Joshua Downs
Chandler’s Living History
Bucheli, Mahoney, Vaaler 2010
Chandler’s Contributions
Among scholarly contributions, explaining and analyzing the evolution
of U.S. business history within social science frameworks
Chandler’s focus on dynamic firm capabilities shares the common
denominator of market frictions (small numbers bargaining, asset
specificity) with transaction costs theory
Thus, we can examine case studies from “The Visible Hand” with a
transaction costs theory lens to complement the explanation of shifts
from the market-based organization’s dominance prior to 1840 to the
subsequent rise of hierarchical organizations.
Market-based Systems: Putting-Out
◦ Merchants purchase materials, delivered to workers, arranged for
sale of finished goods.
◦ Pros: Allowed for extensive production with little capital costs
◦ Cons: Inconsistent quality, high inventory costs, material lost in
transit and to embezzlement
◦ Why it worked:
◦ Compensation based on output provided autonomy and productivity incentive
◦ Localized production using worker’s homes as facilities (high transportation and
capital costs)
◦ Component specialization (low training required relative to craftsmen, local
transportation must be less expensive than training)
◦ Fast growing, low income markets in the South and West for inferior goods
◦ Why it didn’t work:
◦ Worker compensation based on volume, lack of quality controrl oversight
◦ Cannot control production schedule leading to higher inventory costs
◦ Workers incentivized to produce higher volume, lower quality
Market-based Systems:
◦ Manufacturers and “Super Foremen”
◦ Manufacturers commit to periodic contracts with foremen, who are credited for volume of produced goods
◦ Manufacturers provide raw materials, machinery, rented floor space, utilities, day wages
◦ Foremen responsible for hourly labor and associated administrative costs
◦ Pros:
◦ Higher tech, higher volume production of components at a predetermined and acceptable price
◦ Risks associated with volatile labor costs and HR responsibilities assumed by contractor
◦ Cons:
◦ Limits on responsible equipment and resource use were ignored for higher short term production volume.
◦ Quality issues remain but relatively less than Putting-out system
◦ Bottom up innovation became periodic, limiting innovation overall (asymmetric information)
◦ Poor worker discipline and high absenteeism
◦ Why it worked
◦ Component specialization and associated mechanical production innovation and standardization
◦ Centralized production overcomes issues in communication and transportation of “Putting-out” system
◦ Low base wages necessitated high production volumes to reach livable conditions
◦ Why it didn’t work
◦ Periodic and production volume based nature of contracts incentivized opportunism, project-focus
◦ No incentives for independent workers to commit to personal investment in training or deferment to management
authority for dispute resolution (Zone of Acceptance)
Shift to Vertical Integration
◦ Technological improvements across society increased the capabilities of firms
and the size and expectations of the market increased in response. As the level
of quality and complexity demanded by the market for mass produced goods
began increasing: the costs of oversight and standardization to achieve this level
of quality and complexity through a market-based organization increased.
◦ Transaction costs associated with the previous market-based organizational
systems were no longer acceptable in most industries, as the relative costs of
exerting sufficient organizational control through hierarchical integration
decreased below the costs of a market-based organization. Innovations in
accounting techniques and communication enabled more efficient hierarchical
◦ Mass production of highly complex products required in kind mass marketing
capabilities to fully capture these efficiencies, thus mass investments in
integrating distribution and retail followed.
◦ Not the case for many industries lacking high asset specificity and small
numbers bargaining issues. These industries who spurned integration were
typically successful, while attempts to integrate lead to losses.
Product Complexity – McCormick,
Singer and Electric Companies
Complexity of products required highly skilled agents for distribution, sales, financing, & service.
Singer pioneered franchising
models for distribution and
sales to maintain standards
while allowing franchise
agents autonomy to cater to
their particular market’s
Later, Singer added
proprietary showrooms and
sales employees
Zone of Acceptance created,
enabling training and
organizational coordination
to better meet the needs of
McCormick also employed
an exclusive distribution
franchise model with the
mechanic/managers who
operated their
High-Tech products by GE
& Westinghouse required
“sales engineers” to ensure
quality standard, large
investments in human
Credible commitment
exchange enabled
relationship to overcome
asset specificity & small
numbers issues
Perishability –
Swift & United Fruit Company
◦ Invention of refrigerated
train cars allowed for
meat shipments from
Chicago to satisfy
increasing demand of East
Coast Markets.
◦ Train Companies unwilling
to build expensive
refrigerated train cars
(asset specificity),
meatpackers unwilling to
expose themselves to
independent ice and
storage providers (small
numbers bargaining)
United Fruit Company
◦ Bananas only producible south of U.S., can’t
be frozen, short shelf-life necessitates rapid
movement through channels
◦ Independent intermediaries slowed process
through inefficient bureaucracy, large
amounts of bananas lost to spoilage
◦ United Fruit’s forward and backward
integration (railways, communications,
shiplines, plantations) streamlined
bureaucracy, organizational efficiencies
allowed access to new markets
Failures in Vertical Integration
Explained by Transaction Costs
Integration into raw material processing by tobacco and sugar beet producers
Integration into distribution and exclusive retail arrangements with pubs by
Neither industry had sufficient complexity requiring integration, and all
returned to market-based organization after posting losses
GE spurned forward integration for low complexity consumer goods i.e., light
bulbs, as independent retailers were sufficient to market these products (low
asset specificity)
Current Applications
Advances in IT allowing for supplier and
distributor aggregation, the small
numbers bargaining factor is decreasing
in intensity
Even where it persists, relationship
specific IT systems creates mutual sunk
costs, thus reducing opportunism
through mutual credible commitments
IT advances also replace hierarchical
employee input for quality control
Resulting reduction in transaction costs
motivating firms to shift from hierarchy
to market-based organization
Example: Walmart, Proctor & Gamble
On the other hand, innovation
intense new product development
requires greater levels of
coordination between research,
production, distribution and after
sales servicing
Internalization can meet these
coordination requirements and
provide means for firms to enter
new markets like Swift and United
Fruit Companies
Example: Monsanto
Additional Thoughts and Questions
Focus of discussion of organizations polarized on market-based or
hierarchical. Williamson & Parmigiani discuss “hybrid” or “spectrum”
organizations, which would seem applicable to the transition periods from
market-based to hierarchical these firms underwent. Study of transition
periods and relative durations and costs could provide greater insight on
transaction costs theory as a complement to Chandler’s work.
Williamson discusses the strength of legal systems and the importance of
reputation as keys for maintaining contract integrity. How could the status
of the legal system, labor organization, and information availability during
the inside-contracting period enable opportunistic behavior for either
Besides contemporary examples mentioned, what other examples of
integration and de-integration from today can be discussed using
transaction costs lens? (ex. Eden McCallum’s facilitated network, Chicago
Cubs and Tom Tango)
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