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

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

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

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

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

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

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

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

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

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

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

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

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