Where Do Transactions Come
From? Modularity, Transactions
and the Boundaries of Firms
Carliss Y. Baldwin
Organizational Economics Seminar
MIT
February 14, 2008
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© Carliss Y. Baldwin 2008
Motivation:
A Movie of Industry Evolution
Slide 2
© Carliss Y. Baldwin 2008
Computers, 1979
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© Carliss Y. Baldwin 2008
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© Carliss Y. Baldwin 2008
Lots of New Firms
 With
attendant transactions and boundaries
 Transaction-cost economics and property
rights theory cannot explain why industry
structure changes
 As industry evolves where will new firm
boundaries appear?
Slide 29
© Carliss Y. Baldwin 2008
Contributions of the paper
 Task
network model of production applied to
transactions
 Synthesis of transaction cost theory, property rights
theory and multi-tasking models of incentives and
firm boundaries with modularity theory
 Theory of technological change that explains
changing transaction locations and changing
industry structure
 Theory of Transaction-free Zones—their existence
and two basic forms
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© Carliss Y. Baldwin 2008
Outline
 Literature
 Definitions
 Transaction
Location
 Transaction Design
 Modularization
 Transaction-free Zones
Slide 31
© Carliss Y. Baldwin 2008
Literature
Slide 32
© Carliss Y. Baldwin 2008
Transaction Cost Economics and
Property Rights Theory

Based on a sequence of stages model of production (Coase,
1937; Williamson, 1991; Grossman & Hart, 1986; Hart & Moore, 1990;
Baker-Gibbons-Murphy, 2002)
– Upstream supplies Downstream
– Two stages, one interface

Property rights theory takes incompleteness of the
contractual interface as axiomatic
– Given incompleteness, the task is to locate residual control rights
(“ownership”) (Grossman & Hart, 1986; Hart & Moore, 1990; Hart, 1995)

Design of the interface is outside the theory
– What exactly passes between Upstream and Downstream?
– Not a question in these literatures
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© Carliss Y. Baldwin 2008
Knowledge-based
Theories of the Firm
 Reaction
to TCE and Property Rights theory
 Firms are a way to package/divide relevant
knowledge
 Knowledge gives rise to Capabilities/
Competencies /Routines
 But knowledge boundaries are not
transactional boundaries …
“Firms know more than they make.”
(Brusoni, Prencipe, Pavitt, 2001)
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© Carliss Y. Baldwin 2008
Modularity Theory

More micro than the other theories
– Looks at the internal structure of products and processes

Mirroring hypothesis (Henderson and Clark, 1990)
– “Organizations are boundedly rational, and, hence… [their]
structure comes to mirror the internal structure of the product they
are designing.”

Product module boundaries = Organizational boundaries
– [= Firm boundaries] is a common assertion
– but many counterexamples
» One firm, many modules
» Several firms, one module
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© Carliss Y. Baldwin 2008
What does the internal (modular)
structure of products and processes
imply for transactions?
Our topic today…
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© Carliss Y. Baldwin 2008
Definitions
Slide 37
© Carliss Y. Baldwin 2008
Task network
 Network
graph of how something gets
made/produced
– Engineering perspective
 Imagine
a graph of ALL transfers of
material, energy, information between
Upstream and Downstream
– “Activity system” (Porter)
 This
is a directed graph
– Unlike social network graphs
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© Carliss Y. Baldwin 2008
Design of an Aircraft Engine
TRANSFERS
from column to
row
Potential
Flowpath of
TRANSFERS
TRANSFERS NOT
TRANSACTIONS
Slide 39
Sosa, Eppinger,
Rowles,
Management
Science, 2004
Within a single
firm—Pratt &
Whitney
8 subsystems,
54 components,
54 teams
© Carliss Y. Baldwin 2008
Transaction
Mutually agreeable set of transfers with
compensation
 To make a transaction, you must

– Define
– Count (Measure)
– Compensate
Absense <=>
Incomplete Contract
 Cost
of this work = Mundane Transaction Costs
 Contrasting definitions
– Williamson: “transactions are the unit of analysis”
– Greif: transaction is any social interaction (even with
God)
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© Carliss Y. Baldwin 2008
Transaction Location
Mundane transaction costs are
low at module boundaries and
high in module interiors.
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© Carliss Y. Baldwin 2008
What is a module?
A module is “a group of elements (tasks) that are
highly interdependent on one another, but only
weakly dependent on elements outside the
module.” (Baldwin and Clark, 2000)
 Modules are near-decomposable (Simon, 1969)
 Ergo, module boundaries are thin crossing points
in the task network
 Ergo, modules hide information (Parnas, 1974)

– Information hiding ≠ Different knowledge
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© Carliss Y. Baldwin 2008
Example—Smithy and Kitchen
Smithy
Kitchen
CG S1 S2 S3 S4 S5 K1 K2 K3 K4 K5
CG .
Smithy
Kitchen
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S1
S2
S3
S4
S5
K1
K2
K3
K4
K5
x
x
x
x
x
x
x
x
x
x
.
x
x
x
x
x x x
. x x
x . x
x x .
x x x
Pot Hook
Transfer
x
x
x
x
.
x
Why locate the
transaction at the
module boundary?
Minimum knowledge
overlap (KBT)
.
x
x
x
x
x
.
x
x
x
x
x
.
x
x
x
x
x
.
x
x
x
x
x
.
With LOW mundane
transaction costs you
can achieve a MORE
complete contract =>
LESS opportunism
© Carliss Y. Baldwin 2008
When modules are well-defined
 Humans
locate transactions at module
boundaries “without thinking.”
 We exchange finished, usable goods, not
partly finished, unusable ones.
– Conserves knowledge.
– Reduces MTC, hence incompleteness, hence
opportunism.
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© Carliss Y. Baldwin 2008
Transaction Design
Can you have a transaction at a thick
crossing point…
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© Carliss Y. Baldwin 2008
Can you OUTSOURCE Design and
Production of the FAN system?
Out-of-block
dependencies
make this a
THICK crossing
point
The
dependencies
don’t go away
by themselves!
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© Carliss Y. Baldwin 2008
Transaction Design Options—1
 Minimal
Transaction Design
– Pay for Fans only
– Spot market transaction
 Mundane Transaction
Costs —Low
 Opportunistic Transaction Costs—High
– Williamsonian holdup (both ways)
– Defensive investments (Grossman-Hart-Moore)
– Uncompensated multi-tasking (Holmstrom &
Milgrom, 1994)
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© Carliss Y. Baldwin 2008
Transaction Design Options—2
 Maximal
Formal Contract
– Pay for everything
– At at thick crossing point, “everything” is a lot!
 Burden
of Mundane Transaction Costs
– Accountants outnumber the workers!
 Opportunistic Transaction
Costs
– Unnecessary transfers (“scorecarding”)
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© Carliss Y. Baldwin 2008
Incomplete contract optimal (Hart 1995)
Optimal
Transaction
Design
Benefits of
Transaction
Costs of:
Property rights
(residual
control rights)
limit ex post
damage of
renegotiation
Benefits and Costs ($)
Total
Transaction Cost
Opportunistic
Transaction Cost
Mundane
Transaction Cost
0
Minimum
Complexity
Transaction Complexity
Slide 49
Formal
Contract
Maximum Complexity
(depends on thickness of
crossing point)
© Carliss Y. Baldwin 2008
Transaction Design Options—3
 Relational
2002)
Contract (Baker, Gibbons, Murphy,
– Manage by exception
– Create “shadow of the future”
 Burden
of Mundane Transaction Costs
– Less needs to be defined and counted
 Opportunistic Transaction
Costs
– Less opportunism as long as outcomes stay
within reneging bounds
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© Carliss Y. Baldwin 2008
At a Thick Crossing Point
Relational Contracts are better…
Optimal
Transaction
Design
Benefits of
Transaction
Costs of:
Benefits and Costs ($)
Total
Transaction Cost
Formal
Contract
Relational
Contract
Opportunistic
Transaction Cost
Total
Transaction Cost
Mundane
Transaction Cost
Opportunistic
Transaction Cost
Mundane Transaction Cost
0
Minimum
Complexity
Transaction Complexity
Slide 51
Maximum Complexity
(depends on thickness of
crossing point)
© Carliss Y. Baldwin 2008
But you can also design the task
network to suit the transaction.
Redesigning the task network is
called…
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© Carliss Y. Baldwin 2008
Modularization
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© Carliss Y. Baldwin 2008
Software System with Licensed-in
Code (La Mantia et. al. 2008)
Before Modulariziation
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© Carliss Y. Baldwin 2008
Software System with Licensed-in
Code (LaMantia et. al. 2008)
Before Modulariziation
After Modulariziation
No
Dependencies
Licensed
Code
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© Carliss Y. Baldwin 2008
Notice how well this story fits with
Grossman-Hart-Moore’s theory
Misaligned property rights (to code)
 Led to costly ex ante investment (change code
structure)
 To improve ex-post bargaining position (relicensing)
 What’s new is a prediction about the nature of the
defensive investment + Tactical advice

– Isolate purchased code behind a modular interface
Story also fits Baker-Gibbons-Murphy: A relational
contract would have mitigated the problem
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© Carliss Y. Baldwin 2008
Modularizations in Support of
Transactions
 Standardized
Interfaces
– Langlois and Robertson, 1992, stereos and PCs,
– Sturgeon, 2002, modular production systems
– Jacobides, 2005, mortgage banking
 Single
Point of Contact
– Mayer and Argyres, 2004, software
– Staudenmayer et. al., 2005, various
Crossing points were made thinner, but can
still be very thick!
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© Carliss Y. Baldwin 2008
But there are other reasons to
modularize…
 Manage
complexity
 Allow parallel work
 Create options to innovate
See Baldwin and Clark, Design Rules, for
examples
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© Carliss Y. Baldwin 2008
Whatever their stated purpose, task
modularizations create new module
boundaries, with low transaction
costs…
IBM System/360 created the disk
drive industry via a modular interface
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© Carliss Y. Baldwin 2008
Integrations remove module boundaries,
increase transaction costs

Can be used to squeeze out complementors
– Vertical foreclosure
– Fixson and Park, 2007, bike drive trains
Or not—
 With relational contracts can still have an
economical transaction at a thick crossing point
– Japanese auto industry, especially Toyota (Sako, 2004)
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© Carliss Y. Baldwin 2008
Transaction-free zones
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© Carliss Y. Baldwin 2008
When tasks are too interdependent to
split apart
 Humans
automatically create “transactionfree zones”
 “Stuff happens” without being defined,
counted or paid for
– Smithy, kitchen, seminars like this one…
 From
an evolutionary perspective, TFZs are
older than transactions
– Strong, instinctive social norms apply
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© Carliss Y. Baldwin 2008
How do you get valuable things into
a transaction-free zone?
 Birth,
adoption, conquest, inheritance, gift
 Transactions
 Non-transactional methods are fading in
importance
– “Civilization”
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© Carliss Y. Baldwin 2008
Corporations—
“Encapsulated” TFZs

Create a “ring of transactions” around an
enterprise
– Products sold via transactions
– Materials, labor, capital, management brought in via
transactions

Inside, owners/managers have latitude to design as
they wish—
– Even create internal transactions!

Survival of a corporation is predicated on financial
sufficiency
– Sum of transaction payments must be positive
– Otherwise TFZ is bankrupt—must reorganize
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© Carliss Y. Baldwin 2008
Online/Open Source Communities—
“Unencapsulated” TFZs
Information flows freely in and out—no
transactions at the boundary
 Communities make non-rival goods

– No threat of holdup
– Don’t want to exclude anyone who might freely
contribute resources

Mundane transaction costs become an
unnecessary—a burden/drag on productivity
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© Carliss Y. Baldwin 2008
Summary—Empirical Predictions
Modular Boundaries and Thickness are observable!
1. Transactions are more likely to be found at module
boundaries than in module interiors.
2. The design of transactions differs systematically
with the thickness of the crossing point. Spot
transactions are more likely at thin crossing points
and formal and relational contracts at thicker ones.
3. The advantages of formal and relational contracts
over spot transactions and of relational contracts
over pure formal contracts increase with the
thickness of the crossing point.
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© Carliss Y. Baldwin 2008
Empirical Predictions (cont)
4.
5.
6.
Slide 67
Transactors can sometimes modularize a thick crossing point
to reduce transaction costs. Transactional modularization is
most likely to occur when the transactors cannot achieve a
satisfactory relational contract.
In the aftermath of a modularization, entry and competition will
arise at the new module boundaries.
Transaction-free zones are needed to facilitate complex,
interdependent transfers in the task network. Zones that
produce rival goods or require large amounts of indivisible
capital will be transactionally encapsulated, taking the legal
form of modern corporations. Those that produce non-rival
goods using low levels of capital can succeed as open zones
without well-defined transactional boundaries.
© Carliss Y. Baldwin 2008
Contributions of the paper
 Task
network model of production applied to
transactions
 Synthesis of transaction cost theory, property rights
theory and multi-tasking models of incentives and
firm boundaries with modularity theory
 Theory of technological change that explains
changing transaction locations and changing
industry structure
 Theory of Transaction-free Zones—their existence
and two basic forms
Slide 68
© Carliss Y. Baldwin 2008
Limitations of the paper
 No
universal theory of “the” firm
 Anything goes inside a financially sufficient
Transaction-free Zone
– Freedom of design
– Can have transactions within a zone
» transfer pricing
– Don’t need transactions at the boundaries of a
zone
» online/open source communities
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© Carliss Y. Baldwin 2008
“Firms are like lumps of butter
coagulating in a pail of
buttermilk.”
Robertson, quoted by Coase, 1937
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© Carliss Y. Baldwin 2008
Thank you!
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© Carliss Y. Baldwin 2008