Welcome

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

2. What we will study… • Transaction Cost Economics • Virtual Companies & formation of firm boundaries • Economic Theory: Boundary of the firm Markets Networks Firms Agents

3. A Virtual Firm Sun Microsystems, Inc. • Sun Microsystems, a leading maker of computer workstations, concentrates on hardware and software design, where it distinguished itself from competitors, and outsources nearly everything else in its value chain • It relies so heavily on external manufacturers and distributors that its own employees never touch one of its top selling products • After a vendor assembles the machine, another contract supplier delivers it to the customer

4. Virtual Designs In a Virtual Corporation,...: "...the majority of the activities of the firm are contracted or outsourced." This allows the firm to focus on its strategic, core processes (core competencies) Strategic alliances.....

5. Economic Paradox • In 1958 the Harvard Business Revenue predicted that computers would lead to a greater concentration of power in American business because they would allow bosses to keep better track of information within large firms. Eventually, it predicted that the economy would be dominated by a few giants. In 1967 economist J.K. Galbraith argued that new technology would inevitably lead to increasing dominance by big corporations immune to market forces. • These predictions have turned out wrong: the average size of firms has shrunk and competition has decreased since 1960’s. Recent research suggests that the economy is beginning a transition from large, vertically integrated enterprises to organizational forms that draw on resources of small, independent specialists suppliers. For example, in a study of 549 large firms, increased use of IT has found to be associated with substantial decreases in firm size and diversification.

6. 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 Costs C(Q) A $100 B 80 Output $10 0

7. 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.

8. 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.

9. 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

10. 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

11. 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

12. Basic attributes of transactions • Specificity • Frequency • Duration • Complexity • Uncertainty • Difficulty of measuring performance • Connectedness

13. 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”

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

15. 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

16. Basic attributes of transactions • Specificity • Frequency • Duration • Complexity • Uncertainty • Difficulty of measuring performance • Connectedness

17. Specificity & Frequency

18. Your Mission • You are a principal in a high tech start-up with 70m in funding and a rapidly growing customer base. Your business model has been tested in several pilot markets and the board has given the green light to scale up from 2 to 10 markets. This will make significant scalability demands of your IT function that, up to now, you have grown internally. At a management meeting, the chairman asks: “ What do you recommend?“

19. Your Task • Use the tools provided by TCE to evaluate the following alternatives: • Full outsourcing • Partial outsourcing (specify what functions) • Internal integration

20. Consider these factors • Specificity • Frequency • Duration • Complexity • Uncertainty • Performance measurement • Connectedness • Search Costs • Price Determination • Quality Monitoring

21. IT, Complexity & Specificity Hierarchy Product Complexity Market Asset specificity

22. Outsourcers: Who? HP AT&T Index Arthur Anderson IBM Ceridian Dell Lotus Computer Associates US Robotics Primavera EDS Microsoft Compaq Equifax IBM Global Solutions MCI Mom & Pop Consulting Peachtree Software Bell South

23. Factors Favoring Outsourcing • Managers can and should make use of two kinds of arguments in their case for (or against) outsourcing (bandwagon reasoning is not a defensible managerial decision!) Financial arguments • Need for organizations to focus on their strategic assets or core competencies • Realization of greater economies (lower costs) • Need for greater flexibility and expertise in workforce Non-Financial arguments

24. Given a positive financial assessment: Is the Web system or service being considered..... Consider In-house Bids vs. Outsourcer Bids Most Likely to Outsource No A Core Competency/ Strategic Asset? Retain In-house If Outsource, Legal Protections Critical Yes No Yes Does Firm Have Internal Expertise?

25. Outsourcing & Virtual design • A tale of 2 companies….

26. Sell 50,000 computers with only 4 days of inventory • Keep few suppliers very close • 30 suppliers 75% of materials • When order is made, signal is sent to supplier, 90 minutes later, supplies are delivered to Dell. • “We sell what we have, we don´t sell what we don´t have”

27. Dell From HBR • Have as few suppliers as possible • In real time, communicate your inventory levels and replenishment needs to them • Order from suppliers only when you receive demand from customers.

28. By going direct; no Channel Push VARS Manufacturers End Users Wholesalers/Distributors

29. Avoiding the Risks… • Assets & Inventory • Accounts receivable • Use technology to bring benefits of vertical coordination to the network

30. Darling of stock market. • First Virtual company • No inventory, no warehouses • But what happened…..

31. Bringing vertical coordination to the network… but how? 3,500 modular parts 30+ suppliers Over 1 million products, many suppliers

32. IT, Complexity & Specificity Hierarchy Product Complexity Market Asset specificity