Sources of uncertainty: Why companies network to coordinate complex products and services?

whartonMany industries use network governance — a type of coordination characterized by informal social systems rather than by bureaucratic structures within — to coordinate complex products or services in uncertain and competitive environments. For example, the industries of semiconductors, biotechnology, films, music, financial services, fashion and digital games (link here) present ecosystems (or networks) that go beyond the ordinary command-and-control vertical structure. These industries show that sound business structures do not depend of formal contractual relationships.

When does a network surge? Candance Jones, William Hesterly e Stephen Borgatti provided the answer after integrating Transaction Costs Economics (TCE) and social network theories. In the TCE perspective three exchange conditions — uncertainty, asset specificity, and frequency — determine the network governance form:

  1. Environmental uncertainty triggers adaptation because environments are rarely stable and predictable. Source of uncertainty are suppliers, customers, competitors, regulatory agencies, unions, or financial markets.
  2. Asset-specific (or customized) exchanges involve unique equipment, processes, or knowledge developed by participants to complete exchanges. This intensifies coordination between parties. Customization combined with uncertainty requires safeguarding exchanges to reduce behavioral uncertainty, which can range from honest disagreements to opportunism.
  3. Frequency is important for three reasons. First, frequency facilitates transferring tacit knowledge in customized exchanges, especially for specialized processes or knowledge. Repeated exchanges allow tacit knowledge, which cannot be assimilated in short-term interactions, to be assimilated over time. Second, frequent interactions establish the conditions for relational and structural embeddedness, which provide the foundation for social mechanisms to adapt, coordinate, and safeguard exchanges effectively. Third, frequent interactions provide cost efficiency in using specialized governance structures.

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It is interesting to note that under conditions of demand uncertainty, firms tend to disaggregate into independent business units either through outsourcing or subcontracting. This decoupling increases flexibility — the ability to respond to a wide range of contingencies — because resource outsourced or rented, rather than owned, can be reallocated cheaply and quickly to meet changing environmental demands.

Where does uncertainty come from?

Some industries (films, digital games, music, for example) are good examples of businesses with high levels of demand uncertainty but a relatively stable supply of labor. Demand uncertainty is generated by unknown and rapid shifts in consumer preferences, which is exemplified in the digital game industry, where it is unclear what makes an electronic game a hit. Demand uncertainty also is generated by rapid changes in knowledge or technology, which result in short product life cycles and make the rapid dissemination of information critical. In high-technology industries, such as biotechnology and semiconductors, new products and technologies leap frog prior products and technologies, leaving participants scrambling to catch up. Finally, demand uncertainty is generated by seasonality, which makes vertical integration inefficient because swings in markets make predicting both catches and revenues difficult.

uncertainty

Conclusion

Demand uncertainty pushes firms toward disaggregation, whereas customized, human asset-specific exchanges intensify the need for coordination (a.k.a. governance) and integration among parties. Networks governance balance these competing demands by enhancing the rapid dissemination of tacit knowledge across firm boundaries. Additionally, customization of products or services is common among firms in a network. This form of customization involves human asset specificity (e.g., culture, skills, routines, and teamwork acquired through “learning-by-doing”) because it is derived from participants’ knowledge and skills, as is easily seen in the industry of digital games.

References

JONES C,. HESTERLY W.S, BOIGATT, S.P. A General Theory of Network Governance: Exchange conditions and Social Mechanisms. Academy of Management Review. 1997, Vol. 22JJo. 4. 911-945.

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