08the impact of information systems on organizations and markets-gurbaxani-1991(15)
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8/10/2019 08The Impact of Information Systems on Organizations and Markets-gurbaxani-1991(15)
http://slidepdf.com/reader/full/08the-impact-of-information-systems-on-organizations-and-markets-gurbaxani-199115 1/15
T h e I m p a c t o f
I n f o r m a t u o n
S y s t e m s o n
O r g a n i z a t i o n s
a n d M a r k e t s
Z
Z
LU
0
Z
0
f-
3
.J
Vijay Gurbaxani and Seungjin Whang
T h e adopt ion of infor -
mation technology (IT) in organizations has
been growing at a rapid pace. The use of the
technology has evolved from the auto ma tion of
structured processes to systems that are truly
revolutionary in tha t they introduce change
in to fundamenta l bus iness procedures .
Indeed, it is believed that More t han
being helped by computers , companies
will l ive by them, shaping strategy and
i s t ruc ture to f i t new info rm at ion
technology [25] While the impor-
tance of the relat ionship between
infor ma tion technology an d organiza-
t ional change is evidenced by the con-
siderable l i terature on the subject ,
there is a lack of comprehe nsive analysis
of these i ssues f rom the economic
perspective. T he aim of this article is
I to develop an economic und erstand-
ing of how informat ion sys tems
affect some key measures o f organiza-
tion structure.
Th is article analyzes the roles of infor-
m atio n systems, how they evolve an d how
they affect organizations and m arkets. In p articular,
8/10/2019 08The Impact of Information Systems on Organizations and Markets-gurbaxani-1991(15)
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w e a n al y z e t h e i m p a c t o f I T o n t w o
i m p o r t a n t a t t r ib u t es o f f i r m s i f i r m
s iz e a n d th e a l lo c a t io n o f d e c i s io n -
m a k i n g a u t h o r i t y a m o n g t h e v a r i -
o u s a c to r s in a f i rm . T o th i s e n d , w e
s ta r t w i th e c o n o mic th e o r i e s o f o r -
g a n iz a t io n a s th e fo u n d a t io n fo r
o u r a n a ly s i s . T w o s u c h th e o r i e s a re
re l e v a n t to o u r a n a ly s i s :
agency the-
ory , ink ia l ly adv anc ed a nd deve l~
oped by Wilson [68] , Ross [54] , AI-
c h ia n a n d D e ms e tz [2 ] , a n d J e n s e n
a n d Me c k l in g [3 4 ] , a n d transaction
cost economics w h o s e d e v e l o p m e n t i s
d u e ma in ly to C o a s e [1 8 ] , K le in ,
C r a w f o r d a n d A l c h i a n [ 3 8 ] , a n d
W i l l i a m s o n [ 6 5 - 6 7 ] .
A g e n c y th e o ry [3 4 ] r e j e c t s th e
c lass ica l v iew of the f i r m as a un i-
f i e d p r o f i t - m a x i m i z i n g i d e n t i t y a n d
p r o p o s e s a n a l t e r n a t i ve m o d e l o f a
f i rm a s a n a g e n c y re l a t io n s h ip b u i l t
o n a s e t o f c o n t ra c t s a mo n g
self-
interested a g e n t s ( e mp lo y e e s ) . A s a
c o n s e q u e n c e , w h e n d e c i s io n -
m a k i n g a u t h o r i t y i s d e l e g a t e d t o
a g e n t s, i t c a n n o t b e g u a r a n t e e d t h a t
th e d e c i s io n s w i l l b e a l ig n e d w i th
th e in t e re s t o f th e p r in c ip a l ( s h a re -
h o l d e rs ) . T h e d i v e r g e n c e o f i n t e r -
e s t s b e tw e e n th e p r in c ip a l a n d
a g e n t s c a n b r e e d n u m e r o u s p r o b -
l e ms a n d i s c o s t ly to a f i rm (a g e n c y
c o s t s ) . A g e n c y th e o ry (o f th e f i rm)
t r i e s to e x p la in h o w a f i rm c a n b e ,
a n d w h y i t i s, ma i n ta in e d a s a v i a b le
fb rm , of e c o n o m ic o rg a n iz a t io n
e v e n in th e p re s e n c e o f th e s e p ro b -
lems .
T ra n s a c t io n c o s t e c o n o mic s [1 8 ]
a p p ro a c h e s th i s i s s u e f ro m e x a c t ly
th e o p p o s i t e d i r e c t io n . I t s t a r t s b y
lo o k in g a t p ro b le ms in u s in g a mar-
ket a n d v ie w s a f i rm a s a s o lu t io n to
t h e s e p r o b l e m s . T h e t h e o r y r e c o g -
n i ze s t h at t h e o p e r a t i o n o f a m a r k e t
is no t cos t le s s , a s is a s su me d in c las -
s i ca l e c o n o m ic th e o ry , a n d th a t i t i s
imp o r ta n t t o a s s e s s transaction costs
i n th e a n a ly s i s o f e c o n o mic a c t iv i -
t i e s . A c c o rd in g to th i s t h e o ry , t h e
f i rm i s a s u b s t i tu t e fo r th e ma rk e t
m e c h a n i s m , c r e a t e d t o r e d u c e
t ra n s a c t io n s c o s ts .
T h i s a r t i c l e is b a s e d o n th e p re m -
]See [5, 29, 39. 45] for excellent reviews of
research on these issues.
i s e th a t f i rm s i z e a n d th e a l lo c a t io n
o f d e c i s i o n - m a k i n g a u t h o r i t y
a mo n g th e v a r io u s a c to r s in a f i rm
a re , t o a c o n s id e ra b le d e g re e , d e -
t e rmin e d b y th e c o s t s a s s o c ia t e d
w i th a c q u i r in g , s to r in g , p ro c e s s in g
a n d d i s s e m i n a t i n g i n f o r m a t i o n .
A g e n c y t h e o r y a n d t r a n s a c t io n c o s t
e c o n o mic s f a c i l i t a t e th e d e v e lo p -
m e n t o f t h e r e l a t i o n s h i p s b e t w e e n
th e s e in fo rma t io n c o s t s a n d th e a t -
t r ib u te s o f o rg a n iz a t io n s . We p re -
s e n t a mo d e l o f a f i rm w h ic h in c o r -
p o r a t e s t h e c o n s i d e r a t i o n s o f
a g e n c y c o s t s a n d t r a n s a c t io n c o s t s ,
a s w e l l a s o p e ra t io n s c o s t s . T h i s
f r a m e w o r k e n a b l e s u s t o s t u d y t h e
i m p a c t o f i n f o r m a t i o n s y s t e m s o n
o r g a n i z a t i o n s a n d m a r k e t s . O u r
r e s e a r c h , t h e r e f o r e , c o m p l e m e n t s
t h a t o f e c o n o m i c a n d i n d u s t r i a l
o rg a n iz a t io n th e o r i s t s b y a d d re s s -
i n g t h e r o l e o f c o m p u t e r - b a s e d i n -
fo rma t io n s y s t e ms , w h ic h e c o n o -
mis t s t r a d i t io n a l ly t r e a t a s a b l a c k
b o x .
T h e q u e s t i o n o f w h e t h e r I T i n -
d u c e s th e c e n t ra l i z a t io n o r d e c e n -
t r a l i z a t io n o f d e c i s io n ma k in g in
o rg a n iz a t io n s i s o f c o n s id e ra b le in -
t e re s t [5 ]. In b r i e f , w e a rg u e th a t a s
d e c i s i o n - m a k i n g r ig h t s a r e p u s h e d
d o w n w a r d i n t h e o r g a n i z a t i o n a l
p y r a m i d , t h e c o s ts o f c o m m u n i c a t -
i n g i n f o r m a t i o n u p w a r d d e c r e a s e
w h i l e a g e n c y c o s t s r e s u l t in g f ro m
g o a l d iv e rg e n c e in c re a s e . T h e re -
fo re , d e c i s io n r ig h t s in a n o rg a n iz a -
t io n a l h i e ra rc h y s h o u ld b e lo c a te d
w h e re th e s u m o f th e s e c o s ts i s m in -
i m i z e d . M o d e r n I T c a n r e d u c e t h e
c o s t s o f c o m m u n i c a t i n g i n f o r m a -
t i o n b y i m p r o v i n g t h e q u a l i t y a n d
s p e e d o f i n f o r m a t i o n p r o c e s s i n g
a n d m a n a g e m e n t ' s d e c i s i o n m a k -
in g , l e a d in g to mo re c e n t ra l i z e d
m a n a g e m e n t . A t t h e s a m e t i m e , I T
c a n a l s o p r o v i d e m a n a g e m e n t w i t h
th e a b i l i t y to r e d u c e a g e n c y c o s t s
t h r o u g h i m p r o v e d m o n i t o r i n g c a -
p a b i li t i es a n d p e r f o r m a n c e e v a l ua -
t io n s c h e me s , i n d u c in g d e c e n t ra l i -
z a t io n o f d e c i s io n ma k in g .
We a l s o a rg u e th a t IT c a n h a v e a
d i r e c t i m p a c t o n o p t i m a l f i r m s i z e
b y c h a n g i n g i t s u n d e r l y i n g c o s t
s t r u c t u r e. A c c o r d i n g t o o u r m o d e l ,
th e s i z e o f a f i rm i s d e te rmin e d b y
t r a d i n g o f f e x t e r n a l c o o r d i n a t i o n
c o s t s , i n t e rn a l c o o rd in a t io n c o s t s
a n d o p e ra t io n a l c o s t s . O n th e o n e
h a n d , c o s t - e f fe c t iv e IT c a n re d u c e
e x t e r n a l c o o r d i n a t i o n c o st s a n d c a n
le a d a f i rm to in c re a s e i t s u s e o f
ma rk e t s . H o w e v e r , IT c a n a l s o r e -
d u c e i n t e r n a l c o o r d i n a t i o n c o s t s
a n d p r o v i d e m a n a g e m e n t w i t h t h e
a b i l i t y to ma n a g e a l a rg e o rg a n iz a -
t io n e f fe c t iv e ly , t h u s in d u c in g a n
in c re a s e in f i rm s i z e .
T h e o u t l in e o f th i s a r t i c l e i s a s
fo l lo w s . In th e n e x t s e c t io n , a b r i e f
d i s c u s s io n o f a g e n c y th e o ry a n d i t s
i m p l i c a t io n s f o r i n t e r n a l c o o r d i n a -
t io n i s p re s e n te d , fo l lo w e d b y a n
a n a ly s i s o f ma r k e t , o r e x te rn a l , c o -
o r d i n a t i o n u s i n g t r a n s a c t i o n - c o s t
e c o n o mic s . N e x t , w e s y n th e s i z e
th e s e th e o r i e s to d e v e lo p a mo d e l o f
a f i rm w h ic h h a s th re e c o s t c o mp o -
n e n t s - o p e r a t i o n s c os ts , i n t e rn a l
c o o rd in a t io n c o s ts (o f w h ic h a g e n c y
c o s t s a re a p a r t ) , a n d e x te rn a l c o o r -
d i n a t i o n c o st s. T h e i m p a c t o f i n f o r -
m a t i o n s y s t e m s o n a n o r g a n i z a t i o n
i s p u r s u e d n e x t in th re e p a r t s . A n
a n a ly s is o f v a r io u s ro l e s o f in fo rm a -
t io n s y s t e ms i s p re s e n te d , fo l lo w e d
b y a d i s cu s s i on o f h ow m o d e r n I T
a f fe c t s th e c o s t s t ru c tu re o f f i rms ,
a n d d e r i v e t h e r e s u l t i n g i m p l i c a -
t io n s fo r th e a l lo c a t io n o f d e c i s io n
r ig h t s a n d f i rm s i z e . We c o n c lu d e
w i t h a s u m m a r y o f o u r c o n t r i b u t i o n
a n d a p r e s e n t a t i o n o f t h e i m p l i c a -
t io n s o f o u r r e s u l t s .
A g e n c y T h e O r y
F o l lo w in g th e p io n e e r in g w o rk s [2,
5 4 , 6 8 ] , e c o n o mis t s r e a l i z e d th a t
th e i r u s u a l a s s u mp t io n th a t a f i rm
b e h a v e s a s a team t o m a x i m i z e p r o f -
i t s w a s r e s t r i c t iv e in a n a ly z in g m a n -
a g e r i a l b e h a v i o r . T h i s a p p r o a c h d i d
n o t a l lo w a n a n a ly s i s o f s i tu a t io n s
w h e r e m a n a g e m e n t b e h a v i o r w a s
in c o n s i s t e n t w i th s u c h ma x imiz a -
t io n . A lc h ia n a n d D e ms e tz [2 ] a n d
J e n s e n a n d M e c k l i n g [3 4] p r o p o s e d
a v iew of a f i r m as
a nexus of contracts
among self-interested individuals. T h a t
i s, a f i rm re p re s e n t s a s e t o f a g e n c y
c o n t r a c t s u n d e r w h i c h a principal
( e n t r e p r e n e u r ) e m p l o y s agents ( e m-
p lo y e e s ) to p e r fo rm s o me s e rv ic e
o n h i s b e h a l f . A s t ro n g a s s u mp t io n
60
Jan uar y 1991/Vo1,34, No.l/COMMUNICATIONS
OF THE ACM
8/10/2019 08The Impact of Information Systems on Organizations and Markets-gurbaxani-1991(15)
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of th is v iew is tha t an agen t has as
h i s o r h e r o b je c t iv e th e ma x im iz a -
t io n o f th e a g e n t ' s i n d iv id u a l u t il i t y ;
h e o r s h e p r e f e r s m o r e r e w a r d s a n d
le s s e f fo r t , b u t p a y s n o re g a rd to
t h e w e l f a r e o f t h e p r i n c i p a l o r n o n -
p e c u n ia ry v i r tu e s , s u c h a s h o n o r ,
t e a m s p i r i t , i n t e g r i ty a n d p r id e o f
a c h i e v e m e n t . A b o d y o f r e s e a r c h o n
o rg a n iz a t io n s , c a l l e d agency theory 2
f o l l ow e d f r o m t h is f r a m e w o r k .
Ag On cy COS ~S
A g e n c y c o s t s a re d e f in e d a s th e
c o s ts in c u r re d a s a r e s u l t o f d i s c re p -
a n c ie s b e tw e e n th e o b je c t iv e s o f th e
p r in c ip a l a n d th o s e o f a g e n t s . C o n -
s id e r th e o w n e r o f a r e t a i l s o f tw a re
s to re who h ires labor , say , a (se l f-
in t e re s t e d ) s a l e s p e r s o n to d e v e lo p
th e o n - s i t e b u s in e s s c u s to me r ma r -
k e t . S a le s in c re a s e a s th e s a l e s p e r -
s o n e x e r t s g re a te r e f fo r t , b u t e a c h
a d d i t io n a l u n i t o f e f fo r t i n c re a s e s
s a le s b y a d e c re a s in g a mo u n t . T h e
q u e s t io n i s , w h a t i s t h e o p t ima l
c o m p e n s a t i o n c o n t r a c t ? S u p p o s e
th e s a l e s p e r s o n re c e iv e s a f ix e d s a l -
a r y . T h e n a r r o w b e h a v i o r a l a s-
s u m p t i o n s o f o u r a g e n c y m o d e l
p re d ic t t h a t , i n th e a b s e n c e o f a n y
c o s t -e f fec t iv e mo n i to r i n g d e v ic e , h e
w i l l s h i rk f ro m w o rk in g , r e s u l t in g
in n o a d d i t io n a l s a l e s . A n a l t e rn a -
t iv e is g iv in g th e s a l e s p e r s o n a c e r -
t a in p e rc e n ta g e ( s a y 1 0 p e rc e n t ) o f
re v e n u e . T h e n th e s a l e s p e r s o n w i ll
o p t imiz e h i s u t i l it y b y c h o o s in g th e
le v e l o f e f fo r t a t w h ic h h i s ma rg in a l
c o s t o f e x e r t in g e f fo r t e q u a l s h / s
ma rg in a l r e v e n u e , w h ic h i s o n e -
t e n th th e o v e ra l l ma rg in a l r e v e n u e .
T h e re s u l t in g s a l e s v o lu m e i s l i k e ly
t o b e m u c h l o w e r t h a n t h e a m o u n t
e x p e c t e d w h e n t h e s t o r e o w n e r , o r
s o m e o n e n o t e x p o s e d t o a g e n c y
p ro b le m s , a c t s a s a s a l e s p e r s o n .
T h e re a re s e v e ra l p o s s ib le s o lu -
t io n s to th i s a g e n c y p ro b le m. T h e
o w n e r c a n d e s ig n a c o n t ra c t i n
w h i c h p a y m e n t i s m a d e o n l y w h e n
o u tp u t e x c e e d s a p re s p e c i f i e d l e v e l
w h i c h h a s b e e n d e t e r m i n e d s o t h a t
t h e r i g h t a m o u n t o f l a b o r w i ll b e
2The t e rm agency theory has a l so been used
to analyze in t ero rgan iza t ional s e t t i ngs [54] .
Our usage o f t he t e rm i s more in l i ne wi th [34]
and focuses on in t rao rgan iza t ion al i ssues .
a p p l i e d to a ch ie v e th e t a rg e t . T h e n ,
th e s a l e s p e r s o n w i ll b e mo t iv a te d to
a p p l y t h e r i g h t a m o u n t o f l a b o r ,
t h e r e b y r e c e i v i n g t h e c o r r e s p o n d -
in g w a g e l e v el . H o w e v e r , t h i s i s t o o
n a iv e a s c h e me s in c e th e o b s e rv e d
s a le s d e p e n d o n ma n y fa c to r s ( e . g . ,
g e n e ra l b u s in e s s c o n d i t io n s , h a rd -
w a re s a l es a n d c o mp e t i to r s ' ma rk e t -
in g a c t iv it i e s) w h ich a r e b e y o n d th e
c o n t r o l o r e x p e c t a t i o n o f e i t h e r
p a r ty . A l t e rn a t iv e ly , t h e s a l e s p e r -
s o n c a n p a y a f ix e d a mo u n t to th e
o w n e r a n d k e e p t h e r e m a i n d e r ( i f
the re is any) . In th is case , a l l the r isk
d u e to th e u n c e r t a in ty o f th e s a l e s
o u tc o m e i s u n d e r t a k e n b y th e sa l e s-
p e r s o n , w h o i s l i k e ly to b e m o re
r i s k -a v e r s e th a n th e o w n e r . Wh i l e
th e s c h e me i s i n th e r ig h t d i r e c t io n
to s o lv e th e a g e n c y p ro b le ms , i t i s
u n l ik e ly to b e a c c e p ta b le to a r i s k -
a v e r s e s a l e s p e r s o n . ~ F in a l ly , t h e
o w n e r c a n h i r e a n o t h e r p e r s o n t o
mo n i to r th e s a l e s p e r s o n a l l t h e
t ime . (A n d h e ma y h a v e to h i r e
a n o t h e r a g e n t t o m o n i t o r t h e m o n i -
to r , and so fo r th . ) In th is case , the
o w n e r s h o u l d b a l a n c e t h e monitor-
ing cost w i th th e in c re a s e in p ro f i t s
d u e to th e mo n i to r in g .
Mo re o v e r , t h e s a l e s p e r s o n i s
e x p e c t e d t o r e p o r t o f t e n t o t h e
s to re a n d d o c u m e n t a l l h i s s a l es a c-
t iv it i e s, c o n s u min g t ime a n d e f fo r t
th a t c o u ld b e s p e n t o n ma k in g s a l e s
c a ll s . S u c h w a s te w o u ld b e s p a re d i f
th e re w e re n o s h i rk in g s a l e s p e o p le .
T h i s i s a n o t h e r ty p e o f a g e n c y c o s t,
b u t i t is i n c u r r e d b y th e a g e n t 4 a n d
i s th e re fo re c a l l e d th e bonding cost.
D e s p i t e m o n i t o r i n g a n d b o n d i n g
ac t iv i t ie s , the p r in c ipa l may s t i l l
e x p e r i e n c e a p a r t i a l l os s o f h e r w e l -
fa re , w h ic h i s t e rme d th e residual
loss. T o s u m ma r iz e , a g e n c y c o st s a re
th e s u m o f a ) mo n i to r in g c o s t s , b )
b o n d in g c o s t s a n d c ) th e r e s id u a l
loss [32].
ZThe distribution of risk and the associated
rewards are an important element in contract
design. However, the subject is beyond the
scope of this article. Interested readers are
referred to [40].
4We assume here tha t bond ing expend i tu res
incurre d by agen t s a re u l t imate ly t rans fer re d
to the p r inc ipa l , so tha t a l l agency cos t s a re
u l t imate ly borne by the p r inc ipa l .
A g e n c y C O s t E
n n ~ F I / / n B
T h e a g e n c y t he o r i st s ' n e x u s o f
c o n t ra c t s p e r s p e c t iv e o f a f i rm
le a d s to th e r e a l i z a t io n th a t a f i rm i s
a P a n d o ra ' s b o x fu l l o f a g e n c y
p ro b le m s . A s a r e s u l t o f t h e s e p a ra -
t i o n o f o w n e r s h i p a n d m a n a g e -
m e n t , m a n a g e r s o f a f i r m a r e
a g e n t s w h o ma y a c t i n th e i r o w n in -
t e re s t s a t t h e e x p e n s e o f th e s h a re -
h o l d e r s . 5 F o r e x a m p l e , a n i n f o r m a -
t io n s y s t e ms ( IS ) ma n a g e r ma y b e
s u b je c t t o th e s o -c a l le d e mp i r e -
b u i l d e r s y n d r o m e . T o h i m , a l a r g e
I S c e n t e r - - a l a r g e b u d g e t , a l a r g e
s t a f f , s t a t e -o f - th e -a r t c o mp u te r
e q u i p m e n t a n d a b i g o f f i c e - -
c a r r i e s w i th i t p o w e r , p e rk s , h ig h
s a la ry a n d a s ig n o f c a r e e r s u cc e ss .
U s in g h i s e x p e r t i s e in IS o p e ra t io n s
to ju s t i fy h i s a c t io n s, h e ma y o v e r -
c o n s u m e c o m p a n y r e s o u r c e s a t t h e
e x p e n s e o f th e s h a re h o ld e r s [4 6 ] .
A g e n c y p r o b l e m s a r e n o t l i m i t e d
t o s h a r e h o l d e r - m a n a g e r r e l a t i o n -
s h ip s ; ma n a g e r -e mp lo y e e c o n f l i c t s
a r e a n o t h e r s o u r c e o f ag e n c y p r o b -
l e m s. E m p l o y e e s m a y d o a n y o f t h e
f o l l o w i n g : s h i r k , a p p r o p r i a t e c o r -
p o ra te g o o d s , r e c e iv e b r ib e s fo r i ll e -
g a l f a v o rs , a n d a b u s e d e c i s io n
r ig h t s to th e i r o w n b e n e f i t . T h e
c o n f l i c t in g in t e re s t s o f d i f f e re n t
d e p a r t m e n t a l m a n a g e r s w i t h i n a
f i rm a re a l s o a s o u rc e o f a g e n c y
c o s t s . F o r e x a mp le , t h e c o n f l i c t b e -
t w e e n m a n u f a c t u r i n g a n d m a r k e t -
i n g h a s l o n g c o n s t i t u t e d p a r t o f
m a n a g e m e n t f o l k l o r e . M a n u f a c t u r -
i n g i s r e w a r d e d f o r o p e r a t i o n a l e f -
f i c i e n c y , w h i l e ma rk e t in g i s r e -
w a rd e d fo r in c re a s in g s a l e s . N o t
s u rp r i s in g ly , d i s a g re e me n t s a r i s e ,
s in c e th e s e tw o me a s u re s a re n o t
a lw a y s ma x imiz e d b y a c o n s i s t e n t
s e t o f a c t io n s b y th e tw o d e p a r t -
me n t s . A s a r e s u l t , a c o mp a n y ma y
s o me t ime s b e n e f i t b y l im i t in g c o rn -
5See Jackall [31] for a detailed treatment o f
the occupationa l ethics of cor porate manag -
ers.
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m u n ica t i o n b e tween t h e two d e-
par tments [1] .
How does a f i rm ex is t in the face
of al l these proble ms? Fi rst , d i rect
moni tor ing i s possib le . In manufac-
tu r in g en v i ro n m en t s , an im p o r t an t
ro l e o f a g ro u p l ead er i s m o n i to r in g
g r o u p m e m b e r s a n d p r e v e n t i n g
them f i 'om sh i rk ing . Mutual moni-
tor ing i~s also com mo n. Seco nd, e ffi-
cien t o r semieff icien t cont racts are
avai lab le to contro l agents ' act iv i -
t ies . Employee compensat ion i s
o f t en l i n k ed t o p e r fo rm an ce ( e .g . ,
fo r salespeople and tax idr ivers
whose act iv i t ies are cost ly to moni-
t o r) . IS cen t e r s an d c o m p u te r n e t -
wo rk s a r e o f t en co n t ro l l ed b y o rg a-
n i za t i o n a l a r r an g em en t s , su ch as
prof i t cen ters , cost al locat ion , and
other chargeback pol icies [3 , 44 ,
72] . Third , ou ts ide labor markets ,
p rox y f igh ts, an d takeov er act ivi t ies
d iscip l ine managers [23 , 33] .
Four th , inst i tu t ions such as banks,
acco u n t in g f i rm s , an d i n su ran ce
co m p an ies h e lp r ed u ce ag en cy cos t s
t h ro u g h th e i r m o n i to r in g fu n c-
t ions. F i f th , cu l tures and norms
n u r tu red wi th in an o rg an i za t i o n
can p lay a cr i tical ro le in mi t igat ing
ag en cy p ro b l em s . As Ou ch i [4 9 ]
poin ts ou t , a d is t inct character is t ic
o f Jap an e se f i rm s ( sh ared b y t y p e-Z
companies in the U.S.) i s thei r em-
p h as i s o n n o n co n t r ac tu a l a r r an g e-
m en t s t h a t r e ly o n t ru s t an d h u m an
relat ionsh ips . Last , bu t perhaps
m o s t im p o r t an t , h u m an n a tu re i s
no t as ev i l as agency theor ies pain t
i t . People ( including agents) value
h o n o r , i n t eg r i t y , h u m an r e l a t i o n -
sh ips, and the feel ing o f ach ieve-
m en t .
chy , resu l t ing in a var iety of associ -
a t ed i n fo rm at io n -p ro cess in g co s t s :
co s t s o f co m m u n ica t i o n , co s t s o f
m i sco m m u n ica t i o n , an d o p p o r tu -
n i ty costs due to delays in commu-
nicat ion . Decis ion making wi thout
relevant in for mat i on 6 can lead to
subopt imal decis ions, which en tai l
y e t an o th er k in d o f co s t. Th e su m
of these costs , which we cal l
decision
information costs
increases as a deci-
s ion r igh t 7 i s moved h igh er in the
6Systematic adherence to this pol icy leads to a
bureaucracy
which i s an o rgan iza t ion run by
ru les [61 ] . A ru l e means the refusa l t o g ive
d i scre t ion to agen t s who may have spec i f i c
in fo rma t ion re l evan t t o the dec i s ion . Th i s de-
l ibera t e inef f i c i ency is exp la ined by the p r inc i -
pa l ' s e f fo r t s t o redu ce agency cos t s.
7We use the t e rm deci s ion r igh t synony-
mous ly wi th the t e rms dec i s ion respons ib i l -
i t y o r dec i s ion -mak ing au thor i ty , u sed by
o ther au thors .
h ie ra rch y , away f ro m wh ere i n fo r -
mation is most easily available. This
may lead one to hast i ly conclude
that decis ion r igh ts should be lo -
ca t ed a t t h e b o t t o m o f t h e h i e ra r -
chy . This i s p roblemat ic , however ,
s ince the ob ject ives of the pr incipal
and the agents may be inconsis ten t .
Jensen [32] no tes that , as decis ion
r ig h t s a r e p u sh ed d o wn ward i n t h e
o rg an i za t i o n a l p y ram id , d ec i s io n -
informat ion costs decrease whi le
ag en cy co s t s i n c rease . Th ere fo re ,
he argues that decis ion r igh ts
sh o u ld b e l o ca t ed wh ere t h e co m -
bined costs (which we cal l
internal
coordination costs;
see Table I ) are
minimized .
Th e co s t s t ru c tu re v a r i es f ro m
si tuat ion to s i tuat ion . In secur i t ies-
t r ad in g f i rm s , fo r ex am p le , t h e
im p o r t an ce o f t im ely i n fo rm at io n
INTERNAL
COORDINATION
COSTS
AGENCY
COSTS
DECISION
I N F O ~ O N
C ~
- -Monitoring Costs
--Bonding Costs
--Residual Loss
-- Inf orma tion Processing Cos~
• Communication
* Documentat ion
mopportunlty costs due to poor
Information
o e £ 1 m i o n R l g h t B I n
Organhra~ lon8
Figure 1 shows an organizat ional
h i e ra rch y , i n wh ich t h e t o p o f t h e
p y ram id r ep resen t s t o p m an ag e-
m en t an d t h e b o t t o m rep resen t s t h e
em p lo y ees . Th e em p lo y ees o n t h e
spot general ly have bet ter access to
local in format ion , which i s cont inu-
ally subject to change [26]. If all the
decis ions are to be made by top
managers , there i s a need to process
in fo rm at io n u p ward i n t h e h i e ra r -
62
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a n d t h e v o l u m e o f i n f o r m a t i o n t o
b e p ro c e s s e d p e r u n i t t ime a re e x -
t r e m e l y h i g h ; c o n s e q u e n t l y t h e
c o s t s o f c o m m u n i c a t i n g i n f o r m a -
t i on u p w a r d a n d o f m a k i n g s u b o p -
t ima l d e c i s io n s w i th o u t p ro p e r in -
fo rma t io n a re b o th v e ry h ig h . A s a
re s u l t , d e c i s io n r ig h t s a re lo c a te d
w i th th o s e w h o w o rk o n th e f lo o r .
S in c e a g e n c y c o st s a re ma x i miz e d a t
th i s p o in t , s u c h f i rms c o mmo n ly
a d o p t p e r f o r m a n c e - b a s e d c o m p e n -
s a t io n s c h e me s . T h i s i s i n c o n t ra s t
to s o me o th e r b u s in e s s s i tu a t io n s in
w h i c h t h e v o l u m e o f i n f o r m a t i o n
p ro c e s s e d i s r e l a t iv e ly s ma l l a n d
d e c i s i o n m a k i n g c a n b e p o s t p o n e d
u n t i l t o p m a n a g e m e n t c a n e v a l u a t e
a n d a p p r o v e i t . A l f r e d S l o a n o f
G e n e ra l Mo to r s w a s w e l l a w a re o f
th i s t r a d e o f f , w h e n h e s a id ( a s e a r ly
a s 1 9 2 0 ) th a t p ro d u c t io n o p e ra t io n s
s h o u ld b e fu l ly d e c e n t ra l i z e d w h i l e
f in a n c ia l fu n c t io n s o f th e c o rp o ra -
t io n s h o u ld b e c e n t ra l i z e d [7 1 ] .
I n s u m m a r y , a g e n c y t h e o r y p r o -
v id e s u s w i th a c l e a re r u n d e r s t a n d -
i n g o f
internal
c o o rd in a t io n c o s t s .
T o s e e th e r e l e v a n c e o f th e th e o ry
to IT , f i r s t n o te th a t b o th c o mp o -
n e n t s o f in t e rn a l c o o rd in a t io n c o s t s
( i . e . , agency cos ts and dec is ion-
in fo rma t io n c o s t s ) s t e m, in l a rg e
p a r t , f ro m th e a c q u i s i t i o n o f in fo r -
ma t io n . A g e n c y c o s t s a re r e l a t e d to
o b t a i n i n g i n f o r m a t i o n o n t h e
a g e n t s ' b e h a v io r , w h i l e d e c i s io n in -
fo rm a t io n c o s t s a re r e l a t e d to a c -
q u i r i n g a n d p r o c e s s i n g i n f o r m a t i o n
s u r r o u n d in g th e d e c i s io n it s el f . In a
la te r sec t ion , we wil l see how IT, by
c h a n g in g th e c o s t s o f a c q u i r in g
th e s e tw o ty p e s o f in fo rma t io n , a f -
f e c t s th e o rg a n iz a t io n .
n . a n s a c t l o n C o s t T h e o r y
A g e n c y th e o ry fo c u s e s o n o rg a n iz a -
t io n a l p ro b le ms th a t a r i s e f ro m in -
f o r m a t i o n a l c o n s i d e r a t i o n s a n d o n
h o w th e y a re o v e rc o me s o th a t
f i rms a re a v i a b le fo rm o f e c o n o mic
o r g a n i z at i o n . W h i l e t h e t h e o r y p r o -
v id e s u s e fu l i n s ig h t s in to o rg a n iz a -
t io n s , i t c a n n o t e x p la in w h y , u n d e r
c e r t a in c o n d i t io n s , a f i rm c a n b e a
m o r e e f f i c i e n t f o r m o f i n s t i t u t i o n
th a n a ma rk e t . T ra n s a c t io n c o s t
e c o n o mic s p o s i t s t h a t t h e re a re
c o s ts in u s in g a ma rk e t a s a c o o rd i -
n a t i o n m e c h a n i s m a n d t h a t t h e
f i rm i s a n a l t e rn a t iv e me c h a n i s m
th a t f a c i l i t a te s e c o n o m iz in g o n m a r -
k e t t r a n s a c t io n c o s t s . T h e e x i s t e n c e
o f a f i rm a n d i t s r e l a t e d a c t ivi t i e s i s
n o w e x p l a i n e d f r o m t h i s p e r s p e c -
tive.
T ~ e M a r v e l s O F M a r K m
A s H a y e k [26 ] in d ic a te s , t h e ma r -
v e l o f ma rk e t s i s t h e ro l e o f th e i r
p r i c e s y s t e m a s a me c h a n i s m fo r
communicating the knowledge
o f t h e
re l e v a n t f a c t s w h ic h a re d i s p e r s e d
a m o n g m a n y p e o p le . T h r o u g h i ts
p r i c e s y s t e m, a ma r k e t c o l l ec t s a n d
t r a n s m i t s k n o w l e d g e o f p a r t i c u l a r
c i r c u ms ta n c e s o f t ime a n d p la c e
th a t m a y b e p ro h ib i t iv e ly c os t ly fo r
a n y c e n t r a l a u t h o r i t y t o c a p t u re . I n
th i s s e ns e , t h e ma r k e t i t s e l f i s a n
in fo rma t io n s y s t e m w h ic h s e rv e s
t h e w h o l e e c o n o m y . F o r e x a m p l e ,
t h e f u t u r e s p r i c es o f o r a n g e j u i c e
c o n c e n t r a t e e f f i c i e n t ly a b s o rb s r e a l -
t i m e i n f o r m a t i o n o n w e a t h e r c o n d i -
t ions (espec ia l ly in the wi n te r) in
c e n t r a l F l o r i d a w h e r e m o r e t h a n 9 8
p e r c e n t o f U . S . o r a n g e j u i c e p r o -
d u c t io n t a k e s p l a c e [5 3 ] . In th e
s a me v e in , t h e s to c k o r o p t io n p r i c e
o f , fo r e x a mp le , IB M, a lmo s t in -
s t a n ta n e o u s ly a d ju s t s in r e s p o n s e to
n e w i n f o r m a t i o n o n m a r k e t c o n d i -
t i o n s a n d f i r m p e r f o r m a n c e , s u c h
a s th e c o mp a n y ' s s a l e s a n d q u a r -
t e r ly e a rn in g s r e p o r t s [7, 50 ] . Ma r -
k e t s , t h ro u g h th e i r p r i c e s y s t e m,
p r o v i d e a c o o r d i n a t i o n m e c h a n i s m
w h ic h , w i th o u t in v o lv in g a c e n t ra l
a u t h o r i t y , i n d u c e s i n d i v i d u a l s p u r -
s u in g th e i r s e l f - in t e re s t s t o a c h ie v e
goa ls benefic ia l to soc ie ty as a
whole .
W h y a F i r m ?
T h e p r e c e d i n g a r g u m e n t s u p p o r t s
t h e r a t i o n a l e b e h i n d t h e m a r k e t
me c h a n i s ms o f c a p i t a l i s t e c o n o -
mie s . C o n s id e r , h o w e v e r , a n o th e r
p r e d o m i n a n t f e a t u r e o f th e s e e c o n -
o m i e s - t h e f i r m . A f i r m i s e s se n -
t i a l ly a w a y o f b y p a s s in g th e m a rk e t
s y s t e m, s in c e w i th in a f i rm p ro d u c -
t io n i s c o o rd in a te d b y a c e n t ra l a u -
t h o r i t y ( e n t r e p r e n e u r s o r m a n a g -
e r s ) . R e c a l l in g th e v a lu e o f m a rk e t s ,
we (fo l low ing [18]) mus t a sk : W hy is
s u c h a n o rg a n iz a t io n n e c e s s a ry ?
S p e c ia l i z a t io n in l a b o r a n d r i s k
s h a r in g w i l l n o t c o mp le te ly e x p la in
i ts ex is tence , s ince these func t ions
c a n b e p r o v i d e d i n t h e m a r k e t a s
wel l . Coase ' s [18] answe r is tha t va r-
io u s k in d s o f t r a n s a c t io n c o s t s a re
a s s o c ia t e d w i th u s in g m a rk e t s ; e x -
a m p l e s a r e t h e
ex ante
cos ts o f ac -
q u i r i n g m a r k e t i n f o r m a t i o n a n d
n e g o t i a t in g a d e a l , a n d th e
ex post
c o s t s a s s o c ia t e d w i th p re v e n t in g
a n d d e a l i n g w i t h c o n t r a c t d e f a u l t .
H e n c e , a f i rm i s a n e c o n o mic e n t i ty
c re a te d in a n e f fo r t t o e c o n o miz e
o n s u c h ma rk e t t r a n s a c t io n c o s t s .
l r r a n m a c t l o n o r n
Ma r k e t t r a n s a c t io n c o s ts u s e d
h e r e s y n o n y m o u s l y w i t h e x t e r n a l
c o o r d i n a t i o n c os t s m e a n s t h e co o r -
d in a t io n c o s t s in v o lv e d in u s in g a n
outside
m a r k e t ) T h e c o st s o f w r it i n g
a c o n t ra c t a n d s e c u r in g me a n s to
e n f o r c e i t a r e e x a m p l e s o f m a r k e t
t r a n s a c t io n c o s t s . S u p p o s e a c o m-
p a n y h i re s a n o u t s id e s o f tw a re d e -
v e lo p e r to d e v e lo p a n d in s t a l l s o me
s o f tw a re . T h e s o f tw a re c o n t ra c t
w o u ld ty p ic a l ly in c lu d e a l a rg e
n u m b e r o f i t e m s s p e c i f y i n g t e r m s
a n d c o n d i t io n s : fu n c t io n a l s p e c i f i -
c a t io n s , a c c e p ta n c e - t e s t in g p ro c e -
d u re s , a t ime ta b le o f th e d e l iv e ry
p ro c e s s , p ro te c t io n o f t r a d e s e c re t s ,
r e p a i r s a n d m a i n t e n a n c e r e s p o n s i -
b i l i t ie s , l iab i l i t ie s du e to fa i lu res ,
r e q u i r e d d o c u m e n t a t i o n , p r i c e a n d
p a y me n t s c h e d u le s , o p t io n s to
t e r m i n a t e t h e a g r e e m e n t , a n d s o
fo r th . E a c h i t e m re q u i re s s c ru t in y
b y a n a t t o r n e y t o r e d u c e t h e p r o b -
~Researchers of institutional economics do
not fully agree on the use of the terms
agency costs a nd transaction costs. T o
minimize confusion, we use the term market
transaction costs for the costs of using out-
side markets, while we apply the term agency
costs to the costs due to the divergence of
interests between the employer and employ-
ees of a firm.
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abi l i ty of fu ture legal wrangl ing or
a loss of r igh t fu l claims as a resu l t o f
over loo king a seem ingly t r iv ial i tem
in t h e co n t r ac t - - a co s t l y p ro cess .
Th ese co s t s r esu l t f ro m p ro cess in g
a t r an sac t i o n i n t h e m ark e t an d
m u s t b e i n cu r red w i th o u t ad d in g t o
the in t r insic value of the sof tware.
I t i s importan t to no te that these
costs wil l be avoide d i f the com pan y
d ev e lo p s t h e so f tware i n -h o u se . To
av o id t h e i n co n v en ien ce o f o u t -
so u rc in g , t h e co m p an y m ay fo rg o
th e b en ef i t s o f co n t r ac t i n g wi th
an o u t s id e r wh o h as su p er io r so f t -
ware d ev e lo p m en t ex p er t i se . In -
d eed , t h ese a r e a l so m ark e t
t ransact ion costs .
o rd er t o p rev en t o n e p ar ty f ro m
explo i t ing the o t her i f an unspeci -
f ied event occurs , such a contract
m u s t n o w a t t em p t t o acco u n t fo r
fu tu re co n t in g en c i es wh o se o ccu r -
rence i s d i f f icu l t to pred ict , making
the process ex t remely cost ly . On
th e o th er h an d , an i n co m p le t e ly
speci f ied contract leaves the negot i -
a t i n g p ar t i e s v u ln erab l e t o o p p o r -
tun ism. An of ten-u t i l ized so lu t ion
fo r r ed u c in g m ark e t t r an sac t i o n
costs wi tnessed in the marketp lace
i s fo r b u y er an d su p p l i e r f i rm s t o
integrate vertically.
This i s because,
wh en f ac in g an ev e r - ch an g in g en v i -
ronment , a f i rm is relat ively more
cap ab l e ( t h an a m ark e t ) o f im m ed i -
E)rrERNAL
COORDINATION
COSTS
or:.
MARKET
TMNSACI ION
COSTS
OPERATIONAL
CONTRACTUAL
--Search Costs
--Transportation Costs
--Inventory Holding Costs
--Communications Costs
--CoStS Of Writing Contracts
of Pero t ' s Class E hold ings. That i s ,
ver t ical in tegrat ion was used here
to save market t ransact ion costs .
Fu r th e r , t h e ex t e rn a l so u rc in g o f
an i n p u t f ac to r m ay en t a i l ex t r a
co s t s i n o b t a in in g m ark e t i n fo rm a-
t i o n , co m m u n ica t i n g wi th g eo -
g rap h i ca l l y sep ara t ed v en d o r s ,
t r an sp o r t i n g g o o d s , an d h o ld in g
in v en to r i es . Th ese a re a l so m ark e t
t ransact ion costs which could be
red u ced s ig n i f i can t l y b y p ro d u c in g
th e f ac to r i n -h o u se . Acco rd in g ly ,
m ark e t t r an sac t i o n co s t s m ay b e
classif ied in to two categor ies: one i s
associated wi th estab l ish ing and
m ain t a in in g co n t r ac tu a l r e l a t i o n -
sh ips wi th ou ts ide par t ies , whi le the
o th er i s d u e t o t h e l o ss o f o p era -
t ional ef f iciencies (see Table I I ) .
No te t h a t m o d er n I T can d i rec t l y
red u ce m ark e t t r an sac t i o n co s t s i n
th e l a t t e r ca t eg o ry b y p ro v id in g
cost -effect ive means to access mar-
k e t i n fo rm at io n an d p ro cess t r an s -
act ions. IT also has the po ten t ial to
red u ce m ark e t t r an sac t i o n co s t s r e -
lated to contracting, since i t facil i-
t a tes t i g h t e r i n t e r f i rm l i nk s t h ro u g h
in fo rm at io n sh ar in g an d m u tu a l
m o n i to r in g .
Wil l iamson [65 , 66] develops a
co m p reh en s iv e t r ea tm en t o f t h e
character is t ics o f t ransact ions, in -
dust r ies , and markets that consid-
e rab ly a f f ec t t h e m ag n i tu d e o f
t ransact ion costs . He observes ,
am o n g o th er t h in g s , t h a t t h e ex i s -
tence of a f i rm-speci f ic asset (an
asset whose value in i t s nex t -best
use is significantly lower than its
value in the curren t use) i s o f ten a
so u rce o f a l a rg e-m ark e t t r an sac-
t ion cost , s ince special ar range-
m en t - - - t y p i ca l l y t h ro u g h a l o n g -
t e rm co n t r ac t - - i s r eq u i r ed t o p re -
v en t t h e o th er p a r ty f ro m ac t i n g
opportun is t ical ly af ter an i r revoca-
b le investment in the speci f ic asset
is m ade . 9
Ho wev er , a l o n g - t e rm co n t r ac t
may not be a s tab le so lu t ion when
the degr ee o f uncer tain ty (e .g . , in
technolLogy or price) is high. In
9See [2] tbr examples.
ately and cost less ly rest ructur ing
decis ion r igh ts , redeploying re-
sources , and in ternal ly reso lv ing
possible disputes.
T h e r e c e n t d e v e l o p m e n t b e -
tween General Motors (GM) and i t s
sy s t em d ev e lo p er , E l ec t ro n i c Da ta
Systems (EDS), is a case in point
[13] . To in ternal ize i t s t ransact ions
wi th EDS, GM b o u g h t EDS (wh ich
is a market leader in systems in te-
g ra t i o n ) f ro m i t s fo u n d er , H . Ro ss
Pero t . Th e a r r a n g em en t was t h a t
GM issue separate Class E s tock for
EDS sh areh o ld er s . Pero t s t ay ed o n
wi th EDS as a GM d i r ec to r an d h e ld
a s ign i f ican t share of Class E s tock .
As a resu l t , the merger was no t a
ver t ical in tegrat ion , bu t rather a
jo in t v en tu re b e tween GM an d
Pero t . For that reason , conf l icts
d ev e lo p ed o v er t h e ap p ro p r i a t e
t ransfer p r ice for the serv ices EDS
p ro v id ed t o GM. Th e d i sp u t es were
reso lved in 1987 by GM's purchase
T h e M o d o l o f A F i n n : A
l y n t h e e lm O f T h e o r l o m
We h av e seen h o w eco n o m ic t h eo -
r ies o f o rg an i za t i o n i d en t i fy two
im p o r t an t co s t co m p o n en t s o f a
firm--internal coordination costs
a n d
external coordination costs.
In ad d i -
t ion , there ex is t more tangib le
oper-
ations costs--the
costs which a f i rm
in cu r s t o p ro d u ce an d m ark e t i t s
ou tput . This sect ion begins wi th a
d iscussion of economies of scale in
o p era t i o n s . Th en , a t t h e r i sk o f
oversimpl i f icat ion , we presen t a
m o d e l o f a f i rm th a t i n co rp o ra t es
th ese t h ree co s t co m p o n en t s an d
analyze how f i rm size i s determined
to min imize the sum of these costs .
m c o n o l n l e w o f
S C a l e I n o p e r a t i o n 8
Man y in d u s t r i es ex p er i en ce eco n o -
mies of scale in the
production
o f
goods and serv ices , as ev idenced by
th e o b serv a t i o n t h a t m an y o f o u r
p u rch ases a r e p ro d u ced b y l a rg e
G4
Janu ary 1991/Vo1.34,No. I /OOMMUN|GAT|ONSOFTHE A(~M
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e c o n o mie s o f s c a le in th e p ro d u c -
t io n o f in p u t f a c to r s , t h e f i rm c o u ld
tu rn to o u t s id e v e n d o rs w h o , b e -
c a u s e o f th e i r l a rg e r s c a le , c a n p ro -
d u c e th e f a c to r s a t l o w e r c o s t . A c -
c o rd in g ly , s c a l e e c o n o mie s ma y b e
lo s t b y v e r t i c a l i n t e g ra t io n a n d th e
s e l f -p ro v i s io n o f in p u t f a c to r s . In
t h e d e t e r m i n a t i o n o f v e r t i c a l f i r m
s iz e , t h e re fo re , t h e t r a d e o f f i s b e -
tw e e n ma rk e t t r a n s a c t io n c o s t s
(w h ic h fa v o r a v e r t i c a l ly l a rg e f i rm )
a n d t h e s u m o f i n t e r n a l c o o r d i n a -
t io n c o s t s a n d o p e ra t io n s c o s t s
(w h ic h p e n a l i z e a v e r t i c a l ly l a rg e
f i rm) . A s s h o w n in F ig u re 2 , t h e
o p t ima l v e r t i c a l f i rm s i z e i s d e te r -
m i n e d w h e r e t h e c o m b i n e d c o s t i s
m i n i m i z e d .
Horizontal Size.
T h e h o r i z o n t a l
s i z e o f a f i rm i s a me a s u re o f th e
n u m b e r a n d c o r r e s p o n d i n g s h a r e
o f ma rk e t s in w h ic h th e f i rm s e l l s i t s
f in a l g o o d s a n d s e rv ic e s. T h u s , h o r -
i z o n ta l s i z e i s p o s i t iv e ly c o r re l a t e d
w i t h t h e g e o g r a p h i c s c o p e o f t h e
f i r m , w i th t h e r a n g e o f t h e p r o d u c t
l in e , 1° a n d w i th a f i rm ' s ma r k e t
s h a re . A s a f i rm ' s h o r i z o n ta l s i z e
in c re a s e s , t h e b e n e f i t s f ro m s c a l e
e c o n o mie s in c re a s e , r e s u l t in g in
lo w e r a v e ra g e o p e ra t io n s c o s t s .
W h i l e i n t e r n a l c o o r d i n a t i o n c o s t s
in c re a s e w i th f i rm s i z e , t h e imp a c t
o f f i r m s i z e o n e x t e r n a l c o o r d i n a -
t io n c o s t s i s n o t u n a mb ig u o u s a n d
c a n v a r y a m o n g d i f f e r e n t i n d u s -
tries .
N e t ~ o r k - t y p e b u s i n e s s e s - -
r a i l ro a d s , a i r l i n e s , t ru c k in g a n d
c o m m u n i c a t i o n s - - a r e a c a s e w h e r e
e x te rn a l c o o rd in a t io n c o s t s c a n d e -
c re a s e w i th h o r i z o n ta l g ro w th [6 6 ] .
F o r e x a m p l e , a r a i l r o a d c o m p a n y
o p e r a t i n g o n l y o n t h e W e s t C o a s t o f
th e U . S . ma y in c u r s ig n i f i c a n t ma r -
k e t t r a n s a c t io n c o s t s in c o n t ra c t in g
w i t h o t h e r r a i l r o a d c o m p a n i e s t o
s e rv e c u s to me rs d e s t in e d fo r th e
E a s t C o a s t . H o r i z o n ta l g ro w th
w o u ld d e c re a s e th e s e c o s t s . O n th e
l ° T h e p r o d u c t l i n e is n a r r o w l y d e f i n e d a s a
g r o u p o f p r o d u c t s ( e . g . , I n t e l 8 0 2 8 6 , 8 0 3 8 6
a n d 8 0 4 8 6 m i c r o p r o c e s s o r s ) t h a t r e q u i r e s i m i -
l a r t y p e s o f e q u i p m e n t a n d t e c h n o l o g y . B y
b r o a d e n i n g t h e p r o d u c t l i n e , t he f i r m c a n e x -
t r a c t g r e a t e r e c o n o m i e s o f s c a le a n d s c o p e
a s -
s o c i a t e d with spec ia l i za t ion .
o t h e r h a n d , g e n e r a l t r a d i n g c o m -
panies may face a s teep r ise in ex-
t e rn a l c o o rd in a t io n c o s t s a s th e y
e x p a n d g lo b a l ly . In a n y c a s e , h o r i -
z o n ta l f i rm s i z e i s a l s o d e te rmin e d
b y t he t r a d e o f f b e t w e e n o p e r a t i o n s
c o s t s , e x te rn a l c o o rd in a t io n c o s t s
a n d in t e rn a l c o o rd in a t io n c o s t s .
In th i s a r t i c l e , t h e f i rm i s mo d -
e le d a s f a c in g th re e c o s t s c o mp o -
n e n t s - i n t e r n a l c o o r d i n at i o n co st s,
e x t e r n a l c o o r d i n a t i o n c o s t s a n d
o p e ra t io n s c o s t s , w h o s e s t ru c tu re s
a r e a s d e s cr i b e d a b o v e . T h e o p t i m a l
(h o r i z o n ta l a n d v e r t i c al ) s iz e o f th e
f i r m i s d e t e r m i n e d b y t r a d i n g o f f
th e s e c o s t s . I t i s imp o r ta n t t o n o te
t h a t t h e u n d e r l y i n g c o s t s t r u ct u r e s
a re c lo s e ly r e l a t e d to th e a c q u i s i t i o n
o f i n f o r m a t i o n a n d c a n t h e r e f o r e
b e a f f e c t e d b y t h e u s e o f m o d e r n
IT .
O r S l a n l z a t l o n n A n d
I n f o r m a t i o n S Y s t e m s
I n o r d e r t o a n a l y z e t h e i m p a c t o f
i n f o r m a t i o n s y s t e m s o n o r g a n i z a -
t io n s , w e c a te g o r i z e th e ro l e o f in -
fo rma t io n s y s t e ms in a f i rm , d e te r -
m i n e w h a t e f f e c t s m o d e r n I T h a s
o n th e c o s t s t ru c tu re o f a f i rm , a n d
e x a m i n e , f r o m t h e p e r s p e c t i v e o f
a g e n c y t h e o r y a n d t r a n s a c t i on c o s t
e c o n o mic s , h o w th e s e e f fe c t s r e s u l t
in c h a n g e s to v a r io u s a t t r ib u te s o f
th e f i rm .
R o l e s o f I n f o r n l a t i o n y l ~ e m e
I n a n O r g a n i z a t i o n
A n i n f o r m a t i o n s y s t e m i n a n o r g a -
n iz a t io n h a s m u l t ip l e ro l e s : a ) i t in -
c reases sca le e ff ic ienc ies o f the
f i rm ' s o p e ra t io n s (o p e ra t io n s ) ; b ) i t
p ro c e s s e s b a s i c b u s in e s s t r a n s a c -
t io n s ( t r a n s a c t io n p ro c e s s in g ) ; c ) i t
c o l l e c t s a n d p r o v i d e s i n f o r m a t i o n
r e l e v a n t t o m a n a g e r i a l d e c i s i o n s
a n d e v e n ma k e s d e c i s io n s (d e c i s io n
s u p p o r t ) ; d ) i t mo n i to r s a n d re c -
o r d s t h e p e r f o r m a n c e o f e m p l o y e e s
a n d f u n c t i o n a l u n i t s ( m o n i t o r i n g
a n d p e r f o r m a n c e e v a l u a t i o n ) ; a n d
e ) it ma in ta in s r e c o rd s o f s t a tu s a n d
c h a n g e i n t h e f u n d a m e n t a l b u s i ne s s
fu n c t io n s w i th in th e o rg a n iz a t io n
a n d m a i n t a i n s c o m m u n i c a t i o n
c h a n n e l s ( d o c u m e n t a t i o n a n d c o m -
mu n ic a t io n ) . T h i s l i st i s n o t e x h a u s -
t i r e ( e . g . , R &D ) , a n d th e i t e ms a re
n e i t h e r c l e a r - c u t n o r m u t u a l l y e x -
c lu s iv e . We tu rn to a mo re d e ta i l e d
d i s c u s s io n o f e a c h fu n c t io n a n d
e x a min e i t s imp a c t o n th e c o s t
s t r u c t u r e o f t h e f i r m .
Operations.
I n f o r m a t i o n s y s t e m s
c a n h a v e a d i r e c t imp a c t o n th e p ro -
d u c t i vi t y o f m a n u f a c t u r i n g a n d s e r-
v ic e o p e ra t io n s . R e c e n t a d v a n c e s in
f a c t o r y a u t o m a t i o n , C A D / C A M ,
r o b o ti c s , C I M ( C o m p u t e r I n t e -
g r a t e d M a n u f a c t u r i n g ) a n d o p t i c a l
s c a n n e r t e c h n o lo g y h a v e c o n t r ib -
u t e d t o i m p r o v e m e n t i n q u a l it y a n d
p ro d u c t iv i ty a s w el l a s th e r e d u c t io n
o f l a b o r c o s t s a n d a g e n c y c o s ts . A n
o f t e n - o b s e r v e d o u t c o m e o f t h i s
t r e n d i s l a t e - m o v e r a d v a n t a g e
w h i c h f a v o r s l a t e - a r r iv i n g c o m p a -
n ie s w i th th e b e t t e r t e c h n o lo g y a n d
i t s a c c o m p a n y i n g o r g a n i z a t i o n a l
s t r u c t u r e . J a p a n e s e a u t o m a k e r s ,
K o r e a n s t e e l m a k e r s , a n d c l o t h i n g
re ta i l e r s li k e B e n e t to n a n d th e L im -
i t e d h a v e a g g re s s iv e ly a d o p te d n e w
I T a n d p r e e m p t e d e a r l ie r m o ve r s
in th e ir indu s tr i e s [42 , 70] . 11
I n t h i s r e g a r d , I T h a s a f f e c t e d
th e o p e ra t io n s c o s t s t ru c tu re o f a
f i rm in tw o d i f f e r e n t w a y s . F i r s t , IT
h a s in t e n s i f i e d e c o n o mie s o f s c a le
i n o p e r a t i o n b y a l l o w i n g m a s s p r o -
d u c t i o n o n a n u n p r e c e d e n t e d s c a l e
a n d fa c i l i t a t in g th e a v a i l a b i li t y o f
in fo rma t io n a l s c a le e c o n o mie s .
F u r t h e r , I T h a s i n t r o d u c e d a h i g h
d e g r e e o f f l e x i b il i ty i n p r o d u c t i o n
( f o r e x a m p l e , t h r o u g h f l e x i b l e
ma n u fa c tu r in g s y s t e ms ) a n d s ig n i f -
i c a n t l y r e d u c e d t h e c o s t o f m a n u -
f a c t u r i n g a b r o a d p r o d u c t l i n e. T h e
b e n e f i t s o f f l e x ib i l i t y h a v e b e e n fe l t
n o t o n ly in th e ma s s c u s to miz a t io n
o f p ro d u c t s , b u t a l s o in th e s p e e d y
d e l iv e r i e s o f g o o d s a n d s e rv ic e s
[37].
Transaction Processing.
A la rg e
p o r t io n o f th e s e rv ic e in d u s t ry ,
w h i c h r e p r e s e n t s a n i n c r e a s i n g p o r -
t i o n o f t h e A m e r i c a n e c o n o m y ,
H F o r e x a m p l e , t h e n e w K w a n g y a n g p l a n t , a
h i g h l y a u t o m a t e d K o r e a n s t e e l mi l l, t u r n s o u t
9 3 3 t o n s o f s t e e l p e r w o r k e r a y e a r , a s c o m -
p a r e d t o a n a v e r a g e o f 5 28 t o n s in J a p a n a n d
262 tons in the Un i ted S ta tes [42 ] .
66
January 1991/Vol.34,No.1/COMMUNIGATIONS
OF THE ACM
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d e p e n d s h e a v il y o n i n f o r m a t i o n
sys tems for i ts bas ic bus iness func-
t io n s . C o mme rc ia l b a n k s , i n v e s t -
m e n t b a n k s , i n s u r a n c e c o m p a n i e s
a n d c r e d i t c a r d c o m p a n i e s s p e n d
u p t o f iv e p e r c e n t o f t h e i r r e v e n u e
o n IS - re l a t e d a c t iv i t i e s . Ma n y e m-
p lo y e e s in th i s i n d u s t ry a re s imp ly
m i d d l e m e n t o l in k c u s t o m e r s t o i n-
f o r m a t i o n s y s t e m s . T h e A u t o m a t i c
T e l l e r Ma c h in e , S h e l t e rn e t ( a c o m-
p u t e r - b a s e d m o r t g a g e n e t w o r k
bui l t by F irs t Bos ton , [70]) and
E a a s y S a b re ( a s c a le d -d o w n v e r s io n
o f A MR ' s S a b re r e s e r v a t io n s y s t e m,
[7 0 ] ) r e p re s e n t e x a mp le s in w h ic h
e v e n th i s mi d d le ma n i s e l im in a t e d .
R e c e n t a d v a n c e s in IT h a v e o b v i -
o u s l y i n t r o d u c e d a g r e a t d e a l o f
o p e r a t i o n a l e f f i c i en c y in t h e m a r k e t
e c o n o m y b y p r o v i d i n g m o r e e f f i -
c i e n t m a r k e t m e c h a n i s m s a n d t h u s
lo w e r in g th e a s s o c ia t e d ma rk e t
t r a n s a c t io n c o s t s [43 ] . In p a r t i c u la r ,
mo d e r n IT h a s f a c i l i t a t e d th e c re a -
t i o n o f v a l u e - a d d e d p a r t n e r s h i p s
(V A P s) th ro u g h w h ic h a s e t o f in d e -
p e n d e n t c o m p a n i e s w o r k c l o s e l y
to g e t h e r a lo n g th e v a lu e c h a in [3 5 ] .
M c K e s s o n C o r p o r a t i o n , o n e o f t h e
l a r g e st d i s t r i b u t o r s o f p h a r m a c e u t i -
c a l s , i n t ro d u c e d a s o p h i s t i c a t e d
o rd e r -p ro c e s s in g s y s t e m in to i t s
b u s i n e s s w i t h i n d e p e n d e n t d r u g -
s to res [17] . A re ta i le r makes a
r o u n d o f h e r d r u g s t o r e t o c h e c k i f
a n y i t e ms a re o u t o f s to c k . U s in g a
s p e c ia l o p t i c a l s c a n n e r , t h e ma g n e -
t i z e d c h a ra c te r s o f e v e ry o u t -o f -
s tock i tem a re scanned; th is is the
o r d e r e n t r y p r o c e s s . T h e o r d e r e d
i t e ms a r r iv e th e n e x t d a y p a c k e d in
t h e s e q u e n c e o f t h e o r d e r e n t r y .
H e n c e , a si n gl e r o u n d t h r o u g h t h e
s to re a i s l es is e n o u g h to r e s to c k th e
i t e ms . T h i s n e w s y s te m h e lp e d re -
t a i l e r s to r e d u c e in v e n to ry a n d
la b o r c o s t s . Wi th c o s t - e f fe c t iv e IT ,
ma rk e t t r a n s a c t io n c o s t s h a v e b e e n
d r i v e n d o w n c o n s i d e r a b l y , a n d
ma n y f i rms n o w s e e k to r e a p e c o -
n o mic b e n e f i t s t h ro u g h a v a r i e ty o f
s imi l a r i n t e ro rg a n iz a t io n a l i n fo r -
m a t i o n - s h a r i n g a r r a n g e m e n t s .
Monitoring~Performance Evalua
tion.
F r o m t h e p e r s p e c t i v e o f
a g e n c y th e o ry , t h e a v a i l a b i li t y o f
c o s t - e f fe c t iv e mo n i to r in g d e v ic e s i s
o f c ru c ia l v a lu e in r e d u c in g a g e n c y
c o s t s . In fo rma t io n s y s t e ms c o n t r ib -
u te to th i s e n d b y p ro v id in g a n e f -
f e c t iv e to o l to mo n i to r a g e n t s ' a c -
t io n s d i r e c t ly a n d b y k e e p in g t r a c k
o f t he p e r f o r m a n c e r e c o r d s o f a n
a g e n t o r a fu n c t io n a l u n i t i n a f i rm .
T h e f i r s t fu n c t io n i s e x e mp l i f i e d b y
th e u s e o f o p t i c a l s c a n n e r s . C o n -
t r a r y t o o u r p r e s u m p t i o n s , a n o p t i -
c a l s c a n n e r in g ro c e ry s to re s i s
m o r e o f a m o n i t o r i n g d e v i ce t o e n-
fo rc e r e t a i l u n i t w o rk d i s c ip l in e
th a n a me a s u re to s a v e l a b o r c o s t s
( th e p a y b a c k p e r io d i s o v e r t e n
y e a r s ) o r to r e d u c e th e w a i t in g t ime
o f a c u s to me r (mo re l a b o r i s a s
g o o d a s u b s t i tu t e ) [7 3 ] . A n o th e r
e x a m p l e i s p r o v i d e d b y F r i t o - L a y ,
w h ic h n o w i s s u e s h a n d -h e ld c o m-
pute rs to a l l i t s sa lespersons [41] .
Wh i le a l s o r e d u c in g th e t ime re -
q u i re d to p ro c e s s a t r a n s a c t io n , t h e
c o m p u t e r s p r o v i d e d m a n a g e m e n t
w i th a p o w e r fu l mo n i to r in g to o l .
T h e s y s te m a ll o w s m a n a g e m e n t t o
re c o rd s u c h e v e n t s a s w h e n e a c h
s a le s p e r s o n b e g a n h i s /h e r d a y , i n -
t e ra r r iv a l t ime s b e tw e e n s to re s , a n d
e v e n t h e n u m b e r o f c a r d b o a r d
b o x e s r e tu rn e d b y th e s a l e s p e r s o n .
T h e r e a r e n u m e r o u s o t h e r e x a m -
p l es o f c o m p u t e r s b e i n g u s e d t o
mo n i to r th e a c t iv i t ie s o f e mp lo y e e s ,
s u c h a s d a t a - e n t r y p e r s o n n e l a n d
t e l e p h o n e o p e r a t o r s .
D i re c t mo mto r in g , h o w e v e r , i s
o f t e n c o s tly a n d s u p e r f i c i a l . F o r th i s
re a s o n , f i rm s a d o p t e x p l i c i t c o n -
t r a c t s o r im p l i c i t ru l e s o f th e g a me
t o e v a l u a t e t h e p e r f o r m a n c e o f
a g e n t s a n d c o m p e n s a t e t h e m a c -
c o rd in g ly . In ma n y s u c h in s t a n c e s ,
w h e re p re v io u s ly i t h a d b e e n fe a s i-
b l e f o r m a n a g e m e n t t o e x a m i n e
o n l y s u m m a r y r e p o r t s ( w h i c h m a k e
i t r e l a t iv e ly e a s y to d i s g u i s e u n u s u a l
a c t iv i ty) , mo d e r n IT h a s g iv e n
m a n a g e m e n t t h e a b i li t y t o k e e p
t r a c k o f p e r f o r m a n c e a t t h e l e ve l o f
a n in d iv id u a l t r a n s a c t io n .
T h e d i f f e r e n t a p p r o a c h e s t h a t
f i rms a d o p t to mi t ig a te a g e n c y
p ro b le ms ma n i fe s t t h e ms e lv e s in
t h e s t r u c t u r i n g o f i n f o r m a t i o n s ys -
t e m s. T h e f o l l o w in g e x a m p l e i s d u e
to O u c h i [49 ] . R e ca l l t h a t J a p a n e s e
f i rms , i n c o n t ra s t t o U . S . f i rms ,
fa v o r n o n c o n t ra c tu a l s o lu t io n s to
a g e n c y p r o b l e m s . A U . S . - t r a i n e d
a c c o u n t i n g p r o f e s s o r a t a J a p a n e s e
u n iv e r s i ty r e m a rk e d th a t t h e s t a tu s
o f a c c o u n t in g s y s t e ms in J a p a n i s
p r i m i t i v e w h e n c o m p a r e d w i t h
th o s e u s e d in th e U . S . P ro f i t c e n -
t e rs , t r a n s f e r p r i c e s , a n d c o m p u t e r -
b a s e d a c c o u n t in g s y s t e ms a re b a re ly
k n o w n e v e n in th e l a rg e s t c o m p a -
n ie s in J a p a n . A s O u c h i in d ic a te s ,
th i s is n o t s u rp r i s in g in v i e w o f th e i r
m a n a g e m e n t p h i l o s o p h y , w h i c h i s
n o t to c lo s e ly mo n i to r e a c h in d iv id -
u a l 's p e r f o r m a n c e a t th e e x p e n s e o f
t e a m s p i r i t .
N o te th a t t h i s i s n o t b e c a u s e o f
th e a b s e n c e o f in fo rma t io n s y s te ms .
I n f a ct , J a p a n e s e c o m p a n i e s a r e
w e l l k n o w n fo r a g g re s s iv e ly d e v e l -
o p i n g a n d a d o p t i n g n e w I T [ 4 7 ] .
T h e M i n i s t ry o f I n t e r n a t i o n a l
T r a d e a n d I n d u s t r y ( M I T I ) h a s
s u c c e s sfu l ly p ro mo te d t h e d e v e lo p -
m e n t a n d d i f f u s i o n o f I T b e c a u s e it
b e l i e v e s th a t t h e in fo rm a t io n in d u s -
t ry h o ld s th e k e y to fu tu r e c o mp e t -
i t i v e n e s s a c ro s s a w h o le r a n g e o f
i n d u s t r i a l s e c t o r s - - n o t o n l y h i g h
te c h n o lo g y ( ro b o t i c s , ma c h in e to o l s ,
t e l e c o m m u n i c a t i o n s ) - - b u t a l s o t h e
o ld - l in e in d u s t r i e s ( s t e e l , a u to mo -
b i l e s, c h e mic a l s ) a n d e v e n th e s e r -
v ic e s (b a n k in g , i n s u ra n c e , d i s t r ib u -
t ion) [47 , p . 29] . How ever , the
e m p h a s i s o f t h e i r i n f o r m a t i o n s y s -
t e m s d o e s n o t a p p e a r t o b e o n t h e
f u n c t i o n o f m o n i t o r i n g , e v a l u at i n g ,
a n d m o t i v a t i n g e m p l o y e e s , b u t o n
i n c r e a s in g o p e r a t i o n a l p r o d u c t i v i t y
a n d p r o v i d i n g m a n a g e m e n t w i t h
d e c i s i o n - r e le v a n t i n f o r m a t i o n .
Documentat ion / Communicat ion.
T h e r e a r e a m p l e r e a s o n s f o r a c o m -
p a n y to k e e p t r a c k o f c o rp o ra te s t a -
tus and bus iness ac t iv i t ie s . Th e s ta -
tu s a n d c h a n g e s in th e a s s e t s o f th e
c o m p a n y m u s t b e r e p o r t e d t o
s h a r e h o l d e r s a n d t h e I R S . C o r p o -
COMMUNICATIONSOF THEACM/January 1991/Vo1.34, No.1 6~
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rate goals and p lans m ust be cont in-
ual ly d isseminated to employees in
uni ts that are geographical ly d is-
t r i b ut ed . Fu r th e r , d u e t o em p lo y ee
turnover , a company wi l l lose t rack
of detailed business activit ies with-
o u t p r o p e r d o c u m e n t a t i o n . F o r
ex am p le , en g in eer s sp en d a su b -
stan tial amo unt o f thei r t ime docu-
men t ing thei r act iv i ties for the com-
pany. In many cases , docu-
m en ta t i o n an d co m m u n ica t i o n can
be v iewed as bonding act iv i t ies to
log the serv ices provided by the
employees.
Mo reo v er , a co m p an y wh o se
business funct ion i s geographical ly
d i sp er sed f aces p ro b l em s o f s t an d -
a rd i za t i o n . Fo r ex am p le , DeLo rean
p o in t ed o u t t h a t a s m an y as 3 0 p er -
cen t o f al l Chevro let ' s new car or-
ders had errors , such as a dealer
m i s t ak en ly o rd er in g a No v a m o d e l
wi th an engine which was unavai l -
ab le for that car l ine. His so lu t ion
was to bu i ld an eff icien t in forma-
tion system [71]. In this l ight,
Ho n d a Mo to r Co m p an y ' s b i l l i o n -
y en i n v es tm en t i n an i n t e rn a t i o n a l
network linking all i ts divisions scat-
t e r ed t h ro u g h o u t t h e wo r ld so u n d s
qui te reasonable [21] . In the same
v e in , t h e h u g e i n v es tm en t i n o rg a-
n i za t i o n -wid e d a t ab ase m an ag e-
ment systems and wide and local
a rea n e two rk s (W ANs an d LANs) is
p ar t l y i n t en d ed t o m ain t a in
corpo-
rate memory an d r ed u ce i n co n s i s t en -
cies wi th in an organizat ion . Al l in
al l , by provid ing cost -effect ive
m ean s o f acq u i r i n g an d p ro cess in g
d ec i s io n - re l ev an t i n fo rm at io n
with in the organizat ion , IT has
ag a in co n t r i b u t ed t o d ecreas in g i n -
ternal coord inat ion costs .
Decision Support. Needless to
say , in format ion i s a cr it ical e lem ent
in decis ion making . In th is regard ,
t h e fu n c t i o n s o f IS r an g e f ro m s im -
p l e i n fo rm at io n co l lec t io n an d co m -
p u ta t i o n t o au to m ate d d ec i s io n
making v ia sophis t icated ar t i f icial
in tel l igence techniques. Many my-
opic, ad hoc d ec i s io n -m ak in g p ro -
cesses are now rep laced or aided by
a u t o m a t e d m a n a g e m e n t s c i e n c e
t ech n iq u es . Fo r ex am p le , co m p u te r
systems help Her tz in f leet schedul-
ing [20] and Avis with i ts fleet-
purchasing p lan [6] . The ai r l ine
in d u s t ry i s d ep en d en t o n co m p u te r
prog ram s for i t s p r icing decis ions, a
p rac t i ce k n o wn as y i e ld m an ag e-
ment [70] . Homart , a subsid iary of
Sears , runs a mixed in teger pro-
g ram to d e t e rm in e t h e t en an t m ix
wi th in a n ewly d ev e lo p ed sh o p p in g
mal l [8 ] . Many Wal l S t reet t ransac-
t i o n s a r e t r i g g ered b y co m p u te r s .
So m e ex p er t s b l am e co m p u te r -
b ased p ro g ra m t r ad in g fo r t h e
1987 s tock market crash [22] . In
o rd er t o fo recas t t h e m o s t co s t -
effect ive way to sat i sfy the fu ture
needs o f an in ternatio iaal te lepho ne
n e two rk , AT& T ru n s an o p t im iza-
t i o n m o d e l (u s in g Karm ark ar ' s a l -
gor i thm) involv ing 42 ,000 decis ion
variables [12]. Aid in solving such
l a rg e p ro b l em s h as b een b ro u g h t
wi th in the reac h of a decis ion
m ak er , t h an k s t o m o d ern IT .
Th ese a re ex am p les i n wh ich
co m p u te r s so lv e wel l - fo rm u la t ed
m o d e l s u n d er we l l -d e f in ed co n -
st rain ts and object ives . Recent AI
techniques, however , have s ign i f i -
can t ly ex p a n d ed co m p u te r s ' cap a-
bili ty to solve problems that are less
s t ructured and whose so lu t ions re-
q u i r e r e a s o n i n g a n d p e r c e p t i o n - -
tasks which used to be exclusively in
th e d o m a in o f h u m a n in te l li g ence .
Wh en a n u c l ea r p l an t ex p er i en ces
i r r eg u l a r co n d i t i o n s , a co m p u te r
sy s t em sen d s a warn in g m essag e t o
engineers along wi th i t s own d iag-
n o s i s an d p resc r ip t i o n s . MYCIN
assists physicians in the selection of
ap p ro p r i a t e an t im ic ro b i a l t h e rap y
for hosp i tal pat ien ts wi th b lood in-
fect ions [64] . Ford Aerospace uses
In tel l icorp 's KEE to d iagnose mal-
fu n c t i o n s in t h e co m p an y ' s co m m u -
nicat ion satel l i tes [27] , and Infer-
en ce Co rp o ra t i o n h as d ev e lo p ed an
ex p er t sy s t em to h e lp co n t ro l t h e
f l igh t o f the Space Shut t le [28] .
Am er i can Ex p ress h as an ex p er t
system which analyzes cred i t re-
q u es t s i n o rd er t o d e t e rm in e
wh eth er o r n o t t o ap p ro v e a t r an s -
action [24]. Avco Financial Services
uses a neural network to evaluate
loan applications [56].
Whi le Herber t S imon 's [58 , 59]
b o u n d ed r a t i o n a l i t y p a rad ig m re -
mains val id, the bound s that p ro-
h ib i t i n fo rm ed o p t im iza t i o n h av e
b een co n s t an t l y r e l ax ed , an d n o w
th e b o u n d s t ak e o n d i f f e r en t m ean -
in g an d fo rm s . I n fo rm at io n sy s t em s
h av e r ed u ced d ec i s io n i n fo rm at io n
costs by al lowing decis ion makers
cost -effect ive access to in format ion
and powerfu l too ls (e .g . , s imulat ion
an d eco n o m et r i c m o d e l in g ) fo r
an a ly z in g t h e r e t r i ev ed i n fo rm a-
t i o n . Th e im p ro v em en t i n d ec i s io n
qual i ty in tu rn increases opera-
t ional ef f iciency . For example, ac-
cu ra t e fo recas t i n g o f fu tu re d e -
mands, coupled wi th eff icien t
h an d l in g o f m ate ri a l f l o ws an d p ro -
duct ion schedul ing , can ach ieve a
s ig n i f i can t r ed u c t i o n o f i n v en to ry
costs . Indee d , the impa ct o f this in -
fo rm at io n r ev o lu t i o n h as b een f e l t
at a l l levels o f o rganizat ions, indus-
t ry , and society as a whole.
I F n p a c t m o f I ~ a ~ l o n
l l ~ h n @ l o l y o n a n
O r g a n i z a t i o n
We n o w s tu d y t h e im p ac t s o f IT o n
6 8 January 1991/Vol.34, No.l/COMMUNICATIONS
OF THE ACM
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o f n ew t ech n o lo g y i n co m p u te r s
and networking is no t l imi ted to the
red u c t io n o f ex t e rn a l co o rd in a t i o n
costs bu t ex tends to the
reduction of
internal coordination costs.
Since in-
ternal ,coord inat ion costs g row as
firm size increases, the abili ty of
in ex p en s iv e an d p o wer fu l IT t o
red u ce t h ese co s t s m ay d ecrease
thei r relat ive importance in the de-
termin at ion of op t imal f i rm size. I f
ev ery th in g e l se r em ain s t h e sam e,
b y r ed u c in g i n t e rn a l co o rd in a t i o n
costs, cost-effective IT will induce a
vertically
an d
horizontally larger
f i rm.
• As diiscussed earlier, i t was not
pure co incidence that the in tensi -
f ied evolu t ion of the mid-1940s
to the late 1960s which trans-
f o r m e d m o d e r n c o r p o r a t i o n s t o
M-fo rm s , co n g lo m era t es , o r m u l -
t inat ional en terpr ises took p lace
almost paral lel in t ime wi th the
d i f fu s io n o f n ew t e l eco m m u n ica-
t i o n an d co m p u te r t ech n o lo g y
[ 16, 66].
• To a cer tain ex ten t , the evolu t ion
rem ain s an o n g o in g p ro cess . Th e
past two decades have wi tnessed a
n u m b e r o f m e g a f i r m s t h a t a r e
both ver t ical ly and hor izontal ly
l a rg e . Fo r ex am p le , IBM, wh o se
rev en u es h av e g ro wn f ro m $ 4 0 0
million in the early 1950s to $62.7
bill ion in 1989, remains vertically
in t eg ra t ed f ro m ch ip m ak in g t o
c o m p u t e r e q u i p m e n t p r o d u c t i o n ,
d is t r ibu t ion and systems in tegra-
t ion. I t s hor izontal s ize, meas ured
b y th e r an g e o f i ts p ro d u c t l in e
and the ge ogra phic s ize of it s
m ark e t , i s a t an u n p reced en t ed
level . GM is ano ther exam ple o f a
m eg af i rm ; i t g r ew th ro u g h a se -
r ies of hor izontal and ver t ical in -
t eg ra t i o n s an d r em ain s h ig h ly
in tegrated (e .g . , Delco , EDS,
GMAC an d Hu g h es ) . S im i l a r l y ,
Fo rd Mo to r s r ecen t ly p u rch ased
Associate First Capital to
st rengthen i t s f inancial serv ice
uni t , ob tained effect ive contro l
o v er t h e Her t z ca r - r en t a l co m -
p an y , an d acq u i r ed Jag u ar , a
Br i t i sh au to co m p an y . No t su r -
pr is ing ly , these companies are
f r eq u en t ly q u o t ed as ag g ress iv e
u ser s o f IT . An o th er su ch ex am -
ple i s the L imi ted , a lead ing clo th-
in g m an u fac tu re r wi th sa l es o f
$4 .6 b i l l ion , which p ioneered the
u se o f IT i n t h e g a rm en t i n d u s -
t ry . Using a g lobal te lecommuni-
cat ion system, the Limi ted man-
ages a h igh ly in tegrated chain of
d es ig n , m an u fac tu r in g , m ark e t -
ing , d is t r ibu t ion and retai l ing
that spans the world [70] .
In so m e in fo rm at io n - in t en s iv e
industries, certain synergistic activi-
t ies that were prev iously too cost ly
to g o v ern an d were t h e re fo re n o t
p e r f o r m e d , m a y n o w b e a m e n a b l e
to h ierarch ical governance. In th is
case , IT h as co n t r i b u t ed t o
increas-
ing the degree of vertical integration
o r
the scope of fir m activities.
• In the 1970s and early 1980s,
Reu te r s Ho ld in g PLC, a Br i t i sh
news agency , expanded i t s t rad i -
t ional news agency serv ices to
sp an t h e en t i r e v a lu e-ad d ed
chain of secur i t ies in form at ion
serv ices [70] . Reuters in tegrated
1) s tock/news repor t ing , 2 ) s tock
quotat ion systems, 3 ) deal set t le-
m en t n e two rk s , an d 4 ) ex ch an g e
systems. Fur ther , Reuters also
p u rch ased Rich & Co m p an y , a
l ead in g d ev e lo p er o f co m p u te r -
ized t rad ing systems [62 , 70] . In
the Uni ted States , Dow-Jones Inc.
publ ishes the Wall Street Journal
an d o p era t es t h e Do w-Jo n es
stock/news retrieval system [70].
Do w-Jo n es r ecen t ly acq u i r ed
Telerate Systems Inc. , which pro-
v ides elect ron ic s tock quotat ion
systems. Telerate recent ly ac-
q u i r ed FX Dev e lo p m en t , wh ich
d es ig n s an d d ev e lo p s co m p u te r -
ized t rad ing systems, and has a
jo in t ven ture wi th AT&T to sel l a
co m p u te r i zed d i a l i n g sy s t em fo r
foreign exchange [14 , 63] .
• A ser ies of at temp ts have been
made by several ai r l ines , includ-
ing UAL and SAS, to bu i ld an in -
tegrated t ravel serv ice that com-
bines the ai r l ine, car- ren tal and
hotel businesses usin g a CRS [70].
Th e ex p ec t ed sy n erg y f ro m th is
in tegrat ion along the serv ice
value chain i s a more comfor tab le
en v i ro n m en t fo r t h e t rav e l er . Fo r
ex am p le , a u se r o f t h e i n t eg ra t ed
serv ice does no t have to claim h is
o r h e r b ag g ag e a t t h e d es t i n a t i o n
ai rpor t bu t instead p icks up a
p rev io u s ly r ese rv ed r en t a l ca r a t
t h e a i rp o r t l o ca t i o n an d h ead s
d i r ec t l y fo r t h e co n fe ren ce s i t e
(or the beach) . Arr iv ing at the
h o t e l ro o m , h e o r sh e f i n d s t h e
b ag g ag e t h a t was ch eck ed a t t h e
b eg in n in g o f t h e t r i p. Fu r th e r ,
t h e wh o le t r i p i s a r r an g ed e i t h e r
by a phone cal l to a t ravel agent
o r d i r ec t l y t h ro u g h a v id eo t ex
sy s t em ( su ch as Co m p u Serv e o r
Prodigy) . Whi le the at tempt by
UAL was ab o r t ed an d t h a t b y
SAS is sti l l ongoing, these cases
ex em p l i fy n ew sy n erg ies t h a t can
be real ized by in tegrat ing mul t i -
p le s tages of a value del ivery
chain .
Final ly , IT has been inst rumental
in
creating and reaping economies of
scale in operations.
T h e r e c e n t t r e n d
o f a f i rm ' s h o r izo n t a l g ro w th can b e
ex p la in ed p ar t l y b y t h e r ed u c t i o n
o f i n t e rn a l co o rd in a t i o n co s t s an d
market t ransact ion costs o f ten ac-
co m p an ied b y t h e
scale economies of
production and information.
• Accord ing to [16] , the g lobal iza-
t i o n o f m o d ern en t e rp r i ses
star ted in the late n ineteen th and
ear ly twent ieth cen tur ies . To fu l ly
real ize the scale economies ar is-
i n g f ro m co n t in u o u s p ro cess
t ech n o lo g i es , a n u m b e r o f f i rm s
in cap i tal - in tensive indust r ies
ad o p ted t h e n ew t r an sp o r t a t i o n
an d co m m u n ica t i o n s t ech n o lo -
g ies and grew to mul t inat ional
en terpr ise s (M NE) by invest ing
ab ro ad , f i r s t i n m ark e t i n g an d
l a t e r i n p ro d u c t io n . Du r in g t h e
two decades fo l lowing 1950, in -
t e rn a t i o n a l co m m u n ica t i o n an d
co m p u te r n e two rk s b ecam e av a i l -
ab le and have been heavi ly u t i -
l i zed t o co o rd in a t e m ark e t i n g
an d p ro d u c t io n fu n c t i o n s wi th in
a MNE. As the cost o f accessing
th e i n t e rn a t i o n a l m ark e t h as b een
fu r th e r l o wered i n r ecen t y ear s ,
ev en m ed iu m -s i zed co m p an ies
have been ab le to take a posi t ion
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in the g lobal market . This way ,
IT h as b een a m ajo r fo rce i n
sh ap in g t h e cu r r en t co n f ig u ra -
t i o n o f m o d ern g lo b a l co m p et i -
t ion [16].
•
In labor- in tensive indust r ies ,
wh ich ap p aren t l y h av e f ew eco n -
omies of scale bu t require severe
co o rd in a t i o n fo r h o r i zo n t a l
growth [16] , a new breed of f i rms
has harnessed scale economies by
explo i t ing IT. Examples include
Ben e t to n an d t h e L im i t ed i n t h e
g arm en t i n d u s t ry an d Ci t iCo rp
an d Am er i can Ex p ress i n t h e f i -
n an ce m ark e t [7 0 ] . Th ese f i rm s
have estab l ished new modes of
compet i t ion in domest ic and in-
ternat ional m arkets by aggres-
s iv e ly ad o p t in g m o d ern IT . In
the same vein , the las t decade has
seen a gradual sh i f t to g lobal iza-
t ion in a num be r of classical ser-
vice businesses, such as auditing,
adver t i s ing , general t rad ing and
secur i t ies f i rms, where in forma-
t ional economies of scale ex is t
[51].
Ne two rk - ty p e b u s in esses h av e
a l so ex p er i en ced co n s id erab l e h o r i -
zontal g rowth . In th is case, the in -
cent ive toward hor izontal in tegra-
t ion i s twofo ld : explo i tat ion of the
scale economies in operat ions ar is-
i n g f ro m
network externalities
a n d
savings in hor izontal market t rans-
act ion costs . F i rms in network- type
indust r ies aggressively invest in IT
to acquire the ab i l i ty to contro l a
horizontally large co rp o ra t i o n .
• In t h e seco n d h a l f o f t h e n in e-
teen th cen tury , the rai l road in-
d u s t ry ex p er i en ced a se r i es o f
h o r i zo n t a l m erg er s b e tween
n e ig h b o r in g r a i l ro ad co m p an ies .
Since there w ere few, i f any ,
eco n o m ies o f sca l e in p r o d u c t io n
o r i n fo rm at io n , o n ly t h e e f fo r t s
to save on market t ransact ion
costs can possibly explain this
p h en o m en o n [6 6 ] . I t sh o u ld b e
noted that th is sav ing was made
possib le par t ly th rough the tele-
g rap h an d t e l ep h o n e sy s t em s ,
wh ich p ro v id ed a m ean s t o b e t te r
co o rd in a t i o n o f i n t e r r eg io n a l
operat ions. In th is example, cost -
effect ive IT contr ibu ted to in -
creasing the hor izontal s ize of the
f i rm.
• In the past decade fo l lowing de-
r eg u l a t i o n , n e two rk -b ased m ar -
k e ts h av e ex p er i en ced r ap id co n -
cent rat ion . In the ai r l ine
indust ry , fo r example, the s ix
largest carr iers cont ro l 84 per-
cen t o f t h e U.S. m ark e t , r ep re -
sen t ing a large increase f rom 73
perc ent in 1978 [11] . IT, as mani-
fested in CRSs and f requent- f l ier
t rack ing systems, has been cen t ral
i n p ro v id in g co m p et i t i v e ad v an -
tage to the larger ai r l ines .
In su m m ary , we o b serv e two
o p p o s in g e f f ec t s o f IT o n f i rm s ize ,
whose net ef fect may vary f rom si t -
u a t i o n t o s i t u a t i o n , d ep en d in g o n
th e co s t s t ru c tu re o f t h e f i rm an d
th e m o d es o f sy n erg y g en era t ed b y
in tegrat ion .
C o n c l u s i o n
Th i s a r t i cl e ex am in es t h e im p ac t o f
i n fo rm at io n t ech n o lo g y o n two a t -
t r i bu t es o f f i rm s - - f i r m s ize an d t h e
al locat ion of decis ion r igh ts among
the var ious actors in a f i rm. Our
ap p ro a ch b u i ld s o n ex i s ti n g o rg an i -
za t i o n t h eo r i es - - ag en cy t h eo ry an d
transact ion cost economics. We
p resen t a m o d e l o f a f i rm th a t d e -
velops the cost s t ructure of markets
and h ierarch ies by in tegrat ing ele-
m en t s o f t h e two th eo r i es. O u r
analysis shows that a considerab le
share of the costs i s related to the
acquis i t ion and processing of in for-
m at io n an d can t h e re fo re b e r e -
d u ced b y t h e ap p l i ca t i o n o f i n fo r -
mat ion technologies .
Ou r r esea rch sh o ws th a t t h e d i -
r ec t i o n o f t r en d s i n t h e l o ca t i o n o f
decis ion r igh ts i s no t def in i t ive and
d ep en d s o n o th er o rg an i za t i o n a l
an d en v i ro n m en ta l f ac to r s su ch as
th e ro l e o f i n fo rm a t io n sy s tem s i n
the f i rm, character is t ics o f the in -
fo rm at io n f l o ws , an d o rg an i za t i o n
cul ture. In fact , a f i rm may use in -
format ion systems to decent ral ize
some decis ion r igh ts and to cen t ral -
ize o thers , explo i t ing the meri t s o f
both systems and lead ing to a hy-
br id s t ructure.
We a l so d em o n s t r a t e t h a t wh en
IT p lays a s ign i f ican t ro le in reduc-
ing internal coordination costs a f i rm
m ay f i n d i t ad v an t ag eo u s t o g ro w
horizontal ly and ver t ical ly .
Meg af i rm s , su ch as IBM an d GM,
have cap i tal ized on IT to ob tain
such reduct ions, whi le also ach iev-
ing scale economies in operat ions
an d r ed u c in g m ark e t t r an sac t i o n
costs . On the o ther hand , value-
ad d ed p ar tn e r sh ip s o f f e r an a l t er -
nat ive to the megaf i rm st ructure.
Some f i rms have leveraged thei r
u se o f IT t o fo rm VAPs . Wh i l e a
m o t iv a t i o n o f su ch an a r r an g em en t
is the reduct ion in
market transaction
costs ach i ev ed t h ro u g h th e n u r tu r -
ing of a cooperat ive relat ionsh ip ,
IT faci l i ta tes the coord inat ion nec-
essa ry b e tween t h e p a r tn e r s a lo n g
the chain . F i rms in a VAP obtain
op-
erational scale economies an d l o wer
in ternal coord inat ion costs by
choosing to be ver t ical ly smal l and
h o r i zo n t a l l y l a rg e . In t h e g a rm en t
in d u s t ry , fo r ex am p le , t h e L im i t ed
is horizontally and vertically large,
whi le Benet ton i s hor izontal ly large
but vertically small . Sti l l other firms
h av e ex p er i en ced r ap id h o r i zo n t a l
g ro wth t o ex p lo i t o p era t i o n a l eco n -
o m ies o f sca l e . A p ro m in en t ex am -
ple i s in network- type businesses
wh ere sca l e eco n o m ies a r i se f ro m
n etwo rk ex t e rn a l i t i e s . Oth er ex am -
ples include a number of serv ice
businesses , such as audi t ing , adver-
t i s ing , general t rad ing and secur i -
t ies f i rms, where in format ional
econo mies o f scale ex is t . In al l o f
these cases , IT i s heavi ly rel ied on
to faci l i ta te in ternal coord inat ion .
Prev ious research (e .g . , [43]) has
fo cu sed o n t h e im p ac t o f IT o n ex -
ternal coord inat ion costs , lead ing to
the pred ict ion that ver t ical f i rm size
wil l decreas e as the use o f IT grows.
Ou r mode l shows that th is is c lear ly
o n e l i k e ly o u t co m e. Ho wev er , o u r
r esu l t s d em o n s t r a t e t h e im p o r t an ce
o f d ev e lo p in g an i n t eg ra t iv e m o d e l
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that also considers internal coordi-
nation costs and the corresp onding
role of IT. Our model provides a
comprehensive description of the
cost structure of a firm. Based on
the model, we conclude that a
firm's use of IT can result in an in-
crease or decrease in either the hor-
izontal or vertical dimension of
firm size.
It is hope d that ou r analysis pro-
vides a theoretical framework
within which to assess the impact of
an inf ormation system. The frame-
work highlights the roles of infor-
mation technology in organiza-
tional activities and their impact on
the cos1: structures of firms a nd
markets. It is important to note,
however, that information systems
should be assessed and compared
with regard to specific managerial
contexts. Business functions, mar-
ket conditions, industry character-
istics, and organization cultures
each constitute different dimen-
sions in which to evaluate an infor-
mation system; a monolithic appli-
cation of IT concepts at the firm
level witlhout reg ard to these factors
is likely to be incom plete and incor-
rect. This observation leads to the
conclusion that more focused inves-
tigation is necessary in order to
understand the impact of IT on
organizations and markets. One
such avenue for further research is
the pursuit of firm-level and in-
dustry-level cross-sectional anal-
yses-which may bring invaluable
insights to various issues raised, b ut
not fully answered, in the present
article.
Acknowledgments.
The authors have greatly benefit-
ted fro m the constructive com-
ments o,f Cynthia Beath, Chuck
Holloway, Evan Porteus, Neal
Stoughton, Nick Vitalari and the
anonym ous referees and the editor.
The research was supported in part
by the UCI Commit tee on Research
and the ]Fletcher Jones Foun datio n.
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CR Categories and Subject Descrip-
tors: K.4.3 [Computers and Society]:
Organiza t ional Impact s
General Terms:
Economics, Manage-
m e n t
Additional Key Words and Phrases:
Agency theory, decision r ights, f i rms
and markets, f i rm size, t ransact ion cost
economics
About the Authors:
VIJAY GURBAXAN I i s an assistant
professor of i nformat ion sys t ems and
computer sc i ence a t t he Graduate
School of Man agemen t a t t he U niver s ity
of Cal i fornia, I rvine. His pr imary re-
search interests are in the appl icat ion of
microeconomics to t he s tudy of mana-
ger ial i ssues in the informat ion systems
context . Major foci of his research in-
clude informat ion systems budgets, the
di f fus ion of i nformat ion t echnology,
and the organizat ional impacts of infor-
mat ion technology. Author s Present
Address:
Universi ty of Cal i fornia, I r -
v ine , Graduate School of Managemen t ,
I rvine, CA 92717; emai l : Vi jay@Ucip-
pro (Bi tnet) ; Ygurbaxa@uci .edu.
( Internet) .
S EUNGJIN WHANG is an assistant
professor of decision sciences and
Fletcher Jon es Facu l ty Scholar for
1989-90 a t t he Graduate School of
Business, Stanford Universi ty. His re-
search interests include the control of
comp uter r esources wi th in an organiza-
t ion, the impact of informat ion technol-
ogy on organiza t ions and market s , and
the issues of standards and compat ibi l i ty
of informat ion systems.
Author s Pres-
ent Address: Stanford Universi ty,
Graduate School of Business, Stanford,
CA 94305; emai l : [email protected]
t anford .edu.
© 1991ACM0001-0782/90/1200-059 $1.50
C O M M U N I C A T I O N S O F
THE
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