Group 3: Jason Franken Prasanna Karhade Hsiao-Ching Lee Marko Madunic Jennifer Shen

1. “Explaining the Swollen Middle: Why Most Transaction are a Mix of ‘Market’ and ‘Hierarchy’,” Organization Science 4(4): 529-547.Hennart, Jean-Francois. (1993). Group 3: Jason Franken Prasanna Karhade Hsiao-Ching Lee Marko Madunic Jennifer Shen

2. TheSwollenMiddle:AMixof“Market”&“Hierarchy” Motivation: • TCEdoesnotdistinguishbetweenthecostsof using hierarchies vs.price systems,andhence neglectsthecomplexityofeconomicinstitutions. Purpose: • Develop a “comparative institutional” model to analyze institutions (firms & markets) as a mix of two pure organizing methods (hierarchy & price systems).

3. TheSwollenMiddle:AMixof“Market”&“Hierarchy” Threeorganizingcosts to achievegainsfromcooperation: • Information costs – inform parties of potential gains • Bargaining costs – devise the rules for sharing of gains. • Enforcement costs – enforce the sharing rules. Distinguish b/w organizing costs w/n markets and firms: • Transaction (cheating) costs (in market) – cost of measuring output & consequences of imperfect measurement. • Management (shirking) costs (in firm) – cost of directing/ observing behavior (input) & doing so, imperfectly. *Iforganizing costs are zero, either prices or hierarchy will work, but choice matters due to bounded rationality & opportunism.

4. TheSwollenMiddle:AMixof“Market”&“Hierarchy” Two ways to reconcile opportunistic individuals’ interests: Internal control (clan solution) – clan has congruent goals. External control(Hennart focuses on these organizing methods) • Price system – indirectlyguidebehaviorbyrewardingoutput. • Employs price incentives • Sufferscheatingcosts=imperfectlymeteroutput+residualcheating. • Hierarchy – directlyspecifiesbehavior&rewards compliance. • Employs behavioral constraints • Suffersshirkingcosts=imperfectlymeterbehavior+residualshirking. • Substituting between price system and hierarchy is a trade-off between cheating costs and shirking costs. • The chosen institution minimizes total organization costs (cheating costs plus shirking costs)

5. Total Organizing Costs Total Organizing Costs Shirking & Cheating Costs Shirking & Cheating Costs Cheating Costs Cheating Costs Shirking Costs Shirking Costs Markets Contracts Piecework Firms Markets Contracts Piecework Firms TheSwollenMiddle:AMixof“Market”&“Hierarchy” The Continuum b/w Markets & Hierarchies  Hybrids: • Institutions often combine price & behavior constraints. • Min.totalorganizationcosts(cheatingcosts+shirkingcosts). • A cost-min. mix of constraints requires a nonlinear relationship b/w constraints & amount of shirking/cheating. • Hybridexamples:contractsconstrainingsalesrepbehavior, restrictedlicensing, commission, piecework, bonus, stock option.

6. TheSwollenMiddle:AMixof“Market”&“Hierarchy” Model (assumes risk-neutral principal & agent): 1) Institution (market; firm) ≠organizing method (price system; hierarchy). 2) Price systems reward output; hierarchies reward behavior (input). 3) Pricesystemsdeter(encourage)shirking(cheating);hierarchies,theopposite. • Transaction (cheating) costs – cost of measuring output & consequences of imperfect measurement. • Management (shirking) costs – cost of directing/observing behavior (input) & doing so, imperfectly. 4) Bulging Middle is due to diminishing returns in metering output & input.

7. TheSwollenMiddle:AMixof“Market”&“Hierarchy” PriceIncentivesintheFirm(savemonitoringcosts): • Higher incidence of use if: • Large and diversified firms. • Lowmanagerialexpertise(discernbehavior&workquality). • Limited knowledge regarding costly to supervise activities. • Takestwomainforms:piecework&profitcenters. • Both suffer the reappearance of cheating costs. • Piecework –links at least part of pay to output. • Frees management from monitoring employee behavior. e.g., 19th century inside contracting (capitalist provides equipment & pays subcontractor by piece); also known in mining as butty or tribute system.

8. Information, Expectations, and the Theory of the Firm • Profit Centers (M-form) tie manager compensation to subordinates’ performance. • “Quasi-firms” buy inputs & sell outputs to other subunits. • Subunit manager rewarded on performance (max. profits). • Price & behavior constraints on profit centers should vary inproportiontothedifficultyofpricinginternaltransactions. • Grant “full exchange autonomy” to managers when internal transfers of inputs and outputs are few & easily priced. • HQs should dictate prices and manager behavior when internal transactions are numerous and difficult to price. • The higher the costs of monitoring subunits, the greater the benefits of M-form structures.

9. TheSwollenMiddle:AMixof“Market”&“Hierarchy” Summary: Six Propositions 1) Institution (markets; firms)≠organizing method (price system; hierarchy). 2) Price system rewards output; the hierarchy rewards behavior (input). 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.

10. TheSwollenMiddle:AMixof“Market”&“Hierarchy” Summary: Six Propositions 4) Price systems minimize shirking; hierarchies minimize cheating. 5) 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. 6) Most institutions are hybrids; hence, the bulging middle.