Transacting with tech firms

Not so long ago, Big Corporations were the norm. Today, we have an industrial landscape of many small and specialized firms that also inherently need to tra more as they do not control the full chain of resources between inputs and final retail market. This requires certain knowledge of the transaction properties and the transaction hazards. Below, there is an extract from the introductory part of my PhD thesis that further describes this from an academic – theoretical point of view.

Section 1: 1. More specialization & relationship-driven inter-firm interfaces

Today’s commercial landscape is characterized by shorter product lifecycles, competition based on time to market and more demanding customers (or better served customers, who can just pick the provider that serves them first with an innovation that proves to be superior above other offerings). [1] These are all interwoven with each other. A substantial enabler of this change was the emergence of ICT, which can be considered as a general purpose technology that shaped the functioning of an economy.

Previous industrial eras also often depended on general-purpose technologies that were available at that specific time. For instance, the initial industrial revolution at the end of the 18th century was possible thanks mechanical production facilities (water power and steam power). At the end of the 19th century, electrical energy would allow mass production through assembly lines, where workers could do very specialized actions under the principle of division of labor. Since a few centuries now, IT systems allow to further automate processes, but also to allow increasing the complexity (i.e. more tailored to the specific requirement set of the customer).[2]

 

1.1: 1.1. From a pre-industrial to an industrial business landscape

In the pre-industrial era, there were no large corporations and interactions between small economic agents (often individual craftsmen) were around goods. The benefits of some form of coordination, or working together across such entities, were nonetheless already recognized. This happened through craft guilds.[3] These closed communities have non-anonymous and face-to-face properties that did not allow them to operate on a large scale or over large geographical distances. Towards outsiders and other economic agents, such guilds could exercise some monopoly and cartel power. Their closed nature led to barriers to entry. However, the risk for being expulsed from such closed guilds enhanced the attention to trustworthiness and reputation among the members. Innovations that resulted out of such collective institutions or from other institutions in the fifteenth and sixteenth centuries were the creation of standards for commerce (later evolving towards commercial law) and the creation of mutual institutions for encouraging risk-taking behavior (insurance pools).

 

1.2: 1.2. 1st and 2nd industrial revolution: mass production, standardized products & scientific management

When technological progress allowed producing and distributing goods on a mass scale, large corporations that operated according to the principles of rational bureaucracy would overclass small producers.[4] The production of cheap standard products could happen thanks to the benefits from economies of scale. At high fixed costs, and a large output, one could create low average costs. The central coordination of productive resources in a single producer was under those circumstances more competitive compared to decentralized small and independent producers. These economies of scale were also a barrier to entry as a minimum efficient scale to compete could be prohibitive. Complementary resources were exclusively owned and controlled by the large entities, instead of needing coordination or product handoff across different economic entities. Superior access to resources, offers a competitive advantage.[5] The high capital requirements to exclusively own resources could be met thanks to an innovation to pool capital from different individuals: corporations.[6] Such exclusively owned resources could be capital-intensive machinery, but also employees who then worked under long term loyalty for an employer and who performed very specialized and repetitive tasks (the division of labor notion). Those employees followed instructions under scientific management principles.[7] Even marketing and distribution could be more efficiently integrated in such firms, instead of relying on independent wholesalers for it.

The highly abstract nature of the central and scientific (rationalized) management meant that individual customer-specific knowledge could not be used, or that it would not be able to travel the information ladder up to the decision makers. There was also no need for that as the low cost of the products was attractive, and as the market lacked competition from equally inexpensive but more customized products. Market shares were also protected through artificial measures like lock-in contracts or through brand loyalty. This mass production of standardized and cheap goods was a substantial difference against products that were produced and sold by craftsmen. Notions like monopolism are thus naturally related to such paradigm, as this is the pinnacle of economies of scale.

With the number of large firms (i.e. car companies) increasing, complementary economic agents and infrastructure also started to emerge. For instance transportation infrastructure, packaging technology or telegraph communication lines.[8] Those had a reinforcing effect. Larger markets and mass produced products went hand in hand. And as production would be concentrated in the hands of a small number of large corporations, also the securities markets would evolve in conjunction with those corporations and the trading volume that concentrated around such set of firms. This lack of fragmentation, also allowed that investment intermediaries would undertake complementary value adding services for the select few large corporations, like investment research.

The inherent structure of the corporations also implied a competition between investors and those who were in control of the contributed capital, which became known as agency problems. Agency situations have demanded a great deal of our attention and energy, also in lawmaking. Besides corporate regimes, also other legal infrastructure has its origin under the industrial paradigms of mass production and separated ownership and control: competition law for instance, as well as contract law that concentrated on the trade of goods.

Law- and policymakers even continued to focus on the dynamics of those mass-producing institutions till many decades after World War II. They were also an easily observable factor in the economy as their number was limited and their size was large. At some point in time, these large companies created practically all the new jobs. However, since the late 1960s, they have mainly been responsible for the loss of jobs.[9] The next title will illustrate how economic evolutions then favored small economic entities.

 

1.3: 1.3. 21st century: customized products, with fast product cycles, in a knowledge industry

Recently, most sources of competitive advantage came not from static market share but from new technologies, new sources of supply or new types of organization.[10] Faster product cycles allowed bringing products to market faster than competitors (and thus to take away market share). New production principles allowed to operate at lower prices than competitors, even in smaller batches, or allowed to bring more appealing products to customers. Innovating with technology gives thus more possibilities to fulfill the needs of individual customers or niches of customers – and to compete on that.

Also, the minimum efficient scale and fixed costs of many operations have significantly dropped. At the same time has there been a growth in population and income. And further advancements in transportation and telecommunication have resulted in further extended and globalized markets. Also protectionist measures have decreased, and free trade has increased. Services and knowledge have now an important role, and these elements are less physically and geographically limited than goods and physical assets.[11]

Small, agile and specialized businesses now dominate the landscape, and are also the major source of jobs.[12] Large firms often experience more difficulties to behave in a responsive instead of a repetitive way or to reinvent themselves under the changing business dynamics. Innovation and responsiveness cannot be rigorously instructed, and the creative collaboration they require cannot be simply commanded.

However, such small firms have severe constraints to own resources in an exclusive way, and it requires a substantial amount of transaction costs to obtain access to such resources externally, from partners. Transaction costs and coordination costs can have a very important factor to hinder or to foster the functioning of such small firms.

After a time, industrial dynamics may however let such small firms grow towards large firms who then rather protect than build market share. For that, some may however choose to constantly reinvent themselves and constantly re-innovate to maintain that market share in a constantly changing competitive landscape.[13] Pushing forward a de facto standard, or establishing a standard and increasing the switching costs in a network industry, may also allow maintaining or extending existing market share.

Nonetheless, many activities in our society are still so capital intensive that they can only be done by large capital-intensive firms. Therefore, economies of scale will remain a factor to explain the size of some companies. Ocean ships, subsea communication cables, semiconductors or trains cannot be produced in small business entities, even not through coordination between them.

Another source of small firms –besides those that serve a customer niche– are specialized firms in a value chain. Instead of specializing in serving a particular customer niche, they perform one specific element of a value chain. The production and the use of technology is then divided across firms, similar to the division of labor – innovative labor in this case.[14] Using new technologies, such specialized firms can create competitive advantage. A key thing about specialization in a knowledge intensive setting is learning: by continuously doing things, the cost per individual performance becomes lower. Companies with great manufacturing or distribution abilities may not have the necessary R&D skills and vice versa. Instead of building such capacities themselves, accessing that knowledge can result in a reduced lead-time. A number of value chains that used to take place in vertically integrated companies, have now been decomposed or modularized. For instance in the semiconductor industry, one can now find firms that only design semiconductors (fabless semiconductor firms) but who do not own plants (called “fabs” in industry) – this is outsourced to specialized manufacturers (foundries).[15] Firms have become more dependent on suitable partners to stay competitive.

 

Section 2: 2. Hazards and costs in transactions with technology-driven firms

This study will focus on transactions that are a result of a constraint or a strategic choice to access resources externally or to coordinate with other entities. This external sourcing or this coordination implies a higher transaction cost compared to an internal access inside the firm (which is not always available). One of the sources of transactions costs is for instance the difficulty to find a partner. Another source is the exposure to counterparty risks in relationship-driven transactions (opportunistic hazards and poor performance) – and the efforts that it takes to anticipate this. Also, in contrast to normal resources like well-defined products, markets to access such externally owned resources may be incomplete and may not adequately offer enough supply for a specific demand under a specific exchange. This is possibly also due to the transaction costs, if they turn out to be prohibitively high. Even difficulties around valuation can significantly increase transaction costs. A lack of institutions and a lack of transparent information flow may also have a role.

It is the access to relationship-dependent resources that will be discussed in this study, together with some private mechanisms to reduce the transaction costs for them. Such mechanisms may for instance be coordination mechanisms between the different (potential) parties. Such coordination mechanisms may however lack support in our legal infrastructure, or existing coordination mechanisms may prevent the emergence of other ones. A main goal of this study is to expose these problems.

Here, I will first describe some resources around which technology-driven firms may transact, before introducing the different types of transaction costs and their sources.

 

2.1: 2.1. Resources with a high degree of counterparty dependency, and external uncertainty

The resources that are subject to such interfirm or relational transactions, may for instance be capital, knowledge, production capacity, intellectual property, labor or other human assets, inventory management, repair capacity, research capacity, distribution channels, marketing channels (i.e. in new markets), technology, brand loyalty, reputation, supplier networks, etc.

For some resources, there’s already an interfirm or relational market operating with well-understood compensation practices. In the labor market, one is for instance paid in wages (or a combination of wages and profits, as an incentive mechanism). In the intellectual property market, one is paid in economic rents. In the financial markets, one is paid in interests or in profits. Other markets may have other generally accepted exchange practices.

Many of these resources here share a number of properties: for instance a lack of a physical character which otherwise limits the geographical reach, although the firm or person that offers the access to the resource may have such limitation. For instance, in case of knowledge: the physicality depends on the tacit or codified nature of the knowledge.[16] In case of tacit knowledge, the physical limitation depends on the expert who holds the knowledge. Also, many of these markets lack adequate institutions and transparent information flows – and such an underperforming market may actually give a competitive advantage to those who hold certain resources internally or who already have privileged access externally.[17]

 

2.1.1: 2.1.1. Capital

A major resource is of course capital. Investing in technology-driven firms takes normally place through equity. Return will then come from sales in the secondary market, as technology-driven firms will generally not distribute dividends (especially not when aggressive growth is preferred). The entire second and third chapter will discuss the access to capital, and especially the search and contracting costs. This will also largely depend on the question if coordination infrastructure is available or not, or if the equity is rigid (for easier coordination when many investors are present) or rather negotiable.

Instead of return objectives, some may also consider equity stakes for their optionality. A potential acquirer or partner may consider holding a minority equity stake as an option right in a company that holds or develops a complementary asset.[18] This may later result in a full acquisition and thereby result in full control over the complementary asset (which offers a competitive advantage).

 

2.1.2: 2.1.2. Technology (possibly innovative technology)

Through the exclusivity granted by the patent system, the legal system gives (qualifying) knowledge the characteristics of a private good. It may therefore be appropriate to call this privatized knowledge “technology” or “intellectual property”. This should be separated from the products that integrate or bundle the technology. Intellectual property laws have made it easier to trade technology; the owner of the patent can either exploit the patent exclusively, or he can transfer the right to exploit it to a partner.

A “not invented here” syndrome has been identified, as a sort of hurdle to actually import technology that has been developed elsewhere. Another hurdle for a well functioning market, may be the prohibitive transaction costs. Nonetheless, there is such a market, and there has been one since long time. For the US for instance, there has been evidence that before the emergence of large corporations, a vibrant market for patents existed.[19]

 

2.1.3: 2.1.3. Knowledge (possibly innovative knowledge)

Knowledge can for instance be about the familiarity with a local market, or capabilities around technology. Knowledge is a non-rivalrous good, which means that two parties can use certain knowledge simultaneously without it suffering a loss of quality. Knowledge is exchanged under various names: as technical assistance, R&D services, consultancy, employment, acquisitions, etc. Knowledge may be tacit, which means that persons experience difficulties to articulate it.[20] In that case, it requires access to the expert to use the knowledge. For that reason, firms may prefer to locate in regions where knowledgeable workers are available. Considering a need to articulate knowledge may also be a question of costs.[21] Knowledge will also often be absorbed by the counterparty, during a cooperation. This is called absorptive learning.[22] This incurs the risk that competitive knowledge can get lost – thereby potentially creating a competitor.[23]

 

2.1.4: 2.1.4. Reputation / signaling of legitimacy

Young companies face a liability of newness. To overcome this, and to be more credible towards potential clients, employees, investors and other potential parties, such firms may seek endorsement by reputable partners like venture capital firms.[24] Also, business relationships with credible corporations may reduce much of the external uncertainty that would otherwise make potential investors uncomfortable.[25] It signals confidence from established companies, and access to complementary resources (i.e. commercialization channels).

 

2.1.5: 2.1.5. Commercialization: marketing, distribution and supply

Marketing and distribution channels take time to create. Partnering with a firm with existing supply channels can substantially reduce that time investment and the exposure to external risks. This can for instance be used in case of international expansion. A foreign partner may then also have knowledge about the foreign market.

 

2.1.6: 2.1.6. Innovative entities

As already indicated under access to capital, access to complementary resources can also take place under the form of a market for firms. An acquisition of a firm can offer exclusive and transaction cost free access to the complementary resource (knowledge, market channel, market share, economies of scale, etc.). And it didn’t take the time and uncertainty to develop it. Companies often prefer such access at a later but more certain stage of the technology, innovation or market entry.

In the life sciences industry, the focus lies often on buying the entire company, including all tacit and explicit knowledge. In chemical, pharmaceutical and biotechnology industries, with high development costs and long development cycles, exclusive licenses are rather the norm to obtain access to the complementary resource in a rather exclusive way.

Vertical integration is in a Coasian world also a device to overcome opportunistic hazards and information asymmetries. Also for Williamson are organizations considered as devices to economize on transaction costs.[26] Disadvantages relate to the industry trends that have been described above: vertical integration reduces a level of specialization that could otherwise exist, and it may reduce the ability to respond to client information.

 

2.2: 2.2. High transaction costs, and the role of embeddedness in networks and communities

The relationship driven nature of the transactions, but also the uncertainties involved, make them inherently subject to high transaction costs. Not only is it difficult to find suitable partners: unlike instant markets for goods, the mechanisms to find a suitable partner may be more opaque. Also, these transactions create a dependency on the counterparty that acts as a host or carrier of an underlying resource. The exposure to counterparty risks like opportunistic hazards or poor performance in the meantime is substantial, and this requires an adequate level of trust to feel confident to transact with the counterparty, or it creates a cost to design and use contractual mechanisms that prevent such hazards. Thereafter, the ongoing monitoring and the possible enforcement may also be costly. Enforcement will rather be an ex-post mechanism that one will prefer not to use in such transactions: not only due to the high direct costs, but also since recovery from transaction failure may be prohibitively costly. In instant spot markets for goods, rapid transaction takes place because there is a trust infrastructure of laws and enforcement in place that ensures that if either party cheats, they are likely to be caught and punished. This legal framework also applies to relationship-driven transactions, but this is much less satisfactory there – and ex-ante trust plays a much more important role here. Therefore, in contrast to the traditional transaction cost theory, I will attribute substantial attention to the element of trust.

These elements are all in strong contrast to the instant markets for goods or generic services. Relationship-driven transactions are about resources that are much more difficult to standardize and to price (i.e. the price for a 10% equity stake in a non-listed company is difficult to value). This makes the interface between firms much more difficult.

 

Unlike instant and anonymous markets for goods, counterparties and resources in a relationship driven market cannot necessary by found like shopping in a shop or a catalogue. It may require polling a network around a person or firm, or potentially the extended network through referrals of intermediaries (potentially the network of a service provider like a lawyer or a venture capitalist, but perhaps also a professional intermediary). Sometimes, directories and work of mouth may provide information on how to locate potential counterparties. Also, membership in an open or closed community or platform (i.e. a spatial community or an industry community) may allow locating potential counterparties. A disadvantage of networks and communities is that the necessary counterparty may potentially not be part of this network or community. Only few potential parties may publicly advertise their presence in a market (i.e. through advertising or other forms of signaling), although this will be less the case than in markets around standardized and commoditized goods and services. Many parties are just opaque and initially invisible. Still, the flow of information is essential for the functioning of a market, at least for the search for counterparties and for conveying information on their trustworthiness.

The just mentioned communities can be open and informal, but may also be a specifically created form of market infrastructure, and the degree of centralization or fragmentation of such platforms may vary. They become more interesting for potential participants depending on the number of participants that already participate (known as network effects, or increasing returns).[27] Sometimes, the creation of such platforms or community may represent an entrepreneurial opportunity. But if such incentive for a lead partner is missing, then there may be a coordination failure to create one, if no informal community has already been formed organically.

Many internet entrepreneurs have spotted the drastically information lowering effect of the internet and they have created online platforms. Communities/platforms can now be constructed based on a special interest, but at the same cost on a global scale as at a local scale. In part two, I will discuss how such new internet platforms in the financing domain clash with the regulations that have basically embedded the setup where such central platforms were mutually created by intermediaries – and which therefore also required to use such intermediaries to access them.

Search costs alone can even eliminate all potential returns from a transaction. But even if a counterparty can be located, then the search for an alternative (for comparison) can be too costly and that counterparty can exploit this lock-in and can use it as bargaining power.

 

2.2.2: 2.2.2. Trust building & selecting – potentially through contract costs

I use the transaction cost framework to discuss the costs that a relationship-driven transaction incurs.[28] Unlike a trade of a physical asset, the performance is much harder to asses upfront and the personal characteristics of the counterparty are much more important – as the obligation still needs to be delivered after all. During that long time, a party may behave opportunistically or may offer poor performance. Agency settings are an example: agents, like managers may have self-dealing incentives and may exploit information asymmetries to gain from their principals, instead of for their principals.

The transaction costs theory relies on contracting or legal mechanisms (i.e. the threat of legal sanctions, control through equity transactions, etc) to prevent the occurrence of opportunistic hazards or poor performance. These ex-post mechanisms may also create ex-ante trust (as they may create a threat for costly sanctions). Ex-ante trust is important. Adverse selection will take place when no trust is available. Parties will then protect themselves by assimilating all potential partners as opportunistic or poorly performing partners. As a result, good quality counterparties may withdraw from the market when it is too costly for them to signal their inherent quality in an environment where they will be considered as a bad counterparty by default. And as a result, only bad firms will stay in the market and will be available for contracting. This is the “market for lemons” problem, as described by Akerlof.[29] It is an application of Gresham’s law where bad quality is crowding out good quality. To put it otherwise, the market breaks down.

However, the transaction cost theory can be criticized as it fails to recognize non-legal sources of ex-ante trust. This study will however consider a substantial role of ex-ante trust, also from non-legal sources.

A number of reasons explain the increased attention for ex-ante trust. First, ex-post remedies may not offer full recovery (i.e. legal remedies may be limited to foreseeable damages), may be too late, or may lead to a gridlock situation (i.e. reciprocating a non-performance and thereby having a mutual hostage over the situation). Secondly, enforcement costs may also be too high. Finally, the opportunity cost of a long-term interaction in general is high: it may be prohibitively costly to search for another party and to re-enter in such long arrangement. A counterparty may be aware of that dependency and of the lock-in position. This dependency may be related to the resource that forms the core of the transaction: for example a transaction specific asset that has been developed[30], or the case where a resource is unique and necessary (and by extension also the dependency on one specific counterparty). Especially young firms may not be able to recover from such failure.[31] Therefore, ex-ante trust is important to be able to select a counterparty.

Ex-ante trust can be inherent or it can be based on the risk for extrinsic costs like legal or social threats. The notion of trust is often only used to describe the context of inherent trust, or where extralegal sources act as an extrinsic force. It is then ‘self-enforcing’, or a form of ‘private ordering’.[32] I will approach the different sources of trust in a more holistic way.

Sometimes, parties can be intrinsically trustworthy – even without the need for external threats with legal and social sanctions to prevent untrustworthy behavior. However, they may feel a need to signal this. Likewise, there are numerous cases where a party may not be driven by return or self-interest, but rather by intrinsic motivations like love, fun, altruism and duty to contribute into a transaction. The motivation can also be the hope that such inherently non-compulsory gestures will be returned. There is then an expectation of direct reciprocity. There may also be a level of indirect expectation of reciprocity. Expectations based on self-interest or rationality are then ultimately still a basis to explain the behavior to enter into the transaction. But it is an unstable equilibrium as the first instance of non-cooperation can lead to a breakdown.

Trustworthiness will often be a result of the rational threat for sanctions (legal sanctions or social sanctions).[33] Then, the threat and cost of these sanctions (which should thus not only be legal ones) can create a reasonable expectation that one will not behave opportunistically. This offers protection against breakdown of the equilibrium.

Before describing state-provided contract law, which is safeguarded by state-provided enforcement, I will describe extrinsic sources of trust that are based on relational mechanisms.[34] The latter ones may be directly between parties involved, or may be through indirect social mechanisms involving reputation and a threat for sanctions from third parties.[35]

A first relational sanctioning mechanism exists in direct relationships between the parties involved: namely reciprocal hostages or the risk for boycott in cases of repeat transactions. Misaligned behavior will obstruct the possibility for repeat business. But information on the commitment of new potential parties (strangers) is not yet available. Just like the case of intrinsic trustworthiness (which may not be distinguishable from trustworthy behavior that is induced by sanctions), the process of getting to know each other (obtaining information) and to produce credible signals is costly for both parties. As trust will typically be based on personal acquaintance and experience, assuring oneself of the trustworthiness could thus be costly. It may require a time investment and information costs to construct a reasonable assurance ex-ante.

Trustworthiness of strangers also has a substantial perceptional component. Some parties may find it easier than others to consider potential counterparties as trustworthy. Different degrees of perceived trust to deal with strangers do indeed exist (i.e. Italians are known to have a low degree of trust towards strangers to undertake business relationships[36]). Whole regions can find themselves stuck at low-trust and poor-performing equilibriums (a form of prisoner’s dilemma). Preferring to deal with group members instead of strangers may also have to do with biology’s notion of kin selection in order to enhance the group’s fitness vis-à-vis non group members, even at a cost of an individual’s fitness (i.e. the individual may be better of by selecting the stranger as the optimal party may not be part of the community).[37]

Partnering with costly providers of certification can give a shortcut to access new parties, and to gain trustworthiness despite being a stranger. This can be through intermediaries for instance, who have a costly reputation on the line and who are supposed to undertake sufficient due diligence as they have an interest to endorse good quality parties only.[38]

The risk to lose a reputation is also a sanction that applies in indirect relationships. When information can flow transparently, then one can also assess the trustworthiness through information and experiences from third parties. Open feedback information can for instance easily flow in business communities or associations. It gives the information that experience from repeat transactions would give, although these transactions can be done with other parties.[39] Especially in close non-anonymous networks can there be a self-reinforcing interest to honor obligations.[40] That is especially true in settings of close physical proximity. But this can possibly even happen in any open setting, where information about past performances is shared in a fully open and transparent way (potentially publicly available even – as the world’s economy globalizes, it becomes ever more difficult to get rid of a bad commercial reputation.).

Embedding a relationship in a community also increases the effectiveness of social sanctions that need to increase the cost of defecting and that need to impose de-facto trustworthy behavior. For instance, the loss of (costly) reputation through shame and guilt becomes more severe (as it stretches further than just one party). Also formal sanctions or community exclusion –ostracism– are more severe than a simply inter-party boycott.

The embeddedness of actor’s actions in a structure of social relations is something that is often grouped under the notion of social capital.[41] Besides the trust enhancing role, this embeddedness also has a search cost reducing role. However, a counterparty may not be part of one’s network or even the community where one participates in. The reinforcing effect of a community may then have no effect. Also, a collective action problem may prevent such communities from emerging if they do not emerge organically. Such communities will receive more attention in this study, thanks to those important benefits, but also due to that collective action problem. Another collective mechanism to enhance trust, besides communities, may be the mechanisms of insurance

Social sanctions indeed eventually run into an obstacle: they cannot resolve conflicts between complete strangers, or they can take too much time to effectively assure oneself of the trustworthiness of the counterparty. Therefore, parties may use legal mechanisms and state-enforceable contracts to create costs for defection. In a contractual fashion, hostages can also be foreseen to discourage nonperformance. Also, parties can be locked in to prevent opportunistic attitudes when negotiating follow-on contracts under conditions where one party has become dependent on the specific counterparty.

However, it has been highlighted before that such legal sanctions, and even their ex-ante effect, have their drawbacks as well. These legal sanctions may co-exist with the social sanctions that will still be possible.

 

As relationship-driven transactions are already very extensively controlled by social norms and sanctions, one can of course also consider what the effect may be of the combination of social sanctions with legal sanctions. Sometimes, legal norms are nothing more than an expression and internalization of a social norm. But some authors consider that contracts are detrimental to (non-legal) trust.[42] The presence of legal sanctions may make people to conform only to them, as they anticipate that the counterparty will only expect that and not the intrinsic goodwill that they would otherwise additionally give.[43] Because the presence of the sanctioning system will give people the idea that others are self-interested, it may undermine the trust that others may be internally motivated to cooperate. Measures imposed to increase trust extrinsically may unintentionally harm intrinsic trust. This may lead people to perform “just enough” instead of magnificently.

 

2.2.3: 2.2.3. Monitoring costs

The source of disappointing results of a transaction may be difficult to observe: it may be due to external circumstances, or due to opportunism and bad performance. Ongoing performances are especially difficult to measure and to meter, in order to decide if a best effort has been delivered or not. For instance, for knowledge workers, time is a mostly used metering proxy. However, being physically present may not exclude that the employee limits its efforts and invests his knowledge in a side-project instead. Increasing the monitoring mechanisms (i.e. oversight mechanisms), come at an information cost.

 

2.2.4: 2.2.4. Enforcement costs

Before, I already highlighted that enforcement of sanctions comes at a cost and that the counterparty may be aware of this costly enforcement (thereby increasing room for opportunistic behavior). I mentioned that parties might prefer ex-ante mechanisms. This study will not look at legal enforcement.

 

2.3: 2.3. Market incompleteness

The above mentioned transaction costs are a reason of market incompleteness. Costs may be too high to overcome, and transactions may not take place. However, also other reasons may be responsible for this market incompleteness.

First of all, long-term interactions are difficult to value. Especially for transactions that have a form of financial consideration, there will be a lot of valuation problems. Besides the already mentioned exposure to opportunistic hazards and poor performances, there is also an extensive exposure to external risks during the time of the collaboration. Valuations may even be highly subjective, dependent on relative advantage or subject to social interactions (like bandwagon effects, herd mentality, speculation and confidence games, or anchoring if price discovery mechanisms are available). Speculation may even add to this, and may reduce the market to an anticipatory game. This all has the inherent property that there is a potential for bubbles and crashes.[44] Once a run away from one asset class takes place, then transmission effects like spill over and contagion effects (i.e. herding) can even lead to systemic crises.[45]

The external uncertainties may especially have a prohibitive role in transactions that revolve around financial returns. An example of an external uncertainty is for instance the risk of not finding follow up finance (capital risk). Later, I will also describe uncertainties that relate to the technology and the market acceptance, at the operational side of a firm. The risk adjusted return metrics for technology-driven firms may for instance be insufficient compared to other risk adjusted returns from more established companies, or compared to other asset classes in general. But there are also studies that demonstrate very decent returns.[46] Within the different types of government interventions that have been used, and which will be discussed later, influencing the price mechanism has been a popular method to unlock such capital towards technology-driven firms. One can think of tax incentives, co-investment schemes with public money or downside protections. A popular tax incentive is to discard the capital gains tax if a minimum investment period is met (i.e. 6 months in Luxembourg, one year in Portugal or one year in France).[47] Actually, in Europe, about one third of the money in venture capital funds has a public origin (often coming from the European Investment Fund).[48]

Parties may also not be present in the market for other reasons. Patent holders may for instance choose not to license technology, as the technology represents a source of competitive advantage. Another example is companies that lack the interfaces (departments, employees, etc.) to formulate or to deal with requests to enter into partnerships to access resources. Another example is employees in countries with severe non-compete restrictions who may not be available in the employment market as a result of those restrictions. A similar case was the prudent men rule prior to 1979 that prevented US pension funds to invest substantial amounts into (inherently risky) venture capital.[49] Today, capital requirement directives and solvency directives also still lock up capital in Europe, and they require for instance more investment in liquid assets instead of illiquid assets like venture capital. Tax obstacles may also lock up capital, or may render it immobile (i.e. due to the risk that a venture capital investment may create a permanent establishment classification abroad, when an investment is made abroad).[50]

 

2.4: 2.4. Collective action costs and coordination surpluses

The enriched transaction cost model revealed the role of market infrastructure: namely the role of platforms and communities to reduce the search costs, but also to enhance the role of ex-ante trust. In contrast to open markets like markets for instant transactions around goods or standardized shares, or in contrast to partially open markets (i.e. venture capitalists who display themselves publicly, while potential investees may not do so), the opaque markets for the resources under the scope of this study often have network-based mechanisms (through brokers, who extend their reputation), or function through organically grown communities or through platform facilities.

Such community or platform infrastructures thus have an important role to let a market function. For instance, if a transaction is not embedded in a trust community where reputational information can flow, then a cheater may never face any repercussions (i.e. no risk for boycott). Such communities or platforms may spontaneously arise in a non-anonymous spatial context, but also when a lead entrepreneur spotted an entrepreneurial opportunity to build a critical mass of members based on commercial terms. But when this is not the case, platforms or communities may however fail to arise as well. Coordination failures are the current frontier of market failures that need to be looked after.

There are also other examples where coordination may bring surpluses, besides communities and platforms that can internalize negative externalizers, or that can improve the information flows to reduce search and due diligence costs. With a landscape of many specialized agents today, such firms may miss out instances where large vertically integrated firms could benefit from economies of scale or other forms of coordinated action. Large vertically integrated firms do thus not only economize by eliminating the cost of potential opportunistic behavior as Ronald Coase analyzed in his 1937 research on the determinants or the optimal size of a firm.[51] Nonetheless, the existence of small decentralized firms may be grounded on convincing reasons like competitive advantage through economies of specialization or through better responsiveness to environmental circumstances (vertically integrated entities lack the ability to handle localized information or to serve quickly moving markets or market niches). To still have the benefits of vertically integrated firms, such decentralized firms can then bond for interfirm cooperation and coordinated. There can be instances where cooperation offers better outcomes (i.e. less duplicate costs and efforts) than competition. These collective actions are however costly, just like I described how bilateral transactions around resources are costly. Sometimes, the collective action cost may be prohibitive.

Thus, in any landscape with decentralized agents, may there be cases where coordinated actions may lead to a better outcome to those who participate in the coordination. However, the failure to come to such a coordinated action may put the agents involved in a suboptimal setting for which they lack the incentives, the communication flows or the means to overcome the costs to escape the situation: this is an instance of the prisoner’s dilemma but over a larger scale then just two parties.

The problem with such collective actions costs has often to do with finding the right set of incentives at a reasonable cost to let a large group of participants join in a concerted action. If all actions would rely on individual negotiations, then this would be too costly due to the large number of participants. Also, overcoming the cost to engage in concerted action will depend on the number of other participants: network effects dictate that a minimum critical mass is necessary, but that increasing returns will then create an upwards spiral.

It is also important to reserve the advantages to those who contribute in the costs, to prevent breakdown. The presence of free riders who benefit from the advantages, but who would not contribute to the costs, may be detrimental.[52] For instance, if certain formal rules or standards would operate in a community, then Individuals would often face a private cost when complying with the precepts of the rule, and they generally derive a benefit because of the compliance of others with existing rules.[53] There may be cases where not joining may effectively be a better outcome for some parties, which leads to a breakdown of the coordination. The existence of an incentive not to reap the cost, while still using the benefit, requires mechanisms to prevent that.

Besides overcoming a collective action cost with the right incentives, it is also important to anticipate a coordination failure that may exist when participants would still behave competitively instead of according to the prescribed collaborative behavior. To prevent that a party should actually become more powerful vis–à–vis other members after the initiation of a collaboration, and would choose to compete again instead of cooperate, a lock up may also be needed. This protects the coordination participants at a later stage.

A level of coordination may also involve ongoing overhead costs. And depending on the organization, there may be minor cases of misalignment between the managers of the coordination infrastructure and the participants.

Hereafter, I will discuss some cases of coordination efforts. Those may be to create market infrastructure to enhance trust and to reduce search costs. Some trust enhancing mechanism will defend against negative externalizers (opportunistic group members). Other efforts may be rather aimed at lowering the transaction costs between individual members by coordinating between them collectively (i.e. setting standards for the handoff interfaces between members). I will call them type I and type II types of coordination. I will discuss the failures to let such type I coordination arise, in the context of accessing financial resources in part two of this study, and in the context of accessing non-financial resources in part four of this study. I will also discuss how type II coordination is needed between some market infrastructure providers in the financial domain, in part two, and in the non-financial domain, in part four. In part three, I will discuss how standard equity and the corporation provided a useful form of type II coordination, but how they prevent at the same time some transactions where freedom is expressly wanted over the state-provided standardization.

Another type of efforts, namely alliances with a “joint” or “mutual” element between two or more partners, like joint research efforts, joint development efforts, joint sourcing efforts, joint distribution, joint marketing efforts or joint commercialization efforts, will not be discussed here as those are from another nature. The latter ones may also be the formation of a partnership to have more bargaining power towards a common counterparty, like the formation of a cartel or a merger to derive monopoly rents from the clients (although counterbalanced through the existence of antitrust laws). Those latter forms of bonding are rather to protect market share in economy of scale industries or in situation where artificial elements like brand loyalty protect market share (instead of constantly having to spend energy on innovation in order to outrun competitors). They are more a matter of mature firms that have captured market share, and that now may want to benefit from the market share or brand loyalty. Those types of coordination will not be discussed here.

 

2.4.1: 2.4.1. Type I: bonding to create a conductive environment

Communities or platforms where members can learn about each other’s existence and characteristics, can economize on the search costs to otherwise find about such a party. The larger the number of members, the more increasing returns there may be (positive network effects). Also, earlier, I pointed to the increased effectiveness that trust, social sanctions and information flows may have in a community. That may also be a driver for forming such platforms or communities (and the search cost reduction will still be inherent). And besides formal appearances, there may already exist an informal flow of information between the members of an industry, a geography or a group. Also, a formalized community may supplement such informal social network and may for instance be embedded in a regional cluster, or group; that it therefore reinforces.

For instance, the community may protect members against negative externalizers. By excluding negative externalizers from transactions with the group members, it should effectively create an incentive to join the group. It should at least be a severe enough threat that one will be excluded from potential transactions with the group members in case of opportunistic behavior (unless the negative externalizer is in such a powerful position that incentives continue to exist not to join the group). Collective action is sustained through such “closed shop” incentives and with advantages that are only open to members.[54] A sharp difference between outsiders and insiders then exists.

This process is called internalization: namely that one now bears the costs of the actions where he would otherwise only feel the upside while others pay the costs.[55] For instance, the cost of behaving opportunistically is now not only felt by the counterparty but it is indirectly returned to the one who behaved like that in the first place. In kin networks or spatial proximate settings where repeat transactions, information flows, reputation or a sense of group survival are important, this may automatically already be present.

Bonding to protect against externalizers in a group or industry, possibly with setting formal rules governing the relationships between its members, allows to reduce the trust discovery process as opponents will see the cost of opportunism and poor performance increase. It also allows reducing the search costs, besides this increasing effectiveness of social sanctions (i.e. better informational transparency). These forms of bonding can be called special interest communities, or platforms. Such special interest communities can be local, regional, national, international or global in geographical/spatial scope. However, the pervasiveness of IT has substantially lowered the cost of platforms and communities, even over long distances.

If the benefits are so substantial, then operating the infrastructure for such platform or community may even offer a commercial opportunity. This will however not always be the case. Then, instead of an entrepreneurial party that takes the lead role to organize such a platform, industry members may join forces and realize that they need to invest to overcome individual transaction costs (when taken together, these can be called coordination costs) as the benefits will then outweigh the investment to overcome those individual costs once. However, this coordination may be prohibitively costly under the existing incentives (i.e. presence of free riders, existence of ex-ante holdup). This may require government intervention.

Expressly created industry communities or platforms that set formal norms to prevent against externalizers, closely resemble the role of governments in their role of formal sanction providers. One can speak of legal pluralism, where norms can be part of social relations, rather than exclusively be imposed by the state.[56] This view of law acknowledges the importance of the state and of professional actors, but does not privilege state or professional contributions to law over those of other participants in social institutions. Pluralistic normative regimes have long existed in parallel to the state, and still exist today on a large scale. The general coordination mechanism of governments is partly obsolete, as it is now possible to create ad hoc groups for special interests where it was not possible before thanks to the cost-reducing function of IT. Social coordination is now cheaper than before. However, also the state itself still offers sanctions, dispute resolutions and enforcement for the domain of private transactions (i.e. contracts) – as society at large has an interest in lowering the transaction costs and improving the extrinsic existence of trust between economic agents in an economy (this creates positive externalities that will be discussed later).

Just like organically emerged communities, there are also organically emerged norms and customs in such communities (industries for instance). Besides collective action, also auto-creation can lead to norms despite the fact that norms are actually a public good.

 

2.4.2: 2.4.2. Type II: bonding for better coordination

Other situations that may motivate coordination efforts to reach more efficiency are the formation of standards for the interaction and interfaces between the members (i.e. specialized and independent firms). As not all activities take place under the roof of one vertically integrated company, the handover can become costly if no knowledge/capabilities or standards are present to handle that handover cost effectively. As tasks are now often partitioned across different firms, the innovative activity now often relies on knowledge and capabilities of different agents.[57] The collective cost of all transactions can thus be costly.

Standardization may reduce the accumulated transaction costs, especially when many transactions are necessary due to some complexities in the technology landscape. Instead of individual negotiations, which would still be manageable on a bilateral level, a standard may decrease the transaction costs of many transactions (the compound cost of individually negotiated transactions may be prohibitive otherwise). Standards may for instance be on the level of standard contracts (privately provided, or state-provided like standard equity in corporate entities for instance). Just like behavioral expectations following industry community practices, this also creates increasing returns if a whole industry is knowledgeable about them.

Similarly, specialized agents that mainly react to impulses that they can observe, may also lack the ability to process and observe the amount of overview or abstracted information that a larger agent can actually process (and which would be executed through instructions downward in the organization in that case). Bonding to observe and process overview information may also be increase the efficiency of decentralized agents, instead of merely acting on the basis of decentralized reflexes.

Bonding may also offer a bargaining mechanism against parties that may otherwise exercise much bargaining power or that may even create an ex-ante holdup situation. For instance, patent pools try to mitigate the bargaining power of individual (and necessary) patent holders. But they may not necessarily be able to success in this without changes in the legal framework (i.e. as the switching cost and the dependency on essential patents also increase once a pool operates, this makes it only more interesting for essential patent holders to stay out and to seek rents separately with those who have no other choice than to agree).

When more than two parties are involved, like such partner pools or standard setting organizations, a one-time social action problem arises – it requires a number of actors to join but incentives may be lacking, or may allow them to enter into competitive behavior once joined (as described in the previous paragraph). This may justify government intervention.

 


 

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