A Guide for the Growing Complexity of Governance OptionsPublished: November 15, 2007 in Knowledge@Emory
As the world becomes more complex, the complications that can occur with change can be confusing, yet they can also give us an array of new choices that improve our lives. For example, the old-time ice cream parlor offered a limited menu of generic flavors -- chocolate, vanilla, or strawberry. But today, one popular chain of ice cream parlors offers over three dozen flavors on any given day, chosen from a repertoire of over 140 esoteric and specialized flavors like chocolate raspberry truffle or peanut butter cookie dough. And with customers now able to choose a variety of candies and cookies to mix in, the menu of possible ice cream flavors has become virtually limitless.
Today, a similar proliferation of options is occurring in the menu of ways that business relationships can be governed. Consider the choices available to a company for how it obtains the parts, services, skills, and knowledge that it needs to produce its own products and services. The menu used to have a very limited set of generic governance options -- the classic “make or buy” decision. That is, a company could either hire people into its own organizational hierarchy to do the job internally, or it could outsource the work to a supplier in an external market. But like ice cream flavors, the menu of governance options has grown larger and more complicated because it now includes a variety of esoteric and specialized possibilities. Some of these possibilities, like franchising, quasi-integration, and consortia, are variations on the external market. Others, like autonomous profit centers, empowerment, and piece-rate systems, are variations on the internal organizational hierarchy. Still others, like joint ventures, are intermediate blends that meld the market and the organizational hierarchy together.
Helping managers make sense of this complicated governance menu is the mission of Richard Makadok and Russell Coff, both associate professors of organization and management at Emory University’s Goizueta Business School. Their first step is a new research paper on this topic, which recently beat out 654 other papers to win the prestigious Glueck Best Paper Award at the 2007 Academy of Management, an annual gathering for professional researchers that helps create and disseminate knowledge about management and organizations. Their research paper, called “Both Market and Hierarchy: An Incentive-Systems Theory of Hybrid Governance Forms,” has created lots of buzz in academic circles, and generated invitations for Makadok and Coff to present their ideas at leading institutions like Wharton, INSEAD, University of Michigan, Washington University, and Copenhagen Business School.
Much of the buzz is due to the paper’s unusual blend of both practical insights for managers and deep theoretical questions for researchers: On the practical side, the paper addresses questions like, “How do the various types of business relationships on the governance menu differ from each other? And when would each of these options work best?” Meanwhile, on the theoretical side, the paper poses thorny philosophical dilemmas like, “When is a hierarchy no longer recognizable as a hierarchy? When is a market no longer recognizable as a market?”
Makadok and Coff’s initial insight was to recognize that there is a big difference between what they call “intermediate forms” and what they call “true hybrid forms.” Previous researchers had only thought about the governance menu as one-dimensional -- a single continuum stretching between the two extremes of market and hierarchy, with all other alternatives being treated as just intermediate blends of the two endpoints. Makadok and Coff saw that this one-dimensional way of viewing the alternatives was inadequate.
“An intermediate form,” Makadok explains, “is one where all of the characteristics of the relationship are partly market-like and partly hierarchy-like. These characteristics include how authority, ownership, risks, and rewards are allocated between the two parties. Some intermediate forms definitely do exist, like a joint venture where authority, ownership, risks, and rewards are all shared jointly by the two partners. But many of the alternative governance forms simply don’t work this way. Many of them are market-like on some of the characteristics, while simultaneously being hierarchy-like on others. For example, franchising is hierarchy-like in how it allocates authority between the franchisee and the franchisor, yet it’s market-like in how it allocates asset ownership, risks, and rewards. It’s as if one piece of a hierarchical relationship had been selectively grafted onto a market relationship. When that happens, we call that a true hybrid. And you simply can’t capture the full range of true hybrids by looking at the menu one-dimensionally. You need multiple dimensions in order to consider each of the characteristics separately, so that they can vary independently from each other.”
To define what the relevant dimensions are, Makadok and Coff drew upon earlier research published in 1994 by organizational economists Bengt Holmstrom and Paul Milgrom, who had argued that markets and hierarchies differed on three specific dimensions -- incentives (i.e., risks and rewards), asset ownership, and authority. They defined a market as a relationship where the agents who do the work act as independent contractors in the sense that they: (1) enjoy high levels of autonomy to decide how the work will be done and what other activities they will do, (2) have strong performance incentives tied to their productivity (thereby offering a potential of high rewards for high output, but a risk of poor compensation for output shortfalls), and (3) own the assets used in production. By contrast, Holmstrom and Milgrom defined a hierarchy as exactly the opposite on those three dimensions -- i.e., a relationship where the agents act as employees in the sense that they: (1) submit to the employer’s authority by obeying rules about how to do the work and about what other activities may not be done, either at work or elsewhere, (2) get paid based on inputs provided (like time or experience) rather than outputs produced (and therefore bear less risk, enjoy less potential reward, and have less incentive to be productive), and (3) work with assets that are owned by their employer.
Using these three dimensions, Makadok and Coff illustrate the range of possible governance forms in a three-dimensional figure they call “the cube,” in order to explain what true hybrids look like in the real world. The pure forms of market and hierarchy occupy opposite corners of the cube. Near the other six so-called “off-diagonal corners” of the cube can be found the true hybrids, which include consortia, franchising, autonomous profit centers, piece-rate employment, quasi-integration, and empowerment. Franchising, for instance, resembles a market transaction except for its relatively strong authority relationship, where the franchisor provides the business model and the franchisee is required to follow the rules to implement it. “These hybrids are market-like in some ways, but hierarchy-like in others,” explains Makadok. “For instance, some might have agents with high autonomy, but low asset ownership, or vice versa.”
Although Makadok and Coff draw on Holmstrom and Milgrom’s 1994 paper when defining the three dimensions of governance, they nevertheless recognized a major deficiency in this earlier research -- it ignored the true hybrids. “Their paper was all about the conditions under which these three characteristics would all move together in concert in the same direction, either toward the market end of the spectrum, or toward the hierarchy end,” explains Makadok, “In that sense, it looks like an effort to take the three dimensions and reduce them back down to one. That’s where they went wrong, because it ignores the possibility of true hybrids. In order to get true hybrids, you have to allow for the possibility that the three characteristics can sometimes move in opposite directions.”
So, in addition to developing a typology of hybrid governance forms, Makadok and Coff develop a theory to predict when each hybrid might be efficient. They look at how selectively fusing elements of hierarchies into market transactions or grafting aspects of markets onto hierarchies can help managers deal with the challenges of hard-to-motivate or so-called “leverless” tasks like creativity and teamwork. The paper argues that certain hybrid governance forms can help stimulate effort on these “leverless” tasks like creativity and teamwork if there are certain matching patterns of synergies across the different tasks that an agent performs. Depending on which cross-task synergy pattern is present and how important a “leverless” task like creativity or teamwork is to overall performance, that tells you which of the eight governance forms to choose.
“For example,” Makadok notes, “if productivity is enhanced by teamwork, or if asset maintenance is enhanced by creativity -- in other words, if there are synergies between a ‘leverless’ task and any of the ‘leverable’ tasks, then you may be able to indirectly induce effort on the ‘leverless’ task by motivating the ‘leverable’ tasks that it’s synergistic with. You do that by selectively raising the motivational levers for only those ‘leverable’ tasks that are synergistic with the ‘leverless’ task. And doing that can move you closer to one of the hybrids in the cube. For instance, if productivity is enhanced by teamwork, then you can indirectly spur teamwork by selectively increasing productivity incentives. That could move you toward one of the hybrids with high incentives. Or if asset maintenance is enhanced by creativity, then you can indirectly spur creativity by selectively increasing the agent’s incentive to maintain the assets when you give the agent greater ownership over those assets. That could move you towards one of the hybrids with agent-owned assets.”At the end of their paper, Makadok and Coff readily admit that this “incentive-system” logic is only one possible explanation for the emergence and spread of hybrid governance forms, and they discuss numerous other possible factors that might also play a role. Nevertheless, despite this limitation, they see their paper as a significant first step toward understanding the proliferation of governance forms across the economy.
Pictured: Richard Makadok