Slide 1 © Carliss Y. Baldwin 2008 Where Do Transactions Come From? Modularity, Transactions and the Boundaries of Firms Carliss Y. Baldwin Organizational

Slide 1 © Carliss Y. Baldwin 2008

Where Do Transactions Come From? Modularity, Transactions and the Boundaries of Firms

Carliss Y. Baldwin

Organizational Economics SeminarMITFebruary 14, 2008


Motivation: A Movie of Industry Evolution


Computers, 1979



Lots of New Firms

With attendant transactions and boundaries Transaction-cost economics and property

rights theory cannot explain why industry structure changes

As industry evolves where will new firm boundaries appear?


Contributions of the paper Task network model of production applied to

transactions Synthesis of transaction cost theory, property rights

theory and multi-tasking models of incentives and firm boundaries with modularity theory

Theory of technological change that explains changing transaction locations and changing industry structure

Theory of Transaction-free Zones—their existence and two basic forms


Outline

Literature Definitions Transaction Location Transaction Design Modularization Transaction-free Zones


Literature


Transaction Cost Economics and Property Rights Theory

Based on a sequence of stages model of production (Coase, 1937; Williamson, 1991; Grossman & Hart, 1986; Hart & Moore, 1990; Baker-Gibbons-Murphy, 2002)

– Upstream supplies Downstream

– Two stages, one interface

Property rights theory takes incompleteness of the contractual interface as axiomatic – Given incompleteness, the task is to locate residual control rights

(“ownership”) (Grossman & Hart, 1986; Hart & Moore, 1990; Hart, 1995)

Design of the interface is outside the theory– What exactly passes between Upstream and Downstream?

– Not a question in these literatures


Knowledge-based Theories of the Firm

Reaction to TCE and Property Rights theory Firms are a way to package/divide relevant

knowledge Knowledge gives rise to Capabilities/

Competencies /Routines But knowledge boundaries are not

transactional boundaries …“Firms know more than they make.”

(Brusoni, Prencipe, Pavitt, 2001)


Modularity Theory More micro than the other theories

– Looks at the internal structure of products and processes

Mirroring hypothesis (Henderson and Clark, 1990)

– “Organizations are boundedly rational, and, hence… [their] structure comes to mirror the internal structure of the product they are designing.”

Product module boundaries = Organizational boundaries – [= Firm boundaries] is a common assertion

– but many counterexamples» One firm, many modules

» Several firms, one module


What does the internal (modular) structure of products and processes imply for transactions?

Our topic today…


Definitions


Network graph of how something gets made/produced – Engineering perspective

Imagine a graph of ALL transfers of material, energy, information between Upstream and Downstream– “Activity system” (Porter)

This is a directed graph– Unlike social network graphs

Task network


Design of an Aircraft EngineSosa, Eppinger, Rowles, Management Science, 2004

Within a single firm—Pratt & Whitney

8 subsystems, 54 components, 54 teams

TRANSFERS from column to row

TRANSFERS NOT TRANSACTIONS

Potential Flowpath of TRANSFERS


Mutually agreeable set of transfers with compensation

To make a transaction, you must– Define– Count (Measure)– Compensate

Cost of this work = Mundane Transaction Costs Contrasting definitions

– Williamson: “transactions are the unit of analysis”– Greif: transaction is any social interaction (even with

God)

Transaction

Absense <=> Incomplete Contract


Transaction Location

Mundane transaction costs are low at module boundaries and high in module interiors.


What is a module?

A module is “a group of elements (tasks) that are highly interdependent on one another, but only weakly dependent on elements outside the module.” (Baldwin and Clark, 2000)

Modules are near-decomposable (Simon, 1969)

Ergo, module boundaries are thin crossing points in the task network

Ergo, modules hide information (Parnas, 1974)

– Information hiding ≠ Different knowledge


Example—Smithy and KitchenSmithy Kitchen

CGS1 S2 S3 S4 S5 K1 K2 K3 K4 K5

CG .

S1 x . x x x x

Smithy S2 x x . x x x

S3 x x x . x x

S4 x x x x . x

S5 x x x x x .

K1 x Pot Hookx . x x x x

Kitchen K2 x Transfer x . x x x

K3 x x x . x x

K4 x x x x . xK5 x x x x x .

Why locate the transaction at the module boundary?

Minimum knowledge overlap (KBT)

With LOW mundane transaction costs you can achieve a MORE complete contract => LESS opportunism


When modules are well-defined

Humans locate transactions at module boundaries “without thinking.”

We exchange finished, usable goods, not partly finished, unusable ones.– Conserves knowledge. – Reduces MTC, hence incompleteness, hence

opportunism.


Transaction Design

Can you have a transaction at a thick crossing point…


Can you OUTSOURCE Design and Production of the FAN system?

The dependencies don’t go away by themselves!

Out-of-block dependencies make this a THICK crossing point


Transaction Design Options—1

Minimal Transaction Design– Pay for Fans only– Spot market transaction

Mundane Transaction Costs —Low Opportunistic Transaction Costs—High

– Williamsonian holdup (both ways)– Defensive investments (Grossman-Hart-Moore)

– Uncompensated multi-tasking (Holmstrom & Milgrom, 1994)



Maximal Formal Contract– Pay for everything– At at thick crossing point, “everything” is a lot!

Burden of Mundane Transaction Costs– Accountants outnumber the workers!

Opportunistic Transaction Costs– Unnecessary transfers (“scorecarding”)


Incomplete contract optimal (Hart 1995)

0

Transaction Complexity

Benefits and Costs ($)

Total Transaction Cost

Benefits of Transaction

Opportunistic Transaction Cost

Mundane Transaction Cost

Optimal TransactionDesign

Minimum Complexity Maximum Complexity (depends on thickness of

crossing point)

FormalContract

Costs of:

Property rights (residual control rights) limit ex post damage of renegotiation



Relational Contract (Baker, Gibbons, Murphy, 2002)

– Manage by exception– Create “shadow of the future”

Burden of Mundane Transaction Costs– Less needs to be defined and counted

Opportunistic Transaction Costs– Less opportunism as long as outcomes stay

within reneging bounds


At a Thick Crossing PointRelational Contracts are better…

0

Transaction Complexity

Benefits and Costs ($)


Benefits of Transaction



Optimal TransactionDesign

Minimum Complexity Maximum Complexity (depends on thickness of

crossing point)




FormalContract

RelationalContract

Costs of:


But you can also design the task network to suit the transaction.

Redesigning the task network is called…


Modularization


Software System with Licensed-in Code (La Mantia et. al. 2008)

Before Modulariziation


Software System with Licensed-in Code (LaMantia et. al. 2008)

Before Modulariziation After Modulariziation

Licensed Code

No Depend- encies


Notice how well this story fits with Grossman-Hart-Moore’s theory

Misaligned property rights (to code) Led to costly ex ante investment (change code

structure) To improve ex-post bargaining position (re-

licensing) What’s new is a prediction about the nature of the

defensive investment + Tactical advice– Isolate purchased code behind a modular interface

Story also fits Baker-Gibbons-Murphy: A relational contract would have mitigated the problem


Modularizations in Support of Transactions

Standardized Interfaces– Langlois and Robertson, 1992, stereos and PCs, – Sturgeon, 2002, modular production systems – Jacobides, 2005, mortgage banking

Single Point of Contact– Mayer and Argyres, 2004, software– Staudenmayer et. al., 2005, various

Crossing points were made thinner, but can still be very thick!


But there are other reasons to modularize…

Manage complexity Allow parallel work Create options to innovate

See Baldwin and Clark, Design Rules, for examples


Whatever their stated purpose, task modularizations create new module boundaries, with low transaction costs…

IBM System/360 created the disk drive industry via a modular interface


Integrations remove module boundaries, increase transaction costs

Can be used to squeeze out complementors– Vertical foreclosure

– Fixson and Park, 2007, bike drive trains

Or not— With relational contracts can still have an

economical transaction at a thick crossing point– Japanese auto industry, especially Toyota (Sako, 2004)


Transaction-free zones


When tasks are too interdependent to split apart

Humans automatically create “transaction-free zones”

“Stuff happens” without being defined, counted or paid for– Smithy, kitchen, seminars like this one…

From an evolutionary perspective, TFZs are older than transactions– Strong, instinctive social norms apply


How do you get valuable things into a transaction-free zone?

Birth, adoption, conquest, inheritance, gift Transactions Non-transactional methods are fading in

importance– “Civilization”


Corporations— “Encapsulated” TFZs

Create a “ring of transactions” around an enterprise– Products sold via transactions– Materials, labor, capital, management brought in via

transactions Inside, owners/managers have latitude to design as

they wish—– Even create internal transactions!

Survival of a corporation is predicated on financial sufficiency– Sum of transaction payments must be positive – Otherwise TFZ is bankrupt—must reorganize


Online/Open Source Communities—“Unencapsulated” TFZs

Information flows freely in and out—no transactions at the boundary

Communities make non-rival goods– No threat of holdup

– Don’t want to exclude anyone who might freely contribute resources

Mundane transaction costs become an unnecessary—a burden/drag on productivity


Summary—Empirical Predictions

1. Transactions are more likely to be found at module boundaries than in module interiors.

2. The design of transactions differs systematically with the thickness of the crossing point. Spot transactions are more likely at thin crossing points and formal and relational contracts at thicker ones.

3. The advantages of formal and relational contracts over spot transactions and of relational contracts over pure formal contracts increase with the thickness of the crossing point.

Modular Boundaries and Thickness are observable!


Empirical Predictions (cont)

4. Transactors can sometimes modularize a thick crossing point to reduce transaction costs. Transactional modularization is most likely to occur when the transactors cannot achieve a satisfactory relational contract.

5. In the aftermath of a modularization, entry and competition will arise at the new module boundaries.

6. Transaction-free zones are needed to facilitate complex, interdependent transfers in the task network. Zones that produce rival goods or require large amounts of indivisible capital will be transactionally encapsulated, taking the legal form of modern corporations. Those that produce non-rival goods using low levels of capital can succeed as open zones without well-defined transactional boundaries.


Contributions of the paper Task network model of production applied to

transactions Synthesis of transaction cost theory, property rights

theory and multi-tasking models of incentives and firm boundaries with modularity theory

Theory of technological change that explains changing transaction locations and changing industry structure

Theory of Transaction-free Zones—their existence and two basic forms


Limitations of the paper

No universal theory of “the” firm Anything goes inside a financially sufficient

Transaction-free Zone– Freedom of design– Can have transactions within a zone

» transfer pricing

– Don’t need transactions at the boundaries of a zone

» online/open source communities


“Firms are like lumps of butter coagulating in a pail of buttermilk.”

Robertson, quoted by Coase, 1937


Thank you!

Documents

Slide 1 © Carliss Y. Baldwin 2008 Where Do Transactions Come From? Modularity, Transactions and the Boundaries of Firms Carliss Y. Baldwin Organizational