Lecture 2: Organizational Boundaries

Lecture 2: Organizational Boundaries Professor Alexander Settles

Organization Boundaries • Boundaries – why the boundary between firms and the market is located exactly there? Which transactions are performed internally and which are negotiated on the market? • The division between the organization and external environment • Why important? • Boundaries provide control – efficiencies are derived from this control • Clear demarcation between organization’s internal interest and society’s external (or general interest) • Hard, permeable, soft boundaries are crucial for firm organization and operation

Boundaries in Action

Theory of Firm Boundaries • Ronald Coase “The Nature of the Firm” (1937) • Market: resource allocation through price mechanism • Firm: resource allocation by authoritative direction

Coase • Employing the price mechanism to allocate resources is costly • The cost of employing the price mechanism determines firm/market boundary • Enforcing property rights is costly • Balance is reached between these relative cost and boundaries is decided

Transaction Costs • Cost of exchanging good in a market • Cost of enforcing property rights

Falling TC & Economic Organization We should expect… • more market, less hierarchy • fewer intermediaries • more networks

Inside or Outside Sales Force? • Now suppose a third action which exogenously offers a high incentive intensity (sell other’s product) • If outside agent, cannot easily prevent taking this option, so must offer strong incentives to attract attention. Means no info gathering. • If inside, can offer weaker incentives but ban doing third option. • If info gathering important, use inside.

What are Horizontal Boundaries • Identifies the quantities and varieties of products and services a firm produces. • The expansion of a company by purchase or acquisition of similar products or services

Horizontal vs.Vertical Integration • Horizontal is the production of a different product, using the same inputs. • Vertical integration is when a manufacture expands upstream or downstream in the production chain

Examples of Horizontal Integration • Standard Oil Companies acquisition of 40 refineries • Ford Automobile acquisition of Jaguar • Media companies ownership of radio, television, newspapers, books, and magazines

Advantages of Horizontal Integration • Economies of Scale • Economies of Scope • Increased Market Power • Brand Name Recognition • Diversification

What is Economies of Scale? • Economies of Scale- achieved by selling more of the same product. This will make the average cost decline as output increases, but will eventually rise as production reaches capacity constraints.

What is Economies of Scope? • Economies of Scope- achieved by sharing resources common to different products. By using common resources a firms savings will increase as the variety of goods or services increase.

Major Sources of Scale and Scope Economies • Indivisibilities and the spreading of fixed cost • Increased productivity of variable inputs • Inventories

Economies of Scope & Scale • Present whenever large-scale production, distribution, or retail processes have a cost advantage over smaller processes. • They effect pricing and entry strategies. • Not always available in some industries.

How do they differ? • Scale deals with quantities of products or services • Scope deals with the variety of products or services

Horizontal Integration Advantages Cont. • Increased Market Power- over suppliers and downstream channel members • Brand Name Recognition- customer. perception of a linkage between products. • Diversification- less effected by industry swing

Disadvantages • Beyond a certain size bigger is no longer better • Anti-Trust issues can arise • Difficult to control

Vertical Integration • Vertical chain: The process that starts with the acquisition of raw materials and ends with the sale of finished goods and services • Vertically integrated firms: Firms that perform many of the steps in the vertical chain themselves. • Vertical boundaries: What a firm does on its own rather than buy from someone else.

Upstream, Downstream • Goods flow along a vertical chain from raw materials and component parts to manufacturing, through distribution and retailing. • Being “upstream” or “downstream” depends on where you are on this chain. • At each stage in the chain a firm has to make the decision whether to “make” or “buy”

Make versus Buy • Make-or-Buy decision. This is the decision to perform an activity itself or purchase it from an independent firm. • Make- when a firm decides to make or provide the activity, it is vertically integrated. • Buy- when a firm decides to buy activities or inputs from the market, it is Using the market

Defining Boundaries • deciding to make or buy, the firm must compare the benefits and costs of using the market as opposed to performing the activity.

Benefits of Using the Market • Market firms can achieve economies of scale that in-house departments producing only for their own needs can’t. • Market firms are subject to the discipline of the market and must be efficient and innovative to survive. Overall corporate success may hide the inefficiencies and lack of innovativeness of in-house departments.

Costs of Using the Market • Coordination of production flows through the vertical chain may be compromised when an activity is purchased from an independent market firm rather than performed in-house. • Private information may be leaked when an activity is performed by an independent market firm. • There may be costs of transacting with independent market firms that can be avoided by performing the activity in-house

Make or Buy Fallacies • Firms should generally buy, rather than make, to avoid the costs of making the product. • Firms should generally make, rather than buy, to avoid paying a profit margin to independent firms • Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand or scarce supply.

Tangible Benefits of Using the Market • Market firms may aggregate the needs of many firms and thereby have economies of scale. • Market firms use the experience they earn from producing for many firms to obtain learning economies. • Market firms may possess proprietary information or patents that enable them to produce at lower cost.

Intangible Benefits of Using the Market • Agency Costs- They are the costs associated with slack effort and how to deter it. The agency costs associated with more vertically integrated firms will go unnoticed by upper management. • Influence Costs- These are the costs of activities to influence internal capital markets. They include the direct costs of influence activities and the costs of bad decisions that arise from influence costs. Large vertically integrated firms are more prone to influence costs that a small firm could avoid.

Costs of Using the Market • The 3 major costs associated with using the market include: • The costs of poor coordination between steps in the vertical chain. • The reluctance of trading partners to develop and share valuable information. • Transaction costs.

Coordination of Production Flows Through the Vertical Chain • Coordination is critical in order to exploit economies of scale. • For coordination to succeed decisions must be made based on decisions made by others. • It is important because without it suppliers would be unable to produce an adequate supply, distribution may not have enough room to store the product if the supply is off, and retailers must have an appropriate marketing campaign to sell the product. • In order to help coordinate, contracts are used so everyone has an idea of what to expect.

Leakage of Private Information • Private information on how to produce something or consumer trends can give an opposing firm an advantage in the market. • The more you use the market to obtain supplies and distribute your product, the higher the risk of losing control of private information.

Transactions Costs • These include the costs from the expense of negotiating, writing, and enforcing contracts. • They occur when one or more parties seeks private gain at the expense of the greater good.

Industry Trends • The 1980’s saw the emergence of computer and telecommunications as management and production tools. • This allowed for the better coordination of goods from production to distribution. • It also allowed smaller firms to be more competitive with large firms because of reduced cost advantages.

Industry Trends (Cont.) • As a result small firms have become very specialized at performing specific tasks for the market, while manufacturing employment has stagnated. • Firms have become less vertically integrated. • Instead they tend to focus on core business activities, or gaining market share by expanding horizontally.

Employee or Contractor? • Ownership of tools • Effort on production (easy measure), maintaining tools (imprecise measure) • If Worker owns tools, faces strong incentives for maintenance, must offer strong incentives for output. • If Principal owns tools, can offer only weak incentives for maintenance, so must offer weak for output.

Readings • Madhok A (1996) The organization of economic activity: Transaction costs, firm capabilities, and the nature of governance, Organization Science, 7 (5) 577-590.

Property Rights • Property rights tradition, ownership provides the right to use, modify and transform, and enjoy the returns from the asset. • This creates the scope to both reduce the costs (including those that are not related to cheating and shirking) as well as increase the benefits from an asset due to superior capabilities.

Organization Capacity • Ability of organization to create value • The boundary decision may involve factors other than just a minimizing of organizing costs • Firms do not succeed (or exist) because shirking costs are lower than cheating costs but because they simply do certain things better

Transaction cost versus Organization Capacity • (TCM - (ICGOV + ICCAP) • Where: TCM - transaction cost in market; ICGOV - internal governance costs; ICCAP - internal organization costs • (TBINT + TCM) - (ICGOV + ICCAP) • Where: TBINT – transaction benefit internally

SANTOS, F., & EISENHARDT, K. (2009, August). CONSTRUCTING MARKETS AND SHAPING BOUNDARIES: ENTREPRENEURIAL POWER IN NASCENT FIELDS. Academy of Management Journal, 52(4), 643-671.

Research Question • How do entrepreneurs addressing nascent markets shape their organizational boundaries over time? • Comparison of soft-power strategies based on subtle persuasion to dominate new markets, rather than traditional hard-power tactics of coercion based on extensive resource control

Results (1) claim a new and distinct market space and become its “cognitive referent” through identity-based actions; (2) demarcate this market by specifying firm and market boundaries through alliances with established firms; and (3) control the market by overlapping the boundaries of the firm and market over time through acquisitions that eliminate entrepreneurial rivals

Theory contributions Proposition 1. Firms that proactively use identity- claiming mechanisms (i.e., templates, stories, and leadership signals) are more likely to become the cognitive referents in distinct markets. Proposition 2. Firms that proactively use demarcating alliances with established firms (i.e., revenue sharing, equity investment, antileader positioning) are more likely to face lower levels of competition. Proposition 3. Firms that proactively use controlling acquisitions of entrepreneurial rivals (i.e., elimination, market coverage, entry blocking) are more likely to have higher market share.

Proposition 4. Entrepreneurs that intertwine boundary processes are more likely to (a) become the cognitive referents in distinct markets, (b) face lower levels of competition, and (c) have higher market share. • Proposition 5. Firms that use soft-power tactics to shape boundaries (i.e., illusion, exploiting others’ natural tendencies, timing) are more likely to achieve (a) cognitive dominance (become the cognitive referent in a distinct market) and (b) competitive dominance (face a lower level of competition, have greater market share). • Proposition 6. Firms that, over time, proactively combine claiming, demarcating, and controlling boundary processes are more likely to sustain near-monopoly positions in constructed markets.

Boundary Spanning Behavior • Leifer, R and G. P. Huber (1977) Relations Among Perceived Environmental Uncertainty, Organization Structure, and Boundary-Spanning Behavior

Terms and Hypothesis • Organicness – organic structure • PEU – perceived environmental uncertainty • H1 Organicness will be positively associated with PEU • H2 Organicness will be positively associated with the frequency of boundary spanning behavior • H3 Frequency of boundary spanning behavior will be positively associated with PEU

Model Results

Results • Organciness (organization’s organic nature) is associated with boundary spanning behavior

Lecture 2: Organizational Boundaries