1. 1 © Carliss Y. Baldwin and Kim B. Clark, 2002 Where Do Transactions Come From? Carliss Y. Baldwin Harvard Business School Presented at Centre St. Gobain, Paris November 8, 2002

2. 2 © Carliss Y. Baldwin and Kim B. Clark, 2002 Where this work fits into economics Samuelson, 1970: Consider a profit-maximizing firm that sells output along a demand curve…. [The] output is producible by … ninety-nine different inputs. … [T]he production function relating outputs to inputs is smooth and concave: 99 Max [R(v 1, …, v 99 ) –  p j v j ]. v i 1 ∂R(v 1 *, …, v 99 *) / ∂v i = p i, (i = 1, …, 99). But where does the production function (99 inputs –> 1 output) come from? Who defined the products that are “the goods”?

3. 3 © Carliss Y. Baldwin and Kim B. Clark, 2002 Transaction Cost/Incomplete Contracts Williamson, 1985: A transaction occurs “when a good or service is transferred across a technologically separable interface. … [R]arely is the choice among alternative organization forms determined by technology.” UpstreamDownstream “Technologically separable interface” In this literature, technologies and designs are fixed, asset ownership and decision rights move around.

4. 4 © Carliss Y. Baldwin and Kim B. Clark, 2002 But suppose designs and product definitions are not fixed a priori, Then, where do Transactions Come From?

5. 5 © Carliss Y. Baldwin and Kim B. Clark, 2002 But suppose designs and product definitions are not fixed a priori, Then, where do Transactions Come From? From the engineering design of a system of production…

6. 6 © Carliss Y. Baldwin and Kim B. Clark, 2002 Our thesis:  The modular structure of a system of production reveals the places where: –The division of cognitive labor is high, and –Mundane transaction costs are low.  Transactions should go/can go only at those places.

7. 7 © Carliss Y. Baldwin and Kim B. Clark, 2002 Outline of the paper  T&T Network defined  Mapping technique—TSM  Encapsulation of T&T “blocks”  Pinching the T&T Network  Conclusion: Modular structure and mundane transaction costs

8. 8 © Carliss Y. Baldwin and Kim B. Clark, 2002 Disclaimer  We believe what we are saying is neither radical nor new  Many predecessors: –Coase (1937) –Alchian and Demsetz (1972) –Barzel (1989) and North (1990) –Cremer (1980) and Aoki (2001) –Sako (1992) and Fixson and Sako (2001) We aim for a clarification of language.

9. 9 © Carliss Y. Baldwin and Kim B. Clark, 2002 The T&T Network Defined

10. 10 © Carliss Y. Baldwin and Kim B. Clark, 2002 Task & Transfer (T&T) Network  All tasks and transfers needed to complete production of artifacts in the economy  Engineering Design is the work of designing the T&T Network  Transfers are ubiquitous –Because “agents” have bounded cognition and physical capacity –True for both people and machines

11. 11 © Carliss Y. Baldwin and Kim B. Clark, 2002 What gets transferred?  Material  Energy  Information –Data »Money or credit are a special form of data –Designs –“Tags” »Property rights and decision rights are a special form of tag

12. 12 © Carliss Y. Baldwin and Kim B. Clark, 2002 Transfers are  Dictated by technology  Complex  Logical  Necessary (because of bounded capacity)  Designed But not planned centrally

13. 13 © Carliss Y. Baldwin and Kim B. Clark, 2002 Not all transfers are transactions  A “transaction” requires –Standardizing transfers –Counting transfers –Payment for the units transferred  These are extra and costly tasks – => “Mundane” Transaction Costs (MTC)  MTC vary depending on complexity of transfers –Contingent, interdependent, iterative transfers are very complex –Hence such transfers are very costly to make into transactions

14. 14 © Carliss Y. Baldwin and Kim B. Clark, 2002 Mapping the T&T Network

15. 15 © Carliss Y. Baldwin and Kim B. Clark, 2002 Mapping Technique = “Task Structure Matrix” (TSM)

16. 16 © Carliss Y. Baldwin and Kim B. Clark, 2002 The Smiths and the Cooks

17. 17 © Carliss Y. Baldwin and Kim B. Clark, 2002 TSMs show where transfers occur, but not what gets transferred

18. 18 © Carliss Y. Baldwin and Kim B. Clark, 2002 TSMs reveal T&T “Bottlenecks” Transfer Bottleneck

19. 19 © Carliss Y. Baldwin and Kim B. Clark, 2002 Bottlenecks = Transactional “Gateways” “Place Transaction HERE” — Few transfers; One-way transfers; Maximum “Division of cogitive labor”

20. 20 © Carliss Y. Baldwin and Kim B. Clark, 2002 Bottlenecks = Transactional “Gateways” “Place Transaction HERE” — Because Mundane Transaction Costs are Probably Low

21. 21 © Carliss Y. Baldwin and Kim B. Clark, 2002 Encapsulation

22. 22 © Carliss Y. Baldwin and Kim B. Clark, 2002 Design Problem:  If every transfer had to be a transaction, little work would get done.

23. 23 © Carliss Y. Baldwin and Kim B. Clark, 2002 Solution:  Transaction-free zones  “Encapsulated Local Systems” –Predecessors: Families, communes, tribes (Marc Bloch) –Merchants and Proto-firms (Pirenne, Braudel, etc.) –Then: Full-functioned firms (1750s) and Limited-liability Corporations (1830s)

24. 24 © Carliss Y. Baldwin and Kim B. Clark, 2002 Creating an Encapsulated Local System 1 Materials Energy People Machines Internal Flows are Designed by Engineers Data Agents and Resources Come In; Products Come Out

25. 25 © Carliss Y. Baldwin and Kim B. Clark, 2002 Creating an Encapsulated Local System 2 Materials Energy People Machines Data All are Obtained Via Transactions $ $ $ $ $ $$$$ Internal Flows are Designed by Engineers

26. 26 © Carliss Y. Baldwin and Kim B. Clark, 2002 Creating an Encapsulated Local System 3 Materials Energy People Machines Data Transaction- Free Zone: By design, many complex, contingent transfers occur inside the TFZ Internal Flows are Designed by Engineers

27. 27 © Carliss Y. Baldwin and Kim B. Clark, 2002 Boundaries of the Capsule Materials Energy People Machines Data Boundaries = Where Transfers take the form of Transactions, according to the Design of the Enterprise Boundaries are Designed by Engineers, too!

28. 28 © Carliss Y. Baldwin and Kim B. Clark, 2002 Financial Sufficiency Materials Energy People Machines Data When all Claimants Have been Paid… $ $ $ $ $ Revenue $$$$ $$$$$$$$$$$ Money is left over! Costs:

29. 29 © Carliss Y. Baldwin and Kim B. Clark, 2002 Financial Sufficiency = Survival in a Money/Market Economy Materials Energy People Machines Data When all Claimants Have been Paid… $ $ $ $ $ Revenue $$$$ $$$$$$$$$$$ Money is left over! Local System can survive. Costs:

30. 30 © Carliss Y. Baldwin and Kim B. Clark, 2002 Encapsulated Local System = the “Kernel” of a Firm

31. 31 © Carliss Y. Baldwin and Kim B. Clark, 2002 Encapsulated Local System = the “Kernel” of a Firm Why only “kernel”?

32. 32 © Carliss Y. Baldwin and Kim B. Clark, 2002 Because…  Can assemble several Encapsulated Local Systems within “a bigger firm”  Can have transactions within “a bigger firm”  Transaction costs/incomplete contracts/ property rights economics basically looks at different configurations of kernels within/across firms  In practice, Mergers, Acquisitions & Alliances serve to adjust kernel boundaries across firms

33. 33 © Carliss Y. Baldwin and Kim B. Clark, 2002 In summary—  Encapsulation is a technology in the engineering design of the T&T Network  Encapsulation creates the kernels of firms  Kernel boundaries are artifacts, which can be designed and re-designed (within constraints of physics and logic of technology)  Mergers, Acquisitions & Alliances are visible adjustments of kernel boundaries

34. 34 © Carliss Y. Baldwin and Kim B. Clark, 2002 “Pinching” the T&T Network

35. 35 © Carliss Y. Baldwin and Kim B. Clark, 2002 Mundane transactions costs are used to create a “more modular” task structure “Relational” or “obligational” contract needed “Mundane” transaction costs Standards: To Define “Gateway”

36. 36 © Carliss Y. Baldwin and Kim B. Clark, 2002 “Pinching” is an Investment  In a Task Structure and Relationships that support a strict(er) partition of cognitive labor  Value of “Pinching” = + Avoided cost of real-time interdependency/iteration (clt) – MTC (mundane transaction costs) +  Free-riding (smaller unit, better individual incentives) –  Upstream-Downstream opportunism (in supply chain)

37. 37 © Carliss Y. Baldwin and Kim B. Clark, 2002 Conclusion

38. 38 © Carliss Y. Baldwin and Kim B. Clark, 2002 Where do Transactions Come From? The modular structure of a system of production reveals where:  The division of cognitive labor is high… and  Mundane transaction costs are low.

39. 39 © Carliss Y. Baldwin and Kim B. Clark, 2002 The modular structure of a T&T Network  Can be mapped using TSM graphs  Transactions go at the “bottlenecks” of network –Transfers few and simple –Division of cognitive labor high  Blocks need to be “transaction-free zones” –Encapsulated via transactions at the boundaries of the zone –Encapsulated Local Systems = Kernels of Firm  “Pinching” can create a more modular structure –Costs = Mundane Transaction Costs –Standardizing, Counting, Valuing, Payment

40. 40 © Carliss Y. Baldwin and Kim B. Clark, 2002 Merci de votre attention!