gain on a $1000 investment.

31. Investors  Alex invested 100,000 Euro and gained 27,000 for a total of 127,000 Euro.  Anne invested 300,000 Euro and lost 39,000 for a total of 261,000 Euro.  Who is happier? Why?

32. Prospect Theory

33. Prospect Theory Says  1 unit of loss hurts about twice as much as 1 unit of gain. So….We are loss averse  What would you rather have; 10 Euro today, or 5 Euro today and 5 Euro next week? Changes are more important than absolute levels  What is better – you crash your car once and it costs you 1000 Euro. You crash your car twice and it costs you 400 and 600 Euro respectively.

34. Changes..  What is happiness?  Are rich people really happier? (Of course they are)  We anchor everything to our current status.  Sooo What: Combine losses, spread out gains  We tend to hold onto loosing stocks..

35. ...Decisions Are Not Always “Rational”

36. Price Perception Issues are Complex...  More Acceptable Pricing Product-Based Open Discretionary Discounts and Promotions Rewards  Less Acceptable Pricing Customer-Based Hidden Imposed Surcharges Penalties

37. Time  You are going to order a new BMW for 60,000 Euro.  The car dealer A tells you that you can get the car delivered in 7 days.  Car dealer B, who is 4 blocks away, tells you the car can be delivered in 3 days.  Do you walk down the street to the other car dealer – price and other options being equal?

38. Time  You are going to order a special BMW for 140,000 Euro.  The car dealer A tells you that you can get the car delivered in 94 days  Car dealer B, who is 4 blocks away, tells you the car can be delivered in 90 days.  Do you walk down the street to the other car dealer – price and other options being equal?

39. Procrastination  Scenario A May 1: Work 7 hours May 2: Relax  Scenario B May 1 Relax May 2 Work 7.7 hours Today is April 30 th - which option would you choose?

40. Procrastination  Scenario A August 1: Work 7 hours August 2: Relax  Scenario B August 1 Relax August 2 Work 8 hours Today is April 30 th - which option would you choose?

41. What is the average rainfall of New Zealand?  63cm  79cm  114cm  123cm  156cm  164cm  178cm

42. Framing Effects  People base their decisions on the references given  Extremes aversion  2 nd cheapest wine most expensive

43. Endowment Effects  What would you pay for this chair?  10.00 Euro fine  How much will you sell this chair for?  10.01 Euro???

44. What are institutions?  They are a response to:  Moral hazard  Adverse selection  Information asymmetry  Bounded rationality  Opportunism Uncertainty

45. Prisoner’s Dilemma

46. Key Insights of Game theory  Put yourself in your rival’s shoes  Use analysis to identify dominant strategies  Not all games are games of conflict.  Communication can help solve coordination problems.  Sequential moves can help solve coordination problems.  Collusion can be sustained as a Nash equilibrium when there is no certain “end” to a game.  Doing so requires: Ability to monitor actions of rivals Ability (and reputation for) punishing defectors Low interest rate High probability of future interaction

47. OPEC

48. OPEC’s Demise Low Interest Rates High Interest Rates

49. Economics & Rational Choice  Individualism: only individuals make social actions, and social actions cause the macro social outcomes one wishes to explain.  Optimality: individual actions are social actions optimally chosen given the individual’s transitive preferences across opportunities he or she perceives.  Self-Regard: individuals’ actions and social actions are entirely concerned with their own welfare  We are but isolated, atomized, self-serving, algorithms

50. The Manager’s role Procure inputs in the least cost manner Provide incentives for workers to put forth effort Failure to accomplish this results in a point like A $100 80 $10 0 Output Costs A B C(Q)

51. Methods of Procuring Inputs  Spot Exchange When the buyer and seller of an input meet, exchange, and then go their separate ways.  Contracts A legal document that creates an extended relationship between a buyer and a seller.  Vertical Integration When a firm shuns other suppliers and chooses to produce an input internally.

52. Knight (1921) & Coase (1937) Coase (1937) Why do we have firms? Knight (1921) Why don’t we have one big firm? possibility of monopoly rents motivates continuous and unlimited expansion of firms, But we do not always see it. There must be offsetting mechanisms.

53. Ronald Coase (1937) Why do we have firms? there must be some cost in using the price mechanism. Price discovery/search costs Contract negotiation Long term stability of supply sources (uncertainty) Ergo, operation of the market costs something, and by forming and organization and letting some authority to allocate resources, some costs are saved

54. Coase’s Argument  Transactions vary in nature and dimension, and will align themselves with the governance mechanisms which manages these transactions most efficiently.  Size of firm increases until additional rent gained by bringing transaction in house is superceded by cost of bringing it in. That is, it has to be more costly on the market  Coase theorem: Efficiency determines organizational structure

55. Coordination Costs  Price determination  Details of transaction  Disclose existence of buyers and sellers to execute transactions  Search prices or quality control  Compiling and transferring information

56. Basic attributes of transactions  Specificity  Frequency  Duration  Complexity  Uncertainty  Difficulty of measuring performance  Connectedness

57. Asset Specificity  Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship  Site specificity  Physical-asset specificity  Dedicated assets  Human capital  Lead to higher transaction costs and the problem of “hold-up”

58. Rule of thumb Substantial specialized investments relative to contracting costs? Spot Exchange No Complex contracting environment relative to costs of integration? Yes Vertical Integration Yes Contract No

59. Internal Vs External Coordination  Internal: cost of communication and coordination “reduced returns to management”  External: Costs of using market  Balance: Internal External Economies of scale - keep firms at given size,

60. Discussion  Your firm is considering outsourcing its IT function. Use Transaction Cost Economics to help you evaluate this decision.  What important factors are not addressed in a Transaction cost perspective?