Hennart, Jean-Francois (1993). Explaining the swollen middle:

Why most transactions are a mix of “market” and “hierarchy.”

Organization Science, 4 (4): 529-547.

Presented by Jiyoon Chung

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Overview

Research question: Why do most transactions exhibit features of both markets and hierarchy?

Methods of Organizing (the price system and hierarchy) vs. Economic Institutions (markets and firms).

A more complete theory of economic institutions should consider simultaneously the costs of organizing transactions (transaction costs) in markets and those of effecting exchange within the firm (management costs) (p. 530).

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Organizing Methods vs.Economic Institutions

Methods of Organizing: the price system (price constraints) and hierarchy (behavior constraints)• The price system rewards agents on the basis of their outputs.• Hierarchy rewards on the basis of behavior (inputs).

Economic Institutions: markets and firms

There is neither a one-to-one correspondence between prices and markets nor between hierarchy and firm.

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Prices and Hierarchy with Positive Organizing Costs

In a world of zero transaction costs, both the price system and hierarchy would be equally effective (Coase, 1937) (p. 531).

However, with bounded rationality, opportunism, and a divergence of goals among individuals, the price system and hierarchy will both incur costs in organizing economic activities.

• Cheating costs: the sum of the cost of measuring output plus the cost of the residual amount of cheating due to imperfect measurement

• Shirking costs: the sum of the costs of constraining behavior and of those of bearing the residual amount of shirking

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Hybrid Arrangements

Determinants of the choice of institution with non-linear organizing costs• Explains the presence of transactions exhibiting features of both

markets and hierarchy.

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The Use of Price Incentives in Firms

Employers will use price incentives for those activities about which they have limited knowledge and/or those which are costly to supervise (p. 541).

Examples

• Piecework

• Profit centers The mix of price and behavior constraints faced by profit center

managers should vary in direct proportion to the difficulty of pricing internal transactions (p. 544).

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Conclusion

Cheating and shirking costs increase more than proportionately as one concentrates in either pure price or behavior constraints.

Hence, using a mix of both methods generally minimizes the sum of cheating and shirking costs.

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Questions?