· · 2015-08-26management 2 . introduction ... “marketing strategy
TRANSCRIPT
MIT OpenCourseWarehttp://ocw.mit.edu
15.963 Advanced Strategy Spring 2008
For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms. ___________________
______________
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
1www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
15.963: Advanced strategy
Rebecca HendersonEastman Kodak LFM Professor of Management
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
2www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Introduction
Origins of the classA puzzle – and a hypothesisClass outlineDeliverablesHousekeeping
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
3www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
OrganizationalEconomics
In the beginning…
Technology Strategy
SystemDynamics
Um….Do you guys ever talk to each other?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
4www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
OrganizationalEconomics
PIMO: “Program in Innovations in Markets and Organizations”
Technology Strategy
SystemDynamics
Do leading edge research –and bring it into the classroom
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
5www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Our focus:
The dynamics of industry evolution:The dynamics of organizational evolution:And the interaction between them
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
6www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
THE PUZZLEPersistent Performance Differences in Seemingly Similar Enterprises: “PPDs in SSEs”
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
7www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
8www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
9www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Evidence of Persistent Performance Differences(N. Beaulieu, R. Gibbons, & R. Henderson)
A. Large-sample profitability studies(control for industry; N ≥ 11)
B. Large-sample productivity studies(control for some inputs; N ≥ 28)
C. Productivity studies with physical output (control for prices; N ≥ 15)
9www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
10www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
A. Large-Sample Profitability Studies
Decompose firm-level performance (ROA, EVA) into:– Industry effects– Corporate effects– Business Unit/Segment effects
Robustness: PPDs found in– Different data sets (FTC data, Compustat, Stern-Stewart)– Different sectors (manufacturing & retail)
Representative Findings– 30% of variation in performance attributable to firm effects– Significant percentage of firm-level performance attributable to
extreme (best and worst) performers– 35-55% of variation remains unexplained
Schmalensee, Rumelt, McGahan-Porter, Brush et. al., Roquebert et. al., Hawanini et. al., Hansen-Wernerfelt, Mauri-Michaels, …
10www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
11www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
B. Large-Sample Productivity Studies
Investigate sources of productivity growth– Compute total factor productivity as residual– Decompose industry productivity growth (within & between firms, entry & exit)– Replicated in datasets from different countries
Measurement & estimation challenges– Missing data on inputs and prices– Endogeneity of input choices– Entry, exit, and selection biases
Representative Findings– Significant variation in establishment productivity after adjusting for inputs – Persistence at the top of the productivity distribution over 5-10 years– Adjusting for variation in prices increases intra-industry productivity dispersion
Griliches-Mairesse, Klette, Biorn, Haltiwanger-Lane-Spletzer, Bailey-Hulten-Campbell, Foster-Haltiwanger-Syverson, Eslava-Haltiwanger-Kugler-Kugler, …
11www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
12www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Productivity measured in physical output– Examples: defect rates (semiconductor manufacturing), meals prepared,
patents obtained (pharmaceuticals), mortality rates (hospitals)– Performance measures adjusted for internal and external factors (e.g.,
inputs & variation in demand)– Frequently smaller samples and shorter panels– PPDs documented in a variety of industries: e.g. semiconductors, apparel
manufacturing, hospitals, steel mini-mills, ship-building, pharmaceutical research, high-precision machining
Representative findings– Wide dispersion in productivity remains after removing variation attributable
to demand-side factors (i.e. prices)– Some studies document intra-firm performance differences in addition to
intra-industry differences (replication vs. imitation)
Macher-Mowery, Hatch-Mowery, McClellan-Staiger, Huckman-Pisano, Dunlop-Weil, Chew-Bresnahan-Clark, Argote-Beckman-Epple, Henderson-Cockburn, …
12
C. Small sample productivity studies: Productivity in physical units
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
13www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
SOMETHING IS GOING ON
What?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
14www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Two potential (entirely complementary) streams of exploration
Structural position– First mover advantages, economies of scale, economies of scope,
network externalities…• Eg: Oxford & Cambridge, U. Haul, Microsoft, Coca-Cola…
Organizational “capabilities”– But what are they?– Tacit routines? Embedded knowledge? Incentive systems?
Cognitive frames? Customer relationships? Great people? Culture?Style? Leadership?......
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
15www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Our working hypothesis:
One important source of long term competitive advantage is the ability to build and maintain “relational contracts”
“Contracts” that allow the organization to behave in non routine, “far sighted”, “trustful” ways– To maintain “high performance work systems”– To face problems rather avoiding them– To invest in longer term initiatives even when current pressures are
intense– To face “worse before better…”
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
16www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
The core work of the course…
Unpack the sources of long term competitive advantage:– In class– And in the case of a particular firm that you will study throughout
the semester
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
17www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Course Outline
What drives sustained performance?– Review 15.900, Explore Wal-Mart & Southwest
Organizational competence & relational contracts– Review 15.311, Explore relational contracts at Lincoln Electric,
Nucor, Toyota & BP
Changing relational contracts– If relational contracts are so great, how come everyone doesn’t
have one – BP, Delta’s Song, Toyota revisited
Doing strategy when relational contracts matter– Corning, Lilly, Simmons
Leadership revisited– Good to Great, Paul Levy @ the Deaconess Hospital
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
18www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
This course is not:
A conventional course in advanced strategy– Think about taking 15.912, “Technology Strategy” and/or 15.834
“Marketing Strategy”
All that you need to know about designing and building an effective organization– Thing about taking 15.394, “Designing & leading entrepreneurial
organizations” or 15.320, “Strategic organizational design”
All that you need to know about high performance work systems– Think about taking 15.966, “Strategic Human Resource
Management”
Easywww.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
19www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
What I expect from you:
Class participation!Teams of 2-3 people:– Which company will you focus on? Why?
Three two page papers about the company:– Due February 21st, March 4th, March 13th
A brief slide deck outlining your conclusions:– In class, May 13th
A final paper – Due May 15th
And… arriving on time, staying for the whole class, not sending email…
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
20www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
What you can expect from me:
My best efforts to make this a class that you will remember, that will intrigue and challenge you and that might…perhaps… make a difference to your career.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
21www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
MIT OpenCourseWarehttp://ocw.mit.edu
15.963 Advanced Strategy Spring 2008
For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms. ___________________
______________
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
22www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
15.963: Reflections on Delta/SongRebecca HendersonEastman Kodak LFM Professor of Management
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
23www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Performance
Time
Ferment
Takeoff
Maturity
Discontinuity
The issue….
Figure by MIT OpenCourseWare.www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
24www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Discontinuities are challenging because:
They challenge the way the firm creates value:– New technologies/offerings– New customers & new markets
They challenge the way the firm captures value:– New business models, new complementary assets
They require the ability to balance the tension between “entrepreneurial energy” and “coordination”
And everyone is very, very busyAnd unable to deal with “worse before better”
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
25www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Which technologies will succeed?What offerings are possible?
Performance
Time
??
??
?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
26www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
What do customers want?Who will we sell to?
Performance
Time
Established technology
Mainstream customer needs
Niche customer needs
Invasive Technology
Clay Christensen: The Innovator’s Dilemmawww.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
27www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
How will we make money?
Ferment
Takeoff
Maturity
UniquenessComplementaryAssets
Figure by MIT OpenCourseWare.www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
28www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Control & Coordination
How will we execute?
EntrepreneurialEnergy
The energy,creativity & drive
of a startup
The operationalexcellence of a
mature firm
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
29www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Why is it hard to imitate a successful strategy?
• Ignorance/Blindness (Perception)– I don’t know that you’re doing better
• Agency (Motivation)– I’m worried about cannibalizing my existing business– It’s not in my interest to change behaviors
• Confusion (Inspiration)– I don’t know why you’re doing better
• Complexity/Coordination (Coordination)– It’s hard to imitate a complex system– It takes time to build assets– It takes time to build relational contracts– And existing assets constrain my behavior
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
30www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Everyone is very, very busy….
Black and white photograph of river logging removed due to copyright restrictions; in this picture, a few men are surrounded by logs pointing in all directions.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
31www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
And it’s very hard to deal with worse before better
Time
Performance
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
32www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
In summary:
“I see”, he said, “you’re suggesting that we invest millions of dollars in a market that may or may not exist but that is certainly smaller than our existing market, to develop a product that customers may or may not want, using a business model that will almost certainly give us lower margins than our existing product lines. You’re warning us that we’ll run into serious organizational problems as we make this investment, and our current business is screaming for resources. Tell me again just why we should make this investment?”
- Divisional Manager, Telecommunications Equipment Provider
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
33www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
For Toyota:
What are the major strategic threats facing Toyota? – Who are its most important competitors?
What actions should Toyota take in response to these threats?What barriers does Toyota need to overcome in order to take these actions?How should Toyota overcome them?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
34www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
For “your” firm:
What are the major strategic threats facing your firm?– Who are its most important competitors?
What actions should your firm take in response to these threats?What barriers does the firm need to overcome in order to take these actions?How should the firm overcome them?
Please send me no more than four slides answering these questions by midnight, Monday April 7th.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
35www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
MIT OpenCourseWarehttp://ocw.mit.edu
15.963 Advanced Strategy Spring 2008
For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms. ___________________
______________
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
36www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
15.963: Reviewing 15.900Fundamentals of strategyRebecca HendersonEastman Kodak LFM Professor of Management
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
37www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
How can I make $$?
Create the context:– “Choose” or “Build” a great industry
Keep margins high:– Avoid competing too aggressively on price unless that’s really what
you have in mind
Compete like crazy for your share of the profits– Build enduring competitive advantage
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
38www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Create the context: Choose or build (!) a great industry
– One with lots of demand• Big PIE
– With buyers & suppliers you can live with • Multiple, weak buyers/suppliers or partners that help you build PIE
– And with highly differentiated preferences • I really want diamonds, emeralds won’t do
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
39www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Keep margins high
Remember the case of Compass Minerals!
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
40www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Compete like crazy – build:
Institutional connections– Actually we’re the only company allowed to…
Tightly held IP/unique assets– EMI, Blockbuster drugs, Tiger Woods…
Economies of scope and scale– We’re larger, so we’re better/cheaper/faster, have more network
externalities…
Great organizational competencies (!)
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
41www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Economies of Scope & Scale
Volume
Costs“Raw” economies of scale (bigger plants are more efficient)
Brewing, Cement…
Sharing fixed costs across a larger volumeDiapers, Soap powder…
Sharing fixed costs across multiple productsPharmaceuticals, Scientific instruments
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
42www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Economies of scale and scope can demonstrate self reinforcing effects:
As I get bigger, my costs go down – which leads me to get a larger share of the market, which drives down my costs…As I get bigger, I can spread my fixed costs out over more units – so that I can afford to spend more on marketing –or R&D – or training – or service and support -- so that my products become increasingly differentiated, so my sales go up, so I can spread my fixed costs….As I get bigger, there is more software available for my platform, and more people to exchange ideas with…
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
43www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Self reinforcing dynamics in Marketing, Brand & Customer Awareness
DifferentiatedProducts
Order ShareOrders
Revenue
Investment inMarketing & Brand building
Brand Equity
+
+
+
+
IndustryDemand
+
R
R
+
+
+
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
44www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Self reinforcing effects in R&D and Product Development
Order ShareOrders
Revenue
Investment inR&D, Product Development,
New &DifferentiatedProducts
+
+
++
IndustryDemand
+
R
R
+
+
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
45www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Self reinforcing effects with Network Effects & Complementary Goods
Direct & IndirectNetwork Effects
Order ShareOrders
Revenue
Investment inNetwork effects & complementary goods
Installed BaseC. Goods
+
+
+
+
IndustryDemand
+
R
R
+
+
+
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
46www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Sterman identifies more than ten potential self reinforcing effects, including:
Production costsProduct awareness – brand, sales, advertisingNew product developmentNetwork effects, complementary goodsProduct differentiation – e.g. service and support, quality, reliabilityWorkforce quality and loyalty – more profits, more growth, attract better people…
&Mergers and acquisitions
The ability to acquire reinforces all the other loopsThe cost of capital
Higher market value, stock price, lower cost of capital…The rules of the game
The bigger I am, the more I can shape the environment
Source: J. Sterman: Chapter 10, Business Dynamicswww.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
47www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
In successful firms, these effects often reinforce each other….
Diagram of self-reinforcing effects removed due to copyright restrictions.Please see: Sterman, John. Business Dynamics: Systems Thinking and Modeling for a Complex World.New York, NY: McGraw-Hill, 2000, chapter 10. ISBN: 9780072389159.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
48www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
WHAT’S GOING ON IN THE COMPANIES WHOSE STRATEGIES I ASKED YOU TO REVIEW?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
49www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
MIT OpenCourseWarehttp://ocw.mit.edu
15.963 Advanced Strategy Spring 2008
For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms. ___________________
______________
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
50www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
15.963: Closing Reflections Rebecca HendersonEastman Kodak LFM Professor of Management
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
51www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Effective strategies answer three key questions:
How will we Deliver value?
How will we Capture value?
How will we Create value?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
52www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Sources of competitive advantage:
Great context:– “Friendly” suppliers and buyers– Mellow rivalry
Strong structural advantages:– Institutional connections– Unique IP/Assets– Scale & Scope derived advantages:
Marketing, R&D, Production costs, People, Capital…
Differentiated organizational competencies:– Tightly integrated organizational systems whose elements are
“complementary” to each other– Featuring relational contracts where appropriate
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
53www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Self reinforcing dynamics in Marketing, Brand & Customer Awareness
DifferentiatedProducts
Order ShareOrders
Revenue
Investment inMarketing & Brand building
Brand Equity
+
+
+
+
IndustryDemand
+
R
R
+
+
+
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
54www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
But…
Structural advantages often erode…– Can scale be “bought?”
Sometimes they are simply not available– Toyota? Simmons? Southwest?
And well deployed organizational competencies can sometimes do an “end run” around established structural positions:– Google? Apple?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
55www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Organizational competencies can be a powerful competitive weapon:Particularly when they are embedded in every aspect of the ways in which the firm does business:– Who we hire– How we reward and promote– The values we stress and attempt to act on– The metrics we use and the processes we develop– …..
When they are “complementary” to each other and to the key strategic choices of the firmAnd when they build on well established “relational contracts”
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
56www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Relational contracts at Nordstrom..
“Use your good judgment in all situations”
Value
Time
You did *what*!
“I’m just doing exactly what they tell me too – allthat stuff about judgment is just BS – did you
hear what happened to Mary….?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
57www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Performance
Time
Ferment
Takeoff
Maturity
Discontinuity
The sources of competitive advantage often change over time….
Context
Structural Advantage
OrganizationalCompetencies
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
58www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Performance
Time
Ferment
Takeoff
Maturity
So that in maturity, some high performing firms rely almost entirely on structural advantage…
Wal-Mart?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
59www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Performance
Time
Ferment
Takeoff
Maturity
Discontinuity
But in many high performing firms strong relational contracts also develop….
This is the wayone acts around
here…
What’s our purpose, our
values?
Work hard, have fun, get rich
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
60www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Performance
Time
Ferment
Takeoff
Maturity
So that in maturity, many high performing firms have both structural advantages and effective relational contracts
Apple?Google?UPS?Intel?Zara?Saint Gobain?Nestle?Whole Foods?Starbucks?Nordstrom?McKinsey?Goldman Sachs?Disney?Porsche?Genentech?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
61www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
In these firms organizational competencies and structural advantage reinforce each other
Organizational competencies
Structural advantage
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
62www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Keys To Success
© 2007 MIT Sloan School of Management
Level 5 leadership from founder Jim
Casey
Relational Contracts
Promotion from within and trust
Employee ownership
Collective innovation with
partners
Organizational Competencies
Continuous process improvement
Strong performance on hard-to-measure
duties
Outstanding strategic shifts and market awareness
Structural Advantages
Brand Economies of scale
R
Scalable technology
UPS logo removed due to copyright restrictions.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
63www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Performance
Time
Ferment
Takeoff
Maturity
But some firms are forced to rely principally on relational contracts…
Nucor?Toyota?Simmons?Wells Fargo?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
64www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Performance
Time
Ferment
Takeoff
Maturity
Discontinuity
What does this analysis imply about the management of strategic change?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
65www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Strategic shifts are hard:
“I see”, he said, “you’re suggesting that we invest millions of dollars in a market that may or may not exist but that is certainly smaller than our existing market, to develop a product that customers may or may not want, using a business model that will almost certainly give us lower margins than our existing product lines. You’re warning us that we’ll run into serious organizational problems as we make this investment, and our current business is screaming for resources. Tell me again just why we should make this investment?”
- Divisional Manager, Telecommunications Equipment Provider
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
66www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Particularly when everyone is overloaded:
Black and white photograph of river logging removed due to copyright restrictions; in this picture, a few men are surrounded by logs pointing in all directions.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
67www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
And change means dealing with the possibility of “worse before better”
Time
Performance
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
68www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Is it the case that at times of change successful firms:Actively manage relational contracts?– Corning– Lilly– Deaconess
So that they can leverage structural advantages into the new arena…And lay the foundation for robust relational contracts in the new organization?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
69www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
Performance
Time
What does this analysis imply about the management of strategic change?
Delta/Song, Nucor, Disney, Saint Gobain – existing
relational contracts potentially a problem in responding to
challenges?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
70www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
What do these ideas imply for you?
For those of you who are going to be analysts…– What are the firm’s likely sources of long term competitive
advantage? – What threats does it face? – How is it likely to be able to respond?
For those of you who are going to be followers…– What is the existing relational contract? – How do I make sure that I conform to “the deal”?
For those of you who are going to be leaders…– What kinds of structural advantages should I pursue?– What kinds of organizational competencies will be valuable?– What kinds of relational contracts should I build? With whom?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
71www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
© 2007 MIT Sloan School of Management
GOOD LUCK!
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
72www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
MIT OpenCourseWare http://ocw.mit.edu 15.963 Advanced StrategySpring 2008 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
73www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Lecture Note 3 Control Rights
R. Gibbons
MIT
Why would an economic actor want to own an asset? The standard reason (applicable, say, to a share of stock) is that the asset is expected to yield a high return. In this note, however, we explore a second reason: to stop someone else from owning the asset. Obviously, this second reason applies only if the first party cares what the second would do with the asset (so a share of stock does not usually fit in this category, but might if one considered something like a proxy vote in a hostile takeover bid). When one party cares what another might do with an asset, we will say that “control rights” to the asset matter. As will become clear, the key idea is actually the control right, not the asset. For example, we will see that control rights can be moved from one firm to another via contract, even if there is no physical asset to be moved.
We will conduct much of our discussion in terms of a supply transaction involving an upstream party (supplier), a downstream party (user), and an asset (production equipment). The upstream party uses the asset to produce a good that can be used in the downstream party’s production process. If the upstream party owns the asset, we will call her an independent contractor (i.e., someone who works with her own tools); if the downstream party owns the asset, we will call the upstream party an employee of the downstream organization (i.e., someone who works with the boss’s tools). Alternatively, we can think of the upstream and downstream parties as firms rather than as individuals, in which case it is more natural to use terms such as supplier and division rather than independent contractor and employee, respectively. Whether the parties are individuals or firms, if the upstream party owns the asset we will call the parties non-integrated, but if the downstream party owns the asset we will call the parties integrated.
In this model, under non-integration, the upstream party can threaten to use the asset in a way that is not optimal for the downstream party. We will develop several examples of such threats as we go along, but the general point is called “hold-up” (i.e., demanding renegotiation after investments have been made or new considerations have arisen). Under integration, however, the upstream party has no hold-up threat, because the downstream party owns (and hence controls) the asset. We will ask under what
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
74www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 2 R. Gibbons
circumstances the downstream party should own the asset in order to eliminate the upstream party’s hold-up threat.
The analysis of asset ownership in this note parallels the analysis of performance measurement in Lecture Note 1, where we introduced the distinction between an agent’s total contribution to firm value (y) and the agent’s measured performance (p). We argued that a compensation contract such as w = s + bp will create incentives for the agent to take actions that increase p, but that such actions may or may not increase y. For example, in a “single-tasking” environment in which y = a + ε and p = a + φ, the contract w = s + bp creates incentives that increase y. But in a “multi-tasking” environment in which y = a1 + a2 but p = a1, such a contract cannot create incentives for a2, and so misses this potential contribution to y. And in an extreme case such as y = a1 + ε and p = a2 + φ, the contract w = s + bp creates no value at all.
The analogy between asset ownership in this note and contracting in Lecture Note 1 is as follows. When the upstream party owns the asset, the prospect of holding-up the downstream party creates incentives for the upstream party. More specifically, under non-integration, the upstream party has an incentive to take actions that strengthen its bargaining position when the hold-up occurs. We will see that such actions can range from wonderful to acceptable to useless (or even harmful) for the downstream party, just as in the three contracting examples above. The downstream party’s interest in owning the asset, and thereby eliminating the upstream party’s hold-up threat, follows from considering the effect on the downstream party of these actions by the upstream party induced by the prospect of hold-up.
1. Two Examples of Hold-Up
To make the idea of hold-up come alive, here are two examples. The first is fictitious but could clearly be made real, the second is a matter of historical record.
Hildebrand, Gorman, and Alexander
In 1997, three newly minted graduates of a prominent New England business school—Hildebrand, Gorman, and Alexander (HGA)—formed a local consulting firm to conduct studies of corporate organizational problems and counsel clients on their solution. The firm was organized as a partnership. Hildebrand, the most studious of the three, took primary responsibility for analyzing clients’ problems and developing
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
75www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 3 R. Gibbons
organizational proposals for solving them. She had little interaction with clients and the outside world generally. Gorman, an orderly and systematic person, had strong managerial skills. He liked organizing and planning the activities of the firm. He concerned himself with methods for controlling the quality of work and costs. Alexander was an entrepreneurial type, outgoing, and active in various community organizations. She spent much of her time with clients, helping to identify their organizational problems and convincing them that though the organizational solutions proposed by her firm might seem controversial, they could be effectively implemented and would solve their problems. As a result, Alexander was viewed by the outside world and many clients as the firm’s leader.
Originally, the three partners agreed to share profits equally. Profits, rather than salaries, were the primary form of compensation for partners. The agreement to share equally was based on the partners’ belief that the labor contribution each brought to the firm had the same opportunity value, and that each took the same risks and made the same investment in getting the firm started.
The firm was an instant success. Demand for its services caused the partners over the first two years to hire nine young professionals (on salary) to help perform the work. After two years of intense effort on the part of all three partners, each had invested heavily in his or her specialization, resulting in substantial increases in productivity and profits.
Immediately after the 1999 profit distribution, Alexander informed Hildebrand and Gorman that she was dissatisfied with the equal shares in the profit-sharing arrangement. She felt the equal sharing was unfair; that her contribution to the firm was much more valuable than theirs; and that unless they agreed to a revised sharing arrangement that would give her one-half the profits, she would leave the firm. She intended in that event to form a firm of her own, taking with her several of the major clients and four of the professional staff who serviced these clients. Hildebrand and Gorman realized that this was not an empty threat, because Alexander had the loyalty of the four staff.
In what ways could Hildebrand and Gorman have designed HGA differently so as to prevent Alexander’s eventual hold-up? What would have been the pros and cons of doing so?
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
76www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 4 R. Gibbons
GM and Fisher Body
In 1919, General Motors decided to make an unprecedented switch: from open wood car bodies (i.e., convertibles) to closed metal bodies (as we know them today). To make this switch, GM approached the leading body manufacturer, Fisher Body, and asked Fisher to invest in the necessary new plant and equipment. Both parties understood that GM could hold-up Fisher after such an investment, such as by offering to pay only marginal rather than average cost. Consequently, the parties signed a contract that gave Fisher certain protections, including a formula specifying the price as a mark-up of Fisher’s variable costs. But this contract created ways for Fisher to hold-up GM, such as by threatening to overstaff its plants so as to pad variable cost.
Ultimately, GM bought Fisher, but at a high price. The price had to be high because Fisher had to be persuaded to give up its strong bargaining position created by the pricing formula in the formal contract. But the reason that it was efficient for GM to buy Fisher does not hinge on this acquisition price, which is merely a transfer between the parties and so has no effect on the efficiency of operations. Instead, the reason for GM to buy Fisher (according to Klein, Crawford, and Alchian, 1978) was to stop Fisher’s inefficient actions, such as overstaffing.
The striking feature of this long-standing and sensible account (see also Klein, 1991) of the Fisher Body acquisition is that it never mentions life in the Fisher division of GM after the acquisition. But without considering the difference between life as a division and life as an independent firm, the analysis cannot ascertain whether solving one hold-up problem might have created another. That is, if vertical integration stopped Fisher’s hold-up of GM, might it also have created a new way for GM to hold-up Fisher?
2. A One-Shot Supply Transaction
To analyze the pros and cons of hold-up more systematically, consider the following model of a one-shot supply transaction involving an upstream party (supplier), a downstream party (user), and an asset (production equipment). Suppose that the upstream party uses the asset to produce a good that can be used in the downstream party’s production process. The value of this good to the downstream party is Q, but the good also has an alternative use with value R. Such a supply transaction is shown in Figure 1 below.
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
77www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 5 R. Gibbons
UpstreamSupplier
“ProductionEquipment”
DownstreamUser
AlternativeUser
Value = Q Value = R
“Efforts”(a1, a2)
Input
Figure 1: A One-Shot Supply Relationship
To fix ideas, much of the discussion will be cast in terms of a famous business-school case: Crown Cork and Seal Company (Gordon, Reed, and Hamermesh, 1977). The details of the case become important in Lecture Note 4 (where we consider ongoing relationships rather than one-shot transactions); for now, it suffices to say that in the 1950s and ‘60s Crown made metal cans for the soft-drink industry. So suppose that Crown owns a can plant located near a Pepsi plant, but there is also a Coke plant two towns away. That is, Crown is the upstream party, Pepsi the downstream party, and Coke the alternative use. In actual fact, Crown was never integrated with Pepsi or Coke, but we will at times consider the hypothetical case in which Pepsi has purchased the can plant from Crown (in which case the can plant is a “division” of Pepsi).
Suppose that ownership of the asset conveys ownership of the good produced using the asset. For example, if Crown owns the can plant then Crown owns the cans produced there until Pepsi buys them. Furthermore, in bargaining over the sale of the cans, Crown can threaten to sell the cans to Coke (i.e., under non-integration, the
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
78www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 6 R. Gibbons
upstream party can threaten to consign the good to its alternative use). On the other hand, if Pepsi owned the can plant then Pepsi could prevent the can plant from dealing with outside customers.
Suppose also that the production equipment has been specialized to meet the downstream party’s needs. For example, the can plant might have been configured to produce cans to Pepsi’s specifications rather than Coke’s. Then the good’s value to the downstream party will exceed its value in the alternative use; that is, Q > R. The surplus that the upstream and downstream parties can jointly achieve by transacting with each other is thus Q - R, but each party would like to capture all of this surplus. For example, Crown would like to sell its cans to Pepsi for Q, but Pepsi would like to pay only R.
This model has many applications beyond soda cans in the 1950s. For example, suppose that the upstream party is an inventor, the downstream party is a manufacturer, and the asset is the inventor’s invention. Rather than discuss ownership of a physical asset like a can plant, we now consider ownership of intellectual property – the invention. If the manufacturer will own any inventions that the inventor might produce, then the inventor can be thought of as an employee working in the manufacturer’s R&D lab. Alternatively, if the inventor will own her inventions, then she can sell them either to the manufacturer or to an alternative user. The issues raised in this second example (which can be enriched to include issues such as licensing, alliances, and so on) are quite important in the biotech and pharmaceuticals industries.
In addition to expanding the list of direct applications of this model, one can also reinterpret the model more broadly, along the following lines. Organizational sociologists have long emphasized the distinction between formal and informal aspects of organizational structure. Formal aspects include the job definitions and reporting relationships described in an organization chart, as well as formal contracts, voting rights, and other instruments that allocate formal control rights; informal aspects include norms and mutual understandings, as well as networks of non-reporting relationships among individuals. In the model presented above, asset ownership is analogous to one of these formal aspects of organizational structure. We have considered informal aspects in Lecture Note 2 and will return to such aspects in Lecture Note 4.
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
79www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 7 R. Gibbons
3. Analysis of the One-Shot Model
As suggested above, we will be interested in a range of cases, from “single-tasking” to various forms of “multi-tasking.” As an example of the former, consider Q = a + ε and R = a + φ. As examples of the latter, consider Q = a1 + a2 and R = a1, and also the extreme case Q = a1 + ε and R = a2 + φ.
To keep the analysis simple, we will ignore contracts of the kind analyzed in Lecture Note 1. That is, both Q and R are like the agent’s total contribution to firm value (y): well-placed insiders can form reasonable judgments of Q and R, but these variables cannot be objectively measured (as would be necessary if a court were to enforce contracts that depend on these variables). The point of Lecture Note 4 is that it is still possible to use relational contracts that depend on Q and R, just as some firms use subjective bonuses B(y), but in this note we will simply ignore all contracts, whether court-enforced or relational. 1
To begin, suppose that the upstream party owns the asset. This case gives rise to the classic “hold-up” problem, because the upstream party can threaten to consign the good to its alternative use unless the downstream party pays a high price. That is, Crown could threaten to sell the cans to Coke. In the model, Pepsi’s value for the cans is Q and Coke’s is only R < Q. Thus, Crown’s threat to sell the cans to Coke should not be carried out, because Pepsi is willing to pay more than R for the cans. Instead, after such a threat, suppose that Crown and Pepsi agree on some price between R and Q. The key point is that Crown will receive at least R, and this in turn gives Crown an incentive to take actions that increase R: Crown will pay attention to Coke so as to improve its bargaining position with Pepsi. But actions that increase R may have no (or even negative) effect on Q. Thus, Crown may find it privately optimal to take actions that give it a larger share of a smaller total surplus in its relationship with Pepsi. Such actions are inefficient: both Crown and Pepsi could be made better off if those actions were stopped.
Pepsi’s instinctive reaction to this hold-up problem might be the one often prescribed in the transaction-cost literature: buy the can plant, in order to decree that the plant cannot sell cans to Coke. In this sense, vertical integration could indeed prevent one
1 This analysis, and the elaboration reported in Lecture Note 4, are taken from Baker, Gibbons, and Murphy (2002).
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
80www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 8 R. Gibbons
hold-up from occurring, as argued by Williamson (1975) and Klein, Crawford, and Alchian (1978). The insight of Grossman and Hart (1986), however, is that using formal instruments to eliminate one hold-up problem typically creates another. Recall that Klein, Crawford, and Alchian’s (1978) account of the events preceding the acquisition of Fisher Body by General Motors was an example of this conundrum. Grossman and Hart’s abstract model is similar: using asset ownership (another formal instrument, akin to a formal contract) to solve one hold-up problem inevitably creates another. A more detailed analysis of the model above runs as follows.
Non-integration:
In the absence of contracts (as assumed here to simplify the exposition), the parties simply bargain over any issues that arise. Under non-integration, the issue is whether the upstream party will sell the intermediate good to the downstream party. Because Q > R, it is efficient for the upstream party to sell the good to the downstream party rather than commit the good to its alternative use, but the fact that the parties agree on the efficient disposition of the good does not stop them from bargaining over its sale price.
Suppose, for a moment, that R = 0. Then one might imagine that the parties would agree on a price of Q/2: the upstream party would like to extract the full value of Q, but the downstream party would like to pay a price of zero, and they split the difference. (To accommodate unequal bargaining power, we could write the bargained price as αQ, where α measures the upstream party’s bargaining power and satisfies 0 < α < 1.) More generally, if R > 0 (but still < Q) then the downstream party must pay at least R and the bargaining is over the surplus Q – R, so the bargained price (assuming equal bargaining power) is R + (Q – R)/2 = (Q + R)/2.
If the bargained price will be (Q + R)/2 then the upstream party has two kinds of incentives: to take actions that increase Q and to take actions that increase R. But each of these incentives is at half-strength. For example, the upstream party’s incentive to increase Q is half as strong as if the upstream party could extract the full value Q from the downstream party rather than settle for the bargained price (Q + R)/2. The question then becomes whether the upstream party’s half-strength incentive to increase R helps fill this gap.
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
81www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 9 R. Gibbons
In the single-task case in which Q = a + ε and R = a + φ, the gap is precisely closed, because the half-strength incentive to increase R motivates exactly the same action as the missing half-strength incentive to increase Q. But in the first multi-task example, in which Q = a1 + a2 and R = a1, the half-strength incentive to increase R perfectly replaces the missing half-strength incentive to increase a1 but does nothing to replace the missing half-strength incentive to increase a2. Finally, in the extreme case in which Q = a1 + ε and R = a2 + φ, the half-strength incentive to increase R does nothing to replace the missing half-strength incentive to increase Q.
Integration:
In this simple model, under integration there is nothing to bargain about: the downstream party owns the good and so simply takes it. Because we have ignored contracts (both court-enforced and relational), there is zero incentive for the upstream party under integration. Obviously, allowing for contracts would create a more realistic picture of the integration case, but even this stark rendition provides some useful insights, as follows.
For expositional clarity, consider the extreme case in which Q = a1 + ε and R = a2 + φ (but similar conclusions hold for less extreme multi-task environments). In this case, non-integration produces a half-strength incentive for the upstream party to increase P, but this incentive does nothing to increase the upstream party’s incentive to increase Q. That is, the upstream party’s interest in R is solely because higher values of R improve the upstream party’s bargaining position; the actions that increase R never increase the value of the transaction, Q.
In contrast to non-integration, integration has two effects. First, integration eliminates the hold-up threat and so eliminates the upstream party’s interest in R. But second, eliminating the hold-up threat also eliminates the upstream party’s interest in Q, so incentives disappear entirely (in this simple model without contracts). Thus, the firm must find a new way to provide incentives (such as through subjective bonuses, on which see Lecture Note 2).
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
82www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 10 R. Gibbons
4. Conclusion
In summary, I have tried to say five things about hold-up and the boundary of the firm. First, the prospect that you will be able to hold me up creates incentives for you. Second, these incentives may be useful or destructive or both. Third, ownership can stop hold-up. Fourth, using formal instruments (such as formal contracts or asset ownership) to stop one hold-up problem typically creates another. Finally, because solving one hold-up may cause another, hold-up may be your friend: the cure may be worse than the disease.
These conclusions can be put somewhat less abstractly. It is frequently observed (and bemoaned) that firms are “sluggish” or “bureaucratic,” and that incentives are “higher-powered” in markets than in firms. The simple model in this note concords with this observation: under non-integration, the upstream party’s incentives follow from the bargained price (Q + R)/2, whereas under integration the upstream party has no incentives whatsoever. The new idea from this model, however, is that one might choose “sluggish” firms on purpose.2 More precisely, integration (which, in this simple model, has no incentives whatsoever) can be more efficient than non-integration (which creates half-strength incentives to increase R, which may bear no relation to the desired incentives to increase Q). If incentives to increase R induce actions that are a waste of time (or worse), it can be better to settle for “sluggish” incentives, or even no incentives at all.
2 For more on these themes, see Holmstrom (1999).
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
83www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 11 R. Gibbons
References
Baker, George, Robert Gibbons and Kevin J. Murphy. 2002. “Relational Contracts and the Theory of the Firm.” Quarterly Journal of Economics 117: 39-83.
Gordon, Karen, John Reed, and Richard Hamermesh. 1977. “Crown Cork and Seal Company, Inc.” Harvard Business School Case #378-024.
Grossman, Sanford and Oliver Hart. 1986. “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Ownership.” Journal of Political Economy, 94: 691-719.
Holmstrom, Bengt. 1999. “The Firm as a Subeconomy.” Journal of Law, Economics, and Organization 15: 74-102.
Klein, Benjamin. 1991. “Vertical Integration as Organizational Ownership: The Fisher Body-General Motors Relationship Revisited.” In O. Williamson and S. Winter (eds.), The Nature of the Firm: Origins, Evolution, and Development. Oxford University Press.
__________, Robert Crawford, and Armen Alchian. 1978. “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process.” Journal of Law and Economics 21: 297-326.
Williamson, Oliver. 1975. Markets and Hierarchies: Analysis and Antitrust Implications. Free Press: New York.
Lecture Note 3: Control Rights
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
84www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
MIT OpenCourseWare http://ocw.mit.edu 15.963 Advanced StrategySpring 2008 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
85www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Lecture Note 4 Make, Buy, or Cooperate?1
R. Gibbons
MIT
In 1937, Ronald Coase argued that firms will exist only in environments in which firms perform better than markets could. To create space for firms, Coase suggested that some environments might be plagued by “transaction costs” that cause markets to perform poorly. Coase’s paper was to become the cornerstone of the economic theory of the firm (i.e., the “make or buy” decision: which activities should be conducted within firms and which between?), but for several decades the paper lay fallow. Finally, in 1975, Oliver Williamson significantly deepened Coase’s argument by suggesting both why markets might perform poorly and why firms might perform better than markets. Roughly, Williamson argued that markets rely on formal contracts (i.e., those enforceable by a court), whereas firms might use “relational contracts” (i.e., informal agreements not adjudicated by courts) to overcome some of the difficulties with formal contracts.
To support the second prong of his argument, Williamson relied primarily on Barnard (1938) and Simon (1951). But many organizational sociologists had also emphasized the importance of informal agreements in organizations, including Blau (1955), Dalton (1959), Gouldner (1954), and Selznick (1949) in the landmark case studies that signaled American sociology’s departure from Weber’s emphasis on formal organizational structures and processes. By 1962 it was uncontroversial (at least among sociologists) that “It is impossible to understand the nature of a formal organization without investigating the networks of informal relations and the unofficial norms as well as the formal hierarchy of authority and the official body of rules …” (Blau and Scott, 1962: 6).
But informal agreements can be crucial between firms as well as within. In sociology, Macaulay (1963) documented the importance of such “non-contractual relations” between businesses. In law, Macneil (1978) compared classical contracts
1 This note is an abridged version of R. Gibbons, “Firms (and Other Relationships),” Chapter 7 in P.
DiMaggio (ed.), The Twenty-First Century Firm: Changing Economic Organization in International Perspective, Princeton University Press, 2001. Both the note and the larger essay draw heavily on my joint work with George Baker and Kevin J. Murphy (2002).
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
86www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 2 R. Gibbons
(enforced to the letter by courts) and neoclassical contracts (interpreted and updated by arbitration) to relational contracts (interpreted and updated by the parties). And in organization theory, Dore (1983) was the first of many to describe Japanese supply relationships as relational contracts, and Powell (1990) emphasized that relational contracts exist horizontally as well as vertically, such as in the networks of firms in the fashion industry or the diamond trade.2
In this note I summarize a recent economic model of relational contracts within and between firms (Baker, Gibbons, and Murphy, 2002). In this model, the parties’ relationship takes center stage; the integration decision is merely an instrument in the service of that relationship. For example, in a supply relationship between an upstream supplier and a downstream user, the best feasible relational contract between the two parties can differ dramatically depending on whether the parties belong to one firm (vertical integration) or two (non-integration). In this model, the vertical-integration decision is thus driven by whether integration or non-integration facilitates the superior relational contract. Simply put, the old “make or buy” decision should instead be viewed as “make or cooperate” (Kogut, Shan, and Walker, 1992), where both options involve important relational contracts.
1. Review of the One-Shot Supply Transaction
Recall the model of a one-shot supply transaction developed in Lecture Note 3, involving an upstream party (supplier), a downstream party (user), and an asset (production equipment). The upstream party uses the asset to produce a good that can be used in the downstream party’s production process. The value of this good to the downstream party is Q, but the good also has an alternative use with value R, as shown in Figure 1 below.
Recall also one application of this model, in which Crown Cork and Seal Company owns a can plant located near a Pepsi plant, but there is also a Coke plant two towns away. That is, Crown is the upstream party, Pepsi the downstream party, and Coke the
2 For more modern examples of relational contracts between firms, see Nishiguchi and Brookfield (1997)
on hand-in-glove supply relationships, Kogut (1989) on joint ventures, Gerlach (1991) and Gulati (1995) on alliances, Kogut, Shan, and Walker (1992) and Podolny and Page (1998) on networks, Granovetter (1995) and Dyer (1996) on business groups, and Chesbrough and Teece (1996) on “virtual” firms.
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
87www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 3 R. Gibbons
alternative use. In actual fact, Crown was never integrated with Pepsi or Coke, but we will at times consider the hypothetical case in which Pepsi has purchased the can plant from Crown (in which case the can plant is a “division” of Pepsi).
UpstreamSupplier
“ProductionEquipment”
DownstreamUser
AlternativeUser
Value = Q Value = R
“Efforts”(a1, a2)
Input
Figure 1: A One-Shot Supply Relationship
Suppose that ownership of the asset conveys ownership of the good produced using the asset. For example, if Crown owns the can plant then Crown owns the cans produced there until Pepsi buys them. Furthermore, in bargaining over the sale of the cans, Crown can threaten to sell the cans to Coke (i.e., under non-integration, the upstream party can threaten to consign the good to its alternative use). On the other hand, if Pepsi owned the can plant then Pepsi could prevent the can plant from dealing with outside customers.
Suppose also that the production equipment has been specialized to meet the downstream party’s needs. For example, the can plant might have been configured to
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
88www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 4 R. Gibbons
produce cans to Pepsi’s specifications rather than Coke’s. Then the good’s value to the downstream party will exceed its value in the alternative use; that is, Q > R.
2. An Ongoing Supply Relationship
In the 1950s and ‘60s, the metal can industry looked horrible: suppliers were strong (such as U.S. Steel), customers were strong (such as Pepsi, Coke, and Campbell’s Soup), and entry into the industry was cheap (a used production line cost only $150,000 and could be set up in a small space close to an important customer). Industry giants such as American Can and Continental Can were losing money and diversifying out of the industry, but Crown Cork and Seal made money by specializing in customer service. That is, Crown not only began a relationship with a customer by tailoring the specifications of the cans and the schedule for deliveries to the customer’s requirements, but (more importantly) Crown stood ready to modify can specifications and delivery schedules when unusual circumstances arose. Of course, Crown did not make these modifications for free; to the contrary, Crown was able to charge a premium because of its reputation for flexibility and service. In short, in the terminology of this note, Crown had an important relational contract with its customers: Crown would make reasonable modifications under the terms of the existing formal contract; substantial modifications could also be made, but would create the expectation of fair compensation, either on a one-shot basis or by revising the terms of the formal contract for the future.3
Crown’s customer service illustrates both of Williamson’s (1975) ideas. First, formal contracts are almost always incomplete — they often do not specify important future events that might occur, not to mention what adaptations should be made if a particular event does occur. Second, relational contracts may overcome some of the difficulties with formal contracts — relational contracts may allow the parties to utilize their detailed knowledge of their situation to adapt to new contingencies as they arise. Of course, the irony in this illustration is that Crown was not integrated with Pepsi. That is, the motivation for and benefits of relational contracts are exactly as Williamson (1975) described, but the transaction is occurring between firms instead of within. A useful model of relational contracts must therefore be applicable both within and between firms.
3 The facts in this paragraph are drawn from Gordon, Reed, and Hammermesh (1977).
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
89www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 5 R. Gibbons
To see why the theory of repeated games may help in developing such a model, recall that the drawback of any relational contract is that it cannot be enforced by the courts: having a contract that utilizes the parties’ specific expertise makes it prohibitively expensive for the courts to adjudicate disputes. Therefore, relational contracts must be “self-enforcing,” in the sense that each party’s concern for its reputation must outweigh that party’s temptation to renege on the relational contract. Lecture Note 3 gives more detail on why this kind of logic — in which the shadow of the future subdues the temptations of the present — can be modeled using “trigger” strategies in repeated games, in which defection ruins the relationship.
To illustrate a trigger strategy, consider a repeated Prisoners’ Dilemma. A player’s current options are to “Cooperate” or “Defect,” but defection will be discovered and result in “Punishment” forever after, whereas cooperation today will create the same choice between cooperation and defection tomorrow. As suggested in Figure 2, cooperation is the optimal choice today if the present value of the current and future payoffs from cooperation exceeds the present value of the higher current payoff from defection followed by the lower future payoffs from punishment.
Figure 2: Time-paths of Possible Payoffs from Trigger Strategy
To analyze trigger strategies in an ongoing supply relationship, recall the model of a one-shot supply transaction described above, but now suppose that the transaction is to be repeated indefinitely, with the outcome of each transaction observed by both parties before the next transaction occurs. Crown’s promise of customer service is an important relational contract between firms. In the model, think of Crown’s promise as the upstream party’s pledge to deliver a high value of Q to the downstream party. Of course,
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
90www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 6 R. Gibbons
the same promise might also be quite important within a firm. That is, if Pepsi bought the can plant from Crown, Pepsi might well expect and desire its new can division to provide the same modifications to can specifications and delivery schedules that Crown had previously provided.
The key result in this repeated-game model of an ongoing supply relationship is that the size of the incentive to renege on a relational contract (i.e., the extent to which the payoff from defection exceeds the payoff from cooperation in Figure 2) depends on who owns the asset. Consequently, implementing the best feasible relational contract requires making the right choice about integration. In certain settings, integration supports a better relational contract than non-integration can; in other settings, the reverse holds. The remainder of this section is devoted to explaining this key result.
To begin, suppose that the upstream party owns the asset. This case gives rise to the classic “hold-up” problem, because the upstream party can threaten to consign the good to its alternative use unless the downstream party pays a high price. That is, Crown could threaten to sell the cans to Coke. In the model, Pepsi’s value for the cans is Q and Coke’s is only R < Q. Thus, Crown’s threat to sell the cans to Coke should not be carried out, because Pepsi is willing to pay more than R for the cans. Instead, after such a threat, suppose that Crown and Pepsi agree on some price between R and Q. The key point is that Crown will receive at least R, and this in turn gives Crown an incentive to take actions that increase P: Crown will pay attention to Coke so as to improve its bargaining position with Pepsi. But actions that increase R may have no (or even negative) effect on Q. Thus, Crown may find it privately optimal to take actions that give it a larger share of a smaller total surplus in its relationship with Pepsi. Such actions are inefficient: both Crown and Pepsi could be made better off if those actions were stopped.
Pepsi’s instinctive reaction to this hold-up problem might be the one often prescribed in the transaction-cost literature: buy the can plant, in order to decree that the plant cannot sell cans to Coke. In this sense, vertical integration could indeed prevent one hold-up from occurring, as argued by Klein, Crawford, and Alchian (1978) and Williamson (1985). The insight of Grossman and Hart (1986), however, is that using formal instruments to eliminate one hold-up problem typically creates another. I will argue that this Grossman-Hart conundrum arises because of the reliance on formal instruments (such as formal contracts or asset ownership) to eliminate individual hold-up problems, and that a potential solution to the conundrum is to use informal instruments
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
91www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 7 R. Gibbons
(namely, relational contracts) in tandem with formal instruments to at least ameliorate (and perhaps eliminate) all hold-up problems simultaneously.
Imagine that Pepsi bought the can plant from Crown. That is, the downstream party owns the asset. The upstream party is then an internal division rather than an external supplier, but the downstream party is still interested in receiving high-quality service. The downstream party could try to create an incentive for the upstream party to supply high-quality service by promising to pay a bonus to the upstream party if the latter produces a sufficiently high value of Q. Unfortunately, like all relational contracts, this promise is vulnerable to reneging: when the downstream party owns the asset, the downstream party can simply take the intermediate good without paying the upstream party anything.4
Reneging on a promised bonus is just one example of possible hold-ups within organizations. Richer models could capture reneging temptations concerning promotions, task allocation, capital allocation, internal auditing transfer payments, and so on. (See Lawler (1971), Bower (1970), Dalton (1959), Eccles (1985), and many others for evidence that such varieties of reneging are alive and well in many organizations.) The key feature of all of these examples is that one party with authority makes a promise to another party without. In each case, the temptation to renege on such a promise can again be analyzed using Figure 2.
We are now ready to revisit the key result in this section: that the incentive to renege on a relational contact depends on who owns the asset. Suppose the parties would like the upstream party to deliver quality Q* and the downstream party to pay upstream a fee F*. Under non-integration, the upstream party is tempted to renege, by taking actions that increase R so as to collect a fee greater than F*, even if the resulting quality is Q < Q*. Under integration, it is the owner (here, the downstream party) who is tempted to renege, by simply taking the good and not paying the fee F*. Thus, not only the size of the incentive to renege but also the identity of the party tempted to renege depends on who owns the asset.
4 In case such reneging is not immediately plausible, recall the inventor-invention-manufacturer example
sketched in Section 2 of Lecture Note 3. Imagine that the inventor is an employee in the R&D lab of a large pharmaceutical firm, and suppose the firm has promised to share the profits from inventions 50-50 with the inventor. If the inventor creates a drug worth ten billion dollars, do we expect the firm to keep its promise? How would the situation differ if the inventor had worked in her own independent research firm?
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
92www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 8 R. Gibbons
We therefore have a situation dear to an economist’s heart: a tradeoff. Upstream ownership offers the upstream party some recourse should the downstream party renege, and hence decreases the downstream party’s temptation to renege, but upstream ownership also encourages the upstream party to consider the interests of third parties, and hence may create a temptation for the upstream party to renege. In some settings, the first of these considerations is more important, so integration is optimal; in others, the second dominates, so non-integration is preferred. In all settings, however, the guiding principle is to induce efficient actions (and discourage inefficient actions) by implementing the best possible relational contract. Thus, in this simple model, the integration decision is merely an instrument to be used in this quest for a better relationship.
In the model above, I interpret a relational contract between non-integrated parties as a hand-in-glove supply relationship. But there are many other relational forms of organization discussed in the business and organizational literatures, including joint ventures, strategic alliances, networks, and business groups. Although the model above has only two stages of production with one party at each stage, richer models could add both parties and stages. For example, one could begin to model a joint venture as two parties at one stage who create an asset at the other stage that they control by both formal and informal means. Similarly, one could begin to model a business group as several parties at several stages of production, with both cross-ownership and relational contracts linking the parties, possibly through a central party. Formal structures such as fifty-fifty ownership in joint ventures or minority stock holdings in business groups may be better understood using models that study the interplay between these formal structures and informal relational contracts between the parties.
3. Conclusion
In Lecture Note 2 we argued that relational contracts offer important advantages over formal contracts, but relational contracts are vulnerable to reneging. In Lecture Note 3 we argued that ownership can stop hold-up, and that using formal instruments (such as formal contracts or asset ownership) to stop one hold-up problem typically creates another. Finally, in this note we have argued that implementing the best feasible relational contract requires optimizing the boundary of the firm (i.e., the structure of asset ownership). Combining these ideas produces a new perspective on integration: the
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
93www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 9 R. Gibbons
parties’ relationship is the central issue; the integration decision should be made in the service of that relationship. In future discussions, we will use this perspective to analyze both novel organizational forms (such as radical empowerment) and “hybrid” organizations (i.e., cases between integration and non-integration, such as joint ventures and alliances).
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
94www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 10 R. Gibbons
References
Axelrod, Robert. 1984. The Evolution of Cooperation. New York: Basic Books.
Baker, George, Robert Gibbons and Kevin J. Murphy. 2002. “Relational contracts and the Theory of the Firm.” Quarterly Journal of Economics 117: 39-83.
Barnard, Chester. 1938. The Functions of the Executive. Cambridge, MA: Harvard University Press.
Blau, Peter. 1955. The Dynamics of Bureaucracy. Chicago: University of Chicago Press.
__________ and Richard Scott. 1962. Formal Organizations: A Comparative Approach. San Francisco: Chandler Publishing.
Bower, Joseph. 1970. Managing the Resource Allocation Process. Boston: Harvard Business School Press.
Chesbrough, Henry and David Teece. 1996. "When is Virtual Virtuous? Organizing for Innovation." Harvard Business Review. January-February 65-73.
Coase, Ronald. 1937. “The Nature of the Firm.” Economica 4: 386-405.
Dalton, Melville. 1959. Men Who Manage. New York: Wiley.
Dore, Ronald. 1983. “Goodwill and the Spirit of Market Capitalism.” British Journal of Sociology 34: 459-82.
Dyer, Jeffrey. 1996. "How Chrysler Created an American Keiretsu." Harvard Business Review July-August, 32-46.
Eccles, Robert. 1985. The Transfer Pricing Problem. D. C. Heath: Lexington, MA.
Gerlach, Michael. 1991. Alliance Capitalism: The Social Organization of Japanese Businesses. Berkeley: University of California Press.
Gordon, Karen, John Reed, and Richard Hamermesh. 1977. “Crown Cork and Seal Company, Inc.” Harvard Business School Case #378-024.
Gouldner, Alvin. 1954. Patterns of Industrial Bureaucracy. New York: The Free Press.
Granovetter, Mark. 1995. "Coase Revisited: Business Groups in the Modern Economy." Industrial and Corporate Change 4: 93-130.
Grossman, Sanford and Oliver Hart. 1986. “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Ownership.” Journal of Political Economy, 94: 691-719.
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
95www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Spring 2007 11 R. Gibbons
Gulati, Ranjay. 1995. "Does Familiarity Breed Trust? The Implications of Repeated Ties for Contractual Choice in Alliances." Academy of Management Journal 38: 85-112.
Hermalin, Benjamin. 1998. “Toward an economic theory of leadership.” American Economic Review 88: 1188-1206.
Klein, Benjamin, Robert Crawford, and Armen Alchian. 1978. “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process.” Journal of Law and Economics 21: 297-326.
Kogut, Bruce. 1989. "The Stability of Joint Ventures: Reciprocity and Competitive Rivalry." Journal of Industrial Economics 38: 183-98.
__________, Weigian Shan, and Gordon Walker. 1992. “The Make-or-Cooperate Decision in the Context of an Industry Network.” In N. Nohria and R. Eccles (eds.), Networks and Organizations: Structure, Form, and Action. Boston: Harvard Business School Press.
Lawler, Edward. 1971. Pay and Organizational Effectiveness: A Psychological View. New York: McGraw-Hill.
Macaulay, Stewart. 1963. “Non Contractual Relations in Business: A Preliminary Study.” American Sociological Review 28: 55-67.
Macneil, Ian. 1978. “Contracts: Adjustments of long-term economic relations under classical, neoclassical, and relational contract law.” Northwestern University Law Review 72: 854-906.
Nishiguchi, Toshihiro and Jonathan Brookfield. 1997. “The Evolution of Japanese Subcontracting.” Sloan Management Review Fall, 89-101.
Podolny, Joel, and Karen Page. 1998. “Network Forms of Organization.” Forthcoming in Annual Review of Sociology.
Powell, Walter. 1990. “Neither Market nor Hierarchy: Network Forms of Organization.” Research in Organizational Behavior. 12: 295-336.
Selznick, Philip. 1949. TVA and the Grass Roots. Berkeley: University of California Press.
Simon, Herbert. 1951. “A Formal Theory Model of the Employment Relationship.” Econometrica 19: 293-305.
Williamson, Oliver. 1985. The Economic Institutions of Capitalism. Free Press: New York.
Lecture Note 4: Make, Buy, or Cooperate?
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
96www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
MIT OpenCourseWare http://ocw.mit.edu 15.963 Advanced StrategySpring 2008 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
97www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
Reflections on Relational Contracts 15.963, Advanced Strategy Rebecca Henderson, Spring 2008 1. if there’s never going to be a temptation to defect, it’s not a relational contract I’m not convinced, for example, that Amazon’s customers have a relational contract with Amazon. Do they make an “implicit promise” promise to Amazon? I don’t think so. If they want to buy something somewhere else, they simply do so. Some cases are tougher, of course. For example, one might think that Southwest airlines might not need to offer a relational contract (hereafter “RC”) to its baggage handlers. Surely it’s much more interesting to be a baggage handler at SW than at any other airline? So perhaps Southwest doesn’t need to make an implicit promise to get baggage handlers to be “part of the team”, to “do what it takes”? Perhaps, but perhaps not – it might be the case for example, that without an RC, Southwest could abuse such an expectation – forcing baggage handlers to work very long hours, or to do dirty or dangerous work… Which is all by way of saying that for me there’s one simple test of whether an RC is in place. If I know that the party with whom I might have an RC is going to disappear to tomorrow, and if the knowledge doesn’t change my behavior – then I certainly don’t have an RC with them. Thus “we will give you a great product” is probably not an RC, because if they aren’t great products the customer simply won’t buy them, “we’ll go the extra mile when you are dissatisfied” might be?
2. But it might well be a relational contract even if there’s not a temptation to defect right now On the other hand, there may well be a relational contract in place even if there doesn’t seem to be any immediate threat of defection. Both papers on Toyota, for example, pointed out that Toyota’s relational contracts seem fairly stable – that it would be foolish for either Toyota or for its suppliers or employees to break them. To my mind stability is a sign of well working relational contracts. As a manager, an ideal might be to build RCs that are stable in exactly this kind of way – where everyone can see that the benefits for all parties far outweigh any benefits of “defecting”. 3. Firms often (usually?) have multiple relational contracts Nearly every paper made this point well. Nearly every firm discussed has relational contracts not only with its employees with also with its suppliers, and often with its complementors and its customers. The team writing about Intel, for example, included a particularly nice discussion of Intel’s RC with complementors elsewhere in the value chain, and the pressure that was put on the RC when Intel moved into the motherboard. One of the papers about Google described no less than five RCs with Google employees alone! (One interesting question, of course, is whether these contacts are seperable – could Google break one – eg “your work will change the world” – without impacting the others?) 4. Some relational contracts operate in two directions, while some do not Most papers suggested that when a firm offers an RC to its suppliers, the suppliers nearly always offer an RC in return, but that this need not be the case with eg employees or customers. In the case of employees, I might promise to treat you well and keep you on the balance sheet as long as you behavior
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
98www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
in a particular way – but you may not need to make a promise to the firm in return – you might just show up and “do your job”. Again, the key question here is whether you are making a “promise” to the firm that you might be tempted to break. If not, you haven’t offered them an RC. 5. Relational contracts can be (usually are?) unbalanced? Consider the case of Toyota’s relationship with its suppliers. Toyota’s temptation to defect – and the punishment if they do – may well be “larger” than those faced by its suppliers. Different suppliers may have different temptations to defect, and fear different punishments if they do. 6. Can you have a relational contract with your customer? It seems to me that the answer to this is clearly “it depends”. Sometimes, it’s very clear that firms have RCs with their customers. The McKinsey team suggested, for example, that McKinsey has a very clear RC with its customers: namely that they will tell them if they think a particular project is not well specified or not worth doing. Notice that there will be clear temptations to defect from this “but it’s such a big study… and we’re low on work right now…” – so that the both the benefits of “cooperation” will have to be clearly communicated throughout the firm “we’re not the kind of firm that takes on make work kinds of projects…” as will the potential punishments “they will push you hard to take this kind of study, but if you do, it really comes around to bite you, let me tell you about the time we… and about the effects on our other relationships…” Other clear examples when firms often have RCs with their customers are when there is a real (or perceived) threat of “lock in”. Here firms try very hard to persuade their customers they will not defect – jack up prices, cease introducing new products etc – in order to persuade them to buy. But some cases are less clear cut. Are brands RCs? Nearly all the Starbucks and Whole Foods teams made strong cases that they might be. It’s clear that all brands carry an implicit promise, so in that sense one might think of them as RCs. But I think it may be dangerous to carry this too far. Again, my test would be the degree to which the customer’s purchase was driven by a “shadow of the future” or by expectations about the behavior of the firm over time. Google clearly has an RC with its customers, by which it “promises” not to abuse the data it collects about them. But does Coca Cola have an RC with its customers? Probably not – if a particularly can of Coke doesn’t give me a great feeling of refreshment, do I feel betrayed? Perhaps, but I’m not sure it’s useful to think of this in terms of an RC. In the case of Starbucks and Whole Foods, to the degree that the purchase decision is driven by something that cannot be observed at the time of purchase – that the product is produced organically, for example, or that the company is not “abusing” its supply chain, or that the firm will continue to run coffee shops as “neighborhood stores” one might usefully think of this as an RC. But I don’t think the quality of the coffee is the subject of an RC… 7. Can end consumers have an RC with the firm they buy from? Some of the Apple teams clearly think that you can, and that Apple customers “promise” to promote the brand to their friends and to buy products in the future. But would Apple ever “punish” them if they failed to do this? I’ll confess that I’m not convinced. Of course customers can certainly have RCs with their “suppliers” so there’s clearly a spectrum of possibilities here.
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
99www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN
8. The “Social contract” Several teams observed that there were RCs in place that appeared to be functions of the institutional or social environment in which the firm was embedded, in addition to – or in place of – any firm specific RCs. This seems to me exactly right. You could, for example, choose not to tip in a restaurant, or to habitually lie to strangers who ask you for directions on the street rather than to go out of your way to help them. But by and large you don’t lie, cheat or steal. As I said in class, the sociologists discovered relational contracts a long time before the economists did. 9. Embedding RCs in practice There were great hints in several papers as to how RCs come to become embedded in routine practices and ways of behaving within firms. Several papers talked about the hiring practices at Google, Goldman Sachs and McKinsey in these terms, for example. A delightful discussion of Wells Fargo’s practices (whose admonition to its employees – “run it like you own it” is only rivaled by Nordstrom’s “use your good judgment in all situations” as the summary of an RC) was particularly enlightening in this respect. The team discussing Porsche talked not only about how the firm’s strategic positioning (we only make sports cars) reinforces its RC, but also about how the CEO’s decision to “stake his own personal wealth” at a time of financial stress had the effect of dramatically strengthening the firm’s RCs going forwards. 10. The Evolution of RCs over time Here a number of papers raised fascinating questions.
- Is it always the case, for example, that RCs get more stable over time? - What happens to firms that have extended very generous RCs to their employees – think of the
perks at Google for example – when the firm falls on hard times? - To what degree are RCs at small, high growing firms sustained by generous allocations of equity
and a rising stock price? Did MS every have an RC with its employees? Will Google, once growth fades and the firm gets too big for equity to reflect any reasonable measure of individual performance?
These are exactly the kinds of questions we will be looking at over the remainder of the semester…
www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
100www.onlineeducation.bharatsevaksamaj.net www.bssskillmission.in
WWW.BSSVE.IN