1. Slide 1 © Carliss Y. Baldwin 2008 Where Do Transactions Come From? Modularity, Transactions and the Boundaries of Firms Carliss Y. Baldwin Organizational Economics Seminar MIT February 14, 2008

2. Slide 2 © Carliss Y. Baldwin 2008 Motivation: A Movie of Industry Evolution

3. Slide 3 © Carliss Y. Baldwin 2008 Computers, 1979

4. Slide 4 © Carliss Y. Baldwin 2008

29. Slide 29 © Carliss Y. Baldwin 2008 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?

30. Slide 30 © Carliss Y. Baldwin 2008 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

31. Slide 31 © Carliss Y. Baldwin 2008 Outline  Literature  Definitions  Transaction Location  Transaction Design  Modularization  Transaction-free Zones

32. Slide 32 © Carliss Y. Baldwin 2008 Literature

33. Slide 33 © Carliss Y. Baldwin 2008 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

34. Slide 34 © Carliss Y. Baldwin 2008 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)

35. Slide 35 © Carliss Y. Baldwin 2008 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

36. Slide 36 © Carliss Y. Baldwin 2008 What does the internal (modular) structure of products and processes imply for transactions? Our topic today…

37. Slide 37 © Carliss Y. Baldwin 2008 Definitions

38. Slide 38 © Carliss Y. Baldwin 2008  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

39. Slide 39 © Carliss Y. Baldwin 2008 Design of an Aircraft Engine Sosa, 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

40. Slide 40 © Carliss Y. Baldwin 2008  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

41. Slide 41 © Carliss Y. Baldwin 2008 Transaction Location Mundane transaction costs are low at module boundaries and high in module interiors.

42. Slide 42 © Carliss Y. Baldwin 2008 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

43. Slide 43 © Carliss Y. Baldwin 2008 Example—Smithy and Kitchen 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

44. Slide 44 © Carliss Y. Baldwin 2008 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.

45. Slide 45 © Carliss Y. Baldwin 2008 Transaction Design Can you have a transaction at a thick crossing point…

46. Slide 46 © Carliss Y. Baldwin 2008 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

47. Slide 47 © Carliss Y. Baldwin 2008 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)

48. Slide 48 © Carliss Y. Baldwin 2008 Transaction Design Options—2  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”)

49. Slide 49 © Carliss Y. Baldwin 2008 Incomplete contract optimal (Hart 1995) Property rights (residual control rights) limit ex post damage of renegotiation

50. Slide 50 © Carliss Y. Baldwin 2008 Transaction Design Options—3  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

51. Slide 51 © Carliss Y. Baldwin 2008 At a Thick Crossing Point Relational Contracts are better…

52. Slide 52 © Carliss Y. Baldwin 2008 But you can also design the task network to suit the transaction. Redesigning the task network is called…

53. Slide 53 © Carliss Y. Baldwin 2008 Modularization

54. Slide 54 © Carliss Y. Baldwin 2008 Software System with Licensed-in Code (La Mantia et. al. 2008) Before Modulariziation

55. Slide 55 © Carliss Y. Baldwin 2008 Software System with Licensed-in Code (LaMantia et. al. 2008) Before ModulariziationAfter Modulariziation Licensed Code No Depend- encies

56. Slide 56 © Carliss Y. Baldwin 2008 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

57. Slide 57 © Carliss Y. Baldwin 2008 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!

58. Slide 58 © Carliss Y. Baldwin 2008 But there are other reasons to modularize…  Manage complexity  Allow parallel work  Create options to innovate See Baldwin and Clark, Design Rules, for examples

59. Slide 59 © Carliss Y. Baldwin 2008 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

60. Slide 60 © Carliss Y. Baldwin 2008 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)

61. Slide 61 © Carliss Y. Baldwin 2008 Transaction-free zones

62. Slide 62 © Carliss Y. Baldwin 2008 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

63. Slide 63 © Carliss Y. Baldwin 2008 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”

64. Slide 64 © Carliss Y. Baldwin 2008 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

65. Slide 65 © Carliss Y. Baldwin 2008 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

66. Slide 66 © Carliss Y. Baldwin 2008 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!

67. Slide 67 © Carliss Y. Baldwin 2008 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.

68. Slide 68 © Carliss Y. Baldwin 2008 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

69. Slide 69 © Carliss Y. Baldwin 2008 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

70. Slide 70 © Carliss Y. Baldwin 2008 “Firms are like lumps of butter coagulating in a pail of buttermilk.” Robertson, quoted by Coase, 1937

71. Slide 71 © Carliss Y. Baldwin 2008 Thank you!