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The Disaggregation of Corporations: Selective Intervention, High-powered Incentives, and Molecular Units Todd R. Zenger • William S. Hesterly John M. Olin School of Business, Washington Uniuersity, Campus Box 1133, St. Louis, Missouri 63130 Dauid Eccles School of Business, University of Utah, Salt Lalce City, Utah 84112

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any authors have speculated about the impact of technological changes on organizational form. This article moves beyond these speculations by discussing the implications of technological change on the structure of transactions cost in a firm. Jay Barney

Abstract A vast array of organizational innovations and changes are transforming US corporations. Large firms have dramatically downsized, refocused, and vertically disaggregated. They increasingly obtain goods and services, pursue complex development efforts, and exploit horizontal synergies without the aid of formal hierarchy. Large firms are also internally disaggregating into smaller, more autonomous units that are treated much like external subcontractors. The authors argue that these organizational innovations share an important underlying commonalty: economic activity is converging toward exchange involving either internal (within-firm) or external (between-firm) networks of small, autonomous production or service units. Small units and small firms have become the basic building block, the molecular units, of these new forms. Further, exchange among the small, autonomous units is commonly a mix of both market-like and hierarchical features. The authors develop a theoretical explanation for these trends. They argue that disaggregation is motivated by the powerful performance incentives that accompany small size. They further argue that disaggregation is facilitated hy recent innovations in information technology, organizational design, and performance measurement that permit the selective intervention of market elements in hierarchy and hierarchical elements in markets. The enhanced ability to intervene selectively necessitates a rethinking of traditional assumptions about the discreteness of governance choices. Innovations in organization, measurement, and technology shift decisions about optimal governance from simple market versus hierarchy choices to choices of an optimal mix of hierarchical and market elements. Consequently, managers and scholars must increasingly view organizations as complex webs of governance arrangements rather than as entities with definable boundaries.

{New Organizational Forms; Vertical Integration; Incentives; Markets and Hierarcfiies; Organization Economics)

There is growing evidence of a fundamental shift in the forms that govern economic activity. Much has been written describing organizational innovations and experiments that have arisen in recent years. Virtual corporations, cluster organizations, regional networks, hybrid organizations, horizontal corporations, shamrock organizations, and network organizations represent this paradigmatic shift (Daft and Lewin 1993, p. i) in organizational forms. Some of the forms will be discarded with other worn-out management fads. Others may represent nothing more than misguided experiments. Nevertheless, fundamental changes have dramatically altered the way production and services are organized in our economy: firm and unit sizes have decreased, more market-like exchange is taking place within firms, and hierarchical mechanisms increasingly assist in market transactions. The challenge for organizational scholars is both to document and to provide theories to explain these changes. Daft and Lewin note the need for explanation in their editorial essay, "Where Are the Theories for the 'New" Organizational Forms?" We concur with them that "research on organizations does not appear to be undergoing a parallel paradigm shift" and may be ''in danger of becoming isolated and irrelevant to leading the emergence of new paradigms" (p. i).

1047-7039/97/0803/0209/$n5.00 Copyrighl C; lVy7. Inslidilc for Operalions Research and (he Management Scienees

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Our article is intended to partly fill the theoretical void. We note a widening gulf between theoretical notion.s of governance forms and the emerging reality. The traditional logic of comparative institutional choice argues that markets and hierarchies represent discrete governance choices (Masten 1988, Milgrom and Roberts 1990, Powell 1990, Williamson 1991a). According to the comparative view, viable organizational forms require "a syndrome of attributes that bear a supporting relation to one another" (Williamson 1991a, p. 271). Hence, '^selective intervention," in which a single attribute is transplanted from one form to another, is argued to be inefficient or "impossible" (Williamson 1991b, p. 165). Some scholars have persuasively critiqued the dichotomous view of governance forms, arguing that governance solutions are arrayed on a continuum from markets to hierarchies with the vast majority in the "swollen middle" that combines elements of both markets and hierarchy (Bradach and Eccles 1989; Eccles 1981, 1985; Eccles and White 1988; Hennart 1993; Stinchcombe 1985). However, our primary observation is not a swollen middle, but rather a swelling middle. Recent innovations and advances in measurement, monitoring, organizational design, and information technology have eased the selective infusion of market mechanisms into hierarchy and hierarchy into markets. The increased ease of selective intervention has supported a stream of organizational innovations with clear underlying similarity: disaggregated structures consisting of small, highly autonomous units governed by a hybrid mix of both market and hierarchical elements. It is a convergence toward these more disaggregated organizational forms that we seek to explain in this article. We begin with a brief review of recent organizational innovations and present evidence of the pervasive trend

Table 1

The Distribution of Employment by Firm Size, 1963-1987 Percent of Employees in Size Category

All Companies < 100 employees > 10,000 employees Manufacturing Companies < lOO employees > 10,000 employees

1963

1977

1987

39,7 25.6

39.6 28.7

42,4 19.3

19.1 36.7

16.0 45.2

18.7 40.2

Source: Enterprise Statistics, U.S. Bureau of the Census.

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toward disaggregation, then develop an explanation. After exploring the incentive advantages that accompany disaggregation, we present our argument that the emergence of hybrid governance modes stems from a host of factors that ease selective intervention. Those factors make possible the measurement of small internal units and the monitoring of small external units.

Background: Evidence of Disaggregation and Selective Intervention Many observers write about new organizational forms as though their widespread diffusion is an accepted fact. An abundance of anecdotal evidence in the popular press supports the notion of a paradigm shift in organization, but empirical research on the prevalence of such forms is limited (Daft and Lewin 1993). Critics might argue that the anecdotes represent not changes in the way firms organize, but shifts in the rhetoric of management thought (Eccles et al. 1992). Therefore, before developing an explanation, we provide some evidence of the phenomenon. Smaller Firm.s and Units Aggregate organizational data suggest that recent organizational change has reduced organization and establishment size. Empirical evidence indicates that large corporations have dramatically downsized (Birch 1987, Wyatt Co. 1991) and vertically disaggregated. Firms have also refocused their activities, undoing past diversification moves (Davis et al. 1994, Ravencraft and Scherer 1987, Shleifer and Vishny 1991). Reflecting such broad change, average firm and establishment size has dropped significantly in the major industrialized nations, among both manufacturing and service organizations {The Economi.'it 1990). Our analysis of the U.S. Bureau of the Census Enterprise Statistics in Table 1 demonstrates a pattern of increasing firm size through the late 1970s followed by a dramatic decline in firm size by 1987. About 29% of the labor force worked in firms with 10,000 or more employees in 1977, but only 19.7% worked in those very large firms by 1987. Employment in small firms (fewer than 100 employees) correspondingly rose from 39.6% in 1977 to 42.2% in 1987. This trend reflects more than a simple shift toward a service-sector economy. The same pattern of declining size is evident among manufacturing firms. Employment in firms with 10,000 or more employees dropped from 45% of manufacturing employees in 1981 to 40% in 1987. Current Population Survey

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data also support the trend toward smaller firm size. They suggest that 60% of manufacturing employees in 1979, hut only 45.7% in 1991, worked in firms with 1,000 or more employees. Data from County Business Patterns reveal a similar, although less dramatic, trend for average establishment size: a decline from 16.3 empioyees in 1981 to 14.4 employees in 1987. Clearly, these data are consistent with the popular view that downsizing, refocusing, and disintegration yield a more disaggregated economy of smaller firms and smaller establishments. By definition, therefore, firms today more commonly obtain goods and services, pursue complex development efforts, and exploit horizontal synergies without the aid of formal hierarchy. The Infusion of Hierarchy into Market Exchange Although disaggregation has by definition increased the prevalence of market-governed exchanges in the economy, evidence also suggests that the market exchanges have become more hierarchical. Surveys report a broadening use of market governance methods that explicitly incorporate elements of hierarchy; such methods include alliances (Marsh 1993, Oster 1994. Schnellhardt 1994), supplier rating programs (Minahan 1992), and preferred vendor relations. They often involve colocation of employees (Dyer 1994. Dyer and Ouehi 1993, Quinn 1992) and the establishment of cross-firm operating procedures (Stinchcombe 1985). In some cases, contracts give a firm the right to use traditional hierarchical means such as performance measurement and incentive systems for employees in other firms (Stincheombe 1985). Unlike classical market governance, these governance devices are commonly long-term exchange agreements that extend well beyond price and quantity to encompass quality, responsiveness, reliability, and innovation. Often sophisticated information systems, innovative incentive arrangements, and strong social ties support the complex exchanges. Network organizations,' which manage a set of external vendors that design, produce, market, and distribute products, are extreme examples of hierarchy in markets (Best 1990; Bruseo 1982; Johnston and Lawrence 1988; Miles and Snow 1992; Piore and Sabel 1984; Quinn 1992; Saxenian 1990, 1994). Thus, the trends suggest a shift not only toward greater market control, but also toward the infusion of hierarchy within market governance. The Infusion of Market Governance into Hierarchy: Disaggregated Hierarchies There is also evidence of disaggregation in internal governance. Organizations have increased the auton-

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omy of small subunits and reduced the hierarchical authority and behavioral monitoring that characterize internal governance. In extreme implementations, small subunits are structurally configured to produce and exchange definable outputs, are aggressively measured as separate units, and are rewarded directly for subunit performance. Reflecting a decline in hierarchy, managerial spans of control have expanded and entire layers of hierarchy have been removed.A variety of initiatives and innovations have facilitated the broad replacement of hierarchy with marketlike devices. The majority of large firms appear to be involved in widespread efforts to re-engineer, redesign, and restructure (Btisiness Wire 1994, The Economist 1994, Mullin 1993, PR Newswire 1994). Such redesign efforts commonly entail use of cross-functional teams that cluster the broad set of capabilities required to produce an output or perform a process within a subunit (Hammer and Champy 1993). Moreover, the cross-functional teams frequently have broad authority to perform their roles and are subject to performance measures that treat them more like independent or quasi-independent units than part of a bureaucratic hierarchy. Initiatives to measure the performance of small subunits have also been widespread. Total quality initiative.s, benchmarking, and activity-based accounting have enhanced considerably the accuracy of financial and nonfinancial measures of performance used by small organizational subunits (Eccles 1991, Garvin 1991, Haedicke and Feil 1991, Maskell 1991, O'Guin 1990). Group-based rewards have also become more prevalent. Estimates of prevalence among Fonune 1000 firms range as high as 39% (Lublin 1995). Such reward systems compensate individuals on the basis of performance of their subunits. With disaggregated structures, group-based performance assessment, and group-based rewards, employees become very much like owner-operators of small, internal subcontracting units. Those internal initiatives implemented in isolation infuse market elements into hierarchy, but their implementation in concert may radically transform organizations toward institutions that closely resemble internal markets. Although the preceding discussion addresses two directionally opposing trends (toward both markets and hierarchies), the trends appear to share a common destination. First, the fundamental molecular organizational unit—the unit measured and evaluated, and which exchanges autonomously or semi-autonomous!y with other internal or external units—has declined in size. Second, the governance of exchanges among the small molecular units is not restricted to price and

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quantity or to traditional hierarchical control. Internal exchanges involve greater output governance and less authority. External exchanges involve more direct coordination and less reliance on price. Figure 1 is a simple representation of these shifts in governance. For business systems that design, produce, market, and distribute complex products, governance has shifted away from both traditional hierarchy and traditional market exchange (A and B of Figure 1). Replacing those traditional configurations are two functionally similar forms: disaggregated internal structures that promote market-like internal exchange among small semiautonomous subunits (C) and coliaborative, quasihicrarehical links among small autonomous firms (D). In extreme implementations of internal markets (C), subunits have complete exchange autonomy, complete performance responsibility, full decision rights over dimensions that alter performance, and incentive systems that directly reward subunit performance. In extreme implementations of hierarchically-linked markets (D), a web of tightly linked small firms manage the production and delivery of a complex product or service. Our interest, however, is not in documenting

Figure 1

these extreme forms, but in highlighting factors that explain movement in their direction. We seek to document mechanisms that ease selective intervention and thereby promote disaggregation. We argue that internal initiatives and innovation in measurement enhance firms' capacity to circumscribe and isolate internal activities. Newly isolated activities can be managed subsequently much like an internal market, with performance measures and rewards linked directly to subunit outputs. We further argue that advances in systems of monitoring and coordination in buyer-supplier relations more effeetively link autonomous firms. Such features simulate hierarchy and enable firms to avoid integration.

Disaggregated Structures and High-powered Incentives High-powered incentives are the lure of disaggregated, market-dominated systems of governance (Williamson 1985). Disaggregation of a corporation into smaller firms or small, autonomous internal units affords access to high-powered incentives. Empirical studies

Trends Toward Disaggregated Organizations

Traditional Forms

Emerging Disaggregated Forms Infusion of Markets'.

A.

Hierarchical Governance

Highly Autonomous, Market-goverfied Internal Units Infusion of Hierarchy

B.

Market Governance

D.

Autonomous Firms with Hierarchy-1 ike Links

solid lines = legal boundaries of the firm dotted lines = quasi-boundaries

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The Diseiggregalioit of Corporalion.s

confirm that on average small firms offer reward systems that closely link individual performance and pay (Bishop 1987, Garen 1985, Stigler 1962, Zenger 1994). The close link is possible because small firms have efficiency advantages in rewarding individual performance. Fewer individuals contribute to firm performance in a small firm. Hence, individual contributions are more easily observed and rewarded. Further, small firms can deliver high-powered incentives by simply rewarding individuals for firm performance, thus avoiding the costs of individual performance assessment. Large size greatly limits the effectiveness of rewards based on firm performance. In a large firm, an individual has a trivial effect on overall firm performance and hence, rewarding individuals for firm performance has trivia! incentive value. Free riding incentives escalate with increased size, while incentives to monitor and discipline peers diminish. The effort levels of colleagues matter most when they strongly influence pay. Small size also reduces the costs of resolving fairness issues that constrain high-powered incentives. As suggested in the social comparison literature, perceptions of inequity in pay may trigger a variety of costly outcomes such as turnover., reduced effort, or low morale (Adams 1965, Homans 1961, Martin 1981). Highly inflated self-perceptions (Meyer 1975, Zenger 1992) and strong demands for fairness make aggressive rewards for performance problematic. Large performance-based pay differentials must be justified to other employees and managers to avoid the negative eonsequences of perceptions of unfairness. If we assume firm boundaries circumscribe the domain of comparison for individuals, firm size determines the magnitude of costly comparisons and justifications of pay differences. Individuals in large firms may not compare their pay directly to that of all others within the firm, but managers push aggressively toward equity across groups. In small firms, there are simply fewer individuals to whom a particular pay differential must be justified (Zenger 1994). Hence, small firms can exercise greater latitude in adjusting individual pay. Large companies, by contrast, restrict performance-based pay differentials to a very narrow range (Baker et ai. 1988, Medoff and Abraham 1980). Perhaps most importantly, small firms can simply link pay to firm performance, deliver highpowered incentives, and largely avoid comparison issues altogether. The high-powered incentives of small firms have predictable effects on performance. Empirical studies suggest that such incentives of small firms may motivate higher effort than the lower-powered incentives of large firms (Rasmusen and Zenger 1990, Zenger 1994),

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lure superior talent (Bruseo 1982, Zenger 1994), and spur innovation (Kamien and Schwartz 1982). The high-powered incentives of small firms also strongly motivate the development and leveraging of valuable capabilities, routines, and knowledge. In small firms, individuals benefit directly from such investments. By contrast, within a large hierarchy, weak performance incentives provide weak incentives for skill formation and thereby focus attention on the maintenance of existing exchange relations and capabilities. Henee, we conclude that by disaggregating integrated business systems into legally distinct entities, firms infuse powerful incentives that yield an array of desirable outcomes. By disaggregating hierarchies into semi-autonomous internal units, large firms may in part replicate the high-powered incentives of small firms. If an internal unit can be isolated structurally and measured clearly it can function and be rewarded much like a small firm. Indeed, increasingly firms reward individuals directly for group performance (Lublin 1995, Mathews 1995). Consistent with differences in incentives related to firm size, we predict that the scope of internal disaggregation—the size of internal units^has a profound effect on intensity of internal incentives. To reward individuals aggressively for the performance of a large division has limited value. Incentive intensity can be higher when units are smaller. When units are small and clearly measured, individuals have a large impact on group performance measures. In fact, empirical work on group-based pay plans shows that both the intensity of incentives firms offer and the performance outcomes are higher when the groups to which pay is linked are smaller (Zenger and Marshall 1995). Thus, disaggregating hierarchies affords an opportunity to duplicate the high-powered incentives of small firms.

Increased Efficiency of Selective Intervention: Factors Contributing to the Growing Prevalence of Disaggregation Although the lure of high-powered incentives motivates disaggregation, we contend that the enhanced capacity to selectively infuse elements of market governance in hierarchy and hierarchical governance in markets enables and sustains disaggregation. The increasing ease of selective intervention undermines the traditional dichotomous governance choice of the comparative institutional framework (Williamson 1991a). The logic of that framework has been that market

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exchanges undergo a fundamental transformation when internalized by a firm. The transformation reflects discrete differences in the bundles of attributes that form the respective institutions (Milgrom and Roberts 1990, Powell 1990, Williamson 1991a).-^ Hence, large firms find it difficult to replicate internally the powerful incentives of small, market-governed firms, and small firms find it difficult to access the benefits of hierarchy. Some authors dispute this empirical conclusion, arguing for a large middle range of exchanges governed with equal efficiency both internally and externally (Hennart 1993). We argue that regardless of how large or small this middle range has been historically, it is currently increasing rapidly. Our primary contention is

boundaries of the firm (Demsetz 1988). Firms exchange through the market "at junctures where output can be readily measured," (Barzel 1982); they exchange through the firm where measurement is poor. Hence, improvements in measurement increase the number of junctures with measurable outputs, consequently allowing the infusion of market governance or market-like governance into hierarehies. For instance, if firms can easily access measures of subunit outputs that reflect all relevant dimension of performance and allow external comparison, market mechanisms can govern the subunits effectively. Historically, measures sufficient to support marketlike governance have existed only for large organizathat a variety of technological and organizational innova-tional agregates. Financial performance measures and tions has eased considerably the task of selective interven- prices, including transfer prices, have facilitated martion, thus facilitating disaggregation ami the infimon of ket-like governance, but those measures have been high-powered incentives. In particular, technological and available only for rather large organizational aggreorganizational innovation ease the infusion of markets gates such as divisions. Small internal subunits typically within hierarchy by enabling firms to more easily conlack the simple revenue and cost allocation necessary figure, measure, and reward their small subunits. Furto easily devise traditional financial performance meather, technological and administrative innovations have sures (e.g., profit and return measures). They also lack accelerated the infusion of hierarchical elements, such the necessary breadth of functions (i.e., they are much as monitoring, incentive manipulation, command, and too dependent on other groups) to establish aecurate rich communication, into markets. Figure 2 summainternal "prices" for outputs. Hence, evaluating a facrizes the logic of the arguments we develop. tory on the basis of financial return criteria and transfer pricing is problematic given its inability to control Infusing Markets in Hierarchies: Advances in Measuring, product design or marketing. Smaller subunits within Configuring, and Rewarding Molecnlar Units firms face even more problematic measurement issues. Measuring Molecular Units. The efficient funetion- In the absence of accurate performance measures for small subunits, firms may substitute other measures, ing of markets is contingent on accurate measures of such as output volume, that are more easily observed output (Akerlof 1970, Barzel 1982, Kenney and Klein but less comprehensive. Critical dimensions of overall 1983). Indeed, clear output measures define the

Figure 2

A Model of Organizational Disaggregation

Selective Intervention: Markets in Hierarchy • team structure • team measures • team rewards

Technological & Org. Innovation

Disaggregation & High-powered Incentives

Selective intervention: Hierarchy in Markets • • • •

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monitoring incentive manipulation command rich communication

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performance—^quality dimensions, defect rates, timeliness in order processing, and timeliness of delivery— may go unmeasured. To reward a factory aggressively on the basis of output volume leads to neglect of these other performance dimensions. Hence, firms avoid such rewards, and employees are left with weak performance incentives. Infusing powerful incentives to lower levels of a functionally structured hierarchy requires an infusion of alternative, nonfinancial performance measures that have the reliability and validity of financial accounting measures. Recent innovations in measurement—stemming from improvements in information technology, innovations in cost accounting, aggressive benchmarking, and the expanding quality movement—yield more accurate, low cost measures of subunit outputs. Firms have developed and accessed a vast array of new nonfinancial performance measures: measures of quality, customer satisfaction, timeliness of delivery, and innovativeness (Eccles 1991, Maskell 1991). Commonalty of measures, which is critical to effective internal and external comparison, is also expanding. The Baldrige Award in the US and widespread efforts in benchmarking have aided in the diffusion process (Garvin 1991., p. 93; George 1992, pp. 80-81). Consultants, industry associations, and consortia have also been instrumental in promoting this diffusion. Through such venues, firms can compare very specific performance indicators such as defect rates, customer satisfaction levels, and speed of delivery. Such new measures may form the basis of subunit performance evaluation, internal exchange, and subunit rewards. As the methods of subunit performance measurement improve, internal exchange and evaluation more closely mimic market mechanisms. In extreme implementations, internal subunits exchange directly on the basis of measured outputs with revenue allocated to small subunits according to units delivered or service provided. Further, subunits are evaluated and compensated directly for improvements in performance measures. For instance, an internal agreement may reward a production team on the basis of volume, delivery time, and progress on cost reduction and quality programs. This combination of governance elements mimics closely the features that govern an autonomous firm. Organizations have also adapted fmaricial performance measures to evaluate small organizational subunits. Traditional attempts to measure functional subunits financially use crude rules to allocate costs and infer profitability. Simple head count may determine cost allocations from other units. A large factory may

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make little use of corporate-level human resource and information service functions, yet still have those costs allocated purely by head count (O'Guin 1990). The sizable inaccuracies and perceived inequities in cost allocation imposed by such accounting methods deter their use in evaluating and rewarding small subunits. To reward subunits aggressively for such crude financial performance measures only promotes conflict over cost allocations and creates dysfunctional incentives to pursue actions that lower performance. New cost accounting methods improve the accuracy of cost allocation and thereby improve the financial performance measurement of small subunits. In partieular, activity-based costing methods more accurately "price''the contributions of functional subunits by more accurately defining the drivers of costs (Innes and Mitchell 1991). Firms assign costs to subunits or profit centers on the basis of the best causally related cost driver instead of simplistic allocation rules such as volume or head count (Haedicke and Feil 1991). For instance, the cost of a centralized human resource management unit may be allocated to other units according to the number of new hires within the unit, and the number of employees trained, as opposed to allocation based only on head count. Data center services on the other hand might be allocated based on lines printed, storage consumed, and CPU minutes (Haedicke and Feil 1991). The increased accuracy of cost measurement and allocation affords more accurate subunit performance measurement, which aids in internally disaggregating firms. Exchanges among subunits can be managed in a more market-like way. Profit centers know precisely the level of costs that will be allocated for various services such as data processing and personnel services and can optimize their purchase. Activity centers— groups that generate costs—can also optimize cost-reduction efforts and internal marketing of services. Further, with accurate cost drivers in place, activity eenters can be evaluated and compared to external sources of the activities. If external sources perform services for less per unit, activity eenters must lower eosts or lose internal business. Highly efficient internal units may also, in theory, offer services externally. Thus, improved cost allocation allows more aggressive infusion of markets into hierarchy with an accompanying degree of disaggregation. Configuring Around Measurable Molecular Units. A variety of structural initiatives facilitates disaggregation into smaller molecular units. The preceding measurement advances infuse measurement into hierarchy

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without substantial and costly disruption to the current structure. Widespread structural redesign and recngineering efforts (The Economist 1994) also yield a significant infusion of measurement into hierarchies, but with greater accompanying disruption to the functional structure. A common building block of redesigned organizations is a cross-functional team responsible for a definable output. Surveys suggest the incidence of such autonomous cross-functional teams is expanding (Gordon 1992, Mehta 1994, Verespej 1990). A 1992 survey estimated that roughly one-third of corporations use them to govern approximately one-third of their workers (Gordon 1992). Cell manufacturing systems that reorgainze work around small, self-contained units responsible for a defined finished or intermediate product are a common means through which organizations introduce cross-functional teams. A 1994 survey estimated that more than one-third of small manufacturing plants (< 100 employees) and nearly threefourths of large plants (100 + employees) used cell manufacturing systems (Mehta 1994). In many ways, the structural shift toward cross-functional teams is closely analogous to the shift that occurred among large corporations in the 1950s, 1960s and 1970s from functional governance structures to muUidivisional structures. The multidivisional structure created divisions that function as "complete economic units," each responsible for the sale, distribution, manufacture, and design of its own products (Chandler 1962). Divisional performance could be easily measured, compared, and rewarded, thereby minimizing the need for hierarchical coordination and monitoring. Cross-functional teams infuse "complete economic units" to lower levels of the organization. Such teams have the functional capabilities to produce measurable intermediate or final products and have extensive latitude to aehieve output objectives in whatever way they choose. Often teams rotate jobs, manage their own quality control, perform discipline, evaluate team members, seleet new members, and manage their output schedule (O'Dell and McAdams 1987, Verespej 1990). With output performance measures, the teams are monitored, evaluated, and in some cases compensated much like small external contractors. The coordination, monitoring, and incentive-providing functions of hierarchy are replaced by an internal market in which small molecular units produce, exchange, and govern action rather autonomously.

employees (Harris and Raviv 1979, Holmstrom 1979). More accurate measures increase the "optimal" percentage of pay that is performance-based. Hence, both measurement advances and the structural shift to cross-functional teams facilitate the use of higherpowered internal incentives for subunits. Not surprisingly, incentive pay for employees has grown dramatically in recent years, primarily through the use of group-based incentive plans such as gainsharing and profit-sharing plans. Estimates of use in the early 1990s range from 15% to 35% (Hewitt Associates 1993, McAdams and Hawk 1992, Mitchell et al. 1990, O'Dell and McAdams 1987, Tully 1993, Weitzman and Kruse 1990). Although a significant percentage of these plans continue to measure performance at the company or division level, an increasing number measure and reward performance at the plant, facility, department, or team level (McAdams and Hawk 1994). The enhanced ability to measure subunit performance makes possible this diffusion of high-powered incentives to lower levels. The smaller the subunits to which pay can be linked, the more effective the incentives. Empirical research confirms that group-based incentive plans linked to smaller units yield more powerful and more effective incentives than group rewards attached to larger organizational aggregates (Zenger and Marshall 1995). In summary, measurement advances and organizational innovations allow aggressive infusion of market control within hierarchy. Subunits can be evaluated and partly rewarded on the basis of group performance. Subunits can exchange internally in a quasicontractural manner. Through the infusion of output measurement, performance incentives improve dramatically. Measurement, incentives, and exchange autonomy substitute for layers of management and centralized decision making. The result is a more market-like internal governance structure that retains only where necessary the monitoring and coordination properties of hierarchies. For many inter-unit exchanges, the formal legal distinction has become the only difference between market and hierarchical governance.

Infusing Hierarchy in Markets: Advances in Linking Molecular Units Governing exchanges through the market often requires more than arm's-length exchange. The efficient performance of many activities requires specialized Rewarding Molecular Units. Agency theorists argue investments in physical or human assets. Through inIhat the accuracy of performance measures determines vestments in specialized tooling, firms lower produethe intensity with which incentives can be imposed on tion costs (Williamson 1975). Similarly, through invest-

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ments in specialized knowledge and capabilities, firms may generate valuable innovation or cost-reducing routines. Hence, a key function of governance is to provide an organizational configuration in which such specialized investments can emerge. Transaction-cost logic argues that substantial levels of specialized investment are difficult to support through market governance. Investments that are highly specific to a particular use trigger incentives to behave opportunistically. By definition, human or physical asset investments that are specific to an exchange are of lesser value in alternative uses. Consequently, one party to an exchange, recognizing that the other party must forfeit the specific investments if the contract is terminated, may seek to renegotiate the contract. Hence, inducing firms to make such specialized investments requires safeguards. Negotiating, monitoring, and enforcing contractual safeguards is likely to prove costly. When such costs of market exchange are high, firms may choose to access governance-cost-reducing features of hierarchy by simply internalizing the exchange (Klein et al. 1978, Williamson 1975). Through internalization firms acquire greater ability to "command" action, monitor performance (Williamson 1975), and manipulate incentives (Holmstrom and Tirole 1991), as well as promote valuable firm-specific language and tacit knowledge formation through social interaction (Kogut and Zander 1992). However, if two firms can selectively infuse elements of hierarchy into an exchange otherwise ridden with contractual hazards, they may avoid pressures to integrate vertically. In avoiding vertical integration, firms avoid reducing performance incentives. For instance, if buyers can effectively monitor suppliers' efforts in quality improvement, cost reduction, and fundamental product innovation, vertical integration is of less value. Similarly, if the seller's payment scheme rewards employees on the basis of buyer satisfaction ratings, incentives to integrate vertically are reduced. Such hierarchical infusion does not eliminate opportunistic incentives in market exchanges, but may provide safeguards sufficient to support more relational forms of market exchange. The reasoning of cooperative game theory further illuminates the value of hierarchical infusion in markets. Simulations suggest that cooperative outcomes more frequently evolve and persist when players share accurate and timely information about actions and behaviors (Axelrod 1984, Axelrod and Dion 1988). Thus cooperation is more Hkely to evolve in repeated market exchanges (i.e., those with cospecialized assets) when monitoring and communication are precise and timely —when exchanging parties can easily, quickly, and


accurately detect cost overruns, defective quality, shipment delays, or poor design. Infusing elements of hierarchy in markets provides such monitoring and communication. Accurate monitoring and timely communication promote cooperation and "trust'"in market exchanges. As Ring and Van de Vcn (1992, p. 489) argue, trust emerges in market exchanges when exchange partners "perceive one another as complying with norms of equity." Through monitoring and measurement, exchanging parties establish adherence to equity norms (Barzel 1982, p. 27). Monitoring and Communication. Advances in information technology greatly ease monitoring and communication across market exchanges and thereby facilitate cooperative exchange. Such technology may allow precise and timely monitoring of suppliers' and buyers' activities. Through advances In telecommunications, computers, and software, firms can electronically manage reasonably eomplex exchanges involving substantial codependence (Holland et al. 1992, Johnston and Lawrence 1988). For instance, computer-aided design and manufacturing systems may trigger materials purchasing, reconfigure production systems to product specifications, and schedule deliveries. Scanner data from a customer may directly trigger production scheduling at a supplier. Such technology circumvents the vast array of individuals who would normally relay information, monitor performance, negotiate, and execute needed adjustments in quantities, quality, design, and delivery schedule/ The infusion of hierarchy's monitoring and communication functions into market exchanges should have predictable effects on disaggregation. Consistent with that reasoning is the finding by Brynjolfsson et al. (1994) of an empirical relationship between information technology investments and the degree of disaggregation in the US economy. Even sophisticated computer-aided systems, however, cannot provide the information richness (Daft and Lengel 1986) necessary to manage the complex adaptation required for many exchanges. Efficient governance and coordination for many exchange conditions (e.g., the design and development of a complex product) may require consistent lact-to-face communication and personal contact (Nohria and Eccles 1992). Such communication provided within hierarchies may be critical in forming the common language, procedural coordination, and learning that is essential to high performance (Kogut and Zander 1992). Hierarchy is more conducive to such communication than markets. However, advances in voice, data, and video communications have reduced and will further reduce the eosts

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of achieving information richness in personal communications across a market exchange. Video communication, fax capability, paging systems, electronic mail, concurrent engineering software, and other groupware software products all facilitate more complex and timely communication without the reduction of incentives that accompanies vertical integration. Individuals can communicate across geographic distance and organizational boundaries in ways that approximate those available among individuals colocated within a hierarchy. Hence, such mechanisms enable separate firms to develop the specialized language and routines that are critical to organizational performance. Administrative Innovation. Firms' innovative imposition of administrative systems and programs to monitor suppliers' activities also infuses hierarchy into markets. For instance, large buyers frequently prescribe particular quality programs or impose rating systems on their suppliers (Magnet 1994). A 1992 survey found that 59% of US manufacturing firms had established formal supplier-evaluation programs and another 30% were in the process of developing such systems (Minahan 1992). Supplemental rating programs require suppliers to use a common set of practices and procedures, provide particular forms of data, and submit to external audits. Commonalty in supplier rating procedures allows evaluation and comparison across suppliers. With such rating systems in place, buyers are less concerned about inferior input quality, poor maintenance, or high defect rates. Hence, managers perceive less need for vertical integration. Firms can instead exchange with smaller, better-motivated outside firms while still safeguarding against opportunism. Cooperative Incentives. The ability to foster cooperation through incentive manipulation is generally considered a distinctive feature of hierarchy (Holmstrom and Tirole 1991). In market exchanges, flawed incentives may encourage firms to underinvest in specialized assets, miss shipment deadlines, or reduce quality as exchange partners search for greater profitability. Internalizing the buyer-supplier exchange and adopting incentives that detach rewards from subunit performance measures removes such opportunistic motivations. However, incentives to cooperate may be accessible through the market, too. Firms craft clever compensation packages that, for instance, link the incentives of employees in a supply firm to the satisfaction ratings of a purchasing firm (Baker and Faulkner 1991). A 1993 survey of 1400 employers by William M. Mer-

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cer, Inc., found that about one-third of responding firms supplemented financial pertbrmance measures with eustomer satisfaction measures in establishing incentive payments to managers (HR Focus 1993). Customer satisfaction measures have also become a more common basis of payout in group incentive plans for nonmanagement personnel. Such plans restrict managers' incentives for opportunistic pursuit of short-term financial rewards at the expense of customers' interests. Directly linking managerial rewards to customer concerns clearly reduces the motivation for integration. Of course, measurement advances, discussed previously, play an important role in facilitating such incentive manipulation. In summary, firms have crafted efficient methods for infusing hierarchical elements^monitoring, incentives, administrative coordination, and even social attachments—into market exchanges. These advances do not eliminate incentives for opportunism in exchanges involving specialized assets. However, they do ease coordination and provide timely information that promotes cooperative exchange. With enhanced monitoring and coordination within market governance, firms can disaggregate or remain disaggregated with less risk of opportunistic behavior. Such disaggregation yields more powerful incentives. It is important to note that although the advances in coordination and communication technology unambiguously promote disaggregation into smaller, more autonomous units, the effect on actual firm size is somewhat more ambiguous (Cairnarca et al. 1993). These efficient communication, coordination, and incentive arrangements can be constructed to manage internal market exchanges as well as external exchanges. However, whether internal or external, they yield more disaggregated governance.

Conclusions Dramatic innovations in measurement, communications, and organizational technology are facilitating the selective intervention of market elements in hierarchy and hierarchical elements in market exchanges. Discrete differences in functionality across governance choices are diminishing. Governance decisions are not simple dichotomous choices between markets, with managers squeezing price reductions from outside vendors, and hierarchies, with heavy bureaucracy and weak incentives. Instead, market exchanges may involve close coordination at multiple levels across multiple departments, or hard-wired computer links, and elaborate

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vendor-evaluation programs. Similarly, hierarchy may entail activities housed in subunits that are managed much like external subcontractors. Thus, through the formation of hybrid governance structures, business systems in the US economy have disaggregated dramatically. The new governance forms are characterized by small molecular units. Increasingly, we observe business systems in which a network of small exchanging teams, factories, divisions, subunits, and firms govern design, production, marketing, and delivery. Whether the boundaries between those entities are internal or external is of decreasing relevance. Cross-boundary exchanges are increasingly similar whether internal or external to the firm. However, such disaggregation generates performance gains through the infusion of powerful incentives. The growing ease of selective intervention triggers a need to rethink the traditional comparative institutional framework. We do not dismiss entirely the importance of the choice between markets and hierarchies. Markets continue to be more market-like than hierarchies, and hierarchies more hierarchical than markets. Markets will continue to afford more effective price incentives than hierarchies. Similarly, hierarchies have access to a greater range of hierarchical features than markets. Nonetheless, for an expanding set of exchanges, the discrete choice between markets and hierarchy is less important than the choice of how to configure the mix of market and hierarchical elements. Coase (I960) first argued that in a world of no transaction costs, the form of organization is indeterminate: all governance forms would be of equal (i.e., perfect) efficiency. An evolving corollary of that argument is that in a world in which different governance modes can mimic the functionality and efficiency features of one another, the form of governance (i.e., market vs. hierarchy) is indeterminate. The conclusion that boundaries are blurring does not necessarily diminish the power of the transactioncost logic. Governance features are still matched to exchange attributes discriminatingly, though the governance choice is no longer discrete for an increasing number of situations. Factors such as asset specificity, particularly human asset specificity, measurement ease, uncertainty, and exchange frequency continue to have a pervasive influence on organizational design. However, the domain of governance options available to managers has expanded greatly. Asset specificity and measurement difficulty are likely to define the boundaries of the molecular units, either teams or firms. The mix of market and hierarchical elements that govern

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exchanges among the molecular units will reflect the exchange conditions among small teams and firms. However, market-like exchange may entail highly autonomous internal subunits, and hierarchical exchange may entail a sophisticated telecommunications link or concurrent engineering software. The expanding overlap of markets and hierarchies as institutions of governance has important implications for how managers think about organization. The dichotomous choice between markets and hierarchies is fundamentally a legal distinction with diminishing consequences. Organizations have greater flexibility today in directly manipulating individual governance features —incentive schemes, monitoring systems, communication links, and dispute-resolution mechanisms—both within and across hierarchies. Hence, for many organizations the metaphor of an organization as a nexus of custom-tailored contracts may be a more useful way to consider issues of optimal governance (Jensen and Meckling 1976) than the traditional focus on optimal boundaries. As with any powerful trend, there is danger of indiscriminate adoption. For example, managers may seek more cooperative supplier relationships for reasons of fashion rather than function. Organizational forms are particularly amenable to imitation that is based on reasons other than efficiency {DiMaggio and Powell 1983). Indiscriminate adoption is likely to increase as disaggregated organizational forms become more widely accepted (Davis et al. 1994). Articles in the business press about respected companies adopting new practices may encourage others to follow, but ones that follow indiscriminately risk losses in efficiency. For instance, aggressive attempts to outsource previously internal exchanges are likely to fail unless external exchanges are supported by hierarchical mechanisms within the market. Miles and Snow's (1992) observation that network arrangements without "visible, external linkages" are more apt to fail supports this reasoning. Also, attempts to decentralize large firms into smaller autonomous units are likely to fail unless measurement systems are in place to provide proper incentives for those units. Clearly we need more careful empirical work on both functional and institutional explanations for these phenomena. We will almost surely see some indiscriminate adoption and ensuing reactionary rhetoric about the dangers of these trends. The changes in measurement, communications, and organizational technology that give rise to the trends, however, are fundamental and enduring. Just as the Industrial Revolution profoundly shifted the organization of work from the small farm to the large firm, the current trends may

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represent a momentous shift from the large firm to the small molecular unit. Acknowledgment A previous version of ihis article was presented at ihe Strategic Management Society Meetings, London, November 1992. The authors thank Jay Barney, Nick Argyres, Julia Licheskind, Karin Lindquist, Anoop Madhok, Laura Poppo, Steve Tallman, and three anonymous reviewers for helpful comments.

Endnotes There is no consensus on Ihe meaning of the term "network organization" (Nohria and Eccles 1992, p. 288), but our use of the term is consistent with that of authors who use it to refer to dense patterns of "working relationships that cut across various intra- and interorganizational boundaries" (p. 289). Others take the term to mean electronic networks based on information technologies such as electronic mail, videoconferencing, and electronic bulletin boards (Nohria and Eccles 1992, p. 289). Though nol network organizations as we define them, those technologies facilitate the emergence and diffusion of network organizations. 'A 1993 survey about layoffs in US companies found that although 5% of the overall workforce was middle managers, 22% of layoffs were of middle managers (American Management Association study cited by Dumaine 1993). Several explanations for the difficulty of selective intervention have been advanced. Some authors argue that organizational forms consist of a distinctive cluster of complementary attributes (Milgrom and Roberts 199(); Powell 1990; Williamson 1991b, p. 171). Selective infusion or extraction of governance elements is disruptive to this complementarity. Using related reasoning, Milgrom and Roberts (1988, 1990) argue that within hierarchies managers have incentives to politically obtain resource allocations that benefit them personally. Such costly "infiuence activities" are avoided when exchanges occur among legally separate firms rather than among internal subunits. Finally, Masten (1988) and Williamson (1991a) argue that different legal regimes support markets and hierarchies and reinforce the dichotomous choice. TTie courts" forbearance in a firm's internal affairs undermines the effectiveness of internal market contracts, whereas "excuse doctrine" limits the effectiveness of authority in market contracts. ""if these information technology investments are themselves highly specific to a particular exchange, they may cause new contracting hazards (see Cainarca et al. 1993). However, as common standards for sueh electronic coordination emerge, the specificity of these investments will decline and in turn reduce contracting hazards.

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Accepted by Jay Bamey. former Departmental Editor; received May 26, 1994. This paper has been wiih the author far one revision.

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