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).

• Radek NowaK

2
The Swollen Middle A Mix of Market
Hierarchy

• Motivation
• TCE does not distinguish between the costs of
  using hierarchies vs. price systems, and hence
  neglects the complexity of economic institutions.
• Most transactions cant be categorized as either
  pure market or pure hierarchy (Powell,
  1987Stinchcombe 1990)
• Purpose
• Develop a comparative institutional model to
  analyze institutions (firms markets) as a mix
  of two pure organizing methods (hierarchy price
  systems).

3
The Swollen Middle A Mix of Market
Hierarchy

• Three organizing costs to achieve gains from
  cooperation
• 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.
• If organizing costs are zero, either prices or
  hierarchy will work, but choice matters due to
  bounded rationality opportunism.

4
The Swollen Middle A Mix of 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 indirectly guide behavior by
  rewarding output.
• Employs price incentives
• Suffers cheating costs imperfectly meter output
  residual cheating.
• Hierarchy directly specifies behavior rewards
  compliance.
• Employs behavioral constraints
• Suffers shirking costs imperfectly meter
  behavior residual shirking.
• 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
The Swollen Middle A Mix of Market
Hierarchy

• The Continuum b/w Markets Hierarchies ?
  Hybrids
• Institutions often combine price behavior
  constraints.
• Min. total organization costs (cheating costs
  shirking costs).
• A cost-min. mix of constraints requires a
  nonlinear relationship b/w constraints amount
  of shirking/cheating.
• Hybrid examples contracts constraining sales rep
  behavior, restricted licensing, commission,
  piecework, bonus, stock option.

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The Swollen Middle A Mix of 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) Price systems deter(encourage)
  shirking(cheating) hierarchies, the opposite.
• 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.

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The Swollen Middle A Mix of Market
Hierarchy

• Price Incentives in the Firm (save monitoring
  costs)
• Higher incidence of use if
• Large and diversified firms.
• Low managerial expertise (discern behavior work
  quality).
• Limited knowledge regarding costly to supervise
  activities.
• Takes two main forms piecework profit centers.
• 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.

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The Swollen Middle A Mix of 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.

9
The Swollen Middle A Mix of 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.