“Explaining the Swollen Middle: Why
Most Transaction are a Mix of
‘Market’ and ‘Hierarchy’,”
Organization Science 4(4): 529-547.
Hennart, Jean-Francois. (1993).
Group 3:
Jason Franken
Prasanna Karhade
Hsiao-Ching Lee
Marko Madunic
Jennifer Shen
The Swollen Middle: AMix 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.
Purpose:
Develop a “comparative institutional” model
to analyze institutions (firms & markets) as a
mix of two pure organizing methods
(hierarchy & price systems).
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The Swollen Middle: AMix 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.
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The Swollen Middle: AMix 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 tradeoff between cheating costs and shirking costs.
The chosen institution minimizes total organization costs
(cheating costs plus shirking costs)
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The Swollen Middle: AMix 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.
Shirking &
Cheating Costs
Total Organizing Costs
Cheating Costs
Shirking Costs
Markets Contracts
Piecework Firms
Shirking &
Cheating Costs
Total Organizing Costs
Cheating Costs
Shirking Costs
Markets Contracts
Piecework Firms
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The Swollen Middle: AMix 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: AMix 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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Information, Expectations, and the Theory of the Firm
Profit Centers (M-form) tie manager compensation
to subordinates’ performance.
“Quasi-firms” buy inputs & sell outputs to other subunits.
Subunit manager rewarded on performance (max. profits).
Price & behavior constraints on profit centers should vary
in proportion to the difficulty of pricing internal transactions.
Grant “full exchange autonomy” to managers when internal
transfers of inputs and outputs are few & easily priced.
HQs should dictate prices and manager behavior when internal
transactions are numerous and difficult to price.
The higher the costs of monitoring subunits, the greater
the benefits of M-form structures.
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The Swollen Middle: AMix 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.
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The Swollen Middle: AMix 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.
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