Transcript Bounded Rationality

Welcome
Strategies of Network Companies
Jonathan D. Wareham
[email protected]
What we will study…
 Transaction Cost Economics
 Virtual Companies &
formation of firm boundaries
Markets
Networks
Firms
Agents
 Economic Theory: Boundary
of the firm
A Virtual Firm
Sun Microsystems, Inc.
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Sun Microsystems, a leading maker of computer workstations,
concentrates on hardware and software design, where it
distinguished itself from competitors, and outsources nearly
everything else in its value chain
It relies so heavily on external manufacturers and distributors that its
own employees never touch one of its top selling products
After a vendor assembles the machine, another contract supplier
delivers it to the customer
Virtual Designs
In a Virtual Corporation,...:
"...the majority of the activities of the firm
are contracted or outsourced."
This allows the firm to focus on its
strategic, core processes (core
competencies)
Strategic alliances.....
Economic Paradox
 In 1958 the Harvard Business Revenue predicted that
computers would lead to a greater concentration of power in
American business because they would allow bosses to keep
better track of information within large firms. Eventually, it
predicted that the economy would be dominated by a few
giants. In 1967 economist J.K. Galbraith argued that new
technology would inevitably lead to increasing dominance by
big corporations immune to market forces.
 These predictions have turned out wrong: the average size
of firms has shrunk and competition has decreased since
1960’s. Recent research suggests that the economy is
beginning a transition from large, vertically integrated
enterprises to organizational forms that draw on resources
of small, independent specialists suppliers. For example, in
a study of 549 large firms, increased use of IT has found to
be associated with substantial decreases in firm size and
diversification.
The Manager’s role
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Procure inputs in the
least cost manner
Provide incentives for
workers to put forth
effort
Failure to accomplish
this results in a point
like A
Costs
C(Q)
A
$100
80
B
Output
0
$10
Methods of Procuring Inputs
 Spot Exchange
 When the buyer and seller of an input
meet, exchange, and then go their
separate ways.
 Contracts
 A legal document that creates an
extended relationship between a buyer
and a seller.
 Vertical Integration
 When a firm shuns other suppliers and
chooses to produce an input internally.
Knight (1921) & Coase (1937)
Coase (1937) Why do we have firms?
Knight (1921) Why don’t we have one
big firm?
possibility of monopoly rents motivates
continuous and unlimited expansion
of firms, But we do not always see it.
There must be offsetting
mechanisms.
Ronald Coase (1937)
Why do we have firms?
there must be some cost in using the price
mechanism.
• Price discovery/search costs
• Contract negotiation
• Long term stability of supply sources
(uncertainty)
Ergo, operation of the market costs something, and by forming
and organization and letting some authority to allocate
resources, some costs are saved
Coase’s Argument
 Transactions vary in nature and
dimension, and will align themselves with
the governance mechanisms which
manages these transactions most
efficiently.
 Size of firm increases until additional rent
gained by bringing transaction in house is
superceded by cost of bringing it in. That
is, it has to be more costly on the market
 Coase theorem: Efficiency determines
organizational structure
Coordination Costs
 Price determination
 Details of transaction
 Disclose existence of buyers and
sellers to execute transactions
 Search prices or quality control
 Compiling and transferring
information
Basic attributes of transactions
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Specificity
Frequency
Duration
Complexity
Uncertainty
Difficulty of measuring performance
Connectedness
Asset Specificity
 Investments made to allow two
parties to exchange but has little or
no value outside of the exchange
relationship
 Site specificity
 Physical-asset specificity
 Dedicated assets
 Human capital
 Lead to higher transaction costs and
the problem of “hold-up”
Rule of thumb
No
Substantial
specialized
investments
relative to
contracting costs?
Yes
No
Contract
Spot Exchange
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
Coordination Costs
Price determination
Details of transaction
Disclose existence of buyers and
sellers to execute transactions
Search prices or quality control
Compiling and transferring information
Basic attributes of transactions
Specificity
Frequency
Duration
Complexity
Uncertainty
Difficulty of measuring performance
Connectedness
Specificity & Frequency
Specificity
Standard
Occasional
Frequency
Frequent
Medium
High
Standard Equipment
Customized Equipment
Constructing a plant
Machinery, PCs, Automobiles
Machinery requiring some custom config.
Turn-key projects
Markets
Company to company negotiation
Company to company negotiation
Once off negotiated transaction
Semi-complex contracts
Very complex contracts/government regulation
Standard Raw Material
Customized Material
Value adding processes as specific site
Sugar, RAM chips, Steel
Raw mat. with special process unique to customer
production processes within one or several
factories within same location/proximity
Markets
Joint ventures, transfer of equity
Hierarchies
Contracts short to medium term
Long-term binding contracts with
Internal integration/ vertical conglomerate
I year supplier: price based on index
significant investment
Your Mission
You are a principal in a high tech start-up
with 70m in funding and a rapidly growing
customer base. Your business model has
been tested in several pilot markets and
the board has given the green light to scale
up from 2 to 10 markets. This will make
significant scalability demands of your IT
function that, up to now, you have grown
internally. At a management meeting, the
chairman asks:
“ What do you recommend?“
Your Task
 Use the tools provided by TCE to
evaluate the following alternatives:
1. Full outsourcing
2. Partial outsourcing (specify what
functions)
3. Internal integration
Consider these factors
1. Specificity
2. Frequency
3. Duration
4. Complexity
5. Uncertainty
6. Performance measurement
7. Connectedness
8. Search Costs
9. Price Determination
10.Quality Monitoring
Product Complexity
IT, Complexity & Specificity
Hierarchy
Market
Asset specificity
Outsourcers: Who?
AT&T
IBM
Lotus
Computer
Associates
Compaq
MCI
Peachtree
Software
Bell
South
Factors Favoring Outsourcing
 Managers
can and should make use of two kinds of
arguments in their case for (or against) outsourcing
(bandwagon reasoning is not a defensible managerial
decision!)
 Need for organizations to focus on their
strategic assets or core competencies
 Realization of greater economies (lower
costs)
 Need for greater flexibility and expertise in
workforce
Given a positive financial
assessment:
Is the Web system
or service being
considered.....
No
Consider Inhouse Bids vs. Most Likely to
Outsourcer Bids
Outsource
A Core
Competency/
Strategic Asset?
Retain In-house
Yes
Yes
If Outsource,
Legal
Protections
Critical
No
Does Firm Have Internal Expertise?
Outsourcing & Virtual design
 A tale of 2 companies….
 Sell 50,000 computers with only 4
days of inventory
 Keep few suppliers very close
 30 suppliers 75% of materials
 When order is made, signal is sent to
supplier, 90 minutes later, supplies
are delivered to Dell.
 “We sell what we have, we don´t sell
what we don´t have”
Dell From HBR
 Have as few suppliers as possible
 In real time, communicate your
inventory levels and replenishment
needs to them
 Order from suppliers only when you
receive demand from customers.
By going direct; no Channel Push
VARS
Manufacturers
Wholesalers/Distributors
End Users
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Avoiding the Risks…
Assets & Inventory
Accounts receivable
Use technology to bring benefits of
vertical coordination to the network
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Darling of stock market.
First Virtual company
No inventory, no warehouses
But what happened…..
3,500 modular
parts
30+ suppliers
Over 1 million
products, many
suppliers
 Bringing vertical coordination to the
network… but how?
Product Complexity
IT, Complexity & Specificity
Hierarchy
Market
Asset specificity